Currency risk is a threat to global IT and BPO service providers. An average Indian provider derives two-thirds (65 percent) of its revenue from the U.S. In most contracts, the service provider carries currency risk by default because the customer companies contract with the U.S.-based subsidiaries. A shift in currency valuation translates directly into revenue and profit reductions for these providers.
Captive units in India also suffer from financial exposure as the value to parent companies is diluted. While the currency shift was “only” 8.4 percent in the first half of 2007, it is a significant percentage of the cost savings (sometimes called labor arbitrage) sought by parent companies.
Parent companies of captive units will continue to assess the return on investment as valuation fluctuates. They will, however, not make any significant change in current investments because of tax advantages, skills availability, business development in India, or other benefits that balance the investment in the country or otherwise neutralize exposure to currency risk.
Customers already report minor changes in behavior that will help the provider either increase revenues or decrease costs of existing relationships. Following are some short-term operational levers service providers may use to pressurize employees to bill 8.5 or 9 hours per day rather than a standard 8 hours a day.
- Increasing the ratio of junior staff to senior staff from a typical 8:1 to a more stretc hed 9:1 or 10:1
- Enforcing payment terms of 30-day net. Current day’s sales outstanding is close to 60 days for
These changes are subtle and customer companies may not even notice them. While the changes may be
permissible within the contract, they place further stress on the vendor-client relationship. While improved productivity will be welcome in most cases, the beneficiary is not the client, but the service provider.
If rupee-dollar valuations continue to shift, customers should expect providers to take more aggressive actions that will include re-negotiations, or other modifications to the contract structure. In most cases, providers cannot invoke renegotiations just because of currency change, but there are many attributes of a contract that could be used as an excuse to reopen discussions. Once the act of negotiating is taken, providers can introduce additional issues such as pricing. (See box for actions that providers can take.)
Currency risk within the context of an outsourcing agreement is not new. In 2004, a Fortune 100 organization required currency risk as an element of an outsourcing contract. Smaller providers qualified out of the bidding. HP saw hedging as an opportunity since its currency risk was lower than the client’s. HP viewed the percentage points for currency risk as extra profit margin rather than uncertainty.
Because of the uncertainty of currency fluctuations, customer companies should watch for symptoms of systemic or structural failure in the relationship. While provider changes in staffing, productivity, or even employee utilization may be within the terms of the contract, they might also carry side effects, including
- Are the gaps in communication resulting in increased errors or failures?
- Does the productivity of the global team appear to be dropping?
- Is the turnover increasing as pressure on employees’ is increasing?
- Is the new staff becoming increasingly difficult to locate or bring
- Are steps being skipped in quality assurance or customer expectations?
- Is the provider team becoming tense or agitated over business issues?
|Captive Unit Management
Companies with captive units are completely exposed to the risk of currency valuation. These companies also often operate globally, and have experience and skills in currency hedging. The first action (or reaction) of global companies should be to include the value of captive unit’s services into the risk assessment and hedging practices.
Companies should also not overlook the indirect tax benefits that may further reduce the benefit of captive units. Many captive centers are located in subsidized or tax-free zones in India. If the values of the services provided are reduced, so will the tax benefit that is derived from that region, placing increased will increase the burden upon the bottom line.
If the rupee appreciation continues, there will be critical impact on the wage differential between the parent company location and India. As wage differential and skills availability are generally the top two criteria for work allocation for captives, these organizations may need to re-visit their portfolio of application and services, and realign it based on revised financial benefits of captives.
Many corporations chose to establish captive units rather than using sourcing because of other business benefits. neoIT research shows that a high percentage of companies with captive units in India are simultaneously investing in expanding business opportunities within the region. (The same principle holds true for China.)
Companies that are expanding business operations in India will experience a neutralizing effect. Revenue and profits will offset the reduced benefits from using captive centers. Furthermore, a common management team to manage activities in the region also reduces the overall cost structure.