How Exchange Rates Affect Outsourcing

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By Zinnov Offshoring Research and Consulting

When putting together offshoring plans, companies rarely look into the currency trends of the destination country. Often, volatile and fluctuating currencies coupled with poor planning can eat into savings -- or worse, end up costing more than the expense of having the work done onsite. Hence, trends in the exchange rate -- a country’s currency price in respect to a foreign one -- has to be one of the major factors taken into consideration when you’re selecting from different offshore destination countries.

A steady lower currency value of the destination country generally ensures higher return on investment (ROI) to the country making the investment. A volatile currency can definitely affect the planning and budget allocation for offshore initiatives.

The global economy is connected through two broad channels -- global trade and finance. The volume of global trade and finance is dependent upon the currency exchange rate between different countries. Countries adopt an appropriate exchange rate regime -- floating, managed or fixed arrangements -- based on significant changes in the world economy over the years. Recent changes include the general increase in capital mobility to developing and transition economies and the abrupt reversals in capital flows to the same.

The exchange rates among the most powerful and sought after currencies (principally the US dollar, the Euro, and Japanese yen) fluctuate in response to market forces, with short-run volatility and occasional large medium-run swings. Out of all the “sought after” currencies, the US dollar is often the currency of choice to the express the exchange rate. This is because the world economy depends on a simple fact -- the US spends.

No currency is wholly fixed or floating. Exchange rates are influenced by a number of factors including:

• Domestic investment climate

• Gross domestic product

• Trade policy

• Foreign direct investments

• Imports and exports

• Inflation

Companies carrying out a location analysis for offshoring should consider exchange rate trends of the currency of the destination country.

A relatively predictable currency trend is preferred. On the other hand, sharp appreciation or depreciation of the currency over a period or, the exchange rates of the currency being highly volatile, could lead to a major impact on cost and savings.

An exchange rate of the currency that is on an upward trend with respect to the dollar or the Euro will have a direct impact on competitiveness of the product you’re buying (such as software development services) as the value per US dollar or Euro is reduced.

An analysis of the long term trends can enable you to plan for potential exchange rate risks of the currency/economy. Looking at long-term trends will help in deciding whether to go in for the long-term investment in the destination country or only look at short-term gains.

By gaining an understanding of the macro economic factors, you can better evaluate how key industries will feel the impact of changes in the exchange rate.

In location analysis, countries where the exchange rate trends are highly correlated to the performance of a very few sectors/industries should be carefully analyzed. Why? The decline in that sector/industry could mean the decline of the whole economy.

Also, studying currency trends can highlight whether the power of the currency is purely based on economics or on certain government policies. Understanding this difference is critical. For example, the Chinese were under heavy pressure from the US government last year to loosen the link between the dollar and the Yuan. Some analysts (particularly in the manufacturing sector) contended that tie was keeping China’s currency gravely undervalued and its exports more attractive. As a result, the Chinese government made the decision to tie the value of its currency to a “basket” of currencies rather than to the dollar. This was as much a political decision as economic.

To give you an idea about macro economic factors, here’s a snapshot analysis of India.

India

Currency

India Rupee (INR)

Current Exchange rate

USD 1.00 = INR 44.6 (as of January 5, 2006)

Major Industries

Half of India's GDP is attributed to the service sector with the remaining half split between agriculture and industry.

Recent Key Sector Growth

Information technology, business process outsourcing (primarily, call centers) and financial services are among India's growth areas in the services sector.

International memberships

UN, The Common Wealth, World Trade Organization (WTO), South Asia Association for Regional Cooperation (SAARC).

Currency Appreciation Against US Dollar

Over the last several years, the Indian currency has appreciated against the dollar. In 2003, the appreciation was helped by Indians abroad depositing their cash in India to benefit from the higher interest rate when compared with other countries. However, the Central bank is expected to step in to lower the currency value to ensure that Indian goods stay competitive.

Political Impact

India is a Federal Republic with a parliamentary form of government. After coming to the verge of an economic crisis in 1991, new reform measures were introduced that include reduction of trade barriers and exchange controls, liberalization of rules on foreign investment and licensing -- all successful in promoting foreign investment.

Other notable factors

A set of labor reforms are expected to be passed to enable further liberalization of foreign investments.

Population Growth from 2001-2005: 1.5%

Real GDP Growth from 2001-2005: 6.5%

Inflation from 2001-2005: 4.0%

Source: Economist Intelligence Unit estimates

Source: OANDA.com

Useful Links:

Read the macro analyses of the currencies of Australia, Canada, China, the Philippines and South Africa:
http://www.zinnov.com/whitepaper_global_currency_trends.html

Find more practical advice about working with offshore teams on the Zinnov Web site blog:
http://www.zinnov.com/blog/index.php

Zinnov Research
http://www.zinnov.com/whyzinnov_research.html

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