The fluctuating dollar has had a significant impact on the Indian IT and Business Process Outsourcing (BPO) market — the largest offshore market — over the last year. Since Sept. ’06, the rupee has appreciated by 10 percent as against the dollar, with the last quarter showing the most unusual 6.8 percent appreciation that has affected the profitability of several companies heavily dependent on the export market.

While ignoring the benefits on the import side, a stronger rupee means Indian goods and services will be less competitive in the main export market. India’s exports to the U.S.A. are mostly labor-intensive, especially when it comes to the IT/BPO industry. Unlike markets like gems and jewelry, where the input import costs are benefited by the higher rupee, IT/BPO is more affected as everything is created within the country.

The consequences of the rupee appreciation have been quite severe on the small and medium-sized Indian IT companies. While the larger IT firms have robust margins and de-risking strategies to counter the effect (i.e. renegotiating a higher price with customer companies or asking for payment in relatively stable currencies such as the euro), the small and medium-sized companies have been impacted the most because of their smaller customer base and higher input costs.

Every 1 percent increase in the rupee’s strength against the dollar impacts a company’s bottomline by 4bps. India’s third-largest IT firm, for instance, reported about 0.23 percent sequential decline in its operating margins for the Apr. to June quarter. At the same time, India’s bellwether company Infosys, registered a lower than guidance profit and revised its earnings’ estimate for 2008. Similarly, several companies have been adversely impacted with this fluctuation, as they do not have a protective clause in their contracts or strong currency-hedging strategies. However, companies like TCS and HCL have been able to hold their guidance and profit forecasts, due to active and clearly devised forecasts and hedging plans.

Global Services PREDICTIONS

To protect themselves against the vagaries of the dollar, IT and BPO service providers will aggressively look to Europe and Japan as markets

The rising rupee will force Indian service providers to set up shop outside India so as to provide low-cost service

Multigeography sourcing will be atttractive to customers. To moderate the effect of currency fluctuation, they will source from various low-cost locations instead of one.

Going Forward
The rupee appreciation over the last year, has shaved off a large portion of the operating margins of export-focused service companies. We expect the trend of the appreciating rupee to continue and this can have a significant impact on the status of India remaining a low-cost destination for outsourcing. The appreciating rupee over the next few years would have an impact on the strategies that firms adopt and the trade in services that happens within the country. There is an imminent possibility of foreign companies shifting work to other emerging locations that are willing to provide low-cost labor and other cost advantages.

The currency volatility will force all companies to re-examine their internal strategies for managing growth and maintaining profitability. Organizations will chalk their future growth plans through expansion to newer untapped markets that allow them to de-risk their firm’s dependency on the dollar.

Service providers especially in the IT/BPO industry in India may not be able to hold out indefinitely. Customers of these offshore service providers, whose contracts are usually negotiated in U.S. dollars, may see prices increase along with contracts that share the risk of currency changes. Service contracts will possibly be structured that lock in labor rates for a defined period of time or lock in lower labor rates with periodic adjustments made for inflation or currency changes.

With the rupee continuing to rise, IT-services companies will look at better pricing, improved margins, utilizations and an optimal mix of onsite/offshore mix in contracts. Companies with a higher proportion of onsite presence will stand to gain, as the rupee appreciation is likely to positively impact their cost base. An Infosys spokesperson has been quoted discussing levers such as “utilization, onsite-offshore ratios, services mix, customer group and regions, rate increases and internal efficiencies” to counter the impact of the appreciating rupee. In a bid to get better pricing, companies might look at tweaking their service mix with a greater high-end component/consulting work in their service offering. Better treasury management and hedging policies too may pay off partially as has been the case for companies that have hedged significant amounts.

Indian companies will continue to actively scout for centers in other low-cost countries (such as Vietnam, the Philippines, China) to outsource work at the bottom of the value chain while keeping the higher value work in more mature markets like India. Indian companies will also continue to grow inorganically by M&A activities especially in non-U.S. markets that de-risks their firm’s future, through a change in the mix of onsite-offshore and the mix of their services portfolio.    

With over 10 years of IT-management experience, Anish has been involved in developing the sourcing methodology for KPMG. Some of his recent work includes doing IT due diligence for an insurance company in the U.K., and an offshore risk-management study for a large broking firm in the U.S.A.