As the dollar continues to stall and the rupee accelerates, currency fluctuation can become a problem for global FAO.

by Paul Nowacki, Saurabh Gupta

Amid rising acceptance of global sourcing to create organization-wide impact, currency fluctuation has emerged as a real problem. The Indian rupee is at a 10-year high relative to the U.S. dollar with an increase of more than 6 percent in less than a year (Figure 1). Currency fluctuation has adversely impacted Indian exporters—including outsourcing service providers. The impact of currency exchange risk on an FAO deal can be significant. The exposure of the FAO market to the rising Indian rupee against the U.S. dollar is high.

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• Among all outsourced general and administrative (G&A) functions, FAO has the highest rate of offshore adoption with over 75 percent of FAO contracts having elements of offshore delivery.

• India has emerged as the hub for sourcing F&A services with 70 percent of the offshore FAO workforce based in India.

• U.S.-based organizations are the leading adopters of FAO. Nearly 60 percent of the FAO contracts to date have been signed in the U.S.

Let’s consider a hypothetical outsourcing contract between a U.S.-based buyer (functional currency is USD) and a supplier with India-based service delivery (functional currency is INR) with the following contract specifics:
Start date: 2003
Term of contract: Five years
Total Contract Value (TCV): US$50 million with equal annual payouts

Let us assume all the currency exchange risk is borne by the supplier. Under this scenario, the supplier in 2003 faces five years of paying out wages and costs in INR; therefore, the supplier is “short” the rupee. The supplier holds an accounts receivable of five years’ revenues denominated in U.S. dollars; they are “long” the dollar. Being long the dollar and short the rupee, the supplier is hurt when the rupee rises relative to the dollar.

Given the rupee appreciation of the past five years, under this agreement, the supplier would have experienced an INR 92 million currency exchange loss if you compare the actual realized fee to the expected supplier fees. This translates into a net negative impact of 4 percent on the top line (see Figure 2). For every 100 basis points (1 percent) rise in the rupee vs. the U.S. dollar, there is a potential negative impact of 85 basis points (0.85 percent) on the operating margins of FAO services. This is a lose-lose situation for buyer and supplier because while the buyer pays out as per the contract, the supplier margins are hurt, which may result in a drop in quality of service and lack of investment in continuous improvement.

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Managing the Risk
Despite the significant exposure to rupee inflation, the FAO market in 2007 demonstrated credible performance. As per Everest Research Institute analysis, the multi-process FAO market has been growing at 22 percent annually on the back of continued strong spending growth with approximately 60 new multi-process contracts being signed in 2007. (Multi-process FAO contracts include contracts with more than two F&A processes in scope, have an annualized contract value of greater than $1 million, and contract term of at least three years.) Most large, India-based suppliers are managing the potential downslide through price increases, hedging, and cost side measures (increased utilization, offshore mix, etc.).

A lot of India-based suppliers have used the currency futures market to manage the currency exchange risk. However, hedging in the currency futures market cannot be done beyond one year, and most FAO contracts have a term of three to 10 years. So a more creative and longer-term hedge outside of standard futures contracts is required.

A simple method for a supplier with delivery from India to create a long-term hedge is to borrow dollars and invest them in India. The supplier could also create a long-term, natural hedge at the corporate level by aligning existing capital structure with the revenue structure. This could be done by raising a part of its debt financing through corporate bonds denominated in U.S. dollars and euros in a proportion that resembles its client portfolio. There are many other creative ways to hedge currency risk and the selection of the appropriate hedge, and it is not necessary to limit to standard currency futures contracts.

The pricing environment has been stable with a slight upward bias for most FAO suppliers. Much of the work is repeat business, and the overall impact on prices is fairly low unless these prices also increase. India-based suppliers would need to be transparent with clients on currency exchange risks and other cost factors like wage inflation to justify pricing increases. Some suppliers are considering outsourcing contracts with billing in INR. While such a strategy protects the supplier from any exchange risk, it might not be in the interest of the buyer as it exposes them to new risk. In principal, the risk should vest with the party best positioned to manage it—usually the supplier. By billing in INR, there is no added incentive for the supplier to push delivery beyond Indian shores, which could impact the market adversely in terms of finding the next frontier for global sourcing. INR billing can impact the competitiveness of India-based suppliers as buyers might start looking at U.S.- or Europe-based suppliers to mitigate risk. The measures discussed above are a short- to medium-term strategy. In the long term, FAO suppliers would need to:

Diversify Client Portfolio. A high client concentration in a particular geography increases the currency exchange impact. In contrast to the U.S., there is limited reduction in India’s arbitrage with respect to the U.K. The Indian rupee has weakened against the pound, which proved favorable for India’s arbitrage position vis-a-vis the U.K. Europe is emerging as a hotbed of FAO activity, too.

Optimize Internal Operations. Suppliers may have to re-evaluate the wage increases, compensation policies, utilization rates, bench strength, use of productivity tools, standardization, and other cost variables that impact margins

Diversify Delivery Location Portfolio. A high concentration of delivery in a particular location increases the risks related to currency exchange fluctuations. Suppliers are diversifying their location portfolios to include multiple offshore regions. We have also seen an accelerated move to Tier-2 locations in mature offshore regions like India. However, most currencies in other offshore destinations (like Czech Koruna, Philippine Peso, Chinese Yuan) besides the Indian rupee have also appreciated against the U.S. dollar. So, location optimization has to be a multi-dimensional strategic decision.

Beyond Arbitrage
Margin pressures are real for FAO suppliers given their exposure to the U.S. dollar. Currencies will continue to fluctuate based on macro-economic factors that are beyond the control of outsourcing stakeholders. Operating cost increases driven by wage inflation and rent inflation are also impacting supplier margins. Buyer behavior is also changing—while clients report direct-cost impact by outsourcing F&A processes, business impact is elusive. Competition in the FAO market is at an all-time high, and the labor-arbitrage-driven offshoring model is fast becoming a standard expectation.

Consequently, while the arbitrage value proposition won’t die in the near future, it is clear the FAO market needs to innovate beyond labor arbitrage to move into the next phase of BPO maturity. Investments and innovation will be important differentiators in the future.

Paul Nowacki, CFA, co-leads Everest Group’s finance and accounting outsourcing consulting practice. Saurabh Gupta is research director at Everest Research Institute.