Will Currency Risk Destroy Your Offshore Outsourcing Deal?

FinanceCurrency exchange rates can confound buyers as they seek savings from Outsourcing.  As the rupee continues to be weak against the U.S. dollar this year, the issues of how foreign exchange rates impact offshore outsourcing arrangements has again come to the fore.  Will the rupee continue to be weak or will macro economic events cause it to strengthen remains a huge question for buyers.

A weak rupee, for example, theoretically boosts the top line of Indian service providers while their clients see no benefit, and a stronger rupee should erode provider margins or depending on your contract, result in an increase in net price to your company as a customer of Outsourcing.  The larger outsourcing  providers should have their own complicated long-term currency hedging strategies in place, meaning some will fare better during currency fluctuations either way in the short term while others will take a hit. At the same time, Indian providers are spending an increasing amount in U.S. dollars to pay for growing operations stateside and must import software and hardware to run its operations on the subcontinent, both of which cost more when the rupee falls.

Figure 1.

currency, chart.

Understanding how to manage these risks is extremely challenging for companies as well as the providers. Now, neither outsourcing party is locked into inflexible contract pricing for seven to ten years the way they were in the past.  There are several options for addressing the issue of foreign exchange rates in an outsourcing deal.

The least risky is a currency risk-sharing clause. Such a term ensures that neither the customer nor the supplier is advantaged or disadvantaged as a result of vacillating currency values during the course of the contract term. The clause should provide a method for calculation—for example, the mid-point rates of the day before the invoicing date as published by Bloomberg. The provision further cites which party will be initially responsible for exchange rate variances—for example the service provider absorbs a plus or minus five percent shift in exchange rate variances, after which the client and service provider then share the variance equally. Such adjustments are usually made on a monthly basis.

Another option is to require the service provider to bear full currency risk. This option—the most common—is popular with smaller and less experienced outsourcing customers who lack the time or talent to hedge foreign exchange rate risk themselves. It’s also a good option for those who want to avoid the uncertainty of potential increases in prices due to exchange rate swings. Under such an arrangement, the provider signs the contract in fixed U.S. dollars regardless of currency value fluctuations. But such a provision comes at a price. Typically, the provider will increase its price by some amount to cover future currency fluctuations or the costs of hedging the currency risk. If the provider hasn’t built in a safety net, adverse swings in currency valuations could hit the customer in the form of decreased service levels.

At the other end of the spectrum, the client may assume foreign exchange risk. By accepting a contract priced in Indian rupees then converted to the U.S. dollar rate on the day of invoice, the client not only bears the downside risk of adverse exchange rate fluctuations in the form of increased service fees but also acquires potential upside benefits of any favorable changes in exchange rates in the form of lower prices. That’s a roll of the dice some sophisticated multinational clients are willing to make if they have in-house currency hedging and risk management expertise—and one that could be paying off this year.

The most extreme—and rare—exchange rate risk mitigation tactic is a contractual provision giving the customer the right to renegotiate or terminate the deal if the exchange rate shifts beyond a certain threshold. Service providers may be less likely to agree to such a clause because it exposes them to sudden, unavoidable revenue loss.

There is no one right way to address currency issues in an offshore services deal. But as with any aspect of an outsourcing relationship, the goal should be a workable outcome for both the customer and the provider. To figure out what mitigation strategy is best for a particular situation, analyze historical currency fluctuations between your country and your providers’ countries to determine the potential impact of exchange rates during your contract term and involving internal finance or treasury departments in deciding what option will work best.

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