The strengthening rupee in the last few weeks has been threatening to hit the Indian outsourcing industry's competitiveness. The rupee has risen by about 9% since March 2007 against the dollar. The exchange rate went up from Rs.44.11 on 1st March 2007 to Rs.40.84 on 15th June 2007 beating most expectations / predictions. Adding to the industry's woes are rising wage rates, attrition and real estate prices. Concerns about a possible downward revision on earnings expectations are now getting increasingly real. We examine the impact this will have on the future of outsourcing companies.

Exchange rate: how far will it go?

Experts are divided over the fate of the rupee against the dollar. Most predictions are pessimistic as yet, owing to sustained inflation and high interest rates in the economy, coupled with booming GDP growth that is attracting huge investment in dollars, increasing the money supply further. The Central Bank (Reserve Bank of India) has been forced to accord greater priority to controlling inflation and has little option but to stake the exchange rate with the hope that the overall impact of the appreciation will be balanced out due to the advantage to imports and import-intensive exporters. However, in this scenario, the rupee may appreciate further in the coming months. Further compounding exporters' problems are recessionary expectations in the US economy, lending no support to prospects of a rising dollar.

On the other hand, there are those who believe that the exchange rate crisis is likely to be short-lived, and will disappear as credit growth to overheated sectors of the Indian economy slows down, bringing inflation under control. This school of thought expects the situation to stabilize by the end of this fiscal.

Impact on outsourcing

The impact will be visibly higher on small and mid-size companies that do not have the financial muscle to internalize the rupee appreciation, and neither have the bargaining power to revise contracts, or to raise billing rates in the near future. The larger companies will be able to sustain better in the near term, but will be in trouble in the long run unless corrective action is taken now.

The impact will basically differ based on factors such as the following:

• Share of dollar dominated revenues (share of the US in the overall business). The larger this is, the greater will be the impact.
• Hedging: Most large companies hedge their exchange rate exposure and revenue growth may not be significantly impacted in the short run. Cash flow hedges as against balance sheet hedges are also being adopted. However, short-term profitability may be eroded by 2-4 percent even if the rupee remains at its current level (and does not appreciate further).
• Exchange rate used for calculating future earnings: Greater flexibility in contract clauses (especially with respect to review of billing rates) will imply better chances of corrective action.
• Recruitment: companies cannot slow down hiring at this stage, as business will continue to pour in. However, there is likely to be circumspection about hiring people at inflated wages.
• Growth in the volume of new business: that allows incorporating the appreciation into future billing rates and contracts.

What next?

By either prediction above, the downward pressure on the dollar is here to stay at least in the short run and outsourcing companies will be wiser to address the concerns before it is too late. Several companies are already cutting costs, especially selling, general and administrative expenses (SGAs), and increasing employee utilization rates. Setting up overseas delivery centers ensure that risks are spread out over geographies (TCS, Evalueserve, Zensar are recent examples).

Notwithstanding the current urgency, this might be a good time for the Indian outsourcing industry to reflect on their business model and ensure future competitiveness and longer-term sustainability. Companies should aim to emerge stronger and be more prepared to tackle such challenges going forward. To use the very clichéd term, "climbing the value chain" will allow companies to charge higher billing rates (although this will mean recruiting better resources at a higher cost). The other option, and one that is often envisioned for the Indian outsourcing industry in the future, is a general move towards greater "productization". This will allow companies to move away from the commoditized service provider image and significantly improve revenue per employee.

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