How Does Currency Risk Play Into The Offshoring Equation?

With Euro Zone turmoil swaying investor confidence from one market to another, this is probably a good time to revisit some of the basics in hedging against currency risk, and how currency stability should factor into vendor selection decisions.

Latin America presents a particularly interesting case, where colorful notes like the Guatemalan Quetzal and the Nicaraguan Cordoba intermingle with dollarized economies in Ecuador and Panama, which in turn play off fluctuations in the Brazilian Real and Mexican Peso. Furthermore, major shocks like the U.S. housing market meltdown and the Greek debt crisis have taken global currencies for a ride over the last three years (we all remember the 2009 greenback freefall).

So what does all of this turbulence mean for outsourcing executives and CFOs when it comes to
currency risk? First let’s start with the basics. Currency fluctuations can affect both buyer and vendor, depending on whether you are in the operational phase, or negotiation phase of a sourcing arrangement. Done deals already negotiated in the buyer’s currency (let’s say the U.S. dollar) will insulate the customer from swings in foreign currencies. However, a weakening U.S dollar can erode vendor margins throughout the life of the contract (lousy exchange rate), which could potentially effect service level quality, as priorities are shifted to other clients.

During the contract negotiation phase, local vendors operating in countries with weakening currencies should have more flexibility to offer discounts (good exchange rate). So even if you plan on passing 100% of the risk onto the vendor and negotiating in your own coin, it’s still probably a good idea to study up on historical data to see how exchange rates might play into the final price. Big sourcing deals often get creative with different methods of allocating currency risk, which can include things like purchasing futures contracts to lock in a desired exchange, or contract stipulations allowing for the renegotiation of fixed rates based on swings in exchange rates.

Ultimately, currency risk is not the be-all-and-end-all of contract negotiations, nor is it the most critical cost factor when scouting out vendors in new geographies. Here it’s important to differentiate between currency risk, and cost of living inflation risk. India is a good example where exchange rates between the rupee and dollar have remained more or less stable, but where consumer prices have jumped up by 9 percent over the last year. Exchange rate fluctuations can be addressed through negotiation, but very little can be done once cost of living starts to climb up.

While Latin America’s currencies tend to be more volatile than the Indian Rupee or Chinese Yuan (since the Chinese have yet to float their currency on the open market), inflation is not yet as much of a factor in countries like Mexico, Colombia, and Chile. The Economist Intelligence Unit put inflation at around 3 percent in these countries. Brazil and definitely Argentina are the most worrisome markets in the region when it comes to inflation. Over the past year Brazil saw consumer prices jump by 7 percent, while in Argentina by 25 percent!

So currency risk is a factor when negotiating a sourcing deal and definitely a factor for offshore
vendors wanting to maximize profits. But currency risk should not overshadow other cost issues when exploring new geographies. When it comes to market fundamentals, cost of living inflation is what ultimately erodes cost arbitrage and profitability. Analyzing other macroeconomic indicators such as unemployment rates, GDP growth, excess credit growth, and of course inflation will give you a better sense of overall market health.