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Indian IT Inc returning to faster growth path

IT industry in India is slowly emerging out of the impact of recession. But, high attrition rates & volatile
currencies are the major worries, writes

The Indian IT sector has survived the past economic crisis rather unscathed; however there are several challenges
that the sector has to overcome towards its ride back to glory. Apart from the delayed repercussions of the economic
crisis there are many other problems which haunt the sector today. An industry which largely depends on the
economic health and spending power of the western countries is much worried about the somberness in this region.
The United States of America and affluent countries in Europe are cautious about spending and their economic
recovery is also giving conflicting signals after the unprecedented financial turmoil of the decade till a year ago.

The IT sector - software and business process outsourcing (BPO), being one of the fastest growing industries in the
country plays a very important role in the economy. India’s software export revenue at $45 billion in 2009-10
contributed to more than 8 per cent of India’s Gross Domestic Product (GDP) and also provided jobs to more than 5
million people, directly and indirectly. No wonder analysts tracking the industry were eagerly waiting for the month of
July to learn about the financial performance of leading IT companies like Infosys, TCS, Wipro Technologies, HCL
and midsize companies like MindTree, Sonata Software, Patni, iGATE among others, which declared their results for
the June quarter, the first one of the financial year after the recession.

A mixed bag

The first IT company to announce the result for Q1 was Infosys Technologies, India’s second largest software
exporter. Surprisingly, Infosys reported a 2.4 per cent decline in Q1 profit at Rs1,488 crore. Infosys revenue for the
quarter rose to Rs 6,198 crore as against Rs 5,472 crore, registering a Y-o-Y growth of 13.3 per cent. The financial
result created a feeling of insecurity for the sector and many questions were raised in this regard.

Infosys CEO S Gopalakrishnan announcing the results said its profit was hit due to increased employee cost and
fluctuating foreign currency including the Euro and US dollars. Indicating optimism and recovery in the India business
Gopalakrishnan also said, “While the global economic environment remains uncertain, we continue to see greater
demand for services from our clients.” However, the results of Infosys didn’t meet the expectation and calculation of
the market researches.

Unlike Infosys the results of other IT biggies were positive. Tata Consultancy Services (TCS), the country’s largest IT
firm by revenue, reported a 15 per cent growth in income to Rs 8,312.74 crore. Similarly, Wipro Technologies IT
services business revenue also grew 14 per cent at Rs 5,500 crore. They also did better in terms of profits. In the
June 2010 quarter, TCS, for example, reported a net profit surge of 24 per cent to Rs1,906 crore and Wipro Rs 1,319
crore, registering a Y-o-Y growth of 31 per cent.

The mid-sized IT firms too had mixed fortunes in terms of revenue and profits in the June quarter. While iGATE
witnessed a jump of 84 per cent in net profit, Sonata Software could raise net profit only by 11 per cent. But MindTree
reported a sharp 72 per cent drop in profit. Though the margins were impacted in the April-June period for almost all
companies most of the players managed to maintain profits and revenue growth.

Very high churn

The sector which is yet to recover fully from the impact of recession faced by its clients, is facing another crisis. The
June quarter showed that managing human resources was a big challenge. With many offers in their pockets, large
number of software engineers changed jobs for higher pay. As a result almost all large companies experienced very
high attrition rates of employees. Experts feel that market recovery and attrition are two sides of the same coin. When
there is a recovery in the business environment employees seek better pastures for growth.

The attrition rate in Q1 for IT Services business for TCS was 12.3 per cent and in BPO business was 20 per cent.
Similarly, the attrition rate in Wipro and in Infosys jumped to around 16 per cent during the April-June period quarter,
which is very high compared to the average rate of around 7-8 per cent in these two companies. “After a near freeze
for more than four quarters, companies are hiring again and the job market is slowly opening up. Another reason is
that clients have allocated budget for IT spending and contracts have been signed leading to increased demand for
talents,” said Zinnov Management Consulting Director Karthik Ananth. So severe was the problem in Infosys that it
had to initiate some new HR programmes to plug employee outflow.

Others like Wipro, MindTree, HCL Technologies and iGATE offered large salary hikes and promotions to stop people
deserting them. “We have done some restructuring for employees with 3-7 years of experience, over 20,000 people
have been promoted since July 1,” said Wipro Technologies CFO Suresh Senapathy.

Fluctuating currency

Another major worry faced by IT firms is the cross currency fluctuation. During the quarter Indian rupee remained
volatile against the US dollar and Euro which was a major worry for the business. The currency volatility and Euro
crisis dented Wipro’s revenue generation from European regions significantly. During the quarterly result
announcement TCS, said the firm made a foreign exchange loss of Rs 47.18 crore in the quarter. Infosys Chief
Financial Officer V Balakrishnan also said “Our profitability was hurt by currency volatility, and lower billing rates.”

European vexation

Since the main customers of Indian IT companies are in the US or in Europe, changes in the value of their currencies
affect the earnings. For example, the recent financial crisis in Greece and Spain forced strong European countries to
throw in billions of Euros to bail them out. This in turn took a toll on the value of Euro and affected earnings of Indian
software exporters. European worries have forced the firms to take a u-turn and adopt a wait and watch policy.
According to B Ramaswamy President and Managing Director of Sonata Software Limited, “For a short-term Euro
crisis may not affect the companies, our major focus in the Europe is travel and tourism verticals and this sector has
witnessed an impact.” Meanwhile Wipro Chairman Azim Premji said “We are seeing strong demand environment
across our industry verticals despite macro challenges.”

New business models

To overcome these challenges companies are also trying out or new business models and are also exploring new
geographies. Many are looking at the Indian domestic market and other emerging markets like the Middle-East and
Latin American countries. Major companies’ feel that clients are cutting short the IT spend and are asking for new
business and pricing model to overcome the pressure. Organisations like Wipro, Infosys and TCS feel demand from
clients for an integrated package which includes IT services, support and BPO which well help IT company and
clients share the risk model.
iGATE Chief Executive Officer Phaneesh Murthy said, “Clients are looking for more value for the money they spend.
Our business offering is based on outcome based model and this kind of offering can be a clear differentiator in the
market place. There will be initial resistance to this model, but outcome based model will become mainstream in the
future.”

Firms have also started investing in latest technologies like Cloud Computing and virtualisation, ‘pay per use’ model
as clients become selective in IT spending.

The road ahead

Industry veterans, analyst and companies believe that there is light at the end of the tunnel. Market is witnessing
some positive developments as well. Indian IT majors have seen addition of new clients, new partnership and have
inked new deals. Experts believe that the issue of attrition will be also stabilised by the second quarter and many
companies have increased their number of campus hires.

Apart from the traditional BSFI verticals, now companies are seeing growth in manufacturing, health care, education
and outsourced product engineering business. These will also help the IT industry to remain highly profitable.

Software companies: Sensitive to the currency!

The Indian software industry is an export-oriented sector, where a lion’s share of the revenues comes from exports.
In fact, for companies like Infosys, India accounts for just 1.5% of the total revenues. One factor common to all the
‘Top-4’ software companies is the fact that all of them earn most of their revenues from the US. Of course, the
proportion varies from company to company, but overall, the importance of the US in these companies’ future growth
plans cannot be underestimated.

Consequently, these companies earn a majority of their billings in US dollars, and as a result, are subject to the
vagaries of exchange fluctuations of the Indian rupee. In this write-up, we briefly analyse the impact of the movement
of the Indian rupee vis-à-vis the US dollar on the sales and EBITDA margins of Indian top-tier software majors.

The undeniable impact

Sales
It cannot be denied that the rupee movement against the dollar does have an impact on these companies’
realisations in rupee terms and thus, on their sales growth. A simple example would be Infosys in FY06, the latest
fiscal. The company recorded a 33.5% YoY growth in its topline in rupee terms. The rupee rate used for conversion
was Rs 44.22 to the dollar, 1.3% lower than the figure used in FY05 (Rs 44.80). In FY06, billing rates were largely
stagnant, with onsite rates falling by a marginal 0.1% and offshore rates increasing by 0.4%. Consequently, the
growth in dollar terms was higher, at 35.3% YoY, and it was very clear that volumes were the only real reason for the
33%+ growth seen in Infosys’ topline (onsite volumes grew at 38.8% YoY, while offshore volumes grew at 31.6%
YoY).
 Infosys in FY06: Core volumes enthuse!
(%, YoY) FY06
Onsite volume growth 38.8
Offshore volume growth 31.6
Onsite billing rates (0.1)
Offshore billing rates 0.4
Sales growth (US$) 35.3
Rupee (appreciation)/depreciation (1.3)
Sales growth (INR) 33.5

Now, we believe that if volume growth is the primary cause (or only) for revenue growth in any quarter or fiscal, it is a
positive sign for the company, since this is the core growth that can be sustained in future. Currency fluctuations are
regular, and one year, exchange rates may be favourable, while in other years, they may not be so favourable. Billing
rates, on the other hand, are unlikely to witness a sustained up-tick, given the relatively higher bargaining power of
the customers, who generally use multiple vendors (think GE, BT, Nortel) and competitive pressures. Thus, the
topline growth of Infosys in FY06 is indeed commendable, when we consider the flat trend seen in billing rates, and
the unfavourable currency movements seen in that fiscal.

EBITDA margins
As we have seen above, the impact of the rupee movements against the dollar does have an effect on the sales
growth in rupee terms. We have taken an unfavourable year (FY06) in terms of currency movements to prove our
point. If we take FY03 as an example, the sales growth rerecorded by Infosys was 39.8% YoY. The rupee rate was
higher by 1.2% for the fiscal (Rs 48.35 to the dollar, against Rs 47.77 in FY02). Adjusted for this, the sales growth
would have been 38.1% YoY.

This, therefore, also has an impact on the company’s EBITDA margins. If we take FY06 again as an example,
Infosys’ operating margins stood at 32.5%. If the realised rupee rate was to be kept constant at FY05 levels (instead
of the actual 1.3% appreciation witnessed), the EBITDA margins increase to 33.3%, an increase of 80 basis points.
Therefore, it is clear that the impact of currency movements (either appreciation or depreciation) can be significant on
the EBITDA margins. For Infosys, a 1% movement of the rupee either way against the dollar typically impacts
EBITDA margins by around 25 to 30 basis points.

The ‘HR factor’

It should be noted that the rupee movement is not the only factor that impacts EBITDA margins of a software
company. In fact, the biggest cost item, in our view, which determines margins, is undoubtedly the employee cost.
The software industry is a people-oriented business, where employees are the ‘raw material’ for any company. Thus,
employee costs form the biggest chunk of the total operating expenditure for any software company, accounting for
around 70% to 75% of total operating costs. Thus, any significant movement in this item is bound to impact margins
as well, and in probably a more significant manner than currency movements. It must be noted that in the graph
below, the primary reason for the fall in margins of companies like Infosys and TCS is the increasing proportion of
employee costs to sales.
 * As per US GAAP

** EBIT margins of the Global IT services business

Billing rates too!

Apart from the above factors, billing rates also play their role in shoring up the topline of the company. This is a factor
of the business mix (a higher proportion of higher-end services like package implementation in sales increases
average billing rates), bargaining power of customers (typically higher, due to the fact that they generally have
multiple vendors) and competition. Thus, we believe that over the longer-term, billing rates are unlikely to trend
significantly upwards with any sort of regularity. Competitive pressures and the relatively low bargaining power of
suppliers (vendors) are likely to keep rates in check. These can be shored up by consistent initiatives on the part of
the vendors to do a greater proportion of higher-end work for their clients, like consulting.

Conclusion
While the movement of the currencies is undoubtedly an important factor to keep an eye on for software companies,
it must not be viewed in isolation. The demand environment, volume growth, billing rates and cost-side pressures are
other major factors to watch out for in order to understand future trends in margins for the software sector. In any
case, all the major software companies do adopt hedging mechanisms in order to mitigate any potential impact of
adverse currency movements on their topline and margins. We remain positive on the sector from a long-term
perspective.
Rupee depreciation worries IT firms
The hedging positions taken up by Indian software companies could come back to haunt them. Most IT companies had hedged at
the Rs 40-42 levels at the beginning of the fiscal, but now the rupee has depreciated to Rs 46. Critically, they are not in a position
to take advantage.

“The rupee depreciation has left everyone by surprise,” admitted MindTree Consulting CFO Rustow Ravanan. “Earlier, we thought
the rupee would appreciate. But it has depreciated extremely sharply, and most players are unable to benefit,” he said.

IT companies on Monday, however, put up a brave face and said the currency fluctuation will not have any impact on Q2
earnings. Infosys said its dollar revenues could be hit by the rise of the US currency against the euro and British pound, although
fall of rupee to two-year low against the dollar would lessen the impact. Cross-town rival Wipro on the other hand stated that it
does not rely on cross-currency volatility to drive its business, and said it would meet its dollar guidance for the quarter ($1.09
billion).

Most software firms had resorted to hedging after the rupee appreciation last year had punched a hole in their earnings.

Infosys CFO V. Balakrishnan said: “Software exporters we will definitely appreciate a stable rupee. Such volatility of the currency
will not help the IT industry.”

International brokerage house UBS did report last week that a sharp and sudden appreciation of the dollar against the British
pound and euro would hit IT firms’ revenue in dollar terms by 1-2 per cent. UBS said the dollar has risen 5.5 per cent, 13.8 per
cent and 13 per cent respectively against the Indian rupee, pound and euro in the current quarter.

Indian IT outsourcing firms have been quick to expand in Europe, Asia-Pacific and the Middle East to cut dependence on the
United States, where business has been hit by the credit crunch and housing downturn. “But now this Plan B could get stuck, as
slowdown has started to spread to Europe as well,” said ShareKhan senior analyst Gaurav Dua. “Rupee strengthening against the
pound could affect European billing.”

Hedging going wrong can also have an impact on guidance, but that's something no IT company is willing to admit. A recent
CLSA report had suggested that Infosys could miss the Q2 guidance due to the volatility of the Indian currency.

Sasken Technologies CFO Neeta Revankar said, “In the short term, currency volatility can lead to wild swings in EBITDA margins.
In the current quarter itself, for most IT companies, the 11 per cent exchange fluctuation will become 5-6 per cent. EBITDA
fluctuations quarter on quarter because of exchange volatility mask the operating improvements/deteriorations in margins,” said
Revankar.

How Dollar Fluctuations Impact the Indian Economy

To better understand the fluctuating dollar value against the rupee, let us get to know some basics:

Exchange rate – the rate at which a currency can be exchanged. It is the rate at which one currency is sold
to buy another.

Foreign exchange market – Also known as “Forex” or “FX”. It is a market to trade currencies
Indian foreign exchange rate system – India FX rate system was on the fixed rate model till the 90s,
when it was switched to floating rate model. Fixed FX rate is the rate fixed by the central bank against
major world currencies like US dollar, Euro, GBP, etc. Like 1USD = Rs. 40. Floating FX rate is the rate
determined by market forces based on demand and supply of a currency. If supply exceeds demand of a
currency its value decreases, as is happening in the case of the US dollar against the rupee, since there is
huge inflow of foreign capital into India in US dollar

Why is the US dollar walking down? – When it comes to the US being a consumer, it has one of the
largest appetites in the world. To keep up its demand for consumption, its imports are huge when compared
to exports. This created pressure since there were more payments in dollars than receipt of any other
currency, which made the supply of the dollar greater for imports payment and less receipt of foreign
currency from exports. This resulted in the depreciation of the dollar’s value, which again caused more
outflow of dollar for import payments. This created a state of inflation and made consumables costlier to
US. To control inflation US resorted to increase in interest rates to cool down pressure on demand side of
consumption. This factor along with recession in all other sectors, particularly real estate, is causing the
mighty US dollar to shake.

Impact of dollar fluctuations on the Indian economy

Until the 70s and 80s India aimed at to be self-reliant by concentrating more on imports and allowing very
little exports to cover import costs. However, this could not last long because the oil price rise in the 1970s
and 80s created a big gap in India’s balance of payment. Balance of payment (BOP) of any country is the
balance resulting from the flow of payments/receipts between an individual country and all other countries
as a result of import/exports happening between an individual country, in our case India and rest of the
world. This gap widened during Iraq’s attempt to take over Kuwait. Thereafter, exports also contributed to
FX reserve along with Foreign Direct Investment into the Indian economy and reduced the BOP gap

Indian rupee appreciation against dollar impacted heavily to the following:

1. Exporters
2. Importers
3. Foreign investors

Exports from India are of handicrafts, gems, jewelry, textiles, ready-made garments, industrial machinery,
leather products, chemicals and related products. Since the 1990s, India is the world’s largest processor of
diamonds. The mentioned export items contribute substantially to foreign receipts. During the periods when
the dollar was moving high against the rupee, exporters stood to gain, when $1 = Rs. 48, was getting them
Rs. 4800 for every $100. Since the beginning of the year 2007, rupee appreciated by about 10%. With its
value of rupee Rs. 39.35 = $1 as on 16 Nov 2007, for every $100, exporters would get only Rs. 3935. This
difference is towing away the profit margins of exporters and BPO service providers alike.

Imports to India are of petroleum products, capital goods, chemicals, dyes, plastics, pharmaceuticals, iron
and steel, uncut precious stones, fertilizers, pulp paper etc. With the same scenario as given for export, if
we analyze - an importer is paying Rs. 3935 now instead of Rs. 4800 paid during yester years for every
$100. This gain on FX is likely to create savings in cost, which could be passed on to consumers, thereby
contributing to control inflation
Foreign investment into India is also contributing well to dollar depreciation against dollar. With the recent
liberalized norms on foreign investment policy like – Foreign investment of up to 51% equity limit in high
priority industries; foreigners & NRIs are allowed to repatriate their profits and capital with exception for
Indian nationals who were allowed to do so only under special circumstances; allowing free usage of export
earnings to exporters, made foreign investment in India very attractive. It is this favorable atmosphere
which made FX reserve surplus in US dollar and helped rupee to appreciate

Conclusively, appreciation and depreciation of rupee cannot certainly be taken as beneficial to the Indian
economy in general. On one hand the rupee appreciation will affect exporters, BPOs, etc., on the other,
rupee depreciation will affect importers. So now it depends on what the future has to reveal for, how
effectively the central bank can balance the FX rates with little impact to the relative areas of FX usage.
Can the Dollar remain king or not, is no longer a million dollar question, but a million Rupee question!

The Day of the Forex Expert

The forex market is no longer about products that nobody understood. A new breed
of business models help firms make sense of their currency exposure
by Pravin Palande | Apr 21, 2010
Pankaj Sampath was a tense man at the turn of the last decade. A dealer in edible nuts and oil-
seeds, Sampath also ran his own trading firm, Samson Trading Corporation. The rupee had
appreciated by Rs. 3 in ten days and he had an export contract payment of $5 million. He was not
sure if he should cover his positions as the direction of the rupee was difficult to predict. He knew
that he would lose money. The question was how much.
He called up Jamal Mecklai, a foreign exchange (forex) consultant who decided to rejig the forex
positions and cut losses for the firm. The rupee continued to appreciate. But Mecklai reduced the
losses by almost 90 percent of what was feared.
Anil Patwardhan, chief financial officer (CFO), KPIT Cummins recounts on a role of forex
consultants to deal effectively with forex exposure. In 2007 many companies were being duped
by toxic deriavative instruments and Patwardhan did not want to add to the list. So he asked an
old friend, Manis Thanawala of Greenback Forex, to advise him on his derivative positions.

“There was a clear case for forex consultants in the market as banks had pushed their products
and the implications came much later on. Since companies need advice and strategies to reduce
the impact of their foreign currency exposures in a volatile market, and work out the sound
hedging policy, the role of the forex consultant is only going to go up”, says Anil Patwardhan,
CFO of KPIT Cummins who prefers to hedge almost 75% of his net exposures from global market
in US dollar terms.

A Bigger Role
These examples highlight the growing importance of forex consultants in India. Corporate India’s
exposure to different currencies has steadily been increasing over the past decade. Big
companies usually have their own treasury departments that hire professionals to deal with these
issues. Other companies look to the forex consultant who advices and trains these firms in
understanding their exposure to forex markets.
Consequently, the forex consultant’s role is getting bigger. While forex firms were traditionally
advisors to their clients, they will now be in a position to also execute the trades. In the next five
years, they will derive bulk of their business through currency futures broking.
Forex trading is the most liquid market in the world with a daily turnover of $3 trillion. In India, the
entire forex trade was on the over-the-counter (OTC) market. The introduction of currency
derivatives on the exchanges has boosted the market. India’s OTC market is at $33 billion and
the exchange traded market is around a few billion on MCX and NSE.
For the month of January 2010, the average daily turnover for currency futures stood at Rs.
28,454 crore which was higher than the cash equity turnover for BSE and NSE which worked to
Rs. 23,975 crore.
According to a report by brokerage firm IDFC SSKI, the OTC market in India will touch $40 billion
by FY 2014 and around $8 billion take place on the exchanges. Greenback Forex is gearing up
for this opportunity. Manis Thanawala and Subramanian Sharma run Greenback Forex from
Vikhroli, a North
Mumbai suburb.
Thanawala, a chartered accountant, started the firm in
1995 after completing his MBA from Pace university,
USA. He belongs to a family of CAs and was a topper
in the CA finals. His speciality is finding inefficiencies
in financial markets. Today he sees a huge
opportunity in hedge accounting and is focussing his
attention there. “Currency broking and AS 30, the new
derivative accounting standards, are the biggest
opportunities for forex players. We believe that in the
next few years advisory business will be priced lower
for our other clients who take our broking and
accounting services,” he says.
Currency broking is big even for Mecklai Financial.
The firm has achieved an 18 percent return for their
clients, trading currency on the Indian exchanges.
CEO Jamal Mecklai feels that the currency exchange
has a long way to go in terms of liquidity but it is
slowly getting there.

HEDGE OR PERISH: Manish Thanawala, Image

:Alok Brahmbhatt

He is taking technology based approach to his clients where he is managing their forex risks
based on the data provided by his clients. An IT company with a strong treasury was taking
readings from the Mecklai model since October 2008 for hedging. The company, which has $250
million of exports, realised that if they followed the model they would have saved $5 million on
their positions. After looking at the results, the company moved to the Mecklai analytical model.
Mecklai says that since 2007-2009, based on simulations, the model has done 3 percent better
than the targets set by their clients.
Critics of this approach say that the software approach has been used before but has not really
worked as companies are not yet clear about the functionality.
But Mecklai knows what his clients expect of him. He has been in the forex consultancy business
since the early eighties after he moved in from the US to help his father who was managing
Mecklai and Mecklai, a firm that was into inter-bank broking since the early seventies. Mecklai, a
chemical engineer from IIT did not have any idea that he would end up in forex. But the going has
been good. Companies like Samson Trading have relied on Mecklai for 20 years.
“You draw a box. Put the market inside this box. As long as the market is inside the box, you
don’t have to do anything. But once it comes and touches any of the corners, either against you
or in your favour you have to act,” says Mecklai. He believes that his software driven approach
will help his clients solve 80 percent of their risk management related problems.
Forex consultants say clients are in dire need of advisory services. The problem is that the clients
think consultants typically take punts on the exchange rate and this can often go wrong. The
derivative crisis proved just that. But Satyajit Kanjilal has a different view. The CEO of
Forexserve, a risk management consultancy, spends most of his time helping companies manage
their risks in such a way that their balance sheets do not have to bleed for the positions that they
take.
A chemical company with a Rs. 2,000 crore turnover approached Kanjilal. It had $8 million debt in
foreign currency at a total cost of borrowing that worked out to 9 percent on a covered basis.
Many banks had approached the company to sell products that they could not understand.
Kanjilal hedged the loan in forwards on the assumption that the rupee would fall. His
rationalisation saved the company Rs. 6 crore within four months. The company realised the
power of hedging and has been with Kanjilal since then. Corporates are realising that a good
hedging policy can help them save a lot of cash based on sound advisory policy.
But the business is moving from a view -based model to a risk management model especially
after the derivative debacle. Companies want to have risk management solutions that will help
them avoid the problems of the past two years where they were totally dependent on the view
-based advisory.
Kanjilal feels that contrary to what others think, firms going for a complete risk management
approach might just help him a lot as they would still require a view as there is always a premium
on good advisory. “We need to have a view and then a strategy to back that view. But first we
need to identify if the balance sheet requires this view and then use this view to take advantage
of the market. As advisors, it is important to give realistic views that work for these companies”,
he says. These days his firm is getting more involved with training equity brokers to get into forex
business. He feels that this is an important step as education itself will have the power to drive in
the volumes.
The new derivative accounting standards that have come into force are the biggest opportunities
for forex players. The rupee is still volatile and the markets are in a tizzy. The need for managing
currency risk is not about to go away soon.
This article appeared in Forbes India Magazine of 30 April, 2010

http://business.in.com/printcontent/12432

The impact of rising rupee on financial management of Indian MNCs

By
 Dr. M. Srinivasa Rao
Professor
Prof. D.S. Prasad
Professor
ICFAI Business School
Hyderabad

Introduction:

In 1999, Goldman Sachs (BRIC Report) predicted that India's GDP at current prices will overtake that of
France and Italy by 2020 and that Germany, UK and Russia by 2025, By 2035, India is expected to be of
3rd largest economy in the world behind US and China overtaking Japan. Goldman Sachs had made these
predictions based on India's expected growth rate of 5.3 to 6.1% in various periods in the past, at present
India is registering more than 9% growth rate. Jim O'Neal, head of the Global Economics Team at
Goldman Sachs, had said on the BBC, "In thirty years, India's workforce could be as big as that of the
United States and China combined." He also added that "India could overtake Britain and be the world's
fifth largest economy within a decade as the country's growth accelerates."

Presently India is the third largest economy in the world as measured by Purchasing Power Parity (PPP)
and twelfth largest in the world as measured in USD exchange-rate terms, with a GDP of US $1.0 trillion.
Amongst the major economies of the world, India is the second fastest growing economy with a GDP
growth of 9.4% for fiscal year 2006-2007. The main reason for this is its diverse economy which
encompasses agriculture, handicrafts, textile, manufacturing and a multitude of services.

However, the BRIC (Brazil, Russia, India, China) report ignored the effect of rapid decline in Purchasing
Power Parity ratios of economies as they approach maturity, resulting in PPP that eventually tend toward
1.0 (as compared to nearly 5.0 for India and China in this current year i.e. the value of 1 US$ in India and
China after conversion into local currency at currency exchange rates was 5 times of that in the US due to
their cheaper currencies). This decline is attributed to the following,

• Inflation
• Appreciation of the local currency

Normally, currencies appreciate when the economies are doing well and the rise in their value is a cause
for celebration. The high value of the Deutsche Mark when Germany was the trendsetter for the world
economy in the 1960s and the 1970s, the high value of yen in the 1980s when Japan seemed set to take
over the world and the dollar's high value in the late 1990s when the US economy brooked no competition
were sources of immense pride for their respective countries.

The Indian journey from 1990s to the mid 2000s:

The Indian rupee (INR) has appreciated by nearly 10% since late 2006, posing an acute dilemma for
Indian policymakers. In some ways, the present strength of the currency, this is now hovering just above
the symbolic Rs. 40: US $1 exchange rate is an enviable position. It suggests that the country's
attractiveness to foreign investors is increasing and signals optimism about the future of Indian economy
in general. However, the concerns of export intensive corporations, who have a crucial role of India's
economic resurgence, and whose goods become more and more expensive for overseas buyers need to be
examined critically and addressed in a timely and effective manner.
The recent strengthening of the rupee is a dramatic departure from the past trends. The currency
depreciated steadily for a decade after being floated in 1993, dropping from an average annual rate of Rs.
31.37: US $1 in the 1993-94 fiscal year (April-March) to Rs. 48.40: US $1 in 2002-03 (an average annual
depreciation of nearly 5%). Between 2003-04 and 2005-06, however, the rupee appreciated against
the dollar by 3% an on average a year—although there was considerable two-way movement of
the rupee from month to month. The trend of steady month-on-month appreciation began in
September 2006 and has been continuous since then.

Although the Indian rupee-US dollar exchange rate has a significant impact on the Indian economy and
business sector, the rupee has also appreciated against other currencies as well. In January-July 2007, the
rupee's value in terms of Pounds, Euros and Yen rose by 8%, 6.9% and 11.2%, respectively. According to
the Reserve Bank of India (RBI) during 2005-06, 86% of Indian exports and 89% of imports were invoiced
in US dollars. The Euro was a distant second, with shares of 8% in exports and 7% in imports.

Why the Indian rupee appreciated?

The main reason for the INR's appreciation since late 2006 has been a flood of foreign-exchange inflows,
especially US dollars. The surge of capital and other inflows into India has taken a variety of forms,
ranging from FDIs to remittances sent home by Indian expatriates. In each case, the flow seems unlikely
to slacken. The main impact of these various types of flows is examined below:

• Foreign Direct Investment (FDI) - India's outstanding economic growth has created a large
domestic market that offers promising opportunities for foreign companies. Moreover, the country's
rising competitiveness in many sectors has made it an attractive export base. These factors have
boosted FDI inflows into the country. For example, in 2006-07, FDI amounted to around US $16bn,
almost three times the previous year's figure. More than half of these inflows arrived in the final
four months of the fiscal year (December 2006-March 2007).
• External Commercial Borrowings (ECBs) - Indian companies have borrowed enormous
amounts of money overseas to finance investments and acquisitions at home and abroad. India's
balance-of-payments (BoP) data reveal that inflows through ECBs amounted to an enoromous US
$12.1bn during April-December 2006, a year-on-year jump of 33%. The flood of borrowed money
is likely to grow in 2007. In the first three months of the year, Indian companies have notified the
RBI of their plans to raise nearly US $10bn in overseas debt markets.
• Foreign portfolio inflows - India's booming stock market embodies the confidence of investors in
the country's corporate sector. Foreign portfolio inflows have played a key role in fuelling this
boom. Between 2003-04 and 2006-07, the net annual inflow of funds by Foreign Institutional
Investors (FIIs) averaged US $8.1bn. Trends during the first five months of 2007 indicate that this
flood is continuing, with net FII inflows amounting to US $4.6 billion. Another major source of
portfolio capital inflows has been overseas equity issues of Indian companies via Global Depositary
Receipts (GDRs) and American Depositary Receipts (ADRs). Inflows from GDRs and ADRs
amounted to US $3.8bn in 2006-07, a year-on-year increase of 48%.
• Investments and remittances - Indians settled in other countries have also been a major source
of capital inflows, with many non-resident Indians (NRIs) investing large amounts in special bank
accounts. While NRIs' emotional connection to their country of origin is part of the explanation for
this, the attractive interest rates offered on such deposits has also provided a powerful incentive.
In 2006-07, NRI deposits amounted to US $3.8bn, a 35% increase over the previous year; the
outstanding value of NRI deposits as of end-March 2007 was US $39.5bn. Another large source of
foreign-exchange inflows has been remittances from the huge number of Indians working overseas
temporarily. Such remittances amounted to a colossal US $19.6bn in April-December 2006, a 15%
year-on-year increase.
The Export Scenario:

Buoyant export growth has also built up India's foreign-exchange holdings. IT and Business Process
Outsourcing (BPO) exports have expanded at robust pace, with exports of software services reaching US
$21.8bn in April-December 2006 (a year-on-year increase of 31%). However, the rupee's appreciation is
alarming exporters, as it makes their products more expensive in overseas markets and erodes their
international competitiveness.

The RBI's deputy governor, Mr. Rakesh Mohan has recently referred to the effects of the rupee's
appreciation as a case of 'Dutch disease'. The term refers to episodes where large inflows of foreign
exchange, usually as a result of the discovery of natural resources or massive foreign investment, have
lead to appreciation of the currency, undermining a country's traditional export industries. ('Dutch disease'
was originally referred to as the adverse impact of the discovery of natural-gas deposits in the
Netherlands on that country's manufacturing exports.)

Trade Policies:

Indian policymakers face a difficult dilemma. On the one hand, the rupee's appreciation has benefited the
economy by making imports cheaper. This is no small benefit since containing inflation has been high on
the policy agenda during the past year, as the annual inflation rate (as measured by the point-to-point
change in wholesale prices) rose to 6.1% in January 2007, compared to 4.2% a year ago. The inflation
rate has subsequently moderated. This may offer the RBI some comfort in it's battle against inflation, but
the bank's new, stricter inflation target (4.5-5% in 2007-08, down from 5-5.5% in 2006-07) suggests that
there will be one more increase in interest rates by the end of 2007.

On the other hand, for both economic and political reasons, policymakers cannot afford to ignore the
problems of exporters. Although exports account for a relatively small share of the economy, India's rapid
export growth in recent years has been an important catalyst of economic growth. Given the limited
extent to which the RBI can intervene in the foreign-exchange market in the face of large and sustained
capital inflows, policymakers can only stem rupee appreciation substantially by easing limits on domestic
firms' overseas investments or restricting inflows, for instance, through further controls on ECBs. The RBI
has already taken tentative steps in this direction, especially recent ECB guidelines for Indian firms to
borrow in foreign currency and eliminating the exemption from ECB limits previously enjoyed by real-
estate firms.

In confronting this dilemma, government policymakers are undoubtedly hoping that there will be no need
for a major intervention. However, the problem is unlikely to disappear soon. The Economist Intelligence
Unit forecasts an average annual exchange rate of Rs. 41.3: US $1 in 2007 (a 13.5% real appreciation
year on year) and Rs. 40: US $1 in 2008 (6%).

Let us now look at the pros and cons of a rising rupee.

Advantages of the rising rupee:

• Foreign debt service: Appreciation of the rupee helps in easing the pressure, related to foreign
debt servicing (interest payments on debt raised in foreign currency), on India and Indian
companies.With Indian companies taking advantage of the United States soft interest rate regime
and raising foreign currency loans, known as external commercial borrowings (ECBs), this is a
welcome phenomenon from the point of view of their interest commitments on the loans raised.
This will help them avoid taking a bigger hit on their bottom-line, which is beneficial for its
 shareholders.
• Outbound tourists/student bonanza: The appreciating rupee is a big positive for tourists
traveling or wanting to travel abroad. Considering that the rupee has appreciated by over 10%
against the US dollar since mid-2002, traveling to the US is now cheaper by a similar quantum in
rupee terms.The same applies to students who are still in the process of finalizing their study plans
abroad. For example, a student's enrollment for a $1,000 course abroad would now cost only
Rs.44,000 instead of the earlier Rs 49,000!
• Government reserves: Considering that the government has been selling its stake aggressively
in major public sector units in the recent past, and with a substantial chunk of this being
subscribed by FIIs, the latter will have to invest more dollars to pick up a stake in the company
being divested, thus aiding the governments build up of reserves.

Disadvantages of the rising rupee:

• Exporters' disadvantage: The exporters are at a disadvantage owing to the currency

appreciation as this renders their produce expensive in the international markets as compared to
other competing nations whose currencies haven't appreciated on a similar scale. This tends to
take away a part of the advantage from Indian companies, which they enjoy due to their cost
competitiveness. However, it must be noted that despite the sharp currency appreciation in recent
times, Indian exports have continued to grow. This is vindicated from the fact that while in the
month of February 2004, India's exports were higher by 35% over the same month previous year,
in the first 11 months of the current fiscal, Indian exports have been higher by 15% year-on-year.
• Dollar denominated earnings hurt: The strengthening rupee has an adverse impact on various
companies/sectors, which derive a substantial portion of their revenues from the US markets (or in
dollar denominations). Software and BPO are typical examples of the sectors adversely impacted
by the appreciation of rupee.

How will rupee appreciation impact Indian Multinationals?

Even though the INR fluctuates a lot, but it is still up 7% making it the best performing currency against
the USD in 2007. A month back it touched a nine-year high. Rupee appreciation will be negative for
overall earnings, says a recent Merrill Lynch research report. According to the report, the companies that
will be impacted negatively by the rupee appreciating include global commodity stocks like Reliance,
Hindalco, Tata Steel and software companies like Satyam, Infy etc. And the gainers will be Jet Airways,
Reliance Communicationsand auto companies like Tata Motors, Maruti, Hero Hondaetc.

The Losers:

Global commodity companies price their products off landed costs. With a decrease in landed costs, profits
for these companies will be hit. As an example, Reliance's 70% of revenues come from exports which
again would be hit by the rising rupee thereby eroding their profitability.

The rising rupee and the fluctuating dollar have affected the Indian IT industry adversely. It has dented
profits and at the same time, many foreign clients with a dollar budget are finding it too expensive to use
Indian service providers. That is, software companies are also going to lose on the back of the
appreciating rupee as their exports are priced in foreign currency.

Infosys, CFO, V Balakrishnan, said that in the fourth quarter of the fiscal year 2006-07, they have seen an
impact of 100 bps on their operating margins because of the movement of the rupee. "But that was more
than offset by the increased non-operating income that we have seen because the effective yield in the
last quarter has increased from 7% to 10%." He said that in this quarter the rupee appreciated by around
1.8% and for every 1% change in the rupee dollar rate the company have an impact of 50 bps.

The management of MindTree, a global consulting house, predict that the rupee appreciation will be the
key hurdle for their future performance. Patni Computers has seen rupee appreciation impacting their
margins by 0.3% in the last quarter.

The Gainers:

On the other hand, sectors that are likely to gain from the currency gaining are auto, engineering and
aviation companies.

The biggest gainers in the auto sector are Hero Honda, Maruti, Tata Motors and Ashok Leyland as the
imported price of their raw materials will cost less. Engineering companies like Suzlon also gain on raw
material cost savings.

Jet Airways is the other gainer on its aviation fuel costs for its domestic routes. Though its international
revenues will get hurt, there will be more savings on account of fuel, lease rentals, interest and
depreciation. Deccan Aviation management has said that rupee appreciation is having a favorable impact
on the lease side.

Companies with foreign currency loans or Foreign Currency Convertible Bonds (FCCBs) like Reliance
Communications, Bharat Forge, Sun Pharma and Ranbaxy are also likely to gain due to rupee
appreciation. Allianz Global feels that a sharp rupee appreciation will have a drag effect particularly on
banks.

Present scenario:

The current impact of rupee appreciation is best demonstrated by what it has done to our textile exports,
a highly employment-intensive sector, driven by small and medium enterprises (SMEs). From a healthy
export growth rate of 21% in 2005-06, it has plummeted to a mere 4.6% during the 11 months of 2006-
07.

CRISIL, a leading credit rating agency has come out with a report (CRISIL Budget Impact Analysis) on
textile impact analysis and is of the view that the package for exporters in the form of enhanced DEPB
(Duty Entitlement Pass Book) and drawback rates will marginally offset the impact of rupee appreciation
and benefit the exporters. The textiles industry is severely affected by the rise of the rupee against the
dollar, since currencies of most of our competitor countries have either remained stable or have
depreciated against the dollar during this period. Chinese Yuan has appreciated by around 4%, Indonesian
Rupiah by around 2.7%, Bangladeshi Taka has remained almost stable and Pakistani Rupee has
depreciated by 0.69%. There is an intense competition in the export market. Small and medium exporters
are unable to pass on their costs in terms of currency appreciation to buyers. The consequent lowering of
export proceeds erodes the top line and profit margins of exporters. Therefore, players would be required
to find additional ways to overcome the additional loss through operational efficiencies and moving up the
value chain to maintain their existing margins.

Looking Ahead:

However certain sections of the economy have welcomed the rupee appreciation. This is because of the
following key reasons:

• Firstly, the IT industry which is strongly lobbying against the appreciation of the INR should realize
that its phenomenal growth during the last decade is partly because of INR depreciation too. INR
depreciated by almost 100% against the USD from a level of 25 in 1992 to 48 in 2003. Further,
Indian economy needs development of infrastructure which warrants huge investments. A big
chunk of the said investments must come from overseas. The host country's currency, viz., INR,
must appreciate to instill confidence into overseas investors.
• Secondly INR appreciation is welcomed by those companies with overseas borrowings. Significant
levels of foreign currency – denominated, especially USD-denominated loans generate forex gains
because of reduced interest payout occasioned by the rising INR. Companies like Ranbaxy and L&T
have been able to generate forex gains in the last quarter because they have substantial exposure
to ECBs.
• Thirdly, major Indian stock indices are able to scale new peaks because of recent appreciation in
the INR. It has been proved beyond any doubt that there is a very strong correlation between our
stock indices and the parity value of the rupee vis-à-vis major currencies like the USD. Analysts
point out that during the last year Sensex and INR exhibited a correlation of approximately 80% as
against the 30-40% exhibited in the last three years. FII's who have heavily invested in India are
reluctant to sell off mainly because of the appreciating INR.
• Lastly and most importantly, INR appreciation has helped control inflation.( It touches a 5 year low
at 3.32%)

Government standpoint:

The government is working on schemes to offset impact of appreciating rupee. The proposed scheme
refunding local taxes and levies to labour-intensive industries with little import content, to offset the
impact of the appreciating rupee, which was at a nine-year high. "The rupee appreciation is a cause of
concern for exporters and manufacturing firms. We are looking at framing a scheme for labour-intensive
industries with no or very little import content to refund the local taxes and levies," Minister of Commerce
and Industries Kamal Nath said on the sidelines of the 3rd India-GCC Industrial Forum. "The rupee rise is
a concern and the Ministry of Commerce is in discussions with the RBI... the rise is also connected with
international factors like fall in the dollar."

Conclusion:

It can be inferred that the issue of INR appreciation will play a major role if India has to become a
superpower nation by 2020. We have seen that as the Indian stock market is booming in the past few
months, the rupee is becoming stronger as compared to the US dollar. This implies as the abiding faith of
foreign investors in robustness of the Indian economy and the inflows are rising at exponential rates. But
the exports are taking a hit because of this phenomenon. This is the dilemma which the policy makers
have to address.

Though the strengthening of the rupee will benefit certain industries, others might face the brunt. But the
gain will be to the entire Indian economy. The basic foundation for any country to become an economic
superpower is to have a strong infrastructure. This need for huge investments, are being met through
FDIs & FIIs. Similar developments in other key areas would truly help India to reach the position of the 3rd
largest economy of the world behind US and China by 2035.

The Future of Foreign-currency Fluctuation

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 Global Services
impacted with this fluctuation, as they do not have a protective clause PREDICTIONS
in their contracts or strong currency-hedging strategies. However, To protect themselves
companies like TCS and HCL have been able to hold their guidance and against the vagaries of the
profit forecasts, due to active and clearly devised forecasts and hedging dollar, IT and BPO service
plans. providers will aggressively
look to Europe and Japan as
Going Forward markets
The rupee appreciation over the last year, has shaved off a large
The rising rupee will force Indian
portion of the operating margins of export-focused service companies.
service providers to set up shop
We expect the trend of the appreciating rupee to continue and this can outside India so as to provide low-
have a significant impact on the status of India remaining a low-cost cost service
destination for outsourcing. The appreciating rupee over the next few
years would have an impact on the strategies that firms adopt and the Multigeography sourcing will be
atttractive to customers. To
trade in services that happens within the country. There is an imminent
moderate the effect of currency
possibility of foreign companies shifting work to other emerging
fluctuation, they will source from
locations that are willing to provide low-cost labor and other cost various low-cost locations instead
advantages. of one.

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.

Lehman’ bankruptcy will hit Indian IT companies

The business community of India is busy in discussing the impact of finance giant Lehman Brothers’s
bankruptcy on Indian economy. Still business experts are analyzing the status of Indian finance market
after this biggest incident of bankruptcy in world history. I, as a software professional, trying to find out
its impact on Indian Software outsourcing market. According to latest news sites and channels, Lehman is
client of 14 Indian software companies. Actually Indian software giants are expecting better results in this
quarter but after this incident, IT firms are not expecting significant contracts in the banking, financial,
securities and insurance sectors. Lehman Brothers has around 550-700 crore rupees projects outsourced to
Indian IT firms. Now the companies whose major client is Lehman will have to face huge losses.

Also around 2500 Lehman employees in its Indian branch are likely to get pink slip by the end of this
month. Even in other IT majors, layoffs are taking place on large scale. The honeymoon of Indian software
companies is over as now they can’t manage a big free pool of software professionals, sitting idle. IT
companies margins have already been affected by the US slowdown and fluctuation in dollar prices as US
companies accounts for more than 60 per cent of their revenue. IT major like TCS, Wipro, Infosys,
Satyam etc. are worried with happenings on Wall Street. There is a old proverb the when a big tree falls, it
directly or indirectly affects all other surrounding tree and small plants. So Lehman is a big tree, it has
fallen and Indian IT firms are small plants surrounding this big tree. No doubt, they have to face the impact
and be ready for new challenges.

The challenges behind Indian Software Industry

Last week, I happened to visit rediff to read about top ten software companies of India. It nicely explained
the achievements of top ten software companies including TCS, Wipro and Infosys. There I got the idea
to discuss whether the Indian software industry is going in right direction or not. Let’s first see the data
and reports released by NASSCOM(National Association of Software and Services Companies). It has
forecast 21-24 % growth rate in software and services revenue in this financial year. Soon our software
exports will touch the magical figure of $50 billion. The software and services exports segment grew by 29
% to register revenues of $40.4 billion this year from $31.4 billion in last year.

So from statistics point of view, everything is fine for this industry. It will employ 4 million people in 2008
and account for 7% of gross domestic product and 33% of India’s foreign-exchange inflows, says the
Nasscom report. According to Forbes magazine “Jobs that are low value-added and easily automatable
should and will disappear over the next decade in Indian Software Industry.” When we compare our
industry with world business then we can easily see that we are still the world’s back office. India’s tech
industry is a “services” (poor) industry. The Indians don’t do the thinking. The foreign customers or clients
do, we Indians just execute.

The Indian software companies never take risk in launching new products. They are happy to just work
for their clients for some dollars. But if the US market will continue to behave in the same way i.e
appreciation of the rupee against the weakening dollar. India’s cost advantage will soon disappear. India
has not learned to invent technology products of its own so this industry will be in real trouble if there is
any scarcity of foreign offers. The top Indian companies have no plans to face this challenge. They are just
happy thousands of new employees every year. The golden goose of Indian software industry is still laying
large, warm eggs, enough to feed the 4 million Indians and their families, servants, chauffeurs and cooks.
What will happen after the death of this golden goose? Let’s wait and watch.

Rising rupee / Foreign exchange exposure of Indian IT companies due to appreciation

In the last few weeks, we have been hearing of the top Indian IT service export companies declaring their
Q1 results (remember the Indian financial year is from Apr 1st – Mar 31st) and almost all of them without
doubt have been hit by a rising rupee. I have written an earlier post on the same topic and it made for
interesting analysis back then – http://ecofin.wordpress.com/2007/05/10/currency-markets-is-the-indian-
rupee-really-appreciating/
I read in the papers today about some steps taken by some of these IT majors such as asking employees to
work on Saturdays to compensate for their exposure to the rupee appreciation! I am not so concerned about
the fact that they are asking their people to work on Saturdays but I am concerned about the fact that they
are trying to relate two different events (from an employee perspective in an employee driven
organization) to justify their need to make employees work on Saturdays to cover for their risk exposure to
the outside forex market. Is this justified – is what I am trying to analyze.
As a qualified student from India’s most prestigious institute in foreign trade, IIFT, New Delhi, I make
these comments.
First of all, before getting into slam-dunking anybody, let us examine the rationale and what are the
possible options for these IT bigwigs to limit their exposure to this Forex exposure and later, we will visit
the upper end of the supply chain impact and its ramifications.
The foreign exchange market is a trillion $ market and is the largest financial market of all –
http://en.wikipedia.org/wiki/Foreign_exchange_market
This market is 5% operated by Governments/banks/companies and 95% by speculators looking to make a
quick buck/profit depending on the currency fluctuations and is also very tightly regulated to minimize
arbitrage opportunities. Unlike stock market, here there are no brokers or intermediaries – the buyers and
sellers come together at an agreed price and this market also is the only market that runs 24 hours due to the
geographic distribution ex: different timezones.
It also has to be remembered that the world of currency market is a zero sum game – this means
somebody’s loss is somebody’s gain. A very interesting article on currency markets being treated as a zero
sum game (copyright vested with the author quoted on the document) can be found here –
http://ecofin.files.wordpress.com/2007/07/zerosumgame.pdf
The currencies of almost all countries fluctuate on a daily basis and this is not some rocket science
phenomenon. Why this becomes so important for Indian exporters (not necessarily only IT) is because the
invoice currency of most of these companies is in USD (US Dollars). This means, they bill their customers
in USD. Therefore, if they make exports worth 100$ and the value of the rupee on the forex market is say
Rs. 47 to a US Dollar, they stand to make Rs. 4700. However, if the value of the rupee appreciates vis-a-vis
the USD (like it is doing now), these very exports of good/services would fetch these export companies that
much lesser. ex: if the rupee appreciates or the USD declines to say 1$ = Rs. 40, then these export
companies would make only Rs. 4000 – this has a direct impact on their revenues and therefore, their
bottom line.
To prevent such oscillations in their net earnings companies follow a very simple concept of hedging (to
hedge their exports) using a number of financial instruments available to them such as Forward exchange
contracts, options etc.
On forward exchange contracts, exporters basically book their export orders at a pre-set dollar price (say 1$
= Rs. 46.30 or something) by buying a forward exchange contract. There are various types of this forward
exchange contracts also such as rollover forward exchange contract etc. but we will not get into their
intricacies here – the overall concept should suffice.
How does this work?
Forward exchange contracts need to be purchased at a predetermined levels. If the forward exchange price
is trading at below the spot price, then it is said to be at a discount while if it is trading at more than the spot
price, then the currency is said to be at a premium.
Forward exchange contracts have no major advantage to aid the company for favorable currency
movements (ex: INR depreciating against the USD in which case the exporters whose invoice currency is
in USD will stand to benefit because they get more INR for each USD) but they do eliminate the downside
risk because no matter what, the company can claim against that contractual price for the total exposure
thereby limiting the risk.
Accounting for this forward exchange contract has been discussed at this link:
www.icai.org/icairoot/publications/complimentary/cajournal_may05/may05p1547-49.pdf
Now, having understood what this market is all about, why hedging is required and how does this hedging
work, let us look into the forex exposure of Indian IT bellwethers and put some numbers to the analysis to
get an idea of their risk exposure and how they have tried to minimize the risk.
All data has been collated from respective annual reports of respective corporations. A source would have
been indicated too.
Infosys states (on its Annual report 2006 – 2007) that it has outstanding forward contracts of $ 170, 000,
000 as of March 31st 2007 when compared to $ 117, 000, 000 as of March 31st 2006. It has 2, 000, 000
Euro which was not there in 2006, and 5, 500, 000 British Pound Sterling as of the same March 31st 2007 –
again, this was not there in 2006.
Just goes to show the increase in the amount of forward contracts outstanding and this time, purchased over
a basket of currencies with who Infosys does a majority of their business with. My guess is they might even
purchase some forward contracts on the Japanese Yen with the increasing business they do in the APAC
region next year! This is pure speculation though.
Infosys also uses derivatives such as options (options contracts outstanding). Last year, they had put
options worth US $ 4, 000, 000 but not this year. Same with a Common strike ratio option they had last
year of US $ 8, 000, 000. However, this year, they have gone in for a range barrier option of US $ 206, 500,
000 this year as compared to last year’s US $ 210, 000, 000. They also have a Euro accelerator option of $
24, 000, 000 this year as compared to UD $ 3, 000, 000 last year. In addition to this, they have a target
redemption structure of GBP 16, 000, 000 this year as opposed to GBP 3, 000, 000 last year. Also, they
have a range barrier option of GBP 8, 250, 000 this year which they did not have last year.
All data indicated above has been taken from the Annual report of Infosys technologies (AR 2006 – 07)
available for a free download from their website at this link:
http://www.infosys.com/investor/reports/annual/Infosys-AR-07.pdf
What does this trend indicate? For one, it does show that the companies are limiting their exposure with the
number of forward contracts booked and the diversity in the types of options purchased to hedge their
exposure in currencies of regions where they tend to export.
Now, that we have looked at the level of exposure etc. and the outstanding forward contracts companies
have (one example given above), let us look at how these companies operate (their primary business
model).
Consultancy companies typically bill people on a per hour per billable person basis to a client. ex: if
Infosys has a billing rate of say (hypothetical) USD 100 per hour per person, then for 100 people working
on a project, this means they bill their customer (XYZ), USD 10000 per day.
If the exchange rate is 1 USD = Rs. 47, Infosys would’ve made Rs. 47 * 10000 = Rs 4, 70, 000 for that day.
Assuming, the foreign exchange rate fluctuates and now the rate stands at 1 USD = Rs. 40, Infosys earns
only Rs. 40 * 10000 = Rs. 4, 00, 000 (Rs. 70K lesser for every day).
Furthermore, onsite billing rates are much higher when compared to offshore rates.
Did these companies consider giving free time to their employees when the INR was depreciating? No.
But, now, they want to make the same employees work on Saturdays to offset this rupee rise. This is not
fair – in my opinion. No company has a control on the currency markets and they have to improve their
productivity if they have to withstand this challenge. How will increased producitivity offset this currency
rise – you might ask? The answer is simple: If the companies increase their utilization rates of employees,
producitivity is enhanced. How is utilization rate measured? Get more people off from the bench and onto
productive projects. As long as one is on ‘bench’, one is not billed. Get this number to as minimal a number
as possible. Improve supply chain efficiency by adhering to better forecasts of when to hire and when to
hold. Another is to increase # of workhours per week so people are utilized better but this has a split side
-would those increased hours be billable? If so, would it be okay with the client as the client has to pay for
the increased hours of service of employee of these firms per week.
Another way to improve utilization rate is to improve efficiency and eliminate redundancy. This is where
Toyota is so efficient in its capacity utilization while GM lags behind though GM has done better this year.
Capacity utilization is also to ensure that plants keep running are are utilized optimally while employee
utilization is where employees are most productive and are utilized efficiently.
Indian IT firms would need to go back to these basic micro economic concepts if they are to withstand the
INR appreciating onslought! The answer is not simply in increasing # of work hours per week – it has to be
said. They need to look elsewhere too.