The Rise of Rupee - Part 2 - Impact on IT

Part 1 focussed on why the Rupee is appreciating against dollar. As an individual, if I convert $1, I get 40 Rupees instead of 46 Rupees - a loss of 6 Rupees for every dollar. How does the IT industry, having made billions worth of IT contracts, manage this loss?

USA is the #1 client for the top Indian IT companies. With major chunk of software exports going to USA, the Indian IT industry has a huge profit margin when the Rupee is low. Most of the outsourcing contracts for 2007 were based on weak Rupee forecast. Now that the Rupee has appreciated, the quarterly results of many companies didn't look good.

• Revenue growth of Infy and TCS has declined by 20%. In 2007, the increase in revenue is 25% compared to 45% increase in 2006
• Wipro has slowest profit growth in two years
• Satyam profit dips 3.8% as compared to the last quarter
• MindTree Q1 net profit dips 16%
• Polaris Q1 net falls to Rs 14.42 crores

During the June 2007 quarter, the top four software services companies have posted the slowest Year to Year growth in five quarters (28.73 %). To maintain the profit margins, IT companies have come up with few options:

1. Hike billing rates

TCS and Infosys have managed to increase their billing rates by 4-5 per cent. Wipro's onsite and off-shore billing rates have grown by 1-2 per cent. In Satyam's case, the number of clients billing more than $5 million increased to 65 from 57.
http://ia.rediff.com/money/2007/jul/23it1.htm

2. Shift operations to "other" cost-effective locations

IT and BPO companies will have to minimize their operational costs to maintain their profit margins.Else risk the threat from other emerging countries like Philippines and Eastern Europe.
http://www.crmbuyer.com/story/58258.html

Infosys Acquires $250-Million Business From Philips For $28 Million. As part of the deal, Infosys will acquire three captive BPO centres of Philips at Chennai, Lodz in Polland, and Bangkok, which employ about 1,400 people.
http://www.livemint.com/2007/07/26003557/Infosys-buys-250-million-reve.html

Or buy Cap Gemini in Europe
http://www.vccircle.com/blog/_archives/2007/7/20/3106055.html

The big 5 US consulting companies have already setup shops in different "cost-effective" locations worldwide. Indian IT companies now have to look elsewhere to keep the profit margins. Better late than never. They will not loose outsourcing deals from the West, provided Rupee stays close to 40. They still get a large number of deals to keep the revenue growing.

The real picture will emerge when the US companies realize India is not the #1 cost-effective offshore/outsourcing destination. By 2010 or sooner, a dollar is expected to fetch only 35 Rupees, if not 30.
http://www.prlog.org/10014884-the-rupee-is-becoming-strong-currency.html

The Rise of Rupee

The entire continent, err...Asia-focused media and bloggers have gone bonkers/bananas over the appreciation of the Indian currency, Rupee (INR). Rupee has appreciated (a lot) against dollar while it has remained quite stable against Euro or Pound. I remember exchange rates of 1$ = 47/48 INR, about 4 years ago. Now the exchange rate is 40 INR for every dollar.

Between January and July 2007, Rupee has risen nearly 10%. Analysts say this is the highest appreciation for Rupee in nearly three decades.

I wasn't paying much attention until my cousin went out of business (almost!) due to the rise in rupee. Also, I should admit that economics is not my cup of tea. Then I thought "let me try to understand this stuff to get a big picture" and asked him to explain. Allow me to walk you through the world of economics (arrghhhh!)

My cousin's company manufactures precision machines and tools for automobile and textile industry. His significant earnings and profit comes from exporting those machines to USA and few European countries.

1. Let's assume he sells one unit for 920 INR (20$) when Rupee is traded at 46 INR/dollar. This includes export taxes, shipping cost, etc. For the buyer in USA/Europe, 20$/unit is a great purchase for a product that meets all the required standards. Usually millions of units are traded. Assuming one million units, the trade costs $20 million. With the appreciation in Rupee, the manufacturer can no longer sell at $20.

Why? Appreciating Rupee in India means the cost of living is going up, increased salaries and wages, taxes, etc.

2. To maintain his profit margin, the manufacturer has to increase his selling price. This puts him at the risk of loosing the export contract. Let's say, both parties agree for fair price of 1000 INR (least possible selling price).

At 1$ = 40 INR, for the buyer, this would end up in paying 25$/unit, resulting in a $25 million trade. A whopping increase of $5 million! My cousin almost lost the contract.

What happened in the last few years? Or months? Demand and Supply happened!

Forex

This is the spot where Foreign Exchange ("forex") comes into play. Developed and developing nations trade currencies in Forex market. They don't trade loads of physical currencies from one country to another but use electronic balances. Here is one topic to research how money is traded, in millions, in cyberspace. Anyway, Economics is all about supply and demand.

"According to the law of supply, as prices rise for a given item (in this case money), the quantity of the item that is supplied will increase; conversely, as the price falls, the quantity provided will fall. The law of demand states that as the price for an item rises, the quantity demanded will fall. As the price for an item falls, the quantity demanded will rise. It is the interaction of these basic forces that results in the movement of currency prices in the forex market."

What??? Let’s explain this using an example.

USA is the primary market for exports amounting to $22 billion. This includes software, textiles, goods, etc. Even with a weak rupee (that is 46 INR/dollar), Indian investors were willing to pay more to invest in US. This also helped exports because US could pay less to get more. There was more demand in US (dollar) and India met its supply. The Reserve Bank of India (RBI), who regulates forex, kept buying dollars. In 2006, foreign investments brought in $8 billion in stocks.

But the US economy stayed the same and dollar started slipping. Meanwhile, investors found India to be the next big thing and started pouring in dollars. The economy kept on climbing which brought a lot of foreign investment.

Just in the first 6 months of 2007, foreign investors bought $7.5 billion in stocks! RBI had to spend more and more just to keep the Rupee stable at 46/45/44 INR. Then they realized they don't need to buy dollars anymore because they are getting what they want from foreign investors. The demand is now in India! The inflation was over 6% in January 2007. So they stopped buying dollars. They didn't want to pay more. They could pay less now to get the same amount in dollars.

Slowly, the exchange rate was reduced. Rupee started rising and the inflation dropped to almost 4% in July. The RBI has said that the rupee will continue to find its true value based on pure market dynamics. The bank has officially declined to comment on any intervention to curb the rupee surge, but traders said that in recent weeks the RBI is widely believed to have bought dollars to prevent the rupee from rising beyond 40.30 levels.

For a detailed look at how forex works and what it means to you, please read this lengthy article.
Or you could read my post again :D

How does this affect me or IT? That will the subject of my next post.

Update:

For expert analysis of this issue, I recommend you to read this article in Time magazine
and views from The Economist