Appreciating Rupee & Indian IT Industry - The way forward



Appreciating Rupee & Indian IT Industry - The way forward?

Submitted by:

IIFT Kolkata

Blitzkrieg

Pankaj Kothiyal Gaurav Pant

pankaj_kd08@iift.ac.in gauravp_kd08@iift.ac.in

+91-9903004482 +91-9903143385

Abstract

The rupee has appreciated by 12.8% to the US dollar in the past 1 year. This appreciation is most likely to harm the Indian economy in the long run because most of this appreciation is not due to a trade surplus but on account to a large inflow of foreign exchange by the FIIs who are looking at a piece of the pie in an economy expanding by nine percent, the second fastest after China. This can reverse at any time, thereby, depreciating the rupee and causing massive inflation. Almost 80% of sales contracts signed by the Indian exporters are in the US dollar therefore the rupee appreciation is cutting deep into the pockets of the Indian exporters as the profit margins are thinning and pricing becoming an issue for the Indian exporters. The Indian exporters are losing their cost competitiveness because they are facing stiff competition from the Chinese, the Pakistanis, the Koreans and the Bangladeshis. The Chinese Yuan, the Pakistani rupee, the Korean won and the Bangladeshi taka have appreciated only by a meager 1% to 5% in the past one year. The Indian IT/ITES industry is facing the brunt of the rupee appreciation as almost two thirds of this industry derives its revenue in the US dollar. In the current scenario most of these companies would have their net profits before taxes reduced by almost 6% by the end of March 2008. For every small rise in the rupee vis-a vis the dollar the revenue of the IT companies descends by a few basis points. Analysts estimates that, every one per cent rise in the value of rupee vis-à-vis US$ can impact earnings before interest and tax of the software firms between 30 and 50 basis point. IT industry experts contend that the continued trend of the appreciating rupee for the last 7 months could potentially have an impact of 50 – 200 basis points (bps) on the companies ‘operating margins’. As a result, the rising rupee along with wage inflation and increased taxation concerns has started to show their impact on the Indian IT and BPO industry. During the last 7 months the rupee vis-à-vis US$ has appreciated by around 11 per cent. The RBI reference rate of the rupee to a dollar was Rs 44.82 on December 12, 2006, which have rose to Rs 39.32 on Oct 30, 2007. With the Fed cutting the interest rates there seems to be no reigns on the influx of foreign currency into the Indian economy. Even the SEBI’s attempt in not allowing the unregistered FIIs to issue PNs has not been able to arrest the flow of the foreign currency into the Indian economy thereby leading to a further appreciation of the rupee against the US dollar.

| Indian Rupees to 1 USD  |

| |

|[pic] |

| |

|[pic] |

| |

|120 days |

|latest (Oct 30) |

|39.3 |

|Lowest (Oct 9) |

|38.48 |

|highest (Aug 16) |

|41.15 |

| |

| |

| |

Weathering the Storm

Short term

Currency Hedging:

A break up of the revenues from the various regions for the major Indian IT majors is given below.

|Rev per Geographical |Infosys |TCS |Cognizant |HCL |Satyam |

|locations | | | | | |

|US |63% |52% |84% |58% |66% |

|Europe |27% |28% |14% |27% |18% |

|India |1% |9% |1% |7% |14% |

|Other |9% |11% |1% |8% |2% |

Source: neoIT estimates

The table shows that almost two thirds of the Indian companies derive their revenues from the US, however many of the contracts signed by these companies in other countries are also based on US dollar, further exposing the country to currency risk. Specifically Infosys and Satyam report that between 70%-75% of their contract values is US dollar based.

Profitably exposure to a 10% shift in Rupee-Dollar valuation

|Company |Profitably exposure |

|Cognizant |2.0% |

|Tata Consultancy Services |3.0% |

|HCL |3.5% |

|Satyam |3.5% |

|Infosys |4.5% |

|Wipro |4.5% |

Source: neoIT estimates

A short term strategy by the Indian companies could be currency hedging to protect themselves against a depreciating dollar. Indian IT companies are proactively hedging their currency exposures using forwards against any rupee appreciation. Infosys has bought forward cover worth US$1.4 billion, TCS has a similar cover to the tune of US$1.434 billion and Wipro has bought a forward cover to the tune of US$730 million as on September 30, 2007. However, with the quarterly revenues of these software giants hitting the one billion mark such hedging strategies would not be able to address the long term impacts of the rupee appreciation which is going to last.

RBI has come to the rescue of the Indian IT firms and exporters by giving them more headroom to hedge against currency risks. Besides allowing companies to cover their currency risks through a dynamic hedging mechanism, RBI, for the first time, has allowed corporates to write or sell currency options. Under the dynamic hedging the previous cap on the forward cover is given away with and on receiving an export order corporates can go ahead and hedge themselves against the receivables on producing the underlying supporting documents on the new order. Apart from the dynamic hedging the corporates have also been allowed to write options. This would allow corporates with considerable risk appetite to design trading strategies according to their call on the dollar movement.

Service level agreements

Switching to Euro based billing

Asking the client to switch from a dollar based billing to a euro based billing .Euro is a far more stable currency compared to the US dollar and could be used as a billing currency by the Indian Service providers. A look at the euro versus the Indian rupee rate shows that the euro has been appreciating in the past 90 days and could be effectively used as a billing currency.

Indian Rupees to 1 EUR

|[pic] |

|[pic] |

|120 days |latest (Oct 30) |lowest (Jun 12) |highest (Oct 18) |

| |56.6863 |53.9396 |56.7639 |

EURUS One Year Chart

[pic]

Source: msn money

➢ A revision in the billing rates by 3% to 5% is also currently pursued by the Indian Service providers to offset the rupee appreciation. Infosys is charging 1.9% higher to its clients compared to last year.

➢ Indexing prices to local salaries rather than fixed prices. Using local salaries would protect the service providers against both currency valuations and salary inflation.

➢ Pushing for managed services or result-based contracts where the service provider can manage the size of the team, offshore/onsite ratio, or team experience.

➢ Delaying the hiring of new staff until contracts are signed and in place, rather than anticipating demand, increasing the ramp up time for clients. New clients should include provisions for transition phase agreements.

➢ Leverage contract technicalities to reopen contract negotiations and then changing prices during the process. This type of “bait and switch” is not common among global service providers, but caveat emperors.

➢ Billing for overtime, holidays and vacations which could have been earlier overlooked.

➢ Enforcing payment on 30 days net rather than the current days sales outstanding of 60 days.

➢ Entering into agreements with the clients for sharing of costs incurred on account of exchange rate fluctuations. In case of any unfavorable movement by the currencies the losses incurred could be shared both by the client as well as the service provider.

Recruitment Strategies

|Salaries:              |Steady Average... |

|Experience |Less than 2 Years |2-5 Years |5-10 Years |Over 10  Years |

|Salary |% of employees |% of employees |% of employees |% of employees |

|  |2004 |2,005 |2004 |2005 |2004 |2005 |2004 |

|IT consultancy |4,784 |5,669 |6,775 |7,774 |9,109 |10,674 |17.4% |

|System Integration |34,011 |42,979 |51,900 |62,065 |72,960 |85,399 |20.2% |

|Application Development|13,997 |17,115 |19,852 |22,586 |25,113 |27,924 |14.8% |

|End-to-end outsourcing |6,328 |8,221 |10,247 |12,343 |14,344 |16,850 |21.6% |

|Discrete outsourcing |16,731 |21,055 |25,819 |31,401 |36,262 |41,509 |19.9% |

|Deploy and Support |23,631 |28,321 |32,907 |37,651 |42,510 |48,186 |15.3% |

|IT education and |4,126 |4,879 |5,609 |6,534 |7,260 |8,067 |14.3% |

|training | | | | | | | |

|Grand Total |103,606 |128,239 |1,53,109 |1,80,354 |2,07,559 |2,38,607 |18.2% |

Source: IDC, 2005

Exhibit 3

Comparison of the Vendor Addressed Market and the In-house Spend by Key Services (INR Million)

|Breakups |2004- vendor addressed |2004-inhouse team addressed|Total market |Vendor addressed market as % |

| |market |market | |of total market |

|IT consultancy |4,84 |11,163 |15,947 |30% |

|System Integration |34,011 |34,011 |63,022 |50% |

|Application Development |13,997 |20,995 |34,992 |40% |

|End-to-end outsourcing |6,328 |NA |6,328 |100% |

|Discrete outsourcing |16,731 |25,095 |41,827 |40% |

|Deploy and Support |23,631 |23,631 |47,262 |50% |

|IT education and training |4,126 |9,628 |13,751 |30% |

|Grand Total |103,606 |1,24,524 |2,28,132 |45% |

Source: IDC, 2005

Exhibit 4

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Exhibit 5

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Exhibit 6

[pic]Source: AT Kearney GSLI, 2007

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