The effect of exchange rates on out-sourcing

An outsource contracter which gets paid in U.S. dollars but pays employees in a local currency gets crunched when the U.S. dollar depreciates relative to that currency - and gets crunched again when the same exchange rate change means that energy and related inputs increase more rapidly in terms of that local currency than they do in the United States.

As you have probably noticed the U.S. dollar has recently moved down against other major currencies in near lock step with the upward frenzy in crude oil prices. Sometime in the future there will be PhD dissertations written about the strategic implications, causes, and international consequences of this, but for right now I only want to look at the impact on IT management strategies for American, Canadian, and European companies.

The big loser, of course, is China: they won't float the Yuan for political reasons, but enough of their contracts -and especially those for manufacturers directly controlled by the army- are pegged to dollars that it doesn't really matter. What does matter is that they pay for two thirds of their oil in U.S. dollars - and on that basis their real price of energy has almost doubled in the last year while currency devaluation has kept U.S. price increases to a minimum. The resulting squeeze between more or less stable revenues and increasing costs is likely to have long term social consequences we can only guess at - but one we know about right now is that the Chinese drive to take more IT out sourcing away from India and Latin America is crashing to a halt.

India isn't much better off as the Rupee can't track down fast enough against the dollar, relative energy costs are increasing, and increasing employee proficiency drives up labor costs already denominated in Rupees. Take those things all together and what you get is a powerful set of incentives driving many expatriates now working in the United States and Europe to head home.

Although I've never seen credible estimates of the percentage of U.S. IT outsourcing undertaken to side step U.S. legislation I assume it's relatively small - meaning that most U.S. IT out-sourcing goes through a two step process: somebody outsources IT work to a contractor, and that contractor places the work with a sub-contractor in Lahore or some other low wage environment.

What's happening now, however, is that the sub gets paid in depreciating U.S. dollars but pays for local staff and facilities in some rapidly appreciating local currency - and that's a cash crunch in the making.

One way to look at this is the obvious one: if this keeps up, their problems will soon be your problems; or, more positively: their problems, if this keeps up, soon be your opportunities.

But will it continue? I haven't a clue - the world's awash in oil with locked in production and tankers sitting idle even while the price goes up -and that's very different from what happened in 1972 and 1985, when there really were production bottlenecks and it took massive U.S. dollar inflation to balance the numbers.

Basically if you believe in rational markets you should be predicting $45 oil - and if you believe in the madness of crowds, well, the sky's the limit. Either way, however, the bottom line for Americans is simple: if your out-sourced IT services have been off-shored, it's past time to take a close look at your contract and re-evaluate the security and value you get from insisting that your needs be met by American workers.

And if you're not American? Take a look at how your government is handling the American action and then decide - because out source contractors with big off shore installations are at risk, and that risk is ultimately yours too.