Stable Currencies Trigger Key Question: Time to Put Contracts into Local Currency?

Outsourcers investing in Latin America have benefited from favorable exchange rates, meaning that everything from labor to real estate has come at a significant discount when compared to the United States or Europe.  But now low yields in mature economies have resulted in capital flowing into Latin America looking for a better return. Result: Strengthening currencies that are putting a crimp on exports.

“Stimulatory policies, particularly in the United States, and the search for higher returns are leading to capital inflows in Latin America,” says Kenneth P. Jameson, an economics professor at the University of Utah with a specific interest in Latin American currency structures. “The size of the currency flows means that they could still have large effects on Latin American exchange rates.”

For outsourcers, getting a handle on long-term trends for specific markets is a must. Nearshore Americas reached out to Consensus Economics Inc., which surveys major banks worldwide. The results for Latin America, with some important exceptions, revealed a stable currency environment for the medium term. In other words, this may be the new normal, though global and domestic policies are in play that could ease some of the pain.

“The move in Europe to put financial transaction taxes into effect in 11 countries is positive,” says Jameson. “If it is widely adopted it could dampen the magnitude of speculative flows and reinforce what a number of the countries are trying to do on their own.”

What those countries are doing is buying dollars. Consensus Economics reports that Chile’s reserves are expected to hit $42.9 billion in 2013, with Colombia’s set to approach US$40, and Mexico – which has taken a hands-off approach – climbing to $175.7. Brazil is in line to record a whopping $392.1 in reserves. If necessary, these economieswill continue to buy dollars to take the pressure off, while also being well positioned to counter-attack to stabilize their currencies in times of crisis. Like Brazil, they can also afford a slow “walk-down” in which the currency weakens to give exporters a break.

Other jurisdictions, however, may have more difficulty.

“For the smaller economies, it all depends on how successful they are in tapping into international trade and capital flows,” says Jameson, adding that “Mexico’s unwillingness to intervene is probably the anomaly.”

Stability then becomes an outsourcer’s friend. Wim Elfrink, Executive Vice President, Industry Solutions & Chief Globalization Officer at Cisco Systems, has argued for years that if an outsourcer is exclusively leveraging labor arbitrage, then they are not building value. In this context, a stable currency environment becomes a blessing, with incremental investment in efficiencies driving long term value.

Building a Currency Strategy

Other than in the example of Venezuela and perhaps Argentina, the larger Latin American countries are now well positioned to pick-and-choose their response.

“For the most part, Latin American countries have become more pragmatic rather than adopting some orthodoxy such as the hard peg or float of the late 1990s,” says Jameson. “The key change has been a more stable macro policy that has insulated them from capital flight and attacks on their currencies.”

To address the issue outsourcers can practice “banding”, in which they carry the currency risk themselves within an agreed upon exchange band – not a bad idea, but it requires agreements for tracking and monitoring. They can peg their SLAs to the US dollar or Euro, which secures margins and service viability. They can hedge – although an outsourcer may pay a premium against a trend that is already hurting them. They could pay in dollars based on a local currency average, a complex approach that does little to hedge against wild fluctuations. Or they could switch long-term SLAs into local currencies, a reasonable move in larger economies, but something that might require client education.

Then there is the option of regional currency plays, which involve deliberate, low risk moves of niche capabilities into areas with favorable exchange rates. Venezuela might represent too much political risk for some – the currency has suffered a series of devaluations under a pegged system since 2003, and the country’s foreign reserves are low – but a country like Argentina has long-term viability combined with a nationalistic, somewhat interventionist administration.Consequently, foreign capital doesn’t like it, its currency remains weak, and along with Venezuela it is becoming something of a pariah.

“I think the difficulties Argentina and Venezuela are having with their strong interventions will reinforces the pragmatic stance,” says Jameson. “It will put limits on how far there will be intervention, while at the same time reinforcing the idea that you need to manage the exchange rate within limits.”

Argentina’s foreign reserves are holding steady at about $40 billion. The peso, now at just under 5 to the dollar, is expected to weaken to 6 to by 2014. That might seem like a good bet, except that Consensus Economics says that “the true inflation rate is thought to be double the official reading of 10.6%”.

The big takeaway is that the bigger economies are not going to experience over-heating currencies in the medium term – in fact, their currencies will stabilize, then weaken slightly, according to data from the Foreign Exchange Consensus Forecasts. The Mexican peso was at 12.99 in 2012; in 2018 it is expected to be at 13.06, a miniscule weakening of .07 a peso. The Brazilian real was at 2.05 in 2102; in 2018 Consensus Economics has it weakening to 2.09. But for Argentina, the peso will weaken from 4.9 to the dollar in 2012 to 7.35 to the dollar in 2018.

Which is to say: a strategy that works today, will likely work tomorrow. And, given the stable outlook, putting contracts in local currencies almost certainly does not expose an outsourcer to runaway strengthening.