Exchange Rates and the effect of Inflation

Thursday, May 3rd, 2012

I was asked very recently by a client how much saving they could expect from the renegotiation of an offer by their incumbent outsourced provider of specialist IT services to extend their contract. The Service Provider proposed a 10% increase. The Client was UK based and the Service provider domiciled in India.

However I needed more information. As you might expect many things went through my mind. Amongst other things these related to cost drivers; balance of power; contractual provisions; efficiency improvements; value and period of extension; exchange rates and inflation rates in the respective countries.

After I had responded, I thought the relationship between the latter two; exchange rates and inflation rates, warranted an article.

The warnings on any investment proposal-will state “the value of your investment can go down as well as up”. The same principle applies to a purchase in any currency.

 When you make a spot purchase, importing from a country with a different currency it is relatively easy to fix the cost and know how much it will be in your own currency.  Buy the same thing at a different time and the price may have risen or fallen.

This led me to consider the effect of inflation on exchange rates.

If we consider the last five years and you tried to guess which countries were relatively stable during this period from an inflation perspective you probably would not be surprised to find Japan or Switzerland amongst the most stable. In fact these were slightly deflationary with Japan approximately 1% lower over the period and Switzerland just less than 0.2% lower. This compares to the Eurozone and USA with 10% inflation and the UK at 18% over the same period. Unfortunately for Venezuela they come in at a whopping 300%.

But this does not take into account the exchange rate movement over the period.

 If we now look at the stable prices of Japan and adjust for the effect of the exchange rate, the trend has been negative for the importers from the USA, the Eurozone and UK.  If we take the worst case of a purchase made at the points in time when the exchange rates were at their highest and lowest during the five year period, the absolute inflation would be for Japanese based imports to:

Eurozone +72%

UK + 111%

USA + 62%

However, these are absolute figures and to calculate the real cost inflation you must factor in the importing nation’s inflation. This would reduce the increases to 56% (Eurozone), 79% (UK)and 46% (USA). Japan does not look so enticing now!

If your head is numb with these numbers then spare a thought for the buyer which has to factor in the volatility of commodity prices with the uncertainty of the future demand for long term contracts.

And what figure did I eventually tell the client that he might expect from the negotiation? Well sorry, that’s between us!

 Need any help with currency or inflation matters in your procurement please call me Ray Gambell on 01744 20698 or email me [email protected]