The currency exchange rate is one of the well-known issues in outsourcing to China.  The Chinese government has traditionally kept the exchange rate for the yuan fairly constant relative to the U.S. dollar to facilitate the growth their economy.  We used to routinely estimate the price for engagements based on 8 RMB per dollar - a nice round number that allowed us to do quick arithmetic in our heads (and also gave us a bit of “cushion”).  This has been changing for some time (sorry, subscription required), but last week we reached a new benchmark.  The yuan traded below 7 RMB per U.S. dollar for the first time in nearly fifteen years.  According to the Wall Street Journal:

“SHANGHAI, China — China’s government allowed the country’s currency to rise to its highest level against the dollar in more than a decade, despite weakening global growth, an indication that Beijing views rising inflation as a bigger danger than the risk of an economic slowdown.

On Thursday [April 10, 2008], the U.S. dollar slid to less than seven yuan for the first time since the early 1990s, ending Shanghai trading at 6.9916 yuan, down from 7.0017 yuan in the previous session. The yuan has now gained more than 18% against the dollar in less than three years, although it has been flat or even depreciated against other major currencies, such as the euro.”

Both sides of outsourcing contracts in China need to be thinking about how much this will continue.  The WSJ article continues:

‘”It’s going to go a lot higher,” says Jim Rogers, a U.S. investor and self-described China bull. Mr. Rogers says the Chinese currency has the potential to strengthen to just two yuan to the U.S. dollar — a 2½-times rise from current levels — noting that the Japanese yen once made a similar rise from 500 to the dollar to 100 to the dollar, albeit over a number of years.’

I’m not sure that I can go as far as Mr. Rogers, although it would be a real challenge for China’s outsourcing industry if he turned out to be right.  The most well thought out guess that I’ve heard from colleagues in China is that the “fair” value is about 4 RMB/$, but that the government would likely stop a rise beyond 6 RMB/$, or thereabouts.

“Others aren’t quite as bullish. Another key measure of sentiment — a derivative product traded by banks around the world called the nondeliverable forward — values the dollar at 6.4 yuan one year from now, which would represent a further gain of 9.2% for China’s currency by this time in 2009. So far this year, the yuan has been rising faster than that, at a 15% annualized rate.”

Given the global nature of software outsourcing, U.S. focused Chinese vendors can’t simply crank their dollar denominated prices by 30% just to stay even.  Instead, they’ll need to learn to operate more efficiently, begin offering services that are worth more and aggressively expand their global delivery to include Europe, Latin America and, of course Asia.  This is exactly the same challenge faced by the Indian outsourcing vendors over the past several years.

Clients, especially those with long-term contracts, should evaluate the impact of the exchange rates on their vendors.  If they want to maintain productive partnerships with their vendors, they may need to renegotiate the contracted rates.  If clients force the vendors to take the entire exchange rate hit, they’ll quickly find that the vendors will adapt by quietly reducing costs and service levels will inevitably suffer.

Technorati Tags:  China, yuan, Currency, Exchange Rate, China Outsourcing