The new UK Government, headed by prime minister Liz Truss and chancellor Kwasi Kwarteng, held its first significant event on 23 September. Labelled as a mini-Budget, it was anything but.
The largest reshaping of tax burdens in decades will have a significant impact on individuals, through adjustments to both the basic and top rate of tax, and to corporations, through the cancellation of planned rises to corporation tax.
Kwarteng and company are hoping the plans will stimulate a sustained increase in economic growth. There is reason to believe that potential measures such as the relaxation of migration caps will mitigate some of the talent issues that have plagued the economy for a decade or more, and the elimination of planned rises to corporation tax rates should result in increased investment by firms.
But the reaction of the currency markets will cause pause for thought for British firms. The dollar has been strengthening against major currencies throughout 2022, but that accelerated in light of Kwarteng’s announcements. The pound also lost ground against the Euro and Indian rupee.
This matters, especially to British firms anticipating signing outsourcing deals in the near future. At its heart, outsourcing is the import of foreign labour. As the currency weakens, imports become comparatively more expensive.
Modern outsourcing deals are, however, significantly more complex than a simple contract for labour. Deals are underpinned by cloud suppliers, such as AWS, Google and Microsoft, all of which are headquartered in the US, meaning their terms with clients are dollar denominated. Perhaps software licensing is also required from suppliers such as ServiceNow or Salesforce. Again, these firms report revenues in dollars.
This tilts the risk profile against the service provider. During stable times, their refined financial modelling and global scale enabled them to accommodate fluctuations in exchange rates. But sterling has dropped by 20% against the dollar in the past 12 months and now sits on the “precipice of parity”. A reversal is conceivable, perhaps even likely, but it seems improbable to expect a return to $1.35, as it was in October 2021, at least in the short term. It’s only natural for that risk premium to be priced into deals.
How providers fully react to this is still to be determined, but the UK managing director of one large service provider forecasts that “unless providers can live with margin dilution, they will have to pass on higher costs to customers”.
“Moreover, as cloud service providers charge in US dollars, many service providers will increasingly look to sign in dollar denominated deals,” they added.
This may be manageable for FTSE 100 firms, whose treasury functions are sophisticated and revenues diverse, but smaller, or more UK-focused firms with less mature global financing models, may struggle to accommodate this.
Extending in existing frameworks
Therefore, if clients are struggling to accommodate price rises on new deals, what should they do? The best course of action may be to understand options to extend in existing frameworks.
“More and more clients will do well to exercise options to extend,” said the managing director. “Commercial risk for change is currently quite high.”
Oftentimes, extensions are pre-agreed at contract signature, and would reflect a very different risk profile. Transformation in outsourcing deals can still yield savings upwards of 30%, depending on the starting point, but the currency markets are eroding some of these gains. The importance of carefully understanding the business case for change has never been higher.
The corollary of the pressure on imports is an increasingly attractive export market. Unfortunately, there could be challenges on the horizon there, too. The possibility of deploying UK based technology personnel on foreign deals looks limited. The service provider managing director said: “Demand for local skills will be quite high in itself. I believe labour arbitrage to offshore will disappear for certain kinds of niche roles, leading to revival or demand for local talent to service the local market.”
Domestic labour will service the local market, but is not sufficiently deep to fulfil global demand.
Truss and Kwarteng’s gamble is that “a rising tide lifts all boats”. And while this storm, too, shall pass, at least in the short term, British technology organisations may feel they are sailing into increasingly choppy waters.
Anthony Drake is a director at tech advisory ISG.