The new UK Government, led by prime minister Liz Truss and chancellor Kwasi Kwarteng, held its first significant event on September 23. Labeled a mini-Budget, it was anything but.
The biggest changes to tax burdens in decades will have a major impact on individuals, through adjustments to both the basic and top tax rates, and on corporations, through the cancellation of planned tax increases to the corporation.
Kwarteng and the company hope that the plans will stimulate a continued increase in economic growth. There is reason to believe that potential measures such as relaxing transfer limits will alleviate some of the talent issues that have plagued the economy for a decade or more, and the elimination of planned An increase in corporate tax rates should result in increased investment by companies.
But the reaction of currency markets will cause pause for thought for British firms. The dollar has been strengthening against major currencies throughout 2022, but that has accelerated in light of the Quartet’s announcements. The pound also lost against the Euro and the Indian rupee.
This is important, especially for British companies hoping to sign outsourcing deals in the near future. At its heart, outsourcing is the importation of foreign labor. As the currency weakens, imports become more expensive.
However, modern outsourcing deals are more complex than a simple contract for labor. The deals are backed 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. Licensing of software from suppliers such as ServiceNow or Salesforce may also be required. Again, these companies report earnings in dollars.
This tilts the risk profile against the service provider. In stable times, their sophisticated financial modeling and global scale enabled them to accommodate changes in exchange rates. But sterling has fallen 20% against the dollar in the past 12 months and is now on the “precipice of parity”. A reversal is conceivable, perhaps likely, but it seems unlikely to expect a return to $1.35, as was the case in October 2021, at least in the short term. It’s natural to price that risk premium into deals.
It remains to be seen how providers will fully respond to this, but the UK managing director of a large service provider predicts that “unless providers can live with margin dilution, they will have to pass on higher costs to customers.”
“Furthermore, as cloud service providers charge in US dollars, many service providers are increasingly looking to sign on to dollar denominated deals,” they added.
This may be manageable for FTSE 100 companies, whose treasury functions are sophisticated and revenues diversified, but smaller, or more UK-focused companies with less mature model of global financing, may find it difficult to accept it.
Expanding on existing frameworks
Therefore, if clients find it difficult to accept price increases in new deals, what should they do? The best course of action may be to understand options to extend existing frameworks.
“More and more clients are good at exercising options to extend,” said the managing director. “The commercial risk for innovation is currently high.”
Often, extensions are pre-agreed upon contract signature, and will present a very different risk profile. Changing outsourcing deals can still yield savings of up to 30%, depending on the starting point, but currency markets erode some of these gains. The importance of carefully understanding the business case for innovation has never been higher.
The result of pressure on imports is an increasingly attractive export market. Unfortunately, there may be challenges on the horizon there, too. The possibility of deploying UK-based technology staff in foreign deals appears to be limited. The service provider’s managing director said: “The demand for local skills will be high in itself. I believe offshore labor arbitrage will disappear for certain types of niche roles, leading to a resurgence or need for local talent to serve the local market.”
Domestic labor will serve the local market, but not deep enough to meet global demand.
Truss and Kwarteng’s gambit is that “a rising tide lifts all boats”. And while this storm, too, shall pass, at least in the short term, British technology organizations may feel they are sailing in increasingly rough waters.
Anthony Drake is a director at tech advisory ISG.