In global operations, every business encounters more risks than it does in local markets. Exchange rate fluctuation is one such risk in cross-border transactions. As localization projects involve transforming one language and message into another, they often involve payment in one country’s currency that will be converted into another country’s currency. What appears to be just a simple conversion may not catch the attention of many managers on the client side. Some believe that the numeric calculations are very easy, while others may find them too confusing.

Defining the Exchange Risk for the Localization Business

When a U.S. software company needs to localize its software into Japanese, it has several options. It can turn to an MLV (Multi-Language Vendor) in the U.S., to an MLV in Japan, or to an SLV (Single-Language Vendor) in Japan. There will be no exchange rate problem for the U.S. MLV if all localization work is done by staff located in the U.S., (e.g., by Japanese immigrants). However, in most cases, resources in Japan will be used at some point during the project. For example, native Japanese proofreaders will often be involved in the sign-off for language quality.

Whether it’s an MLV or SLV in Japan, the U.S. client always wants the best possible deal on the purchase. Hence, it will usually compare offers from several potential Japanese service providers to determine availability and quality, how long it takes to complete a project once an order has been placed, and of course, the price per unit along with the total price (including project management fees and other similar charges).

At this point in the process, a problem often emerges. The U.S. buyer usually prefers to pay for the services in US Dollars, but the Japanese service provider must pay its employees and other local expenses in Japanese Yen. One of the two parties to the transaction will be forced to deal in a foreign currency. Either the U.S. client will end up paying in Dollars, with the Japanese provider forced to convert the payment to Yen. Or, the U.S. client will convert the Dollars to Yen first and then pay the Japanese provider.

In general, payment terms are usually 30-day or 45-day. Since the project itself will also take a certain amount of time to complete, depending on its size, turnaround times can range anywhere from 3 days to 9 months. Hence, the period between the Purchase Order (PO) date and the actual receipt of payment can range from at least 1 month to several. At this point, the risk from exchange rate differentials comes into play, since rates are free to move up and down in response to changes in underlying economic conditions and the monetary policies of individual countries. Suffice it to say that exchange rates vary hourly! During the period of 2001-2005, the Yen/Dollar exchange rate was as high as 135 Yen to the Dollar (at the beginning of 2002) and as low as 103 at the beginning of 2005. Even during 2005, the Yen dropped from 103 to 119, depreciating almost 15.5%!

Table 1 shows the volatility of exchange rates of major currencies represented by ten major localization target languages and markets. An annual 5%~10% of fluctuation for exchange rates is common for these major currencies against the US Dollar.

To further illustrate the exchange risk, let’s suppose the PO value is US$ 1,000 for a project that is completed in January and paid for in March. During this period, assume that there are two fluctuations in exchange rates, from 1:110 (January) to 1:120 (March), and from 1:110 (January) to 1:100 (March). The results are shown in Table 2 below, with sample gains/losses from the exchange rate fluctuations for each party under different payment models. In either case, there will be extra money (∆) caused by the exchange rate float. In a two-party transaction, loss of one party equals a gain by the opposite party. And because exchange rates are always floating and fluctuating, this introduces uncertainty, i.e. risks, to both parties.

For multilingual localization projects, there are usually multiple vendors from different countries with different currencies involved. The situation will thus be much more complicated, as there will be fluctuations in all of the exchange rates involved, rather than only between two currencies. For example, if U.S. English software will be localized into French and German versions for these markets, then the Euro will also be involved, with a totally different fluctuation path than that of the Yen.

What to Do About the Risks?

Now that we have outlined the existing risks, we can turn our attention to the matter of what to do about them from the standpoint of budget planning. Achieving success in this area requires close cooperation among the Service Provider Manager, the Project Manager and the Finance Manager. In all cases, skillful management should allow the players to implement one of the following two strategies.

Eliminate Exchange Risk

If you want to avoid exchange risk entirely, then only do business with partners that are in the same money zone. As applied to the above example, this means that the U.S. software company should only issue localization POs to U.S.-based companies that bill in US Dollars (this probably means that the service providers will depend on in-house Japanese staff, or Japanese freelancers who live in the U.S., or even American staff who master Japanese as second language). In theory (and somewhat in reality), this is possible. However, as more native linguistic resources are located outside of a country, according to the law of supply and demand, the price of purchasing such services will generally turn out to be higher than outsourcing to places that enjoy a greater supply of resources. In exchange for eliminating exchange rate risk, the U.S. client in our example will generally pay higher prices for localization.

The Eurozone is another good example. For localization projects done anywhere within the 12 member nations (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain), there is no risk from exchange rate fluctuations.

Minimize Exchange Risks

Outsourcing is a common method to lower the cost of procuring localization services, especially for large-scale, multilingual localization projects. However, this method cannot avoid exchange risk. Of course, a U.S.-based client may give the PO to a U.S.-based MLV and pay it in US Dollars. This looks safe, but it really is not. This is because the U.S.-based MLV’s business model depends on leveraging resources located outside of the U.S. Exchange rate risk will exist in the transactions between the MLV and its foreign resources. And this, in turn, will affect the client indirectly as the exchange risk will pass from one stage to another in the supply chain – from end service provider to the end client.

To reduce the risk of exchange rate fluctuations, you can employ one or more of the following strategies:

1) Shorten the payment terms

Exchange rate risk is directly related to time: the longer the time before payment occurs, the greater the risk. When planning your project, especially if it is large-scale, set two or three payment milestones, and do not delay payment. This goes counter to conventional financial wisdom, which holds that the payment burden may be lowered if the payment can be postponed to a later time. However, it is just the opposite with exchange risk.

2) Diversify the payment currency

In order to moderate the possible loss or gain caused by payment in a single currency, different percentages can be distributed over multiple currencies agreed to by both sides. The simplest model is to pay half the amount due in each currency. This is more complicated for the Accounting Departments involved, but it will help to lessen the risk to some extent.

3) Include a price adjustment clause in the contract

Many large customers sign a master agreement with their service providers on a yearly basis, fixing the rates for the next 12 months. This practice is based on the assumption that exchange volatility will be small within a year. However, Table 1 above shows us an annual volatility of major currencies from as low as 1.4% to as high as 16.3%. Therefore, a suitable threshold needs to be clarified in advance to address the problem of extraordinary fluctuation, especially for larger localization projects.

Central banks, like the Federal Reserve in the U.S., always announce interest rate adjustments or other changes in their monetary policies without forewarning, which often results in “monetary shock.” Exchange rates are very sensitive to such shocks and will react immediately. For example, on July 21, 2005, the Chinese Central Bank announced the end to its pegging of its currency (RMB) with the US Dollar. They replaced it with a managed float, and the RMB appreciated 2% immediately – almost overnight.

Therefore, adding a clause into a master contract to fix an acceptable exchange volatility range in advance, and then adjusting prices when the limit is broken, will be fair and beneficial to both parties – neither can know what the future holds.

4) Hedging via the bank

The customer (as the payer) and the service provider (as the payee) can take advantage of banks to control their exchange risks through a practice called hedging. In general, if the service provider has a receivable due in a foreign currency at a future date, it can sell a futures contract for the same amount to fix its future income. There are multiple banking products (future, forward, option and swap) that will allow you to control and lock in exchange rates. However, this does require specialized knowledge and trading skills. For clients and service providers with large amounts of settlements in foreign currencies, professional banks should be consulted.

Conclusion

Localization is a business that encounters exchange risk, since multiple currencies are often involved and exchange rates vary constantly. This risk can translate into a loss of income for one party that equals a gain for the other party. As the transaction value increases, the importance of paying attention to exchange risk becomes more obvious and more important. Both clients and service providers can apply packages of countermeasures to avoid, reduce or control the risk efficiently. Achieving this will help stabilize the budget planning process and thus foster a long term win-win partnership for both parties involved.

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Jack Yang is the Strategy Analyst for Transco, based in Beijing, China. Holding a Master's degree in Economics, he is interested in localization market research and business planning. His experience covers production process, quality assurance and project management. You can reach Yang at Jack@Transco.cn.