Recently, a client posed the following question to me:
“The Ethiopian Birr has devalued recently and management wants to offer an across-the-board increase to our staff there. Can you offer any guidance?”
The first thing I asked my client was if she was referring to expats or local staff. She confirmed local staff, not expats. So, I told her if that’s the case, you might want to reconsider such a step. Why?
Cost of Labor vs. Cost of Living
Salaries are set by employers by referencing market data. Cost of labor is what matters most, and it’s influenced by basic economics. Think back to your Economics 101 class – supply and demand explains it. If there is a rich supply of talent for a position in the market, the cost of the talent is stable or might even drop. On the other hand, if there is a tight market for a job with special skills, for example, the price is driven higher.
How does cost of living come into play? It doesn’t really matter. Sure, companies might look at cost of living or inflation to decide for budgeting how much to move salaries. Many organizations rely on market movement instead. Oftentimes, these two figures are strongly correlated. Just as often, though, they’re not. The graph below shows the relationship between inflation and market movement for a few developing countries we studied in 2009. You can see the results are quite unpredictable.
What About Devaluation?
Devaluation occurs when movement in the global currency markets cause a local currency (such as the Birr) to be worth fewer Dollars, Pounds or Euros (examples of so-called “hard currency”). This impacts the country by raising the cost of imported goods, especially imported raw materials and luxury items. The average citizen, however, is affected less directly. They are paid in local currency and buy their goods and services in local currency. So why should the value of their local currency in dollars matter at all? Unless your employees are buying a lot of imported items, the immediate affect of a devaluation on their spending power is limited. Sure, there will be some price inflation too, but watch out.
Impact on Your Business
Suppose the business in Ethiopia is a subsidiary of a European-headquartered company in Switzerland. All of the business results are consolidated at headquarters in Swiss Francs (another hard currency). So the net profit from Ethiopia is going to be less as a result of the devaluation, unless steps are taken to protect the profit. There are only two ways to do this – higher revenues or lower costs.
Can the business raise prices in the same percentage as the devaluation? How will such an increase impact the volume of goods sold? Will consumers or other purchasers defer their purchases or reduce the amount they buy? If you introduce an across-the-board pay increase, costs will increase and this will, in turn, create even a bigger profit gap.
Best Advice – Move Slowly
Time and time again, when devaluations occur, smart employers manage their budgets carefully and look for ways to control spending, not increase it. Eventually, labor markets will be affected by the devaluation event, and the market data will reflect these changes. That is the time to make adjustments. When the Argentine peso devalued in the late 1990s, inflation was high, and salary increases were very small. After about three years, when the economy was well on the road to recovery, inflation was much lower, but market movement was high – salaries were playing “catch-up” in the market.
It’s really common sense. No business can afford increased costs during challenging economic times. A quick check of peer employers will reveal that those employers granting increases are granting small ones like in Argentina.
So the bottom line: Don’t watch the devaluation rates. Don’t watch the inflation rates. Think like your CFO who wants to protect profits and keep costs stable. Watch what is really happening in the market. One rate which you should watch is unemployment, since that is an indicator of labor supply in many cases. And like I said before, supply and demand explains the market behavior over time.
How have you managed periods of devaluation or other extreme economic events in your company? Please share your experience with us.
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