Heavy inflows of cash from abroad and an accelerating economy are pushing the Indian rupee to its highest levels against the dollar in about four years. If the dollar doesn't rebound vs. the rupee, or if revenue doesn't increase more than expected, currency trends could hurt the red-hot offshore outsourcing sector.

"Our fiscal 2005 estimates for leading Indian outsourcing firms could be at risk for a 5% to 10% reduction," said analyst Ashish Thadhani of Brean Murray Research.

Because personnel and other expenses paid in rupees make up a different proportion of revenue for the leading outsourcing vendors, the potential hits vary from a too-strong local currency. Cognizant ( CTSH), for example, has an exposure to the rupee of just 20% to 25%, while Infosys' ( INFY) exposure ranges from 30% to 40%.

As a rule of thumb, Thadhani said, a 1% appreciation of the rupee could adversely impact net profit margin of leading firms by 20 to 50 basis points. (Brean Murray does not have a banking relationship with the companies mentioned in this story.)

Costs and margins are especially critical in outsourcing. After all, low costs are why so many American companies have moved call centers and other operations to India.

For example, workers at a call center in Kansas City, a relatively low-cost area by U.S. standards, are paid about $10 an hour. Similar work in Mumbai (formerly Bombay) pays $1.50 an hour. That advantage has cost the U.S. thousands of jobs and ignited a political firestorm that will likely affect the national election.

Any fallout from the strong rupee probably won't show up in first-quarter results. It's likely that the outsourcing companies hedged against the weakening dollar during the first three months of the year.

But that strategy won't continue to work if the trend continues. "If it keeps up, you don't find anyone on the other side" betting on a weaker rupee, said Howard Simons, president of Rosewood Trading and a contributor to RealMoney.com.

Could the outsourcers pass on higher costs related to currency moves? Not likely, said Thadhani. Because currency effects are uncontrollable, few (if any) outsourcing contracts have clauses permitting adjustments.

Paradoxically, the same flow of cash that is putting pressure on margins has also buoyed share prices in India, and that in turn raises prices of the American Depository Receipts, or ADRs, of leading Indian firms. Indian companies traded in the U.S. typically follow the Indian market, but with a heavy premium.

On Thursday, following a strong day in the Indian market, Infosys gained $2.23, or 2.8%, to close at $84.06, while Cognizant gained 93 cents, or 2.1%, to $46.18. Among other big Indian outsourcers, Satyam Computer ( SAY) gained 98 cents, or 4.8%, to $21.50 while Witpro ( WIT) rose 46 cents, or 1.1%, to $42.60.

India's strong growth has also contributed to the soaring rupee. In the last quarter of 2003, the economy soared by 10.4%, after growing 8.4% in the previous quarter. Given continued growth, said Simons, the current level of the rupee -- it rose 1% Thursday to 43.4 to the dollar -- isn't unreasonable.

Not all of the handful of analysts following the Indian outsourcing companies are in agreement about the seriousness of the currency swing. "Much of the appreciation has happened in just a few weeks. That's not enough evidence to project that it will keep appreciating," said Sameer Nadkarni of WR Hambrecht.

Moreover, a revenue of increase of about 2.5% would make up for the extra costs caused by the dollar's depreciation, and "that's very possible given growth rates," he said. (Hambrecht does not have a banking relationship with the companies mentioned in this story.)

The effect of the rising rupee is, of course, exactly the opposite effect U.S. firms have grown accustomed to amid the dollar's persistent weakness vs. most major currencies.

Vadim Zlotnikov, chief investment strategist of Sanford Bernstein, estimates that "the weaker dollar contributed an estimated 2% to 3% of the 8% corporate sales growth last year" and an even greater percentage of the profit growth. "Many of the technology, health care products, and commodities companies derived as much as 70% of the revenue growth from currency, and benefited from higher incremental margins and lower taxes on international sales," he wrote in a report to clients.

It was probably inevitable that the outsourcing providers would eventually run afoul of world currency markets. South Asia, long under the economic heel of the West, became a source of cheap labor. But as the Indian economy strengthens, and the rupee inevitably appreciates, India is faced with losing at least some of its initial competitive advantage.

Is outsourcing on the way out? Hardly. But the spike in the rupee and the consequent difficulties for the outsourcers should serve as a warning to those who've tried to profit from the trend: In an increasingly complex and interrelated world, sometimes even the winners can lose.

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