Monday, September 26, 2011

Inflation Indices

At some point in every procurement person’s career you will encounter a period of higher than normal inflation. If you are really unlucky you can encounter one with hyper-inflation. I had that experience as I needed to contract to construct a plant in Brazil during a period of hyper-inflation. What is hyper-inflation? In Brazil at the time he inflation rate was three percent per day, ninety percent (90%) per month or something like thirty thousand three hundred seventy seven percent (30,377%) per year. While it would have been much easier to pay in dollars that didn’t have the inflation rate, the law in Brazil required that
all contracts in Brazil had to be paid for in Brazilian currency, which at the time was Cruzados. This meant that virtually every purchase that didn’t have immediate delivery and immediate payment and every contract that had an extended performance period needed to include an inflation index.

The first decision that I needed to make was which inflation index should I use? The government published an inflation index that many believed understated the level of inflation. The banks published their own inflation index that many people considered to be more accurate. Contractor’s groups published their own inflation index that our financial people in Brazil though overstated the inflation. Working with our financial people we decided to go with a blend of all three where the inclusion of the government index would offset the contractor published index that we thought overstated the inflation.

Establishing the index was the easy part. The more difficult part was when it came to invoices and payments. Invoices were based upon the original contracted price for the work that had been performed. Those invoices then needed to be adjusted based upon the inflation that had occurred from the original contract date to the date of the invoices being submitted. Payments needed to be immediate so they weren’t also subject to inflation. This meant that an item that had an original contract value of CZ100,000 the invoice after 30 days required a payment of CZ190,000, It it was paid after 2 months it would be CZ361,000. After three months it would have been CZ685,000. Each additional period was increased by the compounding effect of the inflation. The amount of administration that was require to calculate the payments was significant as the further out in the contract you went the more the amounts needed to be compounded and every month could have a different rate based upon the average of the indices. Toward the end of the work each monthly payment was more than the original contracted price.

For every change that changed the contract price those changes weren’t calculated from the original date of the contract, they were calculated based upon the date that the cost of the change was agreed and then payments for those changes were subject to the inflation index from that point until payment. This meant that you had to not keep track the inflation that occurred for each change.

My biggest concern in the process was not the inflation itself but that the payments were being correctly calculated. The reason why I wasn’t concerned was my budget was in U.S. dollars and when we needed to purchase Brazilian currency to make payments, the inflation also affected the currency exchange rate so as inflation went up, the amount of Brazilian currency that we purchased with the dollar increased at the same rate as the government published inflation rate.

If you ever need to enter into an agreement where an inflation index is required there are two things I would suggest. One is work with your financial or treasury people to help determine what rate or blend of rates you should use. Make sure that you have people that can help you with the calculation of what should be paid.

From a contracts perspective the changes you need to make to a contract for inflation is first to establish the agreed indices. You need to establish the administrative requirements for invoicing. You may need to negotiate a different payment term, especially if the inflation rate will be high. Other things like determining what the value of the work would be for making milestone or progress payments should be no different. You do need to be concerned about the supplier wanting to front end load the payments. Whether you agree to do advance payments on certain items to avoid inflation would always need to be weighed against the risks inherent with advance payments ..