Emerging Markets Insights

Original article appeared in the Financial Times on February 21, 2012

A friend recently joked over dinner that it is cheaper now to get your shoes shined by a Brazilian in New York than by a Brazilian in São Paulo.

This week, a quick check showed the claim to be true – the price of a shoe shine in central São Paulo was R$10 (about $6) before a tip while one from a Brazilian shoe shiner working the New York office market was $5 including tip.

You might say that serves people right in the first place for getting others to shine their shoes, but that is an argument for another column. The fact is the shoeshine test is just another indicator of the remarkably high cost of business in Brazil.

For managers of multinationals in the booming economy, particularly those arriving fresh off the boat with a spreadsheet full of profit targets copied and pasted from the business plans of their peers in India and China, the country’s high-cost base is the first thing that will hit them. Whether it is that credit-card bill after a night out in Rio de Janeiro or the first hard look at the company wage bill in the office, the new manager will soon have to confront what is called Custo Brasil – the Brazil cost.

This is the conundrum businesses face: Brazil is a high-growth market in terms of opportunities for revenue expansion but it is on average a low-margin market in terms of profitability, particularly for companies in the start-up phase.

The new chief executive will quickly realise that his or her success or failure in Brazil will depend on managing the expectations of the company’s overseas bosses. The trick is to persuade them to invest in the country’s growth while also counselling patience when they demand to know why margin growth is not, at least initially, matching that of other emerging markets.

The conundrum was captured in a survey by Frontier Strategy Group, an business advisory company with a focus on emerging markets, which quoted an unnamed client with a consumer goods business as saying: “I know that Brazil is key to our long-term growth strategy, but my biggest challenge is that for every additional percentage point of growth that we see from Brazil, our overall regional profitability declines.”

Frontier Strategy estimates that the average net margin in Latin America is 10.5 per cent, or nearly a third of gross margins. In Brazil, net margins are 5.4 per cent, or nearly one-seventh of gross margin.

Manufacturers are generally worst hit by the Custo Brasil. A startling illustration of this is the Volkswagen Fox, a Brazilian-made car that has a starting price of more than R$32,000 ($18,660) but sells in the UK at just under £7,000 ($11,100).

The Brazil cost is also reflected in the country’s number 126 ranking out of 183 in the World Bank’s Doing Business report. Frontier Strategy details how it costs double a person’s salary to hire someone in Brazil because of taxes and welfare payments. Meanwhile, it takes 120 days to open a new business in Brazil compared with the OECD average of just under two weeks. So does all this mean that no one is making money in Brazil? No, it is just that the barriers to entry are higher. Companies must clearly identify those costs that are associated with Brazil and benchmark themselves against their peers to see whether their costs are in line with industry averages.

The next step is to develop a strategy that minimises the Custo Brasil – for instance, by identifying the fastest-growing regional markets within the country that have the best infrastructure. Or by finding a balance between targeting the wealthier but more mature south-east and the faster-growing but under-developed north-east.

Companies can also try to make the Custo Brasil work for them. The government is erecting barriers against imports but foreign companies that set up plants locally – such as in the automotive sector – usually enjoy the same protections as Brazilian ones.

Most important is that headquarters understands the equation that, at least in the early years, top-line growth in Brazil will not necessarily mean equivalent expansion of the bottom line.

Ask the shoeshine men. It is a safe bet that even though the São Paulo shoe shiner is earning more per shine, the cost of his brushes and polishing creams are a lot higher than for his brother in New York.

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The following is an excerpt from a recent entry in the Silicon Hutong blog by Frontier Strategy Group expert adviser David Wolf.

You could argue that this story [Apple in China] and the reception it is getting is a function, in part, of the end of the Steve Jobs Reality Distortion Field, or, as I overheard someone say the other day in reference to Apple, “the King is Dead, the Gloves are Off.” That may be true, in part, but I think that this story is the harbinger of a wider issue plaguing the global manufacturing sector, and the challenges Apple is facing with its suppliers are simply the most visible examples.

The problem goes deeper than the conflict implicit in asking a supplier to give you the best price AND to manage its business in a way that increases its costs. The matter of working conditions is part of a bigger question about the value and importance of control over the means of production. (Don’t worry, I’m not about to go off on a Marxist tangent here. Bear with me.)

I started my career managing the output of 30-odd factories and suppliers in greater China making furniture, jewelry boxes, and small gift items for a medium-sized US importer. I learned a hell of a lot from that job, but the lesson that has stuck with me throughout my career is that you cannot change what you cannot control. We like to think that a customer like Apple would, by virtue of the size of its business, be able to strong arm its suppliers into complying with its codes of behavior, or even “incentivize” a supplier to go along by raising prices. In reality, it is nowhere near that easy. Any customer, even one the size of Apple, exerts influence over how a supplier is run, but not control. A customer can exact some concessions from a supplier on factors outside of product features and quality, but at some point, any self-respecting factory owner is going to push back and say “you may buy from me, you may be my biggest customer, but you don’t own me. I’ll give in to you on some things, but beyond that, you need to let me run my own business.”

The original post is called, “The Beginning of the End of Outsourcing”

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FSG View: Stimulus efforts are beginning to take effect, but Brazil is not out of the woods yet as industrial output continues to stall

Market Trends

The two-speed economy continues to develop in Brazil with unemployment sinking to a record-low 4.7% in December. Tight labor markets and real wage hikes are helping to fuel consumer spending while industrial output and manufacturing continue to lag.

Current stimulus measures, coupled with an increase in public spending and lending by the BNDES, should keep the Brazilian economy out of recession in 2012, but will likely be less effective than in 2009 as consumer expectations and business confidence are not as anchored as they were during the previous crisis.

Key Developments

Government efforts to jumpstart the economy by loosening consumer credit are bearing fruit as recent data released by the central bank show that seasonally adjusted economic activity rose 1.15 percent in November from October. Retail sales rose 1.3% over the same period, the fastest pace in 15 months.

Labor costs are expected to rise even further as the government enacts new regulations requiring companies to pay overtime rates for after-hours work calls or emails. While this measure is unlikely to affect compensation for senior managers, FSG expects companies to see an uptick in overtime pay at the analyst and junior management level.

The government announced that the manufacturers of certain tablet computers will qualify for a series of tax incentives, clearing the way for Foxconn to begin producing Apple iPads in Brazil.

The fact that Foxconn required preferential tax treatment to make iPad production profitable is illustrative of the type of cost challenges faced by multinationals looking to produce in Brazil.

Looking Ahead

FSG will be monitoring consumer prices in Brazil to see if the central bank can manage to bring inflation down while continuing to aggressively slash interest rates

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On January 1, the Nigerian government removed the long-standing subsidy on fuel, increasing prices from 65 to 150 naira per liter. Following local protests and negotiations, President Jonathan reduced the increase to 97 naira per liter, a 50% increase

While some view this as a clever strategic move, the haphazard implementation (including using the military to quell protests) has called into question the government’s ability to implement other much-needed reforms

Drivers

Reduced Political Capital: The new president’s “honeymoon” has officially ended. The president can no longer count on broad-based political support, and has recently been stymied by state governors, unions, state legislators, and religious leaders

Poverty and Inequality: A perception that reforms favor elites and businesses will continue to plague the president. Critically important will be future implementation of the president’s “jobs agenda” for generating employment, especially among youth

Fighting Corruption: Recent anti-corruption moves, such as dismissing state governors, are largely symbolic and the president’s policies must succeed where others have failed

FSG View

The fuel subsidy removal is unlikely to be repealed. Higher local fuel prices and reduced consumer discretionary spending should be priced into operating budgets immediately

The next three months will be critical to bolstering government credibility and preparing for upcoming economic improvements

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Turkey had a strong 2011, with GDP growth exceeding 8% for the year. However, we expect a noticeable slowdown in 2012 to 1.7% YoY. The main drivers of the slowdown are weakening industrial production as eurozone demand for Turkish exports slows, tightening credit conditions in the eurozone, and rising inflation in Turkey. These factors will come together to put downward pressure both on business and consumer demand and will affect multinational companies across a wide variety of sectors.

However, Turkey has consistently surprised on the upside over the past several months, and a very gradual slowdown of the economy in 2012 is becoming increasingly likely. What is more, as the Turkish lira remains relatively weak, the exchange rate will favor companies exporting from Turkey and will partly offset the declin in export demand from the eurozone. We expect Turkish growth to accelerate once again in 2013 as the effect of the eurozone crisis wears off and Turkey’s current account deficit narrows, improving market confidence in the country’s economic stability.

Meanwhile, 2012 is a year of opportunity for companies looking to invest on the Turkish market. With tighter credit conditions and low export demand putting pressure on the local companies’ financial stability, a weak currency, and lower investment from the eurozone, MNCs will have more targets to choose from for M&A this year, at a lower cost of investment, and facing weaker external competition for priority targets. With the market expected to rebound next year, companies that invest in Turkey this year will find themselves positioned for stronger growth in 2013 and beyond.

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From The Wall Street Journal’s China Realtime Report | by, Tim Orlik

China’s Vice President Xi Jinping is hitching his wagon for a trip westward across the U.S. this week. The farther west he travels, the less he is likely to have to deal with one of China’s most persistent diplomatic headaches: the value of the yuan.

In his first stop in Washington D.C. considerable attention is still focused on the exchange rate as the key to the economic relationship. A fading Chinese current account surplus has dented the argument for yuan undervaluation. But Stephen Schwartz, Asia economist at BBVA and a former International Monetary Fund economist, says that in an election year and with unemployment high, lawmakers will not change their message on the Chinese currency.

“They will stick to their guns” he said.

Moving further west, Mr. Xi will visit Iowa, where soybean farmers count China as their main export market. Chad Hart, an expert on agriculture at Iowa State University gives China’s 1.3 billion stomachs credit for keeping unemployment in the state low: “Any time you raise farm incomes you raise employment.”

A stronger yuan would boost Chinese demand for Iowa’s soybeans, but that is not the only issue for the state’s agricultural sector. Mr. Hart says that for the seed industry, concerns about intellectual property protection are key to maximizing benefits of the China relationship.

The final stop on Mr. Xi’s visit is Los Angeles, where the value of the yuan is likely not at the top of the agenda. For the technology and entertainment companies that cluster on the U.S. West Coast, concerns about intellectual property protection and market access are firmly to the fore.

The Chinese government limits theatrical distribution of foreign films on the mainland to 20 a year. Worse, with the latest Hollywood releases available on bootlegged DVD in every street corner, piracy costs U.S filmmakers untold billions of dollars a year.

Back in Beijing, meanwhile, many U.S. businesses would prefer to keep the exchange rate off the agenda altogether. In 2011, the American Chamber of Commerce in China identified yuan appreciation as one of the biggest risks facing their members, alongside deteriorating U.S. China relations and increased protectionism from the Chinese government. That’s because for U.S. companies with production located in China, a stronger yuan actually has a negative impact on competitiveness.

Michael Crain, head of Bingham Consulting’s China operation and former chief of staff to the U.S. ambassador, speaks for many China-based U.S. businesses when he says that exchange rate is not the main issue.

“The reality is that no matter what happens to the exchange rate, jobs are not going to come back to the U.S. The focus should be on boosting exports and making China live up to its World Trade Organisation Commitments,” he said.

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Trend

• Nigeria’s underlying growth trajectory continues to be strong, with 6.6% GDP growth forecast for 2012
• A recent uptick in inflation is likely to accelerate, with inflation forecasts increasing from 10% to 14-15%
• Core inflation (which excludes volatile components food and energy) has remained steady at 10.8%

Drivers

• Fiscal Policy Expansion Continues Unabated: The new government’s 140% increase in the minimum wage and partial removal of the fuel subsidy will cause a significant increase in prices in Q1
• Limited Monetary Policy Options: The Central Bank instituted a number of anti-inflationary measures in Q4 2011: devaluing the naira to ₦155/USD, increasing the benchmark interest rate to 12%, and eroding its foreign reserves to 6 months of imports from 17 months. Though foreign reserves have since recovered, the Central Bank has few tools available to aggressively stem inflation

Frontier Strategy Group View

• Inflation is likely to rise significantly in the next two months. Operating costs, particularly transportation and input prices, are likely to increase through summer 2012
• Ongoing fiscal outlays to support the fuel subsidy regime will also weigh on local prices
• With few monetary policy tools available to support the naira, currency volatility will be a concern. The naira will remain stable if oil prices remain moderate (US$100-120/bbl) and the partial fuel subsidy removal is not reversed. Otherwise, the Central Bank will be under significant pressure to further devalue

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Industrial companies are feeling the slowdown of investment acutely. Siemens has reported a 16% YoY decline in revenue from China in Q1 FY 2012

Other industrial giants such as Caterpillar and ABB have also experienced minor declines in sales in the most recent quarter, the first such decline for many companies since they entered China

Companies tied to the real estate market and infrastructure investment have been hit particularly hard. Elevator maker Otis has seen its YoY revenue growth rate slow to 7% in Q4 2011 against an average of  20% throughout the year

Frontier Strategy Group View

China is making small steps to loosen monetary policy, but the actual extent of loosening is going to be smaller and slower than many international investors expect

As a result, industrial companies are going to experience moderate to negative growth, depending on how dependent they are on infrastructure investment, real estate, and heavy industrial production

The super high growth rates of 2009 and 2010 are not likely to be seen again anytime soon
as demand falls back to a more sustainable growth rate

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As exports and consumer demand slow and regional governments seek to reduce spending, growth is weakening across the region and a difficult year is ahead for both B2B and B2C MNCs. GDP growth forecasts will likely be revised further down as CEE economies struggle with continuing volatility and recession in the eurozone. Kazakhstan and Russia continue to benefit from high energy prices, but remain vulnerable to an oil price decline

• Bulgaria: The economy will slow in 2012, but a conservative budget will act as a buffer against an external macroeconomic shock
• Croatia: Croatia is in for a challenging 2012 that will bring austerity measures, pain for local consumers, and possibly a recession
• Czech Republic: Avoiding a deep recession in 2012 is possible if there is clear progress on the eurozone crisis and the German economy remains strong
• Hungary: The government will struggle to regain investor confidence as its controversial policies are undermining market trust in Hungary
• Kazakhstan: MNCs can expect continuity in government policies and populist measures in 2012
• Lithuania: The liquidation of a major local bank threatens to offset the budget this year and may mean more austerity measures
• Poland: MNCs pursuing investments in Poland are well-positioned to capitalize on the country’s undervalued currency
• Romania: Romanian consumers remain deeply pessimistic about the economy’s prospects, a trend that will impact consumer goods MNCs
• Russia: Economic performance will slow only moderately as the government will support high consumer spending ahead of the elections
• Serbia: The key driver for Serbia’s growth this year remains the economic performance of the eurozone
• Slovakia: The consumer outlook remains negative through 2012 as any new government would have to cut public spending
• Turkey: Economic growth will slow gradually over the next several months
• Ukraine: Growth will slow this year and could decline sharply if commodity prices drop as a result of the recession in the eurozone

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Latin America continues to look strong as 2012 gets rolling. Brazil’s growth remains subdued, but stimulus efforts are beginning to have an effect, and Mexico continuing to spend heavily in the run-up to the July presidential elections. Meanwhile Peru and Colombia continue to perform well despite a volatile international environment.

• Argentina: Risks to multinationals are growing as Argentina doubles down on trade restrictions in response to deteriorating economic fundamentals
• Brazil: Stimulus efforts are beginning to take effect, but Brazil is not out of the woods yet as industrial output continues to stall
• Chile: Chile is poised to weather global economic volatility with strong macroeconomic fundamentals and a sovereign wealth fund
• Colombia: Retailers and manufacturers remain confident as the economy continues to grow, buoyed by strong investment and stable commodity prices
• Costa Rica: Fragile public finances and a weakening economy have led the government to raise taxes, imperiling future foreign direct investment
• Dominican Republic: Economic decline in Europe and new immigration laws will have adverse effects on the tourism, agriculture, and mining industries
• Ecuador: Government spending and stable commodity prices will support growth in 2012, but overexposure to oil continues to present risks
• Mexico: Better-than-expected US growth has not stopped government authorities from pursuing stimulative policies to boost consumer spending
• Panama: An increasingly unpopular Martinelli administration will face a cooling but still high-performing economy in 2012
• Paraguay: Paraguay is developing a two-track economy with consumption thriving as exports falter
• Peru: President Humala is doubling down on his centrist, pro-business policies by pushing out leftists from key government posts
• Uruguay: Uruguay is at the mercy of economic developments in Argentina and Brazil, with current trends pointing to a slowdown in 2012
• Venezuela: Chávez’s erratic decision-making indicates an increasingly toxic business environment for MNCs

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