The Sovereign Debt Crisis in Emerging Markets (Part II)

What can your business do?

Most companies react to crises by cutting costs and strengthening cash positions. These companies fail to separate from the pack during the inevitable recovery that follows every crisis. Leading companies:

  1. Plan opportunistically – Build acquisitions target lists ahead of downturns. Companies that want to be in emerging markets for the long term correctly identify environments with low valuations and favorable exchange rates as strategic entry points. Other companies pursue Greenfield strategies to the same ends. Going local can mitigate currency risk and pricing strategy disruptions as both inputs and outputs are denominated in one currency. Companies that go local during downturns, inorganically or organically, capture market share from competitors who import into the market because depreciating local currencies price local customers out of the market for imported goods.
  2. Mitigate risk while positioning for recovery – Selectively extend financing to suppliers and distributors to ensure that ecosystems remain liquid and can survive a downturn. Rebuilding supply chains and indentifying new distribution partners is more expensive than providing support during tough times.
  3. Prioritize markets to identify winners – Rigorous data-driven prioritization is paramount when there is increased competition for investment dollars. Leading companies quantify the size of the opportunity, the growth trajectory of the opportunity, as well as the individual risks present in the marketplace before making the case for resource allocation.

Identifying emerging markets winners

We can determine the emerging markets that will outperform and underperform by the level of trade exposure a market has to the center of the crisis. Broadly, emerging markets can be broken into three groups: markets that have a high linkage, a medium linkage, and a low linkage to the center of the crisis.

Low linkage:

The clear outperformers in the short term are India, Indonesia, and Sub-Saharan Africa. These markets are characterized by rapidly growing domestic demand and diversifying economies that are creating middle class growth. These markets have limited trade relationships with Europe. As a result, multinationals are gearing up investment plans across these regions, hoping that ensuing growth makes up for losses in Europe.

China is an exception. It is linked to the crisis in Europe but has built enough savings to weather a downturn in manufacturing exports. However, China has a domestic credit bubble that makes its economic outlook less clear. That said, multinationals will continue to invest in China as historic performance has been robust.

Medium linkage:

The Middle East and Latin America are linked to Europe because of trade in commodities: oil from the Middle East and foodstuffs from Latin America. In the Middle East, reduced European demand for oil will impact state revenues, but most markets have more than enough reserves to weather a crisis. As a result, we expect Middle Eastern markets to continue to grow and invest in long-term projects that will help maintain stability and diversify the economy.

While commodities play a role in Latin America, the real driver of growth there is domestic consumption and a growing middle class. A slowdown in Europe may shave a few points off growth in the region, but it will not stop the secular trend of robust middle class growth that is driving the market.

High linkage:

Russia is positioned to be the biggest underperformer. Oil exports to Europe are driving Russian GDP growth more than ever before. Russia emerged from the 2008 crisis weakened as much of its hard currency reserves were spent placating the population while no meaningful diversification of its economy was achieved. As oil prices fall below the $110 per barrel built into the Russian budget, Russia will enter deficit. It has already borrowed from capital markets for the first time in years.

Turkey will be another underperformer, although the demographic and economic fundamentals in Turkey are so strong that a downturn there will create excellent buying opportunities for companies planning to be in Turkey for the long term. The crisis is already impacting the lira, which has depreciated rapidly against the dollar as Turkish exports to Europe slow.

Central and Eastern European (CEE) markets will suffer for the same reason as Turkey – increased reliance on manufactured exports to Europe. In CEE, Poland stands out as the strongest market.

Contingency planning is key

The crisis will create risks and opportunities for businesses. Leading companies will distill the fundamentals, develop contingency plans, and communicate those plans throughout their organizations ahead of the crisis.

 

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