The financial media has been dominated by cries of “Emerging-Markets Crisis” in the past week, as both currencies and stock markets tumbled. Corporate executives would be well served to turn off the television and instead take a second look at their 2014 business plans. Multinational companies have their work cut out for them to ensure a successful year ahead, so it is essential that their emerging-market executives separate signal from noise and focus on their most important management challenges.
With the media focused on hour-by-hour events, I hope to provide FSG clients with a big-picture view that puts recent news in perspective and integrates the comprehensive resources you have available today. First, let’s clarify what’s really been happening in the markets, and what is truly relevant to corporate leaders.
1. Corporate investment in emerging markets remains strong, despite capital-market volatility.
Companies with global ambitions are doubling down on developing markets, not retreating. More than 60% of corporate foreign direct investment went to emerging markets in 2013, despite portfolio “hot money” moving in the opposite direction. FSG’s MNC sentiment tracking shows that interest in frontier markets has doubled in the past year, indicating likely direct-investment increases in even riskier (and still fast-growing) markets.
The crisis today is one of confidence among money managers, as “tapering” of the US Federal Reserve’s quantitative easing program increases their cost of capital. A lower risk appetite has naturally reversed the flow of capital into emerging markets that surged in 2009. The economic fundamentals of most emerging markets have not changed notably, other than the effects of the currency volatility itself.
We have seen this movie before, in May 2013’s “taper tantrum” and its August sequel, when uncertainty over the timing of Fed tapering triggered abrupt emerging-market currency selloffs. The Brazilian real, for instance, lost and then regained over 12% of its value over the span of six weeks in August and September – and lost it again starting in November. Everyone knows the Fed will reduce stimulus further over time, which means further pullbacks from higher-risk markets are inevitable. So, the surprise last week was just about timing, not substance.
2. The media uses “emerging-markets crisis” as shorthand, but last week’s market turmoil was really about relatively few countries – and the news was not as startling as portrayed.
Yes, there are real reasons for MNCs to be concerned about political instability in Turkey and Ukraine, and economic policies in Argentina and China – all of which have dominated headlines recently. But at least for FSG clients, these risks should have already been built into 2014 plans.
Our September report on 2014 Global Performance Drivers highlighted Ukraine, Turkey, and Argentina as most vulnerable to a liquidity crisis because of their high levels of short-term external debt. For such countries, even moderate changes in investor sentiment cause major currency movements. Unfortunately, the media tends to gloss over key differences in their market fundamentals that matter to companies.
- Argentina: Argentina’s devaluation was the spark that lit last week’s currency turmoil. In fact, we forecasted a post-election devaluation last May. We believe the peso has further to fall but timing is difficult to predict, so contingency planning is the order of the day.
- Turkey: The political crisis surrounding Prime Minister Erdogan made Turkey a target for currency traders. We expect political instability and currency depreciation to continue despite last week’s aggressive interest rate hike, contributing to softened demand in 1H 2014. That said, 2014 disruptions are unlikely to diminish medium-term growth, presenting an opportunity to “buy low.”
- Ukraine: We warned clients of a likely 10-30% devaluation of the hryvnia last August, and have kept clients apprised of the business impacts of political turmoil, including liquidity crunches and delayed public and private investment.
- China: Slower growth is not a crisis, even though many financial analysts cite it as a reason for last week’s market churn. It is in fact evidence of a transition from an overextended investment-led economic model to a sustainable consumer-led model. The excessive bad debt in China’s shadow banking system, however, could lead to a real crisis — one of the top risks that we highlight in our Events to Watch in 2014 report.
3. Don’t let fear of “contagion” cloud your analysis of emerging-market opportunities.
“Contagion” implies that markets with real problems are tightly connected, so that a liquidity crisis or spending crunch in one will swiftly spread to many others. The markets that were most troubled last week generally do not have tightly linked financial markets. Trade links generally connect emerging economies more tightly with developed markets than with each other (with China a notable exception). We believe that corporate planners should be more concerned about downward pressure on emerging-markets growth resulting from linkages with the stagnant Eurozone than from linkages with a volatile Argentina or Ukraine.
4. Managing currency volatility should be a top priority for MNC leaders in 2014.
The most serious risk is not of contagion collapsing currencies across emerging markets, but rather repeat bouts of currency volatility driven by fund-manager portfolio reallocation and herd mentality. This can have deeply disruptive effects. Our Events to Watch in 2014 report lists currency volatility as the most likely cause of 2014 plans going awry. As a result, we have initiated regular coverage of currency movements and trends for FSG clients in our new FX Quarterly series, which we will update at the end of February.
Some markets are likely to experience extreme volatility on an ongoing basis (Argentina, Iran, Syria, and Belarus top our volatility index forecast). FSG analysts are closely watching indicators such as short-term external debt, current-account balances, and portfolio capital outflows to monitor when markets are in the greatest danger of a currency crunch, and we encourage you to do the same using FSG’s Monthly Tracking Tool.
5. Take action now to mitigate the impact of currency volatility on your 2014 performance.
Currency volatility can wreak havoc on internal operations and among business partners, but its effects can be mitigated. A multi-functional approach to contingency planning ensures that all key domains – from sales to supply chain, from talent to finance – are ready for the next bout of turbulence. The question for emerging-market leaders is how to manage volatility, not how to avoid it.
- Formulate contingency plans for profit repatriation
Currency depreciation can turn what seems like a local-market success story into an earnings disappointment from the corporate perspective. The worst-hit markets may compound the problem by instituting capital controls to prevent further flight and devaluation. Given the recent “pivot to profitability” in how emerging-market executives’ targets are set (as opposed to traditional revenue targets), regional general managers’ careers may suffer in the absence of a structured profit repatriation strategy.
- Support local partners
Most MNCs depend on local distributors, suppliers, and other partners who lack the scale or sophistication to manage an extended period of currency volatility. Proactively providing liquidity, attractive repayment terms, and temporary discounts could earn enduring loyalty – and even turn an arms-length relationship into an affordable acquisition opportunity.
- Evaluate product localization
Consider adopting a localization strategy to mitigate the impact of these possible scenarios by producing and sourcing locally. Factoring in currency impacts to market-share gains and government incentives may change previous cost-benefit assessments of going local.
- Review your geographic portfolio
Identify the fundamentally healthy markets where companies are likely to pull back but your company is underpenetrated – many markets with strong domestic demand as their key economic driver should be less affected once the dust settles. Smart companies are adjusting their geographic footprint by assessing regional opportunity at the level of provinces (e.g., ASEAN and Latin America) and country opportunity at the level of cities (e.g., Russia and India).
- Consider investing more aggressively in frontier markets
While many emerging-market forecasts have been revised downward, frontier markets have exhibited much stronger performance, in terms of both growth expectations and equity-index performance. Markets such as Nigeria, Peru, and Kazakhstan will be resilient regardless of currency shocks, thanks to their modest short-term debt and healthy levels of private consumption.
6. Executives in emerging markets must aggressively manage perception and expectations at the corporate center.
The very experience that makes seasoned emerging-market leaders unfazed in a period of volatility can make them forget how their colleagues at headquarters feel when the names of far-off markets are suddenly crawling across their TV screens day after day. When investors get nervous, the Board, CEO and CFO have to justify their investments in emerging markets that they may not even think about on a regular basis. When that happens, it’s essential that expectations and assumptions are well aligned between the corporate center and leaders in the regions.
- Reassess 2014 targets and resource allocation
Companies should adjust forecasts down in the markets experiencing the most acute currency devaluation. Central banks may raise interest rates to support the currency and maintain prices on imported goods. The trade-off for higher rates will be slower-than-expected economic growth. As economic conditions change on the ground, any changes to corporate targets and plans should be swift and data-driven.
- Get corporate buy-in to triggers for mid-year course correction
It’s time to be proactive in resetting expectations and, if necessary, re-making the business case for emerging-market investment. Regional GMs and country managers should demonstrate that they have specified key risks to the plan (FSG’s short list of Events to Watch in 2014 spans all regions of the globe), and have documented contingency plans. Agree in advance on events that would trigger a reset of goals or course correction in strategy. Companies that systematically monitor and adjust to changes in emerging markets grow market share twice as fast.
Don’t let Wall Street distract you from execution – or rewrite your business plans.
As an executive responsible for international growth, in a time like this it’s essential to not be distracted by the media’s emerging markets storyline. Keep your eye on what matters to your company’s success, and the timeframe in which you are committed to deliver results. You don’t control the markets, but you can control your business.