Multinationals must build contingency plans for Russia

European foreign minister
European foreign ministers gathered in Brussels on Tuesday. Associated Press

The EU has decided to impose more sanctions on Russia. For now, these fall short of the so-called Level 3 sanctions that could be against whole sectors of Russia’s economy and crucially, its banking sector. However, the international fallout from the downing of flight MH17 and the growing tensions between Russia and the West mean that Level 3 sanctions are increasingly a possibility.

For an MNC executive, this means that it’s time to plan. Level 3 sanctions would dampen Russian growth further, reducing demand across industries; they would cause significant problems for customers and distributors to access finance, affecting operations; and are likely to be met with Russian retaliation that could make it more difficult for MNCs (especially American ones) to do business in Russia. All of this will have an impact on a company’s customers, finance, supply chain, people, and marketing strategy and MNCs should be building step-by-step play books on how to respond to spillover across their Russia operations.

martinachart2This is not to say that MNCs should be pulling out of Russia. In fact, planning is so important because of the significant role that Russia plays in many MNCs’ EMEA and even global portfolios. Companies that have stuck with Russia through crises have historically reaped significant benefits and this could be an opportunity for MNCs to strengthen partner and customer relationships and to make low-cost investments.

Meanwhile, larger strategic questions are looming in the background for EMEA and global leadership teams. With the likely opening of Iran for business, a Russia that is increasingly closing in on itself could lose out in the competition for corporate investments.

For a full report on Russia contingency planning, FSG clients can click here. A full report on preparing for a post-sanctions Iran is also available.

Preparing Your Business for Post-Sanctions Iran [Infographic]


International negotiations involving Iran’s nuclear program were extended until November 24, which is good news for Western multinationals. Senior executives should use this extra time to lay out plans for entering or expanding in the Iranian market. Today, FSG released a report for our clients that outlines actions to take in order to prepare for major challenges and capitalize on huge opportunities in post-sanctions Iran.

Many companies are preparing to enter or expand in post-sanctions Iran, and 40% of FSG clients surveyed already view it as a priority market. A comprehensive nuclear deal and the subsequent opening of the Iranian market would represent the biggest shake-up to the MENA portfolio since the Arab Spring erupted between late 2010 and early 2011. Iran’s population is the second largest in MENA, and its oil and gas reserves are the 4th and 2nd largest in the world, respectively.

Before committing significant resources to overcome operational challenges in Iran, senior executives must first determine whether their organizations are even willing to take the risk by reassessing market potentialsanctions exposure, and indirect vulnerabilities, such as reputational risk. Iran’s opportunities will not outweigh the risks for every company. However, pharmaceuticals, medical devices, and consumer goods companies are especially likely to prioritize post-sanctions Iran given its attractive demographics and future spending power.

For companies focused on entering or expanding in post-sanctions Iran, it is imperative to prepare for the top three challenges identified by FSG clients in a recent poll: a lack of access to bank services, compliance risk, and difficulties in becoming a first mover ahead of competition. FSG clients can read our report on post-sanctions Iran to learn about actions for overcoming these challenges and many others.

FSG Poll Results

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What the Latest Sanctions Against Russia Mean for MNCs

The latest rounds of EU and US sanctions against Russia fall short of imposing restrictions on entire industries, but they do have a number of hidden spillover effects for Western multinationals operating in the market. Beyond the obvious impact on MNCs selling to the energy and defense companies directly targeted by sanctions, a broader set of MNCs operating in Russia should be concerned about the banks that have been included in the sanctions list.

Impact on MNCs:

MNCs selling business goods and services are most likely to be indirectly affected by the sanctions, because some of their customers may face a higher cost of credit. Beyond businesses that directly work with the sanctioned banks, Russia’s financial market as a whole is likely to see more expensive credit as more international banks try to restrict new lending out of cautiousness. In the long term, higher lending costs contribute to the contraction in domestic investment, which will prolong Russia’s economic stagnation and reduce demand across all industries.

Actions for executives:

Executives whose business may be affected should speak with their local teams and identify key customers who may work with the sanctioned banks. Such customers may face the risk of rising borrowing costs, particularly if their credit lines need to be rolled over in the near future.

Three consequences of the new round of sanctions:

  1. They could reduce demand from small and medium enterprises.

Both the European Bank for Reconstruction and Development (which the EU will ask to halt new lending in Russia) and VEB, a bank sanctioned by the US, lend extensively to small and medium businesses. A cut in their lending will result in reduced investment and demand for B2B goods and services at a time when investment activity is already deeply depressed.

Chart: VEB will be prohibited from borrowing at maturities longer than 90 days on US capital markets

  1. Multiple industries could be see more expensive credit.

VEB and Gazprombank, the two banks the US sanctioned, lend extensively to the corporate sector, including industries such as oil and gas, metallurgy, machine-building, chemicals, and others. 40% of VEB’s lending in 2013 was for infrastructure. Interest rates for corporate customers of both banks are likely to increase, hitting multiple industries at once.

  1. Lending in Belarus could also be hurt.

Subsidiaries of VEB and Gazprombank hold almost 10% of the Belarussian banking market and are largely dependent on parent-bank financing. Their lending activity and cost of credit is likely to be negatively affected by the US sanctions, affecting some MNCs’ corporate customers in Belarus.

Understanding how the new US sanctions work:

The banks sanctioned by the US – VEB and Gazprombank – are among the largest in Russia. They lend primarily to corporate customers across multiple industries and much of their portfolios consist of long-term loans. To finance these loans, they need to borrow at long maturities on international financial markets, which is exactly the kind of borrowing that US sanctions have restricted. Their alternative sources of long-term capital are notably more expensive and would require them to increase lending interest rates, hurting the businesses to which they lend. Because of the size of these banks, increases of their interest rates are likely to have a spillover effect across the Russian banking sector as a whole.

View the video below to see FSG’s Martina Bozadzhieva discuss investing in Ukraine and Russia on CNBC yesterday.

Trouble in Portugal reminds us that the eurozone’s woes are far from over

Executives should be wary of headlines for recovery in Western Europe, and prepared for the heavy downside that Europe’s fragile political and economic order could experience. Although news media highlight positive aggregate growth (the eurozone is forecast to grow 1.2% YOY in 2014), Western Europe remains plagued with high public debt loads and thus highly susceptible to volatility in financial markets.

In our latest Western Europe outlook, we warn senior executives about the impact that unrest at banks or in politics could have across European markets and MNCs’ performance in the region. Specifically, any uptick in political risk could manifest itself in higher borrowing costs for the government in question and across southern Europe. The increase in borrowing costs could also make business in those markets more expensive and would destabilize local governments as their cost of high debt loads rises, reducing confidence and the production and jobs growth that would spur Europe to recovery.

Photo: Banco Espirito SantoImage: Bloomberg News

In the most acute case of the European sovereign debt crisis in recent months, Banco Espirito Santo International SA, a Portuguese bank, delayed payments on some securities, following a warning in May that its parent company faced a “serious financial situation” that “could be damaging”. While southern European government bond yields have remained fairly stable, their decline, sustained since summer 2012, is unlikely to continue. European stocks saw a broad decline, notably 1.90% for Italy’s FTSE MIB and 1.98% for Spain’s IBEX 35. Portugal’s PSI 20 took the worst hit, sinking 4.18% on the news. The biggest question now is whether the delays will result in government involvement, which could spark a much more serious financial market reaction and increase borrowing costs across Europe.

That European banks have not been in the news does not imply that they are healthy, or even improving. As they undergo stress tests, European banks are pulling capital onto their balance sheets, leaving less resources available to lend to businesses. Bank lending to non-financial corporations has declined an average of 2.9% YOY in the first five months of the year. In fact, credit contractions in 2013 and 2014 are the worst since the crisis began. What’s more, Moody’s downgraded 82 European banks in May in response to a new EU law that makes banks mutually responsible for risks in the event of another crisis. The majority of these banks were not southern European, but rather from creditor nations such as Germany (12), France (10), and Austria (8), highlighting the breadth at which Europe’s banking crisis has sustained its reach.

In response to this broad European macroeconomic trend, companies can monitor a few important indicators of change:

  • Loan growth: credit growth would imply positive trends in supply and demand for the funds that fuel consumption and production growth
  • Unemployment: gauge which economies are most at risk for austerity fatigue and thus political unrest
  • Bond yields: an increases could indicate market perceptions of increased political risk
  • Results of bank stress tests in Q4 2014: while disruptive, any major bank failures will help companies to identify which countries’ recoveries are likely to lag behind

FSG clients can find out what this means for their business and how to respond in our latest Western Europe regional outlook, and in our Western Europe team’s recent blog posts and podcasts.

Iraq Crisis: Reacting Rashly to Instability Could Hurt Your MENA Business

Photo: Iraq Crisis: A Kurdish soldier with the Peshmerga keeps guard near the frontline with Sunni militants on the outskirts of Kirkuk, an oil-rich Iraqi city on June 25, 2014.  Spencer Platt, Getty Images

Right now all eyes are on the conflict in Iraq. However, political instability is the regional norm, as seasoned senior executives can attest. Companies must avoid making rash decisions in response to regional volatility. Otherwise, there is a danger of cannibalizing long-term prospects for MENA growth.

Senior executives must be proactive in controlling the conversation with their corporate office to counteract the steady stream of negative media attention that is focused on the region. Despite the terrible human toll from the Iraq crisis, and increasing links to the devastating Syrian civil war, only 11% of MENA GDP is derived from markets that are highly exposed to spillover from the conflicts.

Senior executives should assess how deteriorating stability in Iraq impacts their MENA strategy, but a measured response is required. FSG suggests considering three actions for your regional business:

1. Course-correct your MENA strategy, but do not waste resources on a complete overhaul.

Risk-tolerant companies can gain long-term market share as others freeze investments or pull out of Iraq and surrounding countries. At the same time, MNCs can focus on a profitability-driven strategy in stable countries such as Saudi Arabia and the UAE. Our clients can use FSG’s market prioritization tool to aid in reassessing where to concentrate regional resources. They can also track signposts in our Iraq report and updates from FSG’s MENA Monthly Market Monitorto help decide when changes are appropriate.

2. Leverage local partners to maintain a foothold in affected areas in the MENA region.

Risk-averse companies can maintain a foothold in unstable markets by relying on local partners to reduce financial and security risks. It will be important to work with partners to monitor changing regional perceptions of Western brands if there is a sustained Iraq conflict in which foreign intervention is possible. Clients can review FSG’s Managing Distributors in MENA for additional strategies.

3. Count on de facto or de jure Kurdish independence, which brings opportunities and risks.

Kurdistan’s capture of oil-rich Kirkuk puts it on an accelerated path toward de facto or de jure independence. Kurdistan could become even more of an investment destination as a result. But manage expectations, as there are new challenges, including potential fuel shortages as a result of disruptions to the Baiji oil refinery and Erbil’s exposure to a rise in terrorist attacks. Clients can read our Iraq Frontier Market Access report for more on Kurdistan and use our monthly MENA report to track developments.

(Image courtesy Getty Images, Scott Platt: A Kurdish soldier with the Peshmerga keeps guard near the frontline with Sunni militants on the outskirts of Kirkuk, an oil-rich Iraqi city on June 25, 2014.)

Four Reasons Why Iraq’s Impact on Oil Prices is Overstated

Written by: Fadi Khalife, Frontier Strategy Group Intern, EMEA

The recent events in Iraq naturally heighten concerns surrounding higher oil prices given the country’s position as OPEC’s second largest crude producer. However, despite a spike in oil prices over the last week due to the expansion of a broad based coalition of Sunni insurgents, led by ISIS, in northern Iraq, this volatility is likely to be short-lived. For MNCs, this means that it may be too early to adjust plans to account for a sustained spike in global energy prices.

Here are the reasons why:

1) Most of Iraq’s oil production and exportation is in the south

The seizure of oil fields appears to be a strategy of ISIS in general, as it has performed similar operations in eastern Syria to generate revenue by selling oil. However, it is important to remember that most of Iraq’s large producing fields and refineries are in the south, an area that has been largely unaffected by militant activity. Iraq’s northern oil exports used to amount to 300,000 bpd prior to March this year, but have since been shut off due to attacks on the pipeline to Turkey.  However, this figure still remains low in comparison to the 2.58 million b/d (as of May this year) that are exported from the country’s southern terminals.

iraq mapMap showing oil fields and pipelines: the most important are most are located in the south away from the fighting (Source: WSJ)

2) The expansion of territory gained by Sunni insurgents is unlikely to continue at its current pace due to the potential of foreign involvement

In particular, both the US and Iran have shown willingness to assist the Iraqi army fight the insurgency. Although Baghdad would be a natural next target for the groups, the capital is heavily fortified and any advancement on the city could trigger foreign military intervention, such as US aerial attacks.  Furthermore, Iraqi Shi’ite volunteers are being recruited in large numbers to counter the ISIS advancement and any attack on Shi’ite pilgrimage sites would almost certainly lead to Iranian military support

3) While fighting at the Baiji refinery is domestically disruptive, the facility does not export any oil

The refinery accounts for one third of the nation’s refining capacity (up to 310,000 b/d at full capacity) but it mainly supplies northern Iraq and Baghdad and does not export any oil products. Three quarters of Iraq’s oil production is in the southern part of the country so the danger to oil exports from fighting at the facility is low

4) The short-term volatility of global oil prices is likely to be mitigated by the thawing of relations between Iran and West

This is because both have an interest in curbing the expansion of Sunni insurgents, and better relations could eventually lead to a boost in Iranian crude exports to global markets which would offset the potential fall in Iraqi production. Just this week, UK Foreign Secretary William Hague announced that the British embassy in Iran will reopen and both the US and Iran have expressed a willingness to collaborate to curb the ISIS advancement

For more analysis of the recent violence on energy prices, FSG clients may access the report here.​

Kenya: Worsening Insecurity Impacts Business and the Economy

As another major terrorist attack has hit Kenya, companies should expect this not to be the last one in the near future. Terrorism is creating a growing sense of fear that is harming consumer-oriented businesses and tourism, a major driver of the Kenyan economy. However, despite causing disruptions and uncertainty in the short-term, rising insecurity will not derail Kenya from its path of economic expansion in the medium-term and companies should ensure that they maintain a balanced view of the impact insecurity will have on their operations, customers, and long-term plans for the market.

Kenya WSJAt least 48 people were killed when militants attacked Kenyan coastal Mpeketoni on June 16th (Picture: Associated Press) 

To put Kenya’s terrorist threat into perspective, it is important to understand the underlying dynamics that form the root cause for mounting volatility:

  • Origins of the terrorist threat: Insecurity arises from political instability in neighboring South Sudan and Somalia. Since the Kenyan army’s military incursion into Somalia in 2011, there has been an upsurge in terrorist attacks on public places. The main threat comes from radical Islamist group Al Shabaab and homegrown Islamist militants.
  • The tarnished tourism industry fuels volatility: Tourist numbers tumble every time a new attack hits the country, triggering a drop in prices for hotel rooms. This leads to a rise in unemployment and economic grievances in coastal areas, which creates a fertile recruitment ground for radical causes.

The Toll on the Tourism Sector
New travel warnings to Kenya’s major tourist areas issued by the US, Britain, France, and Australia could cause large job losses and shave off a 1.0% point of GDP growth. The sector accounts for more than 10% of GDP. The number of tourist arrivals already declined by 7.0% from July 2012 to July 2013.

  •  Weak governance exacerbates insecurity: In its fight against terrorism, the government is mistreating Muslims and has arrested thousands of mainly ethnic Somalis. Its behavior is fueling discontent.

However, despite rising insecurity, Kenya’s positive economic drivers will outshine the challenges: Terrorist attacks will cause sporadic disruptions but the vibrant private sector, rising consumer spending and Kenya’s important role as a hub for East Africa are strong economic drivers which are unlikely to be derailed by insecurity. FSG clients should review our recent report, Market Spotlight: Kenya, which covers Kenya’s medium-term macroeconomic outlook and provides strategies companies can implement to be prepared for a rise in insecurity.

Actions companies can take:

  • Guarantee the security of your employees: Refrain from putting employees in international hotels or from holding marketing events in major hotels or malls, as these could become a target.
  • Adapt to changing consumption patterns: Package goods for consumption activity at home, as consumers are more likely to consume at home because of security concerns.
  • Maintain a balanced view: Carefully assess the risks stemming from terrorist activity to your business operations and demand for your products, as these may ultimately not be significant and should not warrant a decrease in investment in the market.


MNC Insight: Five things I learned during my 10-day visit to Dubai

I met with more than a dozen Dubai-based senior executives from multinational companies across several sectors. Five important issues emerged during our conversations:

1. Improving performance in Africa is the focus of MEA strategic planning 

During my visit to Dubai, 70% of the companies that I met were focused on improving their performance in Africa. Interestingly, most of the companies use Dubai as a hub for Sub-Saharan Africa. The UAE is already an established regional hub for the Middle East, because of the advanced commercial infrastructure, air travel links to rest of the world (Gulf flights can reach 2/3 of world’s population in 8 hours), access to skilled, albeit expensive expatriate labor, and relative ease of anticipating local costs.

2. MNCs are frustrated increasingly by the procurement process in Saudi Arabia 

Many executives cited an extended and unclear procurement process as an obstacle to business growth. There are new procedures and staff in many ministries, in part to ensure compliance, and this has led to more delays in the approval process. SAGIA, Saudi Arabia’s investment agency, recently announced a new fast-track option for processing foreign investor applications and I will investigate how it is being implemented during my upcoming visit to the market.

3. Executives are still mystified by MENA’s frontier markets, particularly Algeria and Iraq

In Algeria, companies often work through a local partner, but have underperformed due to a difficult operating environment. Many are watching whether President Abdelaziz Bouteflika’s fourth term will usher in an era of growth or support stagnation. In Iraq, most companies do not have enough info to navigate the market appropriately and find it difficult to make the case for resources given dramatic headlines that appear in Western news outlets every day.

4. Investment in Iran is still a taboo topic for many despite the market’s huge potential

Iran has the 2nd largest population in MENA and among the largest oil and gas reserves in the world. Yet the market opportunity still seems too far off for many MNCs, especially those with US headquarters. Interestingly, I met with a consumer-oriented Danish company that is trying to get expansion plans approved by their board. The executives are worried about rising competition from American companies if a nuclear deal is reached in July.

5. Companies are not worried enough about MENA’s vulnerability to a Chinese slowdown

China’s growth trajectory was not a concern for many executives until I connected the dots to the overall health of MENA economies. The Middle East supplies nearly 50% of China’s oil. Strong Chinese demand drove an oil price surge that increased GDP in GCC countries by $1 trillion between 2003 and 2013. In addition, 15% of MENA exports go to China and Chinese-based companies are major foreign investors in the region. As a result, executives need to factor into their strategic plans how a slowdown in China (below 7% annual growth) would hurt economic activity in MENA.

ECB’s negative deposit rates will leave eurozone to muddle along

Central banks act when expectations miss to the downside; today was the rule and not the exception. The European Central Bank (ECB) cut interest rates, notably lowering the interest rate on the deposit facility into the negative territory of -0.10%. The ECB’s response to very low price growth is too little too late, but it sends an important message to markets that Europe’s head economists understand the eurozone’s downside risks and are willing to act against them, at least marginally. Europe’s growth will not be improved as a result of today’s action, but the ECB has helped the economy dodge the vicious market correction that inaction would have prompted.

Considering the practical effects of negative interest rates, banks effectively will be charged for any reserve cash they hold over reserve requirements. A reduction of interest rates for banks doesn’t necessarily translate into a reduction of rates for Europe’s business and household savers ─ that’s a decision that banks make on an individual basis and concerns their own margins  ─ but sustained low profits make it likely that banks will carry the cut over to their business and consumer customers.

Lower rates, and even negative rates, will not spur banks to lend, which would provide the much-needed boost for European business which relies heavily on bank lending for their corporate financing. Near-zero rates for years have not improved lending activity, and European bank stress tests will discourage banks from shedding any capital from their balance sheets. Perhaps more importantly, demand for loans will not improve as a result of these measures, nor will banks suddenly decide to trust businesses and households.

Lending is contracting at the fastest rate since the crisis as of Q4 2013
(Loans to non-financial businesses and households, %YOY)
ECB Rate Cut

The ECB assuredly recognizes this shortcoming, and thus announced its intent to intensify the preparatory work related to outright purchases of asset-backed securities (ABS). In other words, quantitative easing (QE) is still on the table for the next meeting on July 3. Although it is not yet clear what assets the ECB can buy within its mandate, quantitative easing would be a large step toward boosting the European economy, reducing the value of an overpriced euro and encouraging export growth in most European markets, creating jobs and reducing inflationary risk.

In the meantime, the ECB’s rate cut will serve only as a market signal. The central bank cannot yet engage the highly politicized QE, but knows that markets would lash back at inaction in light of prolonged low inflation. FSG’s base case for growth in Europe thus remains intact: the region will see very low growth in the long term, which will separate outperforming companies from their peers similar to the Japanese experience of the “lost decade”. FSG clients may use the new Western Europe Regional Outlook, to be released June 9, to outline specific opportunities for growth in a low inflation environment.

What is the East African Community and what does it mean for business?

With all eyes set on the race for oil production between Uganda and Kenya, a development of a different sort is taking place some 200 miles to the south in Arusha, Tanzania. The East African Community (EAC) is conducting a plenary session to discuss trade policies with representatives from the five member states of Burundi, Rwanda, Kenya, Tanzania and Uganda in attendance. Meetings of the sort are not unusual in Sub-Saharan Africa. The EAC, however, is quite unique.


The East African Community

As Sub-Saharan Africa’s most integrated trade bloc, the EAC is a large, single market with a combined GDP of $US 99.8 billion and 141 million people. It allows for the free movement of goods and labor, and is home to large infrastructure projects that bound the region together. Unlike other African trade blocs such as SADC, COMESA and ECOWAS, the EAC’s goal is not purely economic: its ultimate vision is to become a political federation with a single currency. Despite some frictions between each country’s head of state, the EAC has prioritized regional integration at a pace unforeseen in Sub-Saharan Africa.

MNCs can therefore enjoy several benefits when selling or establishing a local presence in the region:

  • Infrastructure projects and the breakdown of trade barriers create a larger economy that is more attractive to investors
  • The EAC’s ongoing physical and institutional reforms cut the costs and risks of doing business
  • Political stability and proximity to Central Africa, South Sudan, and Ethiopia offer wider regional access
  • Increased competition because of the EAC’s single market results in cheaper goods, but adds pressure to profit margins

While the EAC is home to a broad consumer base that demands a wide variety of goods from various industries, it also faces several challenges to doing business. Inconsistencies in customs valuations, export taxes and rules of origins abound, while the infrastructure is aging. Transport costs along the EAC’s two major corridors are some of Sub-Saharan Africa’s highest. The timeline for integration has not been kept. However, the EAC is addressing these challenges with new projects, investments and treaties. For example, one-stop border posts in select towns will ease bottlenecks associated with intra-regional trade, and the ongoing construction of the LAPSETT transport corridor will provide alternative routes to distribute goods in the wider region. The EAC’s evolving landscape underscores the importance of looking at the region – and Sub-Saharan Africa as a whole – through a long-term lens.

Regional integration is key to Sub-Saharan Africa’s economic growth and will continue to be pushed at the top of policy-makers’ agendas. Old boundaries will continue to break down in favor of highways, pipelines, railway lines and power grids that will redefine regional dynamics. MNCs planning to expand their Sub-Saharan Africa presence should consider clusters of linked markets, as economic zones will continue to influence dynamics in ways more impactful than individual countries. The EAC might be Sub-Saharan Africa’s most integrated trade bloc, yet it is also symptomatic of a bigger, long-term trend of economic realignment on the continent.

To learn more about the EAC, FSG clients may review the full report on our client portal.