Emerging Markets Insights

Continuing the discussion from my previous post on ASEAN strategy, here are some additional points to consider:

1. Country-Level Analysis Not Enough:

a. As the region matures and companies increase their focus on it, executives need to conduct in-depth provincial analysis in order to understand where the specific demand-side opportunities lie and where there is the ideal supply-side support

b. In a market where affordability is a key challenge faced by all MNCs, executives ought to conduct their opportunity analysis on a provincial basis, to focus their investments towards the top choices

c. While provincial data is not available for many indicators, companies can begin with macroeconomic analysis by looking at gross domestic product, per capita wealth, population, and some expenditure patterns

2. Keep Your Focus on the Hot Spots: 25% of the Provinces Hold 75% of the Wealth

a. Wealth in Southeast Asia remains highly concentrated thus companies looking to expand in the region should focus their efforts on the top-tier provinces, which make-up for more than 75% of the GDP of the entire region

b. Depending on the specific province, companies will have to adopt different tactics in order to access end customers, who are likely to have varying consumption patterns as a function of their location and source of wealth

c. Companies could also conduct consumption pattern studies to get a better idea of their expenditure habits (use expenditure or food vs. non-food figures)

*Source: Frontier Strategy Group Analysis; Individual Government Statistical Publications

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The rise of the Southeast Asian (SEA) region is unquestionable, with the majority of the regional executives increasing their focus towards the region, not only due to the robust increase in demand but also its attractiveness as a potential manufacturing hub for all of APAC. However, discussions with corporate headquarters still remain highly country-focused, requiring regional executives to proactively “make the case” to move towards creating a medium-to long-term regional strategy for SEA.

1. Regional Mindset With A Country Specific Focus

a. Appreciate National Differences: Companies should not expect to have similar experiences across this region; each individual country will require in-depth analysis due to its varying economic maturity and wealth

b. Adopt A Scalable Regional Strategy: Executives should adopt a regional mindset, developing a long-term expansion strategy that accounts for the country-level differences but simultaneously leverages upon synergies and creates scale

Understanding country-level differences is paramount to forming a regional strategy when the same region has the world’s largest producer of rice, largest call-center outsourcing provider, largest producer of hard-drives, and largest coal exporter. See graph below to see the variations in the key economic contributors for the major ASEAN countries (as of 2011):

2. Communicate Strengths of the Region Back to Corporate

a. Region Provides for an Attractive Investment Climate – Many SEA countries are very MNC friendly and aggressively promote this feeling by providing long-term investment incentives to stimulate strategically important industries. Highly attractive investment incentives programs such as the Economic Transformation Program by Malaysia, MP3EI by Indonesia, Public-Private Partnership by the Philippines, and Zone-Based Investment Incentives by Thailand have become a popular tool to attract FDI dollars into the region

b. Easier to Manage than India – In terms of demand, the ASEAN region and its member countries share similar characteristics with India. However, doing business in SEA is widely agreed to be easier than doing business in India, which features: unpredictable policy making, high levels of bureaucracy, increasing corruption, differing tax regulations, and an acute lack of infrastructure improvements

c.  Profitability Game – Not Just a Top Line Growth Story – Companies have found SEA to not only have strong growth potential, but also the potential for higher margins compared to India and China.

i.  SEA is still relatively less crowded in terms of competition, both from MNCs and local companies. Relative cost of inputs remains lower in the region, especially for medium-to low-end manufacturing facilities.

ii.  The region’s strong consumption appetite, both from its growing middle class and the government, makes its growth somewhat resilient.

iii.  The region offers dual advantages for MNCs; it functions not only as a source of domestic consumption demand, but also as a production hub for exporting to the immediate region and beyond.

Executives needs to quickly adopt a regional-mindset, setting for themselves a clear vision for growth in the ASEAN region and planning for a future where the region not only functions as a leader for APAC but maybe for a scale which would allow for global leadership. Many large MNCs have already begun their quest for building businesses that have a common vision and strategy across the region.

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Starting now, companies will face increasing workforce risks in Indonesia. Wages will rise by 15-30% over the next 12 months, pushing companies towards a labor cost trap, and a new regulation slated for implementation later this year will restrict companies’ flexibility on staffing.

It’s been a rough Q1 for many executives in Indonesia.  Double-digit minimum wage hikes, which came into effect at the beginning of the year, are driving up labor costs for companies across the board and putting significant pressure on their bottom lines.  This effect has been particularly acute in Greater Jakarta where mandated increases reached upwards of 40%.

Adjusting to these wage hikes has been a painful process, and executives would undoubtedly welcome a reprieve from dramatic shifts in their labor costs.  Unfortunately, however, a reprieve is not in the cards.  Over the next 12 months, workforce risks for companies in Indonesia will only continue to increase.

Mindful of upcoming elections and ongoing labor protests, Indonesia’s politicians will continue raising minimum wages, likely by another 15-30% over the next 12 months.  This will push companies towards a trap in which they must pay out hefty sums before reducing headcount and driving productivity among their remaining employees.

If this weren’t difficult enough to deal with, Jakarta has also passed a regulation that will restrict companies from using temporary contracting for most positions. (In Indonesia, this practice is commonly referred to as “outsourcing” and remains a very sore point with labor leaders.)  When the regulation comes into effect in the middle of November, over 13 million workers currently employed under temporary contracts could start demanding full-time employment.

These developments have the potential to create significant liabilities for multinationals operating in Indonesia.  With this in mind, executives should take steps now to mitigate rising labor costs and upcoming staffing limitations.  Companies that proactively manage these workforce risks should be able to offset some of their costs.  Those that don’t will look back 12 months from now and reminisce about how good they had it in Q1 of 2013.

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This blog entry is the second of a two-part series. Part one can be read here: Understanding the ASEAN Economic Community.

8 Key Changes All Executives Should Prepare For

1. All member states will gain economically from the AEC with real income expected to increase significantly
2. Overall exports will outpace imports in the manufacturing sector, easing integration into global supply chains
3. MNCs can find themselves in a more competitive position against local players in terms of pricing as production and transport costs are reduced
4. ASEAN + 1 FTA’s with East Asian neighbors (China, Japan, South Korea) will have notable impacts on the region
5. AEC is not just about lowering tariffs; infrastructure improvements, better intellectual property rights protection, harmonized investment laws, and easier movement of capital and skilled labor are part of the agenda
6. Overall trade in services will increase with imports of services likely to outgrow exports (in most sectors)
7. Growth is likely to be inequitable among member countries, thus companies should conduct in-depth studies in order to understand individual market dynamics
8. FDI should witness a surge as both inter-ASEAN and external foreign investments pour into the region

See graph below for results from a study by Ken Itakura on the impact of AEC on the exports and imports of the individual countries. Take all projections with a pinch of salt; they are a result of a simulation analysis that makes assumptions that might remain unmet

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What is The ASEAN Economic Community (AEC)?

Contrary to common belief, the goal of The ASEAN Economic Community is not just to form a free-trade area, but to create a highly integrated economic community by 2015, that focuses on four pillars, majority of which will impact multinational companies. See the graphic below for a simple analogy explaining the relationship of the ASEAN to the ASEAN Economic Community:

What is FSG’s View on the ASEAN Economic Community?

1. Multinationals across the board stand to gain from the AEC, either by directly participating in the growth story through their industry specific strategies or indirectly through the spillover effects of increased economic activity
2. The AEC is more than just a free-trade agreement; MNCs should soon begin to experience other benefits as the region begins to improve its infrastructure, have better intellectual property rights protection regulation and harmonized investment laws, and allow for easier movement of capital and skilled labor
3. Foreign direct investment should witness a surge as both inter-ASEAN and external foreign investments pour into the region to benefit from the access to the larger market, lower trade barriers, and increasing ease of doing business
4. It is unlikely that ASEAN can achieve its target of completely building the AEC by 2015. However, the deadline of December 31, 2015 does not indicate a magical date when the economic community suddenly ‘turns on’; it is already happening and therefore companies can benefit from the changes taking place right now

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Setbacks in the hopeful open sky policy for ASEAN, as well as more nervy news for Egypt’s declining fiscal health round off this week’s headlines highlighted by our research analysts:

The Wall Street Journal wrote an article on ASEAN’s open sky policy setbacks due to Indonesia:

“A good example showcasing the good intentions of the community and their positive impact on commerce in the region, but the unfortunate slow progress due to its consensus based approach of ratifying policies.”
- Shishir Sinha, Research Analyst for Asia Pacific

Arham Online, an Egyptian news website, reported currency reserves declining as Egypt’s state grain buyer steps aside:

“Egypt’s announcement that it is running out of wheat reserves is very troubling. Currency has weakened 15% since 2011 and FX reserves are down to US$13.6 billion. So it is becoming more expensive to import wheat and Egypt is running out of money to pay for it. Any significant spike in global commodity prices, a drought in Russia or Ukraine, etc. could lead to a larger economic crisis.”
- Matthew Spivack, Practice Leader for the Middle East and Africa

The Financial Times’ Beyondbrics blog, centered on emerging market news and also frequently read by FSG, posted a potential pulse in the Brazilian economy; the optimistic sentiment is not universally shared with regional executives:

“Though the Central Bank of Brazil is now stating that economic growth came in stronger than expected in 2012, this contrasts substantially from the sentiments our senior executives operating out of Brazil have expressed to FSG over the last few months. Most senior executives continue to see Brazil suffering from a sharp slowdown through the beginning of this year.”
- Antonio Martinez, Senior Research Analyst for Latin America

*Compiled by Hal Olson

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Companies should monitor Jakarta’s flood prevention initiatives to determine whether the new governor can affect change.

A recent deluge in Indonesia, which drove over 100,000 people from their homes and brought much of Jakarta to a standstill, has drawn significant attention to the country’s infrastructure deficit.  For the second time in six years, Indonesians in the nation’s capital found themselves underwater as a result of a neglected drainage system.

Jakarta’s new governor Joko Widodo (a.k.a. “Jokowi”) aims to put things right by making flood prevention a priority.  According to media reports, his administration plans to normalize 13 rivers running through the capital and dredge all its dams and lakes.  He has also announced plans to conduct a wide-ranging audit and require all buildings in the city to have infiltration wells.

Jokowi certainly has his work cut out for him.  He will have to plow through the entrenched interests and bureaucracy that have traditionally slowed infrastructure development in Indonesia if he is to put these plans into action.  With this in mind, companies and investors should monitor his progress.

If Jakarta’s governor is able to implement his proposed flood prevention measures, this will suggest that some of the barriers that have traditionally hindered infrastructure development in Indonesia are beginning to fall.  If he is not, then it is unlikely that infrastructure development in the capital will accelerate anytime soon.  After all, if a wildly popular governor can’t install flood prevention systems in the wake of a devastating deluge, what hope is there for the rest of Jakarta’s infrastructure?

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Important to remain alert: Amidst the enthusiasm, multinationals should not underestimate the fragility of Myanmar’s long path of development that can easily be derailed by misguided leadership and influential crony businessmen. Here are four red flags for you to look out for:

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I wrote in this post that for many global businesses operating in emerging markets, the most common sales channel is to operate through distributors.  In Indonesia, one of the truly hot frontier markets in the Asia-Pacific region, this is especially true and a key success factor for MNCs.  Geographically fragmented across many large and small islands, the country has a growing consumer base but is difficult to navigate.  Even foreign companies FSG supports that have been there for over a decade continue to have an indirect or hybrid channel presence, not a pure direct sales force.

I recently spoke with one of FSG’s expert advisors in Indonesia, Ignatius “Iggi” Khomasurya, about the distribution environment there.  He had three basic messages for companies looking to enter or expand operations in Indonesia.  First, there are some interesting trends underway that are expanding opportunity for multinationals and worth a careful look.  Second, though it is a challenging business environment (beyond the geography), it is navigable with proper planning.  Third, there are some big mistakes he has seen other companies make, that you don’t have to.

Trends

The more things change… Cold chain is starting to expand in Indonesia.  This means distributors increasingly deploy refrigerated trucks across the country, which is great news for many businesses, especially those involving food and pharmaceutical products.

A second trend is that the rise of cloud computing is increasing local business interest in deploying enterprise technology and software for sales force automation.  Previously, setup, maintenance and connectivity concerns were prohibitive, but in the cloud, those costs are greatly reduced.   So you can start to expect your distribution partner to report “real time” daily sales figures by area, salesman, store type and SKU.  On the cutting edge, a local FMCG has deployed 1,000 iPads to its sales force.  If you want your distributors to track pipeline inventory in real time, it might not happen tomorrow, but it is no longer a hope that is worlds away.

The more they stay the same… The average consumer in Indonesia does not yet trust e-commerce, and many do not yet have a credit card.  In fact, Iggi said, there are 27 issuers and only around 20 million credit cards in Indonesia, out of a population of 240 million (and many people who do have cards hold two).  This means people (and businesses) use cash and are very tight on cash flow.  As a result, middle and low income Indonesians often prefer to buy a SKU with a small “cash ring” on a daily basis (say a 10 ml shampoo sachet) rather than bulkier packages (a 100 ml shampoo bottle), even if that means forgoing a bulk discount and convenience.

A fourth and final trend is that unlike most other Southeast Asian countries, Indonesia is still dominated by traditional rather than modern retail, and that is changing very slowly.  There are around 2 million outlets in Indonesia selling goods that needs to be replenished regularly. The supermarket presence in Indonesia is growing, but volume sold through convenience stores is growing faster.   Even so, the government is concerned that mom and pop stores will be killed off by modern retail, so it is intervening.  Recently a rule passed to cap the number of stores owned by a single company, such that expansion beyond a certain number can only be done through a franchise model.  This rule aims to facilitate the conversion and revitalization of fading mom and pop stores in a way that still encourages small local business ownership to professionalize and survive.

Difficulties

One of the largest difficulties for MNC’s operating in Indonesia is that local distributors are biased towards believing that foreign companies are trying to take advantage of them.  They are especially concerned that MNC’s will use them to blaze a distribution trail and then take over with their own sales force, offering poor compensation for their initial efforts.  Indonesians are often not confrontational, but Iggi says there are some “bad apples” that can become very antagonistic when an MNC attempts to exit a distribution arrangement with them.  Antagonism is a particularly likely outcome when a distributor feels humiliated and is sensitive to losing face.  Retaliation can be directed at your individual manager, or at your company.  In both cases, distributors can lean on and attempt to mobilize official powers on their behalf.

Threats against individuals can include action in the realm of immigration (instant deportation), taxation or in extreme cases police or military action.  Iggi knows of a local lawyer whose advice to a distributor was to have an expatriate general manager arrested and put in jail to force more favorable negotiation terms.  Some well-known MNCs have had their expatriate staff jailed or passports taken away in the midst of negotiations.  This is scary stuff, but real.

Threats to companies usually involve lawsuits. Iggi tells about a company sued by a distributor that “lost face” when the MNC exited to set up its own sales and distribution unit.  The courts tied up the company’s plans for the next three years, prohibiting appointment of a new distributor or a sales team.  The company went from 70% market share in Indonesia to around 30% by the time the ordeal was resolved.

The majority of distributors are not this uppity.  The ones to watch out for are those with owners with both sensitive personalities, and the resources to retaliate when displeased.  These difficult distributors often have a reputation and can be identified ahead of time by checking in with MNCs and local businesses operating in the community, whether in Jakarta or in the outlying provinces.

Advice

Fortunately, Iggi did not leave us feeling down on Indonesia.  By keeping a few lessons in mind, it is possible to capture Indonesia’s opportunities without incurring the wrath of distributors against the individual manager or company.

First, spend the time to find a good distributor. There are many good ones in Indonesia. Again, ask other MNCs or the people on the ground for character references, and conduct a professional background check if your budget allows.  One word of caution when selecting distributors: screen for motivation, not just ability.  One channel manager at a fast moving consumer goods company in Indonesia recently told Iggi they look for five things in a distributor: 1. Strong financials and good connections; 2. Distribution permits set up and ability to expand distribution; 3. Ability to hire and develop salesmen; 4, Ability to handle collections; 5. Ability to manage in-store merchandising and promoter personnel. At first glance this appears to be a pretty robust list.  But something important is missing.  That manager is just looking for ability, the elements of which are usually external and visible.  But he is not paying enough attention to a core question: who are these people, what motivates them, and are our objectives really aligned?  Because it can be complicated to exit a relationship in Indonesia, you want to be as sure as possible that you are entering a durable relationship.

Second, hire a good local lawyer.  Not when you’re in trouble, but just as a part of your local overhead.  Your general counsel from corporate center is probably an excellent lawyer, but they do not know how to help you structure contracts in Indonesia such that both you and the distributor both agree on what the contract really says.  A good local legal counsel can also help tackle the challenging situations above and draw both parties towards quick, amicable resolution.

Third, when you exit a distributor, understand that it expects to be paid “fairly” in exchange for going away quietly.   It is not unusual for a distributor to expect a significant severance package – on top of the expectation that you will buy out any remaining inventory that they are holding and on occasion help pay the cost of personnel redundancy.  One way to potentially avoid such a payout is to put the distributor on the defensive a few months before you broach the subject of terminating your relationship.  You can put them on the defensive by setting clear measurable expectations that they are not meeting, and by writing official letters pointing to breach of contract.

Fourth, when switching distributors, get involved in the details on both the outgoing and the incoming end.  Make sure you map out the client base the first distributor was reaching, and ensure that the new distributor guarantees to reach the same outlets and more.  Some companies have left a distributor that promised coverage of 60,000 outlets to gain a distributor that promised to reach 75,000 – only to find out after the transition was nearly complete that the second distributor did not have strong links to most of the original 60,000 outlets which were larger accounts and had been loyal customers.

Finally, if you decide to transition to a direct sales force, remember it is tricky to build one from the ground up in Indonesia.  Your best bet is to “hijack” the sales force that was already working for you, but was employed by your distributor.  To ensure this is possible, it is important to structure the initial distribution arrangement so that you have dedicated sales personnel working for you within the distributor, which you help train.  This is not uncommon, and if it is so arranged, these sales personnel will often gladly work for you later.  If negotiated smoothly, the distributor is content to see this happen rather than simply laying off a bunch of employees and creating a labor or morale problem on top of its lost business.

In conclusion, Indonesia is stable and growing, but it is still in some ways the Wild East, especially when it comes to channel management.  As the world’s fourth most populous country it should receive serious attention by any APAC regional executive when conducting market prioritization exercises.  FSG believes that the size of opportunity in Indonesia is actually head and shoulders above the other individual members of the ASEAN pack over the next several years.  We do not discourage operating there, but you’ll want to stay extra alert, and get plenty of local advice.  And of course you will benefit from staying connected to the collective wisdom of other MNCs operating in the country, which is one of FSG’s sweet spots.  Good luck, and let us know if we can help.

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Indonesia is becoming one of the top choices for many multinationals looking to diversify their APAC portfolio as growth in China slows and India experiences high volatility

• Indonesia’s remarkable growth, which is drawing record numbers of global investors, is no longer limited to Jakarta and Java
• To take full advantage of Indonesia’s rapidly growing market, companies must strike a balance between market penetration and cost effectiveness
• Leading companies in Indonesia are accelerating their expansion outside of Jakarta and Java by focusing their efforts on:
• Prioritizing provinces and placing strategic bets
• Understanding the changing market landscape
• Leveraging relationships with local companies and distributors

B2C Companies Should Gauge Relative Opportunity by Tiering their Markets and by Monitoring Proxy Indicators to Add Depth to This Analysis*

• B2C companies should find a strong consumer base on the islands of Java and Sumatra, where the majority of Tier 1 and Tier 2 provinces are located
• Companies can conduct more in-depth studies by including proxy indicators and focusing on key cities during their tiering exercises; this should help them to expand strategically without spreading themselves thin
• Example: Monthly Expenditure, % of Households with Computers, CAGR of cellphone ownership

**Stay tuned for next post on Growth Opportunities in Indonesia B2B Market**

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