What Does The Rise of Manufacturing in ASEAN Mean for Multinationals?

While the rise of Southeast Asia has been discussed widely over the past few years due to its strong consumption demand, the production aspects of the region remain relatively unexplored with many companies not having examined ASEAN’s manufacturing capabilities, its ability to achieve economic integration, and the comparative strengths of the individual members as production units. FSG’s research shows that manufacturing is likely to play a significant role in ASEAN for years to come

The Rise of Manufacturing in ASEAN

Southeast Asia has experienced a strong CAGR of 5.5% in terms of its manufacturing output over the last decade and is now responsible for almost 4% of the global manufacturing output. This growth has been funded both by domestic companies as well as foreign investors; ASEAN surpassed China in terms of the FDI inflow in 2013 and the manufacturing sector received a large chunk of the funds. In fact, more than 30% of all FDI that has flown into ASEAN between 2005 and 2010 (see pie-cart below) has been towards manufacturing, and the sector is likely to continue to be one of the biggest beneficiaries of the growing interest from foreign investors. The major reasons for this drive in investments can be summarized through the ASEAN’s four C’s: Consumption (growth), Cost (low), Commodities (abundant), and Community (single ASEAN trade bloc)

ASEAN 1

However, even though the majority of the ASEAN countries have moved out of the agrarian state and have seen this growth in manufacturing, many are still in the early industrialization phases; meaning that the manufacturing sector is going to continue to see strong growth over the next 10 to 20 years (see graphic on the evolution of countries below) and will play a significant role in the development of the region

ASEAN 2

Assess the Direct Impact of the Rise of Manufacturing

  1. Serving the market: As costs rise elsewhere and the addressable market becomes larger in ASEAN, companies should explore the viability of moving production to the region using a “total factor performance” analysis. It is important to make sure that the analysis looks beyond the simple math of labor-cost and considers total factor performance (labor, transport, leadership, material, components, energy, and capital)
  2. Business customers (B2B) movement: Companies serving other manufacturing and production types of businesses should be assessing what types of industries are likely to invest heavily into Southeast Asia and which are not likely to consider moving beyond China

Gauge the Spillover Effects from the Rise of Manufacturing

  1. Productivity impact: The rise of manufacturing is going to positively impact productivity within the region, which has not seen a large improvement over the past decade. Manufacturing makes outsized contributions to trade, research and development (R&D), and productivity. The sector generates 70% of exports in major manufacturing economies, both advanced and emerging, and up to 90% of business R&D spending. Such productivity growth provides additional benefits, including considerable consumer surplus
  2. Rise in consumption will impact all industries: As the less industrialized countries of Indonesia, Vietnam, the Philippines, Myanmar, and Cambodia move from agrarian societies to manufacturing ones, companies should expect consumption dynamics to evolve. As people move from the less predictable farming sector to the fixed-wage manufacturing sector, they tend to experience strong income growth, increasing their capacity to consume. Even companies not exploring manufacturing opportunities in the region need to be monitoring this trend

Establish a Strategic Role for the ASEAN Region in Your APAC Portfolio

  1. Evaluate a “China Plus” strategy- China’s rise to manufacturing prominence over the past two decades has been staggering. However, rising costs, more sophisticated consumers, and fundamental macroeconomic realities mean that current approaches to manufacturing are losing their relevance. As the imperative for companies in China will be to boost productivity, refine product-development approaches, and tame supply-chain complexity, ASEAN has appeared on the horizon as a viable alternative for companies looking to expand their manufacturing footprint into relatively lower-cost locations. ASEAN countries provide cheaper labor, investor-friendly governments, and are part of established supply chains
  2. Compare the competitiveness of ASEAN (to China and India) – China is unlikely to lose its dominant position as the “factory of the world” anytime soon because of its well-established infrastructure, existing manufacturing facilities, ability to scale quickly, and strong involvement in established global supply chains. However, certain low value-added industries are likely to consider moving out of the country or at least setting up their next facility in Southeast Asia, where the cost of labor can be less than half of that in coastal China. ASEAN countries provide access to several raw materials, and certain locations have strong linkages to trade infrastructure
  3. Explore ASEAN’s complementarity to China- ASEAN countries are also likely to be playing a complementary role to China within several industries that depend on Asia for producing parts and final assembly. Given China’s established role as one of the most productive assembly locations in the world, due to its ability to scale quickly and availability of infrastructure, many companies produce their parts and components in cost-effective locations within the ASEAN region, conduct the final assembly in China, and then have the finished product shipped to the end customer. The ASEAN-China free trade agreement has helped companies create such fragmented supply chains

In FSG’s latest report on the region, titled ‘ASEAN’s Role in Manufacturing’, (a) we explore the rise of ASEAN as a manufacturing hub, (b) diagnose the viability of movement of different types of industries into Southeast Asian countries, (c) conduct a location analysis of the various manufacturing sites in ASEAN, and (d) decipher the impact of the ASEAN Economic Community on manufacturing decisions. FSG clients may click here to see the full report

Global Courtship of ASEAN

Free Trade Agreements have become the flavor du jour and Southeast Asia is not being left behind on that trend. The ASEAN countries are now involved in negotiations for two very different trade agreements: the Trans-Pacific Partnership (TPP) and the Regional Comprehensive Economic Partnership (RCEP) while continuing to pursue their own trade liberalization attempts through the ASEAN Economic Community (AEC).  Below is an outline of the key components of the Free Trade Agreements and what MNCs can expect in 2014:

Global Courtship of ASEAN

Key Insights for MNCs: Understanding the AEC vs. RCEP vs. TPP  

ASEAN Economic Community (AEC)

  • 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
  • All member states will gain economically from the AEC, and real income is expected to increase significantly. Overall, exports will outpace imports in the manufacturing sector, easing integration into global supply chains
  • Growth is likely to be inequitable among member countries; companies should conduct in-depth studies to understand individual market dynamics

Regional Comprehensive Economic Partnership (RCEP)

  • RCEP can be thought of as an extension of the AEC; it will deepen ASEAN’s relationship with its six FTA partners
  • RCEP involves a lot of consolidation; it will build upon guidelines that already exist while working toward fixing the inconsistencies in regulations that exist, both with FTA partners and within the individual ASEAN countries
  • RCEP is dealing with several trade harmonization issues and is therefore concentrating more on “border-based” matters

Trans-Pacific Partnership (TPP)

  • While similar to the RCEP in pursuing trade harmonization, the TPP’s major difference is in its attempt to address issues that companies have to deal with once they want to set up an entity in a country. The TPP goes far beyond the “border-based” matters
  • Proposed regulations in the TPP have a very high standard, but that is necessary, because it still has to go through several rounds of negotiations. Starting with lower standards might leave the final product at a subpar point
  • Certain ASEAN countries might find the TPP appealing, because it would force them pass locally unpopular regulations that can benefit the country in the long run. Vietnam would have to reduce preferential treatment of its state-run-enterprises (SOEs). Participating in the TPP will be lot more complex than joining the RCEP. The TPP is not a group effort, but one where individual countries must decide if they have the political will to undertake the comprehensive domestic overhauls required for membership

What Should Multinationals Expect During 2014?

 ASEAN Economic Community (AEC)

  • The ugly truth is that the AEC 2015 is just the beginning, not an end; expecting all policy targets to have been met and support systems to be smoothly functioning by 2015 would be an unrealistic hope. Negotiations are likely to continue way beyond 2015 as the ASEAN area attempts to meet its original agenda of creating a political-security and socio-cultural community

Regional Comprehensive Economic Partnership (RCEP)

  • RCEP has been designed to deepen the relationship between the ASEAN countries and its six regional partners. Subsidiaries of Western MNCs based within the ASEAN region are likely to benefit more directly. MNCs supplying to other MNCs or to Chinese, Japanese, and Korean companies would benefit from the lower trade barriers and improved logistics within the region

Trans-Pacific Partnership (TPP)

  • While the TPP was planned for completion at the end of 2013, as a result of the US government shutdown and complexity of negotiations when Japan joined the group, the likelihood of completion might stretch beyond the end of 2014, closer to the next US presidential elections in 2016. US President Barack Obama will be working hard in 2014 to be given “Trade Promotion Authority” (TPA). Under TPA, Congress provides authorization to the president to negotiate trade agreements such as the TPP. The president can negotiate and conclude an agreement, but without TPA, Congress is free to amend the agreements during the approval and implementation process. Parties would be very reluctant to conclude a TPP deal if they thought the US Congress would be able to amend it

Thailand’s economy is struggling but will not suffer another 1997 Asian Financial Crisis

Thai FlagThailand’s economy has been struggling this year.  Industrial production has slowed as growth in eight of the country’s top ten export markets has deteriorated, and domestic demand has stagnated as an expiring tax rebate for cars has weighed on consumption.  Unless there is a rebound in China, the US, or Europe over the coming months, the economy is likely to continue limping along slowly.

Thailands top ten export partners

Thailand’s slowdown, together with the recent capital outflows from emerging markets, has aroused fears that the country may suffer a repeat of the Asian Financial Crisis.  After all, that crisis was marked by falling exports and capital outflows as well.  However, it’s important to remember that Thailand’s collapse in 1997 was largely due to a massive real estate bubble, an untenable currency peg, and high levels of short-term foreign currency-denominated debt.  Together, these three factors pushed the economy into a downward spiral when trade slowed and hot money flowed out of the country.

Today, Thailand is free from this triple-threat.  The country does not have a massive real estate bubble, inflated by years of capital misallocation.  The baht floats, so it is no longer vulnerable to speculative attacks from international investors.  And Thailand no longer has huge amounts of short-term foreign currency-denominated debt.  In sum, the country is not in danger of suffering another ’97-style crisis.

With this in mind, companies should not let themselves be distracted from monitoring the established risks to Thailand’s economy: political turmoil in the wake of the king’s eventual death, another round of severe flooding in the event of record rainfall, and a crisis in China, Europe, or the US.  These risks may be familiar, but their potential impact has not diminished.  Companies should ensure that their contingency plans for those risks are up to date instead of preparing for a repeat of 1997.

Distributors Are the Way to Go: Indirect Channels Highly Dominant in the ASEAN-5

Why Is It Paramount to Understand The Optimal Management of Distributors in ASEAN?ASEAN-5 Benchmarking

As in most emerging market regions, multinational corporations (MNCs) operating in the ASEAN-5 are heavily dependent on distributors, making optimal management of these partners key to survival and growth in these highly dynamic markets.

A combination of the three factors below makes it imperative for regional heads to concentrate on improving internal capabilities to complement the unsophisticated nature of the market:

  1. Dominance of Distributors: Most MNCs will be using distributors for their sales in the ASEAN markets, with the indirect channels bringing in 71% of revenues, as compared to 65% in the APAC region overall. Companies will only use their own sales team for handling key clients in relatively well-established geographical locations (national capitals)
  2. Few Established Players: On average, companies tend to use 2–4 distributors but often state that they don’t have enough established partners to work with; 41% of the respondents (based on FSG’s survey) found scarcity of finding alternative distributors to be a key issue
  3. Hands-On Approach Critical: Given that there aren’t many established partners, companies have to find local entrepreneurs with potential and grow them into successful businesses by training and supporting their activities

 

Distribution in the ASEAN-5: Fairly Similar Model Across the Region

When comparing the same industry in the majority of the ASEAN markets, the go-to-market strategy should be fairly similar. However, on-the-ground tactics can differ based on the needs of the individual market and company.

  • Example: In Indonesia, if the firm’s goal is to achieve geographical expansion, then having a few sets of distributors becomes important in order to have some to manage Jakarta, and others to manage outside of Jakarta (Java), where credit management tactics can differ vastly

Common Model of Relationship in ASEAN

 

Using Local Sources Effectively Can Go a Long Way in Helping You Find Distributors

Selecting the right local partner can be the difference between success and failure for most companies expanding within the ASEAN region. Following an analysis of the distribution landscape, companies can identify potential partners through some of the following sources:

Finding Alternative Distributors


Truly Understanding ASEAN: Country-Level Analysis Not Enough

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)

Wealth in Southeast Asia

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

 

Adopt a Regional Mindset with a Country-Level Focus for ASEAN Strategy

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):

Key Economic Contributors of Individual Countries (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.

 

Managing Indonesia’s Workforce Risks in 2013

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.

Minimum wage increases (2012-2013) and firing costs

 

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.

 

Recognizing the Impact of the ASEAN Economic Community

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

Growth in Key Economic Activities Above Baseline in 2015

 

Understanding the ASEAN Economic Community

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:

 

Four pillars of 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

 

Emerging Market View: What Our Analysts Are Reading – 2/22/2013

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