Emerging Markets Insights

How prepared is our business for recession in Russia?

This is the key question multinational companies should be asking themselves as they develop strategic plans for their business in Russia.

Multinational companies are increasingly relying on growth in Russia to compensate for dwindling demand as the eurozone recession deepens and much of Central and Eastern Europe slows. And while Russia has performed relatively better than most of CEE – it grew 4.2% in 2011 – this has been mostly on the back of high oil prices.

High oil prices have supported the ruble, funded high government spending, and benefited Russian consumers who in turn have helped boost GDP growth. However, high oil prices have also made Russia a much riskier market to operate in. Russia will balance its budget this year at US$117/barrel oil up from US$37 in 2007. The country’s rainy-day fund is less than half of what it was in 2008 when it helped the country stave off the worst effects of the global financial crisis. And Russia’s economy is as far as ever from true diversification away from energy.

What does this mean for the country’s economy? Standard & Poor’s estimates that if oil prices fall to US$80/barrel, Russia will be in recession; a decrease to US$60/barrel will lead to a 5% economic contraction. This will reverberate through the whole economy, impacting companies across industries. It will also lead to capital flight, currency depreciation, and, unlike in 2008, political instability.

Although Standard & Poor’s estimates the likelihood of these scenarios playing out in the next 2 years to 30%, there are valid reasons why multinational companies should invest resources in planning for this risk. Global oil prices are not supported by supply-demand fundamentals, and will experience significant declines if the eurozone plunges into deeper recession, China’s slowdown continues, and there is an easing of international tensions with Iran. All of these events are, to some extent, already under way.

This makes planning for a significant slowdown or even recession in Russia is not just an exercise in counterfactuals; it’s an essential piece of how MNCs should be thinking about protecting their business in Russia and preparing it to take advantage of the opportunities a recession will no doubt bring about.

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Nigeria is a tale of two regions as city-level opportunities in the south overshadow widespread insecurity in the north. Companies must overcome corporate HQ fears regarding operational risks to position for long-term success in Nigeria, which remains the most attractive long-term investment destination in Sub-Saharan Africa.

Last month ethnic conflict ravaged northern Nigeria, leaving 150 dead and 100 injured. This continues a troubling trend of violence in 2012. From an investment perspective, this has rattled foreign companies that are wondering if Nigeria is becoming too risky. However, halting or drastically scaling back investment plans would be a mistake for senior executives.

Much of the violence is isolated in the economically underdeveloped north. The total GDP of 7 attack locations between April 5 and May 4 is US$25 billion, which represents less than 10% of Nigeria’s economy. On the other hand, the total GDP of 7 top investment destinations in the south is US$80 billion. This represents more than 30% of Nigeria’s economy.

Nigeria’s five largest cities, all of which are located in the south, have a combined GDP exceeding US$75 billion. This is surpassed only by Angola and South Africa.  City GDP in Nigeria’s south is set to expand significantly this quarter, even if only on paper, because the government is shifting the base year for real GDP to 2009 from 1990. The result will be an overnight gain of 40% that closes the overall economy size gap between Nigeria and South Africa to only 10%.

Southern cities represent great opportunities for companies targeting emerging consumer classes, public sector projects, and other private sector companies flocking to urban areas. Companies should establish good relationships with distributors that know the southern part of the country well. Much of your sales opportunities are likely to be concentrated in this region for the foreseeable future.

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While Turkey is one of EMEA’s most attractive growth markets, MNCs face significant challenges in building a profitable business there. According to Frontier Strategy Group’s clients, strong local competition is one of the biggest obstacles to growth in Turkey. MNCs can improve their profitability and boost their performance in Turkey by leveraging increased scale to cut costs and create economies of scale.

FSG’s research shows that scale leads to improved profitability in Turkey at a higher rate than it does in the BRIC markets. One way in which MNCs can take advantage of this is through M&A. The M&A market in Turkey is particularly favorable due to the weak lira, the slowdown of the economy which is depressing valuations for export-oriented local players, as well as the upcoming introduction of Turkey’s new commercial code which will improve transparency and strengthen shareholders rights. As competition for the best assets from private equity funds intensifies, MNCs will have a limited opportunity to take advantage of this favorable environment and reap the benefits of improved profitability in Turkey.

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Sub-Saharan Africa’s potential for economic growth is no longer a secret.

Some estimates show Africa having as many middle class households as China by 2020.

The region is expected to set the pace for global growth over the next five years, with economic expansion averaging 6 per cent per year. China increased Africa investment by almost 60 per cent last year, while India pledged to expand trade volume to $90bn (£56bn) by 2015.

Much of this investment will be concentrated in fast-growing sub-Saharan African markets like Angola, Kenya and Nigeria. Multinational corporations are increasingly concentrating resources on these types of markets to make up for economic volatility in Europe and political uncertainty in the Middle East and North Africa.

In a survey conducted last year, 42 per cent of senior executives focused on Europe, the Middle East and Africa (Emea) revealed that they are planning to set up a direct presence in at least one sub-Saharan African country in 2012. More than one-fifth of polled executives said they plan to establish an African managing director role within two years to oversee regional operations.

Multinationals intend to capture average profit margins greater than 10 per cent and returns on capital 60-70 per cent greater than in high-growth markets like China, India and Indonesia.

If multinationals want to capitalise on all that Africa has to offer, then a fundamental shift must take place in the way that companies prioritise markets for resource allocation decisions. Africa is far too big and complex to look at as one market, or even as a portfolio of countries. Companies must look at the African opportunity as a portfolio of cities, targeting the urban areas that offer the best opportunities for their business.

To continue reading the full article, visit the Financial Times website.

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If you are not going direct in Turkey, then you are likely missing out on a tremendous opportunity for your business. In our latest research on the market opportunity in Turkey, Frontier Strategy Group identified three questions you should ask about the state of your operations in Turkey:

1. Turkey’s M&A market is ripe for acquisitions, but MNCs increasingly have to compete with private equity funds for the best assets. How is your company leveraging acquisitions to grow its presence in the Turkish market?
2. MNCs leveraging Turkey as a regional sales hub are 9% more profitable in Turkey than the global average for their company. How is your company taking advantage of Turkey’s growing position as a regional hub?
3. Turkish distributors are 23% cheaper as a percentage of profit margins than the global average. How effective is your company at leveraging distributors to increase market penetration in Turkey?

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Consumer spending will remain high through H1 2012, benefiting the consumer goods and technology sectors. However, a struggling industrial sector and a rise in inflation will reverse this trend starting in H2 2012.

Drivers

Historically low inflation, averaging 6.1% in 2011, will support household spending through H1 2012. However, utility and residential tariff hikes scheduled for June will lead to a sharp uptick in consumer prices in the second half of the year.

Unemployment, at 6.1% in December, is at a historic low and is supporting a positive consumer outlook.

High energy prices are supporting the ruble, driving up consumer demand for imported goods.

Frontier Strategy Group View

High consumer spending will buoy demand for consumer goods, pharmaceuticals, consumer electronics, and durable goods through the first half of 2012.

A decline in energy prices remains a downside risk to the broader Russian economy, including to the consumer sector.

Over the next two years, some of the social spending increases promised by Vladimir Putin during his presidential campaign will be carried out, providing support for Russian consumers.

Social spending increases will have the strongest impact on sales of fast-moving consumer goods and out-of-pocket pharmaceuticals.

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Original article appeared in Business Insider

MNCs should anticipate some political and economic liberalization, particularly among regional authorities, after Putin returns to the presidency. However, we expect any new reforms to have limited positive effect on the business climate in the country.

In the short term, Russia may see increased investor uneasiness paired with ruble depreciation and capital outflows, as the elections will be followed by protests. However, we expect the situation to stabilize and investor confidence to return by 2H 2012.

Putin is neither willing nor capable of delivering the reforms demanded by the Russian middle class. Over time, this will erode Putin’s legitimacy and power base. To avoid large-scale political change that may threaten their personal wealth, Russia’s political elite may decide to sacrifice Putin in a partial political liberalization that would see him replaced before his six-year term as president ends. This scenario is particularly likely if there is a major external economic shock, such as a sharp decline in energy prices.

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Relatively high commodity prices are supporting government spending plans for most oil and gas exporters in the Middle East and Africa. If rising tensions involving Iran and Israel turns into a conflict, then commodities prices will climb to much higher levels and stoke inflation regionally. Import-dependent economies in East Africa, North Africa, and the Middle East are particularly vulnerable to commodity price spikes that undermine consumer spending power and make it difficult for SMEs to meet their financial obligations

Algeria: The export-oriented economy is exposed to eurozone volatility due to trade with European markets

Angola: Massive oil diversification budget spending continues this year, which means more opportunities for consumer goods and healthcare MNCs

Egypt: The country’s economy remains on the brink, though investors are hopeful that an IMF deal will provide short-term relief

Ghana: The economy remains strong due to government spending and natural resource riches, though new tax policies are a concern for investors

Iran: The local environment is increasingly precarious due to a combination of economic distress and covert military activity

Iraq: The country’s short- and long-term growth outlooks are positive, supported by increased oil production capacity and elevated global prices

Israel: Apple’s commitment to the Israeli technology sector demonstrates the attractiveness of the country’s tech industry right now

Kenya: Parliament’s bid to unseat the head of the central bank head is only the latest example of domestic political discord

Morocco: Government spending keeps growth positive, but the eurozone casts a long shadow as a fall in remittances impact Moroccans

Nigeria: Strong growth will not be derailed, though inflation and security risks pose challenges to the economy

Saudi Arabia: Economic fundamentals underpin a strong outlook, though MNCs should monitor regional tensions

South Africa: The budget offers opportunities for investment and tax relief to citizens, though alcohol and tobacco tax hikes will sting some MNCs

Tanzania: Inflationary growth continues to place pressure on consumers and the economy

UAE: Tighter Iran sanctions will benefit the UAE through increased oil demand, but a critical trade relationship will suffer

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On January 1, the Nigerian government removed the long-standing subsidy on fuel, increasing prices from 65 to 150 naira per liter. Following local protests and negotiations, President Jonathan reduced the increase to 97 naira per liter, a 50% increase

While some view this as a clever strategic move, the haphazard implementation (including using the military to quell protests) has called into question the government’s ability to implement other much-needed reforms

Drivers

Reduced Political Capital: The new president’s “honeymoon” has officially ended. The president can no longer count on broad-based political support, and has recently been stymied by state governors, unions, state legislators, and religious leaders

Poverty and Inequality: A perception that reforms favor elites and businesses will continue to plague the president. Critically important will be future implementation of the president’s “jobs agenda” for generating employment, especially among youth

Fighting Corruption: Recent anti-corruption moves, such as dismissing state governors, are largely symbolic and the president’s policies must succeed where others have failed

FSG View

The fuel subsidy removal is unlikely to be repealed. Higher local fuel prices and reduced consumer discretionary spending should be priced into operating budgets immediately

The next three months will be critical to bolstering government credibility and preparing for upcoming economic improvements

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The Egyptian pound is likely to devalue by up to 20% against the dollar in 2012. The currency’s slide in value represents the biggest threat to the Egyptian economy.

• Egypt’s government is running out of hard currency to prop up the pound, which will result in a devaluation
• Devaluation is likely to take place following the presidential election at the end of June 2012
  • Egyptian authorities want to avoid an economic crisis that could delay elections

The currency is supported by unsustainable conditions

• Capital flight: Egypt’s revolution drove a 60% contraction in FDI. The tourism sector, a key industry that drives foreign currency accumulation, reported a 30% reduction in revenue last year. Meanwhile, portfolio investors sold more than US$7.5 billion in Egyptian T-bills in 2011, comprising more than 25% of foreign holdings
• Import dependence: As the largest wheat importer in the world, Egypt has a US$23.6 billion trade deficit, adding pressure to the local currency
• Unsustainable monetary policy: The central bank spent US$18 billion, 50% of its total reserves, supporting the currency in 2011

Egypt is running out of funds to stabilize the local currency

• The US$23 billion budget deficit will expand because of  new subsidies and weak foreign investment
• The central bank required a US$1 billion loan from the military earlier this year, which is an unusual step that exposes a lack of funding for the institution
• Most of the US$10 billion pledged by the G8 and GCC countries has not yet reached Egypt. Donor countries want to see a greater level of economic stability before releasing funds
• Renewing discussions with the IMF over a US$3.2 billion loan will not make a significant difference in funding if an agreement is reached

Political and social factors undermine the currency’s outlook

• Political uncertainty is undermining the outlook for the currency as investors, both domestic and foreign, do not want to hold Egyptian pound-denominated assets
• To reduce uncertainty, Egypt must achieve several political milestones this year, including presidential elections and the writing of a new constitution
  • The constitution will define the military’s future role in Egypt
  • An unclear transition timetable from military to civilian rule could deepen local tensions
  • The same underlying factors that led to the revolution, such as high inflation and unemployment, are still serious concerns and may be drivers of continued instability

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