Emerging Markets Insights

There is some optimism among Middle East analysts and US government officials regarding easing tensions with Iran. The renewal of direct nuclear negotiations and the Obama administration’s determination to avoid an oil price spike during an election year has supported these developments.

An averted regional conflict would mean a modest decline in the cost of doing business in MENA, but this hinges on a breakthrough in the next round of nuclear negotiations and shifts in internal political dynamics in Iran and Israel.

As a result of easing tensions, a modest decline in oil prices would be gradual and have global implications on the cost of doing business and consumer spending power, particularly in import-dependent markets.

In the Middle East and North Africa, an improved risk profile would lead to lower insurance premiums for transport and a lower cost of production. MNCs would have greater pricing flexibility without facing the choice of whether or not to pass on higher costs to customers. While an improved environment bodes well for making the case for investment, it is unlikely that the corporate center will shift its cautious approach to the region.

Companies should monitor key signposts to anticipate the trajectory of this developing story in MENA:

1) Nuclear negotiations on May 23 in Baghdad: A lot is riding on the emergence of concrete steps from this round of negotiations and failed talks could swing the atmosphere away from cautiously optimistic very quickly. The Iranians are already managing expectations by messaging that this will be part of a process rather than a breakthrough round.

2) Centralization vs. decentralization of Israeli decision-making: FSG has told clients for months that centralized decision-making with Prime Minister Netanyahu and Defense Minister Barak increases the likelihood of a conflict, while decentralized decision-making with institutions decreases it. Israel’s centralized approach to Iran is increasingly being opposed by the military and intelligence institutions.

3)    Political messaging and domestic realities in Iran: Iranian messaging that the Istanbul talks were a victory is a significant development, because the government might be laying the groundwork for a negotiated settlement. Ongoing sanctions, and tightening of oil restrictions on July 1, may have changed how the Iranians are calculating negotiations due to a weakening currency and overall economic pressure.

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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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Companies are moving to more direct models in Saudi Arabia to capitalize on increasing public expenditure in priority sectors like education, healthcare, housing, and related infrastructure.

A local presence allows MNCs to be closer to customers and to leverage partners more effectively.

Drivers

Companies know their products better than distributors: Visiting local partners on an infrequent basis is not enough to imbue expertise in your product offering. There will always be a gap between realized and actual market potential without this knowledge.

Closer oversight of partners: Establishing a more direct presence allows companies to manage local partners closely and take advantage of special treatment due to the government’s mandate to prioritize companies with a local presence.

Business climate stability amid regional uncertainty: The Saudi market is growing in regional importance as companies de-prioritize business in less stable markets such as Egypt, Iran, Lebanon, Syria, and Tunisia.

Recognition of rising MNC competition: MNCs must get closer to customers due to the rapid expansion of foreign MNCs and regional conglomerates into the Saudi market.

Frontier Strategy Group View

Companies should no longer expect to capture the full potential of the Saudi market if they are based elsewhere in the Gulf region.

MNCs are finding it easier and more necessary than ever to go direct or form joint ventures in Saudi Arabia. The commercial infrastructure improved significantly over the past decade, exemplified by Saudi Arabia’s #12 global ranking in the World Bank’s Ease of Doing Business Index.

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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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Country and regional heads are increasingly turning their attention to their government engagement function. Government decisions, from regulatory issues to government sales, can deeply impact the bottom line.

Companies wrestle with a variety of questions when it comes to running successful government engagement functions. These questions can be broken down into three principal challenges:

1. Ensure the company invests the right amount in government engagement.

2. Generate positive engagement when government actors are initially unreceptive.

3. Capitalize on the abilities of third parties without putting the company at risk.

In response to these challenges, most companies resort to a reactive, problem-solving approach. In order to succeed, the government engagement function should reframe traditional ROI evaluations to embrace the broader goals of government engagement, thus creating a proactive decision framework. This new ROI approach applies to each of the three major challenges companies face:

1. Justify Your Investment – First understand how to tailor your investments to the realities presented by each country’s business and political environment.

2. Earn Your Influence – Make sure you time the ―I‖ well in ROI.

3. Discipline Your Delegates – Do not take short cuts with third parties. A low ―I‖ does not guarantee high ROI if the ―R‖ turns out to be negative.

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Nigeria’s government must walk a tightrope to successfully implement its reform agenda and satisfy angry citizens who are feeling the pain of fuel subsidy rollbacks. However, a resolution to the current political impasse is likely so any major changes to your strategy is a mistake

• Fuel subsidy rollbacks caused gasoline prices to rise by more than 100% to US$0.94 per liter. As a result, Nigeria’s two largest unions called indefinite strikes that could threaten the economy if a compromise is not reached and work stoppages spread to the oil sector
• President Goodluck Jonathan is framing the rollbacks as critical for the economy, which was burdened by the recurrent costs that total more than US$6 billion annually or roughly 25% of the budget
  • The government claims it will reallocate the cost savings to spend on education, healthcare, and the energy infrastructure. However, the public is skeptical due to past wasteful spending and a draft budget that allocated more money to security than health, education, and energy combined

Three ways you can respond to the latest developments in Nigeria

• Diversify your production toward more high-margin products
• Leverage Frontier Strategy Group’s making the case materials and city-level data to quantify ROI in Nigeria
• Consider forward-buying key imported raw materials with cash-flow management tools as price pressure is likely to maintain upward momentum

Three ways fuel subsidy rollbacks impact Nigeria’s investment climate in 2012

• More competition for the purse: B2C companies will face more cross-sector competition to capture discretionary spending from cash-strapped Nigerian consumers
  • The rollbacks will stoke food and fuel inflation, which impacts most Nigerians whom live on less than US$2 per day
  • Heightened price sensitivity may cause consumers to trade down for value in the short term
• Difficulty in making the case: Nigeria’s medium-term growth potential remains the best among African peers, but negative headlines will raise doubt among some risk-averse corporate centers 
  • The strikes coupled with a recent spike in sectarian violence will scare away some investors
• Higher cost of doing business: All companies with local operations should brace for higher costs as instability weakens the naira and increases the likelihood of a currency devaluation
  • Strikes amid ongoing sectarian violence, mid-teens inflation growth, and depleted currency reserves raises the specter of a devaluation
  • A silver lining of a currency devaluation would be to make Nigeria a more attractive regional export hub

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Growth Beyond Oil

• Real GDP growth is projected at 7.4% in 2011. At this rate, Nigeria’s economy will double in the next 10 years
• Nigeria depends on oil exports for more than 80% of government revenue and 95% of foreign-exchange income. The government has recently announced a 10-year plan to cut oil dependence
• Nigeria’s non-oil sector continues to be a major driver of the economy, largely driven by improved activities in wholesale and retail trade, finance and insurance, telecommunications, and building and construction. The non-oil sector is projected to grow at 8.8% in 2011 compared to 8.5% in 2010

Nigeria’s Bullish Consumer

• Plentiful: Nigeria is the world’s 8^th largest country by population. In the next 5 years, Nigeria will increase its population by the size of Romania
• Urban: Lagos (GDP $37bn), Kano (GDP $5.5bn), and Ibadan (GDP $9.5bn) are three of Africa’s largest cities
• Optimistic: Nigeria is ranked as the most optimistic consumer market in Africa

FDI in Nigeria

• Recent FDI in Nigeria includes investments by NSN, Google, Diageo, and Nestle (US$94.4m plant) as well as the construction of the Lekki Free Trade Zone (LFTZ)

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