Emerging Markets Insights

(This post is adapted from FSG’s report on how the Syrian Civil War impacts the MENA business climate. The report is part of FSG’s monthly series on managing volatility in the MENA region and is available for FSG clients here.)

Seasoned Middle East executives are confident in steady sales growth rates regardless of sensational news headlines from the region. Companies that overreact to the region’s latest developments risk falling behind aggressive competition, especially from the Gulf and Turkey. However, Western multinational companies should avoid following the lead of their governments that are taking a wait-and-see approach on Syria.

Companies must adjust business plans for the Levant region and surrounding markets as the Syrian Civil War will not end anytime soon. Fighting has already led to more than 70,000 deaths, one million refugees, and two million internally displaced in Syria. The conflict will increasingly spill over Syria’s borders and hurt economic and political stability in Iraq, Jordan, Lebanon, Israel, and Turkey.

Planning ahead allows companies to weather short-term instability, while still positioning for long-term growth in the Middle East. FSG suggests that businesses consider taking actions across core functions:

• Human Resources: Mitigate risk for staff and local partners located in areas that are most vulnerable to spillover from Syrian fighting: Anbar province, Iraq; Jordanian-Syrian border areas; Tripoli, Lebanon; Bekaa Valley, Lebanon; southern Lebanon; northern Israel; and southeastern Turkey. Designate alternative locations for offices, outline emergency plans regarding whether employees should come to the office, and set up IT capabilities to allow people to work remotely.

• Logistics: Reorient shipping routes through Lebanon’s Port of Beirut and Jordan’s Port of Aqaba until at least 2015. Syrian ports are not viable supply chain options for transiting goods to other parts of the Levant, Eastern Mediterranean, Iraq, and Europe. Regionally, prepare for increased insurance rates and longer transportation times for the duration of the Syrian Civil War, which could last years without any major change in the environment, such as an international intervention.

• Sales: Reassess sales targets for your businesses in Iraq, Jordan, and Lebanon. The Syrian Civil War represents an immediate threat to economic stability in Jordan and Lebanon and political stability in Iraq. Emphasize a market share-driven strategy to position for long-term growth after political turbulence associated with the Syrian Civil War subsides. Your business can focus on a profitability-driven strategy in relatively stable and economically vibrant markets in the Gulf Cooperation Council like Saudi Arabia, Qatar, and the UAE.

• Marketing: Utilize social media tools to establish customer loyalty, recruit local talent, and reach new customer segments in the region. Even if the corporate office wants expansion plans to be put on hold, this is an effective way to maintain and create new relationships without the cost of a strong physical presence on the ground.

• Partners: Establish relationships with Syrian-run businesses that moved operations to nearby countries. These businesses will be positioned to reenter the market after the cessation of fighting. Egypt is an attractive destination for Syrian businesses looking to take advantage of low labor costs, reasonable cost of living, and the local textile industry infrastructure. Jordan is a natural destination for Syrian-run tourism companies that focus on the broader MENA region. Lebanon’s multi-communal society is attractive to Christian businessmen who fled Syrian cities like Aleppo, Damascus, and Homs.

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More than two years of economic and political turmoil in North Africa has reoriented foreign investors toward the most stable market in the sub-region: Morocco. The country’s relative stability is mostly driven by two factors: steep increases in food and fuel subsidy spending and modest political reforms following street protests in February 2011. These two factors have allowed Morocco to avoid the same fate as its North African neighbors and emerge as a top investment destination.

Running out of money

Government spending on subsidies has promoted stability, but it has also contributed to Morocco’s precarious fiscal position. FX reserves are barely enough to cover four months of imports, which is a 10-year low, and the budget and current account deficits are straining the economy. This is forcing the government to consider cutting the same food and fuel subsidies that promoted stability. Such a move could come this year and impact all industries operating in the country, raising input and supply chain costs and reducing customer purchasing power. The government estimates that reducing or eliminating subsidies would lead to annual inflation rates jumping to 7% from 2% during the next few years.

Planning for subsidy rollbacks this year

Companies should prepare a flexible response to Moroccan subsidy rollbacks to mitigate risk and identify opportunities. The impact of subsidy rollbacks will depend on which areas of the economy are targeted and speed of implementation. Below are three subsidy rollback scenarios and recommended actions for foreign companies:

1. Full subsidy rollback (high impact/ least likely)

This scenario includes rolling back fuel subsidies, which comprise more than half of total subsidy spending. A change to heavily subsidized fuel would reverberate across Morocco’s economy and lead to a higher cost of distribution and inputs. Companies should plan to adjust tactics for core functions like finance, marketing, and sales in the context of a period of significant belt-tightening in 2013. All industries should look into forward contracts for local inputs given the likelihood of a spike in inflation. Technology companies should position their products as cost-saving solutions and emphasize their after-sales services.

2. Partial subsidy rollback (medium impact/ most likely)

This scenario includes electricity and sugar with an initial reduction of up to one-third of total subsidy spending. The plan would undermine private consumption, especially for the middle class which is not eligible for cash payments that could go to as many as 2 million poor Moroccan families.  Companies should consider supporting top partners and offering special prices to important customers, because higher electricity costs would hurt local businesses. Consumer goods companies should switch to smaller packaging and emphasize value items in their product portfolio.

3. Limited subsidy rollback (low impact / somewhat likely)

This scenario primarily focuses on sugar, which is an obvious target for the government. Artificially low prices created by subsidies led Moroccans to become among the highest per capita sugar consumers in the world. Not all companies will need to respond to limited subsidy rollbacks. FMCG and other consumer goods companies should consider offering short-term financing to top partners and engaging the overnment as a preemptive step to turn the potential crisis into an opportunity.

Do not run, Do not hide

Instead of investing time and energy in lobbying the government to spare your industry, leading companies should consider preempting the reform initiative. Assess the feasibility of waving your eligibility for subsidies, agree to replace government payments for top suppliers for a two- or three-year period, or adjust pricing downward as part of a corporate social responsibility effort. This effort could be a high-profile move and highlighted as an effort to support the Moroccan people during tough economic times.

Maintaining a foothold in Morocco is critical for foreign companies operating in North Africa, which has the greatest long-term investment potential in MENA. The region is not for the faint of heart, but companies are often rewarded for sticking out short-term instability for long-term opportunity. Other companies may leave in response to protests or uncertainty, opening up opportunities for gaining market share.

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Israel’s surprising 2013 general election results weaken Prime Minister Benjamin Netanyahu’s political power, which has wider ramifications on the economic and political landscapes in Israel, the region, and beyond. The election results reduce the likelihood of an Israeli strike on Iranian nuclear facilities, assuming the governing coalition moves toward the center. This could lead to lower global oil prices, because it would help reduce a key risk to MENA regional stability in the short term.

A pre-election poll by Ha’aretz Daily explains some of the underlying factors that influenced the surprise gains for leftist and centrist parties. Only 10% of Israeli voters ranked Iran’s nuclear program as the most important issue that they were considering, while nearly 50% cited socioeconomic issues as their top concern. Security issues remain important, but companies should expect the next government to prioritize addressing economic issues like high cost of living, income inequality, the budget deficit, and social benefits for ultra-religious groups.

Netanyahu and the Knesset will be under pressure to rebalance the Israeli economy, while following through on campaign promises to not raise taxes. One consequence could be tax hikes on large companies rather than Israeli citizens to raise government revenue. To address a widening budget deficit, Israel’s central bank is calling for tax hikes and significant cuts to the state budget for education, healthcare, infrastructure, and defense. The central bank governor also warned that failing to raise taxes and cut the budget will result in significantly higher budget deficits for several years.

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Saudi Arabia will be the critical growth driver for foreign companies operating in the Middle East and North Africa (MENA) in 2013. However, economic and political uncertainty in the region has led many companies to form an overreliance on the Saudi market. As a result, senior executives must ensure they are prepared to tackle major developments that could alter Saudi Arabia’s investment climate next year. FSG has identified 7 major developments across the political, economic, and business landscapes that could impact the investment climate significantly.

1) Regional stability
Saudi Arabia could become increasingly involved in neighboring conflicts in Bahrain and Yemen to prevent spill over. In addition, a longstanding rivalry with Iran could escalate in Iraq, Lebanon, and Syria. While it is unclear whether or not Iran perpetrated this year’s cyber-attack that rendered useless 30,000 computers for Saudi oil giant ARAMCO, the Shamoon virus illustrated a potent, 21st century weapon that can be used against the sensitive oil infrastructure in the kingdom.

2) Domestic stability
Underreported unrest in Saudi Arabia’s oil-rich Eastern Province could escalate as a result of increasingly harsh crackdowns in 2013. Prince Mohammad, who is credited with pushing al Qaeda out of the country during the past 10 years, has been promoted to Interior Minister in part to maintain stability in the Eastern Province. Saudi Arabia has dedicated a chunk of its social sector spending program on the underserved province, which means plenty of investment opportunities in 2013 and beyond. However, more than a dozen Saudis were killed in Eastern Province protests in 2012. High unemployment and heavy-handed responses by the police remain catalysts for unrest.

3) Leadership succession
It is unlikely that the next leader of Saudi Arabia will change King Abdullah’s path drastically. Saudi Arabia needs to maintain close trade ties with Europe, Asia, and the US, given the country’s dependence on oil resources for export revenue and longstanding foreign investment plans to diversify the economy. If Crown Prince Salman were to become the next ruler of Saudi Arabia, it would represent continuity from King Abdullah’s reign.

The major concerns lie in the process of succession, particularly due to the opaque and untested Allegiance Council that is charged with selecting new leadership. King Abdullah has already set the precedent of bypassing the Council by twice selecting a new Crown Prince without utilizing the official mechanism. Assuming the Allegiance Council is activated, the process could still accentuate rifts between rival factions within the royal family. Behind-the-scenes infighting could spill out into the public eye, which would be a destabilizing factor in the kingdom. If the leadership role is passed to the third generation, it may ruffle the feathers of remaining princes in the second generation. Yet a dearth of qualified second generation princes means this generational leap is imminent.

4) Global economic volatility
Saudi Arabia is uniquely positioned to withstand global economic instability in the medium term due to currency reserves that surpass US$600 billion. Higher-than-expected oil prices this year will lead to a budget surplus for another year in a row. As a result, government spending priorities are unlikely to be altered by economic stagnation in Asia, Europe, and the US. Those spending priorities include: education, healthcare, housing, and transportation infrastructure.

On the other hand, a weaker global environment would dampen FDI flows into Saudi Arabia, particularly if the eurozone and US economies contribute to a slowdown in Asia. Economies in Asia are also important customers for Saudi exports such as oil, petrochemicals, and plastics. If global economic stagnation undermines oil prices, companies should expect more pressure on contractors to keep costs down to maintain their own profitability and keep government clients happy.

5) Consumer prices
Many Saudi consumers are insulated from the most severe swings in global commodity prices due to generous government subsidies. While Saudi Arabia was able to insulate its citizens from price spikes following international droughts in 2012, climate change will likely make food shortages a more common occurrence globally. Regional instability has the potential to disrupt transportation of goods across borders, which places upward pressure on food prices as well. Food costs account for 25% of Saudi household expenses so it will be difficult for the country to remain insulated to sustained global price swings.

It is unclear when Saudi Arabia will start to implement its new mortgage law, which should lead to an explosion in housing demand across the country. The current housing shortage places upward pressure on housing costs, but a significant increase in housing demand will be another factor to push up prices in the short term.

6) Labor regulations
Private sector firms are being fined if the majority of their workforce is non-Saudi with a penalty of US$640 for each excess foreign worker. While this is a negligible cost for foreign companies without a significant presence in the country, the fine could hit harder for local Saudi companies, many of which are foreign company partners and customers. The construction industry’s reliance on foreign labor, which comprises up to 95% of the workforce, could lead to project delays. All companies should diversify their workforce to include more GCC nationals, who are not counted as foreigners under the new labor regulations.

Saudi Arabia is committed to rebalancing the local labor market due to demographic trends that cannot be ignored. More than 60% of Saudi Arabia’s population is under the age of 24, and youth unemployment rates are up to 25% or higher. The economy must create an estimated 400,000 new jobs every year to bring down the unemployment rate. Currently, 90% of the private sector’s workforce is comprised of expatriates. This must change for the long-term viability of Saudi Arabia’s economy.

7) Rising competition
Volatility in the rest of MENA is leading to rising competition in Saudi Arabia where companies are focusing on market opportunities. Next year’s FDI inflows are expected to reach US$20 billion in Saudi Arabia, which significantly outpaces other regional investment destinations. Even among relatively stable and well-capitalized Gulf Cooperation Council countries, Saudi Arabia is rapidly growing its share of foreign investment from 54% in 2011 to a forecast of 60% by 2014.

Competition from GCC neighbors, especially Qatar, will push Saudi Arabia to increase its attractiveness for foreign businesses. For example, Saudi Arabia plans to invest more than US$200 billion in port infrastructure amid upgrades in Qatar as it prepares for the 2022 FIFA World Cup and in the UAE, which is upgrading Jebel Ali in Dubai and continuing to build out Khalifa Port in Abu Dhabi.

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Despite economic and political instability, the Middle East and North Africa (MENA)’s economies will continue to expand, offering both opportunities and risks. In the current business landscape, effective distributor management is a critical element to capitalizing on opportunities and mitigating risks in MENA.

Local partners can provide a buffer to operational risks in order to assuage the corporate center, which might be concerned about some of the more volatile markets. Local partners can also provide critical capabilities like market insight and value-added services, which help companies to capture growth opportunities that might otherwise be out of reach.

More than two-thirds of FSG clients that were polled said they rely on distributors to reach their customers in MENA. In addition, nearly 70% plan to expand their local presence during the next three years and distributors will play a critical role in this process.

Companies that are assessing new partners should vet the prospective distributors based on considerations that are unique to the MENA region:

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Listen to Matt Lasov, Head of EMEA research, and Martina Bozadzhieva, Practice Leader for Central and Eastern European research, discuss how slowing demand could impact Turkey business operations in 2013, and how leading companies are rethinking their allocation strategies to take advantage of newly created opportunities.

To listen to or download the podcast, click on this link to access the iTunes store.

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The Middle East and North Africa’s shifting environment is making it more difficult for companies to justify investment. Several events are fueling the perception of MENA’s instability. Economic and political transitions in Egypt, Libya, and Tunisia are giving pause to foreign investors who are taking a wait-and-see approach to their entry and expansion strategies. There are serious concerns that Syria’s devastating civil war will increasingly undermine stability in neighboring markets, including Iraq, Jordan, and Lebanon. Other threats to stability, such as the fallout from a deepening eurozone crisis and the specter of a conflict involving Iran, keep corporate offices jittery about regional investment.

Despite a challenging environment, huge opportunities exist for companies operating in MENA. The MENA region’s resilient economy is expected to continue expanding steadily through 2013 and beyond. The region’s youth population has reached 200 million and it will grow significantly during the next two decades when MENA’s total population approaches 500 million. An estimated US$100 billion per year is needed for infrastructure investment to sustain growth rates and boost economic competitiveness. 

EMEA executives have a difficult time making the case for MENA, even though other regions in EMEA also have challenges. Economic growth in Central and Eastern Europe is slowing rapidly. Sub-Saharan Africa remains very risky operationally. Spending power in wealthy GCC countries is nearly 50% higher than in Central and Eastern Europe. MENA’s GDP will surpass US$4 trillion by 2015, which will be 2.5 times larger than Sub-Saharan Africa.

Even if your corporate office is not thinking about MENA investment, others are focusing on the high-reward markets. Companies will be fighting for a smaller piece of the pie due to rising competition. In a recent FSG survey of leading companies, more than 65% plan to increase their current presence in MENA markets during the next 1 to 3 years. Nearly one-third of surveyed companies expect to enter at least one new MENA market within the next 3 years.

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Foreign companies have reason for cautious optimism in Egypt after President Morsi’s stunning consolidation of power last month. Monitor economic and political signposts to anticipate the investment climate’s trajectory. If Egypt can achieve the first two signposts below by late 2012 and the other signposts by early 2013, then companies can accelerate plans to expand investment.

1. Egypt secures US$4.8 billion IMF loan: This would signal the government’s ability to prioritize economic challenges. The World Bank (US$200 million) Qatari (US$2 billion) loans have built confidence already

2. A new constitution by year-end: Non-Islamists may feel pressure to compromise on the constitution, because Morsi can appoint a new body if there is no consensus. However, a national referendum is meant to ensure the constitution is a balanced document

3. Orderly currency devaluation: An IMF loan would provide positive momentum for more funds from multilaterals, Qatar, Saudi Arabia, and the US. This would position the central bank to manage an orderly currency devaluation, potentially phased over two to three quarters

4. Morsi transfers legislative power: Elections are expected 3 months after a new constitution is adopted and a power transfer to a newly-elected legislature is critical to demonstrate that decision-making will be transparent

5. President Morsi builds consensus: Morsi must convince skeptics that his agenda does not only benefit the Muslim Brotherhood. He is appointing independent figures to several posts as a result

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While Nigeria remains one of the most attractive long-term investment destinations in Sub-Saharan Africa, companies operating in the northern and central regions are facing operational risks resulting from increasing insecurity and revenue losses as consumers are staying at home.

Contrary to mainstream media coverage; the frequent attacks in northern and central Nigeria cannot only be linked to Islamist Group Boko Haram. The escalation of violence is born out of socio-economic grievances and longstanding tribal, ethnic, and religious animosities.

While the south is experiencing an economic boom, the northern and central areas are not. Instead they are struggling with staggering poverty levels of 60-70+%. Attacks have so far mainly targeted government officials and churches – both representatives of the wealthy south.

As violence increases, businesses divert investments southwards contributing to economic decline in northern and central Nigeria. However, companies that maintain a presence in affected regions can increase customer loyalty and gain market share by highlighting their commitment through tough times. Having a contingency plan allows companies operating in the area to manage risks and seize any opportunities as they materialize.

Some companies already see investment opportunities in affected areas. Considering the risk level relatively low compared to other dangerous areas such as the Niger Delta, Dufil Prima Foods, part of the Singapore-based Tolaram Group, recently opened a manufacturing site in the northern city of Kanu to save on transportation and distribution costs. South African telecoms provider MTN is also making major investments in radio and transmission to increase its capacity and offer improved services to customers.

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Photo: Regional cement demand demonstrates opportunity across Saudi Arabia

The Saudi government is spending more than US$300 billion on major infrastructure projects through 2014. Development projects are dispersed throughout the country to create jobs, raise the standard of living, and attract foreign investment in less-developed areas. As a result, companies should no longer expect to capture the full potential of the Saudi market if they are only based in tier 1 cities like Dammam, Jeddah, and Riyadh. Expanding outside of Saudi’s major cities allows companies to reach more customers in the country’s population centers, where major public investment is targeted. Government funds will support rapid growth and these cities are likely to grow faster than the core markets, because they are starting from a lower base.

Concentrate on western Saudi Arabia in the medium term

The Saudis are pouring in money to develop various cities in the western region, which accounts for nearly 40% of construction activity through next year.  Public expenditure is driven by education, healthcare, housing demand, and religious tourism in the region. The spending trends are attracting foreign investment to Rabigh, Mecca, and Medina.

• Rabigh: importance is tied directly to the construction of nearby King Abdullah Economic City (KAEC), which is already attracting investments from major foreign multinationals like pharmaceutical company Sanofi and chocolate manufacturer Mars. Both companies plan to invest at least US$60 million in manufacturing facilities. Rajhi Steel is building a US$4 billion heavy steel complex as part of KAEC.   The plant will have a capacity of 1.8 million tons per year and will play an important role in future development in the city and region.

• Medina: benefits from infrastructure development related to religious tourism and construction plans for Knowledge Economic City (KEC). CBH Real Estate Development plans to build a shopping mall in Medina with an initial budget of US$530 million to accommodate the growing demand for retail space due to religious tourism. The Saudi government has allotted US$8 billion for Medina’s Knowledge Economic City, which is expected to be completed in 2020.

• Mecca: religious tourism drives infrastructure development. An estimated US$40 billion will have to be spent in Mecca within the next decade to meet rising demand for hotel accommodations. The number of pilgrims is expected to double to 13.8 million by 2019, requiring 82,000 rooms. There are currently an estimated 50,000 rooms in Mecca.

Frontier and service cities offer long-term opportunities

The Saudi government aims to develop the country’s north and south in order to raise the standard of living and promote stability. Government spending priorities provide companies with opportunities in frontier cities as a result. Expanding into frontier cities such as Hail and Jizan is a way to capture long-term ROI with an Economic City being built in each location. Buraydah is becoming increasingly important as a trade corridor for Riyadh, which will continue to attract government investment in public sector and IT projects.

• Buraydah: location means it will play a critical part in the US$5 billion North-South Railway. The rail project is meant to connect the northern mineral-rich region with Riyadh via Buraydah. The national budget allocates US$183 million to establish and equip hospitals in Qassim Province. Much of the money will be directed to Buraydah due to the city’s role as commercial center of the province. Al Baik Food Systems, a Saudi-based fast food restaurant chain, has announced plans to open two outlets in Buraydah by 2014.

• Hail: attracts investment as part of the country’s strategy to increase industrial activity in the north. Alfanar Construction Company is upgrading the Hail -2 Power Plant to extend electrical capacity. The US$120 million project was delayed by a year, but it is expected to be completed this year. Saudi Arabia’s Health Ministry approved US$400 million in projects in Hail Province. The new projects include the establishment of two 300-bed hospitals with a total cost of more than US$140 million.

• Jizan: development is tied to the government’s desire to create jobs and increase the standard of living in the southern region. Bids are set to be accepted next quarter for King Abdullah Bin Abdulaziz Airport, which will be an important component of future development in Jizan and the rest of the southern region. After several delays, KBR Inc. is building a refinery in Jizan for Saudi Aramco. The facility will refine up to 400,000 barrels of oil per day when it is completed in 2015.

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