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.

Share/Bookmark

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.

Share/Bookmark

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:

Share/Bookmark

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.

Share/Bookmark

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

Share/Bookmark

Turkey is on a clear slowdown trajectory. Both the consumer and the business sectors are seeing a gradual deceleration of growth, and GDP expanded by only 3.2% in Q1 2012, compared with last year’s annual growth of 8.5%. We expect Turkey’s slowdown to continue through the end of the year as the eurozone crisis continues to depress export demand while high inflation, a weakening currency, and more expensive consumer credit undermine consumer demand.

However, this slowdown should not lead multinationals to consider Turkey a declining opportunity. In fact, now is a critical time for companies to invest in positioning themselves for the post-crisis opportunity in the market.

While Turkey is slowing, it is still weathering the eurozone crisis better than most of Central and Eastern Europe. With strong demographic fundamentals, growing investment, a diversified economy, and increasing importance as a regional hub, Turkey offers long-term opportunity that promises a relatively fast recovery once the eurozone crisis is back on a path of growth.

More importantly, we’re seeing growing investor interest in the market. Cash-rich multinationals, many of them European, are taking advantage of the weak lira to make cheaper investments in setting up or expanding their local presence, including through local manufacturing. A reflection of this trend was healthy growth in FDI at US$6.5 billion in the first five months of 2012.

Turkey’s government is aggressively working to attract foreign investment, in particular in local manufacturing. Its recently-announced incentive program has attracted substantial interest from multinationals, with over 270 applications for incentives already submitted.

This trend of increased investment in the economy, however, does not just signal multinationals’ continued confidence in the Turkish market as well as growing opportunity for B2B companies. It will also contribute to growing competition on the Turkish market, already one of the most competitive emerging markets globally. Companies caught off guard will see growing competition on price from both local companies and multinationals with a local presence undermine their profitability and restrict their ability to take advantage of the opportunity in Turkey. For companies committed to the market, this is the right time to invest in Turkey.

Share/Bookmark

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.

Share/Bookmark

The Arab Spring has ushered in a new era for the Middle East and North Africa region. Foreign companies must adapt to a changing local environment or risk falling behind competition. Companies can take practical steps to mitigate risks and capture opportunities across the region.

1. Vet local partners with an eye toward the stigma of previous regimes

Be mindful of which local companies built their success on connections with previous regimes. Some are likely to be targeted by anti-corruption initiatives as new governments seek to demonstrate progress with economic and political reforms. In Libya and Tunisia, companies will want to disentangle from partners with close ties to the previous regimes. The same will be true of Egypt in the long term. 

2. Consider price sensitivity in the medium term to solidify long-term customer loyalty

Ongoing instability involving oil-producing countries will place upward pressure on commodity prices, hurting consumers in import-dependent economies. Companies should pursue special pricing initiatives to be accompanied by advertising campaigns to express solidarity with the people.

3. Maintain relationships with experienced bureaucrats and key embassy staff in transitioning markets

The bureaucratic cores of most governments will stay in place. Senior executives should establish close relationships with career bureaucrats that handle product registration, taxation, and tariffs. Ambassadors and staff can assist companies in reaching out to local government officials.

4. Contemplate opportunistic M&As or resetting expectations with local partners

Assets are trading at extremely low valuations. They look even cheaper when currency devaluations are factored in for markets like Egypt. Now may be the time to shop for companies and deepen your presence in the region. Weakened market conditions can help companies reset contracts to drive efficiency gains in the short term.

5. Build robust contingency plans to mitigate risks and capitalize on opportunities

Escalating violence in Syria raises the threat of spillover in Iraq and Lebanon, and a clash between the Egyptian military and Muslim Brotherhood would set a dangerous precedent for the region. Companies that take an informed approach to contingency planning for these types of events will preserve resources, while mitigating risks and maximizing upside opportunities. Multinational companies with plans in place will be positioned to gain market share while competitors scramble to respond.

Share/Bookmark

The dust has not yet settled from recent political events in Egypt.  However, it is already clear that the reinvestment timeline is delayed for foreign companies due to increased political uncertainty, which will drive short-to-medium term economic deterioration.

There is an uncertain political outlook due to several recent developments, including the military’s decree that weakened presidential powers, the judiciary’s decision to disband parliament, and an uncertain future for the body tasked with writing the country’s new constitution. While direct confrontation is not inevitable, the potential for conflict with the Muslim Brotherhood will increase as the military delays or annuls important political decisions.

Economic deterioration

There are serious ramifications for Egypt’s economy. Egypt’s efforts to secure a US$3 billion IMF loan are undermined by the absence of a parliament and ambiguity regarding President Mohammed Morsi’s powers. This could jeopardize much-needed aid from other institutions, such as the European Union and World Bank.

Ongoing political turmoil increases the likelihood of a disorderly currency devaluation of up 15% to 30%. This would significantly raise food and fuel prices, increasing social tensions. Egypt has around US$15 billion in foreign currency reserves, which can only support the pound for roughly four months.

Given the new constitutional provisions that enshrined expansive military powers, the transfer of power is purely symbolic. Decision making about the economy will be opaque, taking place behind closed doors, adding to the uncertainty surrounding reinvestment.

High risk environment

With recent events, risk will remain high, altering the risk/return profile for companies interested in the market:

This assessment is driven by several risks: 

Unclear government commitments: Without a parliament, the military may issue high-level decrees on the economy or large government projects, but these decrees may be reversed or difficult to implement.

Reputational degradation: Supporting policy decrees by the military could undermine brand equity, particularly among MENA customers. If President Morsi is able to extract meaningful concessions from the military, then this risk could be neutralized.

Currency depreciation: Egypt’s currency is extremely vulnerable to capital flight, reduced hard currency flows from tourism, and a drop in remittances due to fears of ongoing political uncertainty.

Higher cost of doing business: Numerous fault lines threaten Egypt’s stability, which could disrupt regular business operations, especially in big cities like Alexandria and Cairo.

Risk mitigation strategies

Companies should implement risk mitigation strategies to protect investments in Egypt:

Maintain relationships with experienced bureaucrats: The bureaucratic core of the government will stay in place regardless of political upheaval. Senior executives should establish close relationships with career bureaucrats that handle product registration, taxation, and tariffs.

Leverage Saudi partners: Egypt’s stability is in the interest of Saudi Arabia, which will pour in money to support the military’s efforts to spend domestically and promote stability. This might be a good time to utilize your Saudi partners to expand presence in Egypt.

Focus on people for long-term sales growth: Companies can differentiate themselves as employers of choice and improve retention levels by prioritizing the safety and well-being of staff amid political and economic instability. This is also an opportunity to hire staff away from other multinational companies that are freezing expansion plans as a result of uncertainty.

Set up alternate/satellite locations for the workplace: Position your organization to overcome transportation disruptions if there is a return of demonstrations, clashes between the police and protesters, or industrial actions.

Uncovering opportunities

There are benefits for companies with a high risk tolerance:

Brand loyalty: Demonstrate your support by continuing some level of investment. A marketing campaign to accompany investment can build brand loyalty in turbulent times. Maintaining visibility is critical for future investment.

Undervalued acquisition targets: Assets will be trading at extremely low valuations after a currency devaluation of the Egyptian pound, which seems to be inevitable. Now may be the time to shop for companies and deepen your presence in the market.

Stronger local partnerships: Companies can strengthen relationships with partners by offering short-term financing amid tight credit conditions.

Market share gains: Multinational companies with risk mitigation plans will be positioned to gain market share while competitors are scrambling to respond to events in Egypt.

Share/Bookmark

Going direct is not always the best strategy in Turkey

Companies looking to scale their presence in Turkey often assume that a transition to a fully direct presence in the market is the most logical next step as they seek to grow. However, this is not always the case. Instead, for many companies across industries, a hybrid presence is a more cost-effective way to cover the market.

What makes hybrid an attractive option for companies looking to grow their presence in Turkey?

First, Turkish distributors are relatively cheap. Turkish distributor margins are 23% lower than the global average distributor margins, according to FSG’s annual growth benchmarking survey. For companies selling low-margin products to numerous, geographically dispersed customers, working through a distributor could be the most cost-effective strategy to cover those markets.

Second, Turkish distributors can offer multinational companies access to markets that are difficult and/or costly to cover via a direct sales force. This is particularly true for Turkey’s traditional market – bazaars, open-air markets, individual merchants. The traditional market is heavily driven by relationships and having a local distributor with strong connections on the ground can make or break your access to this market.

Finally, multinationals in some industries, such as consumer goods, can find distributors with enough capabilities to be strategic partners. Because of the well-developed consumer market in Turkey, there is a wide supply of distributors who have the geographic coverage, networks, and capabilities to effectively cover the market.

Despite these advantages of working with Turkish distributors, companies often still need a direct presence to ensure the high quality customer support and technical expertise that higher-end or more technologically sophisticated products require. Multinationals who work with corporate or large business clients also find that a direct presence is the best way to serve these types of clients.

As a result, a hybrid model based on segmenting the market and selecting the right channel to cover each segment is often the most cost-effective strategy of scaling your presence in Turkey.

Share/Bookmark