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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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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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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While political instability dominated headlines in the Middle East, the Iranian rial quietly devalued by 35% against the dollar at local currency exchange bureaus during a four-month period. Continued devaluation increases the likelihood of further instability in the region

• Iran’s fragile economy will bend rather than break for the time being, but the devalued rial will place pressure on consumers that are already struggling to afford staple goods as a result of high inflation rates
• The Iranian rial’s steep depreciation is a result of effective sanctions preventing hard currency from flowing into Iran, exacerbating the current account deficit
• The result is more pressure on the system, which increases the likelihood of instability in Iran and the Middle East

Sanctions and political tensions underline a dreary economic outlook

• Increasing trade isolation: Iranian officials are finally admitting the toll of sanctions on the economy. An EU crude embargo and tighter US sanctions will worsen the situation
• Rising political tensions: The alliance of bazaar merchants, hard-line clerics, and Revolutionary Guard commanders will continue to marginalize Ahmadinejad and his allies ahead of the parliamentary elections in March 2012
• Dwindling foreign currency reserves: While the size of Iran’s foreign currency reserves is unclear, money in circulation increased by 20% in the 2H 2011. This is an indication that Iran is struggling to fund monthly cash payments to citizens that are meant to soften the blow of subsidy rollbacks
• Accelerating inflation growth: CPI is officially 20%, but prices are likely increasing by much more especially food and fuel prices due to the subsidy rollback initiative and tightening sanctions
• Eroding consumer and private sector confidence: Typically resilient Iranian consumers and merchants appear to be losing patience with the current economic conditions
  • The government was forced to halt all direct official sales of gold as customers queued in long lines to swap their hard currency
  • The rising cost of raw materials will further damage confidence in the economy

Iran’s economic volatility has regional and international implications for 2012

• Iran’s foreign policy will remain erratic: Ahmadinejad’s recent flirtation with conciliatory rhetoric will stand in stark contrast to Supreme Leader Ayatollah Ali  Khamenei’s strategy to meet a “threat with a threat”
• Escalating tensions with Gulf Arab countries: Saudi Arabia and other GCC countries blame Iran for stoking popular unrest in the region. Their support for tougher Western sanctions will escalate tensions
• Danger of regional conflict: The fall of Syria’s regime, a key Iranian ally, would upset the regional status quo and could set off a proxy war in Syria or Lebanon
• Oil price volatility: More effective international sanctions would place upward pressure on global oil prices, though further deterioration in the eurozone could act as a counterbalance

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Original Article in MarketWatch

Matt Lasov, director of global research at Frontier Strategy Group, said the emerging markets’ performance in 2012 depends on their relationship to the euro zone.

“The euro zone is in a recession that is likely to get worse,” Lasov said. “We see a two in three chance that there is a breakup of the euro zone in 2012 — most likely Greece leaving.”

And “success for emerging markets will be determined by linkages to the euro zone,” he said.

“The clear outperformers in the short term are India, Indonesia, and Sub-Saharan Africa,” according to a research note from Frontier Strategy Group, referring to those markets as having “low linkage” to the euro zone. “These markets are characterized by rapidly growing domestic demand and diversifying economies that are creating middle class growth” and they have limited trade relationships with Europe.

The Middle East and Latin America are linked to Europe because of trading in commodities, the note said, referring to these markets as having “medium linkage” to the euro zone. “Reduced European demand for oil will impact state revenues, but most markets have more than enough reserves to weather a crisis.”

Russia, meanwhile, is “positioned to be the biggest underperformer,” the note said. “Oil exports to Europe are driving Russia GDP growth more than ever before,” and as oil prices fall below the $110 per barrel built into the Russian budget, “Russia will enter deficit.”

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• Regional Spending – There are two key trends driving outlook in MENA:
  • MENA’s oil exporters are increasing spending of public funds to expand infrastructure and social stablility
  • Oil importers are not so lucky, and struggle with their fewer resources to keep unrest at bay
• Business Strategy – Takeaways:
  • Instability will continue to dominate the regional narrative
  • Slow government transition should not scare away investors
  • MENA’s volatility necessitates an external strategic focus for foreign MNCs

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