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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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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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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Trend

The ruble is depreciating against the dollar as markets anticipate Russia will run a deficit in 2012. We expect the Russian government to intervene in the foreign exchange market in Q1 2012, but a significant decline in oil prices could lead to rapid ruble depreciation as Russia would lose the hard currency necessary to support the ruble

Drivers

• The eurozone crisis is driving investors away from emerging markets currencies, including the ruble. The result is a stronger dollar which will put downward pressure on oil prices. Low oil prices will in turn weaken the ruble in H1 2012
• Weak exports combined with Russian demand for imports (see Trend #2) are also contributing to a weaker ruble
• Large capital outflows, expected to reach over US$70 billion for 2011, are putting downward pressure on the ruble. The outflows will continue to impact the exchange rate at least through the March 2012 elections

FSG View

• We expect the ruble to remain weak through H1 2012 and to depreciate significantly when the eurozone crisis leads to a decline in oil prices
  • The Central Bank of Russia is able and willing to intervene to keep the ruble from depreciating significantly and will do so increasingly as elections draw near. However, it does not have the firepower to offset the effects of a sharp decrease in oil prices
• A weak ruble will contribute to the gradual deterioration of Russian consumer outlook in late Q1 2012 and negatively impact B2C companies and MNCs importing into Russia. Companies producing locally will be well-positioned to take advantage of consumers switching to cheaper, domestically-produced goods
• The weaker ruble will strengthen the position of Russian exporters but will not compensate for the decrease in demand from European markets
• MNCs need to factor a weaker ruble and higher volatility in their planning for 2012 and consider forward-pricing and hedging strategies to limit the impact of a weaker ruble on their business

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As Western Europe continues to struggle with the sovereign debt crisis and currency depreciation, declining exports, and lower 2012 growth prospects engulf Central and Eastern Europe, the outlook for Russia seems surprisingly solid. Despite a slow downward revision of 2012 growth forecasts from earlier this year, Russia is still projected to grow at about 4% in 2012.

However, the 2008-2009 crisis made it painfully clear that Russia is not and cannot be an island of stability when European and potentially global markets are in turmoil. Since 2009, Russia has grown even more dependent on energy exports, with its 2012 budget balancing at oil price of over $110 per barrel.

In the short term Russia is growing on the back of strong consumer demand, but this in no way eliminates the significant downside risk of an oil price decline. With the Eurozone already heading into a mild recession and the possibility of global financial market contagion, a significant decline in oil prices is a real possibility. A drop in oil prices could unleash a chain reaction (see graph) that would undermine Russia’s economy and, at best, depress Russia’s GDP growth.

For MNCs, this means having contingency plans for a significant downturn in Russia over the next 6-8 months to address ruble depreciation and declining demand on the domestic market.

On the positive side, MNCs should also be prepared to take advantage of M&A opportunities as attractive local assets will be priced at a discount.

In the long term, the Russian market continues to hold significant opportunity for foreign companies, especially after the country joins the WTO later this year. However, MNCs need to account for the significant risk the Eurozone crisis is posing to Russia’s performance in 2012 and be prepared to respond to rapid changes in the market.

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Saudi Arabia is identified by most of Frontier Strategy Group‘s clients as their number one market in the Middle East and North Africa (MENA). Foreign investment opportunities abound as the government aggressively diversifies its oil economy by executing on plans to spend more than US$300 billion on education, healthcare, IT infrastructure, and other non-oil sectors.

At the same time, doing business in Saudi Arabia can be difficult due to operational challenges. The introduction of new and stringent labor regulations, which could begin to affect MNCs as early as December 2011, is the latest example.  The new law, known as Nitaqat, seeks to bolster Saudi employment in the private sector by imposing limits on the number of foreign workers that companies can maintain.  In response, some companies are considering relocating operations or shifting strategic focus in MENA. FSG advises clients that such a shift would not be wise, as it would significantly weaken any regional investment strategy.

The kingdom’s economy makes up nearly 40% of regional GDP and high public spending on the local population and government projects ensures opportunities across sectors. Any company eschewing this opportunity will not be able to make up for the losses incurred.

The Saudis are unlikely to back down

The latest iteration of the Saudization program introduces the most comprehensive measures to achieve higher employment yet.  The numbers explain why: more than 60% of Saudi Arabia’s population is under the age of 24, and youth unemployment rates are upwards of 25%.  In order to keep up with demographics, the economy must create 400,000 new jobs every year.  Increasing private sector employment would ease pressure on the public sector, which cannot carry the full burden of job creation in the long-term.  Currently, 90% of the private sector’s workforce is composed of expatriates. The government is likely willing to take a hit to FDI to accomplish its goal, which it believes could play a large role in staving off domestic unrest and supporting its young population in a sustainable way.

Christopher Johnson, who is managing attorney at Sharif law office in Riyadh, comments that, “Saudi Arabia sees the labor issue as an existential one, and crucial to flowing with rather than against the ‘Arab Spring‘.  There are also strong pressures from the Majlis al-Shura, the king’s advisory body, to limit foreign investment, on the theory that many of the services currently provided by foreign companies should be reserved for Saudis.”

What MNCs need to know about Nitaqat

Nitaqat updates quotas for the percentage of a company’s workforce that must be composed of locals. It designates non-compliant companies as red or yellow, and compliant and exceptional companies as green or blue.  Companies finding themselves in the yellow or red categories could face a host of restrictions, such as limitations on issuing or renewing visas for expatriate workers. On the other hand, compliant companies will benefit from an expedited hiring process. For example, there will be fewer restrictions on hiring away stand-out workers from other major players. Nitaqat replaces the blanket 30% quota across industries that failed to shift the composition of the workforce significantly.

The new labor plan varies in application by company size and industry. For example, while a manufacturing company only needs to employ 15% Saudis to avoid penalties, oil and gas sector players must employ at least 45% to meet the same threshold. Zahid Hussain, head of OD for an Al-Rajhi Group Company based in Jeddah, says that some industries will be impacted less than others. “Medicine and pharmaceutical, aviation, education, fashion, media, advertising, marketing, will be less affected compared to automobile, telecom, IT, and HR as the former already have a large chunk of locals on the job.”

MNCs must adapt to the new labor regulations

While Nitaqat will pose new challenges, an informed executive can take the right steps to successfully navigate the shifting labor landscape and capitalize on new opportunities as a result. Even though private sector salaries will rise to compete with public sector wages, Zahid Hussain points out that the new regulations will save companies money in other areas such as visas, travel, and relocation.

Matthew Lewis, Director of the Middle East at executive search firm Boyden advises foreign companies to, “hire locals and concentrate on training. It is easier than in other Gulf countries when you consider the size of the population and deeper talent pool as a result.” Christopher Johnson is finding success in hiring Saudi expatriates, who are returning in increasing numbers to the kingdom. “There are 100,000 Saudi students abroad that are beginning to return. They are more flexible and adaptable than their brothers who stayed home,” says Mr. Johnson. This ‘re-pat’ strategy is one that other companies have found success in implementing in Sub-Saharan Africa.

Small to medium size businesses may be the most affected by the new regulations.  As a result, companies should make sure that local partners are not impacted and offer help if so. The Saudi government admits that up to 20% of companies could find themselves in the red zone with punitive action beginning in December 2011. Leveraging resources to assist a local partner now is a much more palatable option than the disruptions to business operations over an extended period of time.

No escape from the new Middle East

MNCs must adapt to the new environment due to Saudi Arabia’s market opportunity, but also because more stringent labor regulations are becoming a wider regional trend. In October, Gulf Cooperation Council labor ministers agreed to provide greater employment opportunities to their citizens through new policies. This year’s regional unrest has acted as a catalyst to accelerate the implementation of rigorous nationalization standards. The new regulations are not anti-globalization, but they are nationalistic in character and protectionist in some instances. While this is the new reality of the Middle East, the fundamentals of investment remain as strong as ever: high government spending, oil revenue, economic diversification programs, and attractive demographics.

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Venezuela presents a major challenge for MNCs who recognize the country’s market potential and high profit margins, but are troubled by the risks associated with any significant presence in the country. The upcoming elections in 2012 and recent concerns over Chavez’s health has renewed speculation over medium-term political and economic scenarios for Venezuela.

Advantages of Venezuela

Attractive demographics offer long-term prospects

• 90% of Venezuelans live in cities and half of Venezuela’s 30 million people are under 25
• GDP per capita is fifth highest in the region

Oil profits allow government to encourage domestic demand

• Government maintains lending rate below inflation to encourage consumption

Business tax system is competitive with the region

• Corporate and ordinary income tax rats are 34%
• Attractive incentives such as non-taxable dividends for distribution of earnings and profit

Major Challenges

The operating environment is opaque and unpredictable

• Little separation between executive, legislative, and judicial branches
• Currency devaluation and expropriation are constant risks

Consumers behave differently than those in free market economies

• Consumer spending is volatile as it is dictated by government spending policies
• Price controls, inflation, and shortages alter consumer purchasing habits

Major structural challenges hinder growth prospects

• Drought has led to shortages and rationing of electricity
• Crime remains rampant, and a source of disillusionment with the Chavez regime
• Oil production is rapidly declining

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With 155 million people and projections of 7.4% GDP growth in 2011, Nigeria is already a “can’t miss” consumer market opportunity. That said, in the next several years there will be multiple bumps on the road as Nigeria transitions from a corrupt, ethnically divided, oil driven economy, to a modern, diversified powerhouse.

In 2012 in particular FSG believes there is a 50% likelihood of a double dip recession. The following outlines what the potential impact of a recession could have based on your current Nigeria footprint:

Remote Exports to Nigeria

• Volumes could decline as currency weakens
• Distributors may be crunched for credit
• Lower logistics, fuel costs as oil prices moderate
• Greater flexibiliy to increase/reduce export volumes
• Indicators to watch: Exchange rates, Oil prices, Credit growth

South Africa Exports to Nigeria

• Volumes could decline as currency weakens agains rand
• Distributors may be crunched or credit as oil prices moderate
• Greater flexibility to increase/reduce export volumes
• Indicators to watch: Exchange rates, Oil prices, Credit growth

Nigeria as a Regional Hub

• Distributors may be crunched for credit
• Lower logistics, fule costs as oil prices moderate
• More protection from volatile exchange rates when assessing domestic market
• Greater responsiveness to market dmeand
• Indicators to watch: Domestic food prices, Oil prices, Exchange rates

Pan-Africa Business Units

• Distributors may be crunched for credit
• Lower logistics, fuel costs as oil prices moderate
• More protection from volatile exchange rates when manufacturing in domestic market
• Greater responsiveness to market demand
• Indicators to watch: Pan-Africa GDP, Exchange rates, Oil prices

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Part one

With unprecedented levels of investor interest both on merit, and because growth may well prove elusive elsewhere, 2012 promises to be an exciting year for sub-Saharan Africa. In this two-part series, I examine some of the key questions businesses looking to the continent should ask themselves as they plan ahead:

(1) Can the continent withstand continuing volatility in commodity prices?

While broadly insulated from sovereign debt and banking-related contagion from the OECD countries, Africa’s vulnerability to commodity price movements – particularly in the form of inflation – remains considerable, and will be a key theme for the region’s macro-economic outlook alongside an average 5.25-5.75% GDP growth projection into 2012, driven by strong domestic consumption. Importers of food and fuel – including Ethiopia, Kenya and Uganda – are already facing sharp inflationary pressure, a situation that could worsen in the year ahead if costs for those inputs trend upward. Producers of oil and industrial metals – Angola and Nigeria the giants in the former category, countries such as Zambia and Congo (DRC) falling in the latter – will meanwhile see their fortunes rise or fall depending on global commodity price and demand shifts, with higher prices boosting government currency earnings but also creating upward pressure on domestic prices. A renewed recession in Western markets, meanwhile, would impact African economies through lower remittances and renewed risk aversion amongst investors from those affected countries. South Africa, with its exposures on metals prices, established manufacturing exports, developed tourism sector, looks particularly vulnerable should worst-case macro-economic scenarios play out in North America, Western Europe and Japan.

(2) Will a series of major elections cause seismic shifts or entrench the status quo?

2011 has been a busy time for elections in Africa: larger countries that have been or are yet to go to the polls this year include Cameroon, Congo (DRC), Nigeria, Uganda and Zambia. Assuming Zimbabwe’s vote is delayed as expected, that country will join a similarly important list for 2012 that also includes Angola, Ghana, Kenya (whose outlook I cover in more detail elsewhere in this list), Mali and Senegal. In addition to the familiar potential for delays, disputes and protests, this wave of elections could be demonstrative of a number of wider cross-border trends. To begin with, that so many countries are organizing and holding broadly free and fair voting each year represents a dramatic and continuing important shift away from the autocratic norms of the 1980s and early 1990s. On the flip side, with accountability and transparency also comes greater policy unpredictability – as mining companies in Guinea discovered in 2010, when a change of president via the ballot box in that country catalyzed a major review of mining licences and royalty payments. Many of the elections will pit very elderly incumbents – Senegal’s Wade and Zimbabwe’s Mugabe are both over 85, while Angola’s dos Santos is entering his 70s – against younger opponents promising an agenda of change, reform and renewal. In addition to generational and policy change, how to manage and beneficially spend these countries’ growing mineral wealth will be a prominent issue in many of the elections – most especially in oil- and diamond-rich Angola and in Ghana’s first vote since it joined the ranks of petroleum producers, but also in Mali and Zimbabwe where mineral finds have yielded much-needed new government revenue streams.

(3) Will North Africa’s wave of anti-government protests shift southwards?

It hasn’t escaped the notice of many Africa watchers that the same cocktail of raw ingredients that broadly underpinned the so-called Arab Spring – long-entrenched and corrupt undemocratic regimes presiding over increasingly youthful and socially connected, technology-savvy populations struggling with unemployment – are also present in a fair number of sub-Saharan countries. It should be noted that mass uprisings leading to regime change are not unknown in the region – the toppling of Madagascar’s previous president in 2009 providing but one recent example – while military-led coups, although far rarer than in previous decades, also continue to occur sporadically in some countries. For some, the question has become why such ‘revolutions’ are not more commonplace given the potentially volatile causal factors in place. The answer to that question likely varies location, but includes – channeling de Tocqueville’s theory of what causes revolutions – a certain degree of lower expectations on the part of poorer African populations (often focused more on basic subsistence / survival or emigrating than marching on the streets) than their Arab counterparts, combined with governments that by and large have still maintained a sufficient monopoly of force and willingness to stamp out dissent fairly ruthlessly before it spreads. With public expectations rising alongside GDP – and food prices – in the months ahead, the potential for more unrest during 2012 is highly credible. Whether this manifests as more ‘manageable’ street protests of the type witnessed already in a number of countries during 2011 (such as Burkina Faso, Mauritania and Uganda) or more sustained disturbances remains to be seen. Other candidate countries for turmoil in the year ahead include Senegal, Gabon, Zimbabwe and Cameroon.

(4) Can Kenya come through a pivotal year unscathed?

It’s been a tough few weeks for Kenya, East Africa’s critical hub market: from the serious food crisis in its north, through the abduction of a female British tourist and the murder of her husband in the coastal resort of Lamu, to a major pipeline fire near the capital Nairobi. The negative impact of such developments on tourist visitor numbers and investor appetite would be negligible compared to the situation should the serious nationwide political violence that accompanied its December 2007 election resurface surrounding new polls due in August 2012. The implementation of a new constitution and wider Kenyan politics remain effectively on hold pending the long-awaited start of hearings at the International Criminal Court in The Hague, involving a number of key politicians accused of involvement in the clashes that paralyzed the country in 2007-2008. Any resurgence in political violence due to the Court’s findings or around the next poll will reverse recovery in the tourism sector, and with it any chance of growth close to the 5.7% YOY GDP figure projected for 2011. In the long-term Kenyan politics needs to move on from confrontational, ethnic-based divisions into more ideological / policy-based debates in order to achieve stabilization and much-needed reform.

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Saturday saw Russia’s biggest political riddle resolved – Vladimir Putin announced he was running for another term as president and offered Medvedev the post of prime minister.  What does this mean for Russia’s business climate?

We now have clarity about Russia’s leadership for at least another six years. United Russia is set to win the elections this fall, and there is no doubt Putin will win the presidential elections in March 2012. This implies continuity in current government policies and actors, and will certainly boost investor confidence in Russia. It should at least partially support Russia’s falling currency and weakening stock market. Although the continuing crisis in the euro zone and the falling oil prices will minimize the announcement’s positive effect on the ruble, we can at the very least expect greater capital inflows through the rest of the year as well as an increase in FDI in the country.

In the short-to-medium term, this is good news for MNCs selling and operating in Russia, especially in the context of an unpredictable global economy. However, there are several potential threats down the road companies should watch out for.

First, there is wide consensus that the Russian economy requires fundamental reform away from its dependence on oil prices and high government spending. Such reform would mean reducing government spending on social programs, and will certainly be met with discontent among the population, something that Putin may or may not be ready to face. There is significant inertia in the Russian government and Putin is if anything a symbol and perpetuator of the status quo. Should oil prices remain high, Russia will hum along well enough. However, a prolonged fall in oil prices will bring about a very serious crisis in Russia, and the country is nowhere nearly as well prepared to weather it now than it was in 2008.

Second, while Russians still see no political alternative to Putin, there is a growing sense of stagnation – political, social, and economic within Russia that Putin is increasingly beginning to symbolize. Russians may vote for Putin, but that doesn’t mean they actively support him and his policies. In the short-to-medium term this has few implications. In the long term, however, it’s the stuff of social upheaval. Russia is inevitably headed into a major political transformation, and it’s now clear its current political leadership is not ready to steward the country through to it.

To sum it up, MNCs will benefit from a relative improvement in Russia’s business climate in the short term, will need to watch carefully for whether and what economic reforms the government undertakes after March 2012, and expect that in the long term, the rules of the game in Russia will change.

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