Emerging Market View: What Our Analysts Are Reading

EM View

On Thursday, EU diplomats will consider increased Russian sanctions. The sanctions include a proposal to ban all Europeans from purchasing any new debt or stock issued by Russia’s largest banks, according to the Financial Times, and FSG’s Head of Research for EMEA says it’s time for multinationals to make contingency plans.

“If some or all of the proposed measures are approved by the EU, MNCs operating in Russia will be significantly affected. Executives should build a targeted contingency plan for their Russia operations to prepare. Read FSG’s report Protecting Your Russia Business for analysis and suggested actions for building a contingency plan in the case of further sanctions against Russia.” – Martina Bozadzhieva

In Southeast Asia, a rising middle class and strong demand for more expensive foods has led to increased investment by Japanese food companies, mirroring FSG predictions on the rising competition from multi-ASEAN corporations.

“The increasing sophistication of regional firms and growing demand is attracting several global players to partner/acquire ASEAN firms. MNCs should explore all types of partnerships with such regional firms; they understand the market better, tend to have deeper distribution networks, and lower-cost operations.” – Shishir Sinha, FSG’s Senior Analyst for Asia Pacific after reading this WSJ article.

Good news for Argentina this week. Last Friday, the Latin American country struck a deal to borrow $7.5 billion from China for power and rail projects, according to Reuters.

“Argentina has reached a deal with China to borrow US$ 7.5 billion to finance energy and railway projects, and the two countries have also signed a three year, US$ 11 billion currency swap, in which Argentina will receive Chinese yuan that it can then use to finance Chinese imports or exchange to USD to bolster reserves. This news is welcome given Argentina’s balance of payment concerns.” – Christine Herlihy, FSG’s Senior Analyst for Latin America.

FSG clients can keep up to date with the latest emerging markets headlines and exclusive analyst commentary on the client portal.

Multinationals must build contingency plans for Russia

European foreign minister
European foreign ministers gathered in Brussels on Tuesday. Associated Press

The EU has decided to impose more sanctions on Russia. For now, these fall short of the so-called Level 3 sanctions that could be against whole sectors of Russia’s economy and crucially, its banking sector. However, the international fallout from the downing of flight MH17 and the growing tensions between Russia and the West mean that Level 3 sanctions are increasingly a possibility.

For an MNC executive, this means that it’s time to plan. Level 3 sanctions would dampen Russian growth further, reducing demand across industries; they would cause significant problems for customers and distributors to access finance, affecting operations; and are likely to be met with Russian retaliation that could make it more difficult for MNCs (especially American ones) to do business in Russia. All of this will have an impact on a company’s customers, finance, supply chain, people, and marketing strategy and MNCs should be building step-by-step play books on how to respond to spillover across their Russia operations.

martinachart2This is not to say that MNCs should be pulling out of Russia. In fact, planning is so important because of the significant role that Russia plays in many MNCs’ EMEA and even global portfolios. Companies that have stuck with Russia through crises have historically reaped significant benefits and this could be an opportunity for MNCs to strengthen partner and customer relationships and to make low-cost investments.

Meanwhile, larger strategic questions are looming in the background for EMEA and global leadership teams. With the likely opening of Iran for business, a Russia that is increasingly closing in on itself could lose out in the competition for corporate investments.

For a full report on Russia contingency planning, FSG clients can click here. A full report on preparing for a post-sanctions Iran is also available.

What the Latest Sanctions Against Russia Mean for MNCs

The latest rounds of EU and US sanctions against Russia fall short of imposing restrictions on entire industries, but they do have a number of hidden spillover effects for Western multinationals operating in the market. Beyond the obvious impact on MNCs selling to the energy and defense companies directly targeted by sanctions, a broader set of MNCs operating in Russia should be concerned about the banks that have been included in the sanctions list.

Impact on MNCs:

MNCs selling business goods and services are most likely to be indirectly affected by the sanctions, because some of their customers may face a higher cost of credit. Beyond businesses that directly work with the sanctioned banks, Russia’s financial market as a whole is likely to see more expensive credit as more international banks try to restrict new lending out of cautiousness. In the long term, higher lending costs contribute to the contraction in domestic investment, which will prolong Russia’s economic stagnation and reduce demand across all industries.

Actions for executives:

Executives whose business may be affected should speak with their local teams and identify key customers who may work with the sanctioned banks. Such customers may face the risk of rising borrowing costs, particularly if their credit lines need to be rolled over in the near future.

Three consequences of the new round of sanctions:

  1. They could reduce demand from small and medium enterprises.

Both the European Bank for Reconstruction and Development (which the EU will ask to halt new lending in Russia) and VEB, a bank sanctioned by the US, lend extensively to small and medium businesses. A cut in their lending will result in reduced investment and demand for B2B goods and services at a time when investment activity is already deeply depressed.

Chart: VEB will be prohibited from borrowing at maturities longer than 90 days on US capital markets

  1. Multiple industries could be see more expensive credit.

VEB and Gazprombank, the two banks the US sanctioned, lend extensively to the corporate sector, including industries such as oil and gas, metallurgy, machine-building, chemicals, and others. 40% of VEB’s lending in 2013 was for infrastructure. Interest rates for corporate customers of both banks are likely to increase, hitting multiple industries at once.

  1. Lending in Belarus could also be hurt.

Subsidiaries of VEB and Gazprombank hold almost 10% of the Belarussian banking market and are largely dependent on parent-bank financing. Their lending activity and cost of credit is likely to be negatively affected by the US sanctions, affecting some MNCs’ corporate customers in Belarus.

Understanding how the new US sanctions work:

The banks sanctioned by the US – VEB and Gazprombank – are among the largest in Russia. They lend primarily to corporate customers across multiple industries and much of their portfolios consist of long-term loans. To finance these loans, they need to borrow at long maturities on international financial markets, which is exactly the kind of borrowing that US sanctions have restricted. Their alternative sources of long-term capital are notably more expensive and would require them to increase lending interest rates, hurting the businesses to which they lend. Because of the size of these banks, increases of their interest rates are likely to have a spillover effect across the Russian banking sector as a whole.

View the video below to see FSG’s Martina Bozadzhieva discuss investing in Ukraine and Russia on CNBC yesterday.

Escalation in Crimea: Impact on MNCs Operating in Western Europe

As MNC executives responsible for Western Europe dissect the events unfolding in Ukraine’s Crimea region, they will fall under more pressure to digest mounting media news and interpret current events’ impact on their business. To address the localized impact of increasing hostilities in Crimea, our latest podcast, introduced in the preceding blog post, focuses on the factors that will impact multinationals’ Ukraine and Russia business regardless of the scenario that unfolds in Ukraine’s Crimea region.

However, the impact of Ukraine’s crisis is extending to the regional level, and could impact European recovery. Executives should act now to consider how the following possible impacts will affect their ability to meet targets in 2014:

  • Any disruption in gas lines will push up prices in Europe. A Gazprom (Russia) decision to cease gas flow to Ukraine would disrupt gas flows to Europe, which only has 18 days of gas reserves and easily could be outlasted by a political crisis. Decreased gas flows would thus increase energy prices and hurt any chance of recovery as consumers focus on inelastic energy costs and away from elastic purchases of goods and services. Europe is Russia’s largest export market, creating disincentives for a gas cutoff that would leave a large hole in the government budget. The Russian government, however, has often put political concerns ahead of economic ones
  • Germany could be the worst hit. Most of Germany’s gas supply flows directly through Ukraine, and constitutes about one-third of its energy mix. German consumers also suffer from the highest electricity prices in Europe, meaning that the country’s exposure to increased energy prices would force the government to abandon its new energy rebalancing policies in favor of keeping prices manageable for its citizens and industry. The result would be increased short-term energy costs and a return to government deficit. Furthermore, Germany’s reliance on exports means that lower demand due to regional volatility would reduce its prospects for outperforming the eurozone in 2014
  • Even European bank exposure to Ukraine could reduce lending activity in Western Europe. While the Ukrainian credit market is almost entirely dominated by local players ─ only Raiffesen of Austria is heavily exposed ─ the European banking system is so sensitive that one bad bank could accelerate the credit contraction already taking place in Europe
  • Continued crisis in Ukraine could disrupt supply chains, which would increase costs. Companies should consider what disrupted supply chains would mean for getting their products to market, and include distributors in the conversation to gain local knowledge and buy-in, and ensure adherence to any contingency plans

Now is the time for executives to build contingency plans, particularly focusing on what increased activity in Ukraine would mean for pricing. Companies that are able to course correct strategic plans and allow for increased costs will be better-equipped to address regional volatility, meet their 2014 targets, and gain market share.

Escalation in Crimea: What it Means for MNCs

With all eyes on Ukraine after Russia threatened military action, MNC executives are under more pressure than ever to rise above the media noise and assess what current events mean for their business. Even though the situation is evolving by the minute, executives’ time is better spent focusing on the factors that will affect their business under any scenario, rather than trying to decipher the multiple directions in which the crisis may evolve.

In our latest podcast (client portal) on Ukraine and Russia, we highlight what executives should focus on:

  • Companies need to have contingency plans for both Russia and Ukraine; any existing plans likely need to be revised in light of events during the weekend
  • Under any scenario, Ukraine is in for significant economic pain in the short term. Targets and plans should reflect that. Pricing may also need to be adjusted
  • Managing corporate’s perceptions of the situation is critical given the flood of media coverage on Ukraine. Executives need to control the narrative on Ukraine and Russia with HQ to ensure that their business is well-positioned to take advantage of any opportunities that the crisis may present
  • 2014 Russia plans need to be revised. Russia is likely to underperform in what was already a poor economic environment. Companies should in particular make sure they have a plan in place to respond to the currency depreciation which threatens to hurt both revenues and profits this year

For a detailed discussion on these and other steps executives should take in response to tensions between Ukraine and Russia, listen to FSG’s podcast (client link) and read our report (client only) on how to protect your Ukraine business from the worst fallout from the crisis. You can download the podcast here (public) or subscribe to our Emerging Markets Podcast Series.

Russia’s Hidden Trend: Regional Slowdown with Significant Implications

Russia slashed its long-term growth target this week, admitting that its economic slowdown is a trend that is here to stay for the next several years.

While the reasons for the slowdown have been discussed extensively, one topic has remained overlooked – the slowdown is not playing out uniformly across Russia’s geography. This has significant implications for multinationals, the majority of which are not planning to pull out of Russia, but are instead looking to allocate their resources more efficiently and to capture growth niches on a segment and geographical level.

To help our clients prioritize Russia’s geographic opportunity, we analyzed the economic health of the country’s regions. We found massive region-level variations in performance. More importantly, we found that the slowdown has been much more pronounced across many regions than the headline numbers indicate – a sign that next year’s outlook could deteriorate further.

Three trends stand out:

Trend #1: Pockets of growth are driven by one-off factors

  • Relatively fast growth in the Far East, Southern, and North Caucasus federal districts is driven by one-off projects, such as the Sochi Olympics, and federal government subsidies

Trend #2: Leading federal districts are underperforming

  • Traditional engines of economic growth, such as the Central and Urals federal districts, are stagnating because of depressed investment by large industrial enterprises in their regions

Trend #3: Slower growth is geographically widespread

  • In every federal district, there are at least several regions that are underperforming significantly, indicating that the economic slump is not isolated to a particular part of the country

The map below (click map to enlarge) summarizes our assessment of the economic health of Russia’s regions so far in 2013. We analyzed regional trends in the consumer and business sector, as well as among the increasingly-indebted regional governments, to find that demand in Russia is being driven by pockets of high growth that are geographically dispersed. This is likely to increase costs for companies looking to capture all growth pockets, and will push more multinationals to prioritize only a small number of regions, which are increasingly likely to outperform the rest. As a consequence, we are likely to see more multinationals focus on profitability and cost optimization of their local operations, rather than on making the kind of large investments that could help jump-start the country’s economy.

FSG Index for General Health of Russia's Regions

 

FSG clients can access the full report here.

Memo to EMEA and LATAM regional heads: time to pick up the phone and chat

Struggling to Combat Slowing Growth and Rising Costs in Key BRICS Markets?

A conversation with your regional counterpart in EMEA, LATAM, or APAC can help you understand the common structural factors driving lackluster growth and help you re-set corporate expectations for growth in 2014

BRIC deceleration

2013 has been a difficult year for the BRICs—economic growth has decelerated across the board due to the confluence of external headwinds and domestic inefficiencies, while the political will to push for necessary structural reforms has proven elusive.

For emerging markets executives seeking to respond to slowing growth in key BRICS markets, cross-regional conversations can be valuable for issue diagnosis and strategy development. The premise of the argument here is a simple one: common problems can and ought to be identified, so that viable strategies for driving profitable growth given less favorable medium-term prospects for the BRICs can be replicated and applied across regions.

I’ve been ruminating about Brazil’s slowdown and potential for recuperation in 2014 for several quarters now, while my EMEA colleague, Martina Bozadzhieva, has been doing the same with respect to Russia.  However,  it wasn’t until we had an opportunity to sit down together and discuss the dynamics driving Brazil and Russia that we learned how much these two seemingly disparate markets have in common.

Listen to our podcast below for a quick recap of the structural factors driving lackluster growth in Brazil and Russia, and get a cross-regional perspective on strategies for managing corporate expectations and improving bottom-line performance across the BRICS.

Download the podcast or access the entire FSG iTunes library here

Russia beyond the headlines: A vibrant start-up environment

Although negative publicity seems to dominate Western coverage of Russia, the country offers many exciting growth stories. Evan Burfield, founder of 1776, a technology start-up incubator based in Washington, DC, shared impressions from his latest trip to Moscow with FSG. In Russia, he met with start-up entrepreneurs, angel investors, and government officials to discover that a community of exciting, ambitious, Western-style technology start-ups has appeared in the country during the past few years. Below, we highlight a few of Evan’s insights from his trip.

Russia has a vibrant start-up community and it looks very much like the one in the West

Surprisingly to many observers, Russia has a growing community of start-ups that would be very much at home in Silicon Valley. One reason for this is that many Russian high-tech start-ups were set up by Russians educated in the West or with experience working in top global consulting companies such as Booz Allen Hamilton, McKinsey, and others. Some Russian emigrants living in West have also returned to Russia to take advantage of the huge growth potential that the country offers.

As a result, you find in Russia the same trends in start-up development as in other countries – big data, education, consumer web, etc. Some Russian companies are cloning Western business models, but are striving to be global players and to expand into markets beyond Russia.

But the sources of start-up capital are different 

Russian startups are supported by an angel community composed of prominent investors whose roots are often in building successful businesses during the 1990s tech sector boom, for example companies such as Russian search-engine Yandex. However, many investors also come from more traditional industries such oil and gas. They may not see stable investment opportunities in their current industries and look to instead invest in what they increasingly see as the next-generation wave of Russian startups.

Russian start-ups face unique challenges

In the U.S., capital and start-ups are readily available and the challenge lies in selecting the right ideas. In Russia, capital is abundant, but high-quality ideas and entrepreneurs are more difficult to find.

One of the reasons for this difference is the shortage of mentors in Russia. Most of the big Russian businesses are in more traditional industries, which means that the pool of successful tech entrepreneurs is small. Local mentors with experience are highly sought after, but are few and far between.

The Russian government both supports and obstructs local start-ups

The Russian government seeks to support start-ups, especially in the technology industry. The most well-known example of this is the high-tech innovation hub of Skolkovo.

On the other hand, start-ups in Russia struggle with administrative issues such as being able to post several years of losses without arising the suspicion of the tax authorities, and the generally very high level of taxation. This makes it critical for them to establish good relationships with the authorities to ensure sustainable growth.

Corruption is less of a problem than is commonly perceived. The burdensome regulatory environment is a much bigger challenge for Russian start-ups. This underlines the attractiveness of special projects such as Skolkovo, which offer reduced red tape and tax breaks.

Exciting opportunities exist for investors with a more balanced view of Russia

There is no doubt that there is a massive misunderstanding of Russia in the US investor community. There is a Western perception of the inherent element of criminality and corruption in all Russian business. But at the same time, this doesn’t mean that there are no sophisticated, Western-style aspects of the Russian economy. In fact, the two exist in parallel.  For example, Russian government rhetoric against the US is also combined with strong interest in and support for collaboration in technology. There is huge demand for start-up engagement on the side of the Russian government as well as from the private business community.  This creates significant opportunities for those investors who are willing to look beyond the headlines on Russia.

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Evan Burfield is a cofounder of 1776, driven by his passionate belief in entrepreneurship as the engine for solving the major problems facing America and the world today—from education to energy efficiency.

Evan became an entrepreneur in 1996 when he founded netDecide, shortly after graduating from the Thomas Jefferson High School for Science and Technology. Before he turned 25, he built netDecide into the leading provider of enterprise wealth management solutions for top tier financial service firms. After netDecide, Evan served as the Director of Strategy and Technology for Oakwood Global Finance, where he led the London-based private equity firm’s analyses of new global markets, new business models in financial services, and data-driven investment strategies. In 2006, Evan returned to Washington, D.C. to found Synteractive, a consulting firm that builds innovative social apps for startups, corporations, and government agencies.

Evan holds Bachelor’s and Master’s degrees in Philosophy, Politics and Economics from the University of Oxford. While at Oxford, he won the Webb Medley prize for outstanding work on the effects of organizational incentives on knowledge sharing. Evan currently serves on the Board of the Rothermere American Institute at Oxford, dedicated to the study of American history and politics.

Emerging Markets Opportunity Not Over

Currency-Volatility-Global-Performance-DriversRecent reversals in capital flows caused large and sudden currency devaluations, faster than many emerging markets expected or could manage. As a result, many market commentators have called this end of the emerging markets opportunity. That statement couldn’t be further from the truth. While companies should always expect challenges in emerging markets, the changing environment will also create a new set of opportunities.

FSG identified four ways companies can capture growth in this shifting environment:

  1. Leverage home-currency strength to win share back from emerging markets–based competition
  2. Double down on local production to reduce production costs
  3. Use balance sheet strength to earn financing margins
  4. Reassess customer segmentation to identify local customer “winners”

FSG looks at these strategies and the drivers of the changing global environment in our 2014 Global Performance Drivers report, now available for FSG clients.

What happened?

Capital flows reversed because of push and pull factors.  As the US economy continues to improve, the Federal Reserve is expected to reduce bond purchases, changing the risk-return payoff for portfolio investors, “pulling” capital out of emerging markets.  We also see slowing growth in emerging markets “pushing” capital to developed markets.  The outflow of capital is more concerning for countries like Turkey, Poland, and Ukraine, which have high levels of short-term external debt. Countries fitting this profile may run into short-term funding challenges that could drive up local interest rates, or in the worst case cause temporary liquidity problems. Other countries like India and Indonesia may now struggle with inflation as currencies decrease faster than is manageable, driving up costs for consumers.

Podcast: Russia, Belarus and Kazakhstan Customs Union | Expert Interview

PODCAST

The Customs Union between Russia, Belarus, and Kazakhstan increasingly attracts the attention of multinationals interested in expanding their presence in the CIS. In this podcast, FSG interviews Alexander Rogan, CEO of Russia Supply Chain and FSG Expert Advisor on the practical implications of the Customs Union for companies looking to transport goods across the CIS, as well as the opportunities that the Union creates for companies investing in the region.

Click here to download the podcast or alternatively access the FSG iTunes podcast library here.

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Alex RoganAlexander Rogan is the CEO of Russia Supply Chain, a series of publications and a consultancy. He previously worked as Managing Director at Priority Freight CIS, a logistics and supply chain company with offices in the EU, UK, and CIS. Mr. Rogan has 28 years of experience in global logistics and currently works in Russia, Kazakhstan, and the Former Soviet Union. Mr. Rogan has also served as Managing Director of AJR Logistics, which provides inbound/outbound logistics in Russia. He has wide-ranging expertise in managing distribution in Russia. He was also the Russian editor for Logistics Leaders and published Russia’s Automotive Supply Chain magazine.

Alexander is available to FSG clients for private consultation – please reach out to your account manager to schedule a meeting.