Emerging Markets Insights

Global uncertainty is increasing. The back-and-forth negotiations surrounding policy decisions on the US Fiscal Cliff, Eurozone crisis, and potential conflicts in the Middle East may be intriguing for political scientists, but for global business executives, they are cause for major headache. These policy decisions don’t just affect the upcoming elections; the anemic growth of the global economy is at stake. Any escalation of one of these major drivers of global risk could seriously thwart hard-earned recovery, and plunge the globe into another recession.

With that said, emerging markets continue to show promise for 2013, even in the face of increased global risk. By focusing on economies that are better positioned to withstand the major influencers of uncertainty, and mitigating exposure to economies that are highly susceptible, growth can still be achieved. For example, economies in: Asia Pacific, Sub-Saharan Africa, and parts of Latin America are relatively well insulated. In the near-term, countries such as: Indonesia, Nigeria, Philippines, and Colombia exhibit the necessary growth fundamentals to withstand some of these potential negative shocks. However, looking at the growth fundamentals alone is not enough. Let’s take a closer look at the three big reasons why emerging market executives need to prepare contingency plan as soon as possible.

1. US Fiscal Cliff – How will you plan for a sharp decline in global demand?

The primary determinant of exposure to the US Fiscal cliff is the amount of exports emerging market regions send to the US. However, the ripple-through effects of the US falling over the fiscal cliff (or probably more appropriately, sliding down the fiscal slope) are much more far-reaching. A reduction in US demand will reduce manufacturing as export-led economies rebalance to reach new market equilibriums. This decline in manufacturing will also reduce demand for the input-commodities, adding downward pressure onto commodity prices. Executives that are caught off-guard by the susceptibility of some economies in their portfolio will find themselves playing catch-up in attempting to rebalance their resource allocation.

2. Eurozone Crisis – Are you prepared for a sudden reversal of foreign direct investment flows?

Trade and financial linkages are the fundamental transmission channels of an intensified Eurozone Crisis. A weakening Eurozone economy, combined with heightened perceptions of global risk, could undermine the foreign direct investment inflows that are currently expected to moderately increase for emerging market economies in 2013. Economies that are dependent on advanced economy capital flows for growth could see a major source of investment dry up.

3. Conflict in Middle East – What happens if there is a major oil shock?

Any conflict in the Middle East could result in a major decline in global oil supply, prompting a spike in oil prices. Higher oil prices would reduce sluggish growth and raise production costs (eroding profitability), while upward pressure on inflation could trigger a reassessment of credit supply in emerging markets. All of these factors combined could cripple indebted economies and threaten a liquidity crisis. The susceptibility and flexibility emerging markets have in dealing with this scenario depends on their adequacy of reserves, and their potential to shift production to exports to enhance their repayment capacity. For example, countries such as Ukraine and Poland are in major danger of a liquidity crisis if economic tensions rise due a reduction in global oil supply.

Only by fully understanding the implications and impacts of these events on business can companies appropriately react to the downside possibility. Executives that plan for the worst will find themselves a step-ahead of the competition if any of these risks materialize. In a highly competitive environment, that extra advantage can be the difference between exceeding and missing performance targets.

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Uncertainty in the global economy, primarily a result of questions surrounding policy decisions in the Eurozone and United States as well as the potential for conflict in Iran, is affecting global economic growth prospects. Growth projections for 2013 continue to fall as worries over fiscal consolidation, financial weakness, and high levels of public indebtedness in advanced economies put downward pressure on global growth. In emerging markets, activity has been slowed by weaker demand from advanced economies, policy tightening in response to capacity constraints, and country specific factors. However, emerging markets are now better positioned to be resilient in the face of crisis compared with 2008, due to policy improvements in the fiscal and monetary space.

As financial markets continue to react to the re-election of Barack Obama, emerging markets globally have a keen eye on the developments surrounding the upcoming US Fiscal Cliff. The impacts of automatic spending cuts and tax increases would be seen worldwide, as declining US demand would affect export-dependent economies across the globe. Lower aggregate demand would also yield downward pressure on commodity prices as global manufacturing decelerates, further damaging economies that are dependent on commodity exports. FSG predicts that emerging market oil exporters could witness drastic reductions in real GDP growth, as much as a .8% decline in 2013.

Even with all of the uncertainty in the global economy, FSG has identified a number of emerging markets countries that nonetheless are expected to exhibit strong growth in 2013. These markets tend to fall into one or more of the following buckets:

Improved political stability

• E.g. Vietnam, Thailand

Ample fiscal cushion

• E.g. Angola, Qatar

Relatively insulated from the Eurozone

• E.g. Philippines, Malaysia

Large domestic populations with a booming middle class

• E.g. China, India, Indonesia

In my next post, I’ll discuss some of the implications of the Eurozone debt crisis and a potential conflict involving Iran on emerging markets growth prospects for 2013.

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Spanish depositors withdrew nearly $100 billion in July, more than double the existing record for one month. The jump in withdrawals was likely driven by households joining corporations in the flight to safety. The Spanish Central Bank says the spike was due to the “July effect of tax payments and by the expiry of securitized funds,” but the Spanish Central Bank has zero credibility after their bogus stress-tests. The system still has roughly $2.9 trillion in deposits according to Morgan Stanley, but that will not be able to withstand an accelerating run on banks without ECB support.

This will be a race for the ECB. During the ECB’s meeting on September 6^th, markets and critically, depositors, will be watching for actions that support eurozone member-states. Bond purchases are the key action that will buy time to allow for economic recovery, but they cannot be limited. It’s too late for that.

While we do expect an announcement around bond purchases, we will focus on measuring the extent of program. Limited support cannot plug monthly losses of $100bn in member-states’ balance sheets. Purchases need to be messaged to the market as unlimited, something we doubt the ECB will do because the politicized nature of ECB negotiations.

Domestic politics are such that any bond purchases will alienate German and Dutch voters. If the ECB is set to launch a bond-buying program, it is better off going all the way as it may not get another chance. You can imagine a scenario where electorates in the creditor states put the program to a vote as a way to stop the flow of funds to debtor states. We hope the ECB can take bold action in light of domestic political realities, but they have yet to take bold action at any point during the crisis.

Watch for Europe to waste another opportunity to slow the crisis and instead continue to kick the can down the road.

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As credit continues to dry up in the wake of the ongoing eurozone crisis and continued macroeconomic uncertainty, multinational companies need to ensure that their distributors and channel partners in emerging markets can weather the storm, purchase inventory, and fund operations. In my previous post, we looked at some of the strategies companies can use internally to shore up their collections efforts and reduce days sales outstanding. In this post, we will focus on three strategies for helping external distributors and channel partners manage their working capital more efficiently.

External Focus: Three Strategies for Helping Partners Manage Working Capital

1. Off-load inventory holding costs by arranging smaller, more frequent shipments to distributors

The retail industry has been among the industries most impacted by the global economic downturn. To help its local distribution partners weather the crisis, one FSG client in the apparel industry has emphasized its flexibility to local distribution partners by reducing minimum order sizes while ramping up the frequency of shipments. This approach has the added benefit of enabling a more rapid response to changing fashion trends, which boosts sales and prevents distributors from accruing stockpiles of unsold (and out-of-fashion) inventory.

2. Provide a shared IT platform to improve efficiency and monitor business health

A FSG client that is a leading manufacturer of white goods has provided its local distribution partners with a shared IT platform that facilitates the free flow of high-value information. The system allows for the sharing of real-time sales data, pricelists, product information, macroeconomic data, and market trends among the company and its distributors. The company gains in-depth insight into the health of its partners’ businesses and can take action to recommend efficiency improvements or recognize early warning signs of looming trouble.

3. Forecast demand and actively manage inventory

Many FSG clients have reported their local partners’ tendency to inefficiently manage inventory, which ties up working capital that could be more effectively allocated to revenue-generating activities. One client in the construction equipment industry has provided its local partners with a software-based demand forecasting system for spare parts that strikes a balance between customer satisfaction (parts availability is critical for minimizing customer downtime) and working capital optimization. After securing buy-in from its partners by demonstrating this win-win relationship, the Council member is able to exert more control over managing inventory levels at the individual dealer level.

In the current economic environment, generating free cash flows and reducing risk continue to be top priorities for MNCs in emerging markets. The current climate provides not only a sense of urgency, but also a window of opportunity, to implement better working capital management practices. If and when we see a return to robust growth in global markets, companies that have established these good habits will be sure to yield more profitable growth than their competitors that have not been so diligent.

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Interview with Matt Lasov, Head of EMEA Research for Frontier Strategy Group

Politically, there is zero will to allow Spain to default but markets have moved faster than politicians every step of the way. It’s very difficult to view European politicians as credible at this point, the markets certainly do not. Remember, default is always a political decision (or in this case indecision). There are policy tools available to fix this crisis, debt monetization for example. The challenge is in getting 17 eurozone governments to agree when they are beholden to domestic voters, though they share a supranational currency. As of now there is no path to solve this fundamental challenge in a timely manner.

Here’s what we know about Spain – and why we think risks are very high:

The story for Spain is bust banks and a dose of social unrest

CDS spreads show 40% chance of default, up from 30%

Youth unemployment at 50% with zero public benefits (there is no available cash for extended unemployment etc…) is a recipe for disaster

12-month yields at 5% and 10-yr at 7% is not sustainable from a funding point of view – borrowing at these rates only compounds the debt crisis.

With high borrowing costs and the 100bn euro loan, Spain’s government debt to GDP jumped to 90%, it was at 60% last year. The credit crisis was effectively transferred from Spain’s banks to its government – a government that lacks cash and the typical policy toolkit – ie printing money, devaluation.

Spain’s bond purchases are fully subscribed but there is zero foreign participation which will be necessary to bring in rates. The only buyers are Spain’s bust banks which are now reliant on government funding. This is a less-than-virtuous circle that cannot last.

Various eurozone bailout funds have the cash to string Greece along, but not Spain/Italy. A true bank recapitalization would overwhelm the size of current facilities.

Timing:

We’ll know more about the willingness of policy makers to credibly solve the problem by June 30^th. At that point the European summit will have ended, the G-20 will be over, and Greece will hopefully have been extended. The pendulum will have hopefully swung from harsh austerity to the balanced deleveraging approach.

If things have not made progress by June 30th, we will need to talk about broader eurozone contingency planning. Policy makers are running out of chances and markets don’t give mulligans.

Meanwhile in Greece:

Looks like a weak coalition of pro-Europe parties will govern Greece.

Greek parties have told the Greek people that they will modify bailout terms but simultaneously told European leaders they would not ask for this.

Driven by the cycle of austerity, social pressures in Greece are too high to bear and coalition parties realize they will need to soften austerity if they are to stay in power for any period of time.

This coalition will not be long lasting. Aside from historic domestic political competition between the parties, the coalition’s legitimacy now depends completely on Europe’s willingness to modify loans. Germany has not indicated it is willing to do this in a meaningful way.

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Russia has been one of the few CEE markets with strong growth as the eurozone crisis drags Eastern Europe into recession. Russia’s GDP expanded 4.9% YoY in Q1 2012 and the economy seems set on a stable trajectory for the rest of the year. This stability, however, is illusionary.

Russia’s growth is already slowing down compared to 2011, a trend that plays out both in the consumer and in the industrial sectors. This is not surprising – both the IMF and the Russian government itself have already warned that Russia’s ability to grow on the back of high oil prices has reached its potential. The economy is set to grow at a sluggish 3-4% per annum unless there are major structural reforms to reduce red tape and improve the business climate in the country.

With Putin back in the Kremlin, none of these reforms are likely to materialize. The recently-announced new Russian government, dominated by Putin loyalists and weak bureaucrats, is unlikely to be a major driver of policy change. Putin’s agenda remains heavily centered on the energy sector, maintaining a large public sector, and sustaining high social spending. His program will only increase Russia’s dependence on oil prices.

In the near term, significant external risks loom over the economy. Global oil prices are unsupported by demand-supply fundamentals and are already on their way down; a deeper eurozone crisis will lead to their further decline. Brent prices declined by 25% in the last three months and the worst of the eurozone crisis is still ahead of us. As Russia’s dependence on oil prices has increased since the 2008-2009 financial crisis, the impact of an oil price bust on the economy will be severe – S&P estimates that Russia will enter recession if oil prices fall below US$80 per barrel.

As a result, Russia’s prospects should be a source of concern, rather than optimism: in the short term the economy is slowing, in the medium term the eurozone crisis poses a significant risk of recession, and in the long term there is little reason to expect growth to improve significantly. While none of these risks have fully materialized yet, companies with significant exposure in Russia need to prepare now to respond to them.

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