Emerging Markets: Fools Gold or El Dorado?


1 September 2005


Increasing affluence in China and India is attracting the attention of the world's corporations. But there is danger as well as opportunity in the world's emerging markets. Steve Coomber reports.


In 1897, 100,000 would-be gold prospectors headed north, to the harsh wilderness of the Yukon, in north-west Canada. They were drawn by tales of undiscovered riches. Yet for most gold diggers, the dream remained a dream; they returned disappointed and poor.

The Klondike is gone, if not forgotten, but a gold rush of sorts exists today. For Klondike, read emerging markets. For prospectors, read corporations of all shapes and sizes, heading to any country where wages are low and growth prospects immense.

"By 2025, India's population will be 1.395 billion and China's 1.441 billion."

Why are companies rushing towards the world's emerging markets with open wallets? The simple answer is profit, but there are other, more complex reasons. So what are they, and is the case for emerging markets cut and dried? And, if companies must get involved, how can they improve their prospects of success?

GOLD FEVER

Here are few simple statistics on the global economy. GDP growth in the USA in 2002 and 2003 was 1.9% and 3.0%, respectively. In the UK, it was 1.8% and 2.2%. In Germany, the figures were 1.9% and 0.1%. In Japan, it was 0.9% and 0.8%.

When domestic markets are lacklustre, companies turn to more attractive prospects elsewhere. In India, growth in 2002 and 2003 was 5% and 7.2%, respectively. Between 1996 and 2003, real GDP growth only once dipped beneath 4% (3.9% in 2001). China posted figures of 8.3% and 9.1% in 2003 and 2004. The CIS, excluding Russia, grew at 7% and 9%.

Growth figures are not always a reliable indication of an emerging market though: they are open to manipulation and may suddenly change for the worse. Population figures are more substantive. They make equally exciting reading to marketers in developed economies.

According to the UN, by 2025, India's population will be 1.395 billion and China's 1.441 billion. These are countries where most of the population has virtually nothing – no consumer goods at least. Millions of people have never seen a refrigerator. These countries are unsaturated markets.

The USA and much of Europe is another matter. Markets in the developing economies are increasingly saturated. Take the statistics for the mobile phone market. They make alarming reading for mobile phone manufacturers. The UK, the Netherlands, Italy and Sweden all have mobile phone subscription figures above 100% of the population.

In the emerging markets, however, it is a different story. In 1999, only 1% of Russians owned a mobile phone. By 2004, that figure had risen to 90% of people in St Petersburg and Moscow. Yet, outside Russia's main cities, over 50% of the population are without a mobile phone. Many have no landline either. Russia-based research company iKS Consulting reported revenue for mobile phone carriers up in the first half of 2004 by 58% compared with the previous year.

FALSE PROMISE

However, as the saying goes, all that glistens is not gold. Look a little closer, analyse the markets in more detail, and the markets may not seem so enticing.

"There are 1.3 billion people in China, that's 2.6 billion armpits: we are going to sell a lot of deodorant."

Don Sull, a professor of strategic and international management at London Business School and McKinsey consultant, advises companies to look beneath the surface before jumping into a market. "With China, for example, a common fallacy is what I call the 2.6 billion armpit fallacy," he says.

"It would be easy for a company to think there are 1.3 billion people in China, two armpits per person, so that's 2.6 billion armpits: we are going to sell a lot of deodorant. Yes, it is mathematically correct, but from a business perspective, it is not that easy." There may be billions of people in China, but most of them are virtually penniless.

THE COST QUESTION

A major reason for the stampede towards emerging markets is cost reduction. Why pay a skilled worker £150 a day in the UK when you can pay a similarly skilled worker £20 a day to do the same job in China?

The rationale for shifting operations offshore or out of the country is often a sound one. It is not all about India or China either. Wage rates in Central and Eastern Europe, for example, compare favourably with those in India. A recent IDC report 'The New Europe EU Enlargement and IT Opportunities in Central and Eastern Europe' put average starting salaries in Central Europe at £6,600. In India the figure was £5,300, in Ireland it was £13,000.

These low-cost countries have an abundance of talent. China produces more engineers than India. It has a reported 400,000 qualified IT engineers – increasing by 50,000 a year – compared with India's estimated 300,000. Russia has one of the most technically accomplished populations in the world. It ranks third in the world in terms of the numbers of engineers, scientists and mathematicians per capita.

Understandably, the growth in offshoring is phenomenal. It is not without risk, however. While the labour unit cost may be low, other costs may offset savings. Supply chain costs for higher-end consumer goods for example can be high. There are also very real security and governance issues.

ADVANCE PARTY

For companies that bow to pressure from stakeholders to enter emerging markets, beyond the initial decision of how much money to throw at it, the most pressing question is how best to go about it.

Martin Steele is a senior lecturer in strategic management at Cranfield School of Management and also a non-executive director of a large international engineering company. He outlines the possible routes into an emerging market, from the perspective of a drinks company.

"It is impossible to eliminate the risk of moving into an emerging market."

"You set up an office and a warehouse and import your product, then get a couple of salesman who go and talk to wine and spirit outlets, go and talk to the local supermarkets and the major retailers and then try to sell through them. That's a classic entry route," says Steele. "At the other end of the spectrum, you buy the leading wine and spirit distributor – if you are allowed to. Or you take a 50% stake in the biggest wine and spirit distributor, and put a couple of people on the board. But the local people still manage."

Both strategies can be effective. Both strategies have their drawbacks. A company such as Proctor & Gamble can use the strength of its brands and the experience of its executives to successfully execute a 100%-owned operation strategy. It may use predominately expatriate employees to begin with and then slowly, over time increase the number of employees from the local market.

At the other end of the scale, Sull points to Danone as a company that tends to make an equity investment in a local company or enter into some kind of joint venture and employs this entry method very successfully.

It is easy to get it wrong though. Many companies do – even huge multinational corporations. Appliance heavyweight Whirlpool took a plunge into China when it did a joint venture with one of the market leaders SMC, based in Shunde in South East China. In hindsight, Whirlpool made a number of bad calls. It put its own managers in, replaced the local sales team and required major decisions to be cleared at global HQ in Benton Harbor, Michigan, by way of regional HQ in Hong Kong. These moves deprived the joint venture of the ability to move quickly as well as important local know-how. Local competitor Galanz increased its share of the market, and the Whirlpool-SMC joint venture struggled.

RISK REDUCTION

It is impossible to eliminate the risk of moving into an emerging market. There are, however, steps that companies can take to help reduce the risk. To begin with, companies should think carefully before taking a minority equity position, especially if it only has one or two people on the board. It may lower risk exposure, but the trade-off in terms of the way it impairs execution and oversight may not be worth it.

A more pragmatic approach is to secure at least a 51% stake, as well as some measure of substantial board representation. This might mean appointing a CEO, but should definitely mean appointing the CFO. The contractual structure needs to be clear. This includes making provision for the jurisdiction for dispute resolution.

Although the temptation may be to control the new operation tightly from the centre, in a rapidly moving market, companies should favour local autonomy. Otherwise, by the time a decision has passed up and down the decision chain, market conditions have changed, local competition has responded and a different challenge has presented itself.

"It is going to take you twice as long, and cost you twice as much, and give you twice as many ulcers as you thought."

Getting the management team right is essential. In the early days, the operation is likely to be comparatively small and entrepreneurial in its outlook. Management needs to reflect this entrepreneurial mindset, yet have sufficient experience in the company. These kinds of people are often scarce in established corporations. With HR and marketing, it often makes sense to use people from the local partner. They will have their finger on the pulse of the consumer market. They will understand the local job market and know what kinds of skills are available and what the benefit structures are.

Companies should also be aware that the dynamics of relationships are likely to change, often dramatically. Steele recounts a situation where a relationship altered to the detriment of the company entering the market.

"One European company set up a joint venture in an emerging country after carefully selecting a partner with the relevant expertise and track record." Steele says: "The objective was to source products more cheaply. The problem was that the partnering company decided they wanted the company to be highly profitable, so they put up prices. With a minority stake, there was nothing the European company could do, and it was left facing similar sourcing costs to those it originally had."

CAREFUL ASSESSMENT

In all these things, due diligence is essential. Companies have to do a thorough risk assessment. What kind of risks are they assessing? "Political risks, regime change, rampant inflation, the seizure of foreign assets," says Charles Blackmore, senior managing director, Europe, Middle East and Africa, at the security and commercial risk assessment firm Vance International. And he hasn't finished reeling off potential threats to the business yet.

He also lists macro-economic volatility with political change; capital controls; war or civil unrest; regulatory change; poorly defined contract and investor rights; lax accounting controls; pressure to play by the local rules; crime; physical security and threats to personnel.

The problem is that due diligence isn't that easy unless you have good contacts on the ground. In Europe or the USA, a CEO would ring around their network of contacts, get the corporate lawyers on the case and hopefully cover most eventualities. With emerging markets, the network of contacts is probably a lot smaller, if it exists at all. And the regulatory environment is often changing at such a rapid pace that it is hard to pin down. This is where companies such as Vance prove invaluable.

Ultimately, companies will inevitably head for the emerging markets. The lure of high growth and low costs is too tempting to resist. Many companies will fail, if only temporarily. Most will learn through trial and error. Reducing the risk of failure is largely a matter of common sense and following a few basic guidelines.

"Due diligence is essential. Companies have to do a thorough risk assessment."
  • Quantify the risks
  • Identify threats
  • Look at the overall market
  • Carry out a project assessment
  • Assess your business requirements

"I don't think there is any particular black art to it," says Blackstone. "It always amazes me that instead of companies doing the country risk assessment and the threat analysis, looking at the overall market and project assessment, putting into place reviews and implementation and looking at their business requirements, so many companies go diving in."

Eventually, companies from mature markets will master their approach to emerging markets. How long those markets will remain 'emerging' is another matter.

"It is going to take you twice as long, and cost you twice as much, and give you twice as many ulcers as you thought," says Sull. "So it is a good idea to have realistic expectations. Too many companies approach emerging markets with a combination of euphoria and ignorance."