A new paradigm
Growth in the world economy has slowed significantly since the boom in the middle of the last decade. The latest EY/Oxford Economics forecast for Rapid Growth Markets downgrades average growth for 2013 in the 25 countries covered from 4.6% to 4.3% for 2013 and to 4.7% from 5.7% for 2014: a significant adjustment. Many commentators have attributed the slowdown in the world’s fastest growing emerging markets to short-term shocks caused by changes in monetary policy in the USA but this explanation ignores more fundamental issues.
For a generation, the prevailing wisdom has been that emerging markets were a one way bet, with guaranteed high rates of growth driven by the combination of the modernisation of the developing economies and the moves to offshoring and outsourcing by the richer economies. This assumed wisdom has come under pressure for a number of reasons:
- As the emerging markets have grown, so their costs, especially labour costs, have increased, placing the differential on which offshoring is based under pressure;
- The financial crisis has reduced the level of credit available globally and this has led to both a reduction in demand and a slowing of the pace of offshoring;
- As a result of the developments above and shocks to supply chains caused by the Japanese earthquake, companies are looking to reconfigure their supply chains to reduce risk and increase their control – a good example is the increased use of Mexico as a production base for US automotive manufacturers – and hence relocation decisions now look at a wider range of geographic models than just a move to the lowest cost destination.
Against this changing backdrop, we also have to consider the impact of the ongoing change in economic policy being pursued by China. It is becoming increasingly clear that China is looking to rebalance its economy and to increase the share of output accounted for by domestic consumption. This change will reduce investment expenditure and hence China’s demand for imported commodities. It will also led to shift in China’s demand for imports, with a likely increase in imports of consumer goods and a slowing of demand for intermediate industrial goods.
A differentiated landscape
The experience of western companies that have invested in emerging markets has been mixed. Top line growth has been readily attainable but the recent financial pages have highlighted several cases of problems in generating value due to margin pressure: emerging markets have their own cultures, customers on average are poorer than western customers and there are different competitors to contend with. The result is a challenging environment in which turning volume growth into value is difficult.
As the EY/Oxford Economics forecast identifies, the outlook is becoming even more challenging. In the boom years, some emerging markets were able to grow at high rates without undertaking major reforms of their economies. The slowdown in the world economy and the changes highlighted above, have exposed fundamental structural weaknesses in many previously fast growing markets. Of the so-called “BRICS”, China is already reforming as discussed above, but Brazil, India, Russia and South Africa all need to drive structural reform in their domestic economies to enable them to return to the high rates of growth previously experienced. The “BRICS” are not alone, challenges exist in many of the other previously strong growth markets in the world economy.
Looking at the forecast in detail, the average growth rate of 4.7% for 2014 masks a wide variation in expected performance. Asia is forecast to grow at 6%, driven by China, Indonesia and Vietnam but India is only forecast to grow at 4.5%, South Africa by 3.2%, Russia at 2.8% and Brazil by 1.9%. The main South American markets will, on average, only grow at 2.9%. The clear message is that emerging markets can no longer be viewed as a single market. This is a very different picture to the situation in 2005 to 2008. How should corporates respond?
Evaluating the new landscape
The global economy is changing and corporates must reflect this in their investment strategies. With growth no longer guaranteed, political risk is now much more significant than it has been for some time. In determining the most appropriate geographic portfolio, corporates need to consider the ability of national governments to deliver economic reform. Clearly, in country strategies will allow an individual business to outperform macroeconomic conditions but an understanding of how the macro environment will evolve is a very important base for forecasting performance. This is not solely an issue for emerging markets, the challenges of reforming the Eurozone have been widely debated and in recent weeks, events in Washington DC have taken centre stage. Hence investors need to devote significantly more attention to understanding political risk and the ability of governments to drive reform.
At the detailed level, the evaluation of either new or incremental investment in emerging markets must consider:
- State of the economy: likely demand and how this will evolve as economic reform is implemented.
- Sectors and segments: in difficult times, the impact of change in the economy will not be uniform so it is very important to evaluate the potential effect by sector and segment, how will inflation, taxes, wage rises impact at a disaggregated level.
- Competition: the competitive landscape and approach to competition differs across countries, western companies have often underestimated these factors when investing in emerging markets, a detailed assessment is essential.
- Cost of doing business: Often a different cost structure exists in emerging markets and it is important that this is fully reflected in business case.
Our clients tell us that they are adopting more and more rigorous approaches to evaluating their investment in emerging markets as they believe poor forecasting has been the key driver of historic failure to meet expectations. The key to better decision making is to ensure a consistent approach to linking the implications of changes in the macroeconomic environment to the specific characteristics of individual businesses.