Business in emerging markets

Emerge, splurge, purge

Western firms have piled into emerging markets in the past 20 years. Now comes the reckoning

Mar 8th 2014
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Phone users smile, shareholders weep


VODAFONE’S latest figures appear at first glance to vindicate the most powerful management idea of the past two decades: that firms should expand in fast-growing emerging economies. Sales at the mobile-phone company fell in the rich world while those in the developing world rose smartly

Corporate strategy is usually a contentious subject: there are fierce debates about how big, diversified and financially leveraged firms should be. But geography has seduced everyone. Vodafone is one of countless Western companies that have bet on the developing world.


Look closer, however, and those figures contradict accepted wisdom. At market exchange rates Vodafone’s sales in the emerging world fell, reflecting the widespread currency depreciations in mid-2013, when America’s Federal Reserve signalled it would taper its bond purchases. This drag may linger: in January the lira and rand tumbled in Turkey and South Africa, two biggish markets for Vodafone. On longer-term measures things look cloudy, too. Over a decade Vodafone has invested more than $25 billion in Turkey and India. These operations made a paltry 1% return on capital last year. Vodafone has created a lot of value for its shareholders—but through its American investments, which it has sold to Verizon for a stonking price.


This year Western firms’ giant bet on the emerging world will come under more scrutiny. Most multinationals are far more profitable in emerging markets than Vodafone. American firms made a 12% return on equity in 2012, roughly in line with their global average. But having grown fast, profits are now falling in dollar terms. There has been a long bout of share-price underperformance as investors have lost their euphoria. An index run by Stoxx, a data firm, of Western firms with high emerging-market exposures has lagged the broader S&P 500 index by about 40% over three years (see chart 1). And the recovery in the rich world will mean there will be more competition for resources within firms.





All this will bring strategic questions into sharp relief. Divisional chiefs from Brazil or Asia will no longer get a blank cheque from their boards. Although the average company has prospered, there have been disasters; plenty of firms and some whole industries need a rethink. The emerging-market rush may end up like a giant version of the first internet boom 15 years ago. The broad thrust was right but some big mistakes were made.

The companies suffering a slowdown in profits come in three buckets. Consumer firms including Coca-Cola, Nestlé, Unilever and Procter & Gamble have suffered a gentle weakening in demand and a currency drag. Most are still upbeat about the long term, says Andrew Wood of Sanford C. Bernstein, an analysis firm.

Companies in the second bucket face a sharper slowdown. They are in cyclical and capital-intensive industries. Fiat Chrysler’s profits in Latin America, a vital cash cow, halved in 2013. This week Volkswagen and Renault joined the ranks of Western carmakers warning of weak emerging-market sales. Last month Peugeot wrote off $1.6 billion of assets, mainly in Russia and Latin America

Emerging-market sales have fallen at Cisco, a technology firm; its boss, John Chambers, reckons it is “the canary in the coal mine”. Industrial giants such as ABB and Alstom have seen orders falter for infrastructure projects, for example the building of power stations, says Andreas Willi of J.P. Morgan.

Those firms with mismatchescosts or debts in firm currencies but sales in depreciating onesface a nasty squeeze. Margins in emerging markets have halved at Electrolux, which makes fridges and other appliances. Codere, a Spanish firm with an empire of gaming and betting shops in Latin America paid for with debts in euros, is now on life support and restructuring its balance-sheet.

In the third bucket are firms with idiosyncratic problems. China’s war on graft has hurt luxury-product makers that have grown fat by selling bling to the Middle Kingdom. Sales at Rémy Cointreau, which makes cognac that Communist Party big-shots quaff, fell by a fifth in the quarter to December, compared with the previous year. Russia’s once-frothy beer market is shrinking as the country conducts one of its periodic crackdowns on alcoholism.

All this may be breezily dismissed as short-term turbulence. But emerging-market wobbles can have a profound impact on corporate strategy. After the 1997-98 Asian crisis many multinationals tilted back towards the rich world. Citigroup and HSBC, two big banks, played down their Asian heritages and spent the next decade building subprime and investment-banking operations in America. Unilever’s operating profits fell in 1997. It felt obliged to tell shareholders that the rich world was itsbackbone” and by 2000 it too had made a huge American acquisition, of Bestfoods.

Rising exposure


The emerging world’s troubles are not as bad as in 1997-98. But the exposure of rich-world firms is far higher than then (see chart 2). Big European firms make one-third of their sales in the developing world, almost triple the level in 1997, reckons Graham Secker of Morgan Stanley. For big, listed American companies the total has doubled, to about one-fifth. For Japanese firms it is about one-tenth, says Kathy Matsui of Goldman Sachs. The bigger a firm is, the greater its exposure tends to be. Rich-world firms do business across the emerging world, with China accounting for 10-20% of it. Consumer goods, cars, natural resources and technology are the industries with most exposure. Property, construction and health care have the least.




Many of these operations pre-date the boom. European firms have footprints in Asia and Africa from colonial times. American firms dominated foreign direct investment (FDI) flows in the 1970s and 1980s. By the 1990s manufacturing firms were creating global production chains. A wave of privatisations in Latin America enticed a new generation of conquistadores from Iberia and North America.

But by the mid-2000s the process had accelerated dramatically as executives and boards latched on to the idea of the fast-growing BRICs (Brazil, Russia, India, China) and their ilk. Once the subprime and euro crises began, the urge to escape the Western world was irresistible. FDI into China in 2010 was more than double the level in 1998. Takeovers became common. In 2007 purchases in emerging markets by rich-world firms reached $225 billion. That was five times the level just half a decade earlier. One measure of how discipline slipped is the valuation of those deals. In 2007 rich-world buyers stumped up a dizzy 17 times operating profits for their targets, double the multiple paid in 2000-03.

Some firms had unexpected identity changes. Suzuki, a Japanese carmaker, found that its formerly sleepy Indian arm accounted for the biggest chunk of its market value. Portugal Telecom’s Brazilian unit kept it afloat during the euro crisis. Having taken control of a beer firm in St Petersburg, Carlsberg, a Danish brewer, became a “Russia play”. Mandom, an 87-year-old Japanese firm, found itself a giant of the Indonesian male-cosmetics market.

Other firms’ efforts to peacock their emerging-market credentials look, with hindsight, like indicators of excess. Having been bailed out for its toxic credit exposures back in America, Citigroup rebranded itself as an emerging-market bank. Schneider Electric, a French engineering firm, and HSBC relocated their chief executives from Europe to Hong Kong (HSBC has since backtracked).

Historians may judge the peak of the frenzy to have been in June 2010. Nathaniel Rothschild, a scion of a banking dynasty (some of whose members are minority shareholders in The Economist), raised $1.1 billion for a shell company in London, set up to buy emerging-market mining assets. Months later it invested in Indonesian coal mines with the Bakrie family, known in that country for its political ties and web of businesses. According to Bloomberg, Mr Rothschild shook hands on the deal without visiting the main mine in question, in Borneo. The transaction was a “terrible mistake”, he later admitted.

Every corporate-investment cycle creates triumphs and disasters, and a lot of mediocrity. The emerging-markets boom will be no exception. Hard figures are elusive but the book value of the equity that Western firms have invested in the emerging world has probably risen by at least $3 trillion since 1998. This is a colossal sum, equivalent to 11% of the emerging markets’ combined GDP in 2013. Many firms have prospered, such as the banks that braved Mexico in the 1990s. But there is plenty of rot, too.

Start with takeovers. There have been $1.6 trillion-worth since 2002. A rule of thumb is that half of all deals destroy value for the acquirer. Like Vodafone, many firms paid dizzy prices justified by pepped-up forecasts. In 2010 Abbott Laboratories, an American drugs firm, paid $4 billion for the small Indian drugs unit of Piramal, predicting it would grow at 20% a year for a decade. Two years later sales were stagnant in dollar terms. Daiichi Sankyo, a Japanese drugs firm, has been badly burned in India, as the company it bought into, Ranbaxy, has hit serious quality problems. Lafarge paid $15 billion for Orascom, a North African and Middle Eastern rival, in 2007. The French cement giant predicted sales would rise by 30% a year. Since then its shares have almost halved, partly due to the crippling debt burden incurred.

Big greenfield projects have broken hearts, too. ThyssenKrupp, a German steel colossus, launched an ambitious project in 2006 to make steel slabs in Brazil and process them in America. Rising costs have made it unviable, and most of the $10 billion sunk has been written off. The firm’s boss has labelled the episode a “disaster”. Anglo American, a mining company, buried $8 billion and the career of its former chief executive, Cynthia Carroll, in a Brazilian project called Minas-Rio. Cost overruns have led to a $4 billion write-off.

Besides such eye-catching failures, there are pockets of serious underperformance tucked away in corners of sprawling multinationals. Consumer-goods firms have made hay in emerging markets, but even the best have some iffy businesses. Procter & Gamble’s margins outside America are half those it enjoys at home. Profits are weak in India and Brazil, where it is a laggard. A.G. Lafley, who returned as the firm’s boss last year, has promised more discipline.

It is the same story with Spanish investments in Latin America. Telefónica makes good money across most of the continent, says Bosco Ojeda of UBS, a bank. But Mexico is a running sore. For 14 years Telefónica has poured in billions of dollars without threatening Carlos Slim, who dominates telecoms there. Even the world’s two biggest brewers, Anheuser-Busch InBev and SABMiller, which have been huge successes, have bought some businesses with low market shares and commensurately weaker profits and returns on capital.

In some cases the underperformance is spread across an entire industry. During a boom every firm thinks it can be a winner, leading to excess investment and saturation. The more capital-intensive the industry is, the greater the pain in store for its weakest members. Insurance is a case in point. India has more than 20 foreign firms slugging it out for tiny market shares while bleeding cash. Turkey is also an insurers’ graveyard. Most European firms have a motley collection of emerging-market assets, but only a few, such as Prudential, AXA and Allianz, have scale. “There are trophy markets where everyone has decided they have to be in. Typically they don’t make a lot of money,” says an executive.

The car industry also has a long tail of flaky businesses. It has invested more than $50 billion in factories in China, with great success, reckons Max Warburton, also of Bernstein. But “China has affected the judgment of a lot of chief executives,” making them too bullish about other emerging markets. More than $30 billion has been invested in developing countries other than China. New factories are opening just as demand has slowed. Ford’s number two, Mark Fields, this week expressed worries about excess carmaking capacity building up in Brazil, Russia and India. Mr Warburton thinks such operations could burn billions of dollars this year. “Everyone is bracing to lose a lot of money.”


Taking the beer goggles off

Some rich-world firms need to take a long, cold look at their emerging-market businesses and work out if they make sense. But there are psychological barriers to this. One is that most Western businesses have low gearingusually it is only when they have a debt problem that they make difficult decisions quickly

Without their emerging-markets pep pill many firms would have dire revenue growth. The developing world has supplied 60-90% of the growth of Europe’s big firms in recent years. And a whole generation of chief executives has learned that quitting emerging markets is a mug’s game. Bosses who panicked and left after the 1997-98 crisis ended up looking like idiots.

Yet companies should allocate capital carefully, regardless of the spare funds they have. Sales growth without profits is pointless. And comparisons with 1997-98 are imperfect. Most industries have become more competitive, as emerging economies’ local firms get into their stride. The low-hanging fruit is gone. Reflecting this logic, a few big industries have already begun to trim their emerging-markets arms.

Exhibit one is banking. After being bailed out, some firms such as ING and Royal Bank of Scotland have largely retreated from the developing world. Bank of America has sold out of its Chinese affiliate. But even big, successful firms which are dedicated to emerging economies are trying to boost returns by trimming back. HSBC has got out of 23 emerging-market businesses. The world’s biggest five mining firms are also adapting to lower emerging-market demand. They have cut capital investment by a quarter since 2012, says Myles Allsop of UBS.

The supermarkets are in retreat after decades of empire-building that led them to invest $50 billion in the emerging world. Synergies have proved elusive, local rivals have got stronger and tastes more particular. In Turkey shoppers prefer discount stores to hypermarkets—the four biggest foreign firms there lost money in 2012. Aside from Walmart’s Mexican unit, most rich-country grocers’ operations in the developing world have low market shares and do not cover their cost of capital

Casino, a French firm, has already shrunk, says Edouard Aubin, of Morgan Stanley. He thinks Carrefour could slim down to five countries from a peak of more than 20 (although it said this week it would keep expanding in China and Brazil). Walmart is cutting the number of stores it has in emerging markets. Tesco seems to have abandoned its dream of controlling big businesses in Turkey and China.

In the next few years more firms may follow the example of some supermarkets and retreat from the developing world. Most, though, will adapt, cutting capital investment and pruning their portfolios. All this will create opportunities for rising local firms. On February 19th, as Peugeot announced its giant write-off of emerging-market assets, Dongfeng, its Chinese partner, said it would take a 14% stake in the French firm and that technology-sharing between the two would speed up. There are rumours that General Motors may sell its loss-making Indian plant to its Chinese partner, SAIC. In 2011 ING sold its large Latin American business to Grupo Sura, a Colombian conglomerate intent on becoming a regional player.

The rich-world firms that remain will need to make their business models weatherproof, not just suited for the sunny days of a boom. That means shifting even more production to emerging markets and borrowing in local currenciesboth are a natural hedge against currency turbulence.

As others falter, the strongest multinationals are making bolt-on acquisitions. In 2013 Unilever bought out some minority shareholders in its Indian business for $3 billion and Anheuser-Busch InBev took control of Grupo Modelo, a Mexican rival, for $20 billion. The year before Nestlé spent $12 billion buying Pfizer’s baby-food business, which is mainly exposed to the emerging world. Rather than being the panacea envisioned by many Western firms during the boom, emerging markets are governed by the oldest business rule of all—survival of the fittest.


Q4 2013 "Flow of Funds" and Geopolitical

by Doug Noland

March 7, 2014


Ominous geopolitical meets exuberant markets. During Q4 2013, Total System Credit increased (nominal) $840bn to a record $58.991 TN, or 345% of GDP. On a percentage basis, total Credit expanded at a 5.8% rate during the quarter, up from Q3’s 3.8% but still below Q4 2012’s 6.2% pace. For all of 2013, system Credit expanded $2.139 TN, compared to 2012's $1.613 TN increase. Total Corporate debt expanded $915bn, or 7.2%, to $13.622 TN. Non-financial Corporate debt expanded $783bn, or 9.0%, second only to 2007’s $856bn.

Total Non-Financial Debt (NFD) expanded nominal $629bn during Q4, a 6.1% pace, to a record $42.021 TN. NFD expanded $1.734 TN for all of 2013, down slightly from 2012’s $1.882 TN increase. For comparison, NFD expanded $1.070 TN in ’09, $1.472 TN in ’10, and $1.376 TN in ’11. During the past five years of so-calleddeleveraging,” NFD increased $7.296 TN, or 21%.

On a seasonally-adjusted and annualized (SAAR) basis, total system Credit expanded $2.246 TN during Q4, the strongest pace since Q4 2012. At SAAR $1.394 TN, Federal borrowings were at the highest level in seven quarters and accounted for 62% of total system Credit growth. Total Corporate borrowings increased SAAR $948bn during Q4. Total Household debt expanded SAAR $49bn (0.4% rate), with non-mortgage consumer debt expanding SAAR $166bn, largely offset by a SAAR $93bn contraction in mortgage borrowings. A notable market tightening of muni finance saw State & Local borrowings contract SAAR $145bn, or 4.9%. This was the steepest quarterly decline in municipal debt in years.

Interestingly, Financial Sector market borrowings expanded SAAR $612bn during the quarter, or 4.4% annualized, to $14.081 TN. This was the strongest growth since 2008. By category, “Agency- and GSE-Backed Securitiesexpanded SAAR $374bn during the quarter to $7.793 TN (high since ’09). From their yearend 2008 high of $8.167 TN, GSE Liabilities have declined only 5%. For the quarter, GSE debt expanded SAAR $206bn and GSE-backed MBS increased SAAR $144bn. For 2013, total GSE Securities expanded $239bn, the first annual growth since 2008, in part financing large payments to the federal government (counted as “receipts”).

Federal Receipts expanded a notable $375bn, or 14.1%, during 2013 to a record $3.038 TN. And with Expenditures up only 0.5% to $3.792 TN, the federal "deficit" registered a significant decline (to a still huge $755bn). I would not extrapolate either the surge in receipts or the rapid slowdown in spending growth. The GSEs and Fed remitted huge sums to the Treasury, while the Fed’s Trillion plus injection of liquidity into the markets created capital gains, corporate profits and a general boost to cash-flow throughout the economy. It is as well worth noting that 2013 federal spending was still almost a third higher compared to the 2007 level.

The banking system continues to show a mild pulse. Bank (“Private Depository Institutions”) Assets expanded at a 4.9% rate during the quarter to a record $15.779 TN. Strong Q4 expansion put 2013 Bank Loan growth at $185bn, or 8.0%. Total Bank Assets were up $956bn for the year, or 6.4%. Yet Reserves (at the Fed) were by far the most rapidly growing bank asset. Reserves jumped $758bn, or 51%, year-over-year to $2.249 TN.

There continues to be little indication of a more broad-based Credit expansion. Finance Company assets declined 1.3% in 2013 to $1.474 TN. REIT liabilities were down 4.4% year-over year (to $761bn). Credit Union assets increased 4.5% in 2013 to $1.005 TN. Broker/Dealer assets expanded about 1% y-o-y to $2.087 TN. Funding Corps gained 2.3% to $2.137 TN, while Fed Funds & Repo contracted 2.9% to $1.919 TN. Asset-Backed Securities contracted 8.7% last year to $1.616 TN, likely partially explained by “private-label mortgages continuing to be refinanced into lower-cost agency-backed mortgages. Then, as a GSE MBS, they can make their way onto the Fed’s balance sheet.

For “flow of fundspurposes, the Fed’s balance sheet is not included in “financial sectoraggregates. For 2013, Fed holdings increased $1.119 TN, just shy of the $1.319 TN crisis year 2008 surge. Last year, Treasury holdings jumped $543bn and MBS holdings rose $564bn. Total Federal Reserve Assets ended 2013 at an unprecedented $4.074 TN. Fed Assets have inflated 328% during six years of the greatest central bank experiment in history.

As I’ve highlighted over recent flow of fundsanalyses, the Household balance sheet remains fundamental to the Fed’s reflationary policymaking. For the quarter, Household Assets increased another $2.403 TN to a record $94.419 TN. And with Household Liabilities up $127bn, Household Net Worth jumped $2.276 TN (13% of GDP!) during Q4.

Household Net Worth inflated a staggering $8.184 TN in 2013, or 11.8%, to a record $80.664 TN. For comparison, Household Net Worth jumped $7.089 TN during 2006 and $6.023 TN in 2007. Over the past five years, Household Net Worth inflated $23.484 TN, or 41%. In five years, Household holdings of financial assets surged 43.5% to end 2013 at a record $66.949 TN, or a record 399% of GDP. For comparison, Household holdings of financial assets ended 1995 at about 300% of GDP before peaking at 385% of GDP to end 2007.

In piecing together recentflow of fundsanalyses, I have not given the Rest of World (ROW) segment the attention it deserves. ROW ended 2013 with holdings of U.S. Financial Assets at a record $21.940 TN. Holdings were up $1.296 TN, or 6.3%, year-over-year. ROW holdings of Treasuries ended Q4 at $5.842 TN, up from $2.376 TN to end 2007. ROW ended 2013 with $862bn of Agency/GSE securities, $822bn of SecuritiesRepos,” about $1.35 TN of bank deposits and net interbank assets, $2.730 TN of Corporate Bonds, $4.656 TN of Corporate Equities, $1.043 TN of Mutual Fund Shares, and $3.823 TN of Miscellaneous Assets (chiefly foreign directed investment).

ROW holdings of U.S. Financial Assets ended 1995 at $3.653 TN, before closing the nineties at $6.209 TN. Unprecedented Current Account Deficits were largely behind the explosion of U.S. financial claims that inundated the world. ROW holdings ended 2007 at $16.199 TN. And in the past five years, ROW holdings of U.S. Financial Assets have surged another $6.554 TN, or 42.6%, to reach almost $22 TN.

I often refer to global central bank international reserve holdings as a good proxy for the dollar liquidity that has destabilized the global financialsystem” over recent years. The incredible growth in foreign holdings of U.S. debt and other financial claims similarly reflects this process that has been ongoing for at least the past two decades.

We’re now fully five years into the “global government finance Bubble.” I have argued that the emerging markets (EM) have been a major recipient of post-mortgage finance Bubble reflationary monetary stimulus. I have posited that EM is this global Bubble’ssubprime.” Moreover, it is my view that the EM Bubble is in the initial phase of deflating.

I stick pretty close to home in my Credit and Bubble analysis. At the same time, it’s fundamental to my money, Credit and Bubble analytical thesis that unchecked monetary inflations and attendant Bubbles have profoundly deleterious effects on financial systems, economies and societies.

I have for some time fretted the geopolitical ramifications of a runaway global financial Bubble and its eventual bursting. From a global perspective, the crazy growth in Fedmoneyprinting isn’t unrelated to Draghi’sdo whatever it takesthat is not unrelated to “Abenomics” and crazy printing by the Bank of Japan that’s not unrelated to crazy Credit excess in China and throughout EM. All the craziness is symptomatic of deep structural maladjustments in finance and economies on a global basis. And with my view of faltering Bubbles and mounting stress in the emerging markets, I have been on guard for heightened geopolitical instability.

After dropping to $368bn in early 2009, Russian international reserve holdings jumped to almost $500bn by mid-2011. Russian reserves ended 2013 at $470bn, little changed over two years. After expanding at about a 5% pace throughout 2010 and 2011, the Russian economy has since largely stagnated. The Russian ruble has declined 15.8% over the past year, with Russian stocks (RTS Index) down 24% and bond yields up almost 200 bps.

March 7 – Financial Times (Catherine Belton): “An ally of Vladimir Putin has accused the US and a ‘global financial oligarchy’ of organising the violent overthrow of power in Ukraine to ‘destroyRussia as a geopolitical opponent. Vladimir Yakunin, a former senior diplomat who now heads Russian Railways, the state railways monopoly, claimed the US had for decades been intent on separating Ukraine from Russia and bringing it into the west’s fold. ‘We are witnessing a huge geopolitical game in which the aim is the destruction of Russia as a geopolitical opponent of the US or of this global financial oligarchy,’ Mr Yakunin said…”

I’ll suggest that the Ukraine crisis potentially marks a critical juncture in global geopolitics. Having been mismanaged and pilfered for years, the Ukraine economy is a basket case and social tinderbox. Meanwhile, the Russian leadership may have calculated that losing the Ukraine to the West at this point would entail unacceptable economic and political costs. The Russians may have decided these costs outweigh the waning benefits associated with the current global financial and economic landscape. Russia and other countries may no longer believe they are benefitting from the forces of global monetary inflation. They may these days see themselves increasingly as losers.

I fear that the unfolding Ukrainian crisis and rising tensions between China and Japan are no mere coincidence. I have no reason to believe that Russian and Chinese officials are coordinating their geopolitical thinking, maneuvers or strategies. I do, however, sense that the changing global financial and economic backdrop is altering incentives, disincentives and the calculus of cooperation, coordination and confrontation.

The world is indeed changing, but certainly not in the manner those seduced by inflating securities prices behold. Sure, central bank liquidity is still expanding and the global debt mountain just keeps rising to the stars, increasingly unhinged from real economic wealth. Yet the global economic pie has begun to decay. I fully expect mounting domestic economic and global political pressures to increasingly dictate a much more aggressive stance with respect to “geopolitics.”

I’ll further add that I don’t believe the ongoing melt-up in U.S. stocks and the rapidly deteriorating geopolitical backdrop are coincidental. Again, from my analytical framework, both are creatures of historic monetary inflation. Serious (faltering Bubble) stress at the “peripherynow dictates erratic behavior many would view (from the old world view) as irrational. Meanwhile, liquidity flooding into the “corefeeds a historic speculative Bubble. The Russians might very well see it in their relative best interest to dig uncompromisingly in for the long hall, believing the West actually has more to lose. The backdrop would seem to ensure we’re entering a period of extraordinary uncertainty, although over-liquefied securities markets remain priced for extraordinarily low risk.