Global business perspectives

3 emerging market risks companies should watch for in 2018

by HBR

February 14, 2018 | 5:49 pm
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Top leaders tend to devote far more time to internal execution and competitive risks than to external risks that can change the playing field. This means that many emerging market risks get cut from the senior leadership agenda.

At Frontier Strategy Group, we observed that in 2017 executives and boards paid the most attention to risks that dominated global headlines: Brexit, the Trump administration’s trade policy, cybersecurity and North Korea. They did not spend as much time thinking about local events that may have implications for their emerging market operations.

Each year, FSG evaluates more than 100 scenarios that could disrupt our economic forecasts for 73 countries. For 2018, we have identified three emerging market risks that top multinational leaders should pay more attention to:

— The election of populists in Brazil and Mexico increasing the cost of doing business.

— Conflict in the Middle East or Africa renewing the migrant crisis in Europe.

— Maritime confrontation between China and its neighbors disrupting trade routes.

If these events occur, they would severely disrupt multinationals’ market strategies, supply chains and exchange-rate assumptions.

LATIN AMERICA: POTENTIAL POPULIST BACKLASH IN MEXICO AND BRAZIL

Latin American subsidiaries are being held to more-aggressive sales and profitability targets in 2018, given a rebounding 2.7% growth rate in real gross domestic product for the region. But there is more business risk in Latin America than many expect. Mexico and Brazil alone account for over 60% of Latin America’s GDP and most regional revenue for multinationals. Both countries have presidential elections in 2018, with front-runners advocating populist-nationalist platforms that would damage investor confidence and financial market stability.

When it comes to risk in Mexico, companies are paying attention to the fraught NAFTA negotiations, but not to the domestic politics that could damage business plans much sooner than any NAFTA changes. Leftist presidential candidate Andrés Manuel López Obrador is well ahead in the polls. He pledges to reverse reforms that have improved labor market flexibility and private sector participation in formerly protected industries like energy. If López Obrador is elected and makes good on these pledges, the cost of doing business will go up, and government spending increases will erode long-term business confidence. We believe that business-friendly candidates can win, but companies should make sure that their Mexico investments have an acceptable rate of return even under this populist scenario.

When it comes to Brazil, the economy is picking up. In our recent survey of 30 managers in the country, 20 reported increased revenue growth, despite Brazil’s scandal-ridden politics. Unfortunately, the business outlook could change if former President Luiz Inácio Lula da Silva returns to office and fulfills his pledges to cancel pension reform and budget constraints. Da Silva could be disqualified due to a corruption conviction, but he maintains a strong lead in the polls, and the far-right candidate Jair Bolsonaro is currently in second place. Either candidate’s success could cause sufficient uncertainty for Brazilian businesses to put the brakes on investment plans.

MIDDLE EAST AND AFRICA: MIGRANT CRISIS REDUX MAY REIGNITE EUROPEAN POPULISM

Europe’s recent migrant crisis illustrates how events in developing countries can create global ripple effects. Millions in the Middle East and Central Africa fled conflict, drought and economic stagnation, and their arrival in Europe transformed Western politics, helping to push Britain out of the European Union and bring right-wing populists to power.

The  flow of refugees has recently slowed, but this is largely due to a pledge by the EU to provide Turkey with 6 billion euros ($7.4 billion) in aid to prevent 3.6 million mostly Syrian refugees and asylum-seekers from traveling to Greece and beyond. However, relations between the two countries have been deteriorating over the last year, due to friction between a Turkish government looking to consolidate power and European governments attempting to support human rights and democratic norms in Turkey. If, for example, the EU chose to impose sanctions on Turkish entities and individuals, Ankara could retaliate by voiding the migrant deal.

This would come at a delicate time for the European economy, making it more difficult for leaders to assemble the necessary coalitions to back complex EU reforms to put European finance on sound footing. Italy could become an epicenter of volatility if it receives a sudden surge of refugees and a coalition of populist and right-wing parties gains power following elections in March.

These political outcomes would devalue the euro below 2018 corporate budget assumptions and diminish a European economic upswing that had boosted many companies’ revenues. Multinationals should pressure-test 2018 sales targets and currency hedging against this scenario.

ASIA-PACIFIC: CHINA SEA FLASHPOINTS COULD OBSTRUCT GLOBAL SUPPLY CHAINS

While North Korea tops most foreign observers’ Asia risk list, China has been laying the groundwork for a confrontation in the South China Sea. In 2017 China constructed 290,000 square meters of dual-use civil-military facilities on the Spratly and Paracel Islands, which are also claimed by Malaysia, the Philippines, Taiwan and Vietnam.

Each year, $5 trillion in commerce passes through the South China Sea. China’s military buildup now allows it to project power across those sea lanes, challenging the freedom of navigation guaranteed by the U.S. Navy for the better part of a century. China can’t exert unilateral control over these trade routes just yet, but expanded military traffic does raise the chances of an unintended clash that would greatly disrupt commerce.

Accidents like a collision, whether between fishing vessels or fighter jets, could provoke a confrontation. The U.S. military would face pressure to support its Southeast Asian allies and to preserve the principle of free commercial navigation. Without a code of conduct or an established mechanism for de-escalation in place, saber-rattling in the South China Sea could spiral into full-scale conflict.

What would be the practical effects for business? A major military standoff between China and the U.S. would disrupt the international supply chains on which modern manufacturing depend, causing shortages for many companies. Consumer and business demand in Asian markets would face a shock at least as deep as the 1997 Asian financial crisis.

To mitigate this risk, companies should assess the resilience of their Asia supply chains, inventories and distribution networks against a sudden disruption. Leaders should also reduce third-party risk by assessing value chains for excessive dependency on particularly vulnerable partners located in countries bordering the South China Sea.

Our research has found that few multinational firms conduct structured reviews of local economic conditions in between annual planning cycles. To ensure that 2018 results exceed expectations regardless of local surprises, corporate leaders should work with regional teams to monitor and assess emerging market risks and put contingency plans in place.

(Joel Whitaker is the global head of research and Antonio Martinez is the director for global economics at Frontier Strategy Group.)

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by HBR

February 14, 2018 | 5:49 pm
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