Risks and challenges in doing business thesis

risks and challenges in doing business in emerging markets. Risks inherent any time a firm operates internationally apply, and are arguably intensified, such as market risk, cultural risk, competition and economic risk. Two risks that are strongest in emerging markets are foreign exchange rate risk and political risk (Sargeant, 2006). International businesses have developed strategies to counter these risks, so that they may enter emerging markets more successfully.

Foreign exchange rate risk, and other forms of economic risk, relate to the higher degree of volatility that firms face in emerging economies. Market highs and lows tend to be intensified, relative to developed markets. While this allows for massive growth, it can also lead to tremendous challenges when things go south. Foreign currencies pose significant problems in emerging markets for two reasons. The first is that they can be exceptionally volatile, and the second is that the market in developing currencies is not liquid. Often, emerging market currencies cannot be traded outside of the borders of that country. Even when such trade is possible, the controls on bringing money out of the country can exist. Further, companies have a more difficult time hedging the volatility of emerging currencies, because there are no derivatives markets for them, and the primary market is illiquid. Firms can address this problem by avoiding local currencies as much as possible, by using dollars or euros when transacting to the best of their abilities. If possible, proxy hedges can provide some protection. For example, if an emerging market has a currency that is pegged to a major currency, a hedge can be done on the major currency. The same holds if the emerging market currency is closely tied to the value of a key export commodity, such a mineral that is mined there or an agricultural product like coffee or sugar that is exported. While such hedges are imperfect, they provide a better measure of protection that leaving the company with naked exposure because of the inability to hedge the foreign currency itself.

Political risk represents the risk associated with action on the part of local government in a foreign country. Examples of political risk include nationalization, unfavorable treatment in the legal system, and the risks associated with sudden changes in government policy or in government itself. One of the most tried and true tactics to minimize political risk, along with a host of other foreign market risks, is to partner with a local firm. This ensures that the venture will be treated as a local firm by the government, in part because so many local entities are going to profit from the venture.

There are other strategies as well. Rajwani (2011) outlines a few of them. These include using insurance against specific incidents, having strong controls and a department specifically assigned to managing political risk, and diversifying political risk around many emerging markets. Understanding the different risks in a market is essential. In some countries, close relationships with one regime might pay off in the short run, but be disastrous in the event of regime change. Knowing the political climate of the country in which you are operating is essential, as the strategies on the ground for dealing with political risk might change frequently with political sentiment. Even using local partners can be an imperfect hedge if those local partners are aligned strongly with one regime in particular. The more neutral that a company remains, the better insulated it might be from the local political climate and its associated risks.

7. In some emerging markets, family conglomerates dominate. There are a number of reasons for this, depending on the country, but these firms often arose at a time when circumstances were favorable and in emerging markets the wealthy tend to have all of the economic opportunity, so a family that succeeds in one industry can often use that success as a springboard to multi-industry success. One example of a family conglomerate in an emerging market is Tata, of India. The Tata Group was founded in 1868 by Jamsetji Tata and quickly grew in steel, textiles, energy and hospitality. India was under British control at the time, and the Parsi community enjoyed a high status among Indians under British administration.

Since that time, Tata has become one of India’s most largest and most important conglomerates, but also one of its most important charitable operations as well. The Tata Group has always placed charity as a central value, and spreads the wealth it generates beyond the family, to India as a whole, benefitting millions of people of all religions. The company today not only includes the steel business, but automaking, telecommunications and has become one of India’s major exporters. The Parsi community lost its special status when the British administration ended, but by that point Tata was well-established within the Indian business community and has been able to maintain its high level of importance and respect within India as a combination of business acumen and its ongoing charitable works.

The family conglomerate model benefits some companies in particular, because they are able to leverage synergies between the different divisions to develop their business. In particular, FCs will often have superior access to capital, and that helps them to start new businesses. They also have advantages over small enterprises in access to government officials, distribution channels and there are often reputational advantages. Certainly, all of the above have been factors in Tata’s continued status as the most important FC in India. In a diverse country like India that values charity, Tata’s charitable work is considered one of the most important aspects of keeping a strong reputation in the country, even when government fell to the Hindu community, and even in areas of Muslim majority.

For a foreign firm entering an emerging market, partnering with a local FC will give that firm the same advantages in that market that the FC has. These firms are among the most skilled in international and large-scale business in their markets, and that conveys advantages to any firm partnering with them. Gibson (2002) points out that FCs often have special competency in financial discipline, trustworthiness and good governance, with their longstanding and multiple business ties within the country standing as evidence of the reliability of FCs, versus for example newer businesses or those with only a recent track record of success based on ties with the current regime. FCs often transcend politics because of their importance to the economies of the country in which they operate. For example, when India was leaning towards communism, Tata businesses were spared nationalization at a time when foreign-owned businesses were nationalized and foreign companies ejected from the market. Again, for a foreign-owned firm, partnering with a local FC gives the firm the best possible strength in that market, the best knowledge and the best access to both distribution channels and to capital.

10. There are several reasons why the average per-capital income is not usually the best indicator of an emerging market’s potential. It does not reflect the growth rate of the country, it does not reflect the risks of the country, it does not take into account wealth concentration and it does not take into account the volatility of economies whose wealth is based on single commodities.

One factor that is key to investing in emerging markets in particular is the nation’s economic growth rate. Past performance of the market is less important than the future performance, especially when high growth rates are required as payoff for the higher risks associated with entering such markets. Markets that have high volatility in particular might have high average GDPs, but if there is no growth in the market then a firm entering the market could face adverse circumstances for many years. At present, many Western markets are low-growth markets with high average GDPs.

This relates to the second point, about the risks associated with economies. The high growth rate is needed where risk of market entry is high. However, broad measures like average GDP per capita do not take into account many of the risks inherent in doing business internationally. One example would be political risk. The growth rate in a country might be high, but so too could the risk of nationalization. In addition, local firms might be given strong preference in a market, such that market entry is very difficult. A high growth rate is nice to have, but it is only one factor in determining the attractiveness of an international market. Those other factors need to be taken into consideration as well.

Economically, it is worth noting that a high average GDP per capita can be skewed by high levels of wealth concentration (Temel, 2004). There are some classic examples of this in the world, but one of the BRICS nations provides perhaps the best example. South Africa has a relatively high GDP per capita, but it also has extreme wealth disparity. Most black South Africans live in poverty, with little hope of escaping that poverty. As a means to gain access to several million people who live a Western lifestyle, South Africa can be a good country to enter, but as a growth story it is much less exciting. Only when the GDP per capita of black and mixed-race South Africans begins to grow rapidly will the country be a truly attractive one for most companies. Arguably, the Human Development Index is a better measure, because it can reflect the overall potential of a nation like South Africa, where the development of one segment of the population is more critical to the market’s potential than GDP, which is driven by another segment of the population.

A fourth reason why average per-capita income is not always the best indicator of an emerging market’s potential lies in the Gulf States. Many Gulf States have very high average GDP per capita figures, driven by oil revenues. The lifestyle of most of the people in these nations, however, is strictly emerging market. The per capita income of the average person in a Gulf nation is much, much lower than the per capita GDP would suggest. The GDP figure is severely skewed by the value of oil, most of which goes to the government of those nations. Complicating the issue that that many Gulf States have locals as the minority, sometimes below 20% of the population. Wages earned by foreign workers are often repatriated rather than spent locally. For the most part, foreign workers are not beneficiaries of government largesse because they are not citizens. If the government in the UAE, for example, spends some of its oil wealth on education and social programs for Emirati citizens, these benefits only accrue to 20% of the population. For a foreign company, the massive wealth of these nations is not only dependent on a single commodity, but that wealth does not reflect the wealth level or social benefits that 80% of the population will receive, and therefore the wealth also does not reflect the true growth potential of those markets.

Works Cited:

Gibson, K. (2002). A case for the family-owned conglomerate. McKinsey Quarterly. Retrieved October 18, 2012 from http://www.mckinseyquarterly.com/A_case_for_the_family-owned_conglomerate_1238

Rajwani, S. (2011). How should firms deal with political risk? Cranfield University. Retrieved October 18, 2012 from http://www.som.cranfield.ac.uk/som/p16495/Think-Cranfield/2011/May-2011/How-Should-Firms-Deal-with-Political-Risk

Sargeant, N. (2006). What risks do organizations face when engaging in international finance activities? Investopedia. Retrieved October 18, 2012 from http://www.investopedia.com/ask/answers/06/internationalfinancerisks.asp#axzz29f2QIadw

Tata.com (2012). Heritage. Tata Group. Retrieved October 18, 2012 from http://www.tata.com/htm/heritage/HeritageOption1.html

Temel, B. (2004). GDP per capita: An accurate gauge or a bum steer? About.com. Retrieved October 18, 2012 from http://economics.about.com/library/weekly/aa043004a.htm

WRI. (1999). Trends point to gains in human development. World Resources Institute. Retrieved October 18, 2012 from http://www.wri.org/publication/content/8604

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