Emerging markets are attractive for investors and companies because of the high-yield potential they offer. But beware, this paradise can also ruin your business if you ignore certain costs. Embarking on an investment in emerging markets is like renovating a house—there must be a budget for the unexpected.
According to a survey of 921 vice-presidents of finance conducted by Ernst & Young, a third of companies underestimate the cost of investing in emerging markets. More than 40% of those surveyed also said that the implementation of their business in these markets had taken longer than expected. And although the most popular destinations are still China, India and Mexico, other countries such as Indonesia, Thailand and Ukraine also appear on the radar.
In these markets, we must develop reflexes in different financial markets developed. “In developed markets, the focus is to reduce costs while in markets like India, for example, the challenge is to manage growth, which can reach 20% per year,” says Christian Martin, partner of Ernst & Young India.
“When you enter these markets, business opportunities are obvious, so don’t waste your time analyzing. Devote your attention to project implementation because there is where the real challenges are,” advises Pinak Maitra, vice-president of finance for the Kipco Group, one of the largest holding companies in North Africa and the Middle East.
Here are six hidden costs that you must not overlook:
Financing costs: In 2010, according to the Institute of International Finance, nearly US$908 billion was invested in emerging markets, an increase of 50% compared to 2009. This abundance of capital in emerging countries can increase the value of their currencies, creating inflation. Several nations, such as Brazil, take a very dim view of inflation and react with suspicion on hot money flows.
Think about how you will finance a project and in what currency. For example, the United States has been exerting pressure on the Chinese government to upwardly revalue its currency, the renminbi, and that could be costly to firms exporting to China in the event of an abrupt adjustment.
In addition, the high interest rates that central banks use to contain rapid economic growth are increasing borrowing costs in these markets. That’s why companies in developed countries will often borrow in their home countries to invest in emerging markets. However, these companies should also calculate the risk of similar increases in interest rates in their own country.
Entry costs: The choice of mode of entry in an emerging market is sometimes more important than the market itself. For example in India or China, it is impossible to establish retail without first creating a partnership with a local company. And there are restrictions in other sectors, particularly in the field of publishing, where foreign companies are not allowed to hold more than 50% of their Chinese subsidiary. To work around the problem, it may be necessary to invest more.
In addition to creating a partnership, Pearson—a publisher of educational manuals—bought a second language school in China to be able to sell books because there is no limit on foreign ownership in this sector. They multiplied distribution channels.
Finally, the choice of partner is crucial. It should also take into consideration that in emerging countries, companies often belong to families. In fact, family-owned businesses contribute an estimated 70% of GDP in some emerging markets. “Often, power is concentrated in the hands of a single member then it is important to identify [that person] and to have access,” says Harriet Mossop, director of consulting services in financial accounting with Ernst & Young in India.
Transaction costs: Emerging markets are different. Consumers do not have the same tastes and per capita income is lower. Companies will often adapt their product to succeed. This means additional investment in research and development. Besides better test their products, they will probably relocate the R&D and perhaps engage local engineers.
Companies can also see their costs increase through representation and distribution. While in the United States, two or three commercial agents may suffice, India, one can easily need 20, and one in each state where you want to sell.
And don’t underestimate extra costs related to infrastructure, even in countries like Brazil, which despite rapid growth still suffers from an inadequate distribution system by road and rail. “Brazil will invest more than $85 billion in infrastructure over the next three years, but in the meantime, logistics remains a challenge. Delays in ports and airports increase costs, “says Marcos Almeida, a partner at Ernst & Young Terco Brazil.
Regulatory costs: Not only do you have to pay costs associated with obtaining permits to construct or operate a business, you must also anticipate future costs. “You may think you have all the required permits, and suddenly discover that they are going to expire soon and that you will take another six months to get new ones.
“It’s enough to make you lose a market,” says Deirde Mahlan, vice-president of finance for Diageo, the multinational wine and spirits firm.
Other costs include compliance with North American standards such environmental ones. Because it is only a matter of time before best practices, standards and regulations which set up everywhere in the developed countries also reach emerging markets.
The human cost: In India, where the inflation rate is the among the highest in Asia, the cost of labour continues to increase. According to the Federation of Indian Chambers of Commerce, labour costs rose by 15% in 2010. It’s the same story in China, where the minimum wage has increased by 20% in some provinces.
The turnover rate of employees who are offered positions in local companies or by growing foreign competitors, is also much higher in emerging markets than in developed countries. You need to take into account training costs and increeases in wages. In short, profitability shouldn’t depend on your firm being an employer of choice just because you’re in an emerging country. Instead, redouble your efforts.
The political costs: There is more than political instability to assess, the study says. More than ever, take into consideration the risk of corruption and invest in a program to fight corruption to protect your firm against it. The majority of finance officials the survey polled declared this risk the most important challenge in emerging countries.