Emerging Markets Connect

Country-Level Risk Assessment: Are You Going Deep Enough?

We had a question submitted a little while ago to the Corporate Strategy Board's "Mergers, Acquisitions, and Alliances" Discussion group [link for members of select CEB programs only] from a member seeking views on how companies establish country risk premiums as they evaluate M&A opportunities. This question actually takes on new relevance these days, as we've seen risks emerge seemingly out of the blue in Latvia and Bulgaria, continued political instability in Thailand, and of course the terror attacks in Mumbai this past November.

A few things we've learned from our member conversations about how companies successfully account for country-level risk in their global footprint strategies:

1. Start with the Usual Suspects. There are a wide variety of reputable sources providing an overview of country-level risks. Some of the resources we've found helpful have been the OECD's Country Risk Classification, which focuses on likelihood of repaying externally held debt, and the Belgian government's export agency ratings, which provide a very useful breakdown of both political and commercial risks. Although it's somewhat outdated, countryrisk.com provides a helpful overview of and direct links to a variety of additional sources.
2. Apply A Weighting Methodology Tailored to Your Company and the Current Activity. Ratings by external agencies are only a starting point, as companies have different levels of risk tolerance. Members have highlighted a variety of methods for factoring their risk tolerance into external ratings. Typically this involves a calculation of the difference between different credit spreads (e.g. a country's long-term government bonds vs. those of the US government, or in-country corporate credit spreads vs. country-level spreads) to establish a country-level risk premium. Members often also layer on top of these a project-specific volatility assumption to establish the overall risk premium of an in-country investment.
3. Price in Insurance. Members also recommend pricing political risk insurance and including that cost in any financial forecasting to get a more complete total cost assessment.
4. Establish An Internal Rating "Agency". Finally, members have established company-level classifications of countries around the world (in formats such as A through E), with varying hurdle rates and risk premiums attached to each classification, and "off-limits" countries clearly established. Centralizing this reduces decision-making uncertainty or conflict across different functions or business units, eliminates the need for repeated assessments, and provides a company-level view on country risk to inform decisions.

Ultimately, country-level risks to businesses are typically a function of both the market itself and the degree of tolerance companies have for the risks that are present in any environment. Some members we've spoken with are comfortable operating in literally any country in the world; others stick primarily to developed economies, as that’s where their most promising customer bases exist. Regardless of methods being used to factor country risk into your evaluations, companies need to be sure they're not only aware of and comfortable with the risk environment they're entering or operating under, but also continuously monitoring that environment, and have sound processes in place for employees to stay safe and to avoid potential ethical dilemmas in less stable environments.

How Global Should R&D Be?

Our colleagues over at the Global Value Network blog had a nice recent piece on global R&D. The basic takeaway, which draws from research from CEB's Research & Techology Executive Council (RTEC): companies with high performing R&D organizations are those that freely change their organizational structure, and those who freely make those changes are most likely to do it to get closer to their key innovation partners around the world. By transitive clause then, high performing R&D organizations work really hard to put R&D as close as they can to where the innovation and talent are, no matter where that is in the world. This links well with recent Booz & Co. research that found that:

• companies that deploy 60% + of their R&D outside their home countries outperform peers, and
• companies that invest more than 10% of their global R&D spend in low cost countries like China and India do better than others.

What Booz also finds, though, is that there needs to be some concentration, or focus, to global R&D activities. Companies with too widely dispersed R&D tend to underperform others. Our RTEC findings agree here, and take things a step further by noting that high performing R&D organizations focus heavily on knowledge exchange across locations, and avoid extensive decentralization, particularly during growth slowdowns.

So how do we globalize to capture innovation where-ever it is, but ensure we're effectively sharing information across locations and staying in line with our larger strategies? Three things our research has found companies need to be doing here:

1. Optimize Global R&D Location Strategies: Remember, global, but not overly dispersed. Of course, locations will be company-specific. Our conversations with members find that global R&D presence tends to evolve, beginning with basic support operations in countries where the company already has a sales presence. As manufacturing moves in-country, R&D support builds out a bit more, and then begins considering getting bigger in-country. But for many companies, manufacturing in-country is a pre-requisite for "big" R&D there, followed by an assessment of the local market demand for innovation. What we think companies have been considering less, but what RTEC demonstrates is important, is how local innovations can drive growth outside emerging markets themselves. That's the next generation opportunity.
2. Communicate Better Across Sites: R&D teams, and all teams really, need to get better at allowing globally dispersed staff to share knowledge across sites. Our members are innovating by building tools for communities to self-organize, with flexible access rights to protect IP but still share information, classification guidelines to allow for better-organized information, and senior-level accountability for monitoring activity.
3. Increase the Effectiveness of Global Managers: Global managers need a new set of skills to be effective: cultural adaptability, global strategic thinking and team building skills, new market savvy, government-relations capabilities, and others. Successful companies are customizing their manager development programs to transition them from technically-skilled project managers, to global team-builders.

RTEC members can access the Council's Globaly R&D Management Handbook at this link.

More on FDI During Slowdown: Emerging Markets No Longer A Safe Haven

One question left unanswered in our post from last week on cross-border investment trends during recessions is this: where do bets typically get made during recessions? Will investments flow away from developed economies (as was the case with Dow) and toward emerging economies as better growth opportunities? Yes and no. Let’s look at some charts: the inbound foreign direct investment numbers (i.e., where the money was going) during the past three recessions for developed and developing economies.

 

What the charts make clear is that there has been an unmistakable evolution in the relationship between cross-border investments into developed and developing economies. In the 1980s, when global FDI was relatively low, investments in developed and developing economies were completely counter-cyclical: as investments flowed away from developed economies, they flowed toward developing economies. By the early 1990s, however, investment in developing economies was accelerating, and the recession didn’t register with the developing world – no retraction as developed economies rebounded. By 2001, the developing world had for the most part “coupled” with the developed world, although the intensity of the investment slowdown was much lighter in the developing world, and the rebound, as noted in our last post, was faster coming there.

A couple of reactions to these trends:
1. Emerging markets will likely not provide a safe haven either as investment sources, or as investment opportunities, during this downturn. Based on the evolution over the past 20 years, we should expect a strong dip in investment flowing to developed economies in the current downturn, and an intensification of the coupling trend, with a similarly strong dip in investments to developing economies. The Dow/Kuwait case we discussed in our earlier post to some extent plays this out, since one of the reasons behind the failure of the deal was the pain being felt in Kuwait from the financial crisis and fall in the price of oil. However, as we mentioned in our last post, the good news is that emerging markets will likely show the first signs of rebound.
2. Successful companies will still look for opportunities during the downturn, but they will be targeted to longer-term strategic objectives. We highlighted for our members a few months ago efforts undertaken by an IT company to build models for country-level analysis. What makes their country evaluation process so instructive is how deeply contextualized their investigation is to (1) their long-term objectives, and (2) the viability of those markets to produce a substantial customer base. Key to this is making sure country analysis is tightly focused on the characteristics of the local market that matter to the company, with models built around those characteristics in ways that don’t become invalidated by relatively short-term fluctuations. As always, CEB members who would like more on this example can send me an email, and we'll get it out to you.

Cross-Border Investments Declining: Are You Preparing for the Rebound?

Threats to the Dow Chemical purchase of Rohm & Haas in the last days of 2008, largely resulting from a collapsed deal between Dow and Kuwait’s state oil company, reminded us of a chart we put together recently detailing global foreign direct investment (FDI) over the past 30 years.

We made three, perhaps obvious, observations about this data when we first looked at it back in October:

First, that’s a pretty steep trend line. The amount of money flowing across borders has been growing exponentially.

Second, it’s a relatively recent phenomenon. You’ll notice that FDI was relatively flat until the second half of the 1980s. So we’ve only been at this in a serious way for about 20 years or so, meaning there’s likely a whole lot we haven’t yet learned.

Finally, you can’t help but noticing the dip a few years back after the 2001 recession. Clearly FDI is not immune to broader shocks to the economy and the political environment. 

It’s that last point that we were reminded of on hearing the Dow news. Is this an indicator of a broader, perhaps deeper, slowdown in cross-border investments as a result of the current recession? Do recessions really mean that companies should cut back on global investments? The answer: What we find is that while recessions are indeed accompanied by a slowdown in cross-border investments, the rebound coming out of those slowdowns is faster than you’d expect, and the amount of investment companies make across borders quickly reaches previously unthinkable levels. Let's take a closer look:

No Surprise, Cross-Border Investments Will Slow – For Now. When we zoom in on the past three recessions, we see that, overall, companies clearly cut back on global investments. The three lines on the chart below show outbound FDI numbers for each of the past three recessions (the last two of these fit the IMF’s definition of a global recession – less than 3% global growth). Pretty obviously similar dips in each case, with the only variation being their relative depth, as well as the amount of time needed to get back to the level of the year prior to the dip (e.g., 6 years in the case of the most recent recession and the 1980 – 82 recession; 3 years in the case of the 1990 - 91 recession).

So the dip is just as we’d expect, it’s real, and it’s consistent. No real news there; we should expect the same will happen in the current downturn.

Get Ready for the Rebound. The real question is, has the dip already happened? The rebound in global FDI began the first year after the downturn in the 1990 – 1991 recession, and two years later in the 2001 recession. What’s more, if we assume that the current downturn will exhibit similarities to one of the past three, the strength of the upward trend will bring total investments by 2014 to levels between 50% to 100% greater than 2007 levels in total dollar terms. That translates into between $3 and $4 trillion, representing between 1% and 2% growth in the ratio of global FDI to global GDP from 2007 levels (2007 ratio was 3.7%; 2014 projection would range between 4.5% and 5.8% based on Economist Intelligence Unit GDP growth projections).

In short, the most forward thinking companies might start increasing global investments as early as this year, and the amount of money flowing globally is set to hit unprecedented highs over the next few years. While high-profile events like the failure of the Dow/Kuwait deal may dominate the news, they may overshadow other signs of improvement.

Look to Developing Economies First. Drilling down into the inbound FDI numbers, the data also show that emerging economies are typically the first to exhibit recovery. In both the 1991 recession, and the 2001 recession, investment began growing in developing economies at least one year before developed economies saw positive growth (1992 vs. 1993 in the former, and 2003 vs. 2004 in the latter). In fact, in the case of the 1991 recession, investments never stopped growing in developing economies, that growth only slowed.

So three take-aways for executives based on these numbers:

1. Opportunities exist to lead the rebound, but it means acting soon. Companies that establish a solid footing in developing economies will position themselves well for the flood of investment that will flow as the global economy recovers. Stronger relationships, distribution networks, pricing advantages, and market positioning are just a few of the advantages to be gained from these counter-cyclical investments. As a rebound can happen as early as 2009, and no later than 2011, there is little time to wait.

2. Developing economies will likely rebound first. In the past two downturns, developing economies have exhibited an inbound investment uptick notably earlier than developed economies. Developing economies (and we include the BRIC’s in this grouping) are poised for a faster recovery on the heels of their strong currency reserves and higher potential growth local markets, and their position in many cases as production hubs for developed economies means money will flow to them first as developed economies begin to churn again.

3. Placing the right bets will be critical. Companies that manage their global footprints well are those that ensure decisions on where to operate and invest are not made in isolation within the organization, and contextualize the data and information that inform their decisions to their own long-term strategic interests, rather than short-term gains. Innovation and Operations Practice members can learn how Oracle Corporation and Sterling Commerce achieve these goals through the following links: Corporate Strategy Board; Logistics Leadership Board; Manufacturing Leadership Board; Procurement Strategy Council; Quality Executive Board; Real Estate Executive Board; Research & Technology Executive Council; Supply Chain Executive Board.