The end of our fixation with the BRICS?

Let’s hope so. It’s time for a more sophisticated approach to trade and investment.

The end of an era…

The departure of Lord Jim O’Neill from government may well signal the end of the focus on the BRICS which has been a central feature of UK trade policy in recent times. This is to be welcomed. The herd like pursuit of opportunities in these markets has distorted public and private activity and led to the UK under-performing on the world stage.

…that started as a sure thing….

It was Lord O’Neill who brought the BRICS to public attention in 2001 in “The World Needs Better Economic BRICs”, a paper written for Goldman Sachs. The concept was based on forecasts of the relatively fast economic growth of these 4 countries, each of which had very large populations.

For the UK, the attraction was that as these countries grew so their populations would become wealthier, creating a huge middle class that would begin to demand the higher value goods and services that the UK produces. Here was a golden opportunity to boost UK exports and halt the steady decline in the UK’s share of world trade that has been evident since World War II.

…almost without limits…

And it was not just the BRICS. Very quickly the narrative expanded to include emerging markets as an asset class. As the BRICS grew so other countries would be brought along. Talk of “Africa rising”, the opportunity in South America and then the “MINTs” (Mexico, Indonesia, Nigeria and Turkey). It was not just the UK Government that bought into the storyline, a strategy of rapid expansion into the emergers occupied boardrooms across the developed world. For a time the world appeared to have moved into a golden age. China was growing at double digits rates annually, reaching 13% GDP growth in 2007 and the emerging markets generally were surging.

Even after the financial crisis hit the west, the trend towards investing in emerging markets continued and even accelerated. I remember sitting next to a corporate executive at a dinner who was desperate to find a company to acquire in Guatemala. This was the first time the alarm bells rang for me. I have worked in the BRICS and a range of emerging markets and I never thought the potential was as high as suggested, in particular the ability to turn growth into revenue and profits, but I was willing to be proven wrong. But a push into Guatemala, surely a sign of overshooting?

…or was it?

It has increasingly become clear that the growth rates seen in the middle of the last decade turned out to be unsustainable. China’s accession to the World Trade Organisation coupled with domestic economic reforms, launched a period of spectacular growth from 2001. This export and investment led surge was supported by the willingness of American consumers to incur ever higher levels of debt to buy what China was producing. The imbalances created, as shown below, should have caught the attentions of policy makers much sooner, but after the financial crisis a slowdown was inevitable.

There was another act to come however, further prolonging the story. After the financial crisis, the USA embarked on a policy of quantitative easing to shore up its fragile economy. This created a significant amount of liquidity, which in turn helped create additional funds for emerging markets supporting further expansion. At the same time, China embarked on a massive infrastructure boom which created a surge in demand for imported machinery and commodities.

In the last few years, it has become clear that this second wave in China was also unsustainable and the Chinese Government has moved to shift towards “rebalancing” the economy to reduce the bias towards exports and investment. This has been a major factor in the sharp slowdown in the growth of world trade and a collapse in prices in many commodity markets, illustrated below with data from Oxford Economics. China has so far been able to stabilise its growth rate at somewhere between 6% and 7% annually but the slowdown in total demand has created a shock for many other economies.

Brazil has found the commodity slowdown extremely painful. The economy has gone into recession, exposing the failure to drive economic reform during the good times when the economy was booming as a result of surging commodity demand. The country now faces a difficult period of readjustment as it deals with a huge debt problem and the need for structural reform.

In parallel with these developments, the collapse in the oil price has exposed the weaknesses of Russia’s economy. Once again the failure to drive reform during the period of strong economic growth has become all too evident. Russia has an outdated industrial sector desperately in need of western capital and know-how but the political environment makes these hard to attract.

India is currently the best performing BRICS economy helped by the introduction of an economic reform programme by Prime Minister Modi. While economic reform is taking hold, it is also true, at least in part, that India’s rise to the top of the ranking has been helped by the decline in growth rates in the other members of the BRICS group.

 But an unsustainable economic growth rate is only one of the issues…

The BRICS and emerging markets top line growth stories were always more fragile than the headlines suggested. But even if strong economic growth over a long period is achievable, the challenge still remains to translate this macro level growth into revenue and, even more difficult, then into value.

The theory is as follows: fast economic growth translates into faster revenue growth than is possible in a developed market and this in turn will lead to higher profits. It sounds simple but the reality is that operating on the ground in the selected markets mean a number of significant obstacles lie in this path – the reality of doing business in emerging markets is very different to the developed world in key aspects which impact profitability in particular.

…value creation is very challenging.

First is the challenge of market entry itself, getting into a position to be able to operate effectively. Emerging markets generally tend to be relatively difficult places to do business. The BRICS are positioned from numbers 51 to 130 in the World Bank’s latest ease of doing business index. Establishing the vehicle to operate can be time consuming and difficult and may require a structure that starts to cede some value even before operations begin.

Once in the market, the specific economics of emerging countries become the key drivers of value creation. Yes, it is true that there are large numbers of consumers in each of these countries, but incomes are relatively low. Pricing can be a challenge, while luxury goods companies may find it easy to achieve similar, or even higher prices, than at home due to the status effect of people wanting to show they can afford to pay high prices (the “Veblen” effect named after an Austrian economist/philosopher), mass market pricing will have to reflect relatively lower income levels.

On top of lower prices, companies also have to deal with higher costs. These reflect the country complexity costs as identified by the World Bank index but also the costs incurred to tailor products to local tastes. More recently, companies have also seen the flip side of growing incomes in developing countries – higher wages and hence higher costs. There really is no free lunch.

Lower prices and higher costs mean margins are squeezed and companies have also found the willingness of companies operating in emerging markets to accept lower margins than is the case elsewhere. The quote below from EY’s recent research on Asia illustrates the challenge:

“When you are out there battling competition that includes both multinational corporations and regional and local companies, you are fighting with a different set of rules,” says Pradeep Pant, former president of Asia-Pacific and EEMA with Mondelez International. “Some are different not only in terms of compliance but also in terms of how those different competitors define profitability, which can put a ceiling on pricing. This is the cross a lot of multinationals have had to bear.”

This squeeze is further exacerbated by the rise of local competitors. A study by Bain showed that in 26 consumer categories worth US $85 Billion in China, local competitors averaged a 70% market share. Other work by Bain, quoted in the same article, has shown there are often two to three times as many brands in emerging markets compared to western economies. The rise of companies such as Huawei and Xiaomi shows how strong local competition can be.

When we take all of the challenges to the economic model from entering an emerging market, it quickly becomes clear how challenging it is to realise value. Yes the markets may grow relatively quickly, though not all of them and not indefinitely, but capturing this growth in a profitable manner at an appropriate level of risk is not easy.

…and it may be easier to destroy value..

As the focus on the BRICS and especially China grew, UK businesses became aware of the opportunity to more their production to China to benefit from lower labour costs, a process known as “offshoring”. The UK has embraced the concept more than any of our peers, offshoring a greater share of production since 1997 according to EY’s research.  Rather than selling to the BRICS, the UK started moving business there.

While the UK has benefited from lower production costs, this has come at the obvious cost of hollowing out of our manufacturing sector leaving us with very thin supply chains. When opportunities to increase exports arise, such as with the recent decline in the value of the pound, our ability to exploit these is limited by our reliance on imports to produce final goods. UK manufacturers have less control over the economics of their supply chains.

Moreover, by offshoring production and generally doing this on a contract basis with locally owned factories, rather than setting up UK owned facilities, new competitors have been created. Chinese companies in particular have been able to generate economies of scale, to learn by doing and to develop their own IP. This ultimately creates new and stronger competitors and further weakens the UK’s competitive position. The UK has seen capital investment fall and investment in skills decline as UK businesses have, in effect, funded capital investment and skills development by our competitors. The failure to invest in facilities overseas, compared to Germany for example, has heightened the impact of this effect.

…and value has often been wrongly assessed.

A crucial issue that has often been ignored in the pursuit of the BRICS is the importance of politics to economic progress and ultimately to helping companies make money. Brazil and Russia failed to drive economic reform during the good times and this is now hampering their recoveries. Shifts in policy in India and China have had significant economic consequences, changing the outlook in absolute and sector dimensions.

Investing in the BRICS (and the emerging markets more broadly) is in large part a bet on the quality and sustainability of economic reform over a long period of time. Which means it is a bet on the political process in each of these countries. Events have shown how risky this can be and hence how far from a sure thing the BRICS ever were.

My sense is that there was an over-optimism in many plans developed to exploit the opportunity in the BRICS and beyond, and this showed up in a failure to price risk accurately. Several CFOs have identified similar concerns in my recent discussions with them. In the urge to get deals done, investment in riskier markets was seen as equivalent to investment in home and other existing markets. The result was a shift in investment towards more riskier, international projects at the expense of domestic market capital expenditure. Not only is it harder to realise value in many of the investments pursued but the risk has not been appropriately priced and hence the risk adjusted value is an even worse story of underachievement. Wrongly priced capital has led to mis-allocations and when we add in the strategic errors which have allowed competitors to prosper funded by UK resources, the scale of value lost becomes clear.

And it is now clear that the BRICS were never a group and nor were the emerging markets. A group requires common characteristics and while size was a feature of each BRICS country, their economies and political systems were widely different. Approaching the opportunity as a single one further encouraged ill-judged decision-making.

A chance to reset our priorities.

The UK Government has been a strong proponent of the BRICS in recent years, devoting a growing share of its trade promotion and support budgets to pursuing the BRICS. The UK has found success elusive as the EY ITEM Club identified. There has been some improvement in recent years but overall the UK has failed to achieve the hoped for success in the emerging markets for our exports. The challenge of the UK achieving ￡1 Trillion in exports by 2020 set out by George Osborne is a pipe-dream, ￡700 million would be an outstanding result given where we are today.

Yet this should not be a surprise. The analysis by the EY ITEM Club presented in the EY Trade report shows how export success is driven overwhelmingly by having the products and services to sell to the fastest growing markets for them. The UK did not have either the commodities or industrial goods to sell to the BRICS as they industrialised. It is no surprise therefore that export growth in these markets disappointed. In fact, as described above, the lack of a joined up industrial policy meant that the UK was actually doing the opposite, transferring value to emerging market corporates.

The UK’s focus on the BRICS and emerging markets in recent years has not only helped strengthen future competitors and weaken our domestic supply base, it has also limited our investment in other locations. German and US manufacturers have turned to Central and Eastern Europe for offshoring activities for the European market but the UK has lagged significantly behind. We have also invested less in robotics in manufacturing further hampering our productive potential relative to our peers.

The reappraisal of the scale and immediacy of the opportunities in the BRICS and other emerging markets together with the the vote to leave the European Union, mean the UK now has the opportunity to reshape its trade strategy. Now is the time to develop a long-term strategy and plan with business and government working together at national and region and city levels..

Both public and private sectors need to work more closely together to identify opportunities and to develop the plans necessary to realise these opportunities. This must start with specific plans for sectors in individual countries. The idea that broad concepts such as the BRICS can easily be translated into value has been shown to be flawed. Each opportunity must be assessed on its merit with a detailed analysis of the likelihood of success and the steps required to achieve this.

China and India do remain interesting and priority markets because of their growth rates but the USA and the European Union offer markets comprising much richer customers and sophisticated needs – attributes that UK businesses tend to be better placed to exploit. Trade support needs to have balance across sector and geographic dimensions that reflect the specifics of potential opportunities.

Then long-term success requires long-term planning and investment. Again public and private sectors need to work together across R&D, education, skills, infrastructure and policy to create the platform for long-term success. Business needs to articulate what it needs and government must support where it is needed. In all of our investor research, roads are seen as the key investment need for manufacturers in the UK yet rail and air dominate the infrastructure debate. More interaction is essential to allow business to explain the benefits of various potential public interventions to allow for the best possible prioritisation.

@MarkGregoryEY

markgregoryeconomics.ey.com

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