Mapping Frontier Economies
Global players in search of double-digit growth are running out of opportunities. Emerging-market giants such as Brazil, Russia, and China are experiencing an economic slowdown. They are increasingly expensive as a base for operations, and it’s harder to export to and import from these countries than it used to be.
As a result, multinationals are paying more attention to low-income, high-risk countries both as new markets for selling goods and services and as platforms from which to export them elsewhere.
These “frontier economies,” as we call them, may not seem like promising terrain; they are characterized by politically manipulated markets, weak legal systems, and either low per capita income or faltering GDP. Yet of the 25 countries forecast to grow the fastest over the next five years, 19 are frontier economies. Among them are Myanmar, Mozambique, Vietnam, and Rwanda. Many are home to the world’s largest untapped sources of minerals and metals, and despite the current soft commodity prices, global investment in developing these resources will continue to boost income and growth. That’s important because it means that growth in frontier economies depends relatively little on overall global economic trends, and first movers can reap better returns on foreign investments than the sometimes alarming country risk factors might suggest.
Some of those risks, moreover, turn out to be overblown, as smart companies are discovering. Politically engineered market distortions in frontier economies are often limited to sectors characterized by very large capital investments, such as natural resource extraction or infrastructure. By contrast, sectors where relatively smaller sums of money are involved (such as value-added work on resources) tend to attract less political interest, and there is scope for competing on value and rapidly growing underdeveloped sectors. For example, Tiffany & Company has successful diamond-polishing operations in Cambodia, Botswana, Mauritius, and Vietnam, along with operations in Belgium.
Even in industries where competition is skewed by government manipulation, foreign players that target the right sectors with the right strategies can prosper. In fact, companies operating in frontier economies often encounter significantly less competition than they’d face in a BRIC or tiger economy and are therefore likely to enjoy higher profit margins for longer periods.
In the following pages we offer a framework to help you figure out whether and where to play and how to win in the spaces you choose to compete in.
Mapping the Opportunities
The first step in identifying opportunities in a frontier economy is to assess the competitive environment of its industries along two dimensions: (1) the degree to which profitability is determined by competition between firms and not by government policies and actions and (2) whether the industry is focused primarily on domestic sales or on exports. Industries will fall into one of four categories.
In this category, relatively small companies sell to domestic customers and compete with one another using normal business strategies, seeking competitive advantage through product differentiation, operational efficiency, marketing, and human resource development. Typical examples of workhorse firms include local manufacturers (furniture makers and water bottlers, for example), service providers (small construction firms, taxi drivers), retailers (grocery stores, pharmacies), and small farms serving the domestic or local market. In most frontier economies, workhorse businesses employ the majority of the labor force. An example of a foreign company operating in this category is Unilever making and selling detergent to local consumers in African countries.
Companies in this category compete with one another in export businesses, often as supply chain partners to large foreign corporations serving developed markets. Such firms typically locate in industry “clusters” to take advantage of low production costs, availability of skilled or cheap labor and other inputs, the presence of multiple and sophisticated suppliers, or demand from the local market. Because export cluster firms compete on price and quality, they benefit from clear and business-friendly laws and regulations, and they require well-developed institutions around contract enforcement. Typical players include electronics and garment manufacturers and international service providers such as shipping lines or call centers. Gap’s clothing manufacturing in Myanmar falls into this category.
Companies in this category serve the domestic market, as workhorses do, but they operate in industries where political influence has a big role. Typical players include large telecommunications companies, utilities, infrastructure providers, cement manufacturers, and gasoline distributors. An example of a foreign entrant in this space is Washington, D.C.–based Symbion Power, an energy company that develops and operates power plants in Tanzania, Kenya, Madagascar, and other frontier markets. In developed countries, businesses of this kind are usually regulated to promote competition or protect customers. In frontier economies, however, regulation primarily directs profits to the government or privileged interests.
Companies in this category are export oriented, but the terms of their operation, including taxes, royalties, and other obligations, are spelled out in contracts with the government. Often large, they operate in the “concession” space—that is, on the basis of government licenses—and include oil, gas, mineral, and other resource extractors. Enforcement of regulations and agreements in this category is typically weak, often resulting in safety and environmental problems. Profits are a function of the bottom line—how cheaply firms can conduct their operations—but revenues are greatly affected by how much the government takes off the top. Mining giant Rio Tinto’s massive copper and gold mine in Mongolia operates in the rentier space.
It’s important to note that industries may fall into different categories in different countries. Take consumer electronics. Samsung is an export business in Vietnam, but in Kazakhstan its sales are largely domestic. It’s also important not to define industries too broadly. Many sectors may hinge on government policies and actions, for example, but contain significant workhorse pockets. In the oil industry, extractors negotiate concession terms with governments and assume expropriation risk, while oil service firms compete for business from the oil majors through the usual channels.
Once you’ve completed the industry categorization, you can segment the GDP of the frontier economy accordingly. This enables you to see how the country’s economy breaks down, exposing the dominant local interests, and gives you a sense of the scale of your opportunity there. (The exhibit “Mapping Frontiers” shows how two very different frontier economies stack up.)
The exercise of mapping industries to the four categories not only reveals where your best opportunities lie but also helps identify your best strategy for pursuing them. That’s because each category is associated with a particular dominant strategy and is exposed to a distinct menu of risks. Let’s begin by looking at strategies and risks for workhorse industries.
Strategies for Workhorses
Successful workhorse firms look like successful firms anywhere: They adapt and leverage existing capabilities and adjust their marketing and distribution strategies to reflect local tastes and constraints. Big multinationals might expect to outperform local competitors, but this is far from universally the case. Domestic companies know the market conditions intimately and have developed the relationships with stakeholders necessary to succeed. (For an example of a strong homegrown competitor, see “Competition May Be Tougher Than You Think.”)
For foreign entrants, competing with strong local businesses often requires some disruptive innovation that challenges the dominant business model in the target country and may well require redefining the entrant’s product or service as well. Take the case of Unilever. Supermarkets and modern retail stores—key players in its typical supply chain—serve only a small fraction of the trade in frontier markets in Africa. Consumers there make less than $2 a day, so they buy small sachets of detergent, toothpaste, or cooking fat on a daily basis in informal shops in their communities. Store owners buy big packs of these products in nearby towns or from distributors and then prepare unbranded packets themselves, which they sell at extremely high prices per ounce or gram.
Drawing on the experience of its subsidiary Hindustan Lever, in India, Unilever realized that there was an opportunity in Africa to serve customers by cutting out the middleman and producing and directly distributing its own small-format packages at a lower price. As it had done in India, Unilever developed a network of salespeople in rural areas, employing a multitiered distribution system with regional distributors in charge of taking the product to local distributors, who provided training and supplies to the salespeople on the ground. Although the margins per unit were low because of packaging and distribution costs, there was potential for huge volume. In other African markets, Unilever has changed not just packaging but characteristics of the products themselves; for instance, it has developed margarine that does not require refrigeration.
Workhorse pockets in rentier or powerbroker sectors are often good target markets for foreign entrants and can serve as a platform for future growth. Take the case of Nigeria-based Sea Trucks Group. Founded in 1977 by Dutch entrepreneur Jacques Roomans, Sea Trucks started as an insurance broker to oil and gas companies in the Niger Delta. Today, the company provides a range of technologically sophisticated products and services, including SURF (subsea umbilicals, raisers, and flowlines), subsea infrastructure, and rigid-pipeline laying. Sea Trucks maximizes local Nigerian participation in planning, engineering, implementation, and delivery of projects for Nigeria-based clients. Roomans, the CEO and president of the group, and the senior team have continued to work out of Lagos even as the company has globalized to other emerging and frontier countries, winning contracts in Malaysia, Angola, Ghana, Brazil, Russia, and Mexico.
Strategies for Export Clusters
Many companies source manufactured goods from suppliers in frontier economies or set up their own manufacturing facilities there, the attraction generally being the availability of cheap labor. In some frontier economies, however, abuses are widespread, and local governments don’t always take action to correct them for fear of losing export opportunities. Consumers in the developed world, however, are increasingly sensitive to labor conditions, environmental damage, and government oppression in frontier economies; their behavior can change the economic picture dramatically.
In 2001 more than half of Myanmar’s $850 million in garment exports went to the United States. But in response to grassroots activism and boycotts protesting Myanmar’s authoritarian regime, followed by a 2003 U.S. embargo on imports from the country, U.S. clothing companies exited Myanmar, and its exports plunged. The pendulum can swing back, of course—with the release of Aung San Suu Kyi, in 2010, investors, multinationals (including U.S. clothing giant Gap), and development agencies started queuing up again in Myanmar.
If companies are to maintain an enduring manufacturing presence in frontier economies, their strategies must be about more than just access to cheap labor; they must act as cluster builders. Smart companies increasingly recognize the long-term synergies—in terms of labor skills, density of suppliers, and regulatory support—that can result when many firms of the same export industry colocate in a frontier economy. Clusters also help to unblock legal restrictions in the developed markets they serve and act as a magnet for aid and development investment.
Consider the Integrated Tamale Fruit Company (ITFC), a nucleus-and-outgrower organization in Ghana’s poor northern region that exports organic mangoes directly to the European market. ITFC has its own 400-acre, professionally run commercial farm, but it also works with more than 1,200 smallholder farmers in the surrounding area (the “outgrowers”). In exchange for an interest-free, in-kind loan and extensive training, the smallholders agree to grow mangoes on an acre or two of their land using organic techniques and to sell them through ITFC’s marketing channels. The proceeds are used to repay the loans. By nurturing this cluster of farmers, the company can operate at greater scale without the tedious and uncertain process of assembling acreage in an area with communal and chieftaincy-organized land use.
ITFC’s efforts, which have led to transformational income growth for local farmers, have attracted the attention of development agencies such as the African Development Bank and the U.S. government’s Millennium Challenge Corporation, as well as the Ghanaian government. These organizations have stepped in to bolster and expand the cluster scheme and to finance improvements in rural roads.
Cluster building in frontier economies is happening in high-tech industries as well. Socialatom Ventures, a U.S.-based venture capital firm, invests in start-ups that sell services globally using Latin American talent. In Medellin, Colombia, it has partnered with Ruta N, a public corporation charged with promoting innovation in the city, to develop a local cluster of start-ups and programmers. Socialatom has also teamed up with local universities to improve their engineering curricula. And through its nonprofit foundation Coderise, it runs boot camps in design thinking and coding skills for children from disadvantaged areas.
Strategies for Powerbrokers and Rentiers
Staking out and protecting interests in rentier or powerbroker sectors is usually harder than operating in a workhorse sector or an export cluster. In many cases, rentier or powerbroker projects take on very public identities that carry significant political risks.
The so-called Water War in Bolivia is a case in point. In 1999, the government of Bolivia privatized SEMAPA, the state-owned water company in Cochabamba. Aguas del Tunari, a joint venture between Bechtel, Edison, and the Spanish energy company Abengoa, was awarded the contract to revamp water provision in the midsize city. (Some 40% of the population often did not have potable water. Low-volume users, who were relatively poor, paid more per cubic meter than wealthier high-volume users. The very poorest, who had no connection to the system at all, had to buy water from tanker trucks at exorbitant prices.) Aguas del Tunari rapidly expanded the supply of water to 30% more of the population. To help the company pay for this and future improvements, the government allowed an increase in water tariffs of 35% in January 2000. NGOs and local social groups immediately condemned the price hike as abusive, and thousands of people took to the streets of Cochabamba to demand that the government terminate the concession. In April the government caved, rolling back the price hikes and eventually revoking the contract.
Foreign firms can reduce this type of risk by increasing and diversifying stakeholders in their success. One way to do that is to create workhorse pockets through CSR programs. Take the case of mining giant BHP Billiton (BHPB), which made a massive investment in Mozambique with its aluminum smelter project. In 2001, working with the Mozambican government and the International Finance Corporation, BHPB set up the Small and Medium Enterprise Empowerment and Linkages Program. The program gave local contractors the skills necessary to compete for contracts with BHPB and trained their workers. This stimulated the development of local engineering firms and disseminated best practices in procurement, materials handling, and engineering services. BHPB began to offer local businesses large shares in its value chain, bringing many positive benefits to the community.
It’s important for foreign firms to realize that when they engage stakeholders, the commitment must be long term. The Canadian resource company Sherritt understands this. Its Ambatovy project, in Madagascar, required the labor of approximately 11,000 locals for the construction phase, which made Sherritt the largest employer in the country. The company’s workforce was a powerful constituency that would complain if the government were to cancel Sherritt’s contract. But employees would also be unhappy about the layoffs that were inevitable as construction wound down. In order to sustain goodwill for the 30-year project, therefore, Sherritt decided to continue to support the construction workers after the construction phase. Sherritt’s CEO at the time, Ian Delaney, explained: “We developed a system to feed the locals we had hired for the project [and who were no longer employed with us] at least a meal a day. We also avoided a major income shock to them and their country by paying them $5 to $15 a month going forward.”
As an alternative to engaging with multiple stakeholders, firms can make themselves indispensable to powerful local players in multiple ways, even some that are removed from the core business. Sherritt took this approach in Cuba. The company required a specific kind of ore for its refinery in Alberta, and in 1994 it chose to develop a mine in Cuba. In order to protect its position, Sherritt set up a joint venture with the Cuban government, sharing ownership of both the Cuban mine and the Canadian refinery. In addition, Sherritt undertook to train workers and helped the Cuban government draft a foreign investment law.
A few years after the mine’s operations started, the government, cash-strapped and without access to international markets, asked Sherritt to help it find financing to develop some abandoned oil fields in Cuba. Sherritt issued a bond in Toronto and invested in a new joint venture with the Cuban government. Together they created other joint ventures to produce energy for the resort town of Varadero and to operate a hotel, a mobile phone company, and a soy processing plant. Sherritt’s good relationship with the government, not to mention its ability to provide the government with much-needed hard currency, has made it a stable and profitable player in Cuba since 1994.
Many analysts see the current environment of rising interest rates and lower commodity prices as a reason to stay away from frontier economies. But following that advice might lead to the same regrets felt by the many multinationals that pulled out of emerging markets after the Asian financial crisis of 1998: They missed a decade and a half of bumper returns. Since equity markets are not deep enough for most investors to get exposure to frontier economies, investments in these places will necessarily be direct and boots-on-the-ground, and may require a decade or more to realize the investment thesis. Patience, careful analysis of long-run growth potential, and an appropriate choice of strategy will reward those companies that stake out a position in today’s frontier economies.