18 Jul 2005  Research & Ideas

Identify Emerging Market Opportunities

Yes, you understand your company needs to compete in emerging markets. But which country is the best fit for you? A Harvard Business Review excerpt by Tarun Khanna, Krishna G. Palepu, and Jayant Sinha.

 

Editor's Note— Companies are increasingly looking to emerging markets like China as a vital source of growth. The problem is these companies often lack an effective strategy for identifying which countries to do business with. In a June Harvard Business Review article, excerpted here, the authors present a "five contexts framework"—issues to consider, in essence—to understand institutional variations between countries. We excerpt a summary of the five contexts.

As we helped companies think through their globalization strategies, we came up with a simple conceptual device—the five contexts framework—that lets executives map the institutional contexts of any country. Economics 101 tells us that companies buy inputs in the product, labor, and capital markets and sell their outputs in the products (raw materials and finished goods) or services market. When choosing strategies, therefore, executives need to figure out how the product, labor, and capital markets work—and don't work—in their target countries. This will help them understand the differences between home markets and those in developing countries. In addition, each country's social and political milieu—as well as the manner in which it has opened up to the outside world—shapes those markets, and companies must consider those factors, too.

The five contexts framework places a superstructure of key markets on a base of sociopolitical choices. Many multinational corporations look at either the macro factors (the degree of openness and the sociopolitical atmosphere) or some of the market factors, but few pay attention to both. We have developed sets of questions that companies can ask to create a map of each country's context and to gauge the extent to which businesses must adapt their strategies to each one. [...]

Political and Social Systems. Every country's political system affects its product, labor, and capital markets. In socialist societies like China, for instance, workers cannot form independent trade unions in the labor market, which affects wage levels. A country's social environment is also important. In South Africa, for example, the government's support for the transfer of assets to the historically disenfranchised native African community—a laudable social objective—has affected the development of the capital market. Such transfers usually price assets in an arbitrary fashion, which makes it hard for multinationals to figure out the value of South African companies and affects their assessments of potential partners.

Executives would do well to identify a country's power centers and figure out if there are checks and balances in place.

The thorny relationships between ethnic, regional, and linguistic groups in emerging markets also affects foreign investors. In Malaysia, for instance, foreign companies should enter into joint ventures only after checking if their potential partners belong to the majority Malay community or the economically dominant Chinese community, so as not to conflict with the government's long-standing policy of transferring some assets from Chinese to Malays. This policy arose because of a perception that the race riots of 1969 were caused by the tension between the Chinese haves and the Malay have-nots. Although the rhetoric has changed somewhat in the past few years, the pro-Malay policy remains in place.

Executives would do well to identify a country's power centers, such as its bureaucracy, media, and civil society, and figure out if there are checks and balances in place. Managers must also determine how decentralized the political system is, if the government is subject to oversight, and whether bureaucrats and politicians are independent from one another. Companies should gauge the level of actual trust among the populace as opposed to enforced trust. For instance, if people believe companies won't vanish with their savings, firms may be able to raise money locally sooner rather than later.

Openness. CEOs often talk about the need for economies to be open because they believe it's best to enter countries that welcome direct investment by multinational corporations—although companies can get into countries that don't allow foreign investment by entering into joint ventures or by licensing local partners. Still, they must remember that the concept of "open" can be deceptive. For example, executives believe that China is an open economy because the government welcomes foreign investment but that India is a relatively closed economy because of the lukewarm reception the Indian government gives multinationals. However, India has been open to ideas from the West, and people have always been able to travel freely in and out of the country, whereas for decades, the Chinese government didn't allow its citizens to travel abroad freely, and it still doesn't allow many ideas to cross its borders. Consequently, while it may be true that multinational companies can invest in China more easily than they can in India, managers in India are more inclined to be market oriented and globally aware than managers are in China.

The more open a country's economy, the more likely it is that global intermediaries will be allowed to operate there. Multinationals, therefore, will find it easier to function in markets that are more open because they can use the services of both the global and local intermediaries. However, openness can be a double-edged sword: A government that allows local companies to access the global capital market neutralizes one of foreign companies' key advantages.

Openness can be a double-edged sword.

The two macro contexts we have just described—political and social systems and openness—shape the market contexts. For instance, in Chile, a military coup in the early 1970s led to the establishment of a right-wing government, and that government's liberal economic policies led to a vibrant capital market in the country. But Chile's labor market remained underdeveloped because the government did not allow trade unions to operate freely. Similarly, openness affects the development of markets. If a country's capital markets are open to foreign investors, financial intermediaries will become more sophisticated. That has happened in India, for example, where capital markets are more open than they are in China. Likewise, in the product market, if multinationals can invest in the retail industry, logistics providers will develop rapidly. This has been the case in China, where providers have taken hold more quickly than they have in India, which has only recently allowed multinationals to invest in retailing.

Product Markets. Developing countries have opened up their markets and grown rapidly during the past decade, but companies still struggle to get reliable information about consumers, especially those with low incomes. Developing a consumer finance business is tough, for example, because the data sources and credit histories that firms draw on in the West don't exist in emerging markets. Market research and advertising are in their infancy in developing countries, and it's difficult to find the deep databases on consumption patterns that allow companies to segment consumers in more-developed markets. There are few government bodies or independent publications, like Consumer Reports in the United States, that provide expert advice on the features and quality of products. Because of a lack of consumer courts and advocacy groups in developing nations, many people feel they are at the mercy of big companies.

Labor Markets. In spite of emerging markets' large populations, multinationals have trouble recruiting managers and other skilled workers because the quality of talent is hard to ascertain. There are relatively few search firms and recruiting agencies in low-income countries. The high-quality firms that do exist focus on top-level searches, so companies must scramble to identify middle-level managers, engineers, or floor supervisors. Engineering colleges, business schools, and training institutions have proliferated, but apart from an elite few, there's no way for companies to tell which schools produce skilled managers. For instance, several Indian companies have sprung up to train people for jobs in the call center business, but no organization rates the quality of the training it provides.

Capital Markets. The capital and financial markets in developing countries are remarkable for their lack of sophistication. Apart from a few stock exchanges and government-appointed regulators, there aren't many reliable intermediaries like credit-rating agencies, investment analysts, merchant bankers, or venture capital firms. Multinationals can't count on raising debt or equity capital locally to finance their operations. Like investors, creditors don't have access to accurate information on companies. Businesses can't easily assess the creditworthiness of other firms or collect receivables after they have extended credit to customers. Corporate governance is also notoriously poor in emerging markets. Transnational companies, therefore, can't trust their partners to adhere to local laws and joint venture agreements. In fact, since crony capitalism thrives in developing countries, multinationals can't assume that the profit motive alone is what's driving local firms.

Several CEOs have asked us why we emphasize the role of institutional intermediaries and ignore industry factors. They argue that industry structure, such as the degree of competition, should also influence companies' strategies. But when Harvard Business School professor Jan Rivkin and one of the authors of this article ranked industries by profitability, they found that the correlation of industry rankings across pairs of countries was close to zero, which means that the attractiveness of an industry varied widely from country to country. So although factors like scale economies, entry barriers, and the ability to differentiate products matter in every industry, the weight of their importance varies from place to place. An attractive industry in your home market may turn out to be unattractive in another country. Companies should analyze industry structures—always a useful exercise—only after they understand a country's institutional context.

About the authors

Tarun Khanna and Krishna G. Palepu are professors at Harvard Business School.

Jayant Sinha (HBS MBA '92) is a partner at McKinsey & Company in New Delhi.

Excerpted with permission from "Strategies That Fit Emerging Markets," Harvard Business Review, Vol. 83, No. 6, June 2005.

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