financing globalisation

FINANCING GLOBALISATIONTHE CREDIT CRUNCH AND ITS IMPACT

ON EXPANDING MULTINATIONALS

Financing globalisation 1

Despite the impact of the credit crisis and accompanyingrecession, companies in developed countries are stillseeking to do business in emerging economies and vice-versa. Indeed, while international trade has existedfor centuries, a globalised marketplace is only in itsinfancy and still offers enormous scope for cross-bordergrowth. Nevertheless, expansion comes at a cost in thiscapital-constrained era and access to capital at the rightprice is one of the key issues in international trade today.

In this report, produced by UK Trade & Investment in co-operation with the Economist Intelligence Unit, weexamine where and why companies are expanding inemerging markets and how this activity is being impactedby the credit crisis.

Some of the trends emerging from this paper include:

� The global downturn has made the assessment of risk in new ventures more complicated than ever. Companies expanding overseas face the twin challenges of overcoming finance hurdles in both their home countries and overseas.

� The emerging market economic crashes of the 1990s are still fresh in many executives’ minds. However, banking systems in Asia in particular, are considerablymore robust today with debt at much lower levels. Credit is even growing in some Asian countries – incontrast with many developed economies.

� Capital markets are effectively closed to all but the largest companies with the healthiest credit ratings. Blue-chip corporations are able to raise capital in euros and dollars, but even then only at wide spreads to government bonds.

� Concerns over economic weakness have led to high levels of currency volatility in recent months. Any company transacting sizeable business overseas needsto be aware of the dangers. By the same token, some companies are benefiting from currency swings.

� Despite the increased macro-economic risks, the potential offered by emerging markets is still well recognised. Many companies are no longer content to merely outsource production to emerging economies, but are looking to establish bases and sellto increasingly wealthy local businesses and consumers.

EXECUTIVE SUMMARY

Financing globalisation 32 Financing globalisation

This may not seem the most opportune time for companiesto enter or expand in emerging markets. In emergingeconomies, local companies are reeling from the 40 per cent-plus markdown in their shares last year,many (but not all) currencies have tumbled against thedollar and foreign direct investment has all but dried up as investors repatriate capital. Choosing a strategicpartner, gaining access to local financing and evaluatingtrade and currency risk has rarely been harder.

To add to the challenges, financing for such venturesis likely to be less forthcoming from domestic sourcesas the developed world struggles to contain the creditcrisis that threatens to become the worst downturn in

80 years. The International Monetary Fund estimatesthat losses on US-originated credit assets alone arenow US$2,200 billion, while Nouriel Roubini, professorat the Stern School of New York University, who warnedof the dangers to the world economy well before theytranspired, says losses on US-generated assets willpeak at an eye-watering US$3,600 billion. All of whichwill hardly encourage fresh lending to companieseither by banks or by the shadow banking system.

The IMF’s latest Global Financial Stability Report,reveals the extent of credit contraction to privatecompanies that is already taking place around theworld (see Figures 1 and 2).

So will the slowdown in emerging markets and thegeneral lack of expansion capital halt the movementof capital from West to East – principally from the US and Europe to Asia? The reality is that companiesprobably cannot afford to ignore the growth potentialof emerging markets, particularly Asia. After all, theIMF forecasts growth of 3.3 per cent in emerging marketsthis year compared with minus 2 per cent in advancedeconomies. And emerging markets growth is likely to hit a healthy 5 per cent in 2010.

Alec Jones, head of emerging markets atPricewaterhouseCoopers, says the case for doingbusiness in developing economies remains intact.“Companies initially wanted to set up low-costmanufacturing,” says Mr Jones. “The change in the last two or three years is that people now want a sliceof the action – they don’t just want to make low-costproducts but want to be part of the fast-growingeconomies and take advantage of rising incomes andconsumption. That goal hasn’t changed despite thecurrent difficulties.”

INTRODUCTION

Figure 1. Deposits at Central Banks(Billions of USD)

Figure 2. Credit Contraction in Private Sectors and Growth in Public Sector(Billions Euro/USD)


The desire to harness the untapped potential certainlydrove the emerging markets strategy of Halifax Fan, a UK manufacturer of industrial fans, which has a turnover of nearly £7 million. Managing directorMalcolm Staff admits the setting up of a factory in China’s Shenzhen region in 2006 was originallydesigned to reduce costs in its core UK market. But the strategy soon changed. Mr Staff says: “We quicklyreceived an order from a Western company in China andafter that we realised that the Chinese market would belucrative in its own right.” Halifax Fan’s Chinese operationsnow sell predominantly to the local market. It targetsrevenues of £1.5 million from China this year and to date is beating this forecast.

But even for companies that are well established inemerging markets, there are risks to be borne in mind.The worry for those with strong memories of the late1990s is that amid the credit crisis skittish internationalinvestors will pull out of emerging markets and onceagain create a domino effect of collapsing economies.Western companies operating in these regions wouldinevitably be caught up in the ensuing maelstrom.

However, there is reason to believe that will not happenthis time. Standard Chartered, a specialist emergingmarkets bank with 90 per cent of its revenues derived fromAsia, Africa and the Middle East, thinks Asia in particularwill resurface relatively stronger from the credit crisis. AlexBarrett, head of client research at Standard Chartered says:“Due to actions taken after the 1990s crisis, Asia has a stronger banking system, is less leveraged and betterfunded than developed economies. Even liquidity is quite good, and there is still strong growth in credit in Indonesia and the Philippines, for example.”

Strangely enough, the global downturn has evenalleviated credit conditions for companies in somecountries. Whereas the Chinese authorities reined inlending last year over fears the economy would overheat,it has now reversed tack. Chinese consumer price inflationfell for the ninth month in a row to 1 per cent in January,according to official figures, meaning that inflation is – forthe time being – not a threat. So more credit has beenmade available from state and partly-state owned banksfor established businesses looking to expand.

There are a number of ways to raise capital for expansioninto emerging markets, all of which come at a differentcost to the company. By far the most common route tocapital is via simple bank debt. Alan Keir, global co-headof commercial banking at HSBC says: “The vast majority of SMEs and, even, bigger companies will fund overseasexpansion from facilities with banks in addition to theirown cash resources.”

However, ongoing cash needs and financing requirementscan become complicated if a company operates across anumber of markets. This is particularly true in emergingmarkets, where financial services are less mature. Tosmooth the process, HSBC appoints a global relationshipmanager to each account. Its International BankingCentre helps companies to set up accounts anywhere inworld. So if a company launches in, say, Indonesia, it will not have to use up valuable resources in sending a delegation to negotiate with local banks in Jakarta.

Even companies with turnover of as little as £1 millionmay need international banking facilities these days.Mr Keir says: “The power of the internet has meant40 per cent of small businesses now do somethinginternationally. All of a sudden they get orders fromabroad and they need help with multi-currency cardpurchases, how to take orders over the web and howto identify and cover their risks.”

TAPPING LOCAL MARKETSThe likelihood of obtaining finance from purely domesticinstitutions depends on the country concerned and thestrength of its banking system. Emerging market bankswere conservatively managed during the time that thecredit bubble was building up in the Western world,so access to financing has not been as heavily impacted.Nevertheless, lending requirements in countries such as India and China will continue to be stringent, perhapsmore so than before, and only companies witha compelling business case need apply for financing.

Building local banking relationships can be a time-consuming process. Mr Staff says: “We would like to operate a local account but you need three years’accounts history in China.” A local account would helpHalifax Fan to maintain vital cashflow. “It’s not alwayseasy doing business there – we sometimes struggle toget paid, and if you inject cash from the home marketyou have to wait a month before you are allowed to get it out again.”

Up until recently, capital markets were also a significantsource of capital for companies wishing to expand.Standard Chartered says most commonly, companieswould conduct a general debt or equity capital raising in their domestic market and use a proportion of theproceeds for overseas expansion. However, raising capitaldirectly in local markets had become more prevalent inthe last few years. Mr Barrett says: “A big company doinga lot of business in an emerging market will want toborrow money onshore so there is less balance sheetrisk.” Often the company will then hedge the currencyrisk (see box Currency convulsions).

While some Western market brand-names can tap localinstitutions (although usually only for bond offerings),many would fail to inspire the necessary confidenceamong local investors to launch an issue. This is one of the many reasons that joint ventures are frequentlysought in emerging markets – aside from offeringlocal market expertise, joint venture partners may havesufficient recognition to attract local capital.

Tapping capital markets is barely in a credible option,though, in the current environment where investors aresuspicious of all but the bluest of blue-chip companieswith the least debt and highest cashflows. According toStandard Chartered, capital markets are essentially closedin Asia. Mr Barrett says: “Asia has seen very few newissues this year. Issues from smaller, high-yield companieshave disappeared almost completely.”

The biggest global companies can still raise money ineuros and dollars, but even then at wide spreads overTreasuries. “In Asia, only the very biggest domesticissuers, usually those that are linked to governments, can raise money,” Mr Barrett adds.

Currency convulsions

Taking a foreign holiday this year? The choice ofdestination this year – more than ever – is likely to reflectthe differential between the currency in which theholidaymaker is paid and the currency of the foreigndestination. Turmoil in the capital markets has not onlyhad an impact on the prices of shares and bonds, but hasalso created wild gyrations in the currency markets. BaxiGroup, which transacts significant business in Turkey, isvery wary about the lira, which is one of the world’s mostvolatile currencies, having lost nearly a third of its valueagainst the dollar last year. Baxi chief executive MartynCoffey says: “We always hedge the currency risk when wetake a large order.” It also faces challenges in Russia,where it prices its products in euros. With the roublehaving fallen by a quarter against the euro in the last six months, Baxi is becoming less competitive againstcompanies that price goods in other currencies. Butcurrency swings can benefit companies too. Halifax Fan’swholly-owned Chinese operation, which will producearound a quarter of the company’s revenues this year,sells its equipment in local currency to local customers.With the renminbi rising from 15Rmb/£1 to 10Rmb/£1 in a year, Halifax gains a sizeable addition to its sterling-denominated profits.

SECURING FINANCE


Although the concept of private equity has started to take hold in emerging markets, the idea of injectingprivate capital into a Western company seeking toexpand abroad is less common. Indeed, since mostprivate equity deals have focused on buyouts andbalance sheet re-engineering in recent years, expansioncapital in general has been in short supply.

Nevertheless, it does exist. Baxi Group, one of Europe'sbiggest manufacturers and distributors of domestic andcommercial heating systems, was refinanced by a privateequity consortium led by BC Partners in 2004. The private equity backing has helped Baxi take significantmarket share across all the major continental territoriesand in the UK. It has also expanded into emergingmarkets such as Romania, Argentina, Russia, China andthe Czech Republic. And it has recently developed a joint venture partnership in Turkey.

Indeed, the fastest-growing parts of Baxi’s business arein Russia and Turkey. In both these countries solid fuelfor domestic heating is being phased out and replacedby gas. Martyn Coffey, chief executive of Baxi, says:“There was incredible growth in demand for heating in houses and apartments last year in Russia.”

Baxi uses its private equity backers’ market pricingpower to help it finance its working capital. “Ourbanking arrangements are in place for the next two to three years,” says Mr Coffey. But he describes theeffect of the credit crisis on some of Baxi’s customers,such as house-builders, as “dire”. Baxi is commonlyviewed by banks as being part of the constructionsector – a perception Mr Coffey describes as erroneoussince the majority of its revenues are derived fromreplacement boilers.

So cashflow is threatened by a growing lack of trustbetween companies, each of which fear their tradingpartners may fail to pay for or deliver goods. The problemis particularly acute between customers and suppliers indifferent parts of the world, jeopardising a global networkthat has been built over years and decades.

HSBC says the lack of trust has become evident ineveryday business. Mr Keir says: “Open accounts areworking less and less well and old-fashioned letters ofcredit [where the bank acts as an insurer] are comingback into fashion.”

Many companies are now wondering where thefinancing sources of the future may lie. Logic dictatesthat credit markets will thaw at some stage, but PwCsays the freeing up of capital will be accompanied bya new paradigm of local sourcing. Banks and othersources of finance, under pressure from governmentsand shareholders, are likely to want to simplify theirbusinesses and may confine themselves to domesticcredit risks. Mr Jones says: “In the future, people onthe financing side will want to do simpler things.

This plays into bank borrowing in local territories. Local banks and local subsidiaries of international banks will come to the fore.”

THE PRIVATE EQUITY ROUTE?While the advantages of investing in emerging marketsare often clear, the way to develop business overseas isoften less so. Choosing the right location, targeting theright market and creating the appropriate structure canbe a labyrinthine task for first-time entrants to emergingmarkets. Halifax Fan, for one, a manufacturer ofcentrifugal fans, initially set up a joint venture in Indiabut suffered a false start. Malcolm Staff, managingdirector, says: “We found the bureaucracy in Indiadifficult to deal with. We also had constant tussles withour joint venture partners over strategy. We perseveredfor about a year then dissolved the company.” HalifaxFan had a much better experience in China, where ithas just set up a second factory after launching aWholly Owned Foreign Enterprise in 2006. Althoughcompeting local manufacturers can be cheaper, Mr Staffsays the company’s ability to provide tailor-made – ratherthan commoditised – machines, attracted clients that were willing to pay higher prices. However, thecompany – scarred by its experience in India – startedcautiously in China, investing just £100,000 from thecompany’s retained earnings to buy basic machines. It began by outsourcing parts of the manufacturing processthat require expensive machines – such as laser-cuttersand industrial paint shops. Its overseas expansion couldhave been easier, but Halifax Fan found the quality of advice from business organisations disappointing.“Many of the people we spoke to knew little more thanwe did,” says Mr Staff.

WINDING PATH TO EMERGING MARKETS SUCCESS

8 Financing globalisation

Even in times of economic stress, capital can find itsway to profitable investments and that applies particularlyto genuinely entrepreneurial companies seeking newopportunities. For them, emerging markets still offerunprecedented opportunities and the long march Easthas only just begun. Nevertheless, along the way thereare some key points for these companies to consider:

1. Companies should not necessarily be more wary of doing business in emerging markets than before the credit crisis began. In fact, there is thepossibility that developing markets may emerge stronger than their developed counterparts, giving an immediate earnings boost to companies with established overseas operations.

2. Steps should be taken, where possible, to establishmore than just a manufacturing presence in emergingmarkets. Wealth in these areas is likely to grow faster than in developed economies, rewarding meticulously researched and well implementeddistribution channels.

3. Companies’ home markets are likely to be the most fruitful places to raise capital for some time to come as banks come under political, economic and regulatory pressure to lend predominantly to domestic customers. Only when well established in a new market with a banking relationship of several years’ duration, is local financing likely to become an option.

4. Currency hedging is an important finance tool in highly volatile markets. Any company taking large orders from overseas customers or making large purchases should consider hedging part, or all, of the value of the transaction.

CONCLUSION

MANY IRONS IN THE FIREBaxi Group has a proud history. Created in 1866 andfamily-owned for four generations, it is known in its home country, the UK, and across the world for itsPotterton, Valor and Homeflame brands. Today it is oneof Europe's biggest manufacturers and distributors ofdomestic and commercial water and space heatingsystems, operating in a market worth over £5.5 billion a year. It employs more than 5,000 people acrossEurope and has a turnover of more than €1 billion.But long traditions are no protection against thecompetitive threats that globalisation brings and Baxilong ago was forced to lift its sights beyond its homemarket. It now distributes its products to numerousemerging markets, using a network of agents and jointventure partners to keep sales costs to a minimum. In Turkey, an area of great demand for gas heating, it

created a 50/50 joint venture with a local company.One of the advantages of this is it can receive ongoingfunding through relationships with local banks. Thecompany may also invest in a plant in Russia, andwould seek to obtain finance locally if this goes ahead.The bulk of its sales, though, are still in developedmarkets, which are mature and therefore requireinnovative approaches. Martyn Coffey, Baxi Group chiefexecutive says: “We now offer a variety of low-carbonproducts, demand for which is driven by legislation andsubsidies.” Although the company realises the mostdynamic future sales growth will come from emergingmarkets, it is also keeping a firm grip on its developedmarket sales. While a shift to the East is drivingstrategic decisions at many businesses, success alsohinges on becoming diversified and staying nimble.

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financing globalisation

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