Lessons on Managing Risk in Emerging Markets


In recent years, as economies in developed countries have slipped and stagnated, a number of U.S. and other companies have sought to fuel growth by investing in emerging markets. There are many benefits to employing such a strategy: By and large, developing countries promise access to new, untapped markets; rising levels of consumption, driven by rapidly growing middle classes; and access to inexpensive labor and materials.


Indeed, with each passing year, the barriers to international trade are being whittled away. Common currencies, more-liberal trade agreements and enhanced communication and cooperation between countries have eased the process of finding lucrative new markets. The possibilities for expansion are immense.


However, emerging markets also pose significant perils, as I learned while on a recent consulting engagement in India. These perils—in this case, bureaucratic delays, unanticipated expenses and fluctuating currencies—are often invisible to a company entering the market for the first time. But they can easily turn a promising venture into a losing proposition if they aren’t dealt with quickly and effectively. 


In India, my team was enlisted to help a large financial services firm build an agricultural extension services practice in the state of Andhra Pradesh. Our team came equipped with a diverse array of skills, and our expertise was sought in developing a feasible operational model. In support of this, we also had to develop financial models and accounting procedures. Both were measures whose importance was underestimated by management.


From the beginning of the project, we experienced some big, unexpected hurdles. For example, we determined at the front end of the project that marketing would be a large component of the firm’s success and that the materials and labor needed for this activity could be obtained for a low cost. However, we didn’t realize some of the hidden expenses that the company would face on the marketing side, such as an expensive, informal “registration fee” required for participation in an important government-sponsored forum.  Despite the name, this fee was more of an off-the-record transaction, arbitrarily determined by government officials, with the only basis for the amount being the client’s ability and willingness to pay. We refused to pay this fee, since doing so could be a violation of the Foreign Corrupt Practices Act, and instead worked to find other ways to spread awareness of our client’s service.


In addition, to make its business model viable, this socially minded firm planned to rely on government contracts to help it reach impoverished farmers. But because so much of the government’s funding ebbed and flowed from year to year–either due to economic or legislative issues, or bureaucratic corruption–the company was unable to determine whether national or local officials would ever be able to fund the project, or whether other funding vehicles should be pursued.


Further, by its very nature, agricultural extension work is a relatively low-margin business. Thus, when the rupee appreciated or depreciated sharply against the U.S. dollar, the effects on the company’s balance sheet and income statements were immediate and substantial. Depending on the magnitude of these swings, the company’s entire investment in the country could be called into question.


As is typical of many businesses pursuing international diversification, my client overcame some of these issues, but on less favorable terms than it had anticipated. Because of the potential corruption issues in dealing with government-sponsored marketing forums, it had to market independently, in a manner that was more expensive and had less reach. Since local government agencies and small businesses in India were unreliable, it had to seek partnerships with larger, international corporations, which had significantly more bargaining clout. And as India’s currency fluctuated wildly, the company had to keep most of its profits in India through reinvestment, even when there was a lack of attractive projects to justify this action.



As countless other companies have learned the hard way in recent years, while investing in the emerging world can be very rewarding, it carries formidable risks as well. These risks, which often slide by without notice in the rush to seize an opportunity, can undermine an otherwise sound operation.


The following are some of the biggest threats to anticipate when entering an unfamiliar, developing market:


Corruption. Emerging economies, more so than those in the developed world, are often saddled with corrupt politicians, bureaucrats and businesspeople. The E7 nations—China, India, Brazil, Russia, Indonesia, Mexico and Turkey, considered the primary sources of the world’s economic growth through 2050—are among the poorest performers on Transparency International’s Corruption Perception Index, which measures public sector corruption. With a score of 3.3 out of 10 (where a score of 10 is “highly clean” and 0 is “highly corrupt”), India ranked 87th out of 178 countries in the 2010 index. Often, corruption is the legacy of previous governments that, while no longer in power, continue to have an influence through people or policies that remain in place. And even when a new government has cleaned house and old institutions and bureaucrats are gone, social norms may continue to keep corruption alive and slow the progress of economic liberalization. For instance, Russia has long suffered from quasi-legal forms of bribery. This practice seems to be a remnant of the country’s former communist rule. 


Moreover, even if local governments are not corrupt in initial dealings, their incentives may change after a foreign firm commits to making an investment. A government that was initially cooperative and willing to provide assistance may impose onerous taxes or restrictions once the host company is heavily invested and doesn’t have the option of a quick withdrawal.


Operating within this business climate, we even found that the farmers with whom we were interacting were initially unwilling to trust us and were highly skeptical of our motives. From their perspective, we were working with the government and regarded simply as one more intermediary that would prevent funding from getting to its intended targets.


Any U.S. company seeking to do business in a foreign country needs to have a clear understanding of its responsibilities under the FCPA and other international laws, such as the United Kingdom’s Bribery Act 2010. The FCPA’s anti-bribery provisions make it illegal to offer or provide money or anything of value to officials of foreign governments or foreign political parties with the intent to obtain or retain business. The provisions apply to U.S. issuers, other domestic concerns (individuals and businesses), U.S. parent companies of foreign subsidiaries, and foreign companies and individuals, including agents.


To protect against charges of corruption, companies need to keep books, records and accounts that accurately reflect their transactions and disposition of assets. In addition, companies need to devise and maintain internal accounting controls aimed at preventing and detecting FCPA violations. They also must have clear policies and procedures that explain how business is to be conducted as well as ongoing training for employees and business partners.


Lack of transparency. Even when corruption per se is not present, there often is very little transparency into the inner workings of government and business. Granted, improving the visibility of financial reporting in the U.S. and other developed nations is still a work in progress. But, in many emerging markets, the commitment to improving transparency lags far behind the norm.  


As a result, major Western corporations have been hesitant to invest substantially in emerging economies, realizing that market opaqueness often can be a smokescreen for shady behavior. In their home countries, large multinationals have very stringent reporting guidelines, and they may be fearful of being unable to meet these standards when working in new countries if transparency is minimal.


Lack of transparency proved to be a major obstacle during our engagement. Not only did we have little insight into the decision-making process of the government agencies that would be granting us contracts (making financial planning extraordinarily difficult and imprecise), but it was even a struggle to get financial and operational information from potential corporate partners who would have benefitted from such communication. A culture of distrust permeated every company with which we interacted.


Currency fluctuations. As was true for the Indian project I worked on, investments in emerging markets can be undercut by currency fluctuations. Though many economists have argued in favor of fixed exchange rates for emerging economies as a way to combat this problem, most countries have avoided this approach, according to the Bank of Canada.


Studies show that emerging nations are particularly susceptible to sharp appreciations or depreciations in currency values. In industries in which margins are low, a currency shift can turn a gain into a catastrophic and inexplicable loss overnight. Even if these swings later reverse themselves, shareholders, especially in the U.S., are more concerned with short-term gains, and these gains can be compromised through unpredictable currency changes.



Despite these substantial challenges, firms considering investments in the emerging world have some concrete steps they can take to reduce risks and improve their odds of success. They include:


Conducting due diligence. Performing due diligence is a critical first step to diffuse some of the risks that come with doing business in an emerging nation. However, to be successful, the measures used need to be different from the “cookie cutter”-type of due diligence used in acquiring a domestic firm or starting an operation within a home country.


While conducting due diligence in an established, domestic industry involves evaluating comparable firms with a robust set of assumptions, companies looking to invest in emerging markets usually don’t have access to this type of information. Invariably, a firm’s research into an emerging market will focus largely on the relationships between government and business in that host nation, as well as in bordering nations. 


Western economies have had persistent success, in part, because of the symbiotic relationship between government and business. But this assumption may not hold true in emerging economies. Indeed, in many cases, there are tangible costs associated with government-related inefficiencies. Such expenses are relatively easy to calculate and should be incorporated into investment decisions. For instance, if the government has a history of imposing undue amounts of red tape that could lead to delays in operating a factory or in exporting goods, this cost can be anticipated and quantified. 


Somewhat more challenging to foresee are the costs stemming from long-term damage to reputation or overt corruption, such as bribery. For obvious reasons, there typically isn’t accurate data about how substantial these costs can be. At best, estimates will be imprecise. Consequently, companies considering investments in countries where these are thought to be typical practices should adjust discount and hurdle rates upward to reflect unforeseen risks.


Improving transparency. In addition to using targeted due diligence, firms must seek to overcome transparency shortcomings that can adversely affect their operations. Because many governments with developing economies don’t require significant transparency as part of corporate governance, the investing companies must be proactive and seek their own remedies.


Identification and education of all interested stakeholders is a necessary precondition for improving transparency. These efforts must include government officials, employees and customers, among other groups. Their interests must be heard and understood in developing rigorous corporate governance codes.


Internal controls, especially, must be enumerated and tested to a greater extent than they are in developed countries. That’s because there may not be the same economic incentives favoring transparency and integrity that are present in other places, and the disincentives for fraudulent behavior, such as enforcement and penalties, also may be missing.


Internal controls should focus especially on transactions in which cash may change hands or in which a party has the potential for unjust enrichment or fraud, such as contracting with chronically underpaid government or business officials. While internal controls in the U.S. often focus on mitigating honest errors or miscalculations, companies investing in the emerging world may need to focus on rooting out deliberate falsehoods.


Moreover, if government agencies are not in a position to guarantee transparency, engaging other multinational corporations as suppliers or customers will impose another layer of discipline and security. And making a decision to work only with partners that demand transparency in their own operations puts pressure on other potential suppliers who otherwise might take advantage of loopholes and lax controls to curtail such behavior. 


Keep in mind that a company will not have to make the same costly provisions for potential fraud-related losses if it can show it had adequate procedures in place to prevent such crimes. Those procedures include having a systematic program of education and training, risk assessment, due diligence, and monitoring and review, among other measures.


If a company can achieve total visibility into all the operations that affect it, and impose the type of stringent corporate governance guidelines that have served developed economies so well, the risks posed by in-country fraud and corruption drop considerably.


Diversifying investments. Diversification can be an effective tool for mitigating the risks associated with emerging markets. While due diligence is often prohibitively expensive and inexact, diversifying across multiple countries can hedge some of these risks. An adverse government action or widespread labor problems in one country can be devastating if that country houses the firm’s only emerging market investment. But if investments are spread across a number of countries, with their own distinct governments, cultures and business climates, problems caused in one location are less likely to jeopardize the whole enterprise.


Naturally, all companies are subject to capital constraints to some extent and, as such, it’s reasonable to pursue less expensive, more tentative forms of foreign investment. For instance, while foreign direct investment often represents an irreversible commitment, joint ventures with local firms or other multinational corporations often may require more modest investments, and can be divested without serious legal consequences. In fact, such arrangements can sometimes allow two companies with complementary skills or assets to work together to minimize each firm’s exposure, both operationally and financially. Teaming up can make international investment less risky and, thus, more appealing to decision makers.


Further, diversifying investments offers the company leverage in dealing with each individual government: Governments are more likely to make concessions or accommodations to foreign firms if they know that withdrawal is a legitimate option. Such diversification, in addition to shielding against operational failures, also can serve as a hedge against the unpredictable currency fluctuations that typify emerging markets.



Despite their risks, emerging markets offer demonstrated returns that are significantly higher than those of most developed economies. Though issues of corruption and uncertainty have impeded progress, emerging markets in general have excelled in recent years.  


Certainly, if the past two decades are any indication of what’s to come, investment in the emerging world will continue to evolve from its current status as a novel and exciting opportunity into a virtual prerequisite for enduring growth. But success will depend on acknowledging, anticipating and mitigating the many risks inherent in such investments. This requires both research and resourcefulness, since emerging-market risks can be difficult to pinpoint and vary widely by country.


The take-away from our team’s experience in India: No stone can be left unturned in the effort to find markets that are both promising and secure.  



Michael Ferguson (michael.ferguson@fuqua.duke.edu) is an MBA student at Duke University. He also has served as a senior consultant in the forensic and litigation practice of FTI Consulting in Washington and senior auditor with Ernst & Young, New York.

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