• Tuesday, April 05th, 2011

Financial Post

A new block of emerging powerhouses is poised to shatter existing global trade patterns. Is your business ready for the next wave?

Illustration by Gary Neill

A new block of emerging powerhouses is poised to shatter existing global trade patterns. Is your business ready for the next wave?

Tim Shufelt, Financial Post Magazine · Apr. 5, 2011 | Last Updated: Apr. 5, 2011 11:59 AM ET

A new bloc of emerging economic powerhouses is poised to shatter existing global trade patterns. Is your business ready for the next wave?

Alfred Hanna was in Panama in December 1989 when the standoff between Gen. Manuel Noriega’s soldiers and the United States military boiled over. At the time, Hanna was overseeing a feasibility study for SNC-Lavalin Group Inc. on the construction of a pair of hydroelectric plants. Just before Christmas, U.S. President George Bush unleashed thousands of troops on the Central American nation to depose Noriega’s military dictatorship. Hanna’s bosses at the Montreal headquarters of the engineering giant asked if he wanted to abandon the work and the country. But the team decided to see the project through to its end. “The Panamanians have never forgotten that we persisted,” Hanna said. “Twenty years after, I go there and everybody remembers and wants to give us work.”

Then, as now, countries most Canadian business leaders consider “non-traditional” — the places they forgo in favour of the comfort and familiarity offered by established economies, especially the U.S. — are right in SNC-Lavalin’s wheelhouse. The company has built a sprawling international presence and knows what it takes to make money in parts of the world where the prospects for growth and the potential for instability are both high and interwoven. SNC-Lavalin’s global approach has since taken it to, among many other corners of the world, the Indonesian island of Sulawesi to construct the US$410-million Karebbe hydroelectric generating facility. “The potential in Indonesia is vast,” Hanna says. Indeed, Indonesia’s economic prospects are so buoyant that the world’s largest archipelago state is part of a basket of countries being hailed as the next axis of global growth. These countries, which have the potential capacity to rival the G7, have been dubbed The Next 11, or simply the N-11.

It’s common knowledge that the balance of global economic power is shifting, as is the need for Canadian industry to reduce its dependence on the U.S. So far, the focus of diversification has largely been on the existing champions of the emerging world: Brazil, Russia, India and, most of all, China — the BRIC nations. But as the world’s second-largest economy, China has officially emerged, says Katie Koch, senior portfolio strategist at Goldman Sachs, which came up with both the BRIC and N-11 monikers. “We don’t think the BRICs should be called emerging markets.”

Even some of the N-11 countries– specifically, Indonesia, Turkey, South Korea and Mexico — have graduated to “growth market” status, Koch says. She explains that any non-developed country is considered a growth market if it has at least a 1% share of global GDP. The remaining N-11 nations– Bangladesh, Egypt, Iran, Nigeria, Pakistan, Philippines and Vietnam — currently fall short, and also suffer from a large variance in terms of income levels, political and social stability, and investing environments. But despite potentially grave risks, all 11 countries are projected to post blistering rates of growth in the coming years. “Many of these countries have the scale, the growth trajectory and the aspirations to one day become at least 1% of global GDP,” Koch says.

The result could be a profound recalibration of the world economic order, according to long-term projections by Goldman Sachs. Collective GDP for the N-11 could reach two-thirds the size of the G7 by 2050, with twice the growth rate in consumer demand. Mexico is projected to become the world’s fifth-largest economy. Indonesia could overtake Japan. And six of the N-11, including Nigeria and Vietnam, could surpass Canada in economic size. “It can be humbling to see some of these changes in the world’s largest economies. Surprising and humbling,” Koch says. However, she adds: “This could play out to be a huge wealth-creation opportunity.”

Driving these changes are demographic forces. In the industrialized world, falling birth rates will constrain growth because countries will struggle to bolster their workforces. Meanwhile, increased longevity is contributing to aging populations that will increasingly sap economies of their financial resources. “It’s a weird kaleidoscope,” says George Friedman, the founder and CEO of Stratfor, a Texas-based political intelligence and forecasting consultant. “You’re seeing one trend that’s been going on for 300 years — the population explosion — ending. It’s transforming the way societies work. But some will be losers and some will be winners by the same phenomenon.”

Koch says the 15 countries that make up the BRIC and N-11 blocs will be the beneficiaries of shifting population tides. A shared trait among all of them is large populations. Indeed, total N-11 population already accounts for almost 20% of the world’s total, ranging from South Korea’s 50 million people to the 230 million who call Indonesia home. In addition, many of these populations are heavily skewed towards a younger demographic. For example, the median age in Nigeria is 19 years old. Combine that people power with the preconditions for growth, and the economic prospects quickly become explosive, Koch says.

But Friedman argues that it’s not enough to have the numbers, particularly if the growth in productive assets — everything from machinery and equipment to new buildings — is insufficient to predicate economic progress. China has tried to mask its lack of this capital formation and, in doing so, set itself up for an impending collapse, Friedman predicts. By slashing its profit margins, China has realized an extreme, prolonged pace of growth that lacks healthy returns on capital. And while the export market has taken off, the domestic economy has trailed behind. As a result, more than one billion Chinese live on less than US$6 a day, Friedman says. “The vast majority of China has a standard of living of sub-Saharan Africa.” To quell social unrest, Friedman predicts China will use its banking system to keep insolvent companies afloat and maintain employment, as Japan did in the 1990s. He suggests a range of possible outcomes for China, none of them good, and none of them leading to the country claiming global economic supremacy.

Turkey, by contrast, stands to make great economic strides by combining its growing workforce with substantial capital formation. And the spoils will go not just to the Turks, but also their neighbours, Friedman says. “Where Germany was an engine for European recovery in the 1950s and ’60s, Turkey becomes an engine for recovery and development in the Baltics, in the Caucasus, in the Arab world.”

One Canadian company that has already capitalized on the Turkish engine is Alliance Grain Traders Inc. Founded 10 years ago by Murad Al-Katib, a Turkish descendent born and raised in rural Saskatchewan, the one-time basement enterprise is now the world’s largest processor and exporter of lentils, controlling about one-third of the global trade. It has a $660-million market cap and grosses about $700 million annually. The company made its big transformative move in 2009, when it made a $100-million bet on Turkey by acquiring a Turkish counterpart. At the time, the deal was bigger than the size of Alliance itself.

“Think about the location of Istanbul,” Al-Katib says. He points out that a four-hour flight heading east or west out of Toronto might not breach Canada’s borders. But four hours in the air from the Turkish capital can land one in North Africa, Dubai, Moscow or London. Turkey is a strategic geographic play, but it has also established a vast trading network in the region that transcends political tensions. “Imagine a country with ties to the Islamic world, yet still has free trade with Israel,” Al-Katib says. “It also reaches into a customs union in the EU, and let’s not forget that all of the Central Asian republics are Turkic republics.”

Unlike some of its neighbours, Turkey has recovered well from the global recession, realizing robust economic growth with relatively low levels of unemployment and inflation, two forces central to the region’s recent uprisings. “Turkey is a diamond in the rough,” Al-Katib says. “It’s a country of stability in a region of instability. It’s within a different class.” A strong majority — and secular — government maintains political stability. And Turkey’s banking and lending community has reached a level of sophistication. “We have a big working capital requirement and we carry $150 million of Turkish bank credits in our Turkish operations,” he says.

Turkey’s already a regional leader, but its ascent in the decade ahead could transform the region’s economy and its influence could moderate the extremist elements that threaten to destabilize the Middle East, according to Stratfor’s forecast. “Of course, Turkey will feel tremendous internal tensions during this process, as is the case for any emerging power,” the report states, and the tension between Islamic and secular forces still represents a “deep fault line. It could falsify this forecast by plunging the country into chaos.”

But Turkey is not alone in this regard. All N-11 members share the potential for disaster, much more so than developed economies. From the chance of bombs dropping on Iran, to hostilities erupting in Pakistan, to the threat of soaring food prices and rampant inflation leading to more Egypt-style revolts, geopolitical risks loom over emerging markets. “The probability of any one of these countries being in a real crisis at any point in time is high,” Koch says.

Nowhere are these risks more glaring than in sub-Saharan Africa, a region that has come to epitomize failed development models and economic vulnerability due to political instability. Still, on a continental level, GDP growth has averaged 5% over the last 10 years, and growth rates of most African countries exceed those in the developed world. South of the Sahara, Nigeria is the region’s oil powerhouse and demographic giant, two assets qualifying it for inclusion in the N-11. In many ways, Nigeria is the great hope of sub-Saharan Africa, and Goldman Sachs projects it will surpass the Canadian economy within about 35 years. “It’s a great example of what other African nations can aspire to,” Koch says.

Nigeria is Africa’s biggest oil producer and ranks 10th in the world by proven reserves with about 2.7% of the global total. It has undergone substantial economic reform and has a credible central bank governor who is seemingly empowered to clean up the banking sector, says Philippe de Pontet, a sub-Saharan Africa analyst at the Eurasia Group, a political risk analysis firm based in New York. The country’s progress, however, has been made from a very low starting point. “From independence up until 1999, it was a terribly mismanaged country. Now I would say it’s just a very mismanaged country,” de Pontet says. Nigeria has much to overcome to realize its economic potential. Like most African states, it is composed of hostile factions thinly held together under a common flag. As a comparison, Friedman cites the tensions between the French and English throughout Canada’s history. “Multiply that a thousand times, and you’ve got Nigeria,” he says.

Among the N-11, South Korea is perhaps the most stable, which is telling given the potential for war in the Korean Peninsula. But South Korea is also among the most developed emerging economies and, like China, its rapidly rising income levels are leaving more and more consumers with money to burn and a demand for the trappings of Western consumer culture such as big-screen and 3-D movies. “There’s a very broad build-out of the entertainment sector in a lot of these markets,” says Richard Gelfond, CEO of Imax Corp.

In China, the number of multiplex screens has tripled to 6,000 over a three-year period, and that total is expected to rise to 25,000 within five years. “There’s also a tremendous demand for luxury-type products,” Gelfond says, calling the Imax offering an “affordable luxury.” Imax has already opened 10 theatres in South Korea, with seven more to come, the result of a deal signed late last year. “They have an appetite for the newest and the greatest,” Gelfond says. “Once our footprint gets to a certain critical mass there, we’ll start doing Korean movies in Imax.”

South Korea hardly seems like a country that belongs in a conversation about emerging markets. It is already “developed” in many senses. It is a member of the Organisation for Economic Co-operation and Development (OECD). Its GDP per capita of about US$20,000 is double that of Turkey or Mexico, about 10 times higher than the Philippines or Egypt, 20 times higher than Pakistan, and 30 times higher than Bangladesh.

However, North Korea’s shelling of a South Korean island late last year renewed fears of a broader military conflict that could potentially engage Western forces. “A big reason that country is still considered a non-developed market is because of geopolitical tensions,” Koch says. But even absent an unlikely resolution to the historic stalemate, South Korean growth prospects could soon vault the country ahead of some G7 economies, including Canada. Only one other N-11 member could do the same: Mexico.

Drug-related violence in Mexico garners plenty of headlines in Canada and the U.S., souring opinions on the state of the country and sullying its reputation as a premier tourist destination. But the drug trade has a huge upside, one on which Mexican expansion is largely based. After factoring in profit margins, drug exports to the U.S. net more than legal exports, Friedman says. “That’s the secret of Mexico. It’s a huge transfer of wealth from the United States to Mexico.”

What begins as a very low-cost agricultural crop ends up as an illicit form of capital formation, adds Friedman. Eventually, as drug money fuels expansion, cartel wars will settle and legitimate enterprises will become more profitable. “I regard Mexico as a real challenger to the United States later in the century,” Friedman says. “It’s going to have a very capable workforce.”

Montreal-based Bombardier Inc. saw a chance to take advantage of that workforce after the Mexican government about five years ago set out to establish an aerospace manufacturing cluster in central Queretaro state. With 90% of Bombardier’s revenues coming from outside of Canada, the transportation giant has an interest in diversifying its manufacturing base, and lower-cost labour in Mexico helps offset its domestic manufacturing costs.

Bombardier’s $200-million commitment began with relatively simple labour-intensive electrical assembly work. But the quality of the labour has advanced substantially, says Bombardier spokesman John Paul Macdonald. “In a very short time, they’re doing subcomponents, they’re doing Learjet 85 wings, they’re getting into more complex work.” The Mexican government has also partnered with the company to establish a specialized training facility. “It’s kind of like an aerospace trade school,” Macdonald says.

If Goldman Sachs’ predictions hold true, Mexico in 40 years will be the world’s fifth-largest economy, bigger than either Russia, Japan or Germany. But the rise of the N-11 will not just be based on attracting money from Western companies such as Bombardier, but on sowing a new crop of corporate champions, Koch says. “What is that going to do to the strategies of Canadian companies and U.S. companies still in the early stages of tapping into that pool of growth?” she asks. “That’s what the world’s going to be all about over the next decade. And for Western multinationals, the name of the game is getting into the middle of that.”


A Snapshot Of 11 Countries Set To Become Some Of The World’s Biggest Economies

MEXICO: Will be the world’s fifth-largest economy by 2050, predicts Goldman Sachs

NIGERIA: Economy could grow 12% this year if new government can resolve the Niger Delta conflict, fix the power sector and boost infrastructure

TURKEY: OECD expects its 6.7% growth rate from 2011-2017 to be the fastest in the N-11

IRAN: World Bank forecasts foreign investment of $2.9B despite international sanctions

PAKISTAN: Expected to strengthen ties with neighbouring China, which should help its economy

EGYPT: Unrest will probably cut economic growth in half to as low as 3%, says Central Bank

BANGLADESH: The N-11’s best-performing stock market grew 43.2% last year on the MSCI frontier markets index

INDONESIA: Fourth-most populous country is one of the most promising, say Citigroup economists

VIETNAM: The poorest N-11 country is expected to have the fastest-rising GDP per capita at 9.7% from 2009 to 2020

SOUTH KOREA: Its GDP per capita of $22,631 in 2009 was the highest in the N-11

PHILIPPINES: The president has asked investors to help build $16B worth of roads, bridges and schools

As a group of potentially large, fast-growing markets, with rising incomes and activity, the N-11 could be an important source of growth and opportunity both for companies and investors alike during the next two decades, according to a Goldman Sachs report in 2007.

The four BRIC nations -Brazil, Russia, India and China -have or will soon surpass Canada in terms of GDP, but Goldman Sachs predicts Mexico, Indonesia, Nigeria, South Korea, Turkey and Vietnam will do likewise by 2050.

Five of the N-11 countries-Turkey, Korea, Indonesia, Philippines and Mexico -are commonly found in emerging market investment indices, but the ability to access N-11 markets varies widely.

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