So You Want to Do Business In a Developing Country?

There are many compelling reasons that companies look to developing countries for growth. Less-developed countries hold the promise of large, fast-growing consumer markets (e.g., the BRICs); an abundance of cheap labor; and access to otherwise unavailable natural resources. Managers are often lured by this unbridled potential.

But there is a reason these countries are considered “developing” – largely because of the under-developed state of their institutional environments (see also Summer Reading: The Birth of Plenty).

Although developing markets hold jaw-dropping potential, it often remains just that. Realizing potential from developing markets is incredibly challenging. Companies often find that the institutional (cultural, political, and economic) environments in the developing markets they enter are not only underdeveloped in an absolute sense, but also in a relative sense. That is, the cultural, political, and economic environments in developing markets are so vastly different from anything that they encounter in their own domestic market (or even in other developed markets) that the costs involved in navigating them exceed even their most conservative estimates.

For this reason, companies from developed countries (and developing countries) often struggle when they enter developing countries. Their investments often fail to achieve desired returns; and worse, they can get mired in red ink.

Take IKEA, for instance. It entered Russia in 2000. Its operations are still struggling, largely due to the nature of Russia’s institutional environment, in which corruption and graft are commonplace. According to the New York Times (see IKEA Tries to Build a Case Against Russian Corruption):

Weeks before the opening of its flagship store outside Moscow in 2000, Ikea was approached by employees of a local utility company. If the Swedish retailer wanted to have electricity for its grand opening, it had to pay a bribe.

Instead, Ikea rented diesel generators large enough to power a shopping mall. The generators roared to life in a loud rebuke to the corrupt executives who thought they had the retailer cornered, and soon the utility turned on the power.

As Ikea opened stores across Russia, and became one of the most outspoken Western corporate critics of Russian corruption, renting generators to thwart extortion from power companies became standard practice. Ikea executives took great pride in their creative solution — renting generators “instead of putting ourselves into a squeeze,” as Christer Thordson, an Ikea board member and global director of legal affairs, put it in an interview.

But Russian graft may have proved more stubborn than Ikea.

The board of Ikea’s operating company, which is based in the Netherlands, has concluded that the Russian executive hired to manage the generators was taking kickbacks from the rental company to substantially inflate the price of the service. Ikea said that such a fraud could cost it about $196 million over two years.

MY COMMENT: IKEA was clever to find an alternative to its energy problem. Unfortunately, it discovered that graft is endemic to Russia’s culture.

Ikea canceled the contract and sought redress in Russian civil court. But in rulings over the last two weeks, Ikea has lost another 5 million euros in damages that the judges awarded the generator rental company for breach of contract.

“We have encountered something here that is outside the scope of what we normally encounter,” Mr. Thordson said, describing the global retailer’s situation in Russia. “I have never experienced anything like this.”

The ballooning costs built into these two deals were so large they eliminated all profit from Ikea’s business managing a dozen shopping centers in Russia in 2008, Mr. Thordson said.

Ikea lawyers, in a letter to the board of Ikea’s operating company, said the opposing lawyers seemed to know the outcome of these cases in advance, suggesting collusion with the judges…“I can only suspect there have been some irregularities behind the scenes,” Mr. Thordson said.

MY COMMENT: Not only did IKEA discover that corruption and graft are endemic to the culture, but that redress through the court system is dubious for foreigners. Even when the judicial system is not corrupted and there are laws on the books to protect the interests of foreign investors, laws on the books do not equate to laws enforced. There is still a large home-team bias.

IKEA learned these lessons the hard way. Unfortunately, problems such as these are all too common for foreign companies operating in less developed countries.

Entry into developing countries is not for the faint at heart…

More on this topic (What's this?)
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A Cheap Comeback Play on the Russian Standoff
Read more on Emerging Markets, Investing in Russia at Wikinvest
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One Response to So You Want to Do Business In a Developing Country?

  1. Udddiii says:

    Thanks Prof. Salomon,

    Russia among the BRICs will probably retard most
    precisely because of the intense graft & corruption.
    Apart from its solid natural resources, Russia does
    not have much else to offer – its (previously top-notch)
    education systems have crumbled, the little that remain
    serve too few students; demographically it is an aging population,
    and Putin’s cronies have infiltrated all nodes of power within the state,
    sucking funds and creating giant barriers to change, in part by
    a) weakening powers of free speech, and b) by disabling the judicial recourse, as you have pointed out. Money alone speaks.

    For business purposes, we should suggest to GS to remove the ‘R’ from BRIC and just make it ‘BIC’. Russia will likely suffer a second
    collapse, though less noticeable than the first.
    After IKEA, hopefully no more useful $ are wasted unless
    the ‘government’ is ousted and cleaned out in toto.
    The regime is not visibly communistic (which would be a clear waste
    of effort for any corporate) but nevertheless a unique case where transaction costs approach infinity.

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Posted in Corporate Strategy, International Business, International Strategy | 1 Comment