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BEYOND 50 DEGREES EAST – CHALLENGES AND OPPORTUNITIES IN HIGH GROWTH MARKETS

This seminar, the 14th in the popular Business of Law series, will debate the findings of a major research project undertaken by Allen & Overy. Entitled ‘50 Degrees East’, the research provides an insight into the issues that businesses are grappling with as the global economy sees a shift of power from developed economies to those in emerging markets, particularly in Asia.

FacilitatorMargaret Doyle – Columnist

Panellists Wim DejongheManaging Partner, Allen & Overy LLP

Sir Thomas Harris KBE CMGSpecial Advisor, Standard Chartered Bank

Thierry LintermansHead of Legal Asia Pacific, Accenture

Lord Wei of ShoreditchChairman, All-Party Parliamentary Group for East Asian Business

Jonathan ZhouPartner, Fangda Partners (Shanghai)

‘50 Degrees East – the rising power of Asia’50 degrees east is the line of longitude that marks the end of the West and the beginning of the East. It is the line across which a strategic shift of power is happening in the global economy from developed markets to developing economies, particularly in Asia Pacific. But is this shift in power recognised as a long-term trend by senior business leaders around the world? And is it influencing their future plans for growth?

These were some of the issues explored by Allen & Overy in a major piece of research conducted with 1000 board-level executives from international businesses across 19 countries. The findings of the in-depth interviews – often surprising and sometimes controversial – were published in three reports at the end of 2011, available here: www.50degreeseast.com.

The first report, ‘Opportunities and challenges’, examines business confidence and threats to the global economic recovery, the shifting balance of economic power, plans for future growth and the barriers that may stand in their way.

The second, ‘Under pressure: funding options in an uncertain world’, looks at global business leaders’ views on preferred types of funding or raising capital, the location of choice for sourcing funding and the predicted major currencies of the future.

The third, ‘Risk and regulation: harnessing or constraining business potential?’, examines how the perceived shift in economic power

from West to East may affect the risks that large multinational businesses face and the regulations that govern their operations around the world.

Optimism and opportunitiesThe single most powerful finding to emerge from A&O’s research was the degree of optimism from business leaders: about the Asia Pacific region, about the security of future funding for their businesses and about the global economic outlook as a whole.

Most business leaders believe the globalising economy creates substantial opportunities, with Asia clearly the stand-out region. 75% of business leaders believe Asia Pacific’s economic influence is on the rise and are putting it at the forefront of their business strategies. Just 2% say its influence is declining.

Within Asia, China is singled out as the country that offers the best opportunities for growth. But the number of markets that businesses are considering investing in is growing. Within Asia, this is being driven by two factors: one is the size of the market – Asia is a huge and extremely diverse region, with many markets and areas to expand into – and the other is the sizeable middle class developing in Asia, bringing significant buying power and opportunities for consumer products.

Perhaps more surprisingly – certainly in A&O’s view – optimism around sources and availability of funding for businesses was also high. 96% of respondents expected their funding needs to match, or to be higher than, current levels. 90% expected that availability of financing would

increase. 56% of respondents thought their funding would still come from traditional bank lending.

This is surprising given the challenges that financial institutions, particularly in the West, are facing. Western banks – especially in Western Europe – have substantial exposure to the sovereign debt crisis in Europe, and are facing increasing capital requirements (with the introduction of Basel III) and a tougher regulatory environment. In this context, the respondents’ optimism about the availability of credit in the Western world has surprised many.

But if optimism is the prevailing feeling among those business leaders who took part in the research, where are they focusing their attentions? Allen & Overy asked interviewees to identify the three markets that presented the best opportunities for growth for their business. Asia Pacific countries represent half of the top ten, led by ‘Chindia’. 44% of respondents put China in their top three countries, and 34% included India. Opinions vary, however, about which offers more – or better – opportunities.

ChinaChina’s position at the top of the table is backed up by Foreign Direct Investment (FDI) data, with A&O’s ‘InvestmentPerspectives’ tool (an online application charting investment flows around the world: www.aoinvestperspectives.com) showing that inflows to China are almost back to their peak 2008 levels of USD108 billion.

Strikingly, 19% of respondents also expect Shanghai to be the most

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important stock exchange by 2020, and 11% predict the renminbi will become the most important currency over the same time period.

Far from the old view of China being, as one panellist put it, “a USSR-type monolith”, it is an incredibly diverse country and appealing to businesses for many reasons. Within that, two strong factors emerge: first it has a middle class growing in both size and prosperity. More than 50% of the population now live in its cities – and they want to buy, consume and, where possible, invest their money outside of China. Second, it has an increasing number of private sector firms who have not expanded much, for a variety of reasons, but are desperate to. One panellist put the figure as high as 2,000 companies in China who want to list on the stock exchange. These two factors are a force for change and, over time, for opening up China’s market.

But China is also considered the hardest market for foreign businesses to enter – although interestingly only slightly behind the U.S. and Russia. Lack of government support, restrictive practices and cultural issues are seen as significant barriers to entry. But by far the biggest obstacle cited in A&O’s research was the regulatory environment.

Despite the numerous reforms to the foreign investment regulations – including the release of the M&A rules in 2006, the Chinese Anti-Monopoly Law of 2008, and the introduction in 2011 of a national security review for acquisitions by foreign investors in sensitive industries – the path to entry is not easy for foreigners.

Foreign investment in certain key industries and sectors, such as financial services, internet businesses and real estate is still restricted.

Even in industries and sectors earmarked for foreign investment, the process involved in setting up an onshore presence is complex and time consuming. The uncertain legal environment, questions of local favouritism and doubts over the quality of the judiciary breed concern – although there have been improvements in these areas, especially in the major cities.

Predictions of the renminbi and Shanghai Stock Exchange rising to prominence by 2020 are, according to many, too fast and require fundamental changes in the domestic economy that will take time. For the Chinese currency to become fully convertible, for example, the cap on savers’ interest rates would have to be removed, which could result in a flight of capital to Hong Kong.

Chinese regulators are aware of the problems in the domestic economy and equipped to deal with them – for example, property prices in Chinese cities have fallen for the fifth month in a row, which indicates that measures to calm things down are beginning to bear fruit. Regulators are, to coin a Chinese phrase, stepping across the stream stone by stone, very carefully.

Lack of protection for intellectual property (IP) has often been seen as a problem in China, but appeared far down the list of issues of concern to businesses, perhaps reflecting the fact that IP legislation does now exist. Indeed, the success rate of multinational companies in IP

litigation in China is comparable to the West. The challenge is that IP legislation differs greatly from one country to the next and, in China, is tailored entirely to the Chinese market. Essentially, businesses operating there need to understand how it differs from other jurisdictions and work with it. This certainly reflects the experience of A&O.

China was described by one panellist as a place where “nothing is easy, but nothing is impossible”. It is a market with so much potential that few businesses focused on growth can afford to ignore it. There are many risks, but the biggest risk of all is the failure to understand and embrace the system. Progress, according to the panellists, is being made and changes are happening. Perhaps the economy will have to hit a real crisis, a major slowdown in growth, before the pace of change and reform picks up. But the Chinese are right not to rush things – their top priority, the panellists agreed, is keeping the country stable. In the meantime, foreign investors and their advisers are finding ways to overcome some of the obstacles that exist.

IndiaThe other major player in the region is, of course, India, with 34% of business leaders putting it in their top three countries offering the best growth opportunities. Many, in fact, consider India to offer better opportunities and an easier path to entry than China.

A report published by Standard Chartered at the end of 2010, the ‘Super Cycle Report’, took a long-term view of what the world would look like by 2030. China, it predicts,

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will see its economic growth start to slow down to around 5% or 6% by the 2020s, and by 2030 India will be growing at a significantly faster rate.

India has much still to do to create the basic infrastructure for a modern economy, but the signs are that it is entering the Rostovian ‘take-off period’ of economic growth. Similar to other Asian countries – Japan, Taiwan, Korea, even China – India is starting to achieve the same transfer of population from low productivity agriculture in rural areas to high productivity cities. This process of urbanisation – of turning people into middle class consumers – is key to growth, and it is predicted to happen in India over the next 10 to 20 years.

India also has the benefit of what it calls the ‘demographic dividend’ – a burgeoning young population that will provide a huge work-force for the future – at the same time as China may start to see the adverse effects of its one-child policy. Skilled labour is also easier to come by in India, it is argued, than China.

Interestingly, in A&O’s research, India was considered to be an easier market to enter than China, the U.S., Russia, Germany and Japan. Cultural issues were considered by A&O’s respondents to be the main barriers to entry – more so than the regulatory environment, for example.

Panellists also cited the country’s “nightmarish” transport infrastructure as a significant barrier to the development of the country. Over the next five years India is projecting a trillion dollars of new infrastructure development – 50% of which will have to come from the private sector, in itself potentially creating

opportunities – but doubts still remain as to whether, and how quickly, the improvements will happen.

Like China, a lot of reforms have been, or are being, put in place in India to encourage foreign investment. For example, single-brand retail investment was recently liberalised (although not multi-brand retail investment), so many single-brand fashion stores are now entering the country. There is momentum, it is felt, for liberalisation in other sectors to follow.

Beyond ‘Chindia’Clearly, interest in China and India is high. But Asia is an enormous continent with many more markets and opportunities.

Indonesia is a country with 250 million people – half the European population – and one of the few countries whose GDP has continued to grow, despite the financial crisis. Certainly in A&O’s view it is a country that presents significant opportunities, having established a presence there in 2010 to focus on energy and resources work, as well as Islamic Finance.

Thailand and Myanmar are also interesting. Myanmar is an enormous country with huge natural resources. If political change happens in the way everyone is hoping, that opens up another major economy in the Asia Pacific – and global – picture. Singapore too has increased in importance as a regional centre – 8% of A&O’s survey respondents put it in their top three countries offering the best growth opportunities. So if one considers these countries together,

they start to look like sizeable and important players in the region.

Intra-Asian competitionAsian countries are increasingly aware of their international competitive position with regard to each other. A plethora of free trade agreements are being entered into, or at least negotiated, between Asian countries. That competitive pressure is exerting an inexorable – albeit slow – pressure on each of the Asian countries to remove unnecessary barriers to doing business. Certainly, for businesses wanting to make an investment in Asia, inward investment authorities in many countries are fighting each other to attract such investment. So there is confidence that a slow – if not always consistent – move towards liberalisation is happening.

Global challengesThese region-specific issues are of course set against the backdrop of global pressures. At the forefront of business leaders’ minds is regulation. Is the West accelerating the shift of economic power to the East by imposing ever heavier regulatory burdens on its banks and corporates? Is its regulatory response to globalisation and the financial crisis playing into the hands of more permissive regimes in high growth economies? The answer emerging from A&O’s research seems to be “yes”. A number of specific issues were raised by panellists.

Financial regulationThe financial crisis has resulted in a substantial increase in regulation,

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mainly in the West. The Dodd-Frank Act in the U.S., for example, is reputed to contain some 100,000 pages of regulation and commentary – an almost impossible volume, as one audience member pointed out, to learn and understand. Although politicians claim that global problems need global solutions, exactly the opposite is happening. The solutions being put in place are being driven by local political needs and local demand, with very limited coordination or harmonisation of new regulation.

Much of the new regulation affects financial institutions. According to a Thomson Reuters survey 14,215 new regulations or regulatory changes – 60 a day – hit the banking industry in 2011. The purpose of that legislation is to protect consumers and strengthen the capital base of the banks, but without coordinated legislation and enforcement mechanisms, the consequences may be the exact opposite of what is intended. Instead, business and assets will transfer to financial institutions in the East and other parts of the world that are not subject to these changing regulations.

FundingAccording to some estimates, around USD4 trillion of corporate debts are up for refinancing in the next three and a half years, and Western corporates depend to a very large extent on bank financing. One of the most surprising findings from A&O’s research was the ‘business as usual’ attitude to sourcing the same levels – or in fact greater levels – of funding.

The challenge of increased regulation, combined with the impact of the sovereign debt crisis in Europe and

greater capital requirements, will hit Western banks hard. A&O’s view is that leverage in the West will be less available – not so, though, in the East and the Middle East. Businesses conceivably will start to look more at Eastern players – whether funds, sovereign wealth funds, investors or even private investors. As a result, Western assets will be controlled more by Eastern money, either through bank loans or more likely through private investment or sovereign wealth funds.

Corporate governanceWhile the economy is becoming increasingly global, corporate governance regulations remains very local. By definition they are dictated by local ownership structures – emerging markets, for example, are still dominated by family-owned businesses, which Western corporate governance rules do not adequately cover. And what happens to shareholders of a U.S.-listed company when it is taken over by a sovereign wealth fund from the Middle East, or a Chinese entity? There is unlikely to be any change or convergence of corporate governance rules in the foreseeable future – certainly in A&O’s view – which poses major challenges for businesses.

Bribery and corruption Another factor for businesses to consider is the increase in bribery and corruption legislation. Over half of A&O’s survey respondents (59%) who expressed an opinion believe their business finds itself at a competitive disadvantage in some markets because of the extraterritorial

reach of laws such as the Foreign Corrupt Practices Act in the U.S. and the UK Bribery Act – both of which can and do reach far beyond their national borders. They feel at a disadvantage when compared to companies from, say, China where the bribery legislation is less strict and has less of an extraterritorial impact.

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So what is the reality? Are business leaders right to be optimistic about the global economic outlook, and about Asia more specifically? Or are the obstacles to doing business there – combined with the challenges arising from the financial crisis – too great to expect Asia to live up to its potential?

In 2011, the global economy grew at a rate of 3%. While parts of the Western world are feeling the pressure of austerity measures and slow economic recovery, Asia in the most part is not sharing that feeling. It is growing at an impressive rate. Even if growth slows to 5% or 6%, there are still significant opportunities there.

Of course Asia will be affected by what’s going on in Europe, but as a region it is no longer dependent on exports to the West. The growth now is in intra-Asian trade and, of course, the emergence of new trade corridors between Asia and the Middle East, Latin America and Africa – interestingly nearly 50% of A&O’s

interviewees in China and India felt Africa’s economic influence was on the rise – making them more optimistic about Africa than respondents from any other countries. So, for the foreseeable future, the indicators seem to be that Asia will continue to present opportunities.

Any debate about the Asia Pacific region must beware of falling into the trap of generalisation. Asia, as has been said, is an enormous region with different cultures, religions, demographics and economic models. But perhaps a good point to end on is the one thing, it was argued, that unites Asians – something that, on top of all the indicators already

discussed, should breed optimism for the region’s future. That is their passion for education. Anybody who has had any dealings with Asians – whether Indian, Taiwanese, Korean or Chinese – cannot help but be struck by their commitment and belief in the power of education for future growth and prosperity. Families’ commitments to providing the best education for their children – whatever their background and means – and their focus on hard work and dedication is, in the words of one panellist, “why Asia is going to matter even more in the future”.

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