Resilience: Winning with risk, Issue 1 — Dealing with the fallout

Resilience Winning with risk

www.pwc.com/resilience

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IntroductionDennis Chesley

Dealing with the fallout Michael Storck & Folker Trepte

Gearing up for protests Jamie Hepburn

Preparing for the payback Craig Scalise

Central and Eastern Europe: Moving up the value chain Otilia Simkova

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Reaping the benefits of a greener China John Barnes

The rise of SAAAME: Rethinking risk in a multipolar world Andrew Dawson

Creating the future we desire: Reflections on Rio+20 Richard Gledhill

Anticipating disruption: Reflections on PopTech Scott Williams

October 2012 Issue 2

A quarterly journal

Special focus on Eurozone

Welcome to the second issue of Resilience: Winning with risk. In the first issue we addressed a number of topics regarding the interrelated themes of strategy, risk and sustainability—the themes that are the focus of our journal. As a quarterly journal we are not trying to report news, but we are trying to be timely in covering topics that are of special contemporary relevance. Thus, in some issues, we will have a concentration of articles on a particular topic.In this issue we are devoting four articles to a topic that is of great interest to executives, policymakers and citizens all over the world: the Eurozone crisis. Its implications for countries and for companies are still unfolding in uncertain ways. This inherent uncertainty requires that companies develop the capability of risk resilience, which we defined in our first issue as ‘the ability of an organisation to recognise, take, and rapidly and effectively adapt to changes and the resulting risk’. Since it is impossible to predict future states-of-the-world that this crisis will bring about, companies need to be able to rapidly recognise events and configurations that will affect them in positive and negative ways and respond accordingly.

Introduction

Resilience: Winning with risk I 1

Writing today, we are uncertain about what the Eurozone crisis will look like only a few months after this issue is published. Even if it appears to be abating, or even under control, we should be careful not to think it has passed or that its implications are fully known. We can learn a lesson from US President Hoover’s 1930 declaration that ‘while the crash only took place six months ago, I am convinced that we have now passed the worst and with continuity of effort we shall rapidly recover’. As we now know with the humility of hindsight, it would take the best part of a decade before global output returned to the levels seen before the Wall Street Crash, and by then the Great Depression had given away to an even graver political crisis.

It is easy to see the parallels with the present-day Eurozone facing a seemingly endless spiral of failed crisis resolutions and contagious instability. Uncertainty is putting a brake on investment and growth, not just in Europe but worldwide. But it is the danger of a meltdown—be this the default of a major economy like Spain,

forced exit of a member state like Greece or even full implosion of the single European currency—that is causing the most anxiety in cabinet rooms and board rooms alike. As steps to hold the Eurozone together continue to falter, the risk of a cataclysmic end game become ever more present—although they are by no means inevitable. In almost all ‘meltdown scenarios’, executives will be facing exchange rate volatility and pressures on financial liquidity and potentially even a prolonged recession in Europe that will spread to the rest of the world to varying degrees. Yet even a more positive outcome that preserves the Eurozone largely intact does not mean that companies can go back to business as usual, since actions taken to preserve the Eurozone will have long-term consequences. Many parties, including PwC, have intelligently examined multiple scenarios for how the crisis will play out, and we intentionally do not offer alternative macroeconomic analysis in this issue. Instead, our articles look at features of the crisis that warrant our attention but have perhaps been underemphasised: particular company actions, physical security implications, subsequent debt unwinding in other markets and the situation in Central and Eastern Europe.

Writing today, we are uncertain about what the Eurozone crisis will look like only a few months after this issue is published.

2 I Resilience: Winning with risk

In our first article

‘Dealing with the fallout’, Michael Storck and Folker Trepte explore the implications of a Eurozone breakup and Eurozone preservation. The authors wisely do not put odds on either of these scenarios. Their focus is on treating each as creating the necessity for scenario planning, an important element of developing a risk-resilient organisation. But unlike the usual formulaic discussions of scenario planning, they do this through the clever construct of a hypothetical but plausible German-listed middle-market engineering company, EuroEngineers, to make the implications of each scenario very concrete. In doing so, they focus on the company’s treasury, finance, sales, procurement, legal and IT functions. For each scenario, they identify the risks and opportunities for EuroEngineers. They conclude with a useful discussion and summary table of the contingency planning that should be done by each function that can be considered for any organisation.

Jamie Hepburn, in ‘Gearing up for protests’, focuses on a particularly incendiary issue that will test just how resilient an organisation really is. In their attempts to resolve the Eurozone crisis, governments are finding themselves forced to cut costs and implement other austerity measures that are reducing jobs and job creation. This is leading to high levels of social unrest and in turn threats to physical security to people and supply chains. He applies conventional wisdom about incident management to this often-overlooked feature of the crisis.

Our next article

‘Preparing for payback’, acknowledges the salience of the Eurozone crisis but provocatively asks whether this intense focus on Europe’s sovereign debt crisis is obscuring the bigger question of ‘Are we entering an era of global debt unwinding’? It is now widely acknowledged that the high levels of debt that financial institutions were able to put on their balance sheets were a major factor leading to the global financial crisis. But Craig Scalise points out that the phenomenon of high levels of debt goes far beyond the financial sector to include governments, corporations in all industries and households. He notes that ‘corporate and household debts, combined with government debt, have nearly doubled as a proportion of GDP since 1980, rising to over 300% for developed economies’. Thus the Eurozone crisis is a kind of wake-up call to the longer-term problem of getting debt back to more reasonable levels. Scalise evaluates various scenarios for how governments can unwind their debt and provides some concrete recommendations for how companies can do so as well, while recognising that they have less control over circumstances than they might think.

Shifting from the downside to the upside of risk, in ‘Central and Eastern Europe: Moving up the value chain’, Otilia Simkova points out that stalling opportunities in the Eurozone beckon companies to the significant opportunities in Central and Eastern Europe (CEE). These opportunities are arising because at the same time as the Eurozone


countries are grappling with their crisis, the CEE countries are shifting their country’s economic strategies from a focus on low labor costs for manufactured products to higher value-added products and services. In part this has been spurred by the reduction in foreign direct investment (FDI) in these countries as a result of the 2008–2009 financial crisis and subsequent Eurozone crisis. As a result, the CEE countries, in different ways, are looking to regain FDI in their countries. This is creating opportunities for companies seeking to invest in the industries in which these countries are strong. In doing so, they must balance the strengths of a well-educated workforce, political stability and government’s eagerness to support incoming investments with the weaknesses of underdeveloped financial markets and the still-limited application of modern technologies to business and organisational models.

We then shift from Europe to the ever-fascinating and increasingly influential China. While a commitment to sustainability—defined as how a company incorporates environmental, social and governance issues into its corporate strategy for creating value for shareholders over the long term while contributing to a sustainable society—is probably stronger in Europe than other parts of the globe, this issue is now in the background as Europe confronts the risks from its current crisis. And while China faces many risks of its own—some of which are being played out rather dramatically as the Chinese Communist Party is selecting its next generation of

leadership—the country is now directly grappling with sustainability as well. In ‘Reaping the benefits of a greener China’, John Barnes argues that ‘the Chinese government is determined to create a greener path to growth’. He also notes the importance of the world’s second-largest economy to do so for the world at large and suggests that this emerging market could become a model for other countries if it is successful. Barnes reviews some of the major regulatory and legislative initiatives to ensure that the country’s economic growth—important for its development and the welfare of its over 1 billion citizens—does not come at the expense of the environment. Because most global companies have some link into China through their supply chains, they must address how to ensure their operations meet the government’s environmental objectives if they want to continue to participate in the opportunities created by China’s economic growth. In order to do so, companies must work with the government in its policymaking processes, engage with non-governmental organisations (NGOs) and collaborate with a wide range of stakeholders.

China is part of a larger economic context—the emerging markets of South America, Asia, Africa and the Middle East (SAAAME)—which presents yet another set of opportunities and challenges as described by Andrew Dawson in ‘The rise of SAAAME: Rethinking risk in a multipolar world’. Not only does the SAAAME region represent the lion’s share of the global population and land mass, with a large and growing consumer base,


but its countries are highly interconnected in terms of their trade flows. This has started with commodities but is now moving into manufactured goods. Western companies must find ways to participate in this economic activity, but doing so is challenging for a number of reasons, including regulatory restrictions and a wide range of risks which many companies are not properly prepared to manage. These challenges are especially high for financial institutions, the focus of Dawson’s article, yet they must find ways to break into the SAAAME market if they are to serve their clients who are trying to do the same. He argues that in order to do so, financial institutions need to supplement their quantitative approaches to pricing risk—leveraging ‘big data’ analysis—with more qualitative assessments. These methods constitute a form of building risk-resilience capabilities in financial institutions.

The last two articles

Reflects on two events that took place in June, both seeking to generate dialogue and agreement about multi-stakeholder strategies to address economic and environmental risks and opportunities. One of the events is well known (Rio+20) but perhaps did not fully deliver on its promise, whereas one is less well known (PopTech Iceland) but cultivated innovative approaches to bouncing back from crises. In ‘Creating the future we desire: Reflections on Rio+20’, Richard Gledhill thoughtfully looks back on the outcomes of this conference attended by tens of thousands of politicians, business leaders, NGO activists and journalists from around the world. Just as there is uncertainty about the ultimate outcomes and consequences of the Eurozone crisis, so is there uncertainty about the long-term impact of Rio+20. The general reaction of activists and most media coverage has been negative, putting more emphasis on what didn’t happen than on what did. Gledhill acknowledges some of the serious shortcomings of the event, but he rightly calls out some of the positive outcomes. These include a wide range of important developments outside the formal international process—such as on valuation, reporting, governance and risk management—and the high level of private sector involvement from some of the world’s largest and most influential companies.


In our final article

‘Anticipating disruption: Reflections on PopTech’, Scott Williams reports on another and more informal global gathering that took place in Iceland, one of the epicentres of the global recession. This event was sponsored by PopTech, a ‘global community of innovators working together to expand the edge of change’, and headlined with the same title as this journal: Resilience. Williams argues that resilience is the reason why some organisations, communities and people bounce back from disruption in their ordered routines and others do not. He outlines why disruptions are likely to become more frequent in a world that is confronting the end of resource-intensive economic growth and which is straining to accommodate a growing and urbanising population. The article illustrates resilience in practice with two captivating examples: the Balinese Water Temple networks—which align natural, social and economic systems—and the country of Japan, which is still coping with the triple disaster of an earthquake, tsunami and nuclear meltdown in 2011.

Like our first issue, the current one covers a wide range of topics, geographical locations and industries. But underneath all of these are some common themes, including the necessity for multinationals domiciled in advanced markets to learn how to manage the risks and opportunities in emerging markets and for emerging markets to manage their own growth prudently; the need for more sustainable growth strategies by both

companies and countries; and the growing importance of resilience as a corporate capability required to cope with an exciting but challenging world that often seems to veer from one crisis to the next. These themes will be further explored in our next issue with a special section exploring leadership perspectives on global risk resilience. In the meantime, we hope you enjoy this current issue and take from it some useful ideas for your own organisation.


Although we have invented EuroEngineers to illustrate the points in this article, it would be typical of many other mid-size enterprises in Germany and other parts of the Eurozone. EuroEngineers has an annual turnover of around €2 billion and 3,500 employees. The main markets for its sales are the EU, US and, to a lesser degree, Asia. The company is listed on the Frankfurt Stock Exchange and mainly finances its operations through bank loans. The company’s IT, treasury and HR functions, as well as its R&D and production, are centrally located in Germany. However, some minor production facilities are located in Ireland and Hungary and supply of components and assembly takes place in the sales markets. So, what are the extreme scenarios which EuroEngineers might be confronted with in the short and long run, and what is the likely impact on the company?

significant cuts in pay in troubled Eurozone member states, would cause a drop in demand in these countries. Suppliers in weaker Eurozone markets are especially likely to suffer from these difficult conditions and might fall into bankruptcy. Falling demand would also curtail exports in more stable Eurozone markets and lead to lower growth prospects within the Eurozone. Growth would become more and more reliant on emerging markets. Thus companies in Europe would face increasing pressure to lower costs to cope with global competition in emerging markets. This increase may even accelerate in the long run: While the current period of uncertainty is causing investors to seek safe havens and the euro to depreciate, its value is

Dealing with the fallout By Michael Storck and Folker Trepte

As the once unthinkable becomes commonplace, effective scenario planning is now crucial to survival and success. While there has been a lot of focus on scenario planning in large financial corporations, how to anticipate and mitigate the threats facing mid-size enterprise has attracted less attention. Using an illustrative mid-size business as our focus, this first article in our Eurozone series explores the impact of the crisis on the company and offers practical solutions to cope with them. Thereby, we focus on two extreme scenarios, as many feel lost with the multitude of various development paths and the necessary precautionary measures will in many cases be very similar.

Reflecting the challenges and dilemmas facing many such businesses, the article pays particular attention to treasury, finance, sales, procurement, legal issues and IT, though scenario plans could cover many more areas than this. So what lies ahead for our company, and what can it do to come safely through the storm?

The fate of the euro will have a significant influence on demand within EuroEngineers’ markets. There are essentially two extreme and disruptive outcomes that the company will need to plan for. On the one side is the preservation of the common currency within the Eurozone through structural reforms, austerity measures and shared fiscal policy in a more deeply integrated EU. On the other is the collapse of the euro in its current form and breakup of the Eurozone. The breakup might range from a single state leaving the monetary union to the full deconstruction of the shared European currency.

Preservation of the EurozoneThe structural reforms and austerity measures of the first scenario would primarily consist of reduced public spending and higher income taxes. These cutbacks, together with


expected to increase again in the long run as trust in the European currency returns. With a stronger euro the global competitiveness of EuroEngineers decreases further.

Although an expansive monetary policy of the European Central Bank (ECB) and low interest rates in the Eurozone may ultimately prove to be conducive to investments, we may nevertheless see conditions on credit markets deteriorating in the near future while risk-averse investors are waiting to see evidence of the effectiveness of these measures.

To offset these risks, the preservation of a common currency for most of Europe would keep transaction and administrative costs at a relatively low level and enhance planning security. In the long run, the structural reforms that are likely to follow in the wake of austerity measures might cause markets in weaker Eurozone member states to grow, equalise European tax systems and push further deregulation. Over time, low interest rates and regained trust in capital markets would also boost investments and growth in the Eurozone. Figure 1 compares the risks with the opportunities.

Figure 1: Weighing the risks and opportunities: Preservation of the Eurozone

Risks • Falling demand, particularly in troubled Eurozone member states

• Increasing value of the euro

• Rising pressure to lower costs

• Growing insecurity in supply chain

• In the short run, deteriorating conditions on credit markets

Opportunities • Lower administrative costs in troubled Eurozone states

• Low interest rates in the Eurozone

• In the long run, growing markets in weaker Eurozone member states

• Equalisation of European tax systems and deregulation in the long run

Source: PwC analysis


Figure 2: Weighing the risks and opportunities: Breakup of the Eurozone

Risks • Deep recession

• Rising value of the euro in a smaller Eurozone with stronger member states

• Crashing credit markets with extremely low liquidity

• Decreasing value of newly introduced currencies in ex-Eurozone member states and corresponding drop in value of assets in these countries

• Introduction of capital controls

Opportunities • Increasing foreign-exchange advantages

• Easier access to capital for investment

• Lower taxes and higher investment incentives in ex-Eurozone markets


Breakup of the EurozoneThe opposite scenario describes a breakup of the Eurozone in its current form. The breakup might lead to an immediate drying up of orders and investments, and plunge the Eurozone into an even deeper recession than in the first scenario. Again, the value of the euro is likely to drop in the short term. However, once a smaller Eurozone with stronger member states is established, its value would probably rise even higher relative to the first scenario. Thus, EuroEngineers’ products would become less competitive and exports might decrease further over time. Conditions in the credit markets would also deteriorate in a similar way to the first scenario, though a rapid collapse of the euro would squeeze liquidity even further.

Weaker member states exiting the Eurozone would probably return to their former currencies. In such cases, those currencies can be expected to decrease in value, leading to a corresponding decrease of the value of the assets in these countries. This, in turn, leads to depreciation and corresponding losses on EuroEngineers’ books. Should the new currency decrease in value, the exiting state is widely expected to impose capital controls to stem sudden outflows from a deeply devalued new currency. Such controls would greatly restrict EuroEngineers’ ability to bring money out of that country.

Alongside these risks, there are also long-term opportunities emanating from a Eurozone breakup. Should the former Eurozone markets have to go through a massive devaluation, while some markets find their currency’s value increased, our company, with its German headquarters, may benefit from these foreign exchange (FX) opportunities, for example, by finding chances to cheaply acquire companies in those weaker states. As a company’s credit rating also reflects country-specific factors and Germany currently enjoys higher political and economic stability relative to the troubled Eurozone markets, EuroEngineers might find easier access to capital for investments. Governments in former Eurozone markets might also offer lower taxes and investment incentives in order to attract investment. Figure 2 compares the risks with the opportunities.

Contingency planningLooking at the risks and opportunities surrounding each of these scenarios, what practical conclusions could EuroEngineers draw from the outcomes?

To prepare for these extreme scenarios, EuroEngineers might open its short- and long-term contingency planning with a focus on sales, procurement, financing, treasury, legal issues and IT. While some of these contingency measures are useful in both scenarios, others are specific for an eventual breakup of the Eurozone.


General measures for any scenarioSales: As both scenarios would, at least in the short run, deteriorate EuroEngineers’ growth prospects, the company should assess how prolonged recession in Europe would constrain consumer spending. Given the immediate risk of insolvent business partners, EuroEngineers may also wish to think about enhancing its contract and claims management for business partners in crisis markets, for example, by insisting on bigger upfront payments for services and products or by reducing payment periods. If the company has its own retailers, EuroEngineers might—in the long run—also think about consolidating its network of stores in troubled markets into fewer and bigger outlets to cope with plummeting sales there. The company would also benefit from a broader customer base, which would reduce dependency on any individual group. For example, it could invest outside the Eurozone in emerging markets. By diversifying its sales regions, the company would certainly reduce its vulnerability.

Procurement: To address falling demand in the short term, EuroEngineers might also move to more flexible payment and delivery arrangements with suppliers. Whether the company is able to introduce flexible payment to

suppliers and at the same time tighten contract and claims management with customers depends on its bargaining position in the supply chain. In addition, our company should figure out whether critical suppliers are located in troubled markets and pay particular attention to their financial stability. To enhance supply chain security, EuroEngineers could work with critical business partners on some win-win propositions for both sides. It could offer credits to its suppliers to make best use of its cash resources, as this can generate a good interest income and secure supply. In the long run, the company could try to diversify procurement markets and suppliers.

Finance: As both scenarios might cause liquidity problems in the short term, EuroEngineers should check its readiness to fund its operations for the next 12 months and to pay back its debts in the absence of its usual access to bank credit or bond markets. The company should also take into account that its loans and bonds might have covenants linked to specific key performance indicators, its rating or the country where it is located.

In both scenarios it is important to check readiness to fund operations, to enhance supply chain security and contract and claims management, and to broaden the customer base.

Specific contingency planning for a breakup of the EurozoneTreasury: A Eurozone breakup would raise the question of how to safeguard cash. To limit its exposure in the short term, EuroEngineers should verify how much cash it actually needs in a possible crisis country. It might move spare cash out of a troubled country into currencies such as the US dollar or the Chinese renminbi and transfer its cash deposits to the safest possible bank. For example, some big companies such as engineering group Siemens and carmakers BMW, Daimler and Volkswagen have already acquired banking licences and are therefore able to deposit funds with the ECB, the safest of all safe havens in the Eurozone. As a breakup of the Eurozone raises FX uncertainties for trade with former Eurozone members, our company should set up procedures to deal with currency uncertainty. Beyond financial hedges for each currency, which become pricier at times of vulnerability, EuroEngineers might also think about ‘natural hedging’ in the long run, which means localising supply chains within the Eurozone and balancing production as much as possible with where it sells and where it buys. This diversification into the biggest possible basket of different currencies would reduce the company’s exposure to currency risks.


Figure 3: Contingency checklist

Function Contingency planning

Procurement & production

• Intensify contract and claims management

• Introduce flexible payment and delivery arrangements with suppliers

• Monitor suppliers’ financial stability

• Work with critical business partners on win-win propositions

• Diversify procurement markets and suppliers

• Increase competitive advantage by moving production to former euro states

Finance & treasury

• Evaluate dependency on existing credit lines and capital markets

• Check readiness to fund operations for next 12 months and pay back debts

• Verify how much cash is actually needed in a possible crisis country

• Transfer spare cash to safest possible currencies and banks

• Check covenants linked to credit ratings

• Set up financial and natural hedges

• Invest outside the Eurozone in emerging markets

• Increase competitive advantage by moving finance back office activities to former euro states

IT • Check readiness of IT systems for a change in the invoicing currencies and in cash flows, as well as its readiness for internal reporting

• Increase competitive advantage by moving IT services to former euro states

Sales • Consolidate network of stores in troubled markets

• Diversify customer base

Legal issues • Amend existing contracts to reflect new legal requirements

• Determine the currency of supplier contracts in case of a Eurozone breakup


Legal issues: In addition to measures in treasury, EuroEngineers should include contractual issues in its contingency planning. Most contracts usually fail to foresee a collapse or partial disintegration of the euro, so existing contracts might need amendments to reflect the new legal requirements. Moreover, the status of supplier contracts should be reviewed. Our company should, for example, determine whether supplier contracts remain in euros or convert into the successor currency.

IT: EuroEngineers should also check whether its IT systems are ready for a potential change in the invoicing currencies and in cash flows, which would follow the introduction of new currencies. IT systems should also be prepared to support internal reporting with new currencies.

Procurement, production and administration: Finally, contingency planning should include measures to take advantage of opportunities arising from the Eurozone crisis. Lower wage levels in troubled markets relative to those in stronger Eurozone member states allow EuroEngineers to gain maximum competitive advantage in the long run from moving production, procurement, financing back office activities and IT services to former Eurozone member states.

Figure 3 summarizes ways that the company can respond to the issues in each of these main areas.

No one size fits allGiven the serious impact of the Eurozone crisis, contingency planning could provide a valuable way to reduce risks and make sure the business is prepared for different eventualities. However, the multitude of potential scenarios should not confuse CFOs and risk managers, as the impact of most scenarios differs less in quality than in intensity and timing. Instead of getting lost in theoretical scenarios, they should be geared up with a comprehensive overview of the major risks caused by the Eurozone crisis,

and develop short- and long-term action plans to adequately manage them. Certainly, a proper contingency plan has to be specific and focus on the peculiarities of the industry, size and location of a company’s operations, as well as its individual investment, sales, procurement, finance and treasury strategy. Therefore, a specific in-depth analysis is important and should be the starting point for all further actions. This will make sure that companies can see through what really matters in these uncertain times and come through stronger.


Michael Storck is a senior manager in the German Governance, Risk and Compliance (GRC) practice and drives the local PwC Euro crisis initiative together with Folker Trepte. He has over 10 years of management consulting expertise with a strong focus on risk management. Storck was responsible for the successful delivery of several Euro crisis projects at medium- and large-scale clients in various industries. He is also an expert in the implementation of Internal Control Systems, Business Partner Compliance Management Systems and international compliance regulations like FCPA and Sarbanes-Oxley.

Folker Trepte is a partner in Germany responsible for the PwC Euro crisis intiative. He joined PwC in 1994 and has extensive experience in the area of financial and commodity risk management. He led several Euro crisis projects for various industrial clients and leads the Corporate Treasury practice in Germany together with two other partners. Additionally, he has deep industry knowledge in the energy, utilities and mining industry.


Protesters were once again on the streets of Spain and Greece in September. These flashpoints form part of a wider anger among much of the ‘99%’ against the financial and political elite (the ‘1%’) in the wake of the Eurozone crisis.

Sit-ins by the Occupy movements worldwide bring together people who would never normally dream of throwing flares or bottles at police. Frustration at what they see as a crisis created by the 1%, disproportionately burdening the 99%, is no less intense than that of the more extreme elements. Such people are coming out onto the streets in ways not seen for a generation.

Demonstrations may become more disruptive and even violent if one of the meltdown scenarios in the Eurozone were to occur. Groups on the political fringes might be emboldened to physically attack institutions blamed for the crisis in the belief that they have tacit support, or at least ambivalence, from the majority. As the riots in the UK in 2011 also highlight, initial

Gearing up for protests By Jamie Hepburn

Popular protests against cuts and austerity are gathering momentum across Europe. These are a foretaste of what may lie ahead. If there are exits or the currency collapses, the impact on jobs and social welfare and ensuing unrest may be difficult to contain. Incident management and business continuity planning are generally associated with issues related to natural disaster. But they may need to be broadened to incorporate the repercussions from economic meltdown.

1 Global Risks 2012, the seventh in an annual series published by the WEF.

Building contingenciesIt is vital for businesses, wherever they operate, to ensure the existence (and regular exercise) of clear incident management and business continuity plans to ensure the resilience of their organisations. These need to be integrated into overall business management—from the C-suite down—to ensure problems are identified and dealt with quickly and effectively, thus limiting the potential damage.

The definition of an incident can be broad—anything from an office closure resulting from public disorder to insider threats posed by employees unhappy with cost-cutting, transportation disruption, economic paralysis and stock market freefall. These should be considered in the same light as the impact of severe weather conditions, major natural disasters or pandemics. It could also include any event which attracts high-profile media attention resulting in damage to the reputation of the business.

protests can descend into widespread lawlessness and looting.

Every year, the World Economic Forum (WEF) surveys people from industry, government, academia and civil society about what they see as the most serious risks facing the world. The results of the latest survey reveal that ‘severe income disparity’ is the biggest risk in terms of likelihood.1 This is certainly not a problem that is confined to Europe. In Global Risks 2012, the WEF warns that the world is sewing the ‘seeds of dystopia’, in which we can ‘expect greater social unrest and instability in the years to come’.

The disruption to business has so far been limited. But the possibility that operations may be closed down during protests or certain companies may even come into the firing line directly is one that the business world must now address alongside the financial and economic fallout. In addition to physical damage and threats to staff, there is the risk of cyberattacks, which ranks fourth in the WEF’s list of likely risks.


A notable example is the spate of attacks on US and Western embassies in the Islamic world in mid-September—particularly the death of the US Ambassador to Libya—following the release online of a US-made film denigrating the Prophet Muhammad. Most hostility was directed at government representative offices, but an outlet of US chain KFC was targeted in Lebanon. The episode was a vivid example of how quickly such events can unfold and the speed of response that mightbe necessary.

In the case of any protests emanating from the Eurozone crisis, the early convening of an incident management team would provide a focal point for considering the scenarios and the risks, and the specific impact on your organisation, which will vary markedly from one sector to another. In particular, it would provide a forum for discussion of more extreme or less immediately apparent risks. Whatever scenario ultimately emerges, a relatively small investment in time early on could pay dividends later. And if done well, it could even result in opportunities from better operational control.

Incident management: Issues to consider

• Formation of incident management team: roles and responsibilities

• Consistency of planning and terminology across the organisation

• Risk identification, assessment and monitoring

• Scenario modelling and team practice

• Incident notification, escalation and communications

• Classification of incidents

• Process for post-incident review and lessons learned

Jamie Hepburn is a manager specialising in country risk, with a particular focus on political and security risk. He is a member of the global Network Integrated Security (NIS) team, with a regional focus on the Middle East. While at PwC, Hepburn’s particular areas of expertise include the security and reputational risk of doing business in high- and extreme-risk countries. His work with NIS underpins recommendations on appropriate risk mitigation—from an assessment of the threat to business assets and people in Iraq, to the reputational risk of working with a new joint-venture partner in an emerging market.


Around the world, developed economies have amassed government debts rivalling levels not seen since the end of World War II.1 These debts could cause a drag on the countries’ growth that lasts for decades, potentially cutting nearly a quarter of their economies.2 The public sector isn’t alone. Corporate and household debts, combined with government debt, have nearly doubled as a proportion of GDP since 1980, rising to over 300% for developed economies.3 High debt across multiple sectors can increase risks to growth and financial stability.4

As the payoff gathers pace, debt unwinding could have severe and unpredictable impacts on the global economy, reshaping the business environment for years to come. In this article, we look at how companies can develop a proactive and effective response.

Trigger to unwindDebt itself isn’t necessarily a problem. At sustainable levels, debt can strengthen an economy by providing more freedom for people to consume, opportunities for businesses to invest and means for governments to

Preparing for the payback By Craig Scalise

Could the intense focus on Europe’s sovereign debt crisis be obscuring a bigger question: Are we entering an era of global debt unwinding? In this third article in our Eurozone series, the collective government, corporate and household drive to back the surfeit of debt could create highly disruptive challenges for many businesses worldwide in areas ranging from higher taxes and dips in demand to inflation, devaluation and asset price instability. Companies should think about how to curtail the upheaval and adapt their businesses to a thriftier era.

1 Carmen Reinhart and Kenneth Rogoff, ‘Too Much Debt Means the Economy Can’t Grow’, bloomberg.com, July 14, 2011.2 Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, ‘Debt Overhangs: Past and Present’, National Bureau of Economic Research, Working Paper

18015,April 2012, p. 21.3 Stephen Cecchetti, M S Mohanty and Fabrizio Zampolli, ‘The real effects of debt’, Bank for International Settlements Working Paper, No. 352, September

2011, p. 5.4 Global Financial Stability Report—’The Quest for Lasting Stability’, International Monetary Fund, April 2012, p. 4.5 The Bank for International Settlements determined that economic growth declines when government debt is above 85% of GDP, corporate debt is above

90%, or household debt is above 85%. The analysis states that healthy debt levels, which provide buffers, are well below these limits (Cecchetti, Mohanty and Zampolli, p. 1). An appropriate buffer can be estimated by the 1997 Growth and Stability Pact, which European Union member states negotiated to set the government debt ceiling at 60% of GDP. Based on this, for illustrative purposes considering each form of debt, 60% of GDP is selected as the threshold for entering the debt danger zone, and 90% is selected as the threshold for excessive debt.

provide services and manage crises. But when it gets out of hand it becomes a problem. Recent analyses suggest government, corporate or household debt levels above 90% of GDP are excessive—debts over this level can reduce growth—while debt levels above 60% are in the danger zone.5 Using these benchmarks, Figure 1 highlights how G10 countries as a whole have excessive government and corporate debts. In contrast, emerging market debt seems generally under control for now.


6 Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, p. 21. and Cecchetti, Mohanty and Zampolli, p. 1.

Tightening the knotCountries have worked their way through high debts before. However, today’s economic environment and the widespread debts do not leave a clear path forward.

Solutions to high debt usually begin with growth—bolstering incomes and tax bases to grow faster than the debts. But developed countries are stuck in slow growth. Indeed, studies are showing that debts at their current levels may be part of what’s holding down the growth.6 So pressure to act is mounting. These debts leave little room to absorb shocks in an increasingly volatile world. Electorates are concerned about future generations’ debt

Figure 1: Advanced economies: Troubling debt across sectorsDebt % of GDP (2011)

0

20

40

60

80

100

120

Household***Corporate**Government*

G10

* Gross general government debt (SNA 2008 S13)** Non-financial corporate debt (SNA 2008 S11)*** Households and non-profit institutions serving households (SNA 2008 S14 + S15)

Source: Oxford Economics

Emerging markets

Excessive

Danger zone

burdens. Businesses are concerned about drags on growth.

Countries across the world—and sectors within the countries—will likely be compelled to face debt unwinding soon even if it means making tough choices.

Taking actionGuiding the business through debt unwinding begins with accepting less control over circumstances, while preparing to adapt to the consequences. Key considerations include how to pay down debts where required. Businesses may also need to rethink corporate strategy, finances and operations to deal with the impact on investment and demand.

1. Reducing debt

Options for reducing corporate debt are often quite narrow and vary by country. In many cases, businesses can consider buying back debt if they’re liquid enough or exchanging debt for equity if dilution is tolerable. Defaulting on corporate debt through bankruptcy or writedowns may be an option in extreme circumstances.

2. Strategy

Business leaders should identify possible scenarios and prepare contingency plans. The scenarios should be used to ensure strategy is effective under long-term slow growth and volatility. Strategy also needs to be able to withstand the implications of knock-on or even unintended consequences such as high inflation, competitive devaluations or trade wars. It should account for how government budget cuts impact a business directly or through customers that sell to governments. All the while, it is important to consider how competitors might respond. Examples could include a rush to invest in and hence overcrowding in faster-growing emerging markets.

This is likely to lead to a fluid strategy that’s different from the past. Leadership should try to instill a culture that supports innovation and flexibility.


3. Finance

Finance is at the heart of debt unwinding exposure. Are there assets concentrated in currencies at risk of devaluation or hedging techniques that would fail in high volatility? Shocks like inflation spikes need to be modelled in detail to identify knock-on effects that could disintegrate profits. Tax increases around the world should be considered. Portfolio composition also needs to be reviewed—by 2016, one-sixth of once-safe sovereign debt is expected to no longer be considered safe.7

4. Operations

Companies need to determine which circumstances put their income most at risk, and how they can make up the revenue. What resources should be moved to be most productive in the face of slow growth? Procurement can assess solutions to currency fluctuations that mismatch costs and revenues. Even administrative functions may need to prepare. Some companies have found that IT needs significant planning to support payroll processes if the Eurozone crisis causes currency changes.

Once a business has taken stock of possible debt unwinding scenarios and their exposure to consequences, it can form contingency plans and test them for workability.

How the debt may unwindOne of the most important areas of the scenario planning outlined in the strategy implications earlier is how a particular government moves to unwind debt. This is a controversial area in which the approaches advocated by different countries and the politicians within them vary significantly. Indeed, there may be many changes of tack through the unwinding, heightening the potential for instability and disruption.

The question at the heart of these policy deliberations is how to balance growth and debt reduction. Any path they choose will come with trade-offs, uncertainty and risks.

Governments may reduce debt aggressively if it’s primarily structural. They’re likely to attack it directly by raising taxes, lowering spending or both. Japan has already started down this route by doubling its sales tax to 10%. European countries are taking extraordinary steps to reduce spending, and austerity is on the table for many developed countries with little tolerance for tax increases.

Other common tactics for slashing debt may be of limited use. Some inflation could ease debt burdens, but most countries will not accept inflation high enough to put much of a dent in their debt. Inflation is a

7 Global Financial Stability Report—The Quest for Lasting Stability, p. xi.

Figure 2: High debt rampant in leading advanced economiesDebt % of GDP (2011)

0

40

80

120

160

200

240

Household***Corporate**Government*

Japan

* Gross general government debt (SNA 2008 S13)** Non-financial corporate debt (SNA 2008 S11)*** Households and non-profit institutions serving households (SNA 2008 S14 + S15)

Source: Oxford Economics

Italy

France

US

Canada

UK

Spain

Germany

Excessive debt

Danger zone


particularly weak prospect for countries saddled with foreign debt, relying on exports or holding short-term debt that would require a bigger inflation spike.8 There’s also little room to reduce debts through currency devaluation with so many countries in similar positions.

With these options limited, debt-focused governments are likely to look at less conventional measures. Outright default or renegotiation is unlikely among developed countries that prize their reputations and credit ratings. Incremental measures are more likely. Countries with large public sectors may privatise state enterprises. Another candidate is closing tax loopholes and clamping down on evasion; the UK has been taking effective measures to reduce evasion, but findings show that the 2009–10 cost of fraud to the government was still GBP 20 billion.9

Debt-focused governments face the risk that their tactics as a whole will dampen growth, possibly even to the point of recession. The tactics can also increase volatility if

Craig Scalise is a Senior Macroeconomic Research Fellow in PwC’s Thought Leadership Institute. Previously, Scalise was a director in PwC’s client services and performed economic analysis for multinational companies. Scalise earned an MBA in finance and organisational quality and a PhD in business economics from the University of Chicago. He has authored a book published by the Singapore University Press that analyses intellectual property policy, and the ‘Entrepreneurial Energy—Its Creation and Capture’ series published by Problems and Perspectives in Management. Scalise has also taught at the University of South Carolina.

8 Carmen M. Reinhart and Kenneth S. Rogoff, This Time is Different—Eight Centuries of Financial Folly, Princeton University Press, 2009, p. 111.9 National Fraud Authority, Annual Fraud Indicator, March 2012, p. 11. 10 Global Financial Stability Report - The Quest for Lasting Stability, p.13.11 Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff, p. 20.12 China, for example, is exposed to indebted economies through its exports, 44% of which went to the European Union, US and Japan in 2011 (National

Bureau of Statistics of China, Statistical Communiqué on the 2011 National Economic and Social Development, February 22, 2012).

policymakers do not fully grasp the consequences of unprecedented debt unwinding.

In contrast, governments that believe their debt is largely cyclical may try to accelerate growth now through lowered taxes and/or increased spending so they can address higher debt later. Lowering interest rates may also be an option, but already-low rates may call for unconventional measures that are not as vetted, including quantitative easing, and increase risks like inflation. Governments can also look to measures that bolster competitiveness, like easing labour laws and supporting innovation. A risk is that this focus may be self-defeating if higher debts weaken growth, either directly or by eroding confidence in the economy. This scenario could leave little to show other than inflation and yet higher debts.

A third option for governments is to split their attention between the two targets, but they’d have a limited arsenal for doing so. These countries

may hold tax rates and spending steady while increasing liquidity and focusing on competitiveness. A risk with this approach is that it may increase inflation while missing both targets—failing to jumpstart the economies while letting the debt burdens grow.

Prolonged challengeThese scenarios foreshadow an era of debt unwinding that would challenge the business environment for years to come. In past episodes, which tended to be less complicated, countries experienced weak growth while unwinding household debt for up to 10 years10 or government debt for more than 20 years.11 Other countries that trade with the deleveraging economies could feel the effects.12 Businesses need to take stock of their exposures and be prepared to respond to the consequences of prolonged debt unwinding.


Over the past two decades, EU investors and consumers have helped drive growth in CEE, leaving this region especially vulnerable to the protracted Eurozone crisis. In response to the crisis, governments in the region have been forced to reorient their growth strategies to focus on developing more resilient sectors and attracting investors outside of the EU. In recent months, a new trend has emerged: a move away from reliance on foreign direct investment (FDI) in low-cost labour production toward strategic FDI, emphasising high-quality labour forces, excellent infrastructure and technological support. On the surface, the shift may seem like a minor adjustment of policies that support export-orientated FDI, but it is in fact a strategic turn of the entire FDI framework toward high value-added production.

Opportunities are emerging in the region for investors seeking strategic assets crucial for high value-added sectors. As companies weigh various

investment opportunities, fundamentals such as political stability and a sound regulatory framework will be crucial, as will the capacity of individual governments to implement the institutional and policy changes necessary to build a knowledge economy.

Low labour costs drive investmentWhen CEE economies opened to FDI after the fall of communism, foreign investors enjoyed a plethora of opportunities. The core countries of the EU comprised the region’s primary investors, and they also became the main consumers of the CEE countries’ products and services. German manufacturing companies, most notably car manufacturers and food producers, moved first into CEE markets.

FDI proved to be vital in facilitating the modernisation, restructuring and privatisation of the previously centrally planned economies of CEE

Central and Eastern Europe: Moving up the value chain By Otilia Simkova

With investment from and export markets in the Eurozone stalling, Central and Eastern Europe (CEE) is looking to shift its focus of growth toward higher-value production and services. This is a bold step for a region that has, up until now, relied heavily on low labour costs to fuel foreign investment. In this fourth article, we look at the challenges and opportunities ahead for countries in the region and foreign investors as CEE prepares to carve out an ambitious new economic path.

1 Kornecki, L. (2008) ‘Foreign Direct Investment and macroeconomic changes in CEE integrating into the global market’, Investment Management and Financial Innovations, FM-4-05058, Issue 4.

countries. With this infusion of FDI came new technology and skills, increased productivity and jobs. The winners in this round of FDI competition were the countries with solid manufacturing track records that are located closest to the western EU markets: the Czech Republic, Hungary, Slovakia and Poland. As Figure 1 illustrates, the correlation between real GDP and inward FDI was very strong in the CEE region between 1990 and 2005,1 suggesting that FDI was crucial to economic growth in these countries. These developments encouraged governments to align their regulatory and incentives frameworks toward foreign investors, resulting in regional competition for investment. As a result, CEE countries developed an almost uniform model of export-oriented investment in low-skilled production, including policies focused on infrastructure investment, build-up of industrial parks and incentives for investors in the form of cash subsidies or tax breaks.


Western European investors benefited from the convenient geographical location, comparatively low labour costs, lower overall production costs and high-quality products in CEE economies. Investors’ business strategies typically focused on producing manufactured goods for export. Notable exceptions to this pattern were investments into underdeveloped financial sectors and infrastructure, which, by their very nature, service the domestic market. The CEE countries competed fiercely among themselves for each and every investor, thereby putting businesses in a strong position, with leverage to negotiate the best possible conditions, investment incentives or subsidies from their host governments.

The Eurozone crisis spurs a rethink The 2008–2009 global financial crisis and the ensuing Eurozone sovereign debt crisis have proved that FDI in CEE countries is highly vulnerable to economic downturns. The share of FDI as a percentage of GDP peaked between 2005 and 2007, but has dropped significantly over the past few years. The European economic downturn and the Eurozone crisis have created difficulties for many European companies. Banks have reduced their lending and consumers lessened their

Figure 1: GDP growth and Inward FDI flows

BulgariaCzech RepublicEstonia

Hungary

Ann

ual %

cha

nge

Poland

Source: IMF World Economic Outlook

-15

-10

-5

0

5

10

15

201120102009200820072006200520042003200220012000

Figure 2: Inward FDI flows

Bill

ions

of

US

do

llars

Source: UN Conference on Trade and Development, UNCTADstat

BulgariaCzech RepublicEstonia

HungaryPoland

0

5

10

15

20

25

201120102009200820072006200520042003200220012000


2 Eurostat, Real GDP growth rate.3 Bulgarian Association of Software Companies (BASSCOM), 1 December 2011, press conference, quoted.

demand for goods and services. These circumstances have prompted rapid capital flight from the CEE region and decreased demand for the exports on which these countries’ economic growth models depended. Exports remain subdued at present amid the ongoing turmoil of the Eurozone crisis and FDI has failed to recover substantially as European companies continue to pursue cautious business strategies in an uncertain economic environment. In a sharp contrast to the pre-crisis period, almost all CEE countries currently trend below the EU average in terms of FDI. For companies seeking new investments, this situation creates an opportunity to take advantage of a strong negotiating position as countries once again compete with each other for a limited pool of FDI (see Figure 2).

Moving upHowever, governments across the CEE region are not competing with one another in the same way as before. The Eurozone crisis has spurred them to rethink their FDI strategies. Empirical observation, as well as economic data, suggests that high value-added sectors have been considerably more resilient to the crisis than those relying on low-cost manufacturing. In Bulgaria, for example, the economy contracted from 6.4% growth in 2007 to -5.5% in 2009 and only last year recovered to 1.7% growth.2 However, Bulgaria’s information and communications technology (ICT) sector expanded throughout the crisis, achieving 5% growth in 2011, and its contribution to Bulgaria’s economy rose to almost 10% of total GDP.3 Countries across

Promoting the Czech Republic’s new FDI strategy

The framework of the Czech Republic’s FDI strategy has shifted from low-cost, labour-reliant manufacturing toward high value-added sectors. An incentive scheme introduced in July explicitly promotes technological and strategic service centres. It offers the same advantages in terms of cash subsidies on investment and tax breaks as was previously extended only to manufacturing companies. The Czech Invest Agency’s priority sectors now comprise software and information and communications technology services, business support services, advanced renewable energy and clean technologies, nanotechnology, aerospace, advanced automotive, life sciences, electronics and industrial machinery sectors. The agency’s latest project, Czech Link, is a merger and acquisitions support programme centred on these industries. Publicity material highlights the opening of R&D centres and energy research clusters, as well as the successes of the Silicon Valley–based Czech Accelerator project for innovative Czech start-ups.

And it is not only the Czech Republic making such advances. Its regional peers are undergoing change, too: Slovakia promotes its university-linked centres of excellence, Latvia provides recruitment support for sophisticated business process outsourcing and Estonia is calling for the next EU budget (2014–2020) to focus on the support of smart economic growth.

Figure 2: FDI as % of GDP

EU (27 countries)

Source: Eurostat

BulgariaEstoniaLatvia CEE average

PolandRomania

-4-202468

10121416

2011201020092008200720062005200420032002


the region recorded similar experiences in other high value-added sectors such as custom software development, sophisticated manufacturing, nanotechnology and clean energy technology. Shared experience motivated governments across the region to redirect their FDI strategies and launch new campaigns to attract investors.

This opens up a new round of investment opportunities in the region, as CEE governments aiming to attract capital and generate growth are once again racing to offer the best conditions for foreign firms. Given that governments tend to rely on supply-side measures to motivate export-oriented FDI, investors in high value-added sectors will be able to take advantage of these schemes and measures, and in many cases negotiate additional advantages. Investment incentive frameworks, which have typically been the most widely used supply-side measure in the CEE region, are now being tailored to accommodate high value-added projects—for instance, by reducing the size of eligible projects (since high value-added investments tend to be smaller) and introducing new schemes for small businesses and for cross-border mergers and acquisitions (since high value-added firms are often new and innovative and have steep costs). New industrial parks focusing explicitly on sophisticated business process outsourcing, software development or biotechnology are being constructed throughout the region. And authorities are seeking to highlight these policy changes. For example, investment agencies have switched from stressing low labour costs to promoting the high quality of the workforce (volume of science graduates, high numbers of PhD researchers and advanced language skills of the population). Meanwhile, nanotechnology colloquiums have replaced manufacturing fairs.

Attracting fresh investment These new FDI frameworks face a sizable challenge. Virtually all investment in CEE countries over the past two decades originated in the EU. While CEE governments tend to be the most comfortable with EU investors, the lingering Eurozone crisis is forcing CEE officials to look significantly further afield to capitalise on their newly developed strategies. So firms based outside of the EU may now find investing in CEE economies easier and more appealing, as they will enjoy the same benefits (political stability, quality infrastructure and favourable regulations) as do companies from the EU.

CEE governments are forging relationships with investors in

Bulgaria’s experience highlights challenges

Bulgaria has been setting the pace in seeking alternative sources of investment, as demonstrated by the recent announcement of Chinese investors’ interest in the Burgas industrial zone. Qatari investors, meanwhile, are reportedly considering launching ventures in Bulgaria in areas ranging from agriculture to infrastructure development.

But difficulties remain. Despite the country’s best efforts, Bulgaria’s once stellar ability to attract FDI started to yield strong results again only this year. In the first six months of 2012, the country attracted €810.1 million ($1.05 billion) in investment—still relatively low, but vastly higher than the €273.9 million ($353.34 million) it attracted a year ago. Approaching new investors has proven to be more difficult than building up relationships with existing ones and challenges remain in governance and the rule of law. Bulgaria’s efforts to build new relationships are likely to be rewarded only in the medium term, and require progress on regulatory reforms.

countries such as China, Qatar and Israel. With regards to China, governments are attempting to develop investment relationships with various companies, building on strong (albeit unbalanced) trade relations with Beijing. One of the latest examples is the declared interest of a Chinese investment fund in Burgas, Bulgaria’s fourth-largest city (see box below). CEE countries are also vying to attract Qatari attention. This includes competing to sign cooperation agreements, opening embassies and sending business delegations to the Gulf kingdom. CEE countries are targeting Israel specifically for its expertise in R&D and technology as growth sectors. Thus far, success has been relatively limited, so the impact of new investors in the region is likely to remain modest in the near future.


Investment considerationsBusinesses considering entering or strengthening their presence in CEE markets should take account of the differences in the foreign investment environments across the region. In general, CEE countries compare very well with other emerging markets when it comes to setting the preconditions for the development of high value-added sectors. A highly educated workforce is perhaps one of the most important qualities of the CEE labour market, which boasts some of the highest tertiary enrollment rates and researcher headcounts in the world.4 In addition, the growth of labour productivity in the region has outperformed that of most of the rest of the world in the past two decades. And general political stability and reliable infrastructure provide basic preconditions for successful business operations. Yet firms operating in the region will find that CEE countries share a common weakness—underdeveloped financial markets—and that modern technologies have only a limited impact on the development of business and organisational models in these states.

Despite these commonalities, CEE countries differ in many ways that potential investors should be aware of when assessing investment decisions. Regulatory quality and governance will remain key factors in investment decision-making for all businesses interested in the region. The regulatory environment and rule of law are most problematic in Romania and Bulgaria. The existing FDI base is also a major factor, as investors are more likely to roll out high value-added manufacturing in markets where this type of work has already been established.

Investors should also be aware of the strengths and weaknesses of various CEE countries with regard to different high value-added industries. As the innovation index in Figure 3 highlights, Estonia is, for instance, typically credited for fostering successful high value-added development in the region. The country deserves its high rankings for ICT services and software development. And Estonia’s internet connectivity and creativity in developing online content remain unrivalled in the CEE region. Estonia, nonetheless, has the lowest number

Figure 3: Global Innovation Index 2012 rankings

Estonia 19

Slovenia 26

Czech Republic 27

Latvia 30

Hungary 31

Lithuania 38

Slovakia 40

Bulgaria 43

Poland 44

Romania 52

Note: The Global Innovation Index ranks 141 countries worldwide, based on innovation as a driver of economic growth.Sources: INSEAD and the World Intellectual Property Organisation (WIPO).

4 Source: World Bank, ‘School enrollment—tertiary’, UNESCO Institute for Statistics.


Figure 4: High value-added sector development in CEE

Turkey PolandCzech

Republic Romania Hungary Slovakia Bulgaria Estonia

Advanced automotive

Aerospace

Renewable energy

Electrical engineering

Mechanical engineering

Biotechnologies

Life sciences

Nanotechnologies

Pharmacy

Software development

Software services

Sophisticated business process outsourcing

High Well-developed industry Medium -Developing industry Low Potential to develop industry

Source: Eurasia Group research

Man

ufac

turi

ngR

& D

Ser

vice

s

of science-related graduates in the region and lags behind some of its neighbours in healthcare-related sectors such as pharmaceutical development and laser optics equipment manufacturing. Slovenia lags behind Estonia’s emerging strength in software, but it leads on R&D in terms of numbers of researchers and expenditure as a share of GDP. At the same time, the Czech Republic has been building on its traditional strength in engineering and applied science, placing emphasis on the development of new capacities in sectors such as nanotechnology and aeronautics. Latvia excels in environmental and sustainability projects, and Slovakia at advanced automotive manufacturing; Lithuania positions itself as a regional leader in life sciences and laser optics, and Romania is a leader in the area of environmentally friendly production.

In the competition for FDI opportunities in the CEE region, investors in high value-added sectors can benefit from governments’ policy redirection, as well as individual countries’ existing strategic assets. But to make the best of these emerging opportunities, strategic planning and decision-making should be supported by a detailed analysis of the specific political risks and regulatory environments of individual countries, as their characteristics differ across sectors. Even though the Czech Republic and Estonia are currently the front-runners for investor attention, other countries in the region can provide better operating environments in particular sectors (for example, it would be difficult to place a metallurgical research facility in Estonia). Moreover, companies looking to invest in the CEE region may find that the countries lagging

just behind the front-runners can offer similar assets at a lower price or with added incentives for investors. In this regional competitive environment, the search for the best opportunities is likely to lead businesses beyond the obvious choices.

In conclusion, the strong fundamentals of political stability, a well-educated workforce and governments’ keenness to support incoming investment have opened up a valuable window of opportunity for technology and other high value-added businesses. Targeting is going to be crucial, with particular countries offering specific expertise. And in this fast-moving and highly competitive investment environment, the most attractive opportunities may be found among the up-and-comers rather than just the front-runners.


Figure 5: CEE countries have increasingly educated labor forces

Bulgaria

0%

10%

20%

30%

40%

2010200920082007200620042003200220012000

Czech RepublicEstonia

HungaryPolandRomaniaSlovakia

2005

Note: Graph shows the percentage of the total labor force with a tertiary education.


Otilia Simkova is an analyst in Eurasia Group’s Europe practice, focusing on Central and Eastern Europe. She previously worked at the Economist Intelligence Unit, specialising in global indexes research. Earlier in her career, Simkova advised corporate clients and investors at the Slovak British-Business Council and Premier Consulting’s UK firm. Simkova holds a master’s degree in Russian and East European studies from the University of Oxford, St. Antony’s College. She also earned a bachelor’s degree in international relations and diplomacy at Matej Bel University in Slovakia. Simkova is currently completing a PhD in the geopolitics of Central Europe at King’s College London.

Agriculture

-5%

0%

5%

10%

15%

20%

Per

cent

gro

wth

Industry Services

Bul

garia

Cze

ch R

epub

lic

Est

onia

Hun

gary

Latv

ia

Lith

uani

a

Rom

ania

Slo

vaki

a

Slo

veni

a

Source: World Bank World Development Indicators

Figure 6: Services and industry increasingly dominate CEE economies


Sustainability is now firmly on the corporate agenda in China. This is reflected in the development of Environmental Health & Safety (EHS) Guidelines, corporate social responsibility (CSR) reporting, energy conservation and emissions reduction (SOx/NOx/water contaminants) and greenhouse gas (GHG) reduction programmes.

Moreover, there is growing consensus that actions to date have not been nearly ambitious enough to tackle the environmental challenges the country faces. This is spurring the Chinese government to accelerate the pace of change with the introduction of new policies, regulations and initiatives. The government push is creating a truly dynamic and evolving market for companies operating in China, in which risks and opportunities go hand in hand. Companies that are adaptive and resilient will be able to respond quickly and positively to the new requirements of this market, and survive and grow. Those that don’t will find themselves marginalised by the operating requirements of the green economy and thus in danger of falling behind.

Reaping the benefits of a greener China By John Barnes

The Chinese government is determined to create a greener path to growth. Companies that are slow to respond could be at risk. But organisations that embrace change and the environmental businesses that move in to support them could gain a valuable competitive edge. More broadly, the success of China’s environmental drive could be crucial to sustainability worldwide. So how can corporations navigate through this new phase in China’s development, and what are the implications for global environmental policy?

The focus on sustainable business in China is being driven by both domestic and international considerations. Domestically, growing environmental problems, fears over energy security and social unrest emanating from health, food security and other environmental concerns have resulted in much greater awareness among both policymakers and the general public of the implications of unsustainable business operations on the country’s citizens and its environment. Internationally, pressure brought to bear on multinational companies (MNCs) in their home markets is being felt right across the global supply chain, including in the ‘factory of the world’—China. For many MNCs, this means embedding change across their whole operations, including China. This is having a knock-on impact on Chinese companies. At the very least, their continued licence to operate is going to depend on their ability to defend their reputations and respond to both peer and market pressure to adopt more sustainable business practices.

Striking out on a new pathIn many respects, the largest challenge for China in making the shift to a green, sustainable economy is that the country will need to tread a new pathway to get there. For the first time, there is no defined road map for China to follow and instead it must strike out at the same point as other countries in defining the rules for sustainable economic growth. Choosing ‘growth first and clean up later’ is no longer an option. Instead, China has to increase efficiency and de-carbonise itself while continuing to industrialise. With the largest population in the world and second-largest economy, the pressure on China to succeed at this transformation is immense.

The price of failureIf China fails, the environmental implications for the rest of the world are immense. The country’s ever-increasing energy use, together with its position as the world’s biggest greenhouse gas emitter, will have a huge impact beyond its own borders and will have a key influence on the world’s ability to limit global warming.1 Moreover, if China fails, the progress made in many developed countries may lose some of its positive impact as their sustainability success is partly due to shifting their polluting industries

1 Vicki Ekstrom, ‘Report: China’s actions are crucial on climate change’, MITNews, May 24 2012.


offshore, to China and other developing nations. If China is not able to address the detrimental impact of these industries on the environment through the development and enforcement of effective policy and regulation, then its environmental problems will become the world’s problems. There is also the danger that China may take a similar approach to that of the West as it expands investment into Africa and other developing countries.

The prize for successHowever, if China’s ambitious plans succeed, this could create a model of sustainable economic growth that can be mirrored in many other developing nations. As China makes continued progress in diversifying its energy mix, innovating with green technologies, implementing laws and regulations around pollution control, and moving its manufacturing sector up the value chain, it will stand as a great example for many other developing nations on how to achieve sustainable economic growth, and how to avoid pitfalls.

Monitoring and enforcementMaking rules and regulations is one thing. Making sure they are enforced is another.

China has no shortage of environment-and sustainability-related policies, regulations and legislation. These stretch from environmental laws focusing on air, water and waste, energy efficiency, renewable energy and carbon intensity targets in the country’s Five-Year Plans (FYPs), to green finance guidelines, CSR reporting recommendations and numerous locally announced regulations. Multiple layers of central, provincial and municipal governments are

involved in developing and implementing policy and regulations. On paper they form a complex yet fairly well-defined regulatory system covering most aspects of sustainability and good environmental practices. While the regulatory landscape continues to evolve and gain greater definition, the key problem associated with the Chinese regulatory environment is not one of policymaking. Rather the challenge lies in how these policies are implemented and enforced, the effectiveness of which will be crucial in generating significant and sustainable behavioural change within companies.

Taking the energy-efficiency targets of the FYPs (the box below explains the role of these crucial policy frameworks) as an example, little information is given in terms of how the national target is to be split and allocated across provinces and cities and even further down to the industry or sector level. Nor is there any detail as to how the government will measure and monitor the achievement of these targets or penalise missed goals. This is particularly troublesome for foreign companies, as many of them don’t know what targets they should be trying to meet. The fluidity of the enforcement process can also mean that loosely defined targets announced in one year may become more rigorously and retroactively enforced in the next. The Chinese government is beginning to address this problem. The Ministry of Environment (MoE) recently established four regional Supervision Centres for Environmental Protection, specifically targeting improvements in the monitoring and evaluation of environmental regulation implementation. However, the lack of clarity that remains in the market still requires companies to

have appropriate contingencies built into their business plans to manage possible regulatory risk exposure. Looking into the future, it is expected that the regulatory environment supporting sustainability considerations in China will continue to mature rapidly, requiring companies to foresee upcoming changes and consider the corresponding risks strategically when making business decisions. For instance, while China currently does not have a soil contamination law, draft legislation has been under review by the State Council for several years and is likely to be published soon. Companies acquiring new land will need to consider soil contamination risks during the due diligence process and correctly reflect this in the deal structure at the time of contract. Otherwise they may face the possibility of significant compliance costs as a result of pollution liability once the law is announced.

China’s Five-Year Plans

China’s Five-Year Plans (FYPs) are blueprints laid out by the central government setting out its overall objectives and goals as they relate to social and economic growth and development, and industrial planning in key sectors and regions. As their names suggest, they are issued every five years, with those announced in early 2011 being the 12th cycle of FYPs. These documents reflect the complex process of Chinese policymaking and contain hundreds of targets, objectives and initiatives, all of which undergo continuous revision, refinement and review throughout the five-year cycle.2

2 ‘China’s 12th Five-Year Plan: How it actually works and what’s in store for the next five years’, APCO Worldwide, 10 December 2010.


Political spotlightChina has been in the spotlight of global climate change debates since it overtook the US as the largest greenhouse gas emitter in the world a few years ago, and is increasingly playing a pivotal role together with other BRICS (Brazil, Russia, India, China, South Africa) countries in international climate change negotiation. The global negotiation process lost some momentum following COP15 in Copenhagen in 2009 when the gathering failed to achieve hoped-for globally binding commitments on emissions reduction. But since then China has become much more active and open in tackling domestic climate change challenges. Actions of note include the announcement of a carbon intensity target to be achieved by 2020, together with ambitious shorter-term energy efficiency and renewable energy targets in the 12th FYP; the development of more than a dozen low-carbon cities and zones were kicked off; seven carbon market pilots will start trial runs next year and a carbon tax may also be announced within the next three years; and, finally, a climate change law is also under development.

All this progress has huge implications for business. The heyday of emissions-cutting Clean Development Mechanism (CDM) projects may have passed, but the knowledge and know-how gained through their development in China about carbon accounting, verification and trading have been hugely beneficial. Many Chinese companies have started to develop in-house carbon trading capabilities and are building their carbon emission inventories in preparation for the upcoming carbon pricing mechanisms. Renewable energy, energy efficiency and low-carbon

technology industries are taking advantage of preferential policies and incentives to grow quickly in China, attracting foreign investors, service providers and customers. In the long term, climate change-related sectors will be an area of growth in generating business opportunities for both Chinese and foreign players.

So too will the ambitions of the Chinese government in moving up the value chain—moving away from an economic model dominated by labour-intensive manufacturing industries and developing more value-added industry sectors, which can contribute to the government’s goal of a harmonious economy. President Hu Jintao has stated ‘economic growth should not be achieved at the expense of the livelihood of people and the environment’. And, more recently, the president has emphasised the importance of resource conservation and environmental protection in China in his talk at the opening of a provincial and ministerial officials training workshop in July 2012,3 all of which demonstrates a clear shift in direction, right at the top of government.

However, climate change will continue to be a controversial political issue in China, at least until a legally binding global agreement is reached post-Kyoto. The National Development and Reform Commission (NDRC), one of China’s leading policymaking agencies, holds most power with respect to climate change-related issues and is reluctant to concede this influence to other departments and local government. China will continue to emphasise ‘common but differentiated responsibilities’ with respect to its climate change responsibilities and is unlikely to approve any aggressive actions at sector or local levels,

concerned they may jeopardise its negotiating position. The recent Civil Aviation Administration of China (CAAC) ban on Chinese airlines taking part in the EU Emissions Trading Scheme is a clear signal. Foreign companies operating in or entering China need to consider such political risks. This includes how they may be treated under new climate change-related initiatives. For example, Will the government allow foreign players to enter the domestic carbon market as verification or advisory service providers? Will foreign businesses’ low carbon products and services be eligible for preferential policies and incentives? Will their GHG emissions be included in any of the carbon market pilots? In the long run, there are certainly significant business opportunities, and those companies entering early and anticipating and managing the political risks well are likely to enjoy strong competitive advantages.

Public scrutinyNon-governmental organisations (NGOs) haven’t had a big impact on the policymaking environment in China. Until recently, there were only a handful of officially registered NGOs throughout the country. But the power and energy demonstrated by Chinese NGOs and volunteers during the Wenchuan earthquake in 2008 means that NGOs are seen in a new light. Since then, the government has become more attuned to the beneficial role NGOs can play in society and consequently relaxed their grip on the NGO community to some limited extent, enabling the establishment of many new grassroots, environmentally focused NGOs. In addition, much improved public awareness regarding sustainability and greatly accelerated information flow thanks to social media have led to growing public

3 ‘Chinese president urges unswervingly carrying forward reform, opening-up’, Gov.cn. July 23 2012.


scrutiny of businesses and their environmental performance. NGOs have played significant roles in identifying and raising public awareness about pollution scandals and monitoring the cleaning process. Chinese companies are finding it harder to ignore their obligations to the local communities in which they operate and are increasingly being forced to address social and environmental concerns as part of their business operations.

NGOs in China potentially have an even bigger role to play in sustainable supply chain management, as so many globally reputable brands source their products from China and are under constant scrutiny from international customers. While they may be able to exempt themselves from legal liability in instances of a breach by one of their suppliers, they are no longer able to avoid reputational damage and the impact of lost business. There are very few companies globally that don’t have a link—large or small—through their supply chains into China. To manage this element of their business well, traditional supplier audit and compliance programmes are not proving comprehensive enough to adequately cover the myriad social,

ethical and environmental considerations that businesses must now factor into their operations. Companies now have to work closely with their suppliers, and even contemplate collaboration with their competitors, to collectively improve a supplier’s performance and help them drive change down to their secondary and tertiary subcontractors. The challenges of sustainable supply chain management are heightened by the fact that many suppliers are already operating on very thin margins and any additional compliance requirements may be beyond the feasibility of their existing business model, creating incentives for non-compliance.

On the front footAs an emerging risk in an emerging economy, sustainability risk management for businesses operating in China needs to be dynamic and considered comprehensively from identification and assessment through to mitigation. The key to success is collaboration, particularly for MNCs. They should seek to actively engage in the policymaking process and work closely with local business

John Barnes is Head of Sustainability & Climate Change services for PwC Hong Kong and China. Originally from the UK’s south coast, he moved to London in the mid-‘80s and after a number of jobs in government and transport, he moved into the financial services sector before joining an international accounting firm. Following a stint in London and Australia he spent almost eight years in Hong Kong before joining PwC in Beijing in 2005. He is passionate about sustainability and climate change and believes that while energy saving and reduction measures are essential, as we move into 2020 and beyond, adaptation will become a critical success factor for business survival.

partners. It is also important for them to interact with NGOs, government agencies and other key stakeholders so that they can understand and contribute to the development of sustainability best practices in China, while at the same time being able to stay on top of the highly unpredictable and volatile risks. Many MNCs with global sustainability programmes may need to give more autonomy and flexibility to the local team in enabling them to play a key role in adapting global programmes to local needs. Many globally designed sustainable supply chain programmes or codes of conduct are not necessarily appropriate to the local situation, and local sustainability teams are often relegated to the role of implementer with limited say in the development of the strategic programme. This can create a gulf between central and local risk management.

Sustainability risks and opportunities are increasingly important to business performance. Businesses that act quickly and proactively will improve operational efficiency, enhance their reputation and reap the business benefits.


The rise of SAAAME: Rethinking risk in a multipolar world By Andrew Dawson

The rise and interconnectivity of the emerging markets of South America, Asia, Africa and the Middle East (together these regions form what PwC terms ‘SAAAME’) is creating a new set of opportunities that transcend conventional notions of risk and reward and are likely to demand a rethink of business and organisational models. The most pressing of these risks is that of being cut out of the commercial loop as trade flows increasingly bypass developed market centres. This article considers how businesses can adapt to the realities of a very different global marketplace in the quest for competitive advantage and the role of financial services organisations in supporting them.

How quickly conventional wisdom can change. Forty years ago, a world dominated by two polarised economic and political systems looked set to endure indefinitely. By the end of the century, the Cold War had given way to a seemingly mono-polar world, with a technologically pre-eminent America at its economic summit.

The world we see today is, for many, quite new and possibly bewildering. While economic growth in mature developed markets is slowing, SAAAME markets are surging ahead. Many commentators are focusing their attention on what are considered to be the largest and fastest-growing BRIC markets (Brazil, Russia, India and China). But the broader regional economies that surround these countries are also undergoing an economic renaissance.

So what are the defining features of a global economic order with SAAAME at its apex? First and foremost, what we’re seeing is nothing new. Western economic dominance is a relatively recent phenomenon and today’s developments are essentially a rebalancing of the global economies.

What do we mean by SAAAME?

‘SAAAME’ refers to South America, Africa, Asia and the Middle East. SAAAME doesn’t include Japan, as this is a large G7 developed economy. Mexico is excluded, as it trades mainly within the North American Free Trade Agreement zone and less with SAAAME. For now, Russia and the Commonwealth of Independent States (CIS) are also excluded from SAAAME, as trade is largely internal or with Europe.

Figure 1: Generating talent for further growth

Sources: QS University Rankings; The Times; PwC analysis

Asian universities, excluding Japan, within the top 200 of the QS world university rankings, 2004 and 2011

Total graduates in all tertiary education programmes, 2004 and 2009

China

2004 2009

Brazil Indonesia Thailand Mexico Saudi Arabia


Collectively, SAAAME makes up the lion’s share of the global population and land mass. SAAAME also has substantial manufacturing capabilities and access to the labour to support this, large and growing consumer markets, and a sizeable pool of both educational establishments and well-educated professionals (Figure 1 shows how both the number and quality of university graduates within many SAAAME markets have risen on the back of the rapid economic expansion in recent years).

But we believe the real issue is not so much the speed of economic growth within the SAAAME markets, but how interconnected the trade flows between them have become. Trade between the SAAAME markets is growing much faster than the developed-to-developed and developed-to-emerging market flows (see Figure 2). At present, these intra-SAAAME flows are dominated by commodities. A telling example of the impact is the fact that China is the fastest-growing customer for Saudi Arabian oil and now vies with the US as the kingdom’s biggest oil market.1

As affluence continues to expand (see Figure 3), the pattern of trade will be increasingly focused on manufactured goods. The trading relationship between China and

1 Financial Times, 28.09.11.

Figure 2: World trade flows, US$ trillions, 2010

Figure 3: Rising middle class

Sources: United Nations Population Division; World Bank World Development Indicators and PwC analysisNotes: GDP per capita is in constant 2005 US$

Sources: WTO; PwC analysisNotes: Russia and the Commonwealth of Independent States (CIS) have not been included in the SAAAME definition because trade is largely international and/or with Europe. Mexico is excluded as it trades mainly within the North American Free Trade zone and less with SAAAME. Both areas remain very important growth markets and should be considered in relation to the SAAAME region.

GDP per capita growth, compound annual growth rate, 1980-2010

Population growth, CAGR % 1980-2010

SAAAME Non-SAAAME

Trade value: $6.92trCAGR 2002-10: 8.0%




Non-SAAAME

SAAAME


Brazil exemplifies the growing interconnectivity of SAAAME. China has now overtaken the US as Brazil’s biggest trading partner, with trade growing exponentially in recent years (see Figure 4). In turn, SAAAME corporations are becoming leading multinational players as they expand across SAAAME and non-SAAAME markets.

Opening up new opportunitiesSo what opportunities does this changing order open up, what are the potential threats to today’s dominant global businesses and what kind of enterprises are going to come through stronger?

Our analysis of the strategic implications of the rise and interconnectivity of SAAAME markets has centred on how this will affect financial services organisations, the main focus of this article. But we’ve also been looking at the implications for their corporate clients, and many of the challenges and opportunities are common to all sectors.

Businesses from around the world are naturally looking at how to strengthen their presence within fast-growth markets and tap into the evolving patterns of trade. Financial institutions that can develop the

Figure 4: Ever-closer ties between China and Brazil

geographical reach and service capabilities needed to follow their clients into new markets will be in the strongest position to attract and retain customers and develop new sources of revenue. While some institutions are looking to exit from ‘peripheral’ markets that do not meet their immediate return objectives, others are seeking to extend their international coverage in recognition of its importance in sustaining client relationships and enhancing performance.

The kind of support financial institutions might be looking to offer includes finance to help clients set up manufacturing facilities and then support for the infrastructure and other developments needed to build demand in local markets. A typical example would be an electronics company setting up a factory in one of the frontier African markets. Smart businesses and their financial services partners are not just looking at the potential for low labour costs, but also how to make the most of the untapped market on their doorstep.

Source: Secretariat for Foreign Trade (SECEX)/Ministry of Development, Industry and Foreign Trade (MDIC).


Jostling for positionThe snag is that foreign entrants are locked out from many parts of the larger and more developed of the SAAAME markets. The difficulties of gaining entry are especially pronounced within financial services. There may be restrictions on licences or foreign ownership. India and China are examples of this. Even if not, some of the acquisition prices are prohibitive. Brazil is an example of this. So a lot of forward-looking financial institutions are going to be looking at the smaller and less saturated markets. For example, trade flows into and from Africa are growing rapidly. This suggests that participating in some key African markets early could provide an important foundation for future growth.

For SAAAME financial services (FS) groups, simply relying on domestic growth is not enough. They also need to find ways to follow their customers and tap into the most valuable trade flows. Some are extending their reach into other emerging markets. But most are taking a fairly cautious approach to international expansion. When you think how big many SAAAME FS groups have become in terms of assets, this is rarely reflected in their international presence. If they stand still, they could quickly lose out to more ambitious competitors. There is a transformational window of opportunity here, but it may be short-lived.

The bulk of the cross-border acquisition and expansion of SAAAME financial institutions has so far been within their home regions. But if SAAAME institutions do become more ambitious in their international expansion plans, their Western counterparts could become targets for acquisition. Western

businesses could be especially attractive to SAAAME giants that are looking to acquire the technology, product expertise or management experience that would allow them to compete on the global stage. Takeover prices in some developed markets are generally favourable for now, especially within the mid-market, but may not be so for long.

New and unfamiliar risksThe rise and interconnectivity of SAAAME also opens up a new and possibly unfamiliar set of risks. The direct risks posed by the increasingly interconnected global economy were highlighted by the $12 billion of losses from the Thai floods of 2011,2 which were concentrated in an area that had seen a rapid rise in international component production in recent years. The losses are not only telling in their overall scale, but also the significant impact of supply chain and business interruption claims coming from other countries, notably Japan.

Beyond the immediate loss potential is a longer-term risk of marginalisation for corporations and financial institutions that fail to keep pace. As more and more commerce flows between the world’s fastest-growing economies, a significant amount of trade is bypassing the West. Western businesses need to find ways to tap into this intra-SAAAME commerce or risk being cut out of the loop. While SAAAME enterprises, financial and otherwise, are nearer to the focus of global growth, they too could lose out if they fail to follow the most valuable commercial flows. In the case of banks, if they can’t offer the trade finance, acquisition support and other services clients need to develop their business internationally, their customers will switch to institutions that can.

As a result, both Western and SAAAME businesses are going to be extending their reach into new and unfamiliar markets where they will need to contend with varied and possibly limited risk data, legal systems and regulatory frameworks, along with the potential for political instability and very different business practices. Businesses may also face licensing or ownership restrictions, requiring them to operate with an ever-growing array of local partners (both within the financial sector and beyond). Getting on top of these risks is one of the biggest considerations for organisations looking to expand within SAAAME.

The underlying risks are organisational as companies seek to develop the governance systems and flexible capabilities needed to operate across more extended lines of command. They will also need to secure enough talent to meet their objectives in markets where qualified people may already be in short supply.

Strategies and risk management systems developed in the West may no longer be relevant in these rapidly changing market conditions. Equally, domestically focused SAAAME institutions may lack the international experience to deal with the complexities and ambiguities of these new market demands.

Shaping the futureThe rapidly changing global environment necessitates a longer-term and more proactive approach to strategic planning. While it’s vital to consider the risks and opportunities in the short term, it’s equally important to develop a clear articulation of how markets and customers are changing and how the business can turn these changes to its

2 Swiss Re Sigma ‘Natural catastrophes and man-made natural disasters in 2011’, 28.03.12.


advantage. Organisations that merely react to market changes and risks as they arise will perhaps face the greatest risk of all—of being no longer relevant to their customers.

Companies will need to explain to investors how their risk profile and risk appetite are likely to change. More comprehensive and effective risk evaluation and pricing will allow investors to target particular risk and reward profiles with greater precision and differentiation. Relations with government, the media and society as a whole are becoming more important as the state plays a central role in economies and the reputation of the institution comes to underpin its shareholder value and licence to operate.

Rethinking strategiesA key priority is determining how these evolving risks are likely to interact and therefore assessing the impact on existing business models. The corresponding priority is how to price the risk, with the guiding principle likely to be ‘every risk is an opportunity as long as it’s priced correctly’. For example, moving into a new frontier market would provide an important foundation for future growth as intra-SAAAME trade flows continue to expand. As a relatively under-developed market, the acquisition costs and opportunities to build market share may be more favourable than in a more prominent SAAAME market such as India or Brazil. For financial institutions, the corollary of this limited development is that there may be scant risk data upon which to price insurance, credit and acquisitions. As a result, new qualitative pricing approaches are likely to emerge to augment quantitative evaluation. In these markets, financial institutions are also going to need new approaches to collateral and recovery in the absence of enforceable legal redress. Within

inter-state relations we’ve already seen deals in which infrastructure investment is dependent on the delivery of materials. While this may be at the extreme end of what a company could enforce, there may be opportunities to enhance the links between investment and repayment.

Across all markets, ‘big data’ analysis offers opportunities to price risks and target customers with greater precision. Big data refers to all the huge and increasing amounts of information that are exchanged every day, most of which go unused. Openings for differentiation include new techniques being developed to extract risk and customer profiling data from the unstructured purchasing, social media and other digital trails people leave.

New risk identification, pricing and mitigating mechanisms will lay the

Project Blue: The forces shaping the future

The impact of the rise and interconnectivity of the SAAAME markets is one of the transformational trends explored in PwC’s Project Blue framework (www.pwc.com/projectblue).

Project Blue considers the forces that are reshaping the global economy and transforming the behaviour of consumers, businesses and governments (see Figure 5). The framework is designed to help businesses assess the strategic implications of these developments for their particular organisation, recognising that what may be a threat for one is an opportunity for another.

The framework begins with the considerations needed to adapt to the current instability. It then goes on to assess what businesses need to do to plan for, and ideally take advantage of, to capitalise on the changes ahead. A key area of focus is the extent to which these developments could disrupt existing business models. We’ve also been looking at how these trends are feeding off each other. A clear case in point is the extent to which rapid growth in emerging markets is spurring a mass influx of people into the cities, which in turn is driving the infrastructure, housing and environmental challenges this presents.

foundations for a very different risk value chain from the financial risk focus seen at present, changing how risk is perceived, how the market is segmented and the kind of opportunities businesses are prepared to pursue.

Out of risk comes opportunityAs the global economy evolves, a sharper —and more strategically focused—risk value chain is going to be crucial in both managing the dangers and capitalising on the opportunities that competitors may miss or be reluctant to pursue. In future editions of Resilience and as part of our Project Blue series, we will be looking at specific aspects of the new risk landscape, the implications for particular businesses and the openings they present.


Andrew Dawson is a senior strategist within PwC’s Financial Services practice and the author and global leader for Project Blue, PwC’s framework for assessing the implications of operating within a rapidly changing global environment. Dawson has consulted on the topic with a number of board members, management teams, government entities and senior officials around the world and spoken at several large events and conferences (including a PwC event hosted in Davos 2012 during the World Economic Forum Annual Meeting).

Pla

nA

dap

t Global and local instability

Regulatory Fiscal Political and social Commercial

Rise and interconnectivity of the emerging markets (SAAAME)

Demographic change

Social and behavioural change

Technological change

War for natural resources

Rise of state-directed capitalism

• Economic strength• Trade• Foreign direct investment

• Capital balances• Resource allocation• Population

• Population growth discrepancies

• Ageing populations

• Changing family structures• Belief structures

• Urbanisation• Global affluence• Talent

• Changing customer behaviours - social media

• Attitudes toward financial institutions

• Disruptive technologies impacting FS

• Digital and mobile

• Technological and scientific research & development and innovation

• Oil, gas and fossil fuels• Food and water• Key commodities

• Ecosystems• Climate change and

sustainability

• State intervention• Country/city economic

strategies

• Investment strategies• Sovereign wealth fund/

development banks


Figure 5: Project Blue framework


In June of this year, Rio de Janeiro played host to tens of thousands of politicians, business leaders, non-governmental organisation (NGO) activists and journalists from around the world for the ‘Rio+20’ summit.

The original Earth Summit in Rio in 1992 had set in train global agreements on climate change and biodiversity. But the economic climate in Europe and elsewhere provided a difficult backdrop for those with optimistic ambitions for the outcome of this year’s Rio+20. Activists spoke of ‘10 years to save the planet’, but for many politicians, saving the euro was perhaps a more urgent issue.

Perhaps inevitably, the end result was a disappointing compromise. The document that was finally signed off, ‘The future we want’, covered a wide range of issues, but lacked ambition and detail. The NGO community, in particular, was vocal in its criticism of the process and the outcome; one group of prominent NGOs countered with their own take on the outcome—‘The Rio+20 we don’t want’.

Creating the future we desire: Reflections on Rio+20 By Richard Gledhill

The Rio+20 UN Conference on Sustainable Development highlighted businesses’ growing commitment to sustainability. But with environmental challenges taking a backseat to economic ones within many governments, could green growth slip back from a lack of political will?

Success or failureHas the perceived failure at Rio exacerbated sustainable development risks, or was it just a milestone on the long road to addressing these? It is probably too early to tell. As previous summits have demonstrated, it isn’t always easy to judge the true impact until a little while after the event.

When rating the success of Rio+20, it is also important to note the developments beyond the formal international process, on valuation and reporting, on governance and risk management, on avoiding deforestation and building natural capital. This is perhaps what Rio did best, spurring and showcasing bilateral activity, partnerships and commitments—‘bottom-up’ actions to complement and sustain ‘top-down’ declarations from the UN process.

One of the other encouraging aspects of Rio+20 was the level of private sector involvement at the conference. Few companies attended the first Earth Summit. But with 1,400 private sector representatives, the Rio+20

Corporate Sustainability Forum drew the highest level of participation from the business community of any UN conference.1 Sustainability is now a strategic issue for business leaders, and some of the most exciting initiatives in Rio were prompted by the corporate sector. The central role that the private sector has to play in delivering sustainable development was even recognised in the final communiqué.

Among the pledges was a commitment from Microsoft to achieve carbon neutrality through offsetting actions. Unilever launched a drive to halve the greenhouse gas impact of their products, and Nike’s target was zero discharge of hazardous chemicals along its entire supply chain, both by 2020.2

The importance of sustainability goes beyond reputation. With competition for natural resources increasing and energy and raw materials prices proving increasingly volatile, the need to develop a more sustainable future makes clear business sense.

1 UN Global Compact media release, 16.06.12.2 UN Global Compact media release, 18.06.12.


There was some disquiet among many G77 developing nations at the Rio+20 summit that ‘green growth’ means ‘less growth’. But as Ban Ki-Moon, UN Secretary General, said earlier in the year, ‘We cannot burn our way to prosperity. Providing sustainable energy to all offers benefits for developed and developing countries alike. It can also enable developing countries to leapfrog over the energy systems of the past and build the resilient, competitive, clean energy economies of the future.’3 And as the article in this edition, ‘Reaping the benefits of a greener China’, notes, President Hu Jintao of China has stated that

3 Address by the Secretary General of the UN to the UN European Sustainable Energy Summit, 16.04.12.

Richard Gledhill leads PwC’s global climate change network. He specialises in climate policy, carbon markets and climate finance. Gledhill advised on some of the earliest, largest transactions in the Clean Development Mechanism and has remained active in the carbon markets, advising developers, governments, funds and investors. He has also advised a number of donor governments and multilateral agencies on climate finance, in particular on REDD+ and green growth. He is a member of the Network Council of the Climate & Development Knowledge Network. He is responsible for the annual survey of carbon market sentiment conducted by PwC on behalf of the International Emissions Trading Association.

‘economic growth should not be achieved at the expense of the livelihood of people and the environment’.

This engagement by the private sector may help to sustain progress through difficult political and economic times. But the message from the private sector at Rio was very clear. Governments need to provide the context for private sector action and investment through coherent, long-term policies, effective regulation and strong leadership. For businesses trying to drive the sustainability agenda, this is the future they want.


A remarkable gathering occurred in June 2012: PopTech Iceland: Toward Resilience. The PopTech conference is a ‘global community of innovators working together to expand the edge of change’ (poptech.org). The ambitious goal of this event was to develop an understanding of why some people and systems are more resilient than others.

It is not difficult to see why resilience is so important in the upheaval and uncertainty of the modern age. But, as PopTech Iceland highlighted in one of its central themes, we are failing to grapple with these challenges. The clearest instance of this failure to prepare for our future may be the thin, patchy ice at the top of the planet. The last great ice melt ushered in the current era of human civilisation. Will the current melt usher in the next?

The question is no longer whether this is happening, but why is this happening? The current resource-intensive model of perpetual growth in a closed system, failure to internalise externalities1 and mispricing of ‘extreme’ risks’2 has resulted in a world where no country is achieving the minimum criteria for sustainability (see Figure 1), that is to say, achieving the minimum human development threshold within the ecological boundaries of our single, inhabitable planet. The challenge is amplified by the forecast population increase by mid-century to more than 10 billion people, which will reduce the available ecological footprint from around 2 hectares per person to just over 1.3 The acceleration of urbanisation, with up to 75% of all people living in cities by mid-century,4 places even greater stress on resources. People in cities use

Anticipating disruption: Reflections on PopTech By Scott Williams

In a world of disruption, why do some organisations, communities and people break down and others bounce back? Earlier this year, a global gathering of innovators came together to share tools and perspectives on what could help us to build a sturdier and more resilient future.

1 Experts estimate that the financial value of the goods and services provided by ecosystems represents approximately 26,000 billion euros per year, i.e., almost twice the annual value of the goods and services produced by humans. This contribution to the global economy is not formally priced into investment or consumption decisions. (Source: PwC, Développement durable, aspects stratégiques et opérationnels. Editions Francis Lefebvre).

2 There are many recent examples, including BP’s Deepwater Horizon incident in 2010 and the Fukushima Dai-ichi nuclear reactor incidents in 2011.3 There are approximately 13 billion hectares of land area on earth. With the current population of 7 billion people, the available per capita is 1.9 hectares,

and with population at 10.6 billion (the high estimate in the UN Departement of Environmental and Social Affairs ‘World Population to 2300’ report) the per capita available land drops to 1.2 hectares.

4 UN HABITAT: State of the World’s Cities 2010/2011 report.

more resources because of increased supply chain dependency. At the same time, the ageing of society reduces the drive, creativity and passion needed for the necessary transformation to a more adaptive society.

At its heart, the problem is a fundamental challenge to ‘modernity’, to the very notion of what it means to be ‘developed’ as it ushers in the era of ‘bounded growth’. As Simonetta Carbonara, an expert on consumer psychology and strategic marketing, eloquently stated in her presentation at PopTech; ‘We must overcome our nostalgia for solidity and target a new liquidity to undermine the rigidity of antecedent, and current, global systems development. Solutions to these transitional challenges are needed now, and they require new thinking’.


Figure 1: Human Development Index, 2010 and ecological footprints, by country, 2007

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0

Human development index

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Sources: Human Development Report 2011; Global Footprint Network; United Nations Population Division; Finance Biodiversity and Ecosystems, Dr. Genevieve Patenaud, 2011; PwC analysis

Defining resilienceAndrew Zolli,5 the PopTech Iceland curator, opened the event by defining resilience in the context of ‘systems + people’ and the need to decouple our structures and systems from scarcity. To achieve resilience, Zolli argued, we must be capable of listening to our collective cultural memory, our experiences of past suffering and learn from them to avoid repeating mistakes and use them to anticipate

the disruptive events to come. His example was particularly relevant for me given my personal experience of the triple disaster in March 2011 in Japan. He spoke of the thousand-year-old tale of caution told by the stone tsunami markers along the Tohoku coastline in Japan—a tale that fell on deaf ears among those pursuing rapid economic growth in the early 1960s. The failure to heed this warning is currently fuelling the biggest protests in Japan in some 40

years. The demonstrations have forced the Japanese government to consider terminating nuclear power in the country by 2040 in a recent update to the nation’s revised energy policy.

A contrasting system capable of anticipating disruption and maintaining functionality and performance was highlighted by another speaker, Steve Lansing,6 who used the Water Temple networks of

5 Andrew Zolli is PopTech Executive Director & Curator and a futures researcher who studies the complex forces at the intersection of technology, sustainability and global society that are shaping our future. He has served as a Fellow of the National Geographic Society, and his work and ideas regularly appear in dozens of leading publications and media outlets. Andrew’s book Resilience: Why Things Bounce Back was published in 2012 by Free Press.

6 Steve Lansing is an external professor at the Santa Fe Institute, a professor of Anthropology at the University of Arizona, with a joint appointment in Ecology and Evolutionary Biology, and a senior fellow at the Stockholm Resilience Centre. His recent research is centered around long-term dynamics of coupled social-ecological systems. One of his current projects explores emergent properties of Balinese water temple networks and he’s currently assisting the Indonesian government to create a new UNESCO World Heritage site to help preserve the temple networks.


Bali as an illustrative example of a highly functional, complex social-ecological adaptive system.

The Balinese Water Temple networks are perfect examples of systemic resource optimisation through ‘glocalisation’—where local neighbourhood cross-checks are critical to achieving regional (or even global) optimum states.7 The invisibility of economic and social systems, such as the Water Temples, operating in harmony, both in time and space, with natural systems gives rise to a key question repeated in various forms during the PopTech event: ‘How do we make effective, natural systems more visible in post-crash paradigms to understand and better prepare pre-crash?’ The answer lies in the alignment of the different time signatures of natural, social and economic systems achieved by the Water Temple networks. Or possibly, as emphasised by Dr. Geoffrey West,8 the idea of ‘bounded growth’ is critical to understanding how to manage and anticipate systemic risk.

West clearly demonstrated that unbounded growth requires accelerating cycles of innovation to avoid collapse, something familiar to businesses in industries ranging from electronics to automotive to fashion. He provided evidence supporting a universal scaling law, which demands an end to growth to achieve resilience and sustainability. From ‘cells and ecosystems’ to ‘cities and companies’ the scaling law holds true. The super-exponential growth experienced in many of the world’s critical systems in the past decade leads to an inevitable and predictable systemic collapse, sometimes referred to as the ‘great deceleration’.

power at the turn of the 20th century, and then again from the ruins of the second world war to become the world’s second-largest economy by 1968). I explained the 5Ds of Japan’s cultural balance sheet (demography, debt, declining competitiveness and lack of diversity balanced by discipline). I also emphasised the urgent need for strong, diverse leadership to unlock the power of the business monoculture and better

7 Lansing and colleagues developed computer simulation models to calculate theoretical optima for rice production in the areas where the Water Temple network continues to operate and demonstrated that the network approach achieved close to the theoretical maximums. The modelling demonstrated that ancient, social-ecological systems can outperform modern scientific approaches in complex ecosystems. For further information refer to www2.econ.iastate.edu/tesfatsi/LansingKremer.BaliWaterTemples.pdf.

8 Geoffrey West is a theoretical physicist whose primary interests have been in fundamental questions in physics and biology, ranging from the elementary particles, their interactions and cosmological implications to the origins of universal scaling laws and a unifying quantitative framework of biology. His research in biology has included metabolic rate, growth, ageing and mortality, sleep, cancer and ecosystem dynamics.

A perspective on resilience from JapanAt PopTech Iceland, I spoke about Japanese resilience and how the nation has the latent capacity to once again emerge from the current crisis, having successfully transformed twice in modern times, and on both occasions in less than 30 years (from an isolated, agrarian economy in the 19th century to a modern, industrial


anticipate and respond to disruptive events. I argued that there is significant latent power in the unity, the so-called kizuna spirit, and the discipline built into the DNA of Japanese corporations to trigger a ‘state shift’ in the future of Japan. But strong leadership characterised by a shared vision, a willingness to challenge narrow industrial-era thinking and a climate of real trust is required, just as it was in the transformations of the past. The difference today is the need to embrace complex interdependencies and diversity, rather than eliminate them, to achieve multi-dimensional national development. Listening to the past, embracing transparent networked communities, focusing on a post-growth or ‘bounded growth’ strategy and releasing the human potential of Japan underlined by a new wave of liquidity, flexibility and creativity could unleash the third great transformation of modern Japan.

Scott Williams has dedicated his life to catalyzing massive, global change to build systemic resilience. He is a Global Sustainability Board member for PwC and the Sustainability Leader for PwC Japan. Williams works to articulate the information asymmetries and perverse incentives that currently inhibit the transformation needed to achieve global sustainable development and systemic resilience. He focuses on improving education and understanding the impact of systemic risks and changing measurement and valuation frameworks used by investors to value inputs and outputs. He has developed a practical framework to build organisational resilience—the EVIT framework. Williams is currently based in Tokyo with his wife and two young children and has worked for PwC for 15 years in Sydney, London, New York and Tokyo.

Diversity spurs resiliencePopTech Iceland highlights the value of diversity in creating dynamic systems. The value of diverse expertise applied to all aspects of the resilience challenge allows ideas and innovations from one sector or discipline to be applied to others at speed and at scale—a message that was reinforced by the business leaders assembled at the UN Rio+20 conference in June 2012. The urgency is well understood. The willingness, in the form of strong leadership, is presently lacking. A renewed emphasis on education—at all levels of business and government—about the increasingly clear links between scientific theory, scientific observations, social instability, environmental degradation, systemic interdependencies and economic performance is the critical first step to accelerate innovation and embed ideas such as those presented at PopTech Iceland.

This is an important step on the pathway to a resilient future.

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Resilience: Winning with risk

Authors

Publishers Dennis Chesley, Miles Everson and Juan Pujadas

Executive Editors Robert G. Eccles Professor of Management Practice Harvard Business School

Christopher Michaelson Director, Strategy and Risk Institute, PwC Global Advisory Associate Professor, University of St. Thomas Opus College of Business

Managing Editor Rania Adwan +1 (646) 471-5116 [email protected] PwC US

Production Editors Angela Pham and Shannon Schreibman

Layout US Studio—Victoria Waranauckas Web Specialist— Gautam Verma

Special thanks to the following parties for their production and editorial assistance: John Ashworth, Chris Barbee, Ashley Hislop, Sarah McQuaid, Malcolm Preston and Alastair Rimmer

Photography credit Peter Hilz/Hollandse Hoogte/Redux

John Barnes+852 2289 [email protected] China

Andrew Dawson+44 (0) 207 804 [email protected] UK

Jamie Hepburn+44 (0) 207 212 [email protected] UK

Craig Scalise+1 (312) [email protected] US

Richard Gledhill+44 (0) 207 804 [email protected] UK

Otilia Simkova+44 (0) 207 553 [email protected] Group

Michael Storck+49 89 5790 [email protected] Germany

Folker Trepte+49 89 5790 [email protected] Germany

Scott Williams+81 80 3158 [email protected] Aarata