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Place your bets on emerging economies

Developing economies present many interesting business opportunities, but success in these markets requires preparation, versatility and a long-term mindset. Learn why.

By Jim Hunter

Although that potential has been obvious for several decades, the resilience shown by these economies in recent years has given it new impetus. Moreover, yesterday’s frontier markets are closing ranks with maturing markets like India and China, making way for the next tier of developing economies.

Investing in a developing country provides an opportunity to both to improve the economy and expand growth. According to the United Nations (UN), foreign direct investment (FDI) flows to developing countries reached a new high of US$759 billion in 2013, topping that of developed countries. While companies entering these markets face clear challenges, those that have taken the plunge include consumer firms, carmakers, banks, telecoms and supermarkets.

This transformation is being driven by factors that include social reforms, the advancement of online and mobile technologies, and demographics. The developing world contains not only most of the globe’s population, but also the majority of its youth.

“Companies that only 'dip their toes' into a developing market or simply seek to apply a nuanced appreciation that was learned elsewhere are likely to fail both from a business and tax perspective.“

Although the developing world is still trying to stem its brain drain, countries like India, where 65% of the population is 35 or younger, should nevertheless provide a critical source of talent as the economy climbs the value chain. A growing middle class is another key trend in these countries. By 2030, the UN projects that 80% of the world’s middle class — 3.9 billion people — will reside in today’s developing countries and account for 70% of total consumer spending.

The change in consumption patterns is most dramatic in China. But by 2022, Brazil, Russia, Mexico, Turkey and India will each have more than 10 million households earning the equivalent of US$35,000 per year. This growth, and the increasing urbanization that goes with it, will fuel higher demand for health and education services; communications, culture and recreation; and infrastructure such as green technologies and public transport. Naturally, that spells opportunity for businesses worldwide.

The diversity of developing countries: no one-size-fits-all

It is hard to overstate the breadth and diversity of developing countries. Brazil and Russia, once ascendant, are now stumbling. China and India still dominate. In fact, China is clearly transitioning from a manufacturing-based economy to a services-based one.

As it does so, wages for Chinese workers are rising. That is helping to grow the middle class, but it is also chasing low-cost manufacturing out of the country. As businesses seek alternatives, two separate developing country regions are ready to step into the gap: the economic communities of Southeast Asia and Africa.

The Association of Southeast Asian Nations (ASEAN) comprises 10 developed and emerging countries whose combined population of 600 million has long captured the imagination of investors. Vietnam, for example, is becoming a manufacturing hub for everything from textiles to electronics. Indonesia has a population nearly the size of the US and is the largest producer of crude palm oil.

Myanmar, strategically located between China and India, is now emerging from years of economic isolation. It has arable land, oil and gas, precious stones, a cheap and young workforce and a government supportive of a market economy.

Africa represents a different but equally fascinating proposition. Nigeria, one of three regional hubs along with Kenya and South Africa, attracts a significant amount of investment owing to its large population and oil reserves. Ghana is smaller but stable, democratic and has abundant natural resources. Rwanda, although geographically small, is ranked among the highest in the region in the World Bank’s ease of doing business index.

EY’s latest Attractiveness Survey reveals that the African continent is now the second most desirable regional investment destination in the world, tied with Asia. Sixty percent of survey respondents with a presence in Africa believe that the continent’s attractiveness improved in 2013. Africa’s resources continue to draw FDI (primarily from the EU and the US), but so do its agriculture and infrastructure.

Increasingly, capturing opportunities in developing countries means tracking the flow of investment to, from and between them. For many years, FDI flowed primarily from developed to developing countries. In 2013, for the first time, FDI between developing countries actually surpassed trade from developed to developing countries, accounting for a quarter of total world exports. China’s exports to other developing countries represent 20% of trade between developing countries, but Vietnam, India, Turkey, Chile and other countries also play a significant role.

Multinational enterprises headquartered in developing economies are becoming increasingly important to global trade. In 2014, the Fortune Global 500 list included 95 companies based in China, up from just 73 in 2012. As these companies expand into established markets like Europe and the US, they are fundamentally altering the nature of global commerce.

Getting down to business

The dynamism of developing economies is remarkable. India went from having fewer than 6 million mobile phones (in a country of 1 billion people) in 2000 to more than 962 million of them by October 2014. Kenya pioneered mobile money: cashless transactions between mobile phone subscribers that can be used to pay for goods and services or transfer funds. The value of these transactions now exceeds 40% of the country’s gross domestic product. In Bogotá, Colombia, a low-cost bus rapid transit system that shuttles two million passengers a day became a worldwide model.

Nonetheless, doing business in developing countries is very different from what many companies are accustomed to. One of the downsides of rapid industrialization and growth in China has been air pollution, which not only has public health implications, but also disrupts transportation and some industries as well. In Pune, India, a fast-growing IT and pharmaceutical hub, there is not enough electricity to meet demands, resulting in supply restrictions. Africa’s infrastructure is still so underdeveloped that it is a major challenge to move goods and people to where they are needed.

And despite its appeal, ease of business varies across ASEAN, making it hard for its member states to attract the FDI they need to expand their economies. Consequently, ASEAN has been working toward a single market to bring about a better flow of goods, services, finance and people since 2007. The initial plan was to achieve an integrated economic region by 2015. But progress has been slow, hampered by language issues, pre-entry requirements and differences in laws and regulations.

One fact that should not be overlooked is the critical role that governments play in building a stable society. While contributing to growth, they also put in place the structures that ensure a predictable planning environment for companies and in turn a better return on investment. Structural reforms achieved following Mexico’s presidential election in 2012 (11 in the first 20 months of the new administration) show how a government can instill confidence. Similar postelection reforms are playing out in India as well.

The tax landscape

Across the developing world, taxation represents a hodge-podge of measures aimed at compliance, expanding the tax base, reorienting business incentives and various degrees of reform. Countries are shifting away from so-called “tax holidays” toward incentivizing certain types of industries, geographies and investments, such as research and development into green technology. Take China, for example, where the east coast is densely populated. The government’s 2000 “go west” strategy is aimed at encouraging investment in hinterland regions such as Sichuan.

Respondents to EY’s 2014 Tax Risk and Controversy Survey identified China, India and Brazil (in that order) as the three emerging markets that pose the highest risks related to tax. Respondents also felt that emerging markets pose more tax risk today than they did two years ago. They include reputational, legislative and enforcement risk, in particular transfer pricing, indirect tax and permanent establishment risk.

One such challenge is posed by local business culture, where fraud policies do not meet the standards of global compliance frameworks. This issue has had a high profile in Asia, but not exclusively. Tax authorities are also perceived to be more aggressive in many developing countries, a perception reinforced by a number of high-profile tax disputes in India, China and elsewhere.

Finally, rapid growth entails considerable policy, legislative and regulatory change as developing countries try to strengthen their tax systems. However, government ability to implement needed policy changes is often outpaced by business expansion needs. While companies seek to know what the tax regulations are and what is appropriate in terms of the law and tax planning, agility and perseverance is necessary as frameworks shift in developing countries.

Perhaps adding to the uncertainty at present in the developing world is the Organisation for Economic Co-operation and Development (OECD) Action Plan on Base Erosion and Profit Shifting (BEPS), arguably the most important current development in international taxation. Key issues across all governments include addressing cross-border frictions such as transfer pricing — especially with regard to the expanding digital economy — and enhancing transparency.

Because developing countries figure so largely as a focus of present and future growth, they need to be fully involved in the discussions on reforming the international tax system, particularly the BEPS project. The G20 group of major economies last year questioned whether developing countries weren’t being left behind in the deliberations.

As a result, the OECD released its Strategy for Deepening Developing Country Engagement in the BEPS Project. As this plays out, it is also clear that indirect taxes (GST, VAT) will continue to play an increasingly important role in broadening the tax base, which is particularly true in developing economies as they move toward consumer-based markets.

Lessons learned

Companies that only “dip their toes” into a developing market or simply seek to apply a nuanced appreciation that was learned elsewhere are likely to fail both from a business and tax perspective. Examples of both successes and failures are readily available.

One key consideration is choosing the right target. In a continent as diverse as Africa, where to start is a strategic decision based on the sector of interest, be it raw materials like oil and gas, or new consumers, among other factors. Being increasingly transparent with authorities and potentially local market partners is also likely to be strategically important.

Carefully addressing the impact of new operations in developing economies on existing risk management structures, controls and policies is important. New risks may present as a result, including reputational risks. The current balance between central and local management of risks may no longer be suitable.

Capitalizing on the rapidly growing middle class in developing countries will require new capabilities too. EY’s 2012 survey, Innovating for the Next Three Billion, found that getting close to customers and understanding the problem that needs to be solved is crucial. Generally, businesses cannot simply take products from the developed world and hope to sell them in the developing world.

Today, companies need to think globally and locally at the same time. They will have to engage deeply in local markets to see how innovations can be applied. Learning how to do business, putting in place the local and extended partnerships needed to build and maintain an enterprise, and engaging with the tax and regulatory landscape takes perseverance as well as passion.

This article is included in Tax Insights issue 13


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