McDonalds Russia:
A Jewel in the McDonalds Emerging Market
Operations?
We are not afraid of competition. The market is still in the making and one who takes
right decisions at the right time will be the leader. We did it 20 years ago When we
saw the first queues that were lining up to our first restaurant in Moscow every day
and night all year round, our success was predetermined and all we had to do was to
develop as fast as possible.1
-
Of the 118 countries where McDonalds Corp. does business, none can boast more
activity than Russia. On average, each location serves about 850,000 diners annually
-- more than twice the store traffic in McDonalds other markets. That has presented
the worlds largest restaurant chain with an unusual dilemma. Russia, with its
burgeoning middle-class and consumer appetites for all things American, is a jewel in
the McDonalds system.3
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Introduction
The year 2008 was considered a landmark year for the worlds largest fast food chain,
McDonalds Corporation (McDonalds). While many companies, cutting across
industries, were caught in the grip of the global economic recession, the fast food
chain registered record performance. [] 2008 was a banner year for McDonalds.
Revenues increased to a record $23.5 billion global comparable sales increased 6.9
percent, and we marked our 68th consecutive monthly increase operating income
and earnings per share rose 17 and 15 percent, respectively (excluding the 2007 Latin
America transaction) and we returned $5.8 billion to shareholders through share
repurchases and dividends paid. These financial results are among the best in our
Companys history,4 said Jim Skinner, Vice Chairman and CEO, McDonalds.
The companys European operations accounted for 42% of McDonalds total
revenues. According to the company, McDonalds had registered sound growth in
Europe in 2008, and this growth was spurred by performance in countries such as
France, the UK, Russia, and Germany. The company also posed strong results in
2009, with these markets spurring the growth.5 McDonalds had started investing in
4
5
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International Business
Russia (then Soviet Union6) in the late 1980s and had ramped up its presence through
the 1990s and early 2000s despite facing some serious challenges. Some experts felt
that Russia was the companys best performing market in Europe and one of its best
performing markets in the world in 2009.7 As of early 2010, McDonalds dominated
the Russian fast food market with a 70 percent market share.8 Out of 10 people who
enter a food court, six go to McDonalds, 9 said Mikhail Goncharov (Goncharov),
general director of the Teremok fast food chain.
McDonalds came into being in the late 1930s as a hot dog stand set up by two
brothers Richard McDonald and Maurice McDonald in California, the US. It started
its international expansion in 1967. McDonalds opened its first outlet in Russia in
1990, more than a decade after it had planned to enter the country. The entry was led
by George Cohon (Cohon), founder of McDonalds Canada operations, who had been
striving to enter the country since 1976.
The company faced several challenges in the country, primarily due to the
bureaucratic set up, strict laws, inability to convert the Russian ruble10 into other
currencies, and economic instability. According to analysts, McDonalds faced the
challenges successfully and developed its own supply chain in Russia, bringing in
experts from other countries. In order to standardize its services, it gave importance to
the training and development of its work force. The number of stores kept on growing
at a slow and steady pace in the 1990s and early 2000s.
In 2005, McDonalds Russia emerged as the second largest among McDonalds
markets in terms of average number of consumers per restaurant.11 From 127 stores in
2004, the company had opened multiple numbers of outlets each year. In 2007 and
2008, it also invested in overhauling the existing stores, with investment worth US$
500,000 on each store.12 Khamzat Khasbulatov (Khasbulatov), McDonalds president
for Russia and Eastern Europe, said that the company was interested in expanding its
business in Russia. He said McDonalds was keen on growing convenient formats like
express windows and drive-thru windows in the country.
Russia is one of the most successfully developing markets of the McDonalds
Corporation in Europe,13 said Khasbulatov. As of early 2010, it continued to be one
the leading revenue contributors to the parent company. With 245 outlets already in
Russia as of early 2010, McDonalds was gearing up to add another 45 outlets by the
end of 2012.14
6
10
11
12
13
14
Prior to 1991, Russia was the largest republic in the Soviet Union (or USSR). The troubled
economic conditions together with political turmoil led to the dissolution of the Soviet Union
in 1991 into fifteen separate countries. As a result, Russia together with Ukraine and Belarus
formed the Commonwealth of Independent States which was later joined by other Soviet
republics.
Yuri Mumchur, Obama in Moscow: True Reset or Just Walking in Circles?
www.russiablog.org, July 8, 2008.
Maria Kiselyova and Maria Plis, McDonalds to Target Stay-at-home Russians,
www.reuters.com, December 17, 2009.
Vladimir Kozlov, McDonalds Supersize Profits Conquer Moscow, www.mnweekly.ru,
January 25, 2010.
Ruble is Russian currency. 1 US$=29.403 Ruble (As of January 2, 2009).
Chris Mercer, McDonalds Plans to Double Russian Presence, www.foodnavigator.com,
February 3, 2005.
McDonalds to Open 40 Restaurants in Russia in 2008, www.cdi.org, April 22, 2008.
McDonalds to Open 40 Restaurants in Russia in 2008, www.cdi.org, April 22, 2008.
Jenny Wiggins, Growing Taste for Quality Goods Lures Big Brands, www.ft.com, January
20, 2010.
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Background Note
McDonalds was started in the late 1930s by Richard and Maurice McDonald in
California, after they failed to make profits from running a movie theater. The
brothers were inspired by a hot dog stand nearby, which always did brisk business
even when other businesses were struggling under the effects of the Great
Depression15.16
In 1937, the McDonald brothers started a hot dog stand called Airdrome, situated at
Arcadia in California. Later, in 1940, they opened a barbeque restaurant in San
Bernardino17 and called it McDonalds Barbeque.18 The barbeque restaurant had about
25 items on its menu like barbequed beef and pork sandwiches. It employed 20
carhops19 to provide service to customers. It soon became a favorite hangout for the
teenagers in the city.20
In, 1948, the brothers found it difficult to manage such a large scale business with its
extensive menus, staff, and the huge crowds that thronged the restaurant. They
realized that the need of the hour was quick service and mass production of food
items. Richard analyzed their menu and found that about 80% of the restaurants sales
were generated by the sale of hamburgers. 21
In December, 1948, the McDonald brothers reopened the store after incorporating new
strategies to enable provision of fast service at a low price. This, they believed, would
help in selling larger volumes. Taking a cue from the automobile industry, they
decided to adopt an assembly line kind of approach to preparing food at the new
restaurant.22 This system was called the Speedee System and it greatly improved the
efficiency of the restaurant. The new concept established the principles of
McDonalds fast food restaurants, and these were later adopted by several fast food
restaurants.
After implementing the new system, McDonalds was able to sell a hamburger at 15
cents (it cost 30 cents earlier) and French Fries at 10 cents.23 Around the same time,
the companys first mascot was conceptualized and was called Speedee,24 primarily
to signify its quick service.
In 1953, the McDonald brothers decided to go in for franchising in order to expand
their business. For a thousand dollars, franchisees would receive the McDonalds
name, a basic description of its service system, and the services of Art Bender 25
(Bender) at the new restaurant for a week, to help them with the business. Bender
trained the people at the franchise, supervised the installation of the equipment, made
contact with the butchers and bakeries for the supplies, etc. McDonalds first
franchisee was Neil Fox, who had a drive-in restaurant in Phoenix, Arizona. This
15
16
17
18
19
20
21
22
23
24
25
Great Depression in the US was a period of acute economic crisis that started in 1929 as a
result of crash of the Wall Street stock market and lasted till around early 1940s.
Jane McGrath How McDonalds Works, http://money.howstuffworks.com
San Bernardino is a county in California, USA.
Dick and Mac McDonald, www.nationmaster.com
A carhop is a waiter or waitress who delivers food to customers in their cars at drive-in
restaurants. Carhops originated in the 1940s when drive-in eateries became popular.
McDonalds-Site History, http://www.route-66.com.
McDonalds-Site History, www.route-66.com.
A Brief History of McDonalds, www.bbc.co.uk, April 18, 2005.
www.mcdonalds.ca.
Speedee looked like a man with a hamburger shaped head, wearing a hat.
Art Bender was associated with the McDonald brothers and was credited with serving the
first McDonalds hamburger at their San Bernardino store. He later became a franchisee of
McDonalds.
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International Business
restaurant became the prototype for the McDonalds chain. The red & white building
with a slanting roof and the Golden Arches on the sides became the model for
McDonalds restaurants. In the years that followed, McDonalds grew from strength
to strength and by the mid-1950s, the fast food chains annual revenues were US$
350,000.26
In 1954, Ray Kroc (Kroc), a salesman for a company that manufactured milkshake
mixers, noticed that one of his largest customers was a California-based restaurant
owned by the McDonald brothers. Kroc found out that they used an assembly line-like
system for making hamburgers and sandwiches and that the restaurant already used
eight milkshake machines. Sensing an opportunity for more business, he went to meet
the McDonald brothers.
One look at the orderly, efficient restaurant that served a huge customer base was
enough to convince him that he could sell the milkshake mixers to every McDonalds
store that opened. The purpose of the visit was to persuade the McDonald brothers to
open more restaurants so that he could sell milkshake mixers to them. But the brothers
were not interested in expanding the business further and seemed content with the
existing operations. Kroc then expressed his willingness to become the franchising
agent of McDonalds restaurants and he succeeded in convincing them. In 1955, the
company was incorporated as McDonalds Corporation.27 The McDonalds bothers
finally sold the business to Kroc in 1961.
Over the years, as the business expanded, the companys operation was divided into
four segments the US, Europe, Asia Pacific, the Middle East & Africa (APMEA)
and other countries including corporate sales (Refer to Exhibit I for Important
Milestones in McDonalds Growth).
In 2003, the company experienced a quarterly loss for the first time since it went
public in 1965. This was mainly due to the decrease in sales as a result of a rising
concern among people about the effects of fast food on health. Responding to the
concern, McDonalds switched to healthier meals and introduced salads and fresh
fruits on its menu.28 As of 2010, McDonalds was headquartered in Oak Brook,
Illinois, with James A. Skinner (Skinner), as Chairman and CEO of the company.
Experts felt that the company had negotiated the economic slowdown well and things
were looking up for the fast food chain (Refer to Exhibit II for the financial summary
of McDonalds Corporation: 2004-2008).
International Expansion
McDonalds began its international expansion in 1967 with its first restaurant outside
the US coming up in Richmond B.C, Canada on June 1. In July 1971, McDonalds
began operating in Tokyo, Japan, in a joint venture with a local partner Den Fujita.29
In the same year, the first McDonalds in Europe came up in the Netherlands.
Restaurants also opened in Munich, Germany; and Australia. In the early 1970s,
McDonalds also entered France and England.
26
27
28
29
http://www.mcdonalds.ca
McDonalds Corporation, Company History, www.answers.com
Geoffrey Jones, Multinationals and Global Capitalism, Oxford University Press.
Den Fujita owned an import company in Japan, specializing in handbags, shoes, and apparel,
before opening McDonalds in Japan.
330
Exhibit I
Growth of McDonalds Corporation
1950s
1954
Ray Kroc became the franchising agent of McDonalds. Krocs vision was
to expand the fast food chain in every American State and internationally
as well. He wanted McDonalds fast food restaurants to serve quality food
by adhering to standards and specifications
1955
1956
By the end of this year, there were fourteen McDonalds restaurants that
served nearly 50 million hamburgers. The company reported annual sales
of US$1.2 million.
1960s
1960
Kroc was running the whole show by this time. He renamed the company
as McDonald's Corporation. He wanted to put up a McDonalds
restaurant in every state of America. He personally looked after the
operations, measured every product, and tasted burgers in every outlet to
ensure that the quality of food served was uniform in every McDonalds
restaurant. In the same year, McDonalds started its advertising campaign
Look for the Golden Arches which gave sales a big boost. The McDonald
brothers were happy with the results and were not concerned about the
company Kroc had formed. In 1960, there were 228 McDonalds
restaurants that reported US$37.6 million in sales, and sold 400 million
hamburgers.
1961
Ray Kroc began letting out more franchises. The revenues that the
company received from the franchises made it easier for him to raise
capital in the financial markets. He utilized some of the money to create an
advertising campaign with the theme, Look for the Golden Arches. The
companys logo was changed from Speedee to a letter M symbolizing
the Golden Arches. Kroc was not happy with the restrictive agreement he
had been operating under and wanted to operate the franchising business
on his own. So he offered to buy out McDonalds for US$ 2.7 million. He
obtained a loan and took over the business from the McDonald brothers.
That same year, he opened a Hamburger University in the basement of a
restaurant in Elk Grove Village, Illinois. It was a training facility where
new franchisees and store managers were taught how to manage a
McDonalds restaurant using sophisticated training techniques and through
high-level management courses.
1963
McDonalds sold one million hamburgers per day in the US. In the same
year, the company introduced Ronald McDonald, a red-haired clown, to
appeal to children.
1965
On July 5, McDonalds was listed on the New York Stock Exchange and
sold its shares for US$ 22.50 each.
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International Business
1968
McDonalds well known product Big Mac30 was created. Fred Turner
became the companys president and chief administrative officer while
Kroc became the chairman and remained CEO until 1973. McDonalds
opened its 1000th restaurant in Des Plaines, Illinois.
1970s
1970
1973
McDonalds introduced its first breakfast fast food The Egg McMuffin31.
1975
1979
McDonalds Happy Meal32 was created and was popular with children as
well as adults.
1980s
1980
By 1980, McDonalds reported sales of US$ 6.2 billion from its 6,263
restaurants in 27 countries and surpassed the 35 billion hamburger
milestone. During the 1980s, McDonalds diversified its menu to suit the
changing tastes of consumers.
1982
1983
1984
On January 14, Kroc died. That same year, McDonalds broke the US$ 10
billion sales barrier and served its 50 billionth hamburger.
1986
1988
1990s
1990
By 1990, McDonalds sales had grown to US$ 18.7 billion with 11,800
restaurants in 54 countries. In 1990, Life Magazine named Kroc as one of
the 100 Most Important Americans of the 20th Century.
1996
1997
By the end of the year, the total number of McDonalds restaurants reached
the 23,000th mark.
1999
30
31
32
332
The Big Mac is a hamburger consisting of two 1.6 oz (45.4 g) beef patties, iceberg lettuce,
American cheese, pickles, onion, and special McDonalds Mac sauce served on a threepart sesame seed bun.
The Egg McMuffin is the signature breakfast sandwich sold by McDonalds in various
sizes and configurations.
Happy Meal is a combo meal with a toy, specially tailored for children by McDonalds.
The meal includes a burger or Chicken McNuggets, French fries, a drink and a toy.
2002
2003
Exhibit II
Financial Summary of McDonalds Corporation (2004-2008)
US Dollars in millions, except
per share data
Company-operated sales
Franchised revenues
2008
16,561
6,961
2007
2006
16,611
6,176
2005
15,402
5,493
14,018
5,099
2004
13,055
4,834
23,522
22,787
20,895
19,117
17,889
6,443
4,313(1)
4,313(1)
3,879(2)
2,335(2,3)
2,395(2,3,4)
4,433(5)
2,866(5)
3,544(5,6)
3,984
2,578(7)
2,602(7)
3,554(8)
2,287(8)
2,279(8)
5,917
1,625
2,136
4,876
1,150
1,947
4,341
1,274
1,742
4,337
1,818
1,607
3,904
1,383
1,419
4,115
3,981
1,823
3,996
3,949
1,766
5,460
3,719
1,217
(442)
1,228
842
1,634
605
695
Total assets
28,462
29,392
28,974
29,989
27,838
Total debt
10,218
9,301
8,408
10,137
9,220
13,383
15,280
15,458
15,146
14,201
1,115
1,165
1,204
1,263
1,270
Total revenues
Operating income
Income from continuing
operations
Net income
Cash provided by operations
Cash used for investing
activities
Capital expenditures
Cash used for (provided by)
financing activities
Treasury stock repurchased
Common stock cash dividends
Financial position at year end:
33
At the time of acquisition, there were more than 850 Boston Market outlets, which
specialized in home-styled meals like rotisserie chicken.
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International Business
Per common share:
Income from continuing
operationsdiluted
3.76(1)
1.93(2,3)
2.29(5)
2.02(7)
1.80(8)
3.76(1)
1.98(2,3,4)
2.83(5,6)
2.04(7)
1.79(8)
1.63
62.19
1.50
1.00
.67
0.55
58.91
44.33
33.72
32.06
Company-operated restaurants
6,502
6,906
8,166
8,173
8,179
Franchised restaurants
25,465
24,471
22,880
22,593
22,317
31,967
31,377
31,046
30,766
30,496
Franchised sales
54,132
46,943
41,380
38,913
37,052
Net income-diluted
Dividends declared
(1) Includes income of $109.0 million ($0.09 per share) from the sale of the Companys
minority ownership interest in U.K.- based Pret A Manger.
(2) Includes pretax operating charges of $1.7 billion ($1.32 per share) related to impairment and
other charges primarily as a result of the Companys sale of its businesses in 18 Latin
American and Caribbean markets to a developmental licensee (see Latam transaction note to
the consolidated financial statements for further details).
(3) Includes a tax benefit of $316.4 million ($0.26 per share) resulting from the completion of an
Internal Revenue Service (IRS) examination of the Companys 2003-2004 U.S. federal tax
returns.
(4) Includes income of $60.1 million ($0.05 per share) related to discontinued operations
primarily from the sale of our investment in Boston Market.
(5) Includes pretax operating charges of $134 million ($98 million after tax or $0.08 per share)
related to impairment and other charges.
(6) Includes income of $678 million ($0.54 per share) related to discontinued operations
primarily resulting from the disposal of McDonalds investment in Chipotle.
(7) Includes a net tax benefit of $73 million ($0.05 per share) comprised of $179 million ($0.14
per share) of income tax benefit resulting from the completion of an IRS examination of the
Companys 2000-2002 U.S. tax returns, partly offset by $106 million ($0.09 per share) of
incremental tax expense resulting from the decision to repatriate certain foreign earnings
under the Homeland Investment Act (HIA).
(8) Includes pretax operating charges of $130 million related to impairment and $121 million
($12 million related to 2004 and $109 million related to prior years) for a correction in the
Companys lease accounting practices and policies, as well as a non-operating gain of $49
million related to the sale of the Companys interest in a U.S. real estate partnership, for a
total pretax expense of $202 million ($148 million after tax or $0.12 per share).
Source: 2008 Annual Report
In 1990, McDonalds opened up in Russia by starting a restaurant in Moscow. This
was the largest McDonalds restaurant at that time. During the year, McDonalds also
opened in Shenzhen, China. This restaurant was even bigger than the Russian one and
attracted a larger number of people (around 40,000) on the opening day. The store was
spread over an area of 28,000 square feet and had 29 cash counters. The Chinese
operation was a joint venture agreement between the General Corporation of Beijing
Agriculture, Industry, and Commerce and McDonalds.
334
2008
2007
2006
US
4,636
4,682
4,410
Europe
7,424
6,817
5,885
APMEA
3,660
3,134
2,674
841
1,978
2,433
16,561
16,611
15,402
US
3,442
3,224
3,054
Europe
2,499
2,109
1,753
APMEA
571
465
379
449
378
307
6,961
6,176
5,493
US
8,078
7,909
7,464
Europe
9,923
8,962
7,638
APMEA
4,231
3,599
3,053
1,290
2,356
2,740
23,522
22,787
20,896
Total
Total revenues:
Total
34
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International Business
By 2008, McDonalds had more than 31,000 restaurants spread over 121 countries
and it was regarded as one of the most successful restaurant chains (Refer to Exhibit
III for a list of countries where McDonalds was operational, as of 2008).35
Exhibit III
List of Countries Where McDonalds was Operational, as of 2008
Year of
Opening
Restaurant
1967
1971
1972
1973
1974
1975
1976
1977
1978
1979
1981
1982
1983
1984
1985
35
336
1987
1988
1990
1991
1992
1993
1994
1995
1996
International Business
Year of
Opening
Restaurant
1997
1998
1999
2000
2001
2003
2004
+ McDonalds outlets ceased operation during the Nicaraguan civil war and reestablished a presence on 11 July 1998 after an absence of two decades.
# List not exhaustive
Compiled from various sources
In every country, McDonalds followed a few basic strategies of entry and expansion.
In some places it opened stores as a joint venture with a local partner while in others it
went in for franchise agreements or self-owned stores. However, it mainly in went for
a franchise mode of operation and about 80% of its restaurants were franchised.
McDonalds tried to maintain a standard menu in all countries. It followed standard
practices of store operation, such as mostly hiring local people, maintaining the same
look and feel to the stores, offering the same level of customer service in all its stores,
the same methods of food preparation, etc.
According to analysts, McDonalds key to international success was think global,
act local. This helped the company to do well in every region in which it opened its
fast food restaurants. It localized its operations depending on the country in which it
338
36
Halal is an Arabic term meaning permissible. It usually refers to food that is permissible
according to Islamic law. McDonalds underwent rigorous inspections by Muslim clerics to
ensure that its food was halal. The chain was then awarded the halal certificate indicating the
total absence of pork products.
37
38
The Jewish Sabbath day, called Shabbat in Hebrew, begins on Friday evening and ends on
Saturday evening. The Jewish refrain from doing any kind of activity on this day.
39
Maharaja Mac is another name for Big Mac, and is made with lamb instead of beef.
Teriyaki Mac is a Japanese styled burger containing pork with mayonnaise, lettuce, and
teriyaki sauce.
The Filet-O-Fish is a fish sandwich containing fish patty made mostly from whitefish, half a
slice of processed cheese, tartar sauce, and filet seasoning on a steamed bun.
40
41
339
International Business
Entering Russia
McDonalds pre-entry plans for Russia started way back in 1976. Cohon, at the time
of the Montreal Games42 in Canada, offered the services of the McDonalds company
bus to some of the Olympic officials from the erstwhile Soviet Union. He took the
officials to a local McDonalds restaurant and offered them some of its signature
dishes. The group enjoyed the food at McDonalds. It immediately struck Cohon that
the McDonalds experience could be taken to Russia. 43
Over the next four years, Cohon kept on persuading government officials to allow
McDonalds to open its outlets in Russia during the 1980 Moscow Olympic Games.
However, that did not materialize. For several years, Cohons plans of entering Russia
did not bear fruit. Cohon paid numerous visits to the Soviet Union, each time trying to
convince the bureaucrats in that country. During some of his visits, he even carried
along a video to show the bureaucrats the visuals of the restaurants, so that they could
understand better what actually McDonalds was all about. But these efforts proved to
be in vain due to the high level of bureaucracy in the country.
According to Cohon, while he earnestly tried to strike a deal to open McDonalds
outlets in Russia, some of the officials at the companys headquarters in the US
criticized his efforts. According to analysts, McDonalds chairman Kroc himself had
ruled out the idea of being able to open an outlet in Russia.44
In April 1988, after the reforms movements of perestroika45 led by Mikhail
Gorbachev, liberalized the Soviet economy, the Soviet government allowed foreign
companies to have 49% ownership in ventures in the country. McDonalds Canada
entered into a US$ 50 million joint venture million with Glavobshchepit46, to open 20
restaurants in the country.47 The deal also allowed the company to purchase land to
build a processing unit.48 The joint venture was called McDonalds Russia.49
McDonalds Canada agreed to reinvest all its profits in Moscow for a chain of
20 restaurants.
The company brought out an employment advertisement in newspapers for 630 posts
and received about 27,000 applications. One of the first managers to be recruited was
Khasbulatov, who contributed significantly to the establishment and expansion of
McDonalds in the country and later went on to become the managing director of the
Russian Operations. The Russian junior managers were sent for training to
McDonalds Canadian Institute of Hamburgerology.
42
43
44
45
46
47
48
49
Montreal Games referred to the 1976 Summer Olympics, or XXI Olympics, held in
Montreal, Quebec, Canada.
Janet Adamy, As Burgers Boom in Russia, McDonalds Touts Discipline,
http://online.wsj.com, October 16, 2007.
Alf Nucifora, Russians Learn to Smile-for Profit, Business News, September 27, 1999.
Perestroika is the Russian term, meaning restructuring, for the political and economic
reforms introduced in June 1987 by the Soviet leader Mikhail Gorbachev.
Glavobshchepit, a part of the government body, was the food services agency of the city of
Moscow. It was later renamed as Mosobshchepit.
Foster, P., McDonalds Excellent Soviet Venture? Canadian Business, Vol. 64, Issue 5,
May 1991.
Tony Royle, The Union Recognition Dispute at McDonalds Moscow Food-Processing,
Industrial Relationship Journal, Blackwell Publishing Ltd., 2005.
As of 2009, McDonalds owned all of its Russian operations.
340
50
51
52
53
54
55
56
57
The Taste of Pace: Situating Fast Food Restaurants in Russias Agrifood System,
http://ageconsearch.umn.edu, May 18, 2007.
McDonalds Russia, Brand Strategy, November 2005.
McDonalds in Moscow, http://goldenessays.com/free_essays/2/economics/mcdonalds-inmoscow.shtml
McDonalds Set for 20% Expansion in Russia, www.sptimes.ru, June 10, 2005.
Maria Levitov, McDonalds to Invest $50 Million, The Moscow Times, March 16, 2006.
McDonalds to Open 40 Restaurants in Russia in 2008, www.cdi.org, April 22, 2008.
Deloitte Touche Tohmatsu (Deloitte), founded in 1845, is one of the leading firms in the
world, delivering professional services like auditing, consulting, financial advisory etc. It is
headquartered in New York, USA.
McDonalds Set for 20% Expansion in Russia, www.sptimes.ru, June 10, 2005.
341
International Business
Expansion in Russia
Right from the early 1990s, McDonalds started to invest in real estate ventures by
acquiring various properties in Russia. As there was some difficulty in the conversion
of the Russian ruble into any other currency, the company thought of using it for
buying farmland and for building an office tower and distribution center in the
country. In 1993, McDonalds first corporate building in Russia came up near
Moscow Kremlin58. The company also leased out office space to Coca-Cola
Company59 and Upjohn60. McDonalds continued to purchase many restaurant
properties over the years.61
In 1993, two restaurants came up in Gazetny Pereulok and Stary Arbat. 62 By the end
of the year, three of its restaurants in Russia had begun to earn profits.63
In 1996, McDonalds introduced the drive-thru format in Russia. It was a new concept
in the country. Initially, people bought the food from the drive-thru windows, then
parked their cars around the store and went inside the restaurants to eat whatever they
bought. Over the years, the Russians not only learnt to appreciate the convenience
associated with the format, but also started to acknowledge the delivery speed.
In 1998, 19 McDonalds restaurants opened in various parts of the country. However,
due to the Russian financial crisis64 and weakening of the economy around the same
time, the company decided to go slow with the expansion. By 1999, the company had
made investments worth around US$ 134 million in the country since 1989. 65
However, the strong bureaucracy in the country continued to create hindrances.
In 1999, Khasbulatov was made the head of the Russian venture of McDonalds.
Things took a turn for the worse around 2000, as the condition of some of the
restaurants deteriorated. Some items on the menu were also losing their appeal.
According to Svetlana Polyakova, Public Relations Manager, McDonalds Russia, by
2001, the company had invested around US$ 215 million in Russia. There were about
6,000 employees at that time.66 As of 2001, McDonalds International held an 80%
stake while the government held the remaining 20% in McDonalds Russia. By then,
there were about 40 stores in Moscow and more than 32 in the rest of the country. 67
The Russian economy also started to improve around the same time in the early
58
59
60
61
62
63
64
65
66
67
342
Exhibit IV
A Brief Note on Russias Economy in the Early 2000s
Since the early 2000s, the Russian economy had seen a steady growth, fueled by the
rise of consumerism. According to analysts, the economy grew at 6.9% rate
between 2003 and 2007. In 2007, there was an increase by 10.4% in the average
Russian disposable income. In 2008, it was estimated that above 60% of the
population had a disposable income of US$ 350 on an average, after regular
household expenses. However, analysts suggested that there existed an income
inequality in Russia, which was higher than that in any other European country but
still lower than that in the US. Analysts said that about 80% of consumption came
from the top 10% earners in the country. Therefore, they added, if the difference
reduced in future and more people became wealthy, consumerism would further
rise.
In addition to the rise in disposable income, consumerism was also boosted by the
availability of liquid money due to growth in the credit market. This gave the
households added power to spend, which in turn propelled the retail sector. Thus,
analysts suggested that the rise of retail trade turnover, consumer spending power,
and increased visits to restaurants and other food joints had become the prime
factors that boosted the Russian economy in the early 2000s.
In 2007, Russia became a favorable place for foreign investment and witnessed
about US$ 100 billion worth of investment, a record for any emerging country and
more than what the worlds top 15 leading economies could attract. Also, most of
these investments were reported to be for a long time basis.
The country witnessed an inflation rate of about 9% in 2007, with the FMCG
section witnessing 13% inflation. Analysts feared that the rising inflation could
impact the growing economy. They pointed out that the consumer prices had
increased since there was an increase in salaries, pension, etc, that led to spending
that was higher than the economic growth. As a result, the supply of money
increased, leading to a decrease in the purchasing power of the ruble. The
circulation of money was also higher, leading to erosion in the purchasing power of
the currency.
The average growth rate of Gross Domestic Product (GDP) in the period between
2000 and 2007 was about 6.5%. In the first half of 2008, the country witnessed a
Gross Domestic Product (GDP) growth of 8%. However, toward the end of 2008,
the Russian economy faced some challenges due to rising oil prices and the
depreciating value of the ruble in the international market.
Like other western countries, Russias economy was affected by the credit crunch,
thus reducing the liquidity in the country. The stock market also crashed. There was
a reduction in industrial production as well, resulting in many lay-offs and job cuts.
Analysts predicted that the crisis would continue in 2009. Some feared that the
growth in the GDP might even reduce by 4% in 2009. Many also believed that
Russia, with cash reserves amounting to US$ 595.9 billion, would be able to pull
out its banking sector and industry from the crisis very soon.
Compiled from various sources
343
International Business
In 2002, there were around 79 Russian stores that together drew around 200,000
customers each day.68 By 2003, McDonalds had a major share of the Russian fast
food market.69 (Refer to Exhibit V for market share of fast food retailers in Russia
between 2003-2006 and to Exhibit VI for a brief note on the fast food market in
Russia: 2006-2008).
Exhibit V
Market Share of Fast Food Retailers in Russia between 2003-2006
Retailer
2003
2004
2005
2006
McDonalds
McDonalds Corp
35.3
30
30.7
30.3
Rostiks
Rostiks International
Inc
3.6
5.9
4.3
Sbarro
Sbarro Inc
2.8
2.9
Rostiks-KFC
Rostiks International
Inc
2.8
Teremok
Teremok - Russkie
Bliny
0.4
0.6
1.4
KroshkaKartoshka
Tekhnologiya &
Pitanie Ltd
0.4
0.6
1.4
Chaynaya Lozhka
Solo OOO
0.5
1.2
1.3
1.4
Baskin-Robbins
1.3
Others
57.4
56.9
57.5
54.1
Total, %
100
100
100
100
Exhibit VI
A Brief Note on the Fast Food Market in Russia: 2006-2008
According to some studies, the Russian fast food service market was one of the
fastest growing segments in the economy of Russia, with a growth rate of between
20 and 30%. In 2005, Moscow's fast-food market alone was estimated to be worth
between US$400 and US$700 million, and was projected to grow at a rate of 20
percent annually for the next few years. 70
Analysts considered a major section of fast food customers to be price sensitive and
keen on new products. With the restaurants growing more sophisticated in Russia,
there was an increased demand for different products. Analysts witnessed a new
68
69
70
Daniel Rogers, Can Mac Fight Back? www.marketingmagazine.co.uk, October 17, 2002.
Dmitry Babich, Yulia Ignatyeva Big Mac Does not Give Up, Foreign Investment-CDI
Russia Weekly, www.cdi.org, February 26-March 4, 2003.
Chris Mercer, McDonalds Plans to Double Russian Presence, www.foodnavigator.com,
February 3, 2005.
344
71
72
345
International Business
eating food was a lengthy procedure, with people sitting at the table for long
periods of time.73
Around the end of 2008, the Russian economy also experienced the effects of the
global economic slowdown and credit crunch. The stock markets performed poorly
and the ruble depreciated considerably against the US dollar. Industrial production
suffered, leading to wage reductions, lay-offs etc. Retail sales also suffered a lot
due to the reduction in spending as well as lack of availability of cheap loans and
liquidity of money.74 However, some analysts opined that the fast food industry
might not be impacted as much as high-end restaurants as people would look for
value for money in these tougher times rather than opting for fine dining
experiences. It was reported that in 2009, Russian consumer sentiment had indeed
been hit dramatically by the economic crisis, and the overall restaurant industry was
estimated to be down 7-8 percent.75 Denying that the crisis had been beneficial for
cheap restaurants, Oleg Sukhotin, executive director of the Russian Association of
Fast Food Enterprises, said, In the fourth quarter of 2009, most fast food
operators' turnover fell by 20% to 45%, year-on-year, and an average bill has also
plummeted. People no longer order pancakes with caviar that much. 76
As of early 2010, companies like McDonalds, KFC, and Sbarro dominated the
Russian fast food market.77 In late 2009, Andrey Petrakov, executive director of the
Restcon company, said that this was the right time fast for food chains to expand
into the Russian market as the market had enough room for new players, and rental
prices had dropped. 78
Source: Food & Drinks Industry Day Converting Opportunities to Business: Russian
and Ukrainian, www.bordbia.ie, 2008; and, Top 10 Consumer Trends in Russia,
www.euromonitor.com, May 7, 2008.
In 2005, the company invested about US$ 10,000 in each restaurant to start a new
breakfast menu. According to Khasbulatov, the decision to launch the breakfast menu
arose after research revealed that around 90% of the people did not have any
opportunity to get breakfast when outside their homes. 79 The breakfast menu mainly
targeted professionals in the big cities like Moscow, who left home very early to avoid
the traffic and needed to have breakfast somewhere outside.
By 2005, there were a total of 129 McDonalds restaurants in Russia, out of which 82
were in Moscow and 15 in St. Petersburg. According to analysts, the company spent
about US$ 1.5 million to US$ 2 million on setting up each new restaurant.80 The
company intended to spend around half of its marketing budget in promoting its
breakfast menu. Around the same time, the Russian operation became the second
73
74
75
76
77
78
79
80
346
2009
2008
2007
2006
2005
33 (Planned)
22
21
23
18
82
83
84
85
347
International Business
McDonalds way was a challenge when most of the local recruits were not familiar
with working under the capitalist system. Experts felt that they were victims of the
inertia brought about by the old system of central planning for so long that
productivity remained low.
Hiring local employees was a challenge though McDonalds first recruitment ad drew
27,000 applications. The company selected a 630-member crew comprising hires of
between 18 and 27 years. Craig Sopkowicz, who was McDonalds quality-control
expert and in charge of the new employees, said, We looked for applicants who lived
close to the restaurant, among other things, in order to control the timeliness of
employees. 86 For most of these new hires, this was their first job as labor laws in
Russia protected teenagers from indulging in any activity that conflicted with
schoolwork. Initially, the company provided a starting salary that was on a par with
the industry average in Russia (1.5 rubles an hour) for new hires.87
Local employees required lengthy training. To be flexible when positions changed, the
new crew was trained in all aspects of the restaurants functions; the new staff logged
in more than 15,000 training hours to ensure control similar to that in western
operations. Before the opening of the first Russian store, a team of 30 newly recruited
managers (including Khasbulatov) was sent to Europe and the Institute of
Hamburgerology in Toronto for comprehensive training. These people in turn trained
the other new employees on quality, customer service, general conduct, as well as the
health and safety standards that were to be followed in the stores. According to an
executive from McDonalds, at first it was difficult to teach the store employees to
smile and look straight into the eyes of the people. To teach the trainees, the training
manuals were translated into Russian and they were also shown videotapes about
various chores, like the right way to wash the windows and clean the floors, as well as
the correct way to arrange the ingredients in the Big Mac.88 Since the company had
some concerns about the employees appearance, it decided to construct an on-site
laundry room so that the companys standards could be ensured.89
In 2006, McDonalds Russia was named as the Best Employer in Russia by the
Russian Chamber of Commerce and Industry. The award recognized the company as a
responsible employer.90 It was also named as the Best Employer in Central Eastern
Europe from 2007-2009 by Hewitt Associates91. As of end 2009, the company
employed more than 24,500 Russians at its restaurants, processing facilities, and
corporate offices, and there were more than 100,000 Russians employed by
suppliers.92 The company executives were Russian and most of them had started their
career as crew-members.
Pricing
The company began its operations by transacting in rubles, so that the customers did
not face any issues with the currency. A few analysts called it a shrewd strategy
targeted at luring the locals who were always attracted to foreign goods but could not
86
87
88
89
90
91
92
348
Procurement
Sourcing and quality control of food was a huge challenge for McDonalds in Russia.
Right at the time of entry, the company realized that many of the ingredients that it
required were not available in the country at all. Greg Steeves, former Chief Operating
Officer of McDonalds Europe, explained, Russia is often plagued by shortages, and
in some cases the ingredients we required, such as iceberg lettuce, didnt even exist in
the country.97
Right from the very beginning, the company understood that importing food items
from other countries would not be a viable option as the rubles earned in Russia would
be unconvertible. In that case, it would have to divert some of the income from
McDonalds Canada or from other international market to procure items for Russia.
McDonalds therefore decided to source food items locally, instead of importing and
started to build partnerships with the local suppliers by providing them with adequate
training. The company had to resort to vertical integration for sourcing raw materials.
In order to control the quality, distribution, and reliability of its ingredients,
McDonalds built a US$40 million, 110,000 sqft plant in a Moscow suburb to process
the required beef, milk, buns, vegetables, sauces, and potatoes.98 This facility also
included laboratories for testing to ensure compliance with quality and consistency
standards. The company also brought in Peter Frings, an agronomist with Mccain
93
94
95
96
97
98
Ann Blackman, Moscows Big Mak Attack, www.time.com, February 05, 1990.
Same-store sales is defined as sales at stores open for at least 13 months.
Russian Ruble 43 Percent Underestimated, According to Big Mac Index,
http://newsfromrussia.com, July 21, 2009.
Jenny Wiggins, Growing Taste for Quality Goods Lures Big Brands, www.ft.com, January
20, 2010.
McDonalds Russia, Brand Strategy, November 2005.
Ann Blackman, Moscows Big Mak Attack, www.time.com, February 5, 1990.
349
International Business
Foods Ltd., to introduce the Russian farmers to the non-native Russian Burbank
potato used to make the companys fries. 99 Some selected farmers were educated on
improving the quality as well as production volumes. Some Netherlands-based potato
farmers and processors helped the local farmers to grow a specific variety of potato
that was suitable for making frozen French fries. Bakers were also brought in not only
from the US and Canada, but also from some European countries like Sweden and
Germany, to develop baking systems for buns and pies. The pasteurization process, set
up by dairy experts from Sweden, was a very significant step as the milk in Russia
was highly contaminated compared to other countries in Europe and the US.
Initially, there were problems in the procurement of beef as well, due to its shortage in
Moscow. Even though European meat experts were brought in to start new feed
programs for the Russian cattle, the local supply was unable to meet the huge demand
of 1,500 tons of beef per year. Also the company was not allowed by the government
to buy meat directly on its own, in spite of initiating such feed programs. It had to
strike a deal with the government-run slaughter houses, but then, the company was
also restricted from picking up its choice of meat. As a result, McDonalds installed
different buyers at various slaughter houses who bought the beef for the company in
limited quantities.100
By 1999, about 75-80% of the raw materials were being sourced from more than 100
local producers in Russia. Our main goal is to develop local suppliers. We check
their production every three months to guarantee quality, 101 commented Khasbulatov.
But even in 2001, the company was importing chickens from France, cheese, fish, and
apple segments from Poland, potatoes cut and frozen from the Netherlands.
While McDonalds continued to select its own suppliers in Russia, in 2007, it handed
over the companys logistics to Alfa Group affiliate Rulog102 in a bid to remove
logistics from its own management. McDonalds also transferred chicken production
to a plant in the Kaliningrad region, which was set up jointly with Brazils Sadia. The
production of beef patties will be handed over before the end of the year to an
enterprise that Italys Inalca is building in the Moscow region Thus, more than 80%
of the products for our chain will be produced on Russian territory. Only the
production and processing of potatoes and fish products will remain abroad, 103 said
Khasbulatov.
Results
McDonalds was a huge success in Russia right from the first day of its operations.
Thousands of customers queued up for hours to experience it. The restaurant served
over 30,000 customers on the opening day. By 1993, the company started making
profits in Russia and did not look back after that. In a country where there was
nothing available, McDonalds was everything, 104 said Russian restaurant magnate
Rostislav Ordovsky.
99
100
101
102
103
104
350
105
106
107
108
109
110
111
112
113
351
International Business
Experts felt that the company had done well in Russia despite facing some serious
challenges. Although the political environment had been murky at times, the company
had increased its investment in the country. In 2009, it planned to invest US$120
million on expanding its operations in Russia.114 Experts noted that other companies
such as Coca-Cola too were investing generously in the country. 115 According to
Douglas Helfer, a senior portfolio manager at the Halbis unit of HSBC Global Asset
Management, They see that the opportunity outweighs the price of the risk. 116
According to McDonalds, it had posted record-high comparable sales growth in
Europe in 2008. It attributed this success to markets such as Russia, France, the UK,
and Germany. According to McDonalds, this was partly due to the fact that the
company created local customer relevance through a tiered menu approach, which had
an effective combination of premium selections, classic menu favorites, everyday
value, and popular limited-time food promotions. Like other markets in the Europe
such as France, Germany, and the UK, the company strove to improve operational
efficiency in its restaurants in Russia and transparently communicated facts about its
brand, the quality and nutrition of its food items, and about itself as an employer.
According to the company, its European operations constant currency increase in
revenues in 2008 and 2007 was mainly due to strong comparable sales in Russia,
France, and the UK.117 We have 25,000 employees in Russia, US$1 billion in sales,
and net profits of US$200 million We are in 130 countries and Russia is, by far, the
best We do 800,000 transactions a year, which is double the number in North
America,118 said Cohon.
Despite a tough environment, with the Russian consumer sentiment being
dramatically hit by the economic crisis, McDonalds Russia continued its stellar
performance in 2009. In 2009, we have seen positive dynamics in customer traffic
and sales. The average bill was higher than in 2008 although it did not reach what we
forecast. We have no fundamental concerns that the situation may turn for the
worse,119 said Khasbulatov.
Industry observers felt that in addition to obtaining a first mover advantage in Russia,
McDonalds had also benefited from being a foreign brand. If we look at ads from
pre-revolutionary Russia, we hardly see a Russian brand. Its all Bormann, Einem,
Wolf, Marx, Singer, etc. So, on a genetic level, our people trust only Western
companies,120 said Goncharov.
114
115
116
117
118
119
120
352
Benjamin Scent and Natallie Cai, To Russia with Love, www.thestandard.com.hk, June
29, 2009.
In February 2006, Coca-Cola announced that it would invest US$1.2 billion in Russia over
the next three to five years as it felt that the sale of carbonated drink would increase during
the economic crisis.
Benjamin Scent and Natallie Cai, To Russia with Love, www.thestandard.com.hk, June
29, 2009.
Moscow Wants to Up Rent on its Two McDonalds, www.dailyherald.com, July 10,
2009.
Diane Francis, Russia Good for Business: McDonalds, http://network.nationalpost.com,
September 11, 2008.
Maria Kiselyova and Maria Plis, McDonalds to Target Stay-at-home Russians,
www.reuters.com, December 17, 2009.
Vladimir Kozlov, McDonalds Supersize Profits Conquer Moscow, www.mnweekly.ru,
January 25, 2010.
Overcoming Challenges
Analysts felt that the biggest challenge before McDonalds Russia was dealing with
the ministries. They felt that these regulators adhered to rigid regulations in doling out
supplies. When we need more sand or gravel for building and go to the department in
charge, they say, Sorry, youre not in my five-year plan, 121 said Cohon. The level
of bureaucracy in the country was a big impediment to growth, according to
Khasbulatov.
Catering to the local population was also challenging as their eating habits were quite
different and many of them were unaccustomed to eating foods such as burgers. For
instance, some people who were initially invited to test the Big Mac reportedly ate it
layer by layer.122 Moreover, eating habits were different. Eating food in Russia was a
lengthy procedure, with people sitting at a table for long periods of time. 123 They
were also not familiar with the drive-thru format. However, with the offerings at
McDonalds being viewed as a novelty by customers, the company had to contend
with long queues.
Right from the first day, the company had to work differently to cater to this market. It
took various initiatives to reduce long waiting lines by hiring private security people
to keep order and by using public-address systems to tell patrons how to place orders.
In some locations, employees took orders on handheld devices before customers
reached the counter. In addition to verbal instructions, customers were given picturemenus to simplify the ordering process. To deal with black marketing and pilferage,
the company maintained a one-door policy. In the initial days, there was a limit of ten
Big Macs to each customer.124 To move things fast, the company also invested in new
cooking equipment that helped serve customers faster. According to Khasbulatov,
When I said I have too many customers, it's a nice problem to have I would love to
continue to have this problem.125
In addition to the political challenges that the company faced, the company also
suffered a financial crisis during the economic turmoil in Russia around 1998. During
that time, the ruble fell drastically in value, leading to high inflation and economic
instability in the country. As a consequence, customer traffic decreased considerably
in the McDonalds stores and sales suffered a serious setback. 126
In 1998, McDonalds also experienced a major labor dispute in its processing plant,
the McComplex, when attempts by security personnel in the unit to form a union were
reportedly blocked by the company time and again. According to analysts, many
laborers accused the company of ill-treating them and of illegally holding them back
from forming a union. At that time, the company, under the pressure of an economic
slowdown, did lay off some employees and reduce salaries, which made the labor
force think about unionization. However, McDonalds Russia denied having ill treated
its employees and said that it was strictly abiding by the Russian laws. The incident
led to legal proceedings as well and tainted the employee friendly image of the
company not only in Russia but also in several other markets during that time.127
121
122
123
124
125
126
127
353
International Business
On February 19, 2007, the McDonalds at St. Petersburg was bombed in a terrorist
attack, injuring six people and damaging the store to a great extent. A similar
explosion had earlier occurred in 2002, when a bomb went off in a car at a
McDonalds restaurant in Moscow.128
In November 2007, McDonalds Russia was suspected of tax evasion and its offices
were raided by tax inspectors, who later claimed US$ 6.5 million from the company.
According to a newspaper, the Kommersant daily, the income tax department
suspected that the company bought meat and packaging materials through the shell
companies and availed of value-added tax redemption on milk and meat purchases
without having proper documentation.129 The Russian Tax officials contended that by
allegedly using unlicensed suppliers, McDonalds had posed a threat to Russian
society. Analysts felt that the Russian tax law was very complicated and left foreign
players at the mercy of regulators.130
Experts said that McDonalds Russia faced minimum competition as it was the
pioneer in fast food chains in the country and enjoyed the first mover advantage. Over
the years, many other retailers came up but none could attain the stature enjoyed by
McDonalds (Refer to Exhibit VII for Leading Fast Food Chains in Russia).
According to analysts, the fact that McDonalds locked the prime locations in the
country well in advance helped it to beat competition later when other companies like
Starbucks Corporation (Starbucks) 131 struggled against the rising real estate prices to
gain a significant presence in the country. When they are paying 3,000 rubles a
month for a 1,500 sq. meter outlet on Arbat, and we are paying $20,000 a month for a
60 sq. meter outlet, who do you think is going to have the upper hand? And thats not
their only outlet with such rent conditions, 132 said Goncharov.
In mid-2009, McDonalds also had to deal with a lawsuit filed against it by the
government that sought higher rental payments from its two restaurants (on Arbat and
on Bolshoy Nikolopeskovsky Pereulok) in the center of Moscow. In the early 1990s,
the company had signed a 49-year agreement with the city government at an annual
rate of 1 ruble per square meter. The government sought to enforce a local law
requiring a minimum annual rental rate of 1,000 rubles (US$30.67) per square meter
and wanted McDonalds to pay this rent.133 In December 2009, Moscow's arbitration
court upheld the city authorities move.134
128
129
130
131
132
133
134
354
Exhibit VII
Leading Fast Food Chains in Russia
Name of the
Chain
Country of Origin
KroshkaKartoshka
Russia (Moscow)
Stardogs
Year of Est. in
Russia
No. of Outlets
2005
2006
2007
March
2008
1991
141
170
230
252
Russia (Moscow)
1993 (2003 as
new brand)
186
197
224
234
McDonalds
USA
1990
137
157
174
190
Baskin
Robbins
USA
1992
118
132
139
139
Teremok
Russia
1998
62
92
135
142
Rostiks KFC
Russia/USA
1993 (2005 as
new brand)
87
97
135
141
Sbarro
USA
1997
52
83
111
114
Riksha I Van
Russia (Moscow)
1998 (2006 as
new brand)
79
90
Chaynaya
Lozhka
Russia (St.Petersburg)
2001
28
42
59
64
Eurasia
Russia (St.Petersburg)
2001
30
49
49
49
Moo - moo
Russia (Moscow)
2000
14
17
17
PrimeStar
Russia/USA
2007
13
14
Grabli
Russia (Moscow)
2003
Source: Russian Federation HRI Food Service Sector-2008, www.fas.usda.gov, July 28, 2008.
In Old Arbat pedestrian Tourist Mall, McDonalds constructed side cafs and served a
dessert menu. McDonalds also began to make stronger McCafes, 135 as a pre-emptive
measure to face competition from Starbucks, much before it entered in Russia in
2007.136 McDonalds, however, faced some competition from a few local retailers like
the Rostiks Group137 and Elki-Palki138 as well as from the US-based companies like
Yum! Brands.139 Some of the local fast food stalls that served local dishes at very low
prices also took away a lot of McDonalds customers and added to the competition.
135
136
137
138
139
McDonalds coffee house style cafs were first launched in Russia in 2002.
McDonalds Becoming Largest Corporate Land Owner in Russia,
www.organicconsumers.org, March 22, 2005.
Rosticks Group (Rosticks), started in 1993, in Russia, operated restaurants in different
formats that included including Il Patio, Planetsushi, Fridays Moka Loka, and Siberian
Crown. There were 174 stores under Rostick in 2004. As of 2007, it controlled 14% of the
restaurant market. Rosticks was the second most popular fast food name in Russia, after
McDonalds.
Founded in 1996, this Russian chain specialized in Russian cuisine and was moderately
priced.
Yum! Brands, based in Kentucky, USA, operates around the world through 36,000
restaurants in 110 countries and territories. In 2007, it reported sales worth US$ 9,100
355
International Business
Despite many obstacles that included two bomb attacks on its stores, Russias two
wars in Chechnya,140 the economic crisis in 1998, and many other challenges,
McDonalds Russia continued to grow at a slow and steady pace. Some analysts also
pointed out that though McDonalds Russia faced a lot of challenges, it remained
shielded from controversies related to the paying of low wages and health-related
accusations that it suffered in the US and European countries. They said that obesity
related controversies did not bother the company in Russia where people themselves
asked for mayonnaise that had 40% fat content.141 This was despite some nutritionists
raising concerns that the local populations love for a burger could lead to health
issues in the country.142
McDonalds also said that though it encountered some problems in dealing with the
regulators, it did not have any trouble in terms of corruption or harassment in Russia.
According to Cohon, Russia was a great place to do business, if politics were not
involved.143
Outlook
With more than two-third of Russias fast food business, McDonalds was a dominant
player. In 2009, Russia was again one of the markets that spurred the companys
growth as it was McDonalds fastest-growing market in Europe in terms of restaurant
openings.
Analysts said that McDonalds strong performance in Russia came at a time when the
country was in the grip of an economic downturn and its competitors were struggling
(Refer to Exhibit VIII for Comparison between McDonalds Comparable Sales in
November 2008 and 2007). According to the company, the sales were driven by
extended operational hours and more variety in the breakfast and regular menu. In the
words of Skinner, McDonalds continued strong performance reflects the benefits of
our multidimensional approach. Convenient locations, extended hours, and quality
food at an outstanding value are all reasons why people are choosing McDonalds. 144
However, Khasbulatov admitted that McDonalds was affected by the economic
downturn and that its growth in the market would slow down. I cant say we have
gained from the crisis by taking the share from more expensive restaurants The
recession has had an impact on our customers and we havent gained from it ... We
wont see the previous pace of growth of 15-20 percent a year any more, 145 he said.
140
141
142
143
144
145
356
million. Restaurant chains under it include Kentucky Fried Chicken (KFC), Pizza Hut,
Taco Bell, and Long John Silver. In 2005, KFC co-branded with Rosticks in Russia to sell
their chicken products.
Chechnya was a Republic within the Russian Federation. This region had been in constant
conflict with Russian Federation for a long time. The First Chechen War was fought
between 1994 and1996 and resulted in the independence of Chechnya. In August 1999, the
Second War started, which ended around mid-2000. It resulted in Russia gaining control
over the separatist region of Chechnya. However, sporadic fighting continued even till
2005.
McDonalds Becoming Largest Corporate Land Owner in Russia,
www.organicconsumers.org, March 22, 2005.
Vladimir Kozlov, McDonalds Supersize Profits Conquer Moscow, www.mnweekly.ru,
January 25, 2010.
Diane Francis, Russia Good for Business: McDonalds, http://network.nationalpost.com,
September 11, 2008.
McDonalds delivers another Month of Strong Global Comparable Sales - November Up
7.7%, www.mcdonalds.com, December 8, 2008.
Maria Plis, McDonalds Eyes Russia Growth with 40 New Stores, http://uk.reuters.com,
February 26, 2009.
Exhibit VIII
McDonalds Comparable Sales in November 2008 and 2007
Major segments of the company
% Increase in Sales
2008
2007
7.7
8.2
US
4.5
4.4
Europe
7.8
10.8
APMEA
13.2
12
7.1
7.0
US
3.9
4.9
Europe
8.8
7.6
APMEA
9.3
10.4
McDonalds Delivers Another Month of Strong Global Comparable Sales November Up 7.7%, www.mcdonalds.com, December 8, 2008.
The company planned to open another 45 outlets in Russia by the end of 2012. 146 It
planned to expand into areas that were less penetrated by fast-food chains. It was also
speculated that the company might launch a franchise scheme to expand beyond the Ural
mountains in the eastern part of the country. Analysts expected McDonalds to spend US$120200 million in 2010 on opening new outlets and also to spend a significant amount on
revamping existing outlets. Establishing the entire production chain for McDonalds
Russia in the country was another priority for the company. Currently, 80% of what
we produce [in Russia] is made in Russia. The task is to move the remaining 20% to
Russia,147 said Khasbulatov.
In January 2010, Burger King entered Russia, opening its first outlet in Moscow. 148
Experts felt that Burger King had taken the plunge attracted by the success of
McDonalds. Subway too planned to expand its chain in Russia from 78 in December
2009 to 1,000 outlets by 2015.149 While analysts expected the competition to intensify
with the entry of Burger King and the emergence of some strong domestic players,
146
147
148
149
Jenny Wiggins, Growing Taste for Quality Goods Lures Big Brands, www.ft.com,
January 20, 2010.
McDonalds to Invest in New Restaurants in Russia, http://bbjonline.hu, February 26,
2009.
Burger King Opens First Outlet in Russia, http://abcnews.go.com, January 21, 2010.
Maria Kiselyova and Maria Plis, McDonalds to Target Stay-at-home Russians,
www.reuters.com, December 17, 2009.
357
International Business
they did not expect McDonalds position to come under threat immediately.
According to Oleg Sukhotin, executive director of the Russian Association of Fast
Food Enterprises, Its difficult to compete with McDonalds because it received
privileges from the city government at least at some stage. But Im sure that, for
instance, Kroshka-Kartoshka has been successfully taking over McDonalds
customers. 150
McDonalds seemed unpurterbed by the competition and felt that there was plenty of
scope for growth in Russia. According to Khasbulatov, more than two third of the
population were not in the habit of eating out. While 70 percent of our population is
not used to eating outside the house, we will have a niche that we should be looking at
carefully as there are big opportunities to make these people eat out, 151 he said.
150
151
358
Food
Industry
1991-2000,
Land
Owner
in
Russia,
McDonalds Set for 20% Expansion in Russia, www.sptimes.ru, June 10, 2005.
359
International Business
25. Explosion hits McDonalds restaurant in St. Petersburg; 6 injured,
www.iht.com, February 18, 2007
26. Russian
Police
See
McDonalds
http://news.webindia123.com, February 19, 2007.
Blast
as
Hooliganism,
McDonalds Russia Fights $6.5 mln Tax Claim, Reuters, www.flex-newsfood.com, December 5, 2007.
360
361
2
3
Matthew Saltmarsh, Andrew E. Kramer, French Retailer to Close Its Russia Stores,
www.nytimes.com, October 16, 2009.
Carrefour to Quit Russia, ehttp://store.businessmonitor.com, October 16, 2009.
London-based Business Monitor International is an independent information provider in the
areas of country risk and information research.
French Hypermarket Chain Carrefour Leaves Russian Market, http://en.rian.ru, October
15, 2009.
Sedmoi Kontinent or Seventh Continent is a Russia-based grocery chain. As of December
2009, it operated through nine hypermarkets and 130 supermarkets in Russia. Its revenues
for the year ending 2008 were 43.8 billion Rubles.
Troika Dialog is one of the largest private investment banks in CIS. Its main lines of
businesses include capital markets, investment banking, asset management, personal
364
Background Note
Carrefour was founded in 1960 by two entrepreneurs Marcel Fournier, a textile
retailer, and Louis Defforey, a wine and food wholesaler from Annecy in Eastern
France. The first two stores that they opened were highly successful. In 1963, a 2,500
square meter store was opened in Sainte-Genevieve des Bois, a Paris suburb. It
occupied an area of 2,500 square meters and had enough space to park more than 400
cars. The store provided a wide range of items, including self-service grocery at
discount prices, and clothing, sporting equipment, electronic goods, and auto
accessories. The store was inaugurated in June 1963 and its huge size earned it the
name hypermarket in the media. Carrefour offered products at the lowest prices as
compared to its competitors by negotiating with wholesalers and suppliers. The
concept of a hypermarket found instant acceptance among the younger people,
suburban dwellers, and price conscious consumers.
In 1966, a 10,000 sq. meter hypermarket was opened in Lyon and a 20,000 sq. meter
hypermarket was opened in Vitrolles. In 1967, Carrefour opened an office in Paris to
coordinate the activities of its various stores in the country. The company began to
enter international markets after a law was passed in France in 1963 to restrict the
development of large stores. Its first international venture was in Belgium, where it
opened an outlet in association with Delhaize Frres-Le-Lion9, in 1969.
In 1970, Carrefours shares were listed on the Paris stock exchange. By 1971,
Carrefour was directly operating 16-wholly owned stores, with an equity interest in
five more stores. It also operated through franchises. In its first venture outside
Europe, Carrefour opened a hypermarket in Brazil in 1975.
7
8
investments, and finance. About 33% of the equity stake in the company is owned by the
Standard Bank Group and the rest is owned by 109 employee partners.
Retail Market Fight too Tough for Carrefour, http://rt.com, October 17, 2009.
Matthew Saltmarsh, Andrew E. Kramer, French Retailer to Close Its Russia Stores,
www.nytimes.com, October 16, 2009.
Delhaize Frres-Le-Lion is a part of The Delhaize Group, a food retailer headquartered in
Belgium. The group was founded in 1867 and operates food supermarkets in North America,
Europe, and Southeast Asia. In 2008, its revenues were 19.02 billion and profit was 467
million.
365
International Business
In 1978, Carrefour developed a hard discount store10 format under the banner Ed, in
France. The stores offered a limited range of products at very low prices. By 1985,
Carrefour was operating in ten countries and had introduced private label products
that were priced 10-20% lower than branded products and were said to be of superior
quality. In 1988, Carrefour entered the US market by opening a 330,000 sq ft
hypermarket in Philadelphia. Another hypermarket was set up in 1991 11. In 1991,
Carrefour acquired French hypermarket chains Euromarche and Montiaur. In 1992,
Carrefour reported sales of 17.86 billion and a net income of 271 million.
In the early 1990s, Carrefour concentrated on establishing larger stores in France
(with an area of more than 2,500 square meters) and sold off its smaller stores. By the
mid-1990s, Carrefours European operations were spread across Italy, Spain, Turkey,
Greece, and Portugal. In 1996, Carrefour opened 30 hypermarkets across the world, of
which 15 were in South America. By 1997, the number of stores in South America
had increased to 60 (Refer to Exhibit I for the timeline of Carrefours entry into
international markets). Carrefour operated through franchises in the UAE, Saudi
Arabia, Oman, Qatar, Egypt, Tunisia, Algeria, and the Dominican Republic. In 1998,
it acquired Comptoirs Modernes SA, which brought 790 supermarkets into its fold. In
1999, it acquired Promods SA12, which owned several hypermarkets, supermarkets,
convenience stores, and discount stores. The acquisitions helped Carrefour become
the top retailer in Europe by the late 1990s.
Exhibit I
Top Global Retailers (2009*)
Rank
Company
Country
Retail Sales
(US$ Million)
USA
374,526
France
112,604
Carrefour SA
Tesco Plc
UK
94,740
Metro AG
Germany
88,189
USA
77,349
USA
70,235
Germany
69,346
Target Corp.
USA
63,367
USA
63,088
10
Germany
54,847
11
12
Hard discount stores sell products at prices that are even lower than those in traditional
discount stores like Wal-Mart. They are small in area and sell a limited assortment of
products.
Subsequently, Carrefour suspended the US operations in 1993, as the stores were not
profitable.
Promods SA was established in 1950, and played a major role in promoting supermarkets in
France. During the 1960s and 1970s, the group expanded rapidly in other countries in
Europe and South America. In 1999, Carrefour purchased Promods SA to become the
second largest retailer in the world.
366
Exhibit II
Carrefour International Expansion
YEAR
COUNTRY
1969
Belgium
1973
Spain
1975
Brazil
1982
Argentina
1989
Taiwan
1991
Greece, Cyprus
1992
Portugal
1993
Italy, Turkey
1994
Mexico*, Malaysia
1995
China
1996
1997
Singapore, Poland
1998
1999
2000
2001
Romania, Switzerland**
2002
Egypt
2004
Saudi Arabia
2005
Algeria
2006
Cyprus
2007
Jordan, Kuwait
2008
Bahrain
2009
International Business
Exhibit III
DESCRIPTION
Offers a wide range of food and non-food products
Offers about 80,000 items.
Hypermarkets
Supermarkets
Hard Discount
Stores
Convenience
Stores
Cash-andCarry
and
Food Service
Source: www.carrefour.com.
Exhibit IV
Carrefour Sales Country Wise (2008)
Country
No. of Stores
France
47,119
5,517
Spain
15,527
3,073
Italy
7,806
1,608
Belgium
5,269
627
2,944
888
989
498
Portugal
368
Country
No. of Stores
Poland
2,424
330
Turkey
1,641
760
Romania
1,190
41
Brazil
8,218
536
Argentina
2,647
589
Columbia
1,228
59
Taiwan
1,361
59
China
3,464
456
Thailand
584
31
Malaysia
326
16
Indonesia
893
73
Singapore
94
4,905
267
108,629
15,430
Partners Franchisees
Total Group
Interview with the Chairman of the Management Board, Annual Report 2006.
The Russian financial crisis of 1998 was triggered by the Asian financial crisis of 1997 and
resulted in high inflation. The food prices went up by 100% and with people stocking up
essential items, shortages were witnessed. By 1999, the country recovered from the crisis.
369
International Business
market in June 2007. The retailer planned to open only hypermarkets initially. It
would then follow this up with other store formats. At that time, it intended to open its
chain in 20 cities. A group of managers from France were stationed in Russia to
prepare for the launch of a new store by early 2008.
Analysts were of the view that Carrefour had delayed its entry into Russia (Refer to
Exhibit V for a note on retail industry in Russia). According to Maria Sulima, a retail
analyst with Metropol15, They are rather late in coming. At this point, it would be
more effective to purchase a chain with already developed logistics and distribution
networks.16 By the time Carrefour entered the market, Auchan SA 17 (Auchan) and
Metro AG18 (Metro) had established a significant presence in the country. Auchan had
a presence in eight Russian cities while in Moscow alone, it had 20 stores. Metro had
74 stores across the country. Other competitors included local players like X5 Retail
Group NV19 (X5) and Mosmart CJSC20 (Mosmart). On Carrefours delayed entry into
the country, Thierry Garnier (Garnier), Group Executive Director, Carrefour, said,
We were waiting for the best moment to enter the market. We are in Russia for the
long term.21
Exhibit V
A Note on Retailing Industry in Russia (2008-09)
As of 2008, the retailing industry in Russia was valued at US$ 480 billion,
witnessing a growth of 27.5% over the previous year. The growth was attributed to
high oil prices and strong economic growth in the market. Food retailing accounted
for 45.3% of total retail sales.
As of 2009, Russia was Europes fastest growing consumer economy and by 2012,
it was expected to overtake the UK and Germany in terms of retail sales, making it
Europes second largest retail market after France. According to the Economist
Intelligence Unit, the retail market in Russia was expected to grow to US$ 745
billion by 2011. Moscow and St. Petersburg were the two largest cities in Russia.
About 14 of its cities had a population of over 1 million and were expected to
account for 60% of the retail growth in the country by 2012.
The countrys retail industry began to grow after 2004 and the growth was mainly
in areas like supermarkets, electrical stores, fashion retailers, etc (Refer to Table A
for the major retailers in Russia and their turnover for 2008).
15
16
17
18
19
20
21
IFC Metropol is a Russia-based investment and financial company. Its activities include
corporate finance, debt instruments, equities, research, depository services, and legal
services.
Carrefour Opens First Russian Store, www.russianamericanchamber.com, June 19, 2009.
Auchan is a France-based multinational retail group. The group is controlled by the Mulliez
family of France. In 2008, its revenue was 39.284 billion and net income was 744
million.
Metro is a Germany-based retail group. It was the fifth largest retailer in the world as of
2009. In 2008, its revenue was 67.96 billion and profit was 403 million.
X5 was the largest retail group in Russia as of 2009. It operates through three formats
hypermarkets, supermarkets, and soft discount stores. In 2008, its sales were US$ 8892
million and EBITDA was US$ 803 million.
Mosmart is a Russia-based multi-format retail chain.
Carrefour Opens First Russian Store, www.russianamericanchamber.com, June 19, 2009.
370
X5 Retail Group
9.0
Magnit
5.0
M.Video
2.7
Kopieka
2.0
Lenta
2.0
Dixy Group
1.5
Seventh Continent
1.4
The growth in the retailing industry in Russia was fueled by high disposable
incomes as most of the Russians unlike US citizens were free of mortgages and
lived in their family homes. As many Russians saw their savings being wiped out
during the crisis during the late 1990s, they preferred to spend money rather than
save it. In 2002, people in Moscow spent 94% of their monthly earnings. By 2007,
per capita income in Russia, which was at US$ 1185 in 2001, had increased to US$
4803.
However, non-Russian companies found it very difficult to do business in the
country, due to the high degree of bureaucracy existing there. Every activity from
obtaining permission for land, finalizing property deals, clearing goods through
customs, or obtaining visas, consumed a lot of time and effort. According to Chris
Skirrow, Head of PricewaterhouseCoopers retail and consumer practice in
Moscow, It is the day-to-day bureaucracy that can grind people down. It
sometimes seems that if a comma is in the wrong place on an invoice you can lose
the tax deduction. One of the biggest problems is unpredictability and unreliability
including tax authorities and the judiciary. There is not only potential for
corruption but also uncertainty, which makes the operating environment a lot more
difficult.22
In several cases, companies opted to bribe the authorities in order to obtain the
necessary permissions. Some of the businesses hired a Krisha (security firm), which
handled payments etc. that enabled businesses to operate smoothly. Many foreign
companies opted to partner with a local company to lead highly complex
negotiations or operate through a franchisee. At the same time, there were retailers
like Ikea, which from the beginning, emphasized that it would work only with those
local governments that would agree to its no-bribery policy. Several local
governments wanted Ikea to open stores in their region to show that they were
against bribery, to attract other investors.
Much of the retail activity in Russia was concentrated around Moscow, where the
salaries were double that in other regions. But the market was highly saturated with
several retailers, both international and local, having a presence in these cities.
22
371
International Business
Another problem that investors faced in Russia was the crumbling infrastructure.
Finding the right people to fit into retail roles was also a major challenge. Though
the countrys education system was highly sophisticated, it churned out more
scientists than management graduates.
In mid-2008, UBS predicted that Russias retail sales would grow by 22% per year
till 2010. But by early 2009, the global economic crisis had started showing its
impact on Russia and the retail sales slowed down after several years of growth.
The retail sales in August 2009 were down 9.8% as compared to retail sales in
August 2008. The crisis showed that Russia lacked good quality retail assets. In
2008, the top ten players accounted for only a 10% market share. The spending
patterns of the Russian consumers also underwent a change with consumers
exercising caution on spending due to the economic crisis. The growing
unemployment rate also had an adverse impact on the retail sector in Russia. The
Russian retail sector was estimated to grow by 3% in 2010.
In the third quarter ending September 2009, the Russian economy witnessed a net
capital outflow of US$ 31.5 billion. By October 2009, with oil prices going up, the
Russian economy showed signs of revival. In spite of all the problems, Russia with
a population of 143 million remained an attractive destination for retailing.
According to the analysts, the top five retailers had a share of 12% in the Russian
food market, and this was expected to increase to 14% by the end of the year.
Consumers still preferred to shop at outdoor markets, street stands, and unbranded
shops but a gradual shift toward larger outlets was being seen.
Compiled from various sources.
In order to step up its presence, Carrefour wanted to have an association with a local
partner, and intended to acquire local grocery chain Seventh Continent, which
operated through 140 stores.
In February 2009, Carrefour made a non-binding offer to Seventh Continent valuing it
at US$ 1.25 billion. On Carrefours interest in Seventh Continent, Marie Lhome,
analyst with Aurel BGC23 in Paris, said, It is more expensive and difficult to set up
operations in Russia. Some retailers, like Ikea, have run into legal issues there. The
interest in Seventh Continent comes from the companys stores prime locations in the
center of Moscow.24 Analysts also expressed doubts about the fit of Seventh
Continent with Carrefours overall strategy, as Seventh Continent was a luxury store.
However, the offer was rejected by the shareholders of Seventh Continent.
Carrefour persisted with its acquisition effort and in May 2009, the company signed a
preliminary letter of intent to acquire a 75% equity stake in Seventh Continent.
Reports suggested that both the companies were under the exclusivity period25 due to
which Seventh Continent could not enter into agreements or talks with any other
potential buyers. Analysts were of the view that after the acquisition, the Russian
retail market would account for 1% of Carrefours total sales.
23
24
25
Aurel BGC is the result of a merger between ETC Pollak, Aurel, and BGC. The services
provided by Aurel BGC include fixed income and equity derivatives. It also conducts
economic and financial research and provides forecasts.
Javier Espinoza, Carrefour Flirts with Seventh Continent, www.forbes.com, April 20,
2009.
During the exclusivity period, both Carrefour and Seventh Continent was banned from
negotiating with any other potential buyers. This, according to analysts, showed that the deal
was imminent.
372
Opening Stores
In June 2009, Carrefour opened its first store in Moscow. Commenting on this
occasion, Jacobo Caller, General Director of Carrefour in Russia, said, We are very
happy to start our business operations in Russia where we will follow our clientoriented principles: offering quality products at low price, great value, and high level
of services to Muscovites. We believe that the opening of the first Carrefour store in
Moscow is an important step for Carrefours development in Russia and will have a
positive impact on the economic development of the city. 26
At that time, Carrefour announced that it believed in the long-term potential of the
country and considered the Russian market to be strategically important for the
development of Carrefour. According to Garnier, As the second world and most
internationalized retailer, the Carrefour Group is now developing its activities in a
new country. Starting our operations in Russia is an important milestone for our
company. The Carrefour Group believes that the Russian retail market has outstanding
long-term potential and considers it to be one of the strategic priorities for the
companys international development. 27 However, analysts cautioned that it would
be difficult for Carrefour to expand in the country without acquiring an established
player. According to Mikhail Terentiev, analyst with Nomura International 28 in
Moscow, It is not very easy to establish a footprint in Russia. If you want to expand
in Russia rapidly it would be a good idea to buy somebody else with a very developed
market.29
Carrefours first store was located in Filion Shopping Mall, and occupied two floors
with a sales area of 8,000 square meters, 58 checkout counters, and 450 staff. It sold
15,000 food items and 30,000 non-food items. Of the total 45,000 SKUs on offer,
over 5,000 were private label products. Fillion Shopping mall occupied an area of
87,000 sq. meters and included a 10-screen multiplex cinema and a theme park. The
shopping mall had facilities to park 3,000 cars. Carrefour had reportedly invested
8.8 million on its first store and its opening was a grand event with the guests being
entertained by mime artists, musicians, dancing troupes, etc.
However, industry experts were not impressed with the location of Fillion Shopping
Mall, pointing out that though it was located close to the city center, it was not easily
accessible, not prominently visible, and was located among low-income group
families.
26
27
28
29
Carrefour Starts Business Operations in Russia and Moves Forward with its International
Expansion, Press Release, Groupe Carrefour, June 18, 2009.
Carrefour Starts Business Operations in Russia and Moves Forward with its International
Expansion, Press Release, Groupe Carrefour, June 18, 2009.
Nomura international is a part of Japan-based Nomura Group, which is an industrial and
financial conglomerate. The group has interests in oil and gas, construction, chemicals,
foodstuff, and finance.
Javier Espionoza, Carrefour May be Stumbling with Russian Dreams, www.forbes.com,
June 18, 2009.
373
International Business
Carrefour instantly attracted customers who mostly shopped there for food products.
One item that proved to be highly attractive was the different varieties of bread that
Carrefour sold. As most of the customers were used to the French retailer Auchan,
they found shopping at Carrefour convenient due to the high service standards,
availability, and wide choice of products.
Just after the first store was opened, newspapers reported that negotiations between
Carrefour and Seventh Continent had been stopped. Thus, Carrefour was not able to
acquire Seventh Continent on which it was banking for its expansion in Russia.
The second store was opened on September 10, 2009, at Krasnodar in South Russia.
For this store, Carrefour entered into an MoU with the local government to implement
an investment project. As per the MoU, the company planned to invest up to US$ 100
million in the region, over five years. Carrefour was to be provided with support in
terms of business development, finding suitable plots, infrastructure, etc. by the
regional authorities.
On this store, Carrefour invested 8 million. The store had a sales area of 8,500
meters, and employed 350 people. The company invested 7.8 million on developing
the store. At that time, it announced that though Russia was under a recession, for the
first time in a decade, the crisis would not change Carrefours plans for the market and
it would open its third store as planned. According to Jacobo Caller, Carrefour
Russias Director, For Carrefour, (the) Russian retail market has outstanding longterm potential. Despite the crisis, we are not going to change our long-term vision of
this country. With Brazil, India, and China, Russia is one of the priorities in the longterm expansion of Carrefour.30 At that time, he also announced that in a few months
time, Carrefour would come out with its elaborate expansion strategy for Russia.
By the time the second store was opened, Carrefour had already announced its plans
to open a third store in Lipetsk and had also entered into a lease agreement to open its
fourth store at River Mall in Moscow. According to the analysts, Carrefour chose
these locations as the major locations like Moscow and St. Petersburg were stagnating
and Krasnodar and Lipetsk were some of the regions that were experiencing rapid
growth.
31
32
374
34
375
International Business
Exhibit VI
Major Retailers in Moscow and St. Petersburg (October 2009)
ST. PETERSBURG
Retailer
Brand
Format
X5 Retail
Group
Perekriostok
Supermarket
Pisterochka
Discounter
Karusel
Hypermarket
16
Okay
Hypermarket
14
Okay
Supermarket
13
Lenta
Lenta
Hypermarket
14
Dixy
Dixy
Discounter
84
Auchan
Auchan City
Hypermarket
Metro
Metro CC
Okay
No. of Outlets
21
278
MOSCOW
Retailer
Brand
Format
No. of Outlets
X5 Retail
Group
Perekriostok
Supermarket
Pisterochka
Discounter
Karusel
Hypermarket
10
Auchan
Auchan City
Hypermarket
Metro
Metro CC
11
Real
Real
Hypermarket
Alye Parusa
Alye Parusa
Supermarket
16
ABC of Taste
ABC of Taste
Supermarket
25
Sellgross
Sellgross
Spar
Spar
Supermarket
Seventh
Continent
Nash Hypermarket
Hypermarket
Seventh Continent
Corner Shop
30
Seventh Continent
Supermarket
54
Supermarket
31
Mosmart
Mosmart
Hypermarket
Stokmann
Stokmann
Hypermarket
Billa
Super
Supermarket
Paterson
Paterson
Supermarket
20
76
181
Source: www.bordbia.ie.
set on bonuses suppliers could pay to the retailers to stock their products, payment
timeframes within which retailer had to pay suppliers, etc. The Russian government aimed to
increase the competition in the retail sector by passing the law.
376
35
The global financial crisis refers to the credit, banking, trade, and currency crisis that
emerged in 2007-08. This was the result of the failure of several US-based investment
companies, mortgage companies, and insurance companies due to the sub-prime crisis in the
country. The sub-prime crisis was the result of mortgage delinquencies and foreclosures,
which had an impact on banks and markets around the world.
36
Carrefour: Abandoning Russia, Datamonitor, October 19, 2009.
37
Colony Capital LLC is an investment firm based in the US.
38
Bernard Arnault is the founder, Chairman and CEO of LVMH Mot Hennessy Louis Vuitton
SA (LVMH), which consists of over fifty luxury brands like Louis Vuitton, Mercier, TAG
Heuer, Donna Karan, Dior, and Fendi. He was the 15th richest person in the world as of 2009
according to Forbes.
39
Carrefour to Exit Russia, Hit by Challenging Markets, www.reuters.com, October 15,
2009.
377
International Business
378
379
Sakhalin-1 Project:
Delivering Excellence in Project Execution
This case is about the Sakhalin-1 Project considered to be the largest and the most
ambitious world-class oil and gas development projects in the world. Located on the
northeast shelf of Sakhalin Island in Russia, the project is developed by a consortium
of Russian, Indian, Japanese, and US oil and gas companies.
Operated by Exxon Neftegas Ltd (ENL), the Sakhalin 1 Project includes three offshore
oil fields, the Chayvo, Odoptu, and Arkutun Dagi. The project is being developed in
four phases using both onshore and offshore drilling fields. The total recoverable
reserves were estimated at 307 million tons of oil and 485 billion cubic meters of
natural gas.
The case describes the development and execution of the project. Advanced
technologies and construction methods were adopted in the execution of the project
which reduced the overall cost of development and minimized environmental impact.
The case highlights how the project overcame the technical and environmental
difficulties to achieve its goals. It discusses how the project team successfully
managed the challenges associated with the project such as limited infrastructure,
complex regulatory rules, limited skilled labor, and difficult logistics. Analysts opined
that with careful planning and efficient use of technologies, the project successfully
completed its first phase of development.
The project, one of the largest single foreign direct investments in Russia, aimed to
fulfill the growing energy demand worldwide. It provided energy supplies for
domestic use and for export to Northeast Asia and consolidated Russia's strategic
position as an energy supplier to world markets. The case also discusses the benefits
the project brought to Russia, particularly to people of the island of Sakhalin.
The case concludes by discussing the future phases of the Sakhalin-1 Project.
Sakhalin-1 Project:
Delivering Excellence in Project Execution
The key to maximizing resource value lies in the ability of a global organization to
apply leading-edge technology and deliver excellence in project execution. Nowhere
is this truer than in the challenging Russian Arctic, where ExxonMobil is proud to be
associated with Sakhalin-1 one of the most ambitious projects industry has ever
undertaken.1
-
Introduction
In December 2008, the American oil and gas company ExxonMobil Corporations2
(ExxonMobil) oil and gas development project in Russia3, the Sakhalin-1 project
received the Excellence in Project Integration Award from the committees and
sponsoring societies of the International Petroleum Technology Conference 4 (IPTC).
The award was given to the company for effectively implementing the first phase of
the Sakhalin-1 Project through the application of modern production engineering
techniques, geoscience knowledge, construction and facilities engineering practices,
health, safety, and environmental processes, human resources policies, community
development, and collective teamwork. Commenting on the achievement, Mark
Albers, senior vice president of ExxonMobil, said, We are extremely proud of the
Sakhalin-1 project achievements. The Sakhalin-1 project is one of the largest energy
investments in Russia and is a testament to international cooperation to successfully
execute this project in one of the most challenging Arctic environments in the world
in a safe and environmentally responsible manner.5
The Sakhalin-1 Project is one of the largest oil and gas development projects in the
world. Located on the northeast shelf of Sakhalin Island, the project comprises three
offshore oil fields, the Chayvo, Odoptu, and Arkutun Dagi. The total oil and gas
1
382
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International Business
Background Note
Sakhalin, one of largest islands in Russia, is located off the east coast of Russia in the
Sea of Okhotsk. Colonized by Russia and Japan in the 18th and 19th centuries, the
island came under Russian control in 1875. The Sakhalin region is popular for its vast
natural and hydrocarbon resources. Oil reserves in the area are estimated to be around
14 billion barrels while the natural gas reserves are approximately 96 trillion cubic
feet.9 Commercial oil reserves were discovered in the region in 1910 in the Okha field.
But because of political unrest, difficult climatic conditions, and lack of adequate
finance, the oil fields could not be developed.
In the early 1970s, a subsidiary of Rosneft,10 Sakhalinmorneftegas Ltd.11
(Sakhalinmorneftegas) pursued the development of offshore oil resources in the
Sakhalin continental shelf. During that time, the Russian oil and gas industry lacked
adequate infrastructure to carry out oil explorations in the region. Moreover, the
industry did not have the technical know-how and had very limited experience of
offshore oil and gas development in sub-arctic regions such as Sakhalin Island.
Therefore, Sakhalinmorneftegas, with support from the Russian government, decided
to seek foreign assistance. Japan was considered as a potential investor as it had some
major oil and gas companies which could provide the needed infrastructure.
Geographically too, it was close to the Sakhalin Island. In 1975, Russia signed a
cooperation agreement with the government of Japan for oil and gas exploration and
development in the region. As per the agreement, Sakhalinmorneftegas had to work
with Japanese consortium Sakhalin Oil and Gas Development Co., Ltd. 12 (SODECO)
to carry out oil and gas development in the region.
Between 1977 and 1989, Sakhalinmorneftegas and SODECO were involved in
exploring the oil fields in the region. The oil exploration process involved seismic
surveys13 and exploratory drilling. The extensive efforts led to the discovery of three
oil fields in the region the Odoptu field in 1977, the Chayvo field in 1979, and the
Arkutun Dagi field in 1989. With the discovery of the oil fields, the Russian
government planned to develop Sakhalin Islands offshore oil reserves and export
energy to Northeast Asian markets, mainly Japan.
In 1991, after the dissolution of the Soviet Union, Russia became a separate state and
the country opened its doors to foreign investments. The Russian government was
looking for more international investors who could explore and develop the oil fields
in the island. The government then decided to auction off sections of the Sakhalin
shelf for developing oil and gas. It began to offer tenders for blocks of acreage on
9
http://www.eoearth.org/article/Energy_profile_of_Sakhalin_Island,_Russia.
Rosneft is the largest oil producing company in Russia. It is involved in the exploration and
production of hydrocarbons, petroleum products, and petrochemicals. For the year ended
2008, the companys average daily crude oil production was about 2.12 million barrels. The
Russian government holds a 75.16% stake in the company.
11
In 2008, Sakhalinmorneftegaz Ltd produced 1.76 million tons (12.9 million barrels) of crude
oil and 0.63 billion cm of gas.
12
Sakhalin Oil and Gas Development Co., Ltd. (SODECO) is a consortium of several major
Japanese companies, including the Japanese National Oil Company. The other principal
shareholders in the company are Japanese investment companies such as JAPEX, Itochu and
Marubeni.
13
The seismic survey is a type of geophysical survey which measures the properties of the
earths sub surface by generating, recording, and analyzing sound waves (also called as
seismic waves) that travel through the Earth. The surveys generate seismic images which
help geologists in locating underground structures that may contain oil or gas reserves. These
surveys are primarily used for oil and gas exploration.
10
384
14
15
16
The Sakhalin Oblast is a federal region of Russia comprising the island of Sakhalin and Kuril
Islands.
The ONGC Videsh Limited (OVL) is a wholly-owned subsidiary of the national oil company
of India, the Oil and Natural Gas Corporation Limited (ONGC). It is involved in the
development of oil and gas acreages including acquisition of oil and gas fields, exploration,
development, production, transportation, and export of oil and gas. The companys
international oil and gas operations produced about 8.802 million metric tons of oil and gas
in 2007-08.
Production sharing agreements (PSAs) is a commercial contract between an investor and the
state government which allows the investor to undertake large scale and long term
investments in the state. The PSA defines the terms and conditions for the exploration and
development of resources through a contract based arrangement that exists over the life of
the project.
385
International Business
Exhibit I
The Sakhalin Blocks (May 2008)
Sakhalin I
Sakhalin II
Sakhalin III
Kirinskii,
Odoptu
Primary Field/Block
Names
Chayvo
Arkutun-Dagi
Veninskaya,
VostochnoOdoptu,
Aiyashkii
Sakhalin V
Sakhalin VI
Pogranichny
Block, West
Schmidt,
Okruzhnoye
field
Pogranichny
Oil Reserve
Estimate
975 million
bbl*
1.0-1.2 billion
bbl
880 million
bbl.
E. Schmidt -2.98
bill. bbls). K-V 8.5 billion bbls
Natural Gas
Reserve Estimate
11 Tcf**
17.3 Tcf
27-38 Tcf
19 Tcf.
15.2-17.7 Tcf
n/a
Phase 1: $4.5
billion, Phase 2:
$20 billion
$13.5 billion
expected
(ExxonMobil$80m in
geological
studies)
$2.6 billion
expected
$3-5 billion
expected
n/a
Net Total
Investment
386
PiltunAstokskoye,
Lunskoye
Sakhalin IV
Phase 1: $5
billion
Sakhalin I
Primary Project
Developers
Max oil
production
from Chayvo
field achieved
in Feb. 2007 at
250 kb/d.
Commercial
gas production
expected in
2008
Exxon
Neftegaz
(30%),
SODECO
(30%), ONGC
Videsh (20%),
Sakhalinmorne
ftegaz
(RosneftSakhalinmorne
ftegaz
Subsidiary,
11.5%), and
RN Astra
(Rosneft
Sakhalin II
Sakhalin III
Sakhalin IV
Sakhalin V
Sakhalin VI
Current: 80,000
bbl/d for 6
months
Phase II:
180,000 bbl/d,
year-round oil
production
expected by
2009, LNG
production
expected by
2009
n/a
n/a
n/a
n/a
Gazprom
(50%+),
Sakhalin Energy
Investment
Company: Shell
(27.5%), Mitsui
(25%),
Mitsubishi
(20%)
Rosneft is
primary
developer.
Veninsky
Block: Rosneft
(49,8%),
Chinese
Sinopec
(25.1%) and
Sakhalinskaya
Neftyanaya
Kompaniya
(25.1%)
BP (49%),
Rosneft (51%)
Elvary Neftegaz:
BP (49%), Rosneft
(51%)
Urals Energy
(via Petrosakh),
Alfa Eco
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International Business
Sakhalin I
Sakhalin II
Sakhalin III
Sakhalin IV
Sakhalin V
Sakhalin VI
Oil production
began in 1999;
Processing
terminal under
construction with
capacity of
66,000 bbl/d of
oil, 1.8 bcf/d of
gas
License
possibly
suspended.
Lukoil in
association
with Gazprom
would
probably take
part in new
tenders for
Kirinskii and
Vostochno
blocks.
There is
speculation
that
unreleased dril
ling results
during 2007
were not
positive. No
drilling
planned in
2008, although
seismic
activities
continued.
Activities in 2008
included seismic
processing,
interpretation and
acquisition on the
existing license
blocks
3 blocks in
Sakhalin VI
have not been
awarded, but
Gazprom seems
to be interested.
Subsidiary,
8.5%)
Status
Mode of gas
export still up
for
negotiation.
Exxon
preferred
pipeline
exports to
China. Other
shareholders,
Gazprom
preferred
piping to LNG
terminal at
Sakhalin II.
388
18
19
20
21
389
International Business
of Russia approved the Justification of Investment 22 (JOI) for the Sakhalin-1 Project.
Approval of the JOI was a key milestone for the Sakhalin-1 Project as it allowed the
project to proceed to the Technical and Economic Substantiation of Construction
(TEOC) stage required for the construction of the oil export pipeline route across
Sakhalin Island to an export terminal. As part of the project documentation stage, the
consortium received over 1,000 additional approvals, licenses, and permits from
federal, regional, and local district authorities in the Sakhalin region.
In April 2003, the Authorized State Body23 (ASB) approved the Development
Program and Budget24 (DP&B) for the Sakhalin-1 Project. Total capital expenditure
for the project was set at US$12.8 billion. In April 2004, the Russian government
approved the TEOC stage which allowed the consortium to start full-scale
construction of facilities at the project site. According to project operator ENL, once
the Sakhalin-1 Project had passed the exploratory stage, project costs increased
significantly. To carry out operations related to the development and construction of
oil fields in the region, tenders were awarded to Russian contracting companies. In
2002, Russian businesses acquired large contracts, and the total value of the contracts
awarded to Russian suppliers and contractors as part of the Sakhalin-1 Project
exceeded US$ 1 billion (Refer to Exhibit II for the list of contacts awarded).
According to Galina N. Pavlova, Director of the Oil and Gas Industry Department of
the Sakhalin Oblast Administration, The successful implementation of the Sakhalin-1
Project became possible thanks to mutually-beneficial cooperation between Federal
and regional Russian authorities, and the members of an international consortium
including operator ExxonMobil, a global leader in the oil and gas industry. This
consortium brings together the talents of major companies: ExxonMobil, SODECO of
Japan, ONGC of India, and the Russian state oil company Rosneft. 25
Development
The Sakhalin-1 Project was executed in phases. According to analysts, a phased
development approach was followed so that the procedures built in the first phase
could be used in the future phases, thereby making the project cost-effective. The first
phase of the Sakhalin-1 Project involved the development of oil and gas in the
Chayvo oil field. The subsequent phases included oil and gas development in the
Odoptu and Arkutun Dagi fields, Chayvo field gas development, and late-life gas
development. It was reported that these future phase developments would push the
Sakhalin-1 Project through 2050.
22
23
24
25
390
Exhibit II
List of Contracts Awarded for Sakhalin-1 Project
Contract Project
Area
Scope of Work
Contractor
DeKastri
ACCESS - Amur
Services Co., LLC.
Orlan, Chayvo,
DeKastri, Yuzhno
ECC-VECO, LLC.
Orlan, Chayvo,
DeKastri, Nogliki,
Odoptu, Yuzhno
OOO Kentech
Sakhalin Technical
Services
Orlan, Chayvo,
DeKastri, Nogliki,
Odoptu, Yuzhno
OOO Sakhalin
Technical Services
Network
Chayvo
Pacific Rim
Constructors
Orlan, Chayvo,
DeKastri, Nogliki,
Yuzhno
Remote Project
Services Group
Global, LLC.
Orlan, Chayvo,
DeKastri, Nogliki,
Odoptu, Yuzhno
ZAO Vostok-Service
Sakhalin
Kholmsk, Korsakov
Sakhalin Shelf
Services
*Data as of 2007
Source: www.sakhalin1.com/en/contracting/opportunities.asp
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International Business
Sakhalin-1 Project started on schedule. The Russian Amur Services Company (ASC)26
provided a complete range of construction support services for the Sakhalin-1 Project
while ECC-VECO LLC27 provided civil construction, maintenance, and other services
for the project. ExxonMobil is pleased with the timely start-up of Phase 1 of the
Sakhalin-1 project. This project employs leading-edge technology including the use of
Arctic development technologies and extended reach drill wells that are among the
longest in the world. Application of this technology for the Sakhalin-1 project is a
significant breakthrough in our ability to develop the resources in the most costeffective, efficient, and environmentally sound way possible,28 said Rex W Tillerson,
Chairman and CEO of ExxonMobil.
The first phase of development involved the construction of offshore and onshore
drilling facilities, an onshore oil and gas processing facility, a crude oil pipeline, and a
marine export terminal with year-round storage and tanker loading facilities (Refer to
Exhibit III for a route map of the first phase of the Sakhalin 1 Project). The first step
in the Phase I of the Sakhalin-1 Project was to access the oil and gas reserves in the
Chayvo field using onshore and offshore drilling procedures.
Exhibit III
Route Map of Sakhalin-1 Project
Source: www.eoearth.org/article/Energy_profile_of_Sakhalin_Island,_Russia
26
27
28
Founded in 2002, Amur Services Company (ASC) provides infrastructure and support
services for construction projects including transportation, cargo hauling, logistics, waste
management, etc.
ECC-VECO LLC is a Russia-based construction company formed specifically to carry out
construction activities at Sakhalin shelf projects.
ExxonMobil Announces Production Start-Up from Sakhalin-1 Project in Russia,
www.sakhalin1.com, October 2, 2005.
392
Onshore Drilling
The Chayvo field was developed using onshore as well as offshore drilling facilities.
To drill the north western flanks of the Chayvo fields which were about 8-11
kilometers offshore, a suitable option was ERD as it not only reduced the amount of
drilling but also saved on time and costs per well. For this purpose, ENL planned to
construct an onshore land rig29 with numerous extended-reach wells from the
shoreline to the Chayvo field. Talking about the application of ERD, Powell said, We
were aware that 11 kilometer (seven-mile) extended-reach wells had been drilled in
the United Kingdom and South America. What about at least partially developing
Chayvo with extended-reach drilling (ERD) from the Sakhalin shore-line? It not only
would offer the potential for lower cost and faster drilling start-up but would reduce
environmental impact as well.30
The construction of the 22-storied land rig and its support equipment began in October
2001 in Louisiana, USA. The rig was designed and built by Parker Drilling
Company31 in less than two years. The rig was disassembled and shipped to Sakhalin
Island, which was about 11,000 kilometers from the construction site, aboard three
cargo vessels. Despite the adverse weather conditions on the Island, the rig reached on
time, was reassembled at the Chayvo field, and was ready for drilling by June 2003.
According to Richard Rush, Sakhalin drilling group manager, The weather-related
delays and logistic hurdles stemming from the absence of a dock at Chayvo worksite
forced us to continue working into late fall and winter. In all, we shipped 1,500 to
1,800 loads by rail and truck, and still managed to get the rig assembled and ready to
drill on schedule by June 2003.32
Named Yastreb (meaning hawk in Russian), the land-based drilling rig was 230 feet
tall (70 meters) and was custom designed to drill extra long extended reach wells from
land-based locations to offshore fields. The rig could withstand temperatures of -400
Celsius and high intensity earthquakes. Its power was 13,000 hp33 almost double
that of conventional land rigs. The Yastreb rig could drill extended reach wells
downward and then horizontally under the sea to a total distance of up to 6.8 miles till
the Chayvo field, making it one of the most powerful land rigs in the world. We
called it the Yastreb, which is the Russian word for hawk. And like a hawk, the
Yastreb has soared to great accomplishments with the extended-reach wells it has
drilled,34 said Sam Vera, drilling engineering supervisor of Sakhalin-1 project.
The rig became functional in November 2003. The rig drilled the first Sakhalin-1 well,
the Z6, to a total measured depth of 9,375 meters (30,938 feet). To improve the
drilling rate and to ensure safety, ENL used modern drilling procedures. Baker
29
A land rig is a drilling machine that drills only on land. It consists of pumps, a derrick or
mast, a substructure, drill pipe, mud tanks, a rotary table, and engines to power the
equipment.
30
The Hawk and the Sea Eagle,
www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish5.pdf.
31
Parker Drilling Company is a US-based global energy company which provides offshore and
onshore contract drilling services, project management, and rental tools to the energy
industry worldwide.
32
World-Class by Any Measure,
www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish1.pdf.
33
Horsepower (hp) is a non-metric unit of power. It is equal to 746 watts.
34
The Hawk and the Sea Eagle,
www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish5.pdf
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International Business
Hughes INTEQs35 AutoTrak Rotary Closed Loop System (RCLS)36 was used to
enhance well-site efficiency and improve the quality of bore holes. With continued
improvements in well design and drilling procedures, the daily drilling rates doubled.
In April 2007, ENL completed drilling of the 17th ERD well, the Z-11,37 at the Chayvo
field. It was drilled in 61 days, about fifteen days ahead of the schedule, with below
expected costs.
By 2007, about 17 ERD wells were drilled from the Yastreb rig as part of Phase I of
the Sakhalin-1 Project. Experts pointed out that since the drilling of the Z6 well in
2003, the time required to drill these wells had come down by more than 50%. The
presence of repair centers close to the Chayvo well installed by the Russian contract
companies ensured smooth drilling without any delays. Repair and maintenance of
key drilling equipment was carried out at these service centers. Otherwise, the
equipment would have had to be repaired at regional centers as far as Singapore.
Experts also pointed out that by using ERD, ENL had curtailed operational costs as
extended reach wells did away with the need for building and installation of additional
offshore structures. Moreover, ERD followed safe drilling practices and addressed
environmental issues by minimizing the impact on marine environment, they said.
Offshore Drilling
To develop the south western flank of the Chayvo field, a gravity-based offshore
platform was used. Called Orlan38, it was one of the largest offshore drilling platforms
constructed in the world. The earthquake and high wave resistant Orlan platform
featured a drilling rig with more than 13,000 hp, a 10 mega-watt power plant, and
living quarters for 120 workers. The Orlan platform was actually a concrete island
drilling system39 (CIDS), which was withdrawn from use and kept in reserve in
Alaska. ENL decided to use the CIDS for offshore drilling at Chayvo. Talking about
the procurement of the Orlan platform, John Plugge (Plugge) offshore subproject
manager of ExxonMobil, said, We were pleased to find it in quite good condition.
But before we reached a decision, we invited a team of about 25 Russian specialists to
come look it over the following summer. Nobody knows ice and the Arctic like the
Russians. After a very thorough inspection, they concurred that it was quite suitable
for Chayvo and could be used for many years to come. This was great news for the
project since we originally estimated the use of CIDS would save a minimum of $100
million. And with the better understanding of costs we have today, we know that the
savings is considerably more. 40
The CIDS platform was shifted to the Amursky Shipbuilding yard located in Far East
Russia for removing the CIDS topside facilities and a large wave deflector was
constructed around the platform base to make it earthquake resistant. In 2001, the
35
36
37
38
39
40
Based in Houston, Baker Hughes INTEQ is one of the eight divisions of Baker Hughes Inc.,
an Oil field service company. It is one of the worlds leading oilfield drilling and evaluation
service companies.
Rotary Closed Loop System (RCLS) is an advanced drilling technique used to drill deep
bore holes in extended-reach wells.
The Z-11 was the longest ERD well in the world. It achieved a total measured depth of
37,016 feet (11,282 meters) or over seven miles.
The Orlan platform was named after a white-shouldered sea eagle unique to the Sakhalin
island.
The CIDS is gravity-based offshore drilling platform. Built in 1983, the CIDS was designed
for year round drilling in Arctic waters.
The Hawk and the Sea Eagle,
www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish5.pdf.
394
42
43
44
45
46
395
International Business
US and Canada and then sea lifted to Sakhalin and assembled. The IPF was installed
by the Expro International Group Plc, a UK-based oilfield services company. In
August 2005, the IPF with the capacity to process 6,300 metric tons (50,000 barrels)
of oil and 4.2 million cubic meters (150 million cubic feet) of gas per day became
operational. In 2006, when the OPF became functional, the IPF was closed down. The
OPF produced stabilized crude oil called Sokhol crude oil which was piped to the De
Kastri oil export terminal. The dry gas obtained was re-injected into the Chayvo field
for conservation.
The Delivery
In August 2006, the Sakhalin-1 Projects oil export system was commissioned. With
the commissioning of the system, the Sokhol crude oil developed by the project was
supplied to international markets. The startup of Sakhalin-1 exports will provide
47
48
The Tatar Strait is a channel between Sakhalin Island and the Asian mainland, in the
Northwest Pacific Ocean, connecting the Sea of Japan and the Sea of Okhotsk.
A jetty is a structure which extends into the sea and generally protects a harbor or coastline
from the effects of currents and tides.
396
50
51
52
53
54
55
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International Business
of Russias Far East Gasification Program. With increased supplies becoming
available from Sakhalin 1, we look forward to being able to move more of our
communities away from dependence on coal to greater use of natural gas. 56
Project Benefits
According to experts, the Sakhalin-1 Project was one of the biggest projects
developed by the international oil and gas industry. It represented one of the largest
single FDIs in Russia managed by a multinational consortium. According to analysts,
the Sakhalin-1 Project had helped Russia in strengthening its position as an energy
supplier to world markets by providing oil and gas supplies for export to domestic and
commercial markets. It also served as a medium for developing friendship between
Russians and other foreign nationals, they said. According to Anna Kuniasky, Vice
President Corporate Affairs, ENL, The joint work on the project, including the many
years of negotiations, is a vehicle for developing friendships between Russians and
foreigners and appreciation for each other's capabilities. This experience has increased
the trust between the Russians and foreigners and thus has contributed to the success
of the Sakhalin-1 project. I also believe that our positive experience will open future
opportunities for foreign investment. 57
The Sakhalin Project was one of the first oil and gas projects in Russia to employ
PSAs. The PSA approach attracted a huge amount of foreign investment as it offered
suitable tax procedures and guaranteed stability of the project over its lifetime. This,
in turn, allowed the development of the project in harsh environmental conditions.
Experts opined that the Sakhalin-1 Project was successful in developing the oil
resources present in the Sakhalin Island in an efficient and cost-effective manner.
Some of the achievements of the Sakhalin-1 Project included the on-schedule
commencement of the first phase of the project, drilling of record breaking ERD
wells, commissioning of the OPF before schedule, timely completion of the export
pipeline and terminal, start-up of the oil export operations, and attaining the targeted
levels of 250,000 barrels of oil per day. Commenting on the key elements which
ensured the success of the Phase I development of the Sakhalin-1 Project, Terni said,
Todays world-scale projects require proven capability to develop, extend, and apply
leading edge technology to all aspects of a project. Technology was fundamental to
the projects focus on developing the Chayvo resource at maximum value. However,
leading-edge technology alone was not enough. Also key to maximizing value was the
ability of ExxonMobils global functional organization to deliver excellence in project
execution from concept selection to start-up and a strong commitment to excellence in
all aspects of project development. Equally important, these capabilities were brought
to bear in partnership with co-ventures, the Russian government, and local contractors
as well as the Sakhalin and Khaborovsk communities to successfully execute the
project on schedule despite one of the worlds toughest environments. 58
Besides developing oil and gas, the project offered economic as well as social benefits
to Russia and to the Sakhalin region in particular. Benefits to Russia from the
Sakhalin-1 Project included direct revenues to the Russian state, major infrastructure
developments, technology transfer, the employment of Russian citizens, and the use of
56
57
58
398
Exhibit IV
Accomplishments of Sakhalin-1 project
The project applied cutting-edge technologies engineered specially for Arctic
operations to develop the Sakhalin Island energy resources with careful regard
for the environment, efficiency, and costs.
The three-dimensional seismology used by ExxonMobil increased exploration
success and reduced exploration costs.
The project undertook successful operations in seas with six feet thick ice
which were carried out using state-of-the-art computer models and five years
of ice data.
The project invested over 17.5 billion RUB (US$700 million) in environmental
projects to help protect wildlife and habitats in the areas of operation.
The design of the project facilities was protective of the Western Gray Whale,
the Orlan eagle, and other wildlife native to Sakhalin Island.
Employees worked over 80 million hours with industry-leading safety
performance. The project's Lost Time Injury Rate (or LTIR) of 0.02/200,000
work-hours was several times better than the international oil and gas
construction industry average.
The project followed a phased development strategy along with detailed and
integrated front-end execution planning. It implemented a plug-and-play
approach which allowed it to capture efficiencies and minimize risk.
The project set 17 world records for extended-reach drilling and also for
drilling speed. The worlds most powerful land-based rig was drilled in the
Chayvo field as part of the Sakhalin-1 project.
59
Ruble (RUB) is the currency of Russia. As on November 2009, 1 US$ was approximately
equal to 28.70 RUB.
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International Business
The project awarded contracts worth over US$5 billion to Russian companies
or joint ventures.
The project funded over US$120 million to improve infrastructure in the
Sakhalin region including hospitals, clinics, roads, bridges, harbors, airports,
and power and water facilities.
The project donated over US$3.5 million in charitable contributions to local
community organizations, including health, youth, arts, and civic projects.
Compiled from various sources
One of the key objectives of the consortium was to promote Russian content. It hired
as many local contractors as possible for the project. ENL, along with the Sakhalin
Oblast Administration and the Ministry of Economic Development and Trade of the
Russian Federation, established a Joint Committee to promote local content. The main
objective of the Joint Committee was to maximize the involvement of Russian
subcontractors and Russian suppliers of goods and services in the project. According
to Neil Duffin, president of ENL, For Russia, a key is to create jobs and maximize
local content that is, Russian goods and services in the project. One of our goals
is to maximize involvement of Russian companies in our operations where possible
and recruit Russians to commence building the operations group in 2002. We also
have employees from both of our Russian consortium partners helping to manage the
project.60
As of 2008, the value of contracts awarded to Russian companies as part of the
Sakhalin-1 Project was about 125 billion RUB (over US $5 billion), more than twothirds of the total contracts awarded to third-party vendors. The consortium also
launched a project website to communicate information related to the Sakhalin-1
Project to Russian contractors and suppliers. Seminars related to the project were held
in Moscow, Khabarovsk, and Yuzhno-Sakhalinsk.
The strategy to promote Russian content was mutually beneficial to the Russian
contractors as well as to the project operators. The project operated smoothly due to
the experience of the regional contractors who understood the local operating
environment better. On the other hand, ENLs latest construction, drilling, and
production procedures helped the local contractors gain sufficient knowledge about
the latest technologies and improve their productivity.
Community Development
Besides creating jobs and awarding contracts to Russian suppliers, the Sakhalin-1
consortium contributed to the well-being of the community as it tried to improve the
standard of life of the communities in which it operated. ENL implemented various
charitable small-grant programs to support communities in the Sakhalin Oblast and
Khabarovsk Krai region. These programs primarily focused on areas of education and
healthcare and support for local people. ENL contributed over RUB 85 million
(US$3.5 million) to support education, healthcare, and cultural projects in the
Sakhalin region such as instituting Teacher of the Year awards, setting up hospitals
for children, organizing summer camps, as well as supporting earthquake victims
(Refer to Exhibit V for community development initiatives of Sakhalin-1 Project).
60
400
Exhibit V
Sakhalin-1 Project: Community Development Initiatives
Education
The Sakhalin-1 project supported educational organizations and elementary and
secondary schools in order to improve teaching and learning and achieve
professional development. It provided educational materials and equipment and
sponsored student programs and extracurricular activities to enhance the quality of
learning.
The Sakhalin-1 project offered grants toward educational development to the
following:
Sakhalin State University, for purchase of equipment for the media laboratory
of the Journalism Faculty.
Junior Achievement Sakhalin Foundation, which helped students from K-12 to
learn the basics of business and economics. In 2005, over 7,500 students
participated in the JA events compared to 1,980 students in 2000.
Sakhalin Oblast Department of Education, where ENL was the General
Sponsor for the annual Teacher of the Year Competition.
Logos Club, which organized intellectual competitions (trivia contests) for
high-school and college-age students in Yuzhno-Sakhalinsk. During the years
of ENLs sponsorship, more than two thousand students participated in the
Logos Club competitions.
Volunteer Involvement Program. ENL offered small grants to support
employees volunteer activities in schools and kindergartens that their children
attended. The program made possible field trips to natural history sites,
classroom improvements, book purchases, and many other contributions.
Val Settlement (Nogliki District) Secondary School, for purchase of personal
computers to improve computer training resources.
Sakhalin Oblast Traffic Inspectorate and the Sakhalin Oblast Committee of
sports and physical culture. ENL sponsored the Safety Wheel children's traffic
safety festival, in which teams from all over Sakhalin competed to show their
knowledge of the rules of the road.
Yuzhno-Sakhalinsk Education Department, to sponsor academic Olympiads in
which over 1,500 high school students took part each year.
Special Correction Comprehensive School for Mentally Challenged Children,
for purchase of athletic equipment and educational materials.
Health
ENL supported programs targeted at health issues and made contributions to
health-related organizations which addressed public health issues and local
community needs.
Examples of organizations and programs that received contributions included:
Paramedics-Midwife Stations in remote areas (Val, Nekrasovka): purchase
of medical equipment.
Nogliki Secondary School for purchase of medical equipment.
Support of the International Conference Publicly Accessible
Defibrillation and Preventive Measures for Sudden Cardio Death.
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International Business
Civic and Community Service
ENL supported civic and community service organizations which fulfilled social
needs and enhanced social and economic conditions. It also supported cultural
organizations, which provided access to art.
Examples of organizations and programs that received contributions included:
Sakhalin Culture Fund rewards which gifted youth and professionals for
their contribution in culture and arts.
Publication of the Sakhalin Oblast Commemorative Book dedicated to the
history of Sakhalin from 1930 to 1950.
Centennial Celebrations of the Yuzhno-Sakhalinsk City Park.
Okha Central Library for purchase of office equipment, software, and
books.
Okha Childrens Library for purchase of personal computers and office
equipment.
Sakhalin Regional Library for purchase of equipment
Yuzhno-Sakhalinsk Chamber Orchestra for purchase of musical
instruments and sponsorship of concerts.
Indigenous Minority People of the North (IMPN) was an important recipient of
ENL
contributions.
ENL financed the following organizations and programs in association with
IMPN:
Summer camp for IMPN children from Ulchi District;
Support of the Giva IMPN Folk Ensemble (Bulava Settlement)
Tourist equipment for IMPN children of the De-Kastri Settlement
Equipment for restoration of documents in the Bogorodskoye Public
Museum
Sponsorship of the Ulchi District Nivkh delegation participation in the 1st
Nivkh Congress
Support of the Bulava social center
Contribution of furniture, athletic, and other equipment for Sofijsk and
Tyr Boarding Schools
Equipment for the sewing lab of Khabarovsk Technical College Bulava
Branch
Source: www.sakhalin1.com
The Sakhalin-1 Project invested over RUB 3 billion (US$120 million) in
infrastructure improvements in the Sakhalin region such as upgrading hospitals, roads,
bridges, ports, and airports. The project also contributed to the development of the
local communities. For instance, the project donated US$ 300,000 for the purchase of
new surgical and diagnostic equipment at the Central District Hospital in Khabarovsk
Krai. In 2007, ENL made significant investments in the modernization of the YuzhnoSakhalinsk Womens Clinic.
402
The United States Agency for International Development (USAID) is the US federal
government organization providing economic and humanitarian assistance to countries
worldwide.
62
Lost-time incident (LTI) is any work related injury which prevents personnel from doing any
kind of work after the accident.
63
Champions for the Safety and Environment,
www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish8.pdf.
64
Champions for the Safety and Environment,
www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish8.pdf.
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International Business
disturb the marine life. The Orlan platform was successfully towed from the ice
conditions of the Bering Sea to the Sakhalin Island. In Russian, Orlan symbolizes
strength, boldness, and speed, and Orlans 3000-mile journey from Alaska to the
Russian port of SovGavan without incidents underlines our commitment to safety and
the environment in all aspects of our business,65 said Tom Hall, manager of Sakhalin1 Project.
Western gray whales, which were considered as an endangered species by the World
Conservation Union,66 inhabited the shallow waters off Sakhalins northeast coast.
Since 1997, the Sakhalin-1 consortium spent about US$15 million on studies related
to these whales and adopted measures to protect them. During the 2001 seismic
survey in the Odoptu field, the project implemented the most extensive whale
protection program ever undertaken by the oil and gas industry. We developed a
monitoring program in which we had trained observers, usually marine biologists,
stationed on the seismic vessel and support boats. When a gray whale was sighted
within a protection zone of four to five kilometers between the vessel and the
mammal, operations were shut down until it had cleared the area, 67 said Dan Egging,
Sakhalin-1 Houston regulatory manager.
To protect endangered birds such as Stellers Sea Eagle (Orlans), the Sakhalin-1 team
carried out field studies in association with environmental experts. For example, with
help from Vladimir Masterov, a leading ornithologist from Moscow State University,
the project conducted a number of baseline studies to identify sea eagle habitat along
the coasts of Sakhalin including the mapping of nests and hunting areas. They
constructed artificial nests and perches to attract the birds to new coastal sites away
from project facilities. The project also gave precedence to protecting native islands
and the livelihoods of reindeer herders, who inhabited the northern Sakhalin Island
and the Khabarovsk Krai. As of June 2008, the project had spent over US$ 700
million in environmental projects to help protect wildlife and safeguard environment
in the areas of operation. Out of this, over US$ 40 million were spent on various
archaeological, ornithological, bathymetric, meteorological, seismic, topsoils,
fisheries, stream crossing, waste management, bioremediation, oil spill response, and
other studies, and another US$ 17 million on initiatives aimed at preserving the
western gray whale population.
Challenges
Experts considered the Sakhalin-I Project to be a multifaceted engineering project as it
posed some of the most difficult challenges that the oil and gas industry had faced
anywhere in the world. The project faced both environmental as well as manmade
problems. These challenges included operating in a harsh physical environment, a
remote location with limited infrastructure, environmental limitations, government
regulations, and lack of skilled labor. Analysts opined that the project team had to
understand the physical, cultural, and political environment of the area to make the
project successful.
65
66
67
404
The World Wildlife Fund (WWF) Russia Program works for the conservation of wild life in
Russia.
69
Environmentalists Appeal to Halt Sakhalin 1 Project Before any Formal Court Ruling,
www.wwf.ru, January 12, 2009.
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International Business
many challenges. I tell them that the company has had experience with all of these
challenges-operating in sub-Arctic environments with short work seasons, researching
and applying ice-breaking technology so we get could get the oil to the market,
working in remote areas thousands of miles from manufacturing and supply centers
which required extensive logistics planning, developing drilling plans for extreme
horizontal drilling, working under complex regulatory regimes, and many others.
However, while we might have faced two or three of these challenges on a project
before, just about every single one of them came together on this project.70
Outlook
After completing its first phase, the project moved on to the next phase which was to
develop oil and gas from the Odoptu field. According to the project consortium,
experience gained during the first phase including ERD, logistics, winter work
productivity, contracting strategies and Russian contractor expertise, regulatory
processes and design criteria would be used to carry out the subsequent phase of the
project. Future phases of the Sakhalin-1 Project would include developing the
Arkutun-Dagi fields, expanding the Chayvo OPF, and further developing the Chayvo
gas field (Refer to Exhibit VI for a brief on the future phases of Sakhalin 1 Project).
Experts felt that the three fields in the Sakhalin oil field area could provide a longterm supply of gas for export and domestic use in Russia. It was estimated that the
Chayvo field alone had enough gas to produce 1 billion cubic feet per day (10 billion
cubic meters per year) for more than 25 years. Similarly, the Odoptu and ArkutunDagi oil fields could sustain oil development for more than 40 years at a production
rate of 1 billion cubic feet per day (10 billion cubic meters per year).
In February 2009, ENL suspended work on the Odoptu and Arkutun Dagi fields at
Sakhalin as the Russian government did not approve its development plans and
budgets for 2008 and 2009. However, production from the Chayvo field was not
halted. Due to suspension of work, a 23% fall in oil production was noticed. As in
February 2009, output decreased to about 193,000 barrels of crude oil per day from a
peak of 250,000 barrels per day in February 2007. It was speculated that production
might further drop by 11% in 200971.
According to some analysts, the reason for the suspension of work at the two fields
was a dispute between ENL and the Russian government over the sale of natural gas
developed from the region. The Russian government wanted the operators of
Sakhalin-1 to sell the natural gas to Gazprom72 to cover domestic needs, while Exxon
planned to export the gas to China. ENL wanted to build a natural gas pipe line to
China and supply 8 billion cubic meters of gas annually to China. But the Russian
government did not approve the pipeline to transport the gas as it wanted ENL to sell
the projects gas to Gazprom at a lower price. Some observers felt that the Russian
government was creating obstacles for the project as it felt that it was losing control
over the domestic oil and gas companies and wanted to confine the Sakhalin-1
consortium just to developing the Chayvo field and to develop the remaining two
fields on its own.
70
71
72
406
Exhibit VI
Future Phases of the Sakhalin-1 Project
Odoptu Development
The second phase of the Sakhalin-1 project included the development of the
Odoptu field. The field is located off the northeast coast of Sakhalin Island about
35 miles (55 km) north of the Chayvo operations. The first stage of development in
the Odoptu field would include modification of the existing Chayvo facilities.
Development plans included the construction of roads to the Odoptu site and the
establishment of on-site housing and work facilities. The Yastreb drilling rig, which
was used for onshore drilling at the Chayvo field, was relocated to the Odoptu site
where it would be used to drill onshore extended reach wells. A 49 mile (79 km)
16-inch flowline would be laid to transport the oil and gas to the existing Chayvo
Onshore Processing Facility, from where the pipeline to the De-Kastri Terminal
would further transport the oil to international markets. As of April 2009, the
Odoptu field development was going through regulatory and government reviews
and the Yastreb rig was relocated to the Odoptu site. The project was to undertake
additional construction activities after obtaining the required regulatory approvals.
Arkutun-Dagi Development
The third phase of development of the Sakhalin-1 project involved the development
of oil and gas from the Arkutun-Dagi field. The field is located approximately 25
kilometers off the northeast coast of Sakhalin Island, east of the Chayvo field. As
part of the Arkutun-Dagi development, a new offshore drilling and production
platform with a gravity base substructure and topsides facilities was to be
constructed. A new flowline would transport the oil and gas from the ArgatunDagi field to the existing Chayvo Onshore Processing Facility, where existing
pipelines would transport the oil and gas for export. Over 30 Russian design
institutes and contractors were involved in the development of the Arkutun-Dagi
field. As of 2009, the development of the Arkutun-Dagi field was passing through
regulatory and government reviews.
Chayvo Field Phase 2 Commercial Gas Development
The Sakhalin-1 project was supplying natural gas to domestic customers in the
Russian Far East as part of the first phase of the Chayvo field development. The
phase succeeding the Arkutun-Dagi field development would be Chayvo Phase 2
gas development. This phase would expand natural gas production by developing
and producing non-associated gas. The development of this phase required a multibillion dollar investment and significant expansion of existing onshore and offshore
facilities at the Chayvo field site including additional drilling, processing, power,
and other infrastructure developments. The gas produced from this phase was to be
supplied to both domestic and export markets. In order to deliver the gas to export
markets such as China and Japan in a cost-effective way, the project consortium
planned to construct a gas pipeline. In October 2006, a Heads of Agreement was
signed with China National Petroleum Company (CNPC) for supply of gas through
pipelines from Sakhali to China.
Source: www.sakhalin1.com
Though the issue related to the supply of natural gas remained unresolved, the
government went ahead and approved the Sakhalin-1 budget after a long delay.
According to analysts, the government approved the budget as the project functioned
under a PSA and any spending delay would reduce the governments income from the
project. It was reported that the budget approved for the project for the year 2009 was
US$ 1.978 billion. Additional spending for 2008 was approved at US$ 404 million,
compared to US$ 627 million in 2007. With the budget approval, the project resumed
its work on the Odoptu field.
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2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
19.
www.eoearth.org/article/Energy_profile_of_Sakhalin_Island,_Russia.
20.
www.sakhalin1.com/en/news/project/pnw_03152002_lamp.asp.
21.
www.sakhalin1.com
408
Volkswagen is committed to the Indian market, the proof of which is the constant
investment and growth that we provide through the various projects initiated. India is
one of our key markets and we know that the future harbors a huge potential.2
-
Introduction
On December 21, 2009, Volkswagen India Private Limited (Volkswagen India), the
group company of Volkswagen Group India, announced that it aimed to sell 300 units
of Beetle, its iconic car, in India in the year 2010. The Beetle was launched in India on
December 04, 2009. Raj Sawant, Business Head of Automark Motors, a Volkswagen
dealer in Ahmedabad, Gujarat, India, said, There are already over 170 advance
bookings across India, and we have started delivering the cars as well. Going by the
initial euphoria, we expect to sell around 300 Beetles in 2010.3
Volkswagen Group India, the Indian subsidiary of leading automobile manufacturer,
Volkswagen AG (Volkswagen), based in Wolfsburg, Germany, had entered the Indian
passenger car market in 2001 by launching its car brand koda. In 2007, two of its
other brands Audi and Volkswagen, were also launched in India.
Over the years, Volkswagen Group India not only launched several products, but also
ensured that its brands were well known among the Indian consumers. Although, the
company had had a presence in the Indian car market since 2001 and the koda and
Audi branded cars were well known among consumers, the Volkswagen brand was
not well recognized in the country. Therefore, in November 2009, the company
launched an integrated marketing campaign to build its brand image. It also launched
a marketing campaign for its iconic model, the Beetle. Volkswagen India expected
that with its brand building exercise, it would be able to increase its sales and capture
a significant market share in the Indian car market. According to Neeraj Garg (Garg),
Director (Passenger Cars), Volkswagen India, It is true the Volkswagen brand is not
well known in the country. This will be corrected with appropriate branding
strategy.4
2
3
411
International Business
Volkswagen Group India had built a widespread distribution network for its three
brands across India. The company offered different car models ranging from luxury
sedans to compact cars. According to Jochem Heizmann, Member of the Management
Board, Volkswagen, India is a huge market that we believe offers us potential. In
India, the passenger vehicle segment has seen a growth despite the current market
situation and Volkswagen plans to tap this. With the varied models across our brands
as well as the establishments that have been set up we hope to be able to cater to our
customers as well as dealers in the best possible manner.5
About Volkswagen
The history of Volkswagen (which means peoples car in German) can be traced
back to the 1930s when Ferdinand Porsche, a reputed automobile engineer and
designer, started designing an affordable car for the common man. In 1936, the first
prototype of the car, called the KdF-Wagen, was designed in Stuttgart, Germany. This
prototype was similar to what later came to be known as the Beetle.
On May 28, 1937, the Gesellschaft zur Vorbereitung des Deutschen Volkswagens
mbH company was founded, and on September 16, 1938, it was renamed as
Volkswagenwerk GmbH. In 1938, the construction work resumed on a production
plant at Wolfsburg, Germany.
During World War II, Volkswagens core focus shifted to the production of military
vehicles. After the War, as the area fell under the occupation zone of the United
Kingdom (UK), in mid-June 1945, the company was revived by Major Ivan Hirst, a
British army officer. Under his management, the company again started producing the
Beetle. By 1946, the production plant at Wolfsburg was producing 1,000 cars per
month.
In 1948, Heinrich Nordhoff (Nordhoff), a former senior manager at Adam Opel
GmbH (Opel), was appointed to manage the company. Under Nordhoff, Volkswagen
started producing a number of Type 2 commercial vehicles like vans and pickups. The
Volkswagen Bus called the VW Bully soon became very popular among consumers.
In 1956, a separate manufacturing base was established in Hanover.
In 1973, the production of new generation of Volkswagen vehicles began with the
Passat. In January 1974, production of the Golf was started at the Wolfsburg plant. In
1974, Volkswagen launched another car the Scirocco.
In 1976, the Golf GTI rolled off the production line. The car, with its110 bhp engine,
became an instant hit among consumers. In June 1983, the company started
production of the second-generation Golf. The company used a highly automated
assembly process for the production of the car, and for the first time in vehicle
manufacturing, robots were used.
In July 1999, Volkswagen started the production of Lupo 3L TDI, which had a fuel
consumption of just three liters per 100 kilometers. In August 2002, the company
started mass production of the Touareg, a luxury-class Sports Utility Vehicle (SUV).
In 2003, production of the fifth-generation Golf was started. On December 09, 2009,
Volkswagen and Suzuki Motor Corporation (Suzuki) 6 announced that they had
entered into a long-term strategic partnership in which Volkswagen purchased 19.9
percent of Suzukis issued shares.
5
6
Volkswagen Group India Holds A Positive Outlook, http://machinist.in, August 29, 2009.
Suzuki Motor Corporation is a Japanese multinational corporation headquartered in
Hamamatsu, Japan. It specializes in manufacturing compact automobiles, a full range of
motorcycles, all-terrain vehicles (ATVs), outboard marine engines, wheelchairs, and a
variety of other small internal combustion engines. It was founded in 1909. As of 2008, it
generated revenues of US$ 33.46 billion and net income of US$ 305.43 million (Source:
http://en.wikipedia.org).
412
Exhibit I
Volkswagens Financial Highlights (2006-08)
(In millions)
2008
2007
2006
113,808
108,897
104,875
Operating Profit
6,333
6,151
2,009
6,608
6,543
1,793
4,688
4,122
1,955
-2,679
7,109
5,631
8,039
13,478
7,133
Sales Revenue
Q3 2008
25956
28932
-10.3
Operating profit
278
1485
-81.3
262
1481
-82.3
161
1161
-86.1
791
-2408
13391
11767
+13.8
Sales Revenue
% Change
Source: www.volkswagenag.com.
Skoda Auto India Private Limited is a subsidiary of Skoda Auto part of Volkswagen Group,
Audi India is a subsidiary of Audi AG, part of Volkswagen Group.
413
International Business
The marketing strategy including product launch, product positioning, promotional
campaigns, and establishing widespread dealer networks of each brand of Volkswagen
Group India which was handled by the group companies and their divisions
separately. Commenting on the rationale for following such a marketing strategy,
Rupert Stadler, Chairman of the Board of Management of Audi AG, said, If you
compare Volkswagen to other big automobile groups in the world, you can see how it
has given independence to individual brands. Each of us has to do our job and not ask
mamas help all the time! This is what finally drives brands in the business.9
Products
Skoda Auto India entered the Indian car market in 2001 by setting up a plant at
Shendra, on the outskirts of Aurangabad, Maharashtra. In March 2007, when Audi
India was set up as a division of VGSIPL, it also started using the same plant. In
March 2009, Volkswagen India and Skoda Auto India started a joint manufacturing
plant at Chakan, near Pune, in Maharashtra. While Skoda Auto India invested 90
million, Volkswagen India invested approximately 580 million to build the plant.
In mid-2009, Audi India assembled only two of its models the A4 and the A6 in
India; the rest were imported as Completely Built Units (CBU). According to Martin
Birkner, the Head of Audi India (Marketing), it would soon assemble more models in
India so as to get a competitive advantage.
As of late 2009, Volkswagen Group India was marketing three different brands
including Audi, koda, and Volkswagen that comprised 15 different models (Refer to
Table II for the cars offered by Volkswagen Group India).
Car Models
Audi
Audi A4, Audi A6, Audi A8, Audi Q5, Audi Q7, Audi TT, Audi
R8.
koda
Volkswagen
Source: www.volkswagenindia.co.in.
Volkswagen Group India received several awards in 2009. CNBC-Overdrive Award
recognized the company as the most successful car manufacturer in 2009. koda
Fabia received the Car of the Year as well as the Compact Car of the Year awards.
The Volkswagen Jetta received the Premium Car of the Year award and the Audi A4
3.2 the Performance Car of the Year award.
Price
Volkswagen Group India mainly catered to the luxury segment of the Indian car
market. Skoda Auto India had four models among which three the New Superb, the
New Laura, and the Octavia, were luxury cars and the Fabia was a mid-segment car.
The Fabia had both petrol and diesel variants. koda branded cars had 20 variants in
total and were available in the price range of Rs. 490,043 and Rs. 2,576,383.
414
Price Range
Audi A4
Audi A6
Audi A8
Audi Q5
Audi Q7
Audi TT
Audi R8
Rs. 1,17,00,000
koda Laura
koda Octavia
koda Fabia
Volkswagen Passat
Volkswagen Jetta
Volkswagen Beetle
Volkswagen Touareg
Promotion
Skoda Auto India and Audi India
In 2001, Skoda Auto India launched its first product, the Octavia, in India. The
company primarily used the print media whenever it launched a new product. To
promote the brand image of the company, it also used print ad campaigns (Refer to
Exhibit II for Skoda Auto Indias Print Ads). In June 2004, the company launched
a print ad campaign which read We fill our airbags with life. In the print ad
campaign, the company emphasized the fact that koda cars had six airbags to ensure
proper safety.
In 2005, Skoda Auto India launched several television commercials (TVCs) to
promote its models. The company launched a TVC with the tagline, You need to be
well-built to carry your loved ones... In 2008, when the company launched the Fabia,
it launched a TVC with the tagline Because Youre Special. (Refer to Figure I for
an Image of koda Fabias TVC). Commenting on the advertisement strategy,
Shashank Vaid, Manager (Marketing), Skoda Auto India, said, We use television
commercials as part of the corporate branding strategy, while the print advertisements
communicate the benefits.10
10
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International Business
Exhibit II
Skoda Auto Indias Print Ads
Source: www.skoda-auto.co.in.
Source: http://www.bigadda.com.
416
Volkswagen India
In September 2007, when Volkswagen India launched its first model, the Passat, in
India, it appointed DDB Mudra Group (DDB Mudra) as its creative agency. In the
first week of September 2007, the company launched an advertising campaign which
aggressively used the print media. Commenting on the rationale for launching the
campaign, Bobby Pawar (Pawar), Chief Creative Officer, DDB Mudra Group (DDB
Mudra)13, said, Volkswagen has just launched the Passat and it has other big plans
for India. They are planning to launch cars here in India to suit every pocket. The brief
for us was to establish the spirit and philosophy of Volkswagen makes people believe
that theres a certain way of life at Volkswagen. 14 In July 2008, the company
launched its second model, the Jetta, in India.
Initially, Volkswagen India did not market its products aggressively. However,
considering the growth potential of Indias automobile market which was expected to
sell two million vehicles in 2014 and three million vehicles by 2018 as compared to
1.1 million vehicles in 2009, the company started laying special emphasis on
marketing its products.
Volkswagen Indias internal research conducted in 2008 showed that the companys
brand was not well known among Indian consumers. According to the Society of
Indian Automobile Manufacturers (SIAM) 15, Volkswagen India had sold only 1,172
cars between April and October 2009, as compared to other European automobile
manufacturers like BMW India Private Limited 16 which sold 2089 cars and MercedesBenz India17 that sold 1869 cars during the same period.18 Therefore, the company felt
11
12
13
14
15
16
17
Law & Kenneth, the Indian subsidiary of UK based Kenneth Worldwide Group Company,
was aleading ad agency in India. As of 2009, it handled creative duties of many leading
brands including Johnson & Johnson Baby Products, ITC Personal Care, Cox & Kings
Travel Agency, Haier Electronics, GoAir, Bajaj Scooters, ICICI Prudential Life Insurance,
Oberoi and Trident group of Hotels etc.
Audi Weighing Options for Luxury Small Car Launch in India,
www.thehindubusinessline.com, August 31, 2008.
DDB Mudra Group is an alliance between the India-based Mudra Group and DDB
Worldwide Communications Group Inc (DDB), a part of Omnicom Group Inc. It is a leading
advertising company in India. Some of its clients are Johnson and Johnson, Hindustan
Unilever Limited, Henkel, Volkswagen, Reliance ADAG, AIG Corporate and Tourism
Australia.
Volkswagen Drives in with Mudra DDB, www.afaqs.com, September 11, 2007.
The Society of Indian Automobile Manufacturers (SIAM) is the apex industry body
representing 44 leading vehicle and vehicular engine manufacturers in India. SIAM works
closely with all the concerned stake holders and actively participates in the formulation of
rules, regulations, and policies related to the automobile industry (Source:
www.siamindia.com).
BMW India Private Limited, the Indian subsidiary of the BMW Group, is headquartered in
Gurgaon, National Capital Region, India. The company offers a wide range of luxury cars
including its BMW 3 Series, BMW 5 Series, BMW 6 Series, and BMW 7 Series. (Source:
www.bmw.in).
Mercedes-Benz India, the Indian subsidiary of Mercedes-Benz, a division of Daimler AG,
was established in 1995. It offers a wide range of luxury cars including the S-Class, the E-
417
International Business
it was necessary to build brand awareness in India. According to Joerg Mueller, Chief
Representative of Volkswagen Group India and President and Managing Director,
Volkswagen India, In India, it is very important because people (have been)
associated with the brand since the time of the Beetle. Then we were not in the market
for many years, and now we are here again. It means that people in India and potential
customers dont know exactly what Volkswagen stands for. Therefore, it is important
now to build up the brand, to make it famous again, and to show what Volkswagen
stands for in terms of our values.19
In November 2009, Volkswagen India for the first time launched an integrated 360
degree communication campaign using the print, electronic, digital, and out of home
media. Till then, the company had been using mainly the print media to promote its
brands the Passat and the Jetta. Commenting on the campaign, Lutz Kothe (Kothe),
Chief General Manager, Marketing and Public Relations, Volkswagen India, said,
Based on a clear brand strategy, Volkswagen is known for its cutting-edge
advertising across the world. Our powerful and creative campaigns continue to have a
special place in the consumers mind through decades. With our first brand campaign
in India, we have strived to achieve the same for our consumers here and are confident
that they will take to it. Our aim has been to break away from the communication
clutter by being innovative and refreshing with the way we narrate our brand story to
the customer.20
MediaCom India Private Limited (MediaCom)21 was the media agency of
Volkswagen India for the campaign. The company planned to spend Rs. 400 million
on the marketing campaign to build its brand image in India. The campaign included
18,000 TV spots, 150 print advertisements in daily newspapers, about 300 OOH
installations, and a digital campaign that would last till February 2010.
The integrated marketing campaign started on November 11, 2009, when the Times of
India (TOI)22 created a roadblock23 for Volkswagen India across its 16 editions and
nine pages.24 As part of the roadblock, Volkswagens brands including the Jetta, the
Passat, and the Touareg were advertised on all the editions of TOI (Refer to Exhibit
III for Volkswagen Indias Print Roadblock). According to Divya Gururaj, MD,
MediaCom, Currently, theres very little awareness for brand VW and the company
has been selling select premium car brands in India so far. But now they are getting
aggressive and print allows them to disseminate a lot of information about the brand.
18
19
20
21
22
23
24
Class, the C-Class, the M-Class, the CLS-Class, the SLK-Class, the CL-Class, and the
Maybach (Source: www.mercedes-benz.co.in).
India, China Key for Honda, Says CEO Ito, www.livemint.com, November 12, 2009.
Ammar Master, We are of the Opinion We Are Right On Time for The India Party,
www.livemint.com, January 17, 2008.
Volkswagen Connects with Indian Hearts in New TVC, www.exchange4media.com,
November 10, 2009.
MediaCom India Private Limited, in which Madison Communications Private Limited had a
51 percent stake, is one of the leading media agencies in India.
The Times of India (TOI) is a popular English-language broadsheet daily newspaper in
India. It is owned and managed by Bennett, Coleman & Co. Ltd. In 2008, the newspaper
reported that (with a circulation of over 3.14 million) it had been certified by the Audit
Bureau of Circulations as the worlds largest selling English-language daily newspaper.
(Source: http://en.wikipedia.org).
A Roadblock is defined as exclusivity in any number of advertisement slots for a single
client over a given period of time (Source: http://ads.economist.com)
Byravee Iyer, Hit the Road, www.business-standard.com, November 24, 2009.
418
Exhibit III
Volkswagen Indias Print Roadblock
International Business
Print gives a far bigger spread to disseminate information and talk about the technical
specifications.25
On November 11, 2009, Volkswagen India also aired its first TVC to promote the
brand instead of a specific car. The TVC was developed by DDB Mudra. The TVC
focused on the Volkswagen brand as a whole and showcased different Volkswagen
car models. The TVC showed a young boy in a Volkswagen showroom deciding on
the cars that he wanted to book in advance at various stages of his life. The boy went
on to select the Beetle for his 18th birthday, the Jetta for when he became the Vicepresident of a company, and the Passat for when he became the Chief Executive
Officer. The TVC ended with Volkswagens baseline Das Auto which, in German,
means The Car, and the tagline, German engineering. Made for India (Refer
Figure II for an Image of Volkswagen Indias TVC to Promote the Brand).
Commenting on the rationale for the TVC, Pawar said, It is about giving people
different cars at different stages of their lives. There is a Volkswagen for every
stage.26 He added, Volkswagen has been known globally for its iconic brand
campaigns. The challenge for us was to transfer that greatness in India as well. The
car is not only the soul of German engineering, but also about the democratization of
innovation.27
Volkswagen India appointed Portland Outdoor Limited (Portland) 28 for the OOH
campaign. The outdoor campaign was launched in 23 cities across India. Portland
announced that the OOH campaign would be implemented in three phases, each over
a period of one month. Commenting on the campaign, Madhuri Sapru, Managing
Partner South Asia, Kinetic & Dialect, said, The brief for the campaign was to
increase the awareness for brand Volkswagen, and to reinforce the perception of
Volkswagen as an innovative company. 29 (Refer to Exhibit IV for Volkswagen
Indias OOH Campaign).
26
27
28
29
When
It
Comes
to
India,
Volkswagen
Isnt
Thinking
Small,
http://economictimes.indiatimes.com, November 25, 2009.
Volkswagen Launches First Brand Campaign in India, www.afaqs.com, November 10,
2009.
Arcopol Chaudhuri, Volkswagen Set to Roll out Brand Campaign for India,
www.campaignindia.in, November 10, 2009.
Portland Outdoor Limited was promoted by the WPP Group, a leading communications
services group in the world (Source: www.wpp.com).
Anushree Bhattacharyya, Portland Drives German Auto Brand Volkswagen to 23 Cities in
India, www.network.media.com, December 01, 2009.
420
Exhibit IV
Volkswagen Indias OOH Campaign
Bindu Nair Maitra, DDB Mudra Creates Launch Pad for Volkswagens Beetle,
www.campaignindia.in, December 07, 2009.
421
International Business
sees the car is one where your heart talks to you. The commercial talks about the
pleasure of riding the new Beetle. At a time when most car designs tend to be all
about hard edges, the new Beetle celebrates curves and voluptuousness.31
Volkswagen India also launched a print and an outdoor campaign to promote the
Beetle. The campaign had the tagline Its official. Curves are back. As part of its
OOH campaign, Volkswagen India took up the entire OOH space at the busy Bandra
Junction in Mumbai. According to Rajiv Sabnis, President, DDB Mudra,
Volkswagen has an innovating spirit when it comes to marketing, just like the cars
they make. They also believe in dominating the media, not just the roads. After the
hugely innovative and impactful TOI roadblock, we conceived the launch of the new
Beetle with an innovative outdoor campaign. The six-part Beetle outdoor came
together part-by-part in the first week of December, heightening peoples anticipation
and excitement about an imminent launch.32
Distribution
As of 2009, koda, Audi, and Volkswagen each had a presence in India through their
separate distribution channels. koda Auto had a strong presence in the Indian luxury
car market through its 62 dealerships covering over 50 cities across India.
As of 2009, Audi India had 14 dealerships across India including cities like Delhi,
Gurgaon, Chandigarh, Ludhiana, Mumbai, Mumbai West, Pune, Ahmedabad,
Bangalore, Hyderabad, Chennai, Jaipur, Kolkata, and Kochi. The company aimed to
have 15 dealers by 2010 and 18 dealers by 2011.33 Volkswagen India said it would
increase its dealerships from 25 to 40 by the end of 2009. The expansion would
involve opening of new outlets in Indore, Jalandhar, Bhopal, Vijayawada, and
Kozhikode. The company already had outlets in several major places in India
including Delhi, Chennai, Bangalore, Hyderabad, Ahmedabad, and Kolkata.
31
32
33
34
35
36
Bindu Nair Maitra, DDB Mudra Creates Launch Pad for Volkswagens Beetle,
www.campaignindia.in, December 7, 2009.
Volkswagen & DDB Mudra Execute a Unique OOH Roadblock in Mumbai,
www.exchange4media.com, December 17, 2009.
India to Be Fifth-Largest Auto Mkt by 2015: Audi India MD,
http://economictimes.indiatimes.com, October 5, 2009.
Audi India to Assemble More Models Locally, Targets 50 percent Growth In Sales,
www.driveinside.com, October 28, 2009.
Audi to Expand More Dealerships in India, http://burnyourfuel.com, June 15, 2009.
The Volkswagen Beetle Finally Comes to India, www.moneycontrol.com, December 14,
2009.
422
37
38
39
40
41
423
International Business
2.
3.
VW
India
Could
Enter
Sub-B
Segment
www.wheelsunplugged.com, December 14, 2009.
4.
5.
Vipin Nair, Volkswagen Aims to Capture 10% of Indias Car Market (Update 1),
www.businessweek.com, December 13, 2009.
6.
Bindu Nair Maitra, DDB Mudra Creates Launch Pad for Volkswagen's Beetle,
www.campaignindia.in, December 07, 2009.
7.
8.
9.
with
Up
Rollout,
10. India, China Key for Honda, Says CEO Ito, www.livemint.com, November 12,
2009.
11. Times
of
India
Creates
Roadblock
www.indiantelevision.com, November 11, 2009.
for
Volkswagen
Brands,
12. Volkswagen India Road Block: Blitzkreig! www.lbhat.com, November 11, 2009.
13. India Eco Summit: VW Group eyes 8% shares in India, www.businessstandard.com, November 10, 2009.
14. Volkswagen Connects with Indian Hearts in New TVC, www.exchange4media.com,
November 10, 2009.
15. Volkswagen Launches First Brand Campaign in India, www.afaqs.com, November
10, 2009.
16. Arcopol Chaudhuri, Volkswagen Set to Roll out Brand Campaign for India,
www.campaignindia.in, November 10, 2009.
17. VW India Eyeing to Clock 3,000 Units Sale during CY 2009,
www.wheelsunplugged.com, October 31, 2009.
18. Audi India to Assemble More Models Locally, Targets 50 percent Growth In
Sales, www.driveinside.com, October 28, 2009.
19. India to Be Fifth-Largest Auto Mkt by 2015: Audi India MD,
http://economictimes.indiatimes.com, October 05, 2009.
20. Volkswagen India Plans to Double Distribution Network,
http://economictimes.indiatimes.com, September 25, 2009.
21. Volkswagen Group India Holds A Positive Outlook, http://machinist.in, August 29,
2009.
22. IFC to Invest 135 Million Euros in Volkswagens Pune Plant, www.businessstandard.com, August 06, 2009.
23. Audi to Expand More Dealerships in India, http://burnyourfuel.com, June 15, 2009.
424
425
3
4
5
6
428
10
11
12
13
14
15
16
Docpharma NV was a Belgium-based generic drugs company that was acquired by Matrix
in 2005.
PharmSource Information Services, Inc. is a provider of information services to the
pharmaceutical and biopharmaceutical companies on contract drug development and
manufacture.
US Food and Drug Administration (FDA) is an agency of the US Department of Health and
Human Services and is responsible for the safety regulation of most types of foods, dietary
supplements, drugs, vaccines, biological medical products, blood products, medical devices,
radiation-emitting devices, veterinary products, and cosmetics.
Jim Miller, Will Delivery Technologies Deliver Profits to CMOs? www.pharmtech.com,
October 2, 2006.
Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories,
www.prnewswire.co.uk, August 28, 2006.
Teva Pharmaceutical Industries Ltd., headquartered in Petah Tikva, Israel, is the leading
generic drugs company. In 2006, it had total sales of US$8.4 billion.
Sandoz, headquartered at Holzkirchen, Germany, is the generics subsidiary of Swiss
multinational pharmaceutical company Novartis AG. In 2006, it had total sales of US$5.9
billion.
Barr Pharmaceuticals, Inc., headquartered in Montvale, New Jersey, USA, is a leading
generic drugs company. In December 2006, it acquired a leading Croatian generic drugs
major Pliva d.d. to become the worlds third largest generic drugs company with combined
429
International Business
Watson Pharmaceuticals, Inc.18 (Watson), etc., were eyeing Indian pharmaceutical
companies as potential targets of M&A deals. This was because, with considerable
pricing pressures in the US, these companies were on the lookout for low-cost
suppliers. In addition to the low-cost manufacturing platform, the attractiveness of the
Indian companies stemmed from the fact that they had large and varied product
portfolios and FDA-approved manufacturing facilities. Indian pharmaceutical
companies also had a number of DMFs19 and ANDA20 filings in the US, the worlds
largest market for pharmaceuticals. Moreover, some of these companies had
developed a significant presence in the European and African markets through the
inorganic route. In this context, analysts felt the acquisition of Matrix would benefit
Mylan. Datamonitor Plcs21 pharmaceutical markets analyst, Joshua Owide, noted,
As the generics industry becomes increasingly competitive, Mylan has found a deal
that will help it to not only target emerging markets but also establish it as a
prominent force in the global market. On the whole, the deal represents an excellent
opportunity for Mylan to strengthen its core business activities. As a generic-focused
pharmaceutical company, manufacturing level competencies, particularly that
pertaining to drug composition, are fundamental to its operation. Subsequently, it is
likely that the synergies created by this deal will optimize Mylans market share and
margins.22
However, not everyone was optimistic about the deal. Some analysts considered the deal
to be too expensive for Mylan given the fact that it valued Matrix at 22x earnings
multiple v/s 18x, the average multiple for the Indian pharmaceutical industry. Others
kept their fingers crossed considering that this was Mylans first foray outside the US,
and as such, the company might face a problem in transforming itself into a global
organization. Mylan defended the deal saying Matrixs acquisition was strategic and was
a calculated risk essential to provide Mylan a global reach.
Background Note
Mylan
Mylan was the second-largest US generic drug maker as of 2006.23 The company was
headquartered in West Virginia, USA, and was involved in developing, licensing,
manufacturing, marketing, and distributing many generic and proprietary drugs. The
company primarily focused on solid oral dosage generic drugs. These generic drugs
17
18
19
20
21
22
23
sales of approximately US$ 2.4 billion. (Source: Victoria Harrison, Barr Acquires 92%
Share in Pliva, www.pharmaceutical-business-review.com, December 23, 2006.)
Actavis Group, Reykjavk, Iceland, is a leading generic drugs company.
Watson Pharmaceuticals, Inc., headquartered in Corona, California, USA, is a leading
generic drugs company.
DMFs (acronym for Drug Master File) contain information on the processes and facilities
used in drug manufacture and storage and are submitted to the US Food and Drug
Administration (FDA) for examination.
An ANDA (acronym for Abbreviated New Drug Application) contains data which when
submitted to FDAs Center for Drug Evaluation and Research, Office of Generic Drugs,
provides for the review and ultimate approval of a generic drug product. (Source:
www.fda.gov)
Datamonitor Plc, headquartered in London, UK, is a leading provider of information
services to key industries.
Joshua Owide, Mylan Laboratories: Entering the Matrix, www.pharmaceutical-businessreview.com, August 30, 2006.
Mrinalini Datta, Mylan Labs to Acquire India Rival, www.iht.com, August 28, 2006
430
Exhibit I
Mylan: A Timeline
Event
24
25
26
Remark/ Rationale
1961
Milan Pharmaceutical is
incorporated
1965
1973
1984
1987
1989
431
International Business
Event
Remark/ Rationale
1991
1993
1996
1996
Establishes Bertex
Pharmaceuticals as its main
branded pharmaceuticals
subsidiary
1998
To
acquire
Topicare27.
its
technology
27
28
29
432
Exhibit II
A Note on the Global Generic Drug Industry
In 2006, the global market for generic drugs was estimated to be US$77 billion. 30
The top four players in this industry were Teva, Sandoz, Barr, and Merck KgaAs 31
generic unit.32 Other notable players in this industry included Mylan, Watson, and
Actavis.
In addition to competing among themselves, the generic drugs companies also
competed with pharmaceutical companies that sold branded drugs on the price
platform. So, they also competed in the total pharmaceutical market that was
estimated to be US$607 billion in 2006 (according to IMS Health 33). Generic drugs
are generally sold under their chemical name. For instance, generic versions of
Viagra may sell under the chemical name Sildenafil citrate. But in some markets,
generic drugs may be sold under a brand name. For instance, Viagra is sold in
India by various companies under names such as Manforce, Penegra, Caverta,
Androz, etc. Such products are called branded generics.
Factors such as a number of patent expirations of blockbuster drugs of researchbased pharmaceutical companies between 2000 and 2006 had given a huge impetus
to the generics drugs industry. In addition, changes in legislation and regulation in
various countries that favored the use of generic drugs and pressure from various
government and other third party payers to adopt low-priced generic drugs to
minimize healthcare costs had led to an increase in the usage of generic drugs. For
instance, in the worlds largest pharmaceutical market, USA, generic drugs
accounted for around 50 percent of the pharmaceutical market by volume. This
made the US an attractive market for companies that manufactured and marketed
generic drugs and some of the largest generic drug manufacturers had a strong
presence in this market. In Europe too, the generic drugs were getting increased
acceptance. While countries like Germany, Sweden, Denmark, the UK, and the
Netherlands were the larger markets for generic drugs, the smaller generic markets
of Spain, Italy, and Portugal were forecast to increase rapidly mainly as a result of
government cost-containment pressures.
Increased acceptance of generic drugs had catapulted the leading generic drugs
companies such as Teva and Sandoz to the league of major pharmaceutical
companies. These companies were also becoming increasingly ambitious and were
often engaging the research-based pharmaceutical companies in litigations by
challenging their patents in order to bring their generic drugs into the market even
before the patent of the branded drug had expired.
Analysts felt that the generic drugs market was poised for high growth rates in the
future. According to Visiongain34, the market for generic drugs would increase to
30
31
32
33
34
433
International Business
US$83.9 billion by 2010.35 IMS Health predicted that the generic drug market
would grow by 22 percent annually until 2010 in the five largest generic markets. 36
However, the generic drugs companies also faced a number of challenges. Factors
such as pricing pressure and several legislative and regulatory hurdles put a lot of
pressure on the generic drugs companies. The patent regulations in the US gave
enough scope for research-based pharmaceutical companies to create barriers for
entry through litigations. Research-based pharmaceutical companies sought to
extend the patent life of their blockbuster drugs and discourage the entry of generic
drugs manufacturers.
In such a scenario, generic drugs companies had to survive in a very competitive
market. These challenges had led to this industry entering a consolidation phase.
Many leading generic drugs companies entered into M&A deals. Between 2005
and 2007, there were as many as 18 M&A deals in this industry. 37 The number of
dominant players had gone down to around six from 14 two years earlier. Some
notable deals were Tevas acquisition of Ivax Corporation 38 in 2005, Sandozs
acquisition of Hexel AG39 and Eon Labs, Inc.40 in 2005, and Barrs acquisition of
Pliva. These deals had put pressure on other generic drugs companies to
consolidate or risk compromising their competitiveness.
Compiled from various sources.
Exhibit III
Selected Financial Data of Mylan Inc.
(in US$ million)
2007
2006
2005
2004
2003
1,611.82
1,257.16
1253.37
1374.62
1269.19
768.15
629.55
629.83
612.15
597.76
843.67
627.62
623.54
762.47
671.44
Research and
Development
103.70
102.43
87.88
100.81
86.75
Acquired in process
research and
development (from
Matrix)
147.00
215.54
225.38
259.48
201.61
173.07
Operating Expenses:
35
36
37
38
39
40
434
50.12
12.42
25.99
34.76
2.37
427.55
287.39
302.17
494.80
413.99
Interest Expense
52.28
31.29
50.23
18.50
10.08
17.81
12.53
Earnings before
income taxes and
minority interest
425.51
274.61
312.25
512.61
426.51
208.02
90.06
108.66
177.99
154.16
0.21
217.28
184.54
203.59
334.61
272.35
Earning from
operations
Minority Interest
Net Earnings
Matrix
Matrix, a listed Indian pharmaceutical company, was an API manufacturer established
in February 2001. It was the worlds second-largest manufacturer of APIs in terms of
DMF filing.41 Its core business was to manufacture APIs and solid oral dosage forms.
Matrix operated in regulated markets such as the US and the European Union and had
a wide range of products catering to the anti-AIDS, cardiovascular, central nervous
system, anti-asthmatic, anti-bacterial, anti-fungal, gastrointestinal, pain management,
and lifestyle related therapeutic segments.
Tracing back the history of Matrix, its foundation lay in the dreams envisioned by its
promoters viz Prasad, C Satyanarayana, and M Ravinder. 42 The trio took over an
ailing Hyderabad-based pharmaceutical company, Herren Drugs & Pharmaceuticals43
(Herren), in June 2000. Matrix was formed as a result of the renaming of Herren in
February 2001. During that time it fended off an acquisition bid by H. Lundbeck A/S44
(Lundbeck). Lundbeck wanted to buy Matrix to own a new process that Matrix
haddeveloped to manufacture Citalopram, a drug originally developed by the Danish
company. Analysts felt that the companys refusal to sell out had earned it a lot of free
publicity.45
In 2002, Matrix filed the process patent for Citalopram under the Patent Co-operation
Treaty. Even before the US patent on Citalopram expired in January 2004, Matrix was
prepared to supply the drug. Initially the company was heavily dependent on the sales
41
42
43
44
45
435
International Business
of Citalopram, which accounted for 50 percent of its revenues in the fiscal year
2002.46 Over the years, Matrix strategically diversified its product portfolio. By 2006,
the companys API product range had increased to 169 and was spread across 17
therapeutic segments. Its API product portfolio also contained 10 anti-retrovirals47
(ARV). Along with this, Matrix had also started selling generic drugs under DMF
filing and Para IV filing48 in the US. It had a number of such Para IV filings in the
pipeline.
To expand its capacity and to penetrate the regulated markets in the US and Europe in
a big way, the company adopted the inorganic growth route. In line with this strategy,
Matrix acquired a 54.89 percent stake in May 2002 in Medicorp Technology
(Medicorp), an API manufacturer which had FDA approval. By the end of the year,
the company further consolidated its size through merger & acquisition deals with
Vorin Laboratories Ltd (Vorin), an API manufacturer. By May 2003, the process of
consolidation of Medicorp and Vorin with Matrix was completed. The merged entity
Matrix Labs was headed by Prasad as the managing director and chairman (Refer to
Exhibit IV for the values added by the three companies to the Matrix Labs).
Exhibit IV
Value Added by the Respective Companies to the Merged Entity (Matrix)
Parameters
Matrix
Medicorp
Vorin
Products
Six: CNS
agents & antibacterial
Ten: Gastro-intestinal,
proton pump inhibitors,
anti-inflammatory &
cardio-vascular
Markets and
customers
Europe
India, Middle
East, Africa and
South Africa
Facilities
TGA and
European
norms
ISO 9000
Regulatory
compliance
----
----
46
47
48
436
Exhibit V
Matrix: A Timeline
Event
Impact/ Benefit
February 2001
February 2002
May
2002
May
2003
Amalgamation of Medicorp
and Vorin into Matrix
Laboratories Ltd.
November
2003
March 2004
March 2004
January 2005
February 2005
April
2005
437
International Business
Event
Impact/ Benefit
June
2005
September
2005
Matrix acquires up to 55
percent controlling interest in
Concord Biotech Ltd., a USFDA approved biotechnology
company in India.
December
2005
50
51
These are regulatory submission documents and may include data from clinical trials, data
from other studies on the drug such as bioequivalence studies, etc.
The German investment partners of the two joint venture companies were H Fischer & Co
International GmbH and CES Beteiligungs GmbH respectively. Both the companies were
part of the lucrative German pharmaceutical industry with a focus on generics.
Niche Generics ltd. is a Europe based generic drug supplier which tries to roll out the
generic drug as soon as the patent expires.
438
% to
total
sales
2005-06
Rs.(Mn)
% to
total
sales
Year-onyear
Growth
%
Generic APIs
5,505
33
3,859
33
43
3,390
21
2,797
24
21
4,295
26
2,484
22
73
Hospital business
2,209
13
1,654
14
34
Contract Manufacturing
Services
1,081
792
36
Total Sales
16480
100
11586
100
42
Particulars
Exhibit VII
Matrix Laboratories Ltd. Financial for Fiscal 2006- 07
Particulars ( Rs. Millions)
2007
2006
Total sales
16,480.27
11586
Total assets
27,989.42
30788.66
Total liabilities
17,399.26
30788.66
1,021.42
2381.72
756.53
2005.63
52
439
International Business
Exhibit VIII
A Note on the Indian Pharmaceutical Industry
In 2006, the total market for pharmaceuticals in India was estimated to be US$7.3
billion. The market is dominated by companies manufacturing and marketing
branded generic drugs. As of 2006, Indian pharmaceutical companies also
produced more than 22 percent of the worlds generic drugs. The significant
presence of Indian pharmaceutical companies in the generic drugs market had been
attributed, in part, to the loose patent regime prevalent in India before 2005.
Between 1970 and January 1, 2005, India recognized only process patents. This
patent environment was not suitable for research-based pharmaceutical companies
as their products could be reverse engineered by Indian pharmaceutical companies
and sold in India. Due to this, many Indian companies specialized in reverseengineering, which enabled them to develop generic drugs at a very low cost. The
competition among the various Indian companies also brought the price down
further. This prompted many research-based pharmaceutical companies to either
market their drugs at a moderate premium price or simply ignore the Indian
market.
After becoming a member of the World Trade Organization (WTO), India had to
comply with TRIPS53 (trade-related aspects of intellectual property rights). TRIPS
ensures that profits from any new product go exclusively to the innovator (patent
holder) for the full duration of the patent. TRIPS came into force on January 1
1995, but some developing and transitional economies were given time to comply
with the agreement. India was given time till January 1, 2005, to enforce a new
patent law that recognized product patents.
However, certain flexibilities have been introduced in TRIPS so that a patients
access to life saving drugs is not denied. A waiver was issued in the WTO Doha
ministerial conference in 2001, stating that intellectual property should not take
precedence over public health. Moreover, countries like India that had newly
introduced TRIPS legislations were allowed to copy any drug that was patented
before 1995, i.e. before the introduction of TRIPS. Those companies that seek to
copy drugs patented after 1995 can do so under a system called compulsory
licensing, if the company that owned the patent was found to have misused its
rights.
On December 27, 2004, the Indian government issued a temporary executive order
to meet the January 1, 2005 deadline. The Indian Parliament passed the new patent
law recognizing product patents, in March 2005. However, the law did not impact
those products invented before 1995 and generic companies still had the right to
continue manufacturing and selling those drugs.
With the change in patent law favoring research-based pharmaceutical companies,
analysts expected problems for Indian pharmaceutical companies, as most of them
did not have the R&D capability to discover new drugs. In such a scenario, the
research-based pharmaceutical companies were expected to be more open to
introducing new products in the Indian market, while most Indian companies
would be dependent on marketing licenses to market these new drugs in India.
Indian pharmaceutical companies were also focusing on contract
53
440
The Deal
In mid-2006, there were speculations that Mylan was in the process of acquiring a
majority stake in Matrix. Though the management at Matrix denied the reports, there
was a 10 percent rise in the companys share prices in anticipation of the deal. 54 These
reports followed reports earlier in the year that the worlds largest generic drugs
company Teva was interested in acquiring Matrix.
On August 27, 2006, Mylan announced its intention of acquiring Matrix in a cash and
stock deal worth US$736 million. With this, Mylan intended to establish a global
presence in emerging pharmaceutical markets such as India, which was the fourth
biggest drug market in terms of volume. 55 Coury commented, Mylan Matrix
transaction marks the beginning of a new era at Mylan where our organization is
continuing to expand beyond our well-established position as a leading domestic
generic pharmaceutical company toward our objective of establishing Mylan as a
world leader in generics and specialty pharmaceuticals. 56 As per the terms of the
transaction approved by the Mylan Board of Directors, Mylan acquired up to 71.5
percent of Matrixs outstanding paid-up share capital. Merrill Lynch & Co., Inc. 57 and
DSP Merrill Lynch Ltd.58 were the advisors to Mylan for completing this deal. Matrix
was advised by ABN AMRO Holding NV 59 and UBS AG60.
54
55
56
57
58
59
60
441
International Business
There were two phases to the Mylan Matrix deal. In the first phase, Mylan purchased
51.5 percent of the paid up share capital of Matrix in accordance with the agreement
made with certain selling shareholders. In order to do so, Mylans wholly-owned
subsidiary, MP Laboratories Ltd. (Mauritius) entered into a Share Purchase
Agreement (SPA) with key shareholders of Matrix viz. Prasad, N Prasad HUF61, G2
Corporate Services Limited, Maxwell (Mauritius) Pte. Limited 62, entities controlled by
Newbridge Capital63, and Spandana Foundation64. In the second phase of the deal on
November 22, 2006, Mylan made a public announcement of an open offer to acquire
20 percent of Matrixs share capital held by the general public. This was done in
accordance with SEBI65 regulations.
On completion of the open offer on December 21, 2006, and closing of the SPA,
Mylan acquired 71.5 percent of Matrixs total paid-up share capital. Both these
transactions were performed at Rs.306 per share (US$6.84 per share), putting the deal
at US$ 736 million, an approximate 15 percent premium to the last 30-days average
stock price of Matrix. Though the price to revenue multiple in relation to the market
value of Matrix stock in December 2006 was 2.8x and the price-to-EBIT multiple was
12.3x, the purchase price (Rs. 306) implied that Mylan valued Matrix at above US$1
billion, with a price to revenue multiple of 3.9x and a price-to-EBIT multiple of
17.2x.66 On January 8, 2007, Mylan finally closed the purchase of 71.5 percent of
Matrixs outstanding share capital. Though Mylan acquired the controlling stake in
Matrix after completion of the transaction, the rest of its share still continued to trade
on the Indian Stock Exchanges (Refer to Exhibit IX for the shareholding pattern of
Matrix). Mylan said that Matrix would continue to operate as an independent entity
after the deal.
One of the strategic pre-conditions attached to this deal was induction of Prasad on
Mylans Board of Directors as head of Global Strategies. Prasad was highly regarded
in the industry as a wealth creator who had bought Matrix for Rs.30 million in 2000
and sold it for an enterprise valuation of Rs.62.1 billion in 2006. 67 This precondition
was intended to make Mylans entry into the global API landscape a successful
venture backed by Prasads long experience in the global API industry. It was also
intended to keep Prasad away from launching a new pharmaceutical company as he
was reportedly keen on pursuing his entrepreneurial dreams. Prasad invested US$25
million of the proceeds from the sale of his share in Matrix in Mylan. 68 The idea
behind retaining an equity stake of five per cent in Matrix and investing $25 million in
Mylan and joining their management team heading the global business strategies is to
ensure confidence levels of the Matrix shareholders, employees, and also to the new
partner Mylan,69 said Prasad.
61
62
63
64
65
66
67
68
69
HUF (acronym for Hindu Undivided Family) is a legal taxable entity in the eye of law and
Income Tax Act of India.
Maxwell (Mauritius) is an arm of Singapore-based investment company, Temasek Holdings.
It held a 13.8 percent stake in Matrix.
Newbridge Capital is a joint venture between Texas Pacific Group and Blum Capital
Partners. Along with its entities, it held a 26 percent stake in Matrix.
Spandana Foundation is a charitable trust promoted by Prasad.
SEBI (acronym for Securities and Exchange Board of India) is the regulatory authority of
Indian securities markets.
Mylan Buys Matrix for $736 Million: Buys Indian Firm to Enter Asian and European
Markets, www.levinassociates.com, 2006.
Gina S Krishnan, Matrix Unloaded, www.businessworldindia.com, September 11, 2006.
Mylan Lab Acquires Stake in Matrix, www.ciol.com, January 9, 2007.
CR Sukumar, Matrix Promoter May Turn Angel Investor, www.thehindubusinessline.com,
September 2, 2006.
442
Exhibit IX
Shareholding Pattern of Matrix
12%
1% 5%
1%
10%
71%
Indian Promoters
Foreign Promoters
Institutional Investors
NRIs
Indian Public
Foreign Nationals
71
443
International Business
Further, the acquisition was also expected to help Mylan enter the high-margin
European market through the Matrix subsidiary, Docpharma. Docpharma was a
leading distributor of branded generics in Belgium, the Netherlands, and Luxembourg,
and was in the process of expanding its operations into France and Italy. By utilizing
Docpharmas sales network, Mylan expected to market its products in the European
markets.
The inclusion of Matrixs world class 10 APIs and intermediate plants would enhance
Mylans back-end supply chain capabilities and provide a low-cost raw material
sourcing platform. This was expected to eventually improve Mylans cost structure
and enable it to compete more aggressively in price competitive markets such as the
US. As a result of the acquisition, Mylan would have an expanded and more flexible
manufacturing base. Some analysts felt that Matrix could well end up as one of
Mylans manufacturing centers.72 However, Mylans spokesman Patrick Fitzgerald
said that the company was not interested in off-shoring its manufacturing to Matrixs
facilities. What we will be doing is source our APIs from Matrix and also expand our
high-barrier-to-entry product capabilities Matrix is the worlds largest supplier of
generic anti-retroviral APIs and will allow us to be a leader in HIV medications, 73 he
said.
According to Mylan, Matrixs product portfolio in the solid dosage forms did not
clash with that of Mylan but rather complemented it. Matrix being the worlds largest
supplier of generic ARV APIs, Mylan would now be able to enter into the highbarrier-to-entry product segments, particularly in the area of ARV. Matrixs finished
dosage form pipeline would enable Mylan to pursue a broader portfolio of products in
a more cost-effective manner.
Matrix had strong reverse engineering and scientific capabilities and access to highly
talented and skilled manpower, which would help Mylan increase its number of
ANDA submissions. Coury said, Matrix brings to Mylan a highly experienced
management team, whose robust international experience and strong track record
managing integration will complement our U.S. team.74
74
Atul Sathe, How Mylan Can Turn around Matrix, www.rediff.com, September 18, 2006.
Mylan in Indias Biggest Pharmaceutical Takeover as it Enters the Matrix, www.inpharmatechnologist.com, August 30, 2006.
Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories,
www.matrixlabsindia.com, August 28, 2006
444
76
77
78
79
80
445
International Business
Many analysts also felt that Mylan had over-paid for the acquisition of Matrix.
According to them, by valuing Matrix at US$ 1 billion plus, Mylan had paid 22x
Matrixs expected earnings. This was high, considering the Indian drug sectors
average multiple of 18x. However, Mylan defended the deal, explaining that the
acquisition was a calculated risk essential to enable it to expand its presence beyond
US generic markets on a global scale and to keep up with its peers. Some analysts too
justified the price paid by Mylan as they viewed India as an attractive market for
pharmaceutical products -- a market that the pharmaceutical companies just couldnt
afford to ignore keeping the future in mind. 81
Some analysts felt that it wouldnt be easy for a company like Mylan, which had only
operated in the US, to suddenly transform itself into a global generic drugs
company.82
81
82
83
84
85
86
Mylan Buys Matrix for $736 Million: Buys Indian Firm to Enter Asian and European
Markets, www.levinassociates.com, 2006.
Mylan in Indias Biggest Pharmaceutical Takeover as it Enters the Matrix, www.inpharmatechnologist.com, August 30, 2006.
Mylan Lab Acquires Stake in Matrix, www.ciol.com, January 9, 2007.
UPDATE 1-Mylan Reorganizes Management after Matrix Deal, www.today.reuters.com,
January 31, 2007.
Mylan Laboratories Announces Strategic Global Reorganization to Maximize Growth
Opportunities and Leverage Efficiencies Provided by New Global Platform,
www.drugnewswire.com, February 1, 2007.
Mylan Laboratories Ups 2007 Outlook, www.businessweek.com, February 1, 2007.
446
Outlook
The acquisition of Matrix helped Mylan to expand beyond the US market and
establish a global presence with 5100 employees in 10 countries. This deal was a
landmark one, suggesting that Indian generic drug makers with FDA approved plants,
a strong product pipeline, and a low-cost and robust manufacturing base were
attractive takeover targets for global generic makers. Some analysts also expected
Mylans acquisition of Matrix to trigger more such M&A deals in the Indian
pharmaceutical industry. In this regard, Sanjiv Kaul, MD, ChrysCapital Management
Company89, said, The ticket size of this deal has been noticed by everyone. It will
open the eyes of both the overseas companies and Indian companies who will realize
that tremendous shareholder value can be unlocked through the divestment route
Just as the Mylan-Matrix deal is based on strong strategic fit, foreign companies such
as Barr, Watson, and Teva will find companies in India which have excellent fits with
them.90 In a nutshell, the Matrix deal, which was completed in January 2007,
provided Mylan with an in-house API supplier, a strong entry platform into the
lucrative European generic markets and the fast growing emerging markets such as
Indian and China, and, above all a robust manufacturing base using a low-cost work
force.
According to analysts, through the acquisition of Matrix and Merck KgaAs generic
unit, Mylan had not only expanded its global reach, but was also in a position to reap
benefits of economies of scale and a more diversified and balanced product portfolio.
According to Goldman Sachs Group91 equity analyst, Randall Stanicky, Mylan would
post revenue and profits of US$5.2 billion and US$362.3 million respectively,
87
88
89
90
91
447
International Business
compared to its revenue of US$1.3 billion and profit of US$188.7 million in 2006. 92
This would also substantially de-risk the entire business from downturns in any
particular market or segment, according to analysts. The management of Mylan was
understandably pleased with their newly acquired global standing and was gearing up
to further build on that. The new Mylan now has all of the critical attributes we need
to ensure future success and deliver powerful growth. We have enhanced scale and
stability, a truly global reach, vertical and horizontal integration, and breadth and
depth in our management team,93 said Coury.
92
93
448
2.
3.
4.
Mrinalini Datta, Mylan Labs to Acquire India Rival, www.iht.com, August 28,
2006.
5.
6.
7.
8.
US-Based Mylan Buys Majority Stake in Matrix, www.indiatimes.com, August 29, 2006.
9.
10.
Joshua Owide, Mylan Laboratories: Entering the Matrix, www.pharmaceuticalbusiness-review.com, August 30, 2006.
11.
12.
13.
Surojit Chatterjee, Mylan Buys Majority Stake in Indias Matrix Lab for $ 736
Million, www.in.ibtimes.com, August 30, 2006.
14.
CR
Sukumar,
Matrix
Promoter
May
www.thehindubusinessline. com, September 2, 2006.
15.
J.Padmapriya, Matrix Founder Prasad Set to Get into the Groove at Mylan,
www.economictimes.indiatimes.com, September 9, 2006.
16.
17.
18.
Atul Sathe, How Mylan Can Turn around Matrix, www.rediff.com, September 18, 2006.
19.
20.
Brian Lawler, The Coming Generic Drug Boom, www.fool.com, October 16, 2006.
21.
Nath Balakrishnan,
December 3, 2006.
22.
23.
24.
Mylan Buys Matrix for $736 Million: Buys Indian Firm to Enter Asian and
European Markets, www.levinassociates.com, 2006.
25.
Mylan Laboratories
Completes
www.cnnmoney. com, January 8, 2007.
Matrix-Mylan:
Accept,
Matrix
Turn
Deliver
Angel
Profits
Investor,
to
CMOs?
www.thehindubusinessline.com,
Laboratories
Transaction,
449
International Business
26.
27.
28.
29.
30.
31.
32.
33.
Tova Cohen and Steven Scheer, Teva Pharma Seen Best Placed to Win Merck
Generics, www.reuters.com, May 8, 2007.
34.
CR Kumar and Bhuma Shrivatava, Mylans India Unit Key to Merck Buy,
www.livemint.com, May 14, 2007.
35.
36.
37.
38.
39.
40.
41.
Mylan Outbids Teva and Private Equity Investors to Acquire Merck KGaAs
Generics Unit, www.globalinsights.com, 2007.
42.
www.fundinguniverse.com
43.
www.myiris.com
44.
www.globalinsight.com
45.
www.googlefinance.com
46.
www.matrixlabsindia.com
47.
www.mylanpharms.com
48.
www.wikipedia.com
450
after
Matrix
Deal,
Introduction
On October 4, 2007, the Consumer Product Safety Commission (CPSC) 5 in the US
recalled more than half a million toys made in China as they contained dangerous
levels of lead. The CPSC announced that the recalled toys included Pirates of the
Caribbean, Baby Einstein, and Totally Me! Funky Room Decor Set decorating
kits, imported and sold by Toys R Us Inc. 6, and a variety of wooden toys imported
and sold by KB Toys Inc. 7 A lot of what is being recalled is because it violates the
law, not that there is an imminent health risk, said CPSC spokeswoman Julie Vallese
(Refer Exhibit I for more information on toy recalls in October 2007).
The October 2007 recall was the latest in a series of Chinese toy recalls by toy
companies and retailers in developed countries. Among the reasons given for the
recalls were excessive levels of lead paint, loose magnets that could be swallowed by
children, or other potentially serious problems.
3
4
Louise Story, Toy Makers Brace for a Chill in Sales, www.nytimes.com, August 16,
2007.
Elitsa Vucheva, EU could Ban Unsafe Chinese Products, www.businessweek.com,
September 14, 2007.
Toying with the Future, http://app1.chinadaily.com.cn, 2002.
The China Toy Association is an industry association, with Chinese toy companies as its
members. It has four committees for each toy category wooden toys, plush toys, plastic
and mechanical toys, and prams.
The United States Consumer Product Safety Commission (CPSC) is an independent agency
of the United States federal government. CPSC was created in 1972 through the Consumer
Product Safety Act that was framed to protect the public from unreasonable risks of serious
injury or death from more than 15,000 types of consumer products that come under the
agencys jurisdiction. (Source: www.cpsc.org)
Toys R Us Inc., headquartered in New Jersey, USA, is one of the largest retailers of toys
and baby products in the world. A public limited company between 1978 and 2005, Toys R
Us was acquired by an investment group. As of 2007, it had around 1,500 stores, with 830
stores in the US.
Founded in 1922 by Kaufman brothers, KB Toys Inc. is a large mall-based retailer of toys.
As of 2007, this privately-owned Massachusetts company operated around 600 stores in the
US.
476
Exhibit I
Products Recalled in the US in October 2007
i.
About 35,000 Baby Einstein Discover & Play Color Blocks, distributed by Kids II Inc.
The blocks were sold around the country between June and September.
ii. About 79,000 Pirates of the Caribbean medallion squeeze lights, imported by the
Eveready Battery Co., a brand of Energizer Holdings, Inc. The flashlights were sold
nationwide and online between September 2006 and October 2007.
iii. About 15,000 Totally Me! Funky Room Decor Sets, manufactured by Hong Kong-based
CKI Toys and imported by Toys R Us Inc. The kits were sold at Toys R Us stores
around the country and on the companys website between May and September 2007.
iv. About 10,000 wooden Pull-Along Alphabet & Math Blocks wagons, Pull-Along
Learning Blocks wagons, 10-in-1 Activity Learning Carts and Flip-Flop alphabet
blocks, imported by KB Toys Inc. The toys were sold at KB Toys stores around the
country between August 2005 and September 2007.
v.
About 63,000 green plastic cups shaped like Frankensteins head, imported by Dollar
General Merchandising Inc. The cups were sold at Dollar general stores around the
country in September.
vi. About 192,000 key chains imported by Dollar General Merchandising Inc. The key
chains featured a metal charm engraved with wisdom, truth, believe, love,
hope or dream. They were sold at Dollar general stores around the country between
June 2005 and August 2007.
vii. About 150,000 bookmarks and journals, imported by Antioch Publishing. The products
featured a variety of decorations including Winnie the Pooh. The bookmarks and
journals were sold at book, card, and gift stores around the country between March 2005
and October 2007. Some of the bookmarks were sold with bracelets.
Background Note
Toys have had a prime place in Chinese society since ancient times. Folk toys made of
wood, clay, and paper have always been very popular with Chinese children. Masks
and clay figurines in the shape of animals have been found in the ruins of ancient
Chinese habitations. The history of modern Chinese toys, however, dates back to the
early 1900s. Around 1910, the first factories that made toys from tin were set up. Toy
making in China started gaining momentum after the May Fourth movement 8 in 1919.
Several toy factories came up in the region around Shanghai. These factories made
clockwork, tin-plate warships, tram toys, simple tin containers, plates, and other
objects. With the demand for tin increasing (for making cans for paints, cosmetics,
8
The May Fourth Movement in China began on May 4, 1919. The movement promoted
Marxism in China and resulted in the birth of the Communist Party of China.
477
International Business
biscuits, and sweets), tin sheet manufacturing units started to be established around
Shanghai in the 1920s and the 1930s. This gave a boost to the local toy industry.
However, in this period, Germany dominated the worlds toy markets with its high
quality tin toys. Though the Chinese tin toys were no match for the German ones as
far as quality was concerned, they scored on the price front. By 1935, Chinese
companies which had earlier been producing tin cans, started making tin-plate toys
including toy planes, wind-up tin monkeys, and other toys.
During the Second World War, war related toys like fighter planes, tanks, and soldiers
constituted a major percentage of toy production in China. The war adversely affected
the German toy industry, with most toy factories there being used for making
ammunition.
In the 1950s, Japanese tin toys started gaining popularity for their novel designs and
good quality. In this period, Japanese toy companies also began producing plastic
toys, which were very inexpensive. In China, toys began to be made with Chinese
designs, as opposed to the western designs being used earlier. According to Marvin
Chan,9 a Hong Kong-born graphic designer,10 Before the 1950s, the toy designs are
very influenced by Europeans, but after, the toys have a more Oriental feel to their
patterns and design.
In the mid-1960s, most Japanese toy companies stopped making tin toys and shifted to
making toys out of plastic and superalloys11. China then became the manufacturing
center for tin toys. Though the tin toys from China were of poor quality initially, the
quality improved over time.
During the Cultural Revolution, 12 toys were used as a propaganda tool in China. Dolls
dressed up in Mao-suits, cars with political slogans, and building block cubes with
propaganda scenes on them were some of the popular toys during this period. 13
The Growth
Chinese toy companies, like other companies in the manufacturing sector, benefited
from the reforms initiated in China in 1979. With the opening up of the Chinese
economy, toy makers from Hong Kong, which by then had become a major global
center for good quality toys, started setting up production facilities in mainland China
in order to take advantage of the lower operational costs. However, most of the valueadded work such as product design, production planning, quality control,
management, and marketing continued to be done from Hong Kong.
Over the years, Chinese entrepreneurs and multinational companies too started setting
up toy factories in China. As several cities of the Guangdong province were allowed
to adopt a more open industrial policy than the cities in the rest of China, most of the
toy factories came up in the Pearl River Delta region of Guangdong Province. The
9
10
11
12
13
Marvin Chan opened the Museum of Shanghai Toys in Singapore. The museum was
dedicated to high quality Shanghai toys made in the period between 1910s and 1970s.
Sonia Kolesnikov-Jessop, A Trip into Chinas Past, through its Toys, www.iht.com,
March 27, 2007.
Superalloys are metallic alloys that exhibit excellent mechanical strength even at high
temperature, and are resistant to oxidation, corrosion, and deformation. Most superalloys are
based on iron, nickel, or cobalt.
The Great Proletarian Cultural Revolution in China was a struggle for power within the
Communist Party of China. The Cultural Revolution started in October 1966 and ended in
October 1976.
Sonia Kolesnikov-Jessop, A Trip into Chinas Past, through its Toys, www.iht.com,
March 27, 2007.
478
The Problems
Though the Chinese toy industry had several strengths, it was also up against several
problems that had the potential to significantly impact future growth. To start with,
Chinese toy companies were faced with the dual pressures of rising costs and
declining prices. On the one hand, buyers demanded lower prices. There is so much
pressure on prices from foreign companies, said Chen Huangman, Secretary General
14
15
16
17
The World Trade Organization (WTO) is an international organization that deals with rules
for international trade through negotiations among its member governments. It also helps
settle disputes between members based on an agreed legal foundation.
The International Toy Fair, organized annually on a one million sq. m. exhibition space at
Nuremberg, Germany, is the worlds leading fair for toys, and hobby and leisure-time
articles. The fair reportedly attracts around 2,750 exhibitors from 60 countries and 80,000
trade visitors from 120 countries.
The China Chamber of Commerce for Import and Export of Light Industrial Products and
Arts-Crafts (CCCLA) was founded in 1988. It coordinates the trade in light industrial
products and arts-crafts, and provides service for its member enterprises. (Source:
www.cccla.org.cn)
Guangdong is a province on the south coast of China.
479
International Business
of the Guangdong Toy Association. Wal-Mart18 in particular, puts a lot of pressure
on prices, and as they order so much from China, it has a large influence, said Li
Zhuoming (Zhuoming), Vice Chairman of the Guangdong Toy Association. 19 And on
the other hand, raw material and labor costs were increasing. Toy factory executives
across the country admitted that they were forced to raise wages, sometimes by double
digit rates, in order to attract and retain young workers.
Exhibit II
Major Toy Manufacturing Centers in China
Yunhe, Zhejiang
Yunhe, a picturesque county in Lishui, a prefecture-level city is a major center for wooden
toys. Around 500 toy factories that manufacture wooden toys have sprung up in the 2000s.
The annual output of the region crosses Yuan 1.5 billion. Yunhe is considered the largest
center for wooden toys in China. The city was given the title Wooden Toy City by the
China Light Industry Association.
Pinghu, Zhejiang
Pinghu, a major city on the Pearl River delta region and one of Chinas largest garment
export hubs, is also a major center for prams. It accounts for around 25% of the prams
manufactured in China. According to 2006 estimates, exports of prams from Pinghu were
valued at $ 4 million. Chenghai, Guangdong
Chenghai district in the city of Shantou is a major toy manufacturing center with more than
2,500 enterprises engaged in the toy business and over 100,000 employed in the industry.
The annual output of toys and gift articles is worth around Yuan 8.8 billion
Yangzhou & Yizheng, Jiangsu
Yangzhou, a prefecture-level city in China, and especially Yizheng city, are famous for their
plush toys (or stuffed toys). There are around 100 large-scale factories in this region, with an
annual output of around Yuan 3 billion.
19
20
21
22
Wal-Mart Stores, Inc. was founded in 1962. It is the worlds largest retailer and one of the
worlds largest corporations by revenues.
Calum MacLeod, Chinas Toy Industry Feels Growing Pains, www.usatoday.com,
December 21, 2006.
A sweatshop is a shop or factory in which employees work long hours at low wages under
poor conditions.
The Institute of Contemporary Observation (ICO), founded on March 18, 2001, is a civil society
organization dedicated to labor development and corporate social responsibility. (Source: www.icochina.org)
Calum MacLeod, Chinas Toy Industry Feels Growing Pains, www.usatoday.com,
December 21, 2006.
480
Exhibit III
Chinese Toy Import and Export Statistics
Category
2005
Exports ($)
2006
Imports ($)
Exports ($)
Imports ($)
16, 18 or 20
Cross-country
bicycles
275,358,952
8,021
260,999,221
17,122
174,573,263
44,643
214,011,194
64,672
565,990,037
9,146,881
663,350,087
9,806,131
19,037,697
541,223
21,731,462
172,980
for
5,791,566
1,292,657
6,958,622
1,277,389
Wheeled
toys
designed to be
ridden by children,
dolls carriages
270,006,643
635,640
355,774,372
943,052
Dolls, whether or
not dressed
318,705,789
11,449,860
389,714,240
13,382,616
66,734,251
9,980,431
72,254,540
3,436,787
35,376,056
9,778,648
37,706,999
13,195,698
Electric
trains,
including
tracks,
signals, and other
accessories
40,557,441
1,816,729
39,582,741
1,066,407
Reduced-size model
assembly
kits,
working models
38,805,107
3,869,446
45,886,660
3,871,976
Other construction
sets and
constructional toys
5,342,864
180,716
12,243,909
255,553
Musical boxes
Mechanisms
musical boxes
23
24
Bama Athreya was testifying to a Senate panel which was considering passing a law that
would make it illegal to import or sell goods in the US that were made abroad in sweatshops
or by prisoners.
Byron Wolf, Sweatshop Toys? Chinas Goods Finds US Homes, www.abcnews.com, October
25, 2007.
481
International Business
Stuffed
toys
representing
animals or nonhuman creatures
1,570,834,234
6,344,984
1,605,111,623
6,407,679
Other
toys
representing
animals or nonhuman creatures
124,539,699
1,692,589
136,856,016
2,263,466
68,014,801
805,718
75,767,193
704,982
Puzzles
355,525,300
8,133,680
397,326,556
10,541,972
226,013,097
3,111,896
307,838,064
4,501,503
716,962,733
5,406,644
724,520,854
11,116,661
Other toys
2,724,867,112
51,348,669
2,855,080,436
51,001,271
3,888,966,084
46,635,371
5,077,008,358
189,892,142
2,472,537,295
136,149,393
3,146,348,401
100,254,202
Articles
Christmas
for
1,073,407,609
1,431,126
1,151,238,737
2,592,939
146,917,463
1,814,837
163,916,886
2,729,764
Toy musical
instruments and
apparatus
Source: www.toy-cta.org.
To put things in perspective, the prices of many exported Chinese toys were a fraction
of the prices of similar toys manufactured in developed countries. For example, the
cost of manufacturing a pair of roller-skates in China was 16.8 euros ($21.15) on an
average, compared to 62.3 euros in Japan.25
Also, toy manufacturers claimed that repeated inspections and evaluations of their
factories in China caused lower productivity. Cited often was the case of a toy factory
that was inspected over 50 times in one year.
In 2005, international toy producers such as Mattel 26, Hasbro27, and Leapfrog
Enterprises Inc. (Leapfrog),28 submitting to international pressure, announced that
they would cancel the orders placed with Chinese toy manufacturers unless these
25
26
27
28
April Mei, Playtime is over for Chinas Toy Industry, www.atimes.com, June 21, 2006
Mattel Inc., founded in 1945, is an American toy company. As of 2007, it is the worlds
largest toy company based on revenues.
Hasbro was founded by two brothers Henry and Helal Hassenfeld in 1923 in Providence,
Rhode Island as a company that sold textile remnants. It started selling toys in the 1940s. As
of 2007, it was the second largest toy maker in the world, after Mattel Inc.
LeapFrog Enterprises Inc., founded in 1995, is a toy company based in Emeryville,
California.
482
Exhibit IV
A Note on the ICTI Code
ICTI released the ICTI Code of Business Practices (ICBP) in 2002. The ICBP is
also called the CARE Process, where CARE stands for caring, awareness,
responsibility, and ethics.
The ICBP bars the use of underage, forced, or prison labor and the denial of a job
on the grounds of gender, ethnic origin, religion, affiliation, or association. Also,
factories have to comply with laws protecting the environment. In all, the code
covers eight aspects: child labor, prison/forced labor, working hours, wages and
compensation, discrimination, working conditions, industrial safety, and EHS
(environment, health, and security).
ICTI delegates the monitoring work to six independent monitoring agencies which
adopt monitoring approaches such as checking local laws, conducting on-site
visit/inspection, interviewing workers, etc. Monitoring involves the inspection of
original documents. Interviews of workers are conducted in a separate room with
no factory representative present, and special efforts are made to protect
confidentiality.
The ICTI certification procedure involves an audit checklist (in the Appendix II
of the Code). A high-ranking official of a factory is required to state whether the
factory has complied with items in the checklist by ticking in the Yes/No box
provided against each item and write how it was implemented in the Comment
box. If the factory has failed to comply with any of the items in the checklist, it
must take measures and then apply to be re-examined, until the certifying agency
approves. After that, it also needs to be inspected by the ICTI Certification
Technical Consulting Committee and confirmed by the ICTI (Asia) Co. Ltd. before
the factory can receive certification. Furthermore, factories need to undergo
evaluation on a yearly basis. Certification will be revoked if factories fail any
evaluation. Toy factories subsidiary factories and subcontracting factories must
also undergo evaluation.
Though only a voluntary code, an increasingly large number of brand name
companies require that their suppliers (of both components and finished goods)
receive the ICTI certification. As per ICTI data, until February 2005, over 150
brand-name companies including Mattel, Hasbro, Leapfrog, Lego, and Toys R
Us, have signed and acknowledged the ICTI certification. These companies
accounted for more than 50% of the global sales of toys.
Source: Liu Songjie, Mainland Toy Companies Facing the ICTI Dilemma,
www.chinalaborwatch.org, February 15, 2006.
29
30
31
ICTI promotes ethical and safe practices in toy factories and looks after the interests of toy
manufacturers in 21 member countries.
The CARE (Caring, Awareness, Responsible, and Ethical) Process is the ICTI program to
promote ethical manufacturing in the form of fair labor treatment, as well as employee
health and safety, in the toy industry supply chain, worldwide. (Source: www.icti-care.org)
Liu Songjie, Mainland Toy Companies Facing the ICTI Dilemma,
www.chinalaborwatch.org, February 15, 2006.
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International Business
At the beginning of 2006, the Chinese government in an attempt to improve the
quality of Chinese toys, imposed the China Compulsory Certification (CCC) 32 scheme
on toy makers. Under the scheme, effective from June 1, 2007, only toys that met
CCC standards would be allowed to be exported to foreign markets or sold in the
domestic market.
In April 2006, the Chinese toy industry suffered a blow when a EU report stated that
25% of the problematic imported products recognized by the Unions Rapid Alert
System for Non-Food Products (RAPEX)33 were toy products, and 85% of these were
toys imported from China. 34 The same month, Chinas General Administration of
Quality Supervision, Inspection, and Quarantine and the EUs Health and Consumer
Protection agency signed a draft guide for strengthening the Sino-EU Cooperative
Action for Toy Safety.
In the months preceding June 1, 2006, Childrens Day in China, the Guangdong
quality inspection authority checked toys produced in the province. The authority
found that more than 45 percent of them did not meet state quality and safety
standards.
Despite lingering quality issues, even as late 2006, foreign buyers continued to
express confidence in the Chinese toy industry. Michael Araten (Araten), President of
KNex Industries Inc.,35 said, Theres a comfort level about China now they have
the investment and infrastructure, and meet U.S. and European safety standards.36
Tom Debrowski (Debrowski), Executive Vice President of Mattel, also held the same
view. He said, There are other places in the world where you can get lower labor
costs, but China has a very well-developed infrastructure, well educated engineers,
excellent transport, and a business-friendly government.37
A Spate of Recalls
In mid-December 2006, in what was to be the first in a series of major recalls, the
CPSC in the US issued warnings against Chinese products like BRIO bell rattles,
Lobby Christmas lights, Holiday Time stuffed Christmas beagles, and three other
types of toys. The commission said that as the parts of these products could be easily
separated, there was a choking risk for children. This apart, high lead 38 content,
battery leakage, and inflammable parts were given as other reasons for the warnings.
Several retail outlets in the US too issued warnings, and recalled the China-made toys.
Around this period, the EU too issued safety warnings on a list of 15 made-in-China
32
33
34
35
36
37
38
The CCC is the compulsory Safety and Quality mark for many products sold in the Chinese
market. The CCC Mark became effective on May 1, 2002. It is the result of the recent
integration of Chinas two compulsory inspection systems (one to check contents of
products for import and export, and the other for quality control) into a single procedure.
(Source: www.ccc-mark.com)
RAPEX is the EUs rapid alert system for all dangerous consumer products, with the
exception of food, pharmaceutical, and medical devices. (Source: http://ec.europa.eu)
April Mei, Playtime is Over for Chinas Toy Industry, www.atimes.com, June 21, 2006.
KNex Industries Inc. was founded in 1992. It is a privately held company, with its
headquarters and manufacturing facility located in Hatfield, Pennsylvania, USA. (Source:
www.knex.com)
Calum MacLeod, Chinas Toy Industry Feels Growing Pains, www.usatoday.com,
December 21, 2006.
Calum MacLeod, Chinas Toy Industry Feels Growing Pains, www.usatoday.com,
December 21, 2006.
Lead is a toxic metal that can cause adverse health effects if ingested.
484
41
42
43
44
45
46
47
Rough Play for Guangdongs Toy Exports, www.tdctrade.com, March 27, 2007.
The recalls of 2007 on consumer goods manufactured in China also included pet food,
toothpaste, lipstick, and certain types of seafood.
Easy-Bake Ovens were launched by Kenner Products (later purchased by Hasbro) in 1963,
allowing little girls to bake treats by themselves.
Nearly 1 Million Hasbro Toy Ovens Recalled, www.money.cnn.com, February 6, 2007.
RC2 Corporation is a US-based designer, producer and marketer of toys and infant products.
The US Consumer Product Safety Commission had banned paint containing more than
0.06% (600 ppm) lead for residential use in the United States in 1978. The US Government
defines lead-based paint as any paint, surface coating that contains lead equal to or
exceeding one milligram per square centimeter or 0.5% by weight.
RC2 Corp. Recalls Various Thomas & Friends Wooden Railway Toys Due to Lead
Poisoning Hazard, www.cpsc.gov, June 13, 2007.
New Easy-Bake Oven Recall Following Partial Finger Amputation; Consumers Urged to
Return Toy Ovens, www.cpsc.gov, July 19, 2007.
Lead Paint Prompts Mattel to Recall 967,000 Toys, www.nytimes.com, August 2, 2007.
485
International Business
manufacturers in China to reemphasize the companys standards. He later described in
an interview what he had conveyed to Mattels contract manufacturers The message
was very clear. If you cannot do these things [meeting the quality standards], please let
us know. No problem, but you wont be doing business with us.48
Although recalls of made in China toys were not a new development (Refer Exhibit
V for recalls of China-made toys between 1988 and 2007 and the reasons), the fact
that the year witnessed the recall of other made in China items such as pet food,
toothpaste, etc. attracted more attention from the world press, thus denting the
international image of Chinese manufacturing in general and toys in particular.
Chinese officials, however, maintained that the majority of its toy exports were safe
and of high quality. Some international toy industry officials came out in support of
the Chinese toy industry, arguing that made in China toys were largely safe and that
the issue was being blown up out of all proportion. There is something like 30,000
different toy products on sale at any one time. How many items have been recalled
lately? Anyone can have something go awry. Its difficult to stay on top of
everything, said Ian J. Anderson, the Asia Pacific director at SGS, a consumer testing
company that worked with Mattel and other toy makers in China. 49
Exhibit V
48
49
Year
Total Number
of recalls
1988
29
1989
52
1990
31
14
45
1991
31
26
1992
25
13
52
1993
20
40
1994
29
16
55
1995
35
19
54
1996
26
13
50
1997
22
41
1998
29
12
41
1999
20
20
2000
31
15
48
2001
23
12
52
2002
25
11
44
David Barboza and Louise Story, Mattel Issues New Recall of Toys Made in China,
www.nytimes.com, August 14, 2007.
David Barboza and Louise Story, Mattel Issues New Recall of Toys Made in China,
www.nytimes.com, August 14, 2007.
486
15
10
67
2004
15
13
87
2005
19
16
84
2006
33
26
79
2007
40
38
95
Recalls due to
Design Flaws
Recalls due to
Mfg. Flaws
1988
29
25
1989
52
42
1990
31
25
1991
31
29
1992
25
16
1993
20
15
1994
29
21
1995
35
32
1996
26
15
1997
22
17
1998
29
23
1999
20
15
2000
31
25
2001
23
15
2002
25
20
2003
15
14
2004
15
2005
19
14
2006
33
23
2007
40
26
10
Source: Hari Bapuji and Paul W. Beamish, Toy Recalls - Is China Really the
Problem? www.asiapacific.ca, September, 2007.
In what could be seen as a positive development for the Chinese toy industry, on
September 21, 2007, the Mattel management apologized to Chinese officials, toy
manufacturers and the country as a whole for the loss of image and said that the
company would take the blame. Debrowski said that the majority of these toys had
been recalled because of loose magnets (around 17.4 million units), which were the
result of design flaws. He apologized personally to Li Changjiang, Director of the
State Administration of Quality Supervision, Inspection and Quarantine, China.
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International Business
Debrowski said, Mattel takes full responsibility for those recalls [of magnetic toys]
and I would like to apologize personally to you, the Chinese people, and all of the
customers who received toys that have been manufactured.50 Mattels press release
stated, Mattel does not require Chinese manufacturers to be responsible for the
magnets-related recalls due to design problems. The magnet-related recalls do not
involve lead paint or manufacturing failures by Mattel or its vendors, including
vendors in China.51 However, regarding the lead related recalls, Mattel stated they
were the result of a minority of manufacturers [in China] not following the companys
guidelines; though even in the case of lead-related recalls, the company said that they
were overly inclusive.52 Mattels follow-up inspections also seem to have confirmed
that some of the recalled toys complied with US standards.
However, after repeated recalls of China-made toys, more consumers in the US were
reportedly looking for alternatives to Chinese toys. Sales of US-made toys apparently
increased and US-based manufacturers found it difficult to meet the sudden increase
in demand. Some of them were forced to hire more people and lease more warehouses
to stock their produce. Every time thered be a new recall this summer, wed get a
huge new order, said Deborah Evanoff, owner of Arrowcopter Inc., a private toy
manufacturing company based in the US. 53 Earlier US producers had been unable to
compete against low-cost Chinese toys, but now they were able to successfully lure
customers using made in USA labels. Some of these manufacturers brought photos
of their manufacturing facilities to toy fairs, and placed advertisements in industry
publications to drive home the point that their quality standards were much higher
than those of Chinese manufacturers.
According to some analysts, the increase in the demand for US-made toys was
unlikely to last. They were of the view that claims by US-based toy manufacturers of
superior quality were not entirely true as the quality of US-made toys varied from
factory to factory and some Chinese toys were of higher quality and yet cheaper.
In 2007, the EU, the second largest export market for the Chinese toy industry,
introduced new environmental safety rules including those that banned the sale of toys
containing over 1% of phthalate54 and five other chemicals. As phthalates were widely
used in the manufacture of plastic toys in China, the new rules were expected to
significantly impact the Chinese toy industry.
Other Issues
Meanwhile, the Chinese toy industry was facing problems on the home front as well. With
labor costs in China increasing rapidly, the industry was beginning to lose competitiveness
in the export market. A survey by the Guangdong Toy Association indicated that Vietnam
and Eastern Europe with their low prices posed a threat to Chinese toy exports. Bryan
Ellis, Chairman of the Toy Industries of Europe, also held the same view. He said,
Production is going to develop elsewhere, in Thailand, Indonesia, India, and Eastern
50
51
52
53
54
488
56
57
58
59
60
61
489
International Business
Exhibit VI
Trends in the Toy Industry as of 2007
Continued popularity of smart toys: Toys with electronics and new technology
integrated into them continue to see increased demand. Some companies have
recreated their very successful toys with new electronic features. For example,
wooden trains by BRIO are now equipped with modern infrared remote control and
electronic sounds. Some newly introduced dolls and toy robots communicate
interactively with other toys in the same product line, such as Hasbros Furreal
Friends.
Sustained interest in licensing: Licensed products continue to be successful in the
market. In the case of video games, companies are now constantly inventing new
characters even as sales of games featuring licensed characters remain satisfactory.
Strong and clear focus on educational, creative, and developmental toys: With
more parents looking at toys as aids to develop their childs listening, creative, and
inter-personal skills, the market for educational toys is growing in size. Hasbro has
launched a product called T.J. Bearytales, an animated bear that encourages
children to read with it. Another company Toy Quest has video books, which
encourage families to learn together through reading and sharing stories.
Trend of shorter product life cycles and a wider variety of novelty designs:
The product life cycle of toys has shortened over the past decade. In order to
achieve higher sales for products in their maturity phase, companies are using
fancy designs and gimmicks. Even for classic toys such as LEGO construction sets
and Barbie dolls, new features are regularly being added or improved to spur new
sales.
Wide interest in multi-media and web-compatible toys: The rising popularity of
the Internet is making companies assimilate real and virtual toys together. New
toys that are capable of linking with the Internet are being introduced. For example,
Bandai, a large Japan-based toy maker, has introduced toy robots that allow buyers
to play games with animated versions of their robots over the Internet.
Youth electronics: Youth electronic toys are kid-size versions of adult products.
As most parents are not very keen on buying their younger children expensive
electronic products, the popularity of youth electronic toys is growing. Kid-sized
and affordably priced MP3 players and digital cameras are some examples of youth
electronics.
Sports-like toys: As concerns about health and child obesity rise, sales of sportslike toys such as aquatic toys and equipment, are growing.
Growing demand for collectibles: Collectors articles have a loyal clientele even
among adults, particularly in the US, Germany, and Japan. The most popular
collectibles are soft toys and dolls, model railways, and parlor games. In response
to the growing demand, more and more companies are introducing two lines for the
same product, one for kids and the other for collectors. For example, besides its
childrens line, Mattel sells collectors lines of Barbie dolls, Matchbox die-cast
cars, and the Hot Wheels racing system.
Adapted from Profiles of Major Hong Kong Manufacturing Industries,
www.tdctrade.com.
490
Outlook
In an attempt to improve the quality of toys, the Chinese government sponsored a twoday training session on October 11 and 12, 2007, on quality control for more than
1,000 people from the Chinese toy industry. At these sessions, Chinese government
officials and executives from multinational companies lectured on European and US
quality and safety standards, Chinas toy licensing system, toy certificate systems,
export test regulations, etc. Participants were also taught how to deal with high lead
levels or design flaws in their products. Officials from the Ministry of Commerce
advised toy companies to specify their obligations with respect to quality in the
contracts so that they could protect themselves from potential losses. 62 According to
Liang Mei, Secretary General of the China Toy Association63, the recalls presented
both a challenge and an opportunity for the Chinese toy industry. 64
In late October 2007, the provincial government of Guangdong announced that it had
suspended or revoked the export licenses of 764 toy factories because of various
quality problems. Another 690 toy factories were ordered to renovate their plants and
improve product quality. According to sources, the provincial government had, by late
October 2007, finished inspecting 85 percent of Guangdongs toy factories and
expected to complete the process soon.
Though the majority view within China was that the toy recalls, especially those of toys
containing high levels of lead, were due to lapses on the part of Chinese toy makers, there
were some who believed that the recalls were part of a conspiracy to sully the image of
Chinas toy industry. Chinas product safety chief, Li Changjiang, was of the view that
some importing countries had orchestrated the recalls so as to protect their domestic toy
industries and slow down Chinas toy exports.
On customer response to Chinese toys post-recalls, Ron Boire, president of Toys R
Us Inc.s North American division, said, Consumers are still confused. However, he
added that he did not see a sea change.65 Chris Byrne, a New York-based toy
consultant,66 talking about toy sales in the Christmas season, said, Its a blip. In the
fourth quarter, a lot of purchases are made based on supplications to the North Pole
and the phrase country of origin isnt in the vocabulary of children writing to Santa.
In late 2007, a weak dollar and US economy that appeared to be slipping into
recession seemed to have impacted exports from China, especially of toys and tiles.
The dollar has depreciated so much that American goods are more competitive. On
the other hand, the import decline tells you about what retailers are thinking about the
holiday shopping season. Theyve cut back orders, said Sung Won Sohn, chief
executive of Hanmi Bank in Los Angeles. 67 In an attempt to encourage toy sales, WalMart, USs largest retailer of toys, slashed prices by 10 percent to 50 percent in
October, several weeks ahead of the usual shopping season. However, analysts feared
that sales in the all-important Christmas season would be disappointing.
62
63
64
65
66
67
China Gives Toy Industry Crash Course in Quality, www.chinapost.com, tw, October 15,
2007.
The China Toy Association, founded in 1986, is an industry organization with more than
1,000 members. It acts as an interface between the toy industry and the Chinese
government. (Source: http://www.shanghai-toy-expo.com)
Tim Johnson, Chinese Toy Factories Retool after Recalls, www.mcclatchydc.com,
October 23, 2007.
Anne Dinnocenzio, Despite Recalls, Chinese Toys Still Sell, www.theledger.com,
October 2, 2007.
Rachel Konrad, Chinese Toy Recalls Benefit U.S. Firms, www.courierpostonline.com, October
15, 2007.
Cargo Decline Portends Consumer Weakness,
http://globaleconomicanalysis.blogspot.com, October 10, 2007.
491
International Business
Meanwhile, the price of crude oil crossed an all-time high of $93 a barrel. This was
expected to increase the cost of plastics, of which the majority of toys were made,
creating further problems for Chinese toy makers.
Despite the problems, some toy industry experts were of the view that the 2007 recalls
would not affect future demand for Chinese toys. Next year at this time when an
awesome new battery-operated toy comes out and its made in China
will people
say no way? It just depends on the mood of the consumer, said Mary Jo Meister,
sales manager for Lauri Toys Inc., a US-based toy manufacturing company. While it
was anyones guess whether Chinese toy exports would contract or not, China-based
toy makers were increasingly hopeful of the booming domestic market. In 2006, Toys
R Us opened its first store in China signaling the huge potential of the domestic toy
market in China. Frank Clarke of Strategy XXI Ltd., 68 the communications agency of
Toy Industry Association Inc. (TIA)69 in New York, said. All our members are
looking at China as a retail opportunity, not just an export base. In the U.S., there are
50 million children in the 0-8 age group. China has 300 million in that age group. 70
According to some estimates, Chinas toy market would grow 40 percent annually in
the next few years to be worth $12.5 billion by 2010.
68
69
70
Strategy XXI Ltd. is a member of the Kreab Group, a communications consultancy. Strategy
XXI solves public relations and public affairs problems for corporations, governments, trade
associations, and non-governmental organizations. (Source: www.strategy-xxi.com)
Toy Industry Association Inc. (TIA) is a non-profit trade association for producers and
importers of toys and youth entertainment products sold in North America. (Source:
www.toyassociation.org)
Calum MacLeod, Chinas Toy Industry Feels Growing Pains, www.usatoday.com,
December 21, 2006.
492
2.
Rachel
Konrad,
Chinese
Toy
Recalls
www.courierpostonline.com, October 15, 2007.
3.
China Gives Toy Industry Crash Course in Quality, www.chinapost.com.tw, October 15,
2007.
4.
5.
6.
7.
Kelly Marshall and Rob Kelley, Mattel Announces Third Toy Recall, www.money.
cnn.com, September 5, 2007.
8.
9.
10.
11.
David Barboza and Louise Story, Mattel Issues New Recall of Toys Made in China,
www.nytimes.com, August 14, 2007.
12.
Mattel Issues New Massive China Toy Recall, www.msnbc.msn.com, August 14,
2007
13.
14.
New Easy-Bake Oven Recall Following Partial Finger Amputation; Consumers Urged
to Return Toy Ovens, www.cpsc.gov, July 19, 2007.
15.
RC2 Corp. Recalls Various Thomas & Friends Wooden Railway Toys due to Lead
Poisoning Hazard, www.cpsc.gov, June 13, 2007.
16.
Rough Play for Guangdongs Toy Exports, www.tdctrade.com, March 27, 2007.
17.
Sonia Kolesnikov-Jessop, A Trip into Chinas Past, through its Toys, www.iht.com,
March 27, 2007.
18.
19.
20.
April Mei, Playtime is over for Chinas Toy Industry, www.atimes.com, June 21,
2006.
21.
22.
23.
Chinas Lockhold on Global Toy Industry Set to ease, www.taipeitimes.com, February 12,
2006.
Benefit
U.S.
Firms,
Facing
the
ICTI
Dilemma,
493
International Business
24.
25.
26.
27.
www.toyassociation.org.
28.
www.strategy-xxi.com.
29.
www.chinalaborwatch.org.
30.
www.amrc.org.hk.
31.
www.cpsc.org.
32.
www.icti-care.org.
33.
http://ec.europa.eu.
34.
www.ccc-mark.com.
494
Introduction
On March 09, 2006, the Spanish Prime Minister, Jose Luis Rodriguez Zapatero
(Zapatero), and his Polish counterpart, Kazimierz Marcinkiewicz, announced at a joint
press conference that from May 01, 2006, Spain would open up its labor market to
workers from Poland and the other seven countries from Central and East Europe
(CEE) which had joined the European Union (EU) on May 01, 2004 4. The
announcement was not unexpected as it had been widely anticipated that Spain would
favor opening up its labor market to the new members 5 of the EU. On February 28,
2006, Portugal had also indicated that it would open up its labor market to the new
members from the CEE. Before that, on February 13, 2006, Finlands Labor Ministry
had proposed that restrictions on labor movement from the new EU member countries
be lifted.
At the time of the 2004 enlargement, the EU had allowed its existing members (the
old member states) to impose restrictions on the free movement of labor from the new
member states for a transition period extendable up to 2011. Twelve out of the fifteen
countries opted for labor restrictions, fearing that there would be a large-scale influx
of immigrants from the new member countries chasing jobs and driving down wage
rates. Only the UK, Ireland, and Sweden decided to allow the new member countries
access to their labor markets (Refer to Exhibit I for a map of the European Union
in 2005).
1
2
3
www.union-network.org/uniibits.nsf
www.cer.org.uk/pdf/essay_eastvswest_jan06.pdf
The Centre for European Reform is a London-based think tank devoted to improving the
quality of the debate on the future of the European Union
The EU was enlarged in May 2004 with ten new members. They were Cyprus, the Czech
Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia. While
the nationals of Cyprus and Malta were given the freedom to access the labor markets
within the EU, others were severely restricted.
Here new members would mean the eight new members from the CEE; i.e., all the new
members of 2004, except for Cyprus and Malta. The old members would mean the 15 EU
member states before the 2004 enlargement.
522
Exhibit I
Map of European Union in 2005
Background
Human migration, or the movement of people from one place to another, is a
phenomenon that is as old as mankind itself. Indeed, it is believed that humans first
appeared in Africa, and subsequently spread out toward the Middle East, Europe,
Asia, Australia, and finally to the Americas. Even after the advent and growth of
523
International Business
human settlements, people have continued to migrate from one place to another,
shaping the growth of civilizations and the progress of human history. For example,
the migration of the Huns, the Goths, and other tribes during and after the fall of the
Roman Empire changed the demographic and cultural landscape of Europe. In the 17th
century, the movement of English religious groups to the New World, seeking a place
where they could practice their religion freely, laid the foundation of the present day
United States.
In modern times, after the advent of the nation states and the consolidation of
nationalities, the migration of people from one nation to another came to be regulated
by the national governments. The inflow of migration into a country became
immigration while the outflow came to be known as emigration. Emigration had a
profound influence on Europe in the 19th century and the early 20th century, when
hundreds of thousands of poor families left Western Europe for the United States,
Canada, Brazil, Argentina, and Australia. 6
Why do people move from one place to another? The reasons could be to escape war,
famines, droughts, disease, political and religious persecution, and poverty. Or they
may migrate for more positive reasons
to seek adventure, better employment and
business opportunities, higher incomes, or better healthcare facilities, or to reunite
with their family members.
In the late 20th century, while the development of transport and communications
turned the world into a global village, increasing restrictions by national governments
on immigration made it very difficult for people to move from one country to another.
The arrival of new immigrants into a country was often seen by its citizens as diluting
their countrys national, ethnic, or religious character. Immigrants were also often
viewed as job-chasers who drove down wages and salaries. However, there were also
others who welcomed the immigrants, seeing them as hard-working people
contributing to the development of the host countrys cultural and economic life.
Immigrants have thus been welcomed and despised at the same time by different
sections of their host country.
Emigration, http://en.wikipedia.org/wiki/Emigration
Jeremy N. Smith, The Father of Europe,
http://www.worldtrademag.com/CDA/Articles/Column/
0489bc5ec5499010VgnVCM100000f932a8c0__
524
10
Norway also applied for the EC membership. But in a referendum held in 1972, its people
rejected the governments decision to join the EC. More than two decades later
in a
referendum held in 1994, the Norwegian electorate again voted against joining the EC.
Antonio Vitorino, The Challenges of Global Migration: An EU View,
http://www.carnegiecouncil.org/ viewMedia.php/prmID/4985
The
Enlargement
of
the
European
Union,
http://www.auswaertigesamt.de/www/en/eu_politik/ vertiefung/erweiterung_html
525
International Business
In June 1993, the EU formulated the Copenhagen Criteria that defined the eligibility for
EU membership. These criteria required that the candidate countries have stable
institutions to guarantee democracy, the rule of law, human rights, and the protection of
minorities (the political criterion); a functioning market economy and the capacity to cope
with competitive pressures and market forces within the EU (the economic criterion), and
the ability to take on all the obligations of membership, i.e. the ability to conform to the
entire body of EU law (the so-called acquis communautaire), and adhere to the aims of
political, economic, and monetary union (the acquis criterion).11
11
12
The
Enlargement
of
the
European
Union,
amt.de/www/en/eu_politik/ vertiefung/erweiterung_html
The
Enlargement
of
the
European
Union,
amt.de/www/en/eu_politik/ vertiefung/erweiterung_html
526
http://www.auswaertigeshttp://www.auswaertiges-
Real GDP Growth Rates in the Old and New Member States in %
2000
2001
2002
2003
2004
Old EU 15
3.8
1.8
1.1
1.0
2.2
New EU 10
4.1
2.4
2.4
3.8
5.1
Source: Katinka Barysch, East versus West?The European economic and social
model after enlargement,
www.cer.org.uk/pdf/essay_social_model_barysch_oct05.pdf.
The old EU economies had also been facing very low employment rates 14 64% as
against the EU norm of 70%. Paradoxically, in spite of high wage rates, there were
also many gaps in the labor market that were unfilled because of the unwillingness of
the domestic labor force to take up certain jobs (Refer to Exhibit for III hourly
labor costs in the EU). At the same time, they also had high unemployment rates
8.5% (Refer to Exhibit IV for unemployment rates in select old EU member
countries). This paradox of high unemployment and huge gaps in the labor market
was explained by the welfare nature of these economies, and their high and rigid wage
rates.
Many of the EU countries were welfare states, where the governments provided
generous unemployment benefits and allowances to workers, to help them get through
periods of unemployment, and find jobs better suited to their abilities and aptitudes.
These allowances, in some instances, had the effect of people deliberately choosing to
remain unemployed. The allowances also made people reluctant to move in search of
13
14
There were also other transition measures such as the precedence of national rules over the
free movement of capital with regard to the purchase of agricultural and forest land in all the
new member states (again Cyprus and Malta along with Slovenia were excluded)
Employment rate refers to the percentage of the labor force that is employed, while
unemployment rate is defined as the percentage of the total labor force that is unemployed
but actively seeking employment and willing to work.
527
International Business
employment. As a result, in many of these these countries, high unemployment rates
coexisted with a large number of unfulfilled job vacancies. These unfulfilled job
vacancies were partly responsible for the slow growth rates of these economies (Refer
to Exhibit V for economic indicators of the EU).
Exhibit III
Hourly Labor Costs in Industry and Services in 2000 &
Labor Productivity in the EU in 2002
Hourly
Labor Cost
in Euros
Labor
Productivity
in 1000
Euros
Sweden
28.56
64.4
Denmark
27.10
Germany
Hourly
Labor Cost
Labor
Productivity
Cyprus
10.74
NA
68.0
Slovenia
8.98
25.4
26.34
56.9
Portugal
8.13
NA
Luxembourg
24.61
90.5
Poland
4.48
16.9
France
24.42
65.6
Czech Rep.
3.90
17.3
UK
23.85
58.1
Hungary
3.83
17.0
Austria
23.60
63.1
Slovakia
3.06
13.3
Netherlands
22.99
55.6
Estonia
3.03
12.0
Finland
22.13
64.3
Lithuania
2.71
12.9
Italy
18.99
56.5
Latvia
2.42
10.7
Ireland
17.31
81.6
Old average
22.10
57.6
Spain
14.22
45.9
New
average
4.20
16.7
Greece
11.62
39.3
Combined
19.09
51.9
Country
Country
NA Not Available. Countries in bold are new EU members. No data were available for
Belgium and Malta.
* French labor productivity data is of 2001.
Source: Eurostat; printed in The Wall Street Journal 1618 April 2004.
Exhibit IV
Unemployment Rates in Select Old EU Members
528
Country
2003
2004
2005
Austria
4.3
4.9
5.2
Finland
9.0
8.9
8.3
France
9.5
9.6
9.5
Germany
9.1
9.5
9.5
Ireland
4.7
4.5
4.3
Italy
8.4
8.0
7.7
Spain
11.1
10.6
9.2
Sweden
5.6
6.4
United Kingdom
4.9
4.7
NA
4.7
NA = Not Available.
Source: OECD
Exhibit V
Economic Indicators of the EU and its Member States
GDP
% of EU
(2004)
GDP
per capita
in PPP $
(USD)
(2005)
Public
Debt
% of
GDP
12,690.6
100.0%
26,900
63.8
-2.6
2.0
Germany
2,714.4
21.4%
28,988
66.0
-3.7
1.8
United Kingdom
2,140.9
16.9%
28,938
41.6
-3.2
2.0
France
2,002.6
15.8%
27,738
65.6
-3.7
1.8
Italy
1,672.3
13.2%
27,984
105.8
-3.0
2.2
Spain
991.4
7.8%
23,627
48.9
-0.3
3.2
Netherlands
577.3
4.5%
29,332
-2.5
1.5
Belgium
349.8
2.8%
29,707
95.6
-0.1
2.7
Sweden
346.4
2.7%
28,205
51.2
-1.4
0.8
Austria
290.1
2.3%
31,254
65.2
-1.3
2.0
Denmark
243.0
1.9%
33,089
42.7
-2.8
1.7
Poland
241.8
1.9%
12,452
43.6
-4.8
1.4
Greece
203.4
1.6%
22,000
110.5
-6.1
3.2
Finland
186.6
1.5%
29,305
43.6
-2.1
1.0
Ireland
183.6
1.4%
37,663
29.9
-1.3
1.9
Portugal
168.3
1.3%
18,503
61.9
-2.9
0.6
Czech Republic
107.0
0.8%
18,370
37.4
-3.0
1.3
99.7
0.8%
15,546
57.6
-4.5
3.7
Country
European Union
Hungary
GDP
in billions
of $ (USD)
(real
exchange
rates)
(2004)
55.7
Deficit
% of
GDP
Inflation
%
Annual
529
International Business
Slovakia
41.1
0.3%
15,066
43.6
-3.3
2.5
Slovenia
32.2
0.3%
20,306
29.4
-1.9
1.7
Luxembourg
31.1
0.2%
61,220
7.5
-1.1
3.2
Lithuania
22.3
0.2%
12,610
19.7
-2.5
2.0
Cyprus
15.4
0.1%
22,330
62.3
-3.5
1.5
Latvia
13.6
0.1%
11,850
14.4
-0.8
6.6
Estonia
10.8
0.1%
13,190
4.9
-1.8
4.6
5.4
0.04%
18,720
75.0
-5.2
2.1
Malta
Source: wikipedia.com.
The EU also faced the problem of an ageing population. As the proportion of retired
people in the population increased, the burden on the working age population in terms
of financing their pension and healthcare costs increased. In 2005, the EU economic
and monetary affairs Commissioner Mr Joaquin Almunia (Almunia) said that under
the existing (current) policies, ageing would increase public spending on pensions,
healthcare, and long-term care by 4% to 8% of GDP in most of the EU's 25 states by
2050.15 In 2004, almost 35% of the EU population was above the age of 50 16. At the
same time, the number of people aged between 0 and 24 was decreasing, creating
possibilities of a demographic crisis in the future. Logically therefore, the economic
problems caused by the unfilled job vacancies and the shrinking population in the
working age group, should have led these countries to welcome immigrants from the
CEE (Refer to Exhibit VI for area and populations statistics of the EU).
Exhibit VI
Population
in millions
Population
% of EU
Area
km2
Area
% of EU
Pop. density
People/km2
454.9
100%
3,976,952
100%
115
Austria
8.2
1.8%
83,858
2.1%
98
Belgium
10.3
2.3%
30,510
0.8%
340
Cyprus
0.8
0.2%
9,250
0.2%
84
10.2
2.2%
78,866
2.0%
130
Denmark
5.4
1.2%
43,094
1.1%
126
Estonia
1.4
0.3%
45,226
1.1%
29
Finland
5.2
1.1%
337,030
8.5%
15
France
60.2
13.2%
547,030
13.8%
111
European Union
Czech Republic
15
16
530
Germany
82.4
18.1%
357,021
9.0%
231
Greece
10.7
2.4%
131,940
3.3%
81
Hungary
10
2.2%
93,030
2.3%
108
Ireland
3.9
0.9%
70,280
1.8%
57
Italy
58
12.8%
301,320
7.6%
193
Latvia
2.3
0.5%
64,589
1.6%
35
Lithuania
3.5
0.8%
65,200
1.6%
55
Luxembourg
0.5
0.1%
2,586
0.1%
181
Malta
0.4
0.1%
316
0.0%
1,261
Netherlands
16.2
3.6%
41,526
1.0%
395
Poland
38.6
8.5%
312,685
7.9%
124
Portugal
10.1
2.2%
92,931
2.3%
114
Spain
40.2
8.8%
504,782
12.7%
80
Slovakia
5.4
1.9%
48,845
1.2%
111
Slovenia
1.9
0.4%
20,253
0.5%
99
Sweden
8.9
2.0%
449,964
11.3%
20
60.1
13.2%
244,820
6.2%
243
United Kingdom
Source: www.wikipedia.com.
In comparison, the new members of the EU, especially the eight members from the
CEE, had similar but bigger problems. In some of these countries, unemployment was as
high as 19% in 2004 (Refer to Exhibit VII for unemployment rates in select new EU
member states). High unemployment coupled with a relatively strong educational
environment created a fertile ground for migration to countries with better employment
opportunities. Added to this was the disparity in wage rates between the CEE countries
and the older EU members. With huge differences in wage rates between the old and the
new members, potential migrants could earn much higher incomes in the old EU
countries. All these factors created an environment favorable to emigration in the new
EU countries.
Exhibit VII
Unemployment Rates in Select New EU Member States
Country
2003
2004
2005
Czech Republic
7.8
8.3
7.9
Hungary
5.9
6.1
7.2
Poland
19.6
19.0
17.8
Slovak Republic
17.6
18.2
16.4
Source: OECD.
531
International Business
The enlargement thus had the potential to stimulate growth in the economies of the
old EU countries, by solving some of their labor problems. However, this was not to
be.
Theoretically, in a free market, market forces determine the supply of and demand for
labor. These forces also determine the wage rates. However, as mentioned earlier, the
wage rates in the old EU countries were quite rigid. In countries like the UK, the
government fixed the minimum hourly wage rates. In Germany, the wage rates in
many sectors were negotiated by trade unions and federations of employers. As the
wage rates were comparatively rigid, there were apprehensions that the incoming
migrants could have the effect of driving the locals from their jobs and into
unemployment, leading to higher government expenditure on unemployment benefits.
It was also feared that the immigrants themselves might eventually claim
unemployment benefits, further draining government resources.
Some conservative politicians seized on the issue with claims that the enlargement of
the EU and the resultant migration from the East to the West would disrupt the labor
markets in the EU-15 and cause a huge drain on the government exchequers through
claims on welfare benefits. Eventually, they were successful in forcing the EU to
provide for an option to limit immigration from the new members. Many of the old
members opted to impose restrictions on immigration from the new member
countries. These measures ranged from requiring immigrants to obtain work permits,
to restricting them from claiming welfare benefits. (Refer to Table I for more details
on the types of immigration regimes in the old EU member countries, relevant to
immigrants from the new member countries).
Belgium, Finland,
Germany, Greece,
France, Luxembourg,
Spain
Ireland, the UK
Sweden
*EEA stood for European Economic Area and comprised Iceland, Liechtenstein,
Norway, and the EU along with its 25 member states.
Source:
Julianna
Traser,
Whos
afraid
of
EU
enlargement?
www.ecas.org/file_uploads/1009.pdf.
Exhibit VIII
Total
Other
Slovenia
Slovakia
Poland
Lithuania
Latvia
Hungary
Estonia
Period
Czech Rep
Q2
2004
2,520
3,730
50
30 42,200
Q3
2004
3,510
5,240
65
40 50,260
Q4
2004
3,020
4,875
55
30 42,075
Q1
2005
2,840
4,950
55
35 42,940
Q2
2005
2,825
6,025
30
30 57,030
Q3
2005
2,980
6,545
35
50 60,775
Q4
2005
2,310
4,995
55
45 49,355
340
265 344,63
5
Total
As %
of
Total
6%
1%
3%
7%
13%
Report
59%
May
December
100%
2005,
The top five sectors of employment for registered workers who applied between May
2004 and December 2005 were Administration, Business & Management (32%),
Hospitality & Catering (22%), Agriculture (12%), Manufacturing (8%) and Food, Fish
and Meat Processing (5%). 17 The immigrants filled labor gaps in the British economy
as process operatives (70,555), packers (18,765), kitchen and catering assistants
(18,255), warehouse operatives (17,430), domestic staff (14,440), farm workers
(12,645), and truck drivers (2,930), among others. The British government in a report
17
Most of the data on this page are from Accession Monitoring Report May 2004
December 2005, A joint online report by the Home Office, the Department for Work and
Pensions, the HM Revenue & Customs and the Office of the Deputy Prime Minister, United
Kingdom, 28 February 2006.
533
International Business
called Accession Monitoring Report May 2004 December 2005 released in
February 2006 said that the impact of immigration from the new member states on the
British economy had been modest but broadly positive (Refer to Exhibit IX for the
sectors in which registered workers were employed).
Exhibit IX
Q3
2004
Q4
2004
Q1
2005
Q2
2005
Q3
2005
Q4
2005
Total
6,590
11,110
13,535
14,155
17,165
21,100
21,360
104,915
Hospitality and
catering
12,000
12,980
9,325
8,085
10,475
11,300
8,420
72,590
Agriculture
activities
8,240
5,660
3,005
4,000
9,295
6,685
2,645
39,525
Manufacturing
2,360
3,750
3,640
3,550
4,280
4,250
3,410
25,245
Food/fish/meat
processing
1,590
2,545
2,345
2,215
2,815
2,935
2,550
16,995
Health &
medical services
1,170
2,220
2,160
2,300
2,580
3,290
2,660
16,380
1,545
1,950
1,860
1,815
2,120
2,525
2,220
14,035
Construction &
land services
1,710
1,995
1,480
1,610
1,905
2,090
1,575
12,365
Transport
600
910
1,210
1,505
1,890
1,815
1,400
9,330
790
950
450
890
1,195
1,135
430
5,840
Education &
cultural act
460
545
490
445
480
510
485
3,400
155
205
170
240
240
255
190
1,450
95
115
130
100
110
195
140
890
Financial
services
135
160
130
115
110
135
95
880
Extraction
industries
75
145
145
85
110
125
115
805
Sector
534
Q2
2004
Sector
Computer
services
Q3
2004
Q4
2004
Q1
2005
Q2
2005
Q3
2005
Q4
2005
Total
130
120
135
100
95
125
95
800
Telecommunications
55
60
60
80
30
45
30
365
Utilities elec.
gas, water
35
50
40
35
35
50
35
280
Sporting
activities
45
60
45
40
15
35
30
266
Government
20
30
25
25
30
40
35
205
Law related
services
35
30
25
20
15
20
20
160
990
850
195
85
80
135
45
2,375
38,830
46,440
40,600
41,480
55,065
58,690
47,985
329,090
Not stated
Total
19
Kevin
Sullivan,
East-to-West
Migration
http://www.washingtonpost.com/wpdyn/content/article/2005/11/27/AR2005112700950_2.html
Migrant workers from east helping to boost EU's
http://www.guardian.co.uk/ eu/story/0,,1705656,00.html
Remaking
fortunes,
Europe,
says
report,
535
International Business
Exhibit X
Applications for Tax-funded, Income-related Benefits in the UK
May 2004 December 2005
Q2
2004
Q3
2004
Q4
2004
Q1
2005
Q2
2005
Q3
2005
Q4
2005
Total
43
60
101
134
123
251
237
949
Allowed to
proceed for
further
processing
22
43
43
63
103
141
127
256
259
992
Total
191
162
184
268
358
497
423
2,083
Allowed to
proceed for
further
processing
12
43
71
149
197
170
188
273
370
540
494
2,232
Total
13
15
44
Allowed to
proceed for
further
processing
Total
14
16
46
Total
disallowed
234
223
288
409
486
761
675
3,076
Total
allowed to
proceed for
further
processing
11
12
16
49
94
194
240
234
294
421
502
810
769
3,270
Total
Report
May
2004
December
2005,
Exhibit XI
GDP Growth Rates of Select EU Member States
Country
2001
2002
2003
2004
2005
Ireland
6.2
6.1
4.4
4.5
Sweden
1.5
3.6
2.6
United Kingdom
2.2
2.5
3.2
1.9
Finland
2.2
2.4
3.6
1.8
Portugal
1.7
0.4
-1.1
0.5
Spain
3.5
2.7
2.9
3.1
3.2
Austria
0.8
1.4
2.4
1.9
France
2.1
1.3
0.9
1.5
Germany
1.2
0.1
-0.2
1.6
0.8
Italy
1.8
0.4
0.3
1.2
Czech Republic
2.6
1.5
3.2
4.4
4.1
Estonia
6.5
7.2
6.7
7.8
Hungary
3.8
3.5
2.9
4.2
3.4
Latvia
6.4
7.5
8.5
7.8
Lithuania
6.4
6.8
9.7
6.7
6.8
Poland
1.4
3.8
5.4
Slovak Republic
3.8
4.6
4.5
5.5
Slovenia
2.7
3.3
2.5
4.6
3.9
Source: IMF.
537
International Business
At the end of 2005, some of the EU economies had very low unemployment rates.
Ireland reported an unemployment rate of just 4.3%, while the UK had 4.7%. In
comparison, Germany had 9.5% unemployment and Poland 17.8%. The GDP growth
rates for 2005 were estimated at 1.9% for the UK, 2.6% for Sweden, and 5% for
Ireland. In contrast, Germany recorded a GDP growth rate of 0.8%, and Italy showed
no growth at all in 2005. The new members, on the other hand, had impressive GDP
growth rates. In 2005, it was estimated that Latvia showed 7.8% growth in its GDP,
Lithuania 6.8%, while for Poland and Hungary the growth rate was 3% and 3.4%
respectively.
In a report released in February 2006, the European Commission urged the rest of the
EU to do what Britain, Ireland, and Sweden had done that is, drop restrictions on
labor migration from Eastern Europe. Vladimir Spidla (Spidla,), the European
employment commissioner, said, Free movement of workers is economically rational
and is enshrined in EU treaties. We have not seen any catastrophic tendencies since
enlargement. Spidla said that Britain, Ireland, and Sweden, which had opened their
borders, had seen a drop in unemployment, a rise in employment, and high economic
growth. In contrast, the 12 old member states which had maintained restrictions on
East European labor had seen undesirable side-effects, such as higher levels of
undeclared work, as well as bogus self-employed work20, the report said.21
Outlook
Though many of the older EU members have imposed restrictions on immigration
from the new member states, it is believed that these countries will eventually have to
take in an increasing number of immigrants to offset the growing number of vacancies
in their labor markets caused by ageing populations and exacerbated by the declining
fertility rates in Europe. The Total Fertility Rate 22 in Europe was estimated to be
20
21
22
The old member countries could restrict only labor force in search of work. No restrictions
could be applied on those seeking self-employment.
Migrant workers from east helping to boost EU's fortunes, says report,
http://www.guardian.co.uk/eu/story/0,,1705656,00.html
Total Fertility Rate is defined as the average number of children expected to be born to a
woman during her lifetime.
538
23
539
International Business
540
541
Introduction
In April 2007, on the back of a rising rupee, the Indian economy became a trillion
dollar5-economy, moving the country into an elite group of nations (Refer Exhibit I
for the List of Trillion Dollar Economies). By August 31, 2007, the Indian currency
was trading at 40.96 against the dollar, as compared to 46.55 on August 31, 2006, an
appreciation of around 12 percent (Refer Exhibit II for Rupee-Dollar Exchange
Rate Movement from August 2006 to August 2007).
The rise in the value of the rupee was a result of the general weakening of the dollar in
international markets, plus Indias growing attractiveness to foreign investors. In
2006-07, India attracted huge capital inflows in terms of foreign direct investment
(FDI),6 and foreign institutional investment (FII).7 External commercial borrowings
4
5
6
249
International Business
(ECB)8 and non-resident Indian (NRI) deposits and remittances also contributed to the
dollar inflow.
Exhibit I
Trillion Dollar Economies as of 2006
S. No.
1
2
3
4
5
6
7
8
9
10
Country
United States
Japan
Germany
China
United Kingdom
France
Italy
Canada
Spain
Brazil
GDP*
(in million USD)
13,201,819
4,340,133
2,906,681
2,668,071
2,345,015
2,230,721
1,844,749
1,251,463
1,223,988
1,067,962
of India (SEBI) to participate in the market. There are limits on the ownership by foreign
institutional investors in Indian companies.
ECBs include bank loans, suppliers and buyers credits, fixed and floating rate bonds
(without convertibility) and borrowings from private sector windows of multilateral
financial institutions such as International Finance Corporation. (Source:
www.banknetindia.com)
The RBI was established on April 1, 1935. Initially a shareholders bank, the RBIs
functions included regulating the issue of currency notes, maintaining reserves to ensure
monetary stability, and operating the credit and currency system of the country.
250
Exhibit II
Indian Rupee-US Dollar Foreign Exchange Rate:
August 2006-August 2007
2006
2007
August
September
October
November
December
January
February
March
April
May
June
July
August
Exchange rate
(As on last day of the month)
46.55
45.96
45.02
44.76
44.23
44.17
44.31
43.59
41.29
40.73
40.75
40.44
40.96
Source: www.rbi.org.in.
On the other hand, the rupees appreciation against the dollar was a welcome
development for Indian importers, who were happy to pay less for their imports in
terms of rupees. Sectors which were neither net exporters nor net importers were
unaffected.
Analysts were divided in their opinion on the long-term effects of the rupees
appreciation against the dollar on the Indian economy. Some believed that as exports
as a percent of GDP are low in India, the rupees appreciation against the dollar,
though sure to impact exports, would not significantly affect the economy as a whole.
They were also confident that Indian exports would gradually regain competitiveness.
However, others were not so optimistic and were in favor of the RBI intervening in
the foreign exchange market.
In July-August 2007, the government of India announced measures to counter the
negative impact of the rupees appreciation on Indias exports. The RBI also started
buying dollars from the market to absorb the oversupply of dollars, indicating that the
rupee-dollar rate had crossed the comfort zone of the central bank.
Background Note
In India, the RBI had always played an active role in the foreign exchange market.
However, since the country faced a severe balance of payments (BOP) 10 crisis in the
10
The balance of payments (BOP) measures the payments that flow between any individual
country and all other countries. It is used to summarize all international economic
transactions for that country during a specific time period, usually a year. The BOP is
determined by the countrys exports and imports of goods, services, and financial capital, as
well as financial transfers. It reflects all payments and liabilities to foreigners (debits) and
all payments and obligations received from foreigners (credits).
251
International Business
early 1990s, there was a greater understanding of the importance of the rupee-dollar
exchange rate on the economy. With reserves down to only around $ 1 billion in mid1991, caused partly due to a fall in exports and also due to a decline in remittances
(following the Gulf war), the country was close to defaulting on its debt repayments.
The Indian government then negotiated with the IMF 11 for SDR12 of around $ 2 billion
to stave off any external debt crisis. 13 However, when the crisis deepened, the country
had to mortgage a part of its gold reserves with the Bank of England. In June 1991,
the rupee (Refer Exhibit III for some background information on the rupee) was
officially devalued by around 20 percent. In 1991, as part of its agreement with the
IMF, India liberalized its economy and following this, BOP stability was more or less
restored in the period, with foreign exchange reserves increasing to $ 9.2 billion by
end March 1992.
Exhibit III
The Indian Rupee: Background
The history of currency in India dates back to the 6 th Century B.C., when first
merchant guilds and later kings and chieftains issued silver coins as a medium of
exchange to facilitate trade. The rupee derived its name from the word
rupyakam meaning silver coin in the Sanskrit language. The forerunner to the
modern Indian rupee was introduced by Sher Shah Suri, a sixteenth century ruler.
The rupee, a silver coin weighing about 11.34 grams, was to remain the chief
currency of India till the early 20th century. One rupee was divided into 16 annas
and each anna was in turn divided into 4 paisa.
In the 1770s, private and semi-government banks issued the first currency notes in
India. Till 1835, the value of rupee varied from one state to another. With the
passage of Coinage Act in 1835, the value of the rupee became more uniform
across the country. Beginning in 1835, the East India Company started issuing a
series of coins. After 1857, the British crown took over the issue of currency.
In the 19th century, with the discovery of large silver mines in the US and parts of
Europe, the value of silver declined radically in comparison to gold. The rupee, as it
was defined in terms of silver, saw its value, vis--vis currencies that were pegged
to gold, decline. In 1898, the rupee was pegged to the British pound, with 15 rupees
making one pound. In 1920, the value of the rupee was increased, with 10 rupees
now equaling one pound. Again in 1927, the rupee value was brought down to 13.5
for one pound, which was to remain the exchange rate of the rupee till 1966.
After India achieved independence on August 15, 1947, the rupee was adopted as
the sole currency of the country. In January 1949, the Reserve Bank of India was
nationalized. That year, the rupee was devalued by 30.5 percent following the
devaluation of other currencies pegged to the pound. In 1957, the rupee shifted to
the decimal system, with one rupee now equaling 100 paisa.14
11
12
13
14
The International Monetary Fund (IMF) is an international organization that oversees the
global financial system by observing exchange rates and balance of payments, as well as
offering financial and technical assistance when requested.
The SDR or the Special Drawing Right is an international reserve asset created by the IMF
in 1969 to supplement the existing official reserves of member countries. Value of SDRs is
based on a basket of key international currencies. SDRs are allocated to member countries
in proportion to their IMF quotas. (Source: www.imf.org)
India joined the IMF on December 27, 1945 as one of IMFs original members.
The Indian rupee follows the Indian numbering system. The ancient system groups numbers
by two decimal places rather then three decimal places as is done in the western system. For
example, three hundred thousand (300,000) would be three lakhs (3,00,000), thirty million
252
15
16
17
(30,000,000) would be three crores (3,00,00,000), and three billion (3,000,000,000) would
be three arabs (3,00,00,00,000).
In a dual exchange rate system, both fixed and floating exchange rates are applied in the
market. The fixed rate is applied only to certain segments of the market such as imports and
exports, and/or current account transactions, and a market-driven (floating) exchange rate is
applied to capital account transactions. (Source: www.investopedia.com)
Managed float regime is the current international financial environment in which exchange
rates fluctuate from day to day, but central banks attempt to influence their countries
exchange rates by buying and selling currencies. It is also known as a dirty float. (Source:
http://en.wikipedia.org)
Harish Damodaran, Forex Reserves: From Penury to Plenty, www.blonnet.com,
November 29, 2002.
253
International Business
Export earnings from the software sector increased from practically zero in 1992-93 to
$ 7.17 billion in 2001-02. Foreign capital inflows in the form of FII and FDI also
contributed to the growth in foreign exchange reserves.
Between January 2003 and March 2004, the rupee began to steadily appreciate against
the dollar. In 2004, the period between March and November was marked by
fluctuations in the exchange rate. From December 2004 to September 2005, the
exchange rate remained at more or less the same levels. The next year was again a
period of fluctuating exchange rates. From September 2006, the rupee again began to
appreciate against the dollar (Refer Exhibit IV for rupee-dollar exchange rate from
1998 to July 2006).
Exhibit IV
Indian Rupee-US Dollar Foreign Exchange Rate*: 1998-2006
1998
1999
2000
2001
2002
2003
2004
2005
2006
January
39.39
42.55
43.59
46.61
48.35
47.96
45.46
43.62
44.20
February
39.01
42.53
43.65
46.56
48.72
47.75
45.27
43.58
44.23
March
39.57
42.52
43.64
46.65
48.77
47.68
44.97
43.59
44.34
April
39.70
42.80
43.68
46.79
48.94
47.39
43.89
43.64
44.82
May
40.47
42.86
44.08
46.95
49.02
47.11
45.18
43.41
45.20
June
42.37
43.21
44.76
47.04
48.98
46.70
45.50
43.52
45.89
July
42.61
43.36
44.84
47.18
48.79
46.22
46.06
43.43
46.37
August
42.84
43.50
45.77
47.17
48.62
45.96
46.32
43.55
September
42.58
43.60
45.97
47.75
48.46
45.85
46.05
43.85
October
42.39
43.55
46.43
48.05
48.39
45.40
45.74
44.76
November
42.43
43.46
46.82
48.04
48.29
45.55
45.03
45.63
December
42.59
43.52
46.78
47.93
48.15
45.57
43.85
45.56
Exhibit V
Indias Foreign Exchange Reserves between 1990-91 and 2005-06
19
20
21
Global depositary receipt or GDR is a bank certificate issued in more than one country for
shares in a foreign company. The shares are held by a foreign branch of an international
bank. The shares trade as domestic shares, but are offered for sale globally through the
various bank branches. (Source: www.investopedia.com)
American Depositary Receipt or ADR is the ownership in the shares of a foreign company
trading on US financial markets.
Indias External Debt as at the End of June 2007, http://rbidocs.rbi.org.in, September 28,
2007.
Indias External Debt as at the End of June 2007, http://rbidocs.rbi.org.in, September 28,
2007.
255
International Business
Exhibit VI
Remittances to India in Billions of US Dollars, 1990-1991 to 2005-2006
Exhibit VII
Source Regions of Remittance Flows to India in November 2007
North America
Europe
East Asia
Others
Africa
Gulf countries
South America
23
24
257
International Business
rates. And the increase in interest rates attracted more capital inflows from abroad,
with the RBI forced to repeat the sterilization process. This unending process was
another reason why the RBI decided to stop intervening in the foreign exchange
market.
Exhibit VIII
Inflation Rates in India
Year
Month
2006
October
5.09
November
5.30
December
5.58
January
6.58
February
6.10
March
5.74
April
5.66
May
4.85
June
4.27
July
4.45
August
3.52
2007
In India, the retail price of petrol and diesel is determined by the government. Owing to
political compulsions, the government had more or less frozen petrol and diesel prices. With
258
26
27
28
29
30
31
increase in the international price of crude oil, the losses incurred by the public sector oil
companies were mounting.
Richa Mishra, Oil Cos: Rupee Gain Softens Impact of Crude Prices,
www.thehindubusinessline.com, May 23, 2007.
Shubhra Tandon, Re Appreciation a Boon for Outbound Tourism,
www.thehindubusinessline.com, September 22, 2007.
Indian exports and imports in euros accounted for 8 percent and 7 percent respectively of all
exports and imports.
The term Dutch Disease was coined by The Economist in 1977 to describe the decline of the
manufacturing sector in the Netherlands after the discovery of natural gas in the 1960s. The
economic model describing Dutch disease was later developed by W. Max Corden and J.
Peter Neary in 1982. The model describes Dutch Disease as the adverse effect on any
sector(s) of an economy caused by large inflow of foreign currency in to the economy and
appreciation of the domestic currency.
The Associated Chambers of Commerce and Industry of India (ASSOCHAM) was
established in 1920 by promoter chambers representing all regions of India. It is Indias
premier apex chamber with membership of over 100,000 companies and professionals
across the country. (Source: www.assocham.org)
Rupee Appreciation to Result $15 bln Fall in Exports in 2007-08, www.indiantaxsolutions.com,
July 7, 2007.
259
International Business
As a high percentage of revenues in most IT and some pharmaceutical companies
were in dollar terms, any appreciation of the rupee affected their revenue realization
and consequently their profit margins. V Balakrishnan, Chief Financial Officer of
Infosys Technologies Ltd (Infosys),32 said, In spite of taking forward cover and
hedging $ 373 million during the quarter under review, the rupee appreciated to Rs
44.53 from Rs 46.29 and impacted our operating margins by 200 base points (two
percent) and led to a revenue loss of Rs 1.45 billion. 33
According to US Department of Commerce data, Indias textile and apparel exports to
the US declined by 0.21 percent in the first half of 2007, even when USs total textile
imports increased by 5.70 percent in the same period. China was able to increase its
textile exports to the US by 33.78 percent, Vietnam, by 21 percent, Cambodia, by 18.5
percent, Indonesia, by 16.5 percent, and Bangladesh, by 13.6 percent 34 (Refer Exhibit
IX for the exchange rate of dollar against currencies of some of Indias
competitors).
Exhibit IX
The Exchange Rate of Dollar against Currencies of some of Indias
Export Competitors: August 2006-August 2007
Country
Currency
August 2007
Appreciation in %
Pakistan
Pakistan Rupee
60.310
60.642
(-0.55)
Bangladesh
Taka
69.110
68.775
0.48
China
Renminbi Yuan
7.958
7.547
5.16
Sri Lanka
102.51
113.01
(-10.24)
Vietnam
Dong
16,010
16,236
(-1.41)
Indonesia
Rupiah
9101
9389.6
(-3.17)
Malaysia
Ringgit
3.680
3.501
4.86
34
35
36
260
38
39
40
41
42
43
India: Apparel Exporters Reel under Severe Order Crunch, CIAe, www.fibre2fashion.com,
October 11, 2007.
Coffee, Tea Exporters Feeling Rupee Rise Heat, www.livemint.com, September 27, 2007.
The Confederation of Indian Industry (CII) was founded in 1895. It is a non-government,
not-for-profit, industry led and industry managed organization. It has direct membership of
over 6,500 organizations from the private as well as public sectors, including SMEs and
MNCs, and an indirect membership of over 90,000 companies from around 350 national and
regional sectoral associations. (Source: www.ciionline.org)
India: Rupee Appreciation Unable to Stem MSME Export, www.fibre2fashion.com,
October 2, 2007.
Mahendra Kumar Singh, Strong Re May Shave off USD 13b Exports,
www.timesofindiaindiatimes. com, July 26, 2007.
SITA Inbound is one of the largest Indian companies in the tourism industry. It operates
inbound tours to India from all over the world, with tour operations and marketing activities
centralized at their head office in New Delhi. (Source: www.sitaindia.com)
Shobha Kannan, Strong Re, Overpricing Likely to Hurt Inbound Tourism,
www.thehindubusinessline. com, October 9, 2007.
261
International Business
Some Perspectives
The trilemma or the impossible trinity as economists sometimes called the
management of exchange rate, interest rate, and inflation rate, has always posed
problems for central banks the world over; and the RBI was not an exception. The
central bank of any country has to ensure that the interest rates keep inflation in check,
but at the same time do not stifle investment; the exchange rate promotes exports, not
stifle them; and lastly the exchange rate and the interest rate manage capital inflows
without restricting them. This was a challenge for the central banks of even the highly
developed economies of western countries. However, analysts were of the view that,
largely, the RBI had been managing the trinity quite well for the last few years, at
least until inflation levels started rising in early 2007.
Most analysts were of the view that the RBIs first priority should be to rein in
inflation and they supported RBIs policy of non-intervention in the foreign exchange
market. However, some were of the view that the RBI should have let the rupee
appreciate gradually rather than leave the rupee to the mercy of market forces. Citing
the example of China, analysts explained that though that country attracted far more in
foreign investment than India, its currency appreciated only by around 2% (between
March and July 2007).
Some analysts were of the view that the rupees appreciation was positive as it would
put pressure on exporters to improve, update, and modernize. They cited the example
of the Japanese export industry in the 1990s, when it faced an appreciating yen, from
nearly 230 yen to a dollar to around 130. The Japanese export industry responded by
improving its productivity and introducing product innovations. Indian exporters, they
said, too should view the rupees appreciation as a challenge. They however agreed
that the government had a significant part to play and should invest in infrastructure as
well as in education and training of human resources. Kamal Nath (Nath), Minister of
Commerce & Industry, while agreeing with exporters that the appreciation of the
rupee against the dollar was a major concern, asked them to make efforts to improve
efficiency. He said, Rupee rise is no doubt a problem, but it is also an opportunity for
all of you to move towards greater efficiency, reducing costs and enhancing
competitiveness.44 However, in July 2007, he announced some measures to offset the
negative impact of rupees appreciation on Indias exports (Refer Exhibit X for the
recommendations of the Ministry of Commerce).
Some analysts advised exporters to decrease their dependence on dollars, asking them
to shift their invoicing to more stable and balanced currencies like the British pound
(Refer Exhibit XI for the exchange rate of the rupee with some major currencies
between January 2007 and August 2007). Others felt that exporters should reduce
their dependence on the US market. Commenting on a possible way out for textile
exports, D K Nair, Secretary General of Confederation of Indian Textile Industry
(CITI)45, said, It is evident that the textile industry has to cope up with the rupee
appreciation and for that defocusing of the US market and currency is one strategy
that the industry will have to adopt. Few industry players are already looking for other
44
45
262
Exhibit X
The Recommendations of the Ministry of Commerce in July, 2007
1. Duty Entitlement Pass Book (DEPB) and Duty Drawback rates may be
enhanced by 5%.
2. Rate of interest on pre-shipment and post-shipment credit be reduced for
exporters to 6% (at present, the rate of interest charged is in the range of 9 to
11%).
3. Exchange Earners Foreign Currency (EEFC) Accounts may be made interest
bearing. (As on date, EEFC Account deposited is stated as current account and
interest on it discontinued since 2000).
4. Scheduled Commercial Banks may be mandated to meet 15% export credit
disbursement target.
5. Notify the Service Tax Exemption / Refunds for exports announced in the
Foreign Trade Policy 2007 without further delay.
6. All arrears of TED (Terminal Excise Duty) & CST (Central Sales Tax)
reimbursement would be cleared by 30th June, 2007 and the Ministry of
Finance will be requested to provide additional funds, if necessary.
7. Export Credit & Guarantee Corporation (ECGC) will reduce its premium rates
by upto 10% to make exports more competitive.
8. A Committee is also being set up to assess job losses due to rupee appreciation
and loss of export orders.
Source: Kamal Nath Announces Package To Counter Impact Of Rising Rupee On
Exports-Assures Exporters Of All To Reach Export Target Of US $ 160 Billion,
www.commerce.nic.in, June 13, 2007.
With the rupees appreciation, considering its overall trade deficit (imports of $ 190
billion against exports of $ 126 billion in 2007), Indian economy was a net gainer.
Analysts saw this as a benefit of currency appreciation. However, others were of the
view that this was a short term gain and continuous appreciation of the rupee was
detrimental for the economy as there would be considerable job losses.
Some analysts were in favor of the rupees appreciation. They were opposed to giving
too much importance to exports. They added that as India itself was a huge market,
with exporters of other countries looking at Indian markets with interest, Indian
exporters should make efforts to develop the domestic market. Domestic
consumption, according to them, would obviate the need to depend on exports for job
creation.
46
47
48
263
International Business
Exhibit XI
The Exchange Rate of Rupee against some Major Currencies
between January 2007 and August 2007
Currency
Exchange rate
Appreciation
January 2007
August 2007
Pound
86.594
82.005
5.29
Euro
57.450
55.419
3.53
Yen (100)
365.234
350.673
3.98
Australian Dollar
34.166
33.110
3.09
Canadian Dollar
37.473
38.432
(-2.55)
Outlook
In June, 2007, the Economist Intelligence Unit 49 estimated that for the year 2007, the
rupees average annual exchange rate against the dollar would be 41.3 (a 13.5 percent
real appreciation year on year), and for the year 2008, it would be 40 (6 percent). 50
In the third week of September, 2007, the US Federal Reserve cut interest rates. This
saw FIIs flock to emerging markets, including the Indian market. Between midSeptember and mid-October 2007, over $ 6.6 billion was injected into the Indian
market.51
In September, 2007, in an effort to placate exporters, the government reimbursed
service tax paid by exporters for port, road transport and rail services (Refer Exhibit
XII for the measures taken by the government). However, exporters were not
satisfied with the announcement, saying it was too little too late. Ganesh K. Gupta,
President of FIEO, said, The packages announced by the government [have] not been
able to offset our losses. The way the rupee is rising, it would be negating not only the
exports but wipe them out. I think now it is time the Prime Minister intervenes and
takes up the matter seriously.52
49
50
51
52
The Economist Intelligence Unit, founded in 1946, is a leading research and advisory firm,
with more than 40 offices worldwide.
India Finance: Rupee Dilemma, www.viewswire.com, June 26, 2007.
2007 FII Inflows Hit $16 Billion, www.indianexpress.com, October 12, 2007.
Steps Soon to Address Rupee Appreciation: Kamal Nath, www.andhracafe.com,
September 20, 2007.
264
Exhibit XII
The Measures taken by the Government
1.
The list was expanded to include three new services general insurance service,
technical testing and analysis service, technical inspection and certification service.
Exporting community was to be exempted from paying service tax for these
services.
2.
Rs 3 billion more for Vishesh Krishi and Gram Udyog Yojana (VKGUY).
265
International Business
address their problems, the government would think of coming up with a more
suitable package. However, he advised exporters to learn to hedge and reprice their
export contracts.
In August 2007, the RBI again began to intervene in the foreign exchange market by
purchasing dollars. The RBI also made it more difficult for Indian firms to borrow in
foreign currency. In an effort to check capital inflows, the RBI introduced new rules
concerning ECBs. Henceforth, companies wishing to go in for ECBs (to be used as
rupee expenditure) were required to take prior approval from the RBI. The RBI also
placed a limit of $ 20 million per company per financial year. While ECBs of up to $
20 million per company to be used as foreign currency expenditure for specified enduses was to come under the automatic route, ECBs of more than $ 20 million was to
require special RBI approval. In either case, the proceeds would have to be parked
abroad. The RBI also increased the annual limit on the amount of remittances from
India from $ 50,000 to $ 100,000.54 The RBI also increased the sterilization bond limit
by Rs 400 billion to Rs 1.5 trillion.55
In September 2007, the Finance Minister, while addressing a gathering in Washington
D.C. said that the rupee-dollar exchange rate was market-determined and that the RBI
would do the needful to control volatility. The rupees real and nominal effective
exchange levels are way beyond comfort levels at the moment, but that is something
we have to learn to live with. This is market-determined and it will be marketdetermined; but if there is volatility or any disorderly movement I suppose the central
bank will intervene using whatever instrument it has. The government does nothing on
that behalf, said Chidambaram. 56
In October, 2007, the RBI increased the limit for bond issuance under the market
stabilization scheme (MSS)57 from Rs 1.5 trillion to Rs 2 trillion for the fiscal year
2007-08.
In October 2007, the Directorate General of Foreign Trade (DGFT) carried out a
survey to study the actual impact of the rupee appreciation on industries. The
Directorate, which came under the Union Commerce Ministry, was to assess the
problems faced by the industries, including falling profitability, and job losses due to
the rupees appreciation and submit its report to the central government.
While Nath had said in September 2007 that there would be no change in the 2007-08
export target, in October 2007, Commerce Secretary Gopal K. Pillai said, It looks
unlikely that the $ 160 billion export target would be achieved for the current fiscal.
We would be quite pleased if it reached even $ 140 billion, estimating that the local
currency appreciates to 38 a dollar.58
Some international institutions estimated that the RBI would not allow the rupee to
appreciate further. Subir Gokarn, chief economist for Asia Pacific, Standard and
Poors59, said, We expect the Reserve Bank of India to resist appreciation beyond
current levels and the rupee will end the year at around 40.50 per dollar. 60
54
55
56
57
58
59
60
Ila Patnaik, Get Real about the Impossible Trinity, www.financialexpress.com, May 24,
2007.
Market Stabilisation Scheme: Revision of Ceiling, www.rbi.org.in, August 08, 2007.
Rapid Rupee Appreciation Is A Matter Of Serious Concern: FM, www.newindpress.com,
September 27, 2007.
The market stabilization scheme was introduced by the government and RBI in early 2004
to tackle strong capital inflows.
India Unlikely to Meet Export Target, www.tradeindia.com, October 10, 2007.
Standard and Poor is a leading credit ratings, investment research, risk evaluation, and
policy advisory company.
Rupee Hits 9-1/2 Yr High, Stocks Support, www.livemit.com, October 10, 2007.
266
India: Apparel Exporters Reel under Severe Order Crunch, CIAe, www.fibre2fashion.
com, October 11, 2007.
2.
3.
Anoop Agrawal, Indian Rupee Rises as Stocks at Record Lure More Global Funds,
www.bloomberg.com, October 10, 2007.
4.
Rupee Hits 9-1/2 Yr High, Stocks Support, www.livemit.com, October 10, 2007.
5.
6.
7.
8.
Deepak Bansal, Appreciating INR: Industry Should Charge the Consumer Less,
www.merinews.com, October 7, 2007.
9.
Hina Mahgul Rind, Rupee Stands Firm against Dollar, www.thenews.com, October 7, 2007.
10.
Gayatri
Nayak,
Dollar
Inflows
Put
www.economictimes.indiatimes.com, October 6, 2007.
11.
RBI
Intervention
Pulls
Re
Down
www.economictimes.indiatimes.com, October 6, 2007.
12.
India
Wont
Miss
$60-B
Software
www.economictimes.indiatimes.com, October 6, 2007.
13.
14.
15.
16.
TB
Kapali,
Rupee
Appreciation
Upsets
www.thehindubusinessline. com, October 4, 2007.
17.
18.
19.
20.
21.
22.
23.
24.
25.
26.
27.
Prabhakar Sinha, Stronger Rupee Saves You from Jitters of Global Gold Price Rise,
www.timesofindiaindiatimes.com, September 29, 2007.
with
Govt
Rupee
in
From
Bind,
9-Yr
High,
Export
Export
Appreciation
Target,
Arithmetic,
CITI,
267
International Business
28.
Anil Varma, Indias Rupee Heads for Biggest Monthly Advance Since April,
www.bloomberg.com, September 28, 2007.
29.
30.
31.
Indias External Debt as at the End of June 2007, http://rbidocs.rbi.org.in, September 28,
2007.
32.
of
Serious
Concern:
FM,
33.
Thats It, They Just Cant Agree! www.economictimes.indiatimes.com, September 27, 2007.
34.
Coffee, Tea Exporters Feeling Rupee Rise Heat, www.livemint.com, September 27,
2007.
35.
Deepshikha Monga & Gaurie Mishra, Rising Re Pulls Down Stocks of US-Listed
Indian IT, BPO Cos, www.economictimes.indiatimes.com, September 26, 2007.
36.
37.
38.
39.
40.
Gary Singh, RBI has been Struggling to Work out a Way, www.nriinternet.com,
September 3, 2007.
41.
42.
Rapid Rupee Appreciation a Challenge, Says Infosys CEO, www.hindu.com, August 30,
2007.
43.
Sanjeev Choudhary, Rise in Rupee, Sluggish Sales Take Toll on Apparel Exports to
US, www.economictimes.indiatimes.com, August 27, 2007.
44.
45.
Deepshikha Sikarwar, Ratna Bhushan & Ashish Agarwal, Industry Must Show Import
Gains on Rising Re, www.economictimes.indiatimes.com, August 3, 2007.
46.
Rupee
Appreciation
Dents
Export
Growth
www.thehindubusinessline.com, August 2, 2007.
47.
Mahendra Kumar Singh, Strong Re May Shave off USD 13b Exports,
www.timesofindiaindiatimes.com, July 26, 2007.
48.
49.
Mitu
Jayashankar,
No
Model
Can
Sustain
www.economictimes.indiatimes. com, July 20, 2007.
50.
Ratna
Ganguli,
Exports
Sops
Elude
www.economictimes.indiatimes.com, July 17, 2007.
51.
52.
Rajeev Malik, Indias Handling of Rupee Remains a Riddle, www.rediff.com, July 14, 2007.
53.
268
bn
Fall
for
in
Outbound
to
Tackle
Re
Sharply
9%
in
Re
Herbal
Exports
Tourism,
Rise,
June,
Rise,
Products,
in
2007-08,
55.
Alok
Ray,
Rising
Rupee:
The
www.thehindubusinessline.com, June 15, 2007.
56.
Kamal Nath Announces Package to Counter Impact of Rising Rupee on ExportsAssures Exporters of All to Reach Export Target of US$ 160 Billion,
www.commerce.nic.in,
June 13, 2007.
57.
John
Rebeiro,
Indian
Outsourcers
www.networkworld.com, June 7, 2007.
58.
59.
60.
Ila Patnaik, Get Real about the Impossible Trinity, www.financialexpress.com, May 24, 2007.
61.
62.
63.
64.
65.
Radhika Bhalla & Rajeev Jayaswal, Finmin Backs RBI in Rupee Tone-Up,
www.economictimes.indiatimes.com, April 24, 2007.
66.
67.
Gargi
Shah,
Rupees
Rise
against
www.thehindubusinessline.com, January 30, 2007.
68.
A Record Appreciation of the Indian Rupee in the Forex Market by 3.8 Percent
Dampening IT Outsourcing Margins, www.indiadaily.com, January 11, 2007.
69.
70.
71.
72.
Devika Johra and Mark Miller, Devaluation of the Rupee: Tale of Two Years, 1966
and 1991, www.ccsindia.org.
73.
www.fieo.org.
74.
www.ciionline.org.
75.
www.assocham.org.
76.
www.investopedia.com.
77.
http://en.wikipedia.org.
78.
www.rbi.org.n.
79.
www.economagic.com.
80.
www.banknetindia.com.
Causes
Hit
by
Dollar
and
Consequences,
Rupee
Appreciation,
Tempers
Gold,
269
Introduction
From January 1, 2006, the University of Michigan in the US put on hold the sale of
the products of The Coca-Cola Company (Coca-Cola) in all its campuses, thus
becoming the tenth US University to do so. The ban was the outcome of a relentless
campaign by student activists and trade union groups, who accused Coca-Cola of
violent labor practices in Colombia and of creating environmental problems in India.
The University of Michigan issued the orders for the ban based on the
recommendation of its University Dispute Board. This was following the inability of
Coca-Cola to meet the deadline of December 31, 2005 that required agreeing on a
protocol on the findings of the commission formed by a set of universities in the US.
The commission had offered to investigate the companys labor practices and that of
its bottlers in Colombia. Coca-Cola did not want the findings of the commission to
have any legal consequences but the attorneys in an earlier lawsuit against Coca-Cola
and its bottlers in Colombia insisted that the findings should be legally admissible in
court of law in the US.
Other prominent US universities that had banned Coca-Cola on similar grounds were
the New York University, the largest private university in the US, Rutgers University
in New Jersey, and the Santa Clara University in California. The University of
Michigan and The New York University were Coca-Colas largest campus markets in
the US. Coca-Colas annual contracts with the University of Michigan, which had
over 50,000 students, were worth around US$ 1.4 million in sales in 2005.
671
International Business
The campaign by student activists and trade union groups to ban Coca-Cola had been
going on for several years in different countries. Coca-Cola was accused, along with
its bottling partners, of hiring paramilitary death squads in Colombia to kidnap,
intimidate, or kill its union leaders and other workers at its bottling plants. Since 1989,
around eight union leaders of Coca-Colas plants in Colombia had been murdered and
many others abducted and tortured.
In India, Coca-Cola had to face opposition from the local people around its
factory in Plachimada, Kerala 2, who charged that the company was responsible for
the draining of the underground water table. In 2003, a BBC 3 report revealed that
Coca-Cola was distributing improperly treated sludge containing toxic
carcinogens and heavy metals like cadmium and lead, as fertilizer to farmers in
the region. Coca-Cola shut down this plant in March 2004 owing to mounting
pressure. The company then decided to shift its operations to a nearby industrial
zone, the Kanjikode Industrial Area.
There were also protests at Coca-Colas Mehdiganj plant in North India over similar
issues. In addition to these accusations, in 2003, the Center for Science and
Environment (CSE)4, made public the findings of its study wherein it reported that the
products of both Coca-Cola and PepsiCo Inc. (Pepsi) that were sold in India, had a
cocktail of harmful pesticide residues in them.
In an official statement, Coca-Cola denied that it had used death squads in Colombia.
The company said that two judicial investigations in the country had not found any
evidence in support of such allegations. Coca-Cola also claimed that there was no
evidence linking it or its bottlers with the groundwater problems at its factory
locations in India. Responding to the allegation that its products contained pesticide
residues, it said that the products that it sold in India were perfectly safe and were in
accordance with global quality standards.
Over the years, Coca-Cola, one of the largest non-alcoholic beverage companies, with
the worlds most widely recognized brand, had been facing a string of problems that
could seriously damage its brand image. The company had also faced allegations
related to anti-competitive business practices in Mexico and had to pay heavy fines
and penalties.
Background Note
The Coca-Cola drink, popularly referred to as Coke, is a kind of cola, a sweet
carbonated 5 drink containing caramel 6 and other flavoring agents. It was invented
by Dr. John Smith Pemberton (Pemberton) on May 8, 1886, at Atlanta, Georgia in
USA. The beverage was named Coca-Cola because at that time it contained
2
3
672
The kola nut is a kind of a nut with a bitter flavor and high caffeine content, and is primarily
obtained from some West African or Indonesian trees.
Historically, a soda fountain referred to soda shops and the part of a drugstore (pharmacy)
where sodas, ice cream, sundaes, hot beverages, iced beverages, baked goods and light meals
were prepared and served. Now the term refers to the carbonated drink dispensers found in
fast food restaurants and convenience stores in the US and Canada.
Indiana, is a state in the US with Indianapolis as the capital.
673
International Business
Exhibit I
Hobble-Skirt Design Bottle
Source: www.brandine.com/images.
Exhibit II
Bell Shaped Fountain Glass
Source: http://wingers.info/menu/Coke.
674
10
11
PET (Polyethylene terephthalate) is a thermoplastic resin of the polyester family that is used
to make beverage, food, and other liquid containers, synthetic fibers, as well as for some
other thermoforming applications.
Roberto C. Goizueta, a Cuban immigrant, had worked up the ranks at Coca-Cola and was its
Chairman and CEO from 1980 to 1997. Under his leadership, Coca-Colas stock value
increased by more than 7200 percent.
675
International Business
In 1986, Coca-Cola merged the company owned distribution network with two large
ownership groups that were for sale -- the John T. Lupton franchises and BCI Holding
Corporations bottling holdings -- to form an independent entity, Coca-Cola
Enterprises Inc. (CCE). CCE, which mainly operated in America and Europe,
distributed 2 billion physical cases of products, representing 21 percent of CocaColas volume worldwide, in 2004. The total revenues of CCE for the same year were
US$ 18 billion.
In 2005, Coca-Cola had operations in over 200 countries selling more than 400 brands
in categories like packaged drinking water, coffees, juices, sports drinks, and teas,
apart from its main soft drink products. The company owned four of the top five soft
drink brands in the world, Coca-Cola, Diet Coke, Fanta, and Sprite. It also had other
popular brands like Barqs, Fruitopia, Minute Maid, POWERade, and Dasani water.
Coca-Cola had became one of the biggest beverage companies in the world by 2005,
selling around 1.3 billion beverage servings per day. The main reasons for CocaColas enormous success were its advertising campaigns (Refer to Exhibit III for a list
of popular advertising slogans of Coca-Cola) and its massive production and
distribution operations spread across the world (Refer to Exhibit IV for brief financial
information).
Exhibit III
Popular Advertising Slogans of Coca-Cola
Year
Slogan
1886
Drink Coca-Cola
1929
1936
1942
1944
1950s
1950s
Be Really Refreshed
1950s
Go Better Refreshed
1963
1969
1971
1979
1985
1985
1993
Always Coca-Cola
1999
Enjoy Coca-Cola
2001
2005
Make it real
676
Exhibit IV
Comparison of Key Financials for the Years 2003, 2004, & 2005
(In US$ million)
December 31, 2005
December 31,
2004
December 31,
2003
Total Revenues
23,104
21,962
21,044
Gross Profit
14,909
14,324
13,282
Operating Profit
6,085
5,698
5,221
Net Profit
4,972
4,847
4,347
Year
Exhibit V
677
International Business
The quality system was constantly revised to meet the latest and most stringent
food and safety regulations including Global Food Safety Initiative 12 (GFSI)
Guidance Document. Coca-Cola believed in the promise of refreshing and
benefiting the customers and strove to keep up this promise through the Quality
System.
Adapted from www2.coca-cola.com.
Coca-Cola prepared a code of business conduct for all its employees that incorporated
the companys core values such as honesty, integrity, diversity, quality, respect,
responsibility, and accountability. The code of business conduct was uniform for all
the companys operations across the world and it clearly defined policies and
procedures to help employees handle various contingencies. Coca-Cola believed that
the companys most valuable asset was its trademark brand and that the value of this
brand had been built over a century by the commitment and integrity of its employees
(Refer to Exhibit VI for Coca-Colas code of business conduct).
Exhibit VI
Coca-Colas Code of Business Conduct
Coca-Cola considered its employees to be the representatives of the company and
expected them to act with honesty and integrity in all the matters pertaining to the
company. The code of conduct covered various aspects such as:
Employee responsibilities
Conflicts of interest
Financial records
Use of company assets
Working with customers and suppliers
Working with governments
Protecting information
Administration of code
Employees were encouraged to ask for guidance when in doubt on issues relating
to the code of business conduct, ethics, and compliance matters and to report
possible violations. The company created an exclusive Internet website,
www.KOethics.com and had an international toll-free telephone number, for
guidance and reporting of such issues. The company arranged for translators for
employees who could not speak English over the provided telephone line. The
employees also had the choice of remaining anonymous and were required to
cooperate with any investigations of code of business conduct.
Managers had the primary responsibility to maintain the code of conduct in the
company. Managers had to understand the code of conduct and report suspected
violations. If any employee violated the code of conduct with the knowledge of the
manager, then both would be held equally responsible for the offence.
Adapted from www2.coca-cola.com.
12
In April 2000, a group of international retailer CEOs identified the need to enhance food
safety, ensure consumer protection, and strengthen consumer confidence, to set requirements
for food safety schemes and to improve cost efficiency throughout the food supply chain.
Following their lead, the Global Food Safety Initiative (GFSI) was launched in May 2000.
678
14
15
Leftist guerrillas were armed groups with socialistic ideologies waging a war against the
Colombian government.
Right-wing paramilitary groups were armed groups supporting capitalistic ideologies
opposing leftist guerillas.
Sindicato Nacional de Trabajadores de Industrias Alimenticias (SINALTRAINAL) is the
National Food Workers Union, which represents Coca-Cola employees in Columbia.
679
International Business
It was further alleged that the following day the paramilitary squads returned to the
plant and made the workers sign a statement on the Coca-Cola letterhead that they
were resigning from their membership of the union. The workers were given a
deadline and threatened with dire consequences, if they refused to sign. The union
members alleged that since they had no choice, most of them resigned on the spot. It
was further said that some members quit their jobs and fled to other cities fearing for
their lives. Another allegation was that the then president of the union had been
summoned by the plant manager and, in the presence of paramilitary men, asked to
leave the city along with other union leaders.
SINALTRAINAL charged that apart from these eight killings, 48 members had been
forced into hiding and 65 members had received death threats. In 1995, five union
members working in a Coca-Cola plant at the city of Bucaramanga were jailed for six
months on charges of terrorism. They were accused of planting an explosive device in
the factory. However, these charges could not be proved and were later dropped for
lack of evidence. The trade union also alleged that the bottlers were systematically
targeting permanent workers so that they could be replaced by contract workers, who
would do more work for lower wages.
In January 2004, a New York City Fact-Finding Delegation16 went to Colombia to
verify these allegations. The delegation concluded that Coca-Colas involvement in
the violation of human rights and labor rights could not be excluded. The report
estimated that there had been 179 major human rights violations of Coca-Colas
workers including the murders. Union members and their family members had been
kidnapped and tortured; workers had been fired for attending union meetings; many
had been asked to denounce their legal rights.
According to the report, the violence and intimidation had occurred with the
knowledge or under the directions of the companys managers at the bottling plants.
The paramilitary groups had had free access to the plants and had cordial relations
with the plant managers. The report said that Coca-Colas Colombian managers had
admitted that they had never investigated the relationship between the plant managers
of their local bottlers and paramilitary groups in spite of so many complaints and
allegations. The report concluded that this lack of action on Coca-Colas part clearly
showed the companys utter disregard for human rights and the well-being of its labor
personnel in Colombia.
17
In January 2004, New York City Council Member Hiram Monserrate and a delegation of
union workers, student and community activists traveled to Colombia to investigate
allegations against Coca-Cola.
Ajegroup, a privately held company based in Peru, is involved in the beverage business.
680
18
19
20
681
International Business
Many local residents in the villages surrounding the factory site alleged that over the
years, they had been faced with depleted underground water levels, leading to water
scarcity. In addition, the bottle washing operation involved the use of chemicals and
generation of effluents. These effluents were allegedly released without adequate
treatment, leading to the contamination of groundwater. As a result, it was reported
that the groundwater turned turbid or milky on boiling and was unfit for consumption.
Another by-product of bottle washing was a foul smelling dry sediment sludge waste.
It was said that the waste was initially sold to unsuspecting farmers as a fertilizer.
When there were no takers, Coca-Cola allegedly offered it free of charge.
In 2003, BBC Radio 4s Face the Facts program revealed that a separate study
conducted by it has shown that the sludge contained high levels of carcinogenic heavy
metals like cadmium and lead. It was alleged that when the farmers came to know that
it was toxic and raised protests, the waste was dumped on the wayside and on the
lands at night. In the same year, the Center for Science and Environment (CSE)
published a report which revealed that 12 soft drink brands sold by Coca-Cola and
Pepsi in India had pesticide levels far higher (almost 36 times more) than what was
permitted by the European Economic Commission (EEC) 21.
Some of the main pesticides found were Lindane, 22 DDT,23 Malathion,24 and
Chlorpyriphos25. It was believed that the use of groundwater which had high pesticide
residues and which had not been properly treated by the companies was the main
reason for such high pesticide levels. These residues could cause cancer, damage to
the nervous and reproductive systems, birth defects, and severe disruption of the
immune system in the long run. The same study concluded that no such residues were
found in the same brands that were sold in the US (Refer to Exhibit VII for other
allegations against Coca-Cola).
22
23
24
25
26
27
28
The European Economic Commission is a branch of the governing body of the European
Union (EU) possessing executive and some legislative powers. It is located in Brussels,
Belgium.
Lindane is an insecticide, which has been banned in 52 countries across the world as it is
believed to cause cancer.
DDT (Dichloro-Diphenyl-Trichloroethane) was the first modern pesticide and is the most
well known. It is also believed to cause cancer.
Malathion is an insecticide with relatively low human toxicity. However, malathion breaks
down, especially in indoor environments, into malaoxon, which is 60 times more toxic than
malathion.
Chlorpyriphos is a toxic insecticide that is widely used in pest control.
The United Steel Workers of America (USWA), established in May 22, 1942, has over 1.2
million active and retired workers as members. The union is headquartered at Pittsburgh,
Pennsylvania.
International Labor Rights Fund (ILRF), established in 1986, is an advocacy organization
dedicated to achieving just and humane treatment for workers worldwide.
The Alien Tort Claims Act (ATCA) of 1789 grants jurisdiction to US Federal Courts over
any civil action by an alien for a tort (breach of civil contract) only, committed in violation
of the law of nations or a treaty of the United States.
682
Exhibit VII
Other Allegations against Coca-Cola
In 1998, Coca-Cola was accused of discriminating against its African-American
employees in pay and promotions and a class action race discrimination lawsuit
was filed against it by its African-American employees. In 2000, after an 18month-long litigation, Coca-Cola was ordered by the court to settle the lawsuit for
US$ 192.5 million. Of the total amount, US$ 36 million was allocated to
monitoring the companys employment practices and stopping discrimination. Of
the remaining amount, US$ 113 million would be paid as cash payment and US$
43.5 million would be adjusted in salaries. Also, Coca-Cola had to agree to form an
outside task force that would ensure that the company maintained fair practices in
pay, promotions, and performance evaluation.
In 2002, there were fresh allegations that the companys African-American
employees continued to remain under-represented in top management of the
company. They were also paid less and dismissed more often than white
employees. In its operations in African countries, Coca-Cola was accused of
having only white employees at the managerial levels while Africans were
employed at lower levels as factory workers and in distribution operations. White
employees were predominantly granted medical coverage for HIV/AIDS while the
local workers were ignored. Coca-Cola workers in the Cincinnati plant in the US
also accused the company of creating a hostile, intimidating, offensive, and abusive
workplace environment and they filed a lawsuit against the company.
In June 1999, Coca-Cola products were banned for a brief period in Belgium after
about 100 students in Belgium fell ill after drinking its products. The illness was
attributed to the use of wrong carbon dioxide gas in the products manufactured in
a plant at Antwerp, Belgium. The ban was lifted after Coca-Cola withdrew all its
products from Belgium, Luxembourg, The Netherlands, and other countries where
the products manufactured in Belgium were being sold. During the same period, in
France, the sale of canned Coca-Cola drinks was suspended briefly following fears
that they had been contaminated with a fungicide used to treat a small number of
transportation pallets.
In June 2005, an investigation authorized by the European Union found that CocaCola had entered into deals with shops and bars to exclusively stock Coca-Cola
products and it concluded that these agreements were anti-competitive in nature.
Coca-Cola in Europe had to agree to end the deals. In 1998, Pepsi made a similar
complaint in the US that Coca-Cola was illegally entering into agreements under
which only Coca-Cola brands would be sold at the fountain sales in restaurants and
other businesses. However the complaint was dismissed in US
Matthew Whitley (Whitley), a former employee of Coca-Cola filed lawsuits against
Coca-Cola for improper dismissal from the service. He claimed that he had been
dismissed after he had brought to the notice of Coca-Colas top management certain
improper accounting practices. During the course of the lawsuit, it was revealed that
Tom Moore (Moore), a former head of Coca-Colas Burger King29 account, had been
aware of a fraudulent test used by one of his direct subordinates, John Fisher, to
boost sales of Frozen Coke at Burger Kings outlets. Coca-Cola later apologized to
Burger King and Moore was forced to resign. Among the other allegations in the
29
The Burger King Corporation, a large international chain of fast food restaurants,
predominantly sells hamburgers, french fries, and soft drinks.
683
International Business
lawsuit was one which said that Coca-Cola had conspired with its suppliers and
artificially boosted sales. Whitley demanded US$ 44 million to drop the lawsuits
against the company. Finally, Coca-Cola settled these lawsuits by agreeing to pay
US$ 540,000 to Whitley.
Compiled from various sources.
This prompted SINALTRAINAL to issue an international appeal for the boycott of
Coca-Colas products until it got justice in Colombia. On July 22, 2003, a boycott
campaign was started by major trade unions in Colombia and it was supported by the
World Social Forum30, student activists, and other various social activist organizations
around the world. The call for the boycott attracted instant attention from student
groups, trade unions, and other organizations all over the world.
In October 2003, in response to the boycott, the student union of the University of
Dublin, the largest university in Ireland, decided to ban Coca-Colas products from
outlets that were controlled by it. An attempt by Coca-Cola to reverse the ban failed
and the boycott spread to other colleges like Trinity College and the National College
of Art and Design. The Union of Students in Ireland, which represented 250,000
students, passed a resolution to support the ban on Coca-Cola. After this, the
Teachers Union of Ireland, the Irish National Teachers Organization, and a number
of other trade unions and political organizations supported the boycott of Coca-Cola.
The call for the boycott of Coca-Colas products also had a significant impact in
England. In 2004, UNISON,31 the largest trade union in UK, passed a resolution
during its National Delegate Conference to support the boycott. In March 2005,
ECOSY,32 an organization for young European socialists and a member of the
federation of youth wings of all mainstream socialist and social democratic parties in
the European Union, voted to support the boycott following a motion tabled by the
Irish Labor Youth delegation. In addition, a number of other trade unions and
organizations joined the Coca-Cola boycott campaign (Refer to Exhibit VIII for a list
of organizations that boycotted Coca-Cola).
England also witnessed an active student campaign to boycott Coca-Cola. The
National Union of Students which represented 750 unions passed a resolution to
verify the allegations against Coca-Cola in Colombia and India. The National Union
of Students held a 25% stake in the procurement agency that had contracts with CocaCola; therefore the decision was significant in monetary terms for the company. If
these allegations were proved to be true, then Coca-Cola could be possibly banned
from almost every college and university in England.
In May 2005, following agitations from student unions and other organizations, 12
universities in America, including large universities such as the University of
Michigan, New York State University, Rutgers University, and Santa Carla
University, formed a Commission and discussed the issue with Coca-Cola. The
Commission offered to investigate the allegations against Coca-Cola in Colombia.
However, Coca-Cola and the Commission failed to reach an agreement on whether the
30
31
32
684
Exhibit VIII
List of Organizations that Boycotted Coca-Cola
Name of the Organization
Membership
1.3 million
1.7 million
0.7 million
0.27 million
1.7 million
1.3 million
0.06 million
Not Available
34
685
International Business
US$ 10 million to the Torino (Turin) Olympic Committee and was the sponsor of
these Games. In another setback to Coca-Cola, the organizers of the Live 8 concerts 35
pulled out of negotiations with the company over sponsorship deals because of public
opposition. Coca-Cola was also banned from the Make Poverty History March 36 held
at Edinburgh, Scotland, on July 2, 2005, attended approximately by 300,000 people.
The impact of these bans and boycotts on Coca-Cola in terms of sales and profits was
very little when compared to its overall business revenues and profits. However the
impact was far greater in terms of the companys brand image and public relations.
Coca-Cola was one of the most widely recognized brands in the world and had been
consistently ranked by Interbrand37 as the number one brand in the world from 2001 to
2005 (Refer to Exhibit IX for the Interbrand top ten brand rankings from 2001 to
2005).
Exhibit IX
Interbrand Top Ten Brand Rankings from 2001 to 2005
Brand Name
2005
2004
2003
2002
2001
Coca-Cola
Microsoft
IBM
GE
Intel
Nokia
Disney
McDonalds
Toyota
11
12
14
Marlboro
10
10
11
Source: http://bwnt.businessweek.com/brand/2005.
35
36
37
Live 8 was a series of concerts that took place in July 2005, in the G8 nations and South
Africa. They were timed to precede the G8 Conference and Summit that was held in
Perthshire, Scotland from July 6-8, 2005. The objective of these concerts was to pressure
world leaders to write off the debt of the worlds poorest nations, increase and improve aid,
and negotiate for fairer trade rules in the interest of poorer countries.
Make Poverty History March was a program organized by The Make Poverty History
campaign. The campaign is a British and Irish coalition of charities, religious groups, trade
unions, campaigning groups and celebrities committed to increasing awareness and
pressuring governments into taking action to alleviate poverty.
Interbrand is company dedicated to identifying, building, and expressing the right idea for a
brand. The company was established in 1974 at London and is now headquartered in New
York.
686
Coca-Colas Response
Coca-Cola opened an exclusive website, www.cokefacts.org, to address these
allegations, especially those related to Colombia and India. In an official statement
featured on the website, Coca-Cola claimed that the allegations against the business
practices in Colombia were false. Two different judicial enquiries in Colombia, one
by a Colombian court and the other by the Colombia Attorney General, had found no
evidence against Coca-Cola or its bottlers linking them to the murders of the union
members. Coca-Cola also quoted a judgment in the lawsuit at Miami, Florida 38,
wherein the judge had dismissed the charges against Coca-Cola, Columbia. A
workplace assessment conducted in Colombia by Cal Safety Compliance
Corporation,39 a respected, independent third party assessor too had found no
instances of anti-union violence or intimidation at the bottling plants.
Coca-Cola and its bottlers conducted an internal investigation and said that they found
no evidence regarding the allegations. The company claimed that on the contrary, the
bottlers enjoyed normal relations with 12 separate unions in Colombia and had
collective bargaining agreements in place with all the unions which covered wages,
benefits, and working conditions. The local bottlers were working along with local
unions and the Colombian government for the workers safety and uplift. They
provided transportation to and from work to any worker who felt unsafe. The bottlers
were providing loans for secure housing of the workers and increasing the security of
union offices. Employees were also given paid cellular phones for emergency use and
were protected from shift and job changes with legal aid.
The Colombian Vice-President, Francisco Santos, who was in charge of improving the
governments human rights record, including investigating cases of violence against
trade union activists, said, This (SINALTRAINAL vs. Coca-Cola) is not a labor
union fight, its a political fight. You cant justify the death of a union leader. (But)
they took a myth and built a campaign out of it. They found a model that works, and
theyve been very successful at (promoting) it. Theyve been able to build this
(martyrdom) image.40 He declared that the government was committed to
investigating and stopping the killings of the labor union leaders. We know there are
problems, were trying to solve them. Its not as easy to get away with killing a labor
leader as it was five years ago. But were (still) not satisfied at all with the results.41
Coca-Cola also rejected the allegations made against it of monopolistic business
practices and anti-competitive trade practices in Mexico. The company said that it
would appeal to a higher authority against the fines imposed by the FCC. Company
spokesman Charlie Sutlive said, As we stated before, we respect the decisions.
However, we have used the appeal processes open to us to present arguments that our
business practices comply with Mexican competition laws, and to demonstrate that
our commercial practices are fair.42
In another official statement, Coca-Cola rebutted the charges against its bottling plant
at Plachimada, Kerala. The company said the plant was not responsible for the
depletion of the underground water table. The company quoted a study conducted in
38
39
40
41
42
687
International Business
October 2002 by Dr. R.N. Athvale, emeritus scientist at the National Geophysical
Research Institute (NGRI),43 which concluded that there was no field evidence of
overexploitation of the groundwater reserves in the area surrounding the plant. The
report added that any underground depletion could not be attributed to the water
extraction in the plant area.
Coca-Cola also quoted another report prepared by the Palakkad District
Environmental Protection Council and Guidance Society in June 2002. The report had
concluded that the factory did not cause any environmental damage at any level. A
report prepared by the Kerala State Groundwater Department too had rejected these
allegations and attributed the depletion to a decrease in rainfall over the years. CocaCola claimed that the plant had established an advanced system for rain water
harvesting to replenish the under groundwater table at the plant.
The company also rejected the allegation that its factory had released un-treated
industrial effluents. Coca-Cola stated that the technology used for waste water
treatment at the plant was among the most advanced in the world, equivalent to the
technology used at its bottling plants in America and Europe. Moreover, the
procedures for treatment and discharge of effluents complied with the standards and
norms set by the Kerala State Pollution Control Board (KSPCB).
In response to the allegations that it supplied toxic sludge to farmers as fertilizer,
Coca-Cola said that the dry sediment slurry waste or sludge, a by-product of its
operations, was not harmful. The sludge was made up of organic and inorganic
material that would not contaminate the land. The sludge was used around the world,
including by Coca-Cola, as a soil enhancer. The generation of sludge in all the
companys plants was monitored for composition and was disposed of properly.
Further, the KSPCB had concluded in a detailed study that the concentration of
cadmium and other heavy metals in the sludge were below prescribed limits and
therefore could not be considered hazardous.
Coca-Cola also rejected the charge that its products in India contained high level of
pesticides and insecticides. The company said that testing for pesticides in finished
soft drinks was a complex process and often produced unreliable and unrepeatable
results. The accurate way of carrying out the test was to test each of the separate
ingredients for its soft drinks before they were combined to make a finished soft drink.
Coca-Cola routinely tested its ingredients in this way to ensure that the final soft drink
product remained safe.
Furthermore, the company quoted a study conducted by the Department of Family and
Child Welfare, Central Government of India, after the allegations were made in
August 2003, which had found that the products sold by the company were perfectly
safe. Coca-Cola said that it was a responsible corporate citizen in India and mentioned
that it had won many awards with regard to environment management and community
development in India (Refer to Exhibit X for awards won by Coca-Cola in India).
Atul Singh, Coca-Cola India President and CEO, felt that the environmental and
pesticide allegations against the company in India were still being debated upon
because of Coca-Cola Indias failure to communicate with its consumers, nongovernment organizations (NGOs), and even its own local employees. He said, Its
(communication failure) not just with consumers and NGOs on the pesticide
controversy, even staffers were not getting the message. 44
43
44
NGRI, based in Hyderabad, India, is an institute dedicated to basic and applied research in
the field of geophysics, groundwater exploration, environmental information, etc.
Interview with Atul Singh, We just failed to communicate, Business Standard, February 7,
2006.
688
Exhibit X
Awards Won by Coca-Cola in India
Category
Award
Community
Development
Environment
Health
45
46
689
International Business
World: Europe Belgium considers lifting Coke ban, http://news.bbc.co.uk, January 16, 1999.
2.
3.
4.
5.
6.
7.
John F. Borowski, For Christmas, will Coca-Cola stop acting like Big Tobacco?
www.educationnews.org, December 22, 2004.
8.
9.
10.
US: Coke to examine overseas labor practices, www.corpwatch.org, June 20, 2005.
11.
12.
13.
Chad Terhune, Isdell could lose Cokes cola crown, www.laborrights.org, December 7, 2005.
14.
Thomas Gary, Coke ban heats up across country, www.nyunews.com, December 08, 2005.
15.
Colin Perkel, Coca Cola hits back as boycott over alleged human-rights abuses gathers
steam, www.cbc.ca, December 27, 2005.
16.
Marla Dickerson, Upstart firm in Peru taking fizz out of cola giants
Coke, Pepsi face unlikely challenger, www.sfgate.com, December 30, 2005.
17.
18.
19.
20.
21.
Colleges boycott Coke over labor concerns, www.taipeitimes.com, January 01, 2006.
22.
23.
24.
Coke should make U-M pay for cola ban, www.detnews.com, January 11, 2006.
25.
Geri Smith, Inside Coca-Colas labor struggles, www.businessweek.com, January 23, 2006.
26.
27.
We just failed to communicate- Interview with Atul Singh, Business Standard, February 7,
2006.
28.
www.brandine.com/images/
690
universities
ban
on
Coca-Cola,
http://bwnt.businessweek.com/brand/2005/
30.
www2.coca-cola.com/heritage/chronicle_birth_refreshing_idea.html
31.
www2.coca-cola.com/ourcompany/pdf/business_conduct_guidelines.pdf
32.
www2.coca-cola.com/ourcompany/commitment_quality.html
33.
www2.coca-cola.com/presscenter/viewpointsmichigan_bor.html
34.
www.cokefacts.org
35.
www.educationnews.org
36.
www.killercoke.org
691
Introduction
In February 2007, Statistics South Africa 3 announced that the real GDP of South
Africa had increased by 5.6% (annualized) in the fourth quarter of 2006, which was
well above market expectations. The South African economy had been growing
continuously since 1998, making it the longest economic upswing in the countrys
history. Business too was booming, with consumer demand growing at a fast pace.
The country was seeing a rapid increase in the number of inbound tourists as well.
Having tripled the number of overseas visitors since 1994, it (the tourism industry) is
regarded as being ready for a second phase of growth, 4 said a report in the Financial
Times (Refer Exhibit I for more information on South Africa).
However, the impressive numbers hid some harsh realities. Around 50% of South
Africas population continued to live below the poverty line and the country had an
unemployment rate of more than 25%. The economic disparity between population
groups in South Africa was wide and usually manifested itself along racial lines.
Analysts attributed this disparity to the apartheid system, a race-based discrimination
policy practiced by the government between 1948 and 1994.
South Africa held its first multi-racial election only in 1994. The elections brought the
African National Congress (ANC) to power. The ANC government took several
policy initiatives to achieve its goal of bridging the economic gap between the white
and non-white sections of the population. It initially focused on social issues, with the
launch of the Reconstruction and Development Programme (RDP). However, in 1996,
with the Growth, Employment, And Redistribution (GEAR) policy, the government
decided to concentrate more on wooing foreign investment and on encouraging trade
and industry.
Despite some success in poverty alleviation, the economic disparity between the
population groups was expected to persist for many years to come and many analysts
blamed the governments shift in policy for the slow change. Meanwhile, the
government had been unable to contend with the growing menace of HIV/AIDS, with
an estimated 5.5 million5 South Africans infected with the deadly virus. The high
crime rate was another issue that required immediate attention.
2
3
4
5
Ernest Harsch, South Africa Tackles Social Inequities, Africa Recovery, www.un.org,
January 2001.
Lucky Jones, Risks Remain for South Africas Economy, www.bbc.co.uk, April 14, 2004.
Statistics South Africa is a government body responsible for collecting, producing, and
disseminating official statistics as well as for conducting of a census of the population.
Good Times in SA: Financial Times, www.southafrica.info, June 12, 2006.
According to UNAIDS estimates (2005).
544
Exhibit I
Indian
3%
9%
Black
79%
With deaths caused by HIV/AIDS increasing, the net growth rate of the population
has fallen into negative territory (-0.4%). The infant mortality rate is high at 60.6.
The life expectancy too is low at 42.7 years. Literacy, however, is high at around
86%.
Compiled from various sources.
Background Note
According to archeologists, South Africa had been inhabited by humans for thousands
of years. Farming communities began settling along what later came to be called the
Limpopo river as early as in the 2 nd Century. The first records of Europeans reaching
the shores of present day South Africa date back to the 15 th Century. In 1485,
545
International Business
Bartholemeu Dias, a Portuguese explorer who was trying to find a sea route to India,
circumnavigated the South African cape. He named it Cabo do Boa Esperanca or
Cape of Good Hope.
The Dutch East India Company6 set up a provision station in Table Bay (Cape Town)
for passing ships in 1652. Beginning in 1657, the company authorities alloted arable
lands in the region around Cape Town (also referred to as Cape Colony) to some of its
employees who were freed from service to pursue farming. In this period, slaves were
brought from Benin and Sulaweisi (Indonesia) to work on the farms. By the 1700s, the
Dutch farmers (referred to as trekboers) began spreading to the interior regions of
South Africa. As a result, the natives were ousted from their lands. The African
natives, especially the Khoisan (the original inhabitants of South Africa), and the
Xhosa people (immigrants from East Africa), resisted the settlers, which resulted in
bloody conflicts that sometimes lasted for several months. However, the Dutch settlers
were able to eventually overpower the African natives, some of whom fled while
others ended up working for the Dutch settlers as servants. By the mid-1700s, the
Dutch government began encouraging orphans and menial workers from Holland to
migrate to the Cape.
In 1795, the British gained control of the Cape from the Dutch. In 1820, the British
government sent unemployed people from Britain to South Africa, to settle down in
the regions between the Cape and Xhosa-dominated territories.
In 1828, following a wave of anti-slavery sentiment in Britain, the British authorities
in South Africa passed an ordinance guaranteeing equal civil rights to all residents of
the Cape Colony, irrespective of their race. In 1834, Britain proclaimed emancipation
for the slaves in all its colonies. However, the slave-owners in the Cape Colony
opposed the decision. So, the British government provided compensation money to
them. The compensation money had a positive impact on the local economy, with
several new business establishments being created with this money in this period.
However, despite their freedom, the ex-slaves had no choice but to become wage
laborers in the newly industrializing economy, where they were, more often than not,
exploited.
Some trekboers, however, refused to obey the British ordinance and decided to move
east and live independently, away from British-governed areas. They moved, along
with their slaves, to a region called Natal (now KwaZulu-Natal), which brought them
in confrontation with the Zulu tribes. The trekboers managed to defeat the Zulus,
though skirmishes continued for several months. Meanwhile, the British authorities,
fearing repercussions in the Cape, annexed Natal, which already had a small British
settlement in Durban. The trekboers, however, established two independent republics
Orange Free State and Transvaal in the region. By the mid-1850s, almost all of
South Africa was under white domination. In 1853, the Cape Colony was granted a
representative legislature by Britain.
In the late 1860s, deposits of alluvial diamonds were discovered along the Vaal River.
The discovery had a major impact on the South African economy. Port facilities were
upgraded to facilitate diamond mining and consequently, coastal cities such as Cape
Town, Port Elizabeth, East London, and Durban experienced an economic boom. In
1872, the Cape Colony was granted self-governance. Orange Free State, Transvaal,
6
The Dutch East India Company (or Vereenigde Oostindische Compagnie) was established
in 1602 as a trading concern. It is considered one of the first multinational corporations. It
had trading outposts in Persia (now Iran), Siam (now Thailand), Canton (now in China),
Formosa (now Taiwan), Malacca (now in Malaysia), Chinsura, Bengal (in India), and
Southern India. It was formally dissolved in 1800.
546
International Business
Exhibit II
The Aims and Objectives of the ANC
To unite all the people of South Africa, for the complete liberation of the
country from all forms of discrimination and national oppression
To end apartheid in all its forms and transform South Africa as rapidly as
possible into a united, non-racial, non-sexist, and democratic country based on
the principles of the Freedom Charter
To defend the democratic gains of the people and to advance toward a society
in which the government is freely chosen by the people according to the
principles of universal suffrage on a common voters role
To fight for social justice and to eliminate the vast inequalities created by
apartheid and the system of national oppression
To build a South African nation with a common patriotism and loyalty in
which the cultural, linguistic, and religious diversity of the people is
recognized
To promote economic development for the benefit of all
To support and advance the cause of national liberation, womens
emancipation, development, world peace, disarmament, and respect of the
environment
To support and promote the struggle for the rights of children
Source: African National Congress Constitution, www.anc.org.za.
548
549
International Business
The late 1970s and 1980s saw many world powers, especially the US and the UK,
starting to put economic pressure on the South African government over its apartheid
policies, which seemed to have become even more repressive over time (Refer
Exhibit III for a comparison of the status of blacks and whites on some
parameters in 1978).
Exhibit III
A Comparison of the Status of Blacks and Whites under
Apartheid in 1978
Blacks
Whites
Population
19 million
4.5 million
Land allocation
13 percent
87 percent
<20 percent
75 percent
360 Rand
750 Rand
Doctors/population
1/44,000
1/400
20 (urban)
40 (rural)
2.75
$ 45
$ 696
1/60
1/22
Source: www-cs-students.stanford.edu.
The Export-Import Bank of the US10 prohibited loans to firms exporting to South
Africa in 1978. The International Monetary Fund (IMF) 11 prohibited loans to South
Africa in 1983. The US passed the Comprehensive Anti-apartheid Act in 1986,
imposing economic sanctions on South Africa. The UK followed suit. In 1986, the
European Economic Community (EEC) imposed a ban on trade and investment in
South Africa. The South African economy suffered the most when a group of
international banks, led by Chase Manhattan, decided in 1985 to withdraw short-term
credits. Not only did the banks stop grant of new loans but they also demanded
immediate repayment of all outstanding debts. The result was a severe debt crisis. The
1980s were also a period of intense droughts, with agriculture being severely affected.
These developments had an adverse effect on the economy, which recorded an
average annual growth of 1.5% in the decade. With population outpacing GDP
growth, the per capita income fell by around 10%.
The last years of apartheid were a time of social and political turmoil. Civil unrest and
violence resulted in the government declaring an emergency in June 1986, which
continued till 1990. In the 1990s, the apartheid system finally gave way to the process
of democratization.
10
11
The Export Import Bank of the US is the official export credit agency of the US. Its mission
is to assist in financing the export of US goods and services to international markets.
(Source: www.exim.gov.)
The IMF is an organization of 185 countries, working to foster global monetary cooperation,
secure financial stability, facilitate international trade, promote employment and sustainable
economic growth, and reduce poverty.
550
12
13
551
International Business
The government set up a special cabinet committee (SCC) to implement the program.
A core committee (CC) was also set up to support the SCC. The CC comprised
ministers, deputy ministers, and directors-general of finance and state expenditure,
public administration, constitutional development, and public works. The office of the
president was also to aid the CC.
A fund, called the RDP Fund, was created to finance the various programs and subprograms under the RDP. The fund secured finances from various sources. The
government reassigned to the fund some part of the budgetary allocations to various
government departments. International and domestic grants were also a major source
of finance. Revenues from state lotteries as well as from the sale of state assets were
diverted to the fund. Also, the funds surplus was invested in investments, the interest
on which went back into the fund. The government allocated Rand 14 2.5 billion in the
1994-95 budget to the RDP Fund. In 1995-96, the amount increased to Rand 5 billion.
The plan was to increase the allotment up to Rand 12.5 billion in 1998 and beyond.
The RDP fund was to finance projects that would have a long-term effect on society
such as housing for the homeless, running water, electricity, and sewerage systems for
millions of homes across the country, infrastructure such as roads, and free education.
It also aimed to create jobs and redistribute land so as to tackle unemployment and the
economic inequalities (Refer Exhibit IV for the socio-economic objectives of the
RDP).
Exhibit IV
Rand is the currency of South Africa. US$ 1 = Rand 6.76 (as of 2006)
552
553
International Business
Unlike the RDP which put the stress on reducing the economic inqualities between the
races, the GEARs stress was more on job creation. And for creating more jobs, the
government decided to expand the private sector. Therefore, the policy suggested
lowering the interest rate and reducing corporate taxes to stimulate higher private
investment. The government was also to reduce its consumption expenditure, relax
foreign exchange controls16, and reduce tariffs. GEAR envisaged increasing nonmineral exports and attracting FDI17. The government felt that with improving foreign
investor confidence, FDI inflows into South Africa would increase.
16
17
18
19
The new rules allowed non-resident South Africans to maintain foreign currency denominated
deposits with South African banks. South African corporates were allowed to preserve foreign
currency earnings for up to thirty days of accumulation (Earlier, they were allowed to retain them
only for up to seven days).
Foreign direct investment (FDI) is defined as an investment involving management control
of a resident entity in one economy by an enterprise resident in another economy. FDI
involves a long-term relationship reflecting an investors lasting interest in a foreign entity.
Ernest Harsch, South Africa Tackles Social Inequities, Africa Recovery, www.un.org,
January 2001.
The exchange rate crisis of South Africa in 1996 forced the SARB to sell massive amounts
of foreign reserves. The central bank was left with only US$ 942 millions in foreign
reserves in 1997. In 1997, the inflation rate was also high, at 8.9 percent. With investors
losing confidence in emerging markets following the Asian crisis, the rand depreciated in
1998 (from 4.61 per US $ in 1997 to 5.53 per US $ in 1998). In response to these
developments, the central bank raised its repurchase rate (the rate at which the reserve bank
charges commercial banks to borrow from it) from 14.8 percent to 22 percent. As the
foreign reserve situation stabilized, the Reserve bank later decreased the repurchase rate to
11.75%.
554
1993
31.2
1994
31.5
1996
35.6
1998
38.6
2000
36.9
13.0
20.0
21.0
26.1
25.8
Exhibit V
South Africa: Main Economic Indicators (1995-2000)
Year
1995
1996
1997
1998
1999
2000
Exchange rate
(Rands per US$)
3.63
4.29
4.61
5.53
6.11
6.93
Inflation
8.8%
7.4%
8.9%
6.9%
5.2%
5.3%
Current account
-2,205
-1,180
-2,273
-2,157
-640
-575
Exports*
30,701
30,263
30,171
29,264
28,267
31,630
Imports
-27,404
-27,508
-29,848
-27,208
-24,554
-27,320
Foreign reserves
(US$ millions)
2,820
942
4,799
4,357
6,353
6,083
GDP at market
price (R bn)
548.1
617.9
685.7
783.9
800.6
888.1
(US$ millions)
* Major export items include Platinum, pig iron, gold, and copper.
Source: International Monetary Fund, International Financial Statistics, and South
Africa Central Bank.
555
International Business
However, some analysts were of the view that the GEAR policy brought about
macroeconomic stability at the expense of growth. And without growth, the
government was unable to reduce poverty or income disparities. They argued that by
cutting down on expenditure, and reducing corporate taxes, the government was in
fact excarberating the economic inequalities in the population. A COSATU20 policy
document in 2000 concluded, The GEAR brought about deep cuts in government
spending between 1996 and 1999. As a result, efforts to improve services to the poor
suffered, despite the continued reprioritization of spending from the rich to the
poor.21
Felicity Gibbs, national manager of Operation Hunger 22 said, I worry about
GEARit appears to enrich the already rich. The way it is being implemented
possibly, the poor people are remaining where they are, and in fact are getting
worse.23 A WEFA24 report on South Africa in January 2001 also had something
similar to say The poor did not enjoy any benefits of the redistributed wealth. In
fact they are even worse off.25 Official statistics released by the government also
clearly indicated that the whites continued to remain a majority among high income
earners and that very few blacks were able to enter the high-income group (Refer
Exhibit VI for the break-up of high-income and low-income earners according to
race in 2001).
Exhibit VI
Colore
Indiand
3% 9%
White
21%
Black
67%
White
84%
21
22
23
24
25
556
Exhibit VII
RDP Achievements between 1994 and 2000
Water
Housing
Electrification
Telephones
Poverty relief
Health
600 new clinics, free health care for pregnant women and
children under 6
Public works
Land
26
27
28
The APF was established in July 2000 in Cape Town. The APFs role is to unite struggles
against privatization in South Africa.
Poverty in Post Apartheid South Africa, www.waronwant.org, July 23, 2003.
Ernest Harsch, South Africa Tackles Social Inequities, Africa Recovery, www.un.org,
January 2001.
557
International Business
With economic inequalities along racial lines remaining very much a part of South
African society, the government passed the Broad Based Black29 Economic
Empowerment Act, 2003, which came into effect in April 2004. The document said:
Unless further steps are taken to increase the effective participation of the majority of
South Africans in the economy, the stability and prosperity of the economy in the
future may be undermined to the detriment of all South Africans, irrespective of
race.30 The Act empowered the minister of trade and industry to issue codes of good
practice31 and to publish transformation charters to promote black economic
empowerment in South Africa. The legislation also resulted in the establishment of the
Black Economic Empowerment Advisory Council (BEEAC).
Around this period, the government introduced the Black Business Supplier
Development Programme (BBSDP). The BBSDP was an 80:20 cost-sharing cash
grant incentive scheme, which offered support to black-owned enterprises in South
Africa. In 2005, the government assisted 577 black-owned businesses with grants of
around Rand 29 million.
The main policy objectives were:
A substantial increase in the number of black people who had ownership and
control of existing and new enterprises
A significant increase in the number of black empowered and black-engendered
enterprises
A significant increase in the number of black people in executive and senior
management positions.
The minister of trade and industry issued the codes of good practice. For example,
Code 100 (Ownership Scorecard) required that blacks should own at least a 25% stake
(+ 1 vote) in a company. Code 200 (or Management Scorecard) was concerned with
black representation at senior executive levels (40% in the top management and 50%
in the Board) and Code 300 (Employment Equity Scorecard) dealt with the
representation of blacks at all levels of management senior management, middle
management, and junior management. Code 400 required companies to spend 3% of
their payroll on improving the skills of blacks. Similarly, Code 500, Code 600, and
Code 700 referred to Preferential Procurement, Enterprise Development (which
encouraged corporates to support initiatives that facilitated access to loans, seed
capital, training), and Socio-Economic Development (which measured the socioeconomic contributions of entities) respectively. Enterprises which followed these
codes were eligible for licenses and concessions.
Despite these programs, the unemployment levels among the blacks remained high.
And more than any other factor, this was due to the low levels of growth in the
economy. David Cowan, economist, Economist Intelligence Unit, said in 2004,
Three per cent is not the worst rate by African standards. But 3% is not big enough
to generate jobs. It just about keeps you where you are. The question now is whether
the government can boost the rate.32
29
30
31
32
558
Outlook
South Africa was a unique country in many ways. While some regions in the country
had infrastructure and prosperity levels comparable to those of developed countries,
other regions were worse off than the least developed countries. There were extreme
disparities in income and wealth among the race groups, as a consequence of the
apartheid system. However, even thirteen years after the death of apartheid, these
disparities remained as glaring as ever. Though in 2005 and 2006, South Africas
economy grew by around 5%, poverty and unemployment rates were still at high
levels. As of March 2006, the unemployment rate was at 25.6% (Refer Exhibit VIII
for major economic indicators and unemployment levels in the 2000s).
33
34
35
36
559
International Business
Exhibit VIII
Economic Indicators in the 2000s
S.
No.
Economic Indicators
2001
2002
2003
2004
2005
2006
2.7
3.6
2.8
3.7
4.3
4.5
CPI*
5.7
9.2
5.8
1.4
3.9
5.4
National Debt
(% GDP)
41.4
37.1
35.7
35.8
35.1
32.8
External current
account balance (%
GDP)
0.1
0.7
-1.5
-3.2
-3.7
-4.9
12.13
8.64
6.64
5.64
6.33
Unemployment (in %)
30.5
26.2
26.7
25.6
37
The Economic Policy Institute (EPI) is a non-profit, non-partisan think tank that seeks to
broaden the public debate about strategies to achieve a prosperous and fair economy.
(Source: www.epi.org)
38
The Gini coefficient, developed by Italian statistician Corrado Gini, is a measure of inequality
of a distribution. It is defined as a ratio with values between 0 and 1. It is usually used as an
income inequality metric, with 0 corresponding to perfect income equality and 1
corresponding to perfect income inequality.
39
Tony Avirgan, South Africas Economic Gap Grows Wider While Brazils Narrows
Slightly, www.epi.org, April 19, 2006.
40
According to the World Health Organization.
560
Exhibit IX
GINI Coefficients for South Africa and Brazil, 1995-2002
Exhibit X
Ranking of Countries on the Basis of Number of People Living with
HIV/Aids
Rank
Country
Prevalence
Rate^
South Africa
5,300,000
21.5%
India*
5,100,000
0.9%
Nigeria
3,600,000
5.4%
Zimbabwe*
1,800,000
24.6%
Tanzania
1,600,000
8.8%
Ethiopia
1,500,000
4.4%
Mozambique
1,300,000
12.2%
Kenya
1,200,000
6.7%
Congo
1,100,000
4.9%
10
USA
950,000
0.6%
561
International Business
Crime was also a serious concern (Refer Exhibit XI for crime rates in South Africa
and some other countries). Since 1994, large numbers of immigrants had been
arriving from other African countries, seeking employment and a better life in South
Africa. However, with local unemployment at high levels, there were fears of civil
unrest and of crime rising further.
Exhibit XI
Murders*
Rank
Country
Murders per
1000 people
Columbia
0.617
South Africa
0.496
Jamaica
0.324
Venezuela
0.316
Russia
0.201
Robberies*
Rank
Country
Robberies per
1000 people
Spain
12.32
Chile
6.92
Costa Rica
4.79
South Africa
4.44
Estonia
3.56
* UN Survey 1998-2000
Source: www.nationmaster.com
The government was aware that its first priority was reducing poverty and creating
new jobs. None of the great social problems we have to solve is capable of resolution
outside the context of the creation of jobs and the alleviation and eradication of
poverty,41 said President Mbeki. The government was quite optimistic that it would
be able to halve unemployment and poverty by 2015. Our second decade of freedom
will be the decade in which we radically reduce inequality, and virtually eliminate
poverty. We know now that we can do it,42 said Ngcuka.
41
42
Ernest Harsch South Africa Marks a Decade of Freedom, Africa Renewal, www.un.org.
July 2004.
Asgi-SA: Accelerated Growth for All, www.southafrica.info, 2006.
562
2.
3.
Economic Policy and South Africas Growth Strategy, www.treasury.gov.za, March 19,
2007.
4.
5.
6.
7.
Tony Avirgan, South Africas economic gap grows wider while Brazils narrows
slightly, www.epi.org, April 19, 2006.
8.
9.
Lynne Thomas and Jonathan Leape, Foreign Direct Investment in South Africa,
CREFSA, London School of Economics, www.lse.ac.uk, October 2005.
10.
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