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Crisis Spurs Grey Market

Latin America’s grey market gets a boost from the region's economic deceleration.

BY TOM RIDEG

Consumer dependence on informal channels declined in Latin America as the leading economies expanded more than 5 percent per year over the last five years.  This growth brought higher employment across all socio-economic levels, increasing personal incomes and creating greater access to goods and services.  Lower interest rates brought increased access to credit and boosted consumer confidence.  

This unprecedented consumption, aided by capital inflows from rising foreign direct investment and exports, lead to appreciating currency levels in the region.  Imported and higher ticket items moved within easier reach of consumers, who became increasingly more reliant on formal channels.  According to the Brazilian Institute of Public Opinion and Statistics (IBOPE), Brazilian consumers bought 38 percent fewer pirated products in September, 2008, compared to the same month in 2007.  

However, informal markets will always remain attractive while Latin American governments impose elevated taxes on formal products, labor and manufacturing costs.  This includes both the black market of counterfeit and/or illegal goods and the grey market, where official merchandise is traded through unofficial distribution channels with no relationship to the manufacturer.  As economies strengthen, these markets do not disappear but see less participation from the middle class and greater participation by the lowest socioeconomic level as they begin climbing the consumption ladder.  This is positive, provided the economies remain strong.

CAUSES FOR CONCERN

The first hit Latin American economies are taking from the global financial crisis is in the foreign exchange markets.  Local currencies are losing value, dramatically affecting the purchasing power of consumers and businesses.  The Brazilian real experienced the sharpest devaluation, standing 25 percent weaker in October than its average rate for 2008, while the Colombian peso saw a 19 percent decline and the Mexican peso 16 percent over the same period.

The increased cost of imported goods and components has an immediate impact on the prices of many high ticket items that have been so successfully penetrating Latin American households over the last three to four years.  This increase in price will place these items back on the consumer’s list of “inaccessible items.”  Consequently, consumption will decelerate, forcing companies reduce costs and investments, including payroll.  This environment creates pressure for both consumers and producers to seek out creative and alternate solutions for their purchases.  Inevitably, many of these creative and alternative solutions will be via an informal market – the grey market.

THE GREY ATTRACTION

Grey markets are strongest in emerging markets that are over-taxed and experiencing currency depreciation.  Imported goods are the first to be affected because they quickly become inaccessible in times of devaluation.  Demand, however, remains high and creates opportunity for informal distribution channels to supply consumers.  If they can bypass import tariffs by bringing the merchandise into the country illegally (or acquiring illegally imported products in country), then the product can again fall in the consumer’s price range.

Locally produced goods are also affected as the gap between grey market prices and retail prices widens even further.  Even though these products are produced at local cost, the tax burden is too high for them to compete.  Furthermore, distributors often take advantage of these fragile moments to increase the prices of locally produced goods to make up for the lost influx of revenue on imported goods.  This is an ill-justified, yet classic, defense reaction to crisis.

Fundamentally, this problem is best addressed by the government through the reduction of taxes.  In 2007, the Brazilian government reduced taxes on computer sales.  This tax reduction led to 50 percent sales growth in less than one year.  During this time period (2006-2007), grey market participation fell from 53 percent to 35 percent in this product category (based on the number of PC’s sold without receipts and without warranty).  A massive devaluation will have an effect on computer sales, but not with the same magnitude as other products that are still heavily taxed.

COMPANIES FIGHT BACK

Identifying best practices to compete in a market where consumers are losing purchasing power and players are cutting costs to remain in the game is challenging, and companies often believe that they have limited control over the grey market.  However, managers at the local and global level can initiate preventative measures to reduce informal activity, positively affecting their bottom-line and the sector as a whole.

Official merchandise that finds its way into grey markets has some point of origin.  Companies must monitor the movement of their raw materials, components, parts and finished products throughout their entire value chain in order identify potential leaking points and concentrate efforts to tighten the controls in these areas.  Companies can begin by conducting internal investigations within their manufacturing and warehousing facilities, and then proceed to ensure that the controls of its suppliers and distributors are also solid through investigative due diligence.  It is also important for companies to conduct background checks individuals that oversee the flow of their products, both internally and externally.

Distribution channel mapping – from the factory to the consumer’s hand – is another important measure that not only reduces risk of fraud but also enables companies to identify opportunities to better compete in the market place.  This process is of vital importance to understand if the product is reaching the end-customer with the identity and message that the manufacturer produced.  In the process, opportunities to streamline distribution and lower the final price to the consumer can also be identified.  Of even higher importance, it can uncover
potential piracy or unfair competition.  

IMPACT BOTTOM LINE

Though the measures mentioned above are important considerations for managers in Latin American markets, they are of equal importance to global headquarters.  Decision-makers in North America, Europe, or Asia must remember that although grey markets exist locally, they impact the bottom-line of the entire organization.

Another important consideration for global managers is that, as mature economies decelerate and Latin American currencies depreciate, production facilities in Latin America become more attractive for investment.  Lower production costs help products remain competitive regionally and globally, as long as the inherent risks are addressed to take full advantage of the opportunity.

These preventive measures are the first steps to reduce the supply of products to the grey market, which will not only benefit the producer but the sector as a whole.   As such, is only fair that associations also play a role in involving multiple companies in a particular sector in such risk management programs.  This will multiply the effect of prevention programs and encourage investment across the sector.

This article is republished with permission from Tendencias, the magazine of Kroll InfoAmericas.    

 

 

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