WHILE THE SKIES ARE STILL BLUE
APPENDIX 4.3: Using Scenario Planning in Financial Crises
Scenario and contingency planning are often neglected during financial crises, when time pressures and tremendous uncertainty push management’s attention to seemingly more urgent tasks. From our experience, however, companies that have learned to incorporate these processes into their on- going management processes have benefited greatly during crises, and many who did not have these processes in place eventually learned to do so. By setting ranges on multiple sets of “parameters” or variables, management can define a set of scenario outcomes to inform assumptions in the com- pany’s budgeting processes, forecast future cash flow trends, and help the company define crisis contingency plans.
The first step of selecting and setting ranges on parameters is often the most time-consuming. When creating and updating scenarios for financial
crises, we recommend that management incorporate at least four sets of key parameters—macroeconomic, financial environment-related, industrial, and political/regulatory. Each of the four sets of parameters should be bro- ken down individually and forecasted for change over time.
1. Take, for example, macroeconomic parameters, which typically include GDP growth, interest rates, exchange rates, inflation rates, and the current account balance as a percent of GDP. To populate a forecast table, management draws upon expert interviews, publications research, and ques- tionnaires to assess the range of each of the parameters in terms of “most likely” and “less likely” outcomes. This is clearly a case where science and art shake hands, but the important thing is to remain as fact-driven as possible.
Defining the ranges on especially the macroeconomic parameters is an absolutely crucial part of the process—whether for financial crises or other- wise, scenario planning is only as useful as the ranges selected on different parameters. One company with whom we worked in Asia mentioned that despite their attempts at scenario planning, the outside financial situation got much worse than they had expected, in part because they had selected narrow ranges on their variables. In other words, “it was the market’s fault”
that they went into difficulty. The company has now learned to be much more aggressive and proactive (looking at other country case examples, carefully monitoring the external environment), and to be mentally pre- pared for a broader range of outcomes.
Working through the remaining three sets of parameters—financial environment-related, industrial, and political/regulatory—requires even more art, and more importantly, experienced, individual judgment.
2. For financial environment-related parameters, net flows of capital, which depend on a separate set of factors related to investor and depositor confidence, are critical for determining how bad the liquidity shortage will be.
Sometimes, outflows from residents matter as much as inflows. In Argentina, for example, the complete lack of confidence due to the debt default, the cur- rency devaluation, and the freeze on deposits (corralito) has led to an esti- mated 15 percent decline in the depositor base in the first quarter of 2002, coming on top of the 23 percent deposit outflow in 2001. This situation is affected more generally by the extent to which capital is available for invest- ment, given constraints on bank lending following a crisis and higher inter- est rates. Capital constraints combine with asset-liability mismatches or the inability to liquidate assets quickly enough to influence the default rate. The default rate, in turn, can signal who is still likely to be standing at the end of the day, what the industry landscape will look like, and how long it will take to recover from the crisis.
3. Understanding the dynamics of industrial parameters is slightly more complicated. Among the four key sub-parameters—market demand and
behavior, government policy toward domestic companies, speed of consoli- dation, and global competitor entry—market demand is the easiest place to start. Changes in market demand and behavior affect both domestic and foreign companies. A slowdown in consumer spending puts a squeeze on producers, and may push companies out the door. The response and timing of domestic and foreign companies affect the industry landscape by deter- mining the speed of industry consolidation. Government plays a big part here as well, either by encouraging certain domestic companies to consider M&A or competing companies to make business swaps, or by opening the door to foreign companies such as through the lifting of foreign ownership limitations.
4. Finally, there are the political/regulatory parameters, which are divided into two groups: internal parameters, including the strength of political leadership, willingness to reform, and ability to reform; and exter- nal parameters, including labor unions or consumer groups, multilateral financial institutions such as IMF and the World Bank, and governments.
So, for example, management must consider the potential for fiscal reform in their forecasts, which might include the adoption of a balanced budget or tax reforms. Management must also evaluate the extent to which govern- ment is putting in place the necessary legal and regulatory frameworks for a stable market economy (e.g., private property laws, corporate governance mechanisms). If managers do not perceive the government to be serious about such reforms (e.g., Japan, Venezuela, Argentina), then they should increase their assessment of market risk in their scenario planning.
These parameters provide a basic starting point for any company; each company should tailor the parameters or introduce new ones based on “killer risks” that are specific to the company’s situation and could bring it down in the early days of a financial crisis. For banks, killer risks might include: failure by the central bank to act as a lender of last resort; regulatory intervention or takeover; or a catastrophic business failure in a subsidiary that could pro- duce a contagion effect for the group at large. For corporates, the list includes: prospects for near-term debt rollovers or the complete severing of bank relationships; lack of investor confidence accompanied by dumping of stock; or a commodity price collapse in response to deflation (e.g., Japan) or price increases of key inputs, such as oil (e.g., Korea).
Second, after going through this exercise of setting ranges for all of the parameters, management can then define a limited set of outcomes. By assigning probabilities to each outcome—essentially bundles of different variables—it can prioritize which variables to use as key assumptions in the company’s financial models, and also forecast future cash flow trends.
Changes in the GDP growth rate might influence sales growth, or interest and inflation rates might affect the carrying cost of cash. Even qualitative
parameters, such as political or banking system stability, work together with more quantitative figures such as consumer spending trends, to help set pric- ing and revenue assumptions. Any key variable that could put noticeable stress on the company’s cash position in a volatile economic environment should be included. Examples include changes in demand conditions for the company’s products and services (price and volume), operational risk fac- tors (supplier pricing or margins to dealers), and funding conditions (e.g., financing variables across different countries, viability of supplier funding or consumer funding).
Finally, these outcomes provide something tangible, finite, and fact- based against which management can design contingency plans. How the scenarios predict interest rate changes, for instance, will affect expectations on cost of debt, and exchange rate fluctuations will influence the company’s hedging strategy. Other questions include: Which assets could a company most easily divest to raise cash? Which plants or offices, if closed, would cut costs most sharply or preserve the most cash? Which products or services are least profitable and could be jettisoned? Conversely, what critical busi- ness lines and customer relationships must be preserved at any cost? In gen- eral, management should establish a contingency plan for each outcome.
(This part of the process can take weeks to complete.)
Like Emerson, action plans should be developed based on best case and less likely scenarios, and reviewed by senior management. This review process helps senior executives integrate ongoing risk management into day- to-day tactical issues as well as longer-term strategy. Management needs to execute aggressively against each one, and bring in outside help when neces- sary, including accounting firms, law firms, and investment banks, to ensure that all of the required skills are available.
While some international companies may opt to use the Economist Intelligence Unit or other commercial country risk ratings, we recommend that companies also build and monitor their own scenarios for countries in which they have substantial operations. Many of the critical inputs are what we term “softer” variables, or information that is usually not published but is instead obtained through informal channels (see Box 3.2: A Dinner Party for Eight, in Chapter 3). On the other hand, if a company has only a mini- mal presence in a country, or entry into that specific country is not a key strategic priority, then it is better to use commercial risk ratings.
Successful scenario planning for financial crises ultimately requires seemingly plain ingredients. The first is excellence in financial forecasting and reporting processes. Without this, incorporating crisis-related variables into existing but malfunctioning models will not produce trustworthy, fact- based results. As in other operational areas, crises require that management first get the basics right. The second is quality of judgment. Defining the
ranges on planning parameters requires experience, creativity, and owner- ship. At Emerson, former CEO Charles Knight required that division heads assume full responsibility for their own planning processes rather than handing it off to subordinates. Companies need to ensure that they have the right talent and proper alignment of incentives to ensure that scenario plan- ning is thoughtfully managed.
5
Capturing Strategic Opportunities After the Storm
Soon after the financial crisis hit Thailand in July 1997, it was not long before the contagion swept through the rest of Asia. First came Malaysia and the Philippines, where before year’s end the ringgit lost 56 percent of its value and the peso fell 53 percent, respectively. Then came Indonesia and Korea, where the rupiah lost 139 percent of its value and the won plunged by 121 percent. Even the mighty Singapore and Hong Kong dollars came under attack.1
While many foreign and domestic investors were pulling out of these dangerous markets, some realized that times of great uncertainty—when financial and competitive landscapes change almost overnight—are exactly when companies should seek out new strategic opportunities. Instead of running away, these managers went even deeper into their markets to rethink their strategies.
Douglas Daft, then head of Asian operations for Coca-Cola, was one of them. As the Asian crisis spread, Daft summoned his executives and a select group of academicians and outside advisors to an offsite in California. He invited this group of outsiders to expand the thinking of his executive team in a time of wrenching change. He wanted to seed his team’s strategy and plan- ning discussion with a debate on macroeconomic, trade, policy, and social issues, and he wanted all of his executives thinking with a broadly defined frame of reference. They discussed not only how Coca-Cola could manage short-term needs, but also how it could capture new growth opportunities and emerge from the crisis in a better position than before. He reminded them that the company had achieved one of its greatest breakthroughs in its international markets at the end of World War II, when it discovered new opportunities in the broken landscape of Western Europe and Japan.
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How could Coca-Cola find an opportunity in the crisis to acquire some locally branded products? How will the regulatory regimes likely change?
How should Coke’s local divisions and bottlers work with new regulatory regimes to support reforms that could reduce import and retail trade barriers?
How could the company change its distribution strategy in different regional markets, such as Korea, where getting into “mom-and-pop” retail stores was difficult, or China, where it lacked bottlers, or Indonesia, where it had few vend- ing machines? Is there a breakthrough distribution strategy in Indonesia?
To answer those questions, Daft not only convened his group of advi- sors, but also started a monthly series of two-day, offsite workshops with internal managers to push those questions further and develop common viewpoints. Eventually, these strategic thinking sessions helped Coca-Cola significantly strengthen its position across Asia. In Korea, it completed the purchase of full control of its bottling business from Doosan and other bot- tlers in Korea, as well as in China, Japan, Malaysia, and the Philippines, in an attempt to rationalize the system. The company also shifted away from a country-defined market perspective to viewing the region as a whole, which was reflected in its development of a regional procurement business to aggre- gate purchases of aluminum, sugar, PET (for its plastic bottles), and coffee.
Coca-Cola is just one example of how companies can discover new opportunities in the months following a financial crisis. From our experi- ence, two groups of companies have been and are very successful at doing this. The first is a set of international companies we will refer to simply as
“global players.” This includes companies such as Interbrew, Holcim, LaFarge, Renault, Johnson & Johnson, Citigroup, Unilever, Emerson, GE Capital, Newbridge Capital, and Lone Star. Given their global operations, which provide them with a diverse financial safety net, these companies clearly have the luxury of thinking strategically because their own survival usually is not at stake.
There is also a second set of companies that does well, and these are domestic companies. We will call them “local champions.” This includes companies such as Banco Itaú in Brazil, Ramayana in Indonesia, Kookmin Bank in Korea, the Ayala Group in the Philippines, Alfa Bank and Roust in Russia, and North Carolina National Bank (NCNB, now BankAmerica) in the United States. Through a combination of insightful understanding of the environment in which they operate, winning strategies, and the ability to seize major discontinuities, these companies ended up winning significant market share and successfully expanding into new business lines in the wake of financial crises.
Both sets of companies capture strategic opportunities by doing three things right. First, they recognize that crises are times of radical change, and therefore significant opportunities become available. Former NCNB
CEO Hugh McColl clearly understood this starting point and leveraged it to gain entry into new U.S. markets during the Texas banking crisis in the mid-1980s, a powerful story that we review as a special case study at the end of this chapter (see Appendix 5.1: Leveraging Strategic Opportunities in Financial Crises: The Successful Story of NCNB).
Second, they completely assume away the boundary conditions that confined them before the crisis. Clever managers relax their operating assumptions about traditional boundary constraints in five key areas: the regulatory regime; the competitive landscape; customer behavior and needs;
organizational capacity for change; and social values. They recognize that the rules have changed, which opens up new strategic opportunities.
Finally, global players and local champions share several common traits in the way that they execute against these opportunities. First, they set aggressive performance aspirations. Second, both types of companies search for merger and acquisition opportunities. Third, they respond to opportuni- ties quickly. Lastly, they exhibit determined leadership. Leaders in times of crisis must be courageous, but implicit in their courage is a great sense of vision and commitment. In the deepest trough of a crisis, when the weary and the wary retreat, it is the visionary who searches and finds the best strategic opportunities and then acts on them to achieve the most valuable competitive gains.