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McDonalds Russia: A Jewel in the

McDonalds Emerging Market Operations?


McDonald's Corporation is one of the oldest chains of quick service restaurants in the
world and the largest. It was started in the late 1930s by two brothers Richard and
Maurice McDonald in California, the US. Within a few years, the chain had become
quite popular and it started to grow in numbers. The founders started to franchise out
the stores to other partners at a premium price. In 1967, it started its international
expansion for the first time by entering Canada and subsequently ramped up its
presence in other international markets.
McDonald's opened its first outlet in Russia in 1990. It entered at a time when the
country was still struggling to gain political and economic stability after reforms had
been introduced.
It started by developing the food processing unit and training the local suppliers.
McDonald's became an instant hit in the country where the culture of fast food was as
new as the burger. The company experienced many obstacles along the way but it
continued its slow and steady growth in the country. As of 2010, Russia was one of its
key markets in Europe and some experts considered it as the jewel in McDonald's
system.
The case details the difficulties McDonald's had in entering the country and discusses
how it overcame various challenges to establish itself firmly in the market. It discusses
in detail some of the strategies adopted by McDonald's in Russia, including HR
strategies, procurement strategies, expansion strategies, etc. that helped it gain a
strong footing in the Russian market - so much so that the company accounted for
more than two-third of the fast food market in Russia.

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
-

Khamzat Khasbulatov2, McDonalds Corporation, president for Russia


and Eastern Europe, in December 2009.

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
-

- The Wall Street Journal, October 16, 2007.

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

Maria Kiselyova and Maria Plis, McDonalds to Target Stay-at-home Russians,


www.reuters.com, December 17, 2009.
Khamzat Khasbulatov was one of the four managers for the first outlet of McDonalds in
Russia. He was named to McDonalds top Russia position in 1999 and later took on the
responsibility for the companys Eastern European restaurants.
Janet Adamy, As Burgers Boom in Russia, McDonalds Touts Discipline,
http://online.wsj.com, October 16, 2007.
McDonalds Corporation, 2008 Annual Report, www.mcdonalds.com
McDonalds Delivers Another Year of Strong Results in 2009, www.chainleader.com,
January 25, 2010.

327

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.

328

McDonalds Russia: A Jewel in the McDonalds Emerging

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.

329

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

McDonalds Russia: A Jewel in the McDonalds Emerging

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

Kroc started a new franchising company under the name McDonalds


System, Inc. and in the same year opened his own McDonalds drive-in at
Des Plaines, Illinois. McDonalds franchising agreement was that anyone
who wished to become a franchisee would initially pay a sum of a
thousand dollars. Later on, 1.9 percent of the annual profits of the
restaurant were to be paid. Kroc would then pass 0.5 percent of the takings
to the McDonald brothers, keeping the other 1.4 percent with him.

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

By 1970, McDonalds reported US$587 million in sales from almost 1,600


restaurants in all 50 states of the US.

1973

McDonalds introduced its first breakfast fast food The Egg McMuffin31.

1975

McDonalds opened its first drive-thru restaurant in Oklahoma City.

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

McDonalds received The American Marketing Association Achievement


Award for excellence in marketing programs.

1983

Chicken McNuggets were introduced. By the end of the year, McDonalds


had become the second largest retailer of chicken based products in the
world.

1984

On January 14, Kroc died. That same year, McDonalds broke the US$ 10
billion sales barrier and served its 50 billionth hamburger.

1986

McDonalds opened its ten thousandth restaurant.

1988

Fortune Magazine listed McDonalds hamburgers among the 100 products


America makes best.

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

The fast food chain reached the 20,000-restaurant mark.

1997

By the end of the year, the total number of McDonalds restaurants reached
the 23,000th mark.

1999

McDonalds acquired its first stake in a Colorado-based fast food chain,


Chipotle Mexican Grill, by buying a minor share in the company. In 1999,
McDonalds 25,000th unit opened.

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.

McDonalds Russia: A Jewel in the McDonalds Emerging


2000s
2000

In May, McDonalds bought the bankrupt Boston Market chain 33 for


$173.5 million in cash and debt, the largest acquisition till date. In the
2000s, McDonalds introduced low-calorie menu items and switched to
healthy cooking ways like using low fat oil.

2002

In October, McDonalds introduced its famous Dollar menu.

2003

In September, McDonalds launched its advertising campaign on MTV


with the tag line, Im lovin it. This was McDonalds first global
campaign to be advertised in more than 100 countries. This campaign was
successful as store sales for the year 2003 increased by 2.4 percent after
falling 2.1 percent in 2002.

Compiled from various sources

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

Total shareholders equity

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:

Shares outstanding in millions

33

At the time of acquisition, there were more than 850 Boston Market outlets, which
specialized in home-styled meals like rotisserie chicken.

333

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

Market price at year end

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

Total Systemwide restaurants

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.
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McDonalds Russia: A Jewel in the McDonalds Emerging


In 1992, two outlets were opened in Poland and each separately surpassed the records
set earlier by Russia and China in terms of first day transactions. The year also
witnessed McDonalds entry into Africa with the opening of a restaurant in Morocco.
By the early 1990s, McDonalds had a presence in 58 countries worldwide.
In October 1993, another important phase of the companys expansion came when it
entered the Middle East market by starting a restaurant in Tel Aviv, Israel. Slowly,
restaurants also came up in the Gulf region in Saudi Arabia, Oman, Kuwait,
Bahrain, the United Arab Emirates, and Qatar and Egypt. By 1995, there were about
7,033 McDonalds restaurants spread across 89 countries and they generated sales
worth US$14 billion.34
In 1996, McDonalds entered India with a restaurant coming up in New Delhi. In
India, it entered through a franchisee. By 2007, international sales were reported to be
a major contributor to the companys annual revenue (Refer to Table I for the
revenues of McDonalds Four Operational Regions: 2006-2009).

Table I: Revenues of McDonalds Four Operational Regions: 2006-2009


(In US$ million)

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

Other Countries and Corporate

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

Other Countries and Corporate

1,290

2,356

2,740

23,522

22,787

20,896

Company operated sales:

Other Countries and Corporate


Total
Franchised and affiliated:

Total
Total revenues:

Total

Source: McDonalds Corporation, Annual Reports, www.mcdonalds.com

34

McDonalds History, www.mcdonalds.ca.

335

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

Country and Date of First Restaurant Opening


Canada - June 1
Puerto Rico November 10
Costa Rica December 28
Guam- June 10
Australia-May 30
Japan - July 20
Netherlands-August 21
Panama -September 1
Germany (West)- November 22
France-May 30
El Salvador-July 20
Sweden-27 October
Guatemala-June 6
United Kingdom-October 1
Netherlands Antilles-16 August
Hong Kong-January 8
Nicaragua+
The Bahamas August 4
New Zealand -June 7
Switzerland - October 20
Ireland - May 9
Austria - July 21
Belgium- March 21
Brazil-February 13
Singapore - October 20
Spain - March 10
Denmark - April 15
Philippines September 27
Malaysia April 29
Norway November 18
Taiwan (Republic of China)-January 28
Andorra June 29
Finland December 14
Thailand February 23
Luxembourg July 17
Venezuela August 31
Italy - October 15
Mexico- October 29

McDonalds Corporation, www.fortune500news.com.

336

McDonalds Russia: A Jewel in the McDonalds Emerging


Year of
Opening
Restaurant
1986

1987
1988

1990

1991

1992

1993

1994

1995

1996

Country and Date of First Restaurant Opening


Cuba April 24
Turkey October 24
Argentina November 24
Macau - April 11
Serbia - March 24
South Korea -March 29
Hungary April 30
Union of Soviet Socialist Republics - 31 January (in Russian SFSR, now Russia)
Peoples Republic of China - October 8 (in
Shenzhen)
Chile November 19
Indonesia February 23
Portugal - May 23
Greece-November 12
Uruguay November 18
Czechoslovakia (Later became the Czech Republic
and Slovakia) - March 20
Poland June 17
Monaco - November 20
Brunei December 12
Morocco December 18
Northern Mariana Islands 18 March
Iceland - September 3
Israel - October 14
Slovenia December 2
Saudi Arabia December 8
Kuwait June 15
New Caledonia - July 26
Oman July 30
Egypt October 20
Bulgaria December 10
Bahrain December 15
Latvia December 15
United Arab Emirates December 21
Estonia April 29
Romania June 16
Malta July 7
Colombia July 14
Slovakia October 13
South Africa November 11
Qatar December 13
Honduras December 14
Croatia February 2
Samoa March 2
337

International Business
Year of
Opening
Restaurant

1997

1998

1999

2000
2001
2003
2004

Country and Date of First Restaurant Opening


Fiji May 1
Liechtenstein May 3
Lithuania - May 31
India October 13
Peru October 18
Jordan November 7
Paraguay November 21
Dominican Republic - November 30
Belarus December 10
French Polynesia December 10
Ukraine - May 28
Cyprus - June 12
Macedonia - September 6
Ecuador - October 9
Isle of Man - December 15
Suriname - December 18
Moldova - April 30
Lebanon September 18
Pakistan -September 19
Sri Lanka -October 16
Georgia -February 5
San Marino - July 6
Gibraltar -August 13
Azerbaijan - November 6
American Samoa - 29 September
Mauritius July 4
Kazakhstan
Montenegro - June

+ 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

McDonalds Russia: A Jewel in the McDonalds Emerging


was operating. For instance, to make it easy for Japanese consumers to pronounce the
chains name, McDonalds was changed to Makudonaldo. Keeping in mind local
sentiments, McDonalds restaurants in Arab countries, Malaysia, and Singapore
maintained halal menus36 and did not serve pork, abiding by Islamic laws for food
preparation. In Saudi Arabia, McDonalds did not display statues or posters of Ronald
McDonald, since the display of idols was prohibited in Islam.
In Israel, McDonalds outlets did not serve dairy products 37, and they were closed on
Saturdays, the Jewish Sabbath Day38. In India, McDonalds restaurants served
Vegetable McNuggets, to cater to the vegetarians and a mutton-based Maharaja Mac39
as in that country some communities considered the cow sacred and did not eat beef.
In Ireland, the McDonalds promotions stated Our name may be American, but were
all Irish.
McDonalds even altered the original menu to meet the needs of the customers in
different countries. It adapted its product offerings to suit the tastes of the local
people. In tropical countries, guava juice was added to the McDonalds menu. Beer in
Germany, fired egg sandwiches in Malaysia, chilled yogurt drinks in Turkey, espresso
and cold pasta in Italy, and vegetarian burgers in the Netherlands were some of the
menu variations at the McDonalds restaurants. McDonalds offered choice and
variety with locally suitable menus such as the Teriyaki Mac 40 in Japan and variations
of the Filet-O-Fish41 in China. It also introduced McGriddles sandwiches in Japan.
In Norway, McDonalds sold a grilled salmon sandwich called McLaks. It sold
spaghetti noodles served in sweet tomato-based sauce, hot dogs and grated pasteurized
cheese called McSpaghetti in Philippines. McHuevo, a poached egg hamburger, was
available at McDonalds outlets in Uruguay. In Thailand, McDonalds introduced the
Samurai Pork Burger with sweet sauce.
Irrespective of variations and additions, the basic structure of the McDonalds menu
remained uniform throughout the world comprising a main course of burger or
sandwich, fries, and a Coca Cola drink. Even though the main course varied in some
countries, the signature product of McDonalds the fries were present in all its
menus worldwide.
As for the prices, they were set in each country on the basis of the demand for the
item. For instance, in the US, a Big Mac with fries was priced low as it was a common
food item but in some other countries where it was perceived as a luxury, it was priced
higher.

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

Jews do not eat or cook meat and dairy products together.

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

McDonalds Russia: A Jewel in the McDonalds Emerging


According to Cohon, he had made good friends in the political circles of Russia,
which turned out to be very valuable for the company as these people lent their
support to the companys activities in the country. For instance, the Russian army
helped to dig trenches when the processing unit, called McComplex, was being built.
In 1989, a 100,000 square feet McComplex, built at an investment of US$ 45 million,
was opened in Solntsevo, a suburb near Moscow. It manufactured buns, cheese,
burger patties, as well as other items, not just for the Russia market but also for the
companys other restaurants in 17 other countries.50
On January 31, 1990, McDonalds opened its first restaurant in Russia at Pushkin
Square, Moscow. The opening was widely publicized not only by the Russian media
but by the international media as well. It was the largest McDonalds restaurant till
that time, spread over 23,680 square foot area on multi levels, had a seating space for
700 customers, and 27 cash registers. According to reports, around 40,000 people
queued up and waited for two hours for the opening. 51 According to Khasbulatov, on
the opening day, there were queues outside the store even at closing time at night and
he had to unwillingly turn them away. On the opening day, the store first served
orphans and children, before entertaining other guests, who included high ranked
government officials as well as some celebrities. 52 The store broke the then existing
records for the number of customers served on the opening day.
This store marked the beginning of not just the first McDonalds in Russia but the first
fast food restaurant to ever come up in Russia. With this beginning, McDonalds also
became a symbol of the advent of American capitalism in the country, opined the
analysts.
In contrast to its standard procedure of going in for a franchising agreement or a joint
venture, the McDonalds outlets in Russia were wholly owned without any partners.53
The company also did not use franchising in Russia despite it being a key factor for its
international operations in other countries. According to Khasbulatov, this was due to
the fact that there were some gaps in the existing legislations relating to franchising in
Russia. In Russia, the law on commercial concession governed franchising, but
franchisers often felt that the legislation lacked clarity.54 However, the company did
not rule out the franchise option. Commenting on the companys franchise program,
Khasbulatov said franchising will appear in Russia as soon as it becomes possible,
but for now there is no motivation to sell franchised restaurants.55
Analysts felt that it was a wise decision for the company since the fast food industry
was new in the country and it was difficult to find an efficient partner who would
completely understand the operation and stand up to the quality standards set by the
company. As Alexander Gragin, a partner at Deloitte 56, Moscow, put it, Regional
restaurant franchises [in Russia] can really vary in the quality and service that they
offer. The tricky part of selling franchises is finding reliable partners in the regions.
Also the legal situation with franchises at the federal level is as yet unclear. 57

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

Moscow Kremlin is the official residence of the President of Russia.


Coco-Cola Company is a leading beverage company with a worldwide presence.
Upjohn was a pharmaceutical company.
Erin E. Arvedlund, McDonalds Gobbles up Russian Real Estate, www.iht.com, March 18,
2005.
Dmitry Dobrov, Kommersant Vlast Food Industry 1991-2000, www.russiajournal.com,
October 26, 2001.
Janet Adamy, As Burgers Boom in Russia, McDonalds Touts Discipline,
http://online.wsj.com, October 16, 2007.
The Russian financial crisis started in August 1998, primarily due to a financial crisis in
Asia. There was a decline in world commodity prices, which impacted countries that
depended heavily on the export of raw materials. Russia, which depended a lot on the
exports of petroleum, natural gas, metals, and timber, was also affected.
Natalia
Olynec,
Big
Mac
Blues
in
Russia,
Bloomberg
News,
www.bellybuttonwindow.com, 1999.
US Fast Food Firm Expanding in Russia, Interfax, CDi Russia Weekly #136,
www.cdi.org, January 05, 2001.
Vladimir Kozlov, Fast-Food Profits Offer Food for Thought, www.russiajournal.com,
November 29, 2001.

342

McDonalds Russia: A Jewel in the McDonalds Emerging


2000s, and this provided a boost to the companys growth plans (Refer to Exhibit IV
for a brief note on Russias economy in the early 2000s).

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

Global brand owner

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

Dunkin Brands Inc

1.3

Others

57.4

56.9

57.5

54.1

Total, %

100

100

100

100

Source: Russian Federation HRI Food Service Sector-2008, www.fas.usda.gov,


July 28, 2008.

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

McDonalds Russia: A Jewel in the McDonalds Emerging


trend among Russians who tended to spend more on food and dining out more
than any other country in Europe. Moreover, the increasing number of shopping
centers and malls in the country were in a way propelling the fast food culture, as
most of these places had food courts with various low priced fast food stalls and
restaurants.
According to research conducted by Euromonitor Plc.71, almost 50% of the Russian
population in the age group of 16-50, bought fast food at least once a week. The
studies showed that 64% of the customers considered location as the most
important factor among the reasons that drove customers into the stores, followed
by 54% of customers who focused on cost. 43% of customers regarded quality and
25% regarded cleanliness as the factors that made them visit any fast food store.
According to analysts, one quarter of Russian restaurants were situated in Moscow
itself, out of which 60% of the market share was held by low-priced restaurants,
14% by elite restaurants, and 11% by fast food outlets. The most popular catering
formats in Russia were cafs that offered lunch deals with the buffet option. The
European and Asian menus were considered as the most popular ones. As of 2007,
the fastest development in the restaurant segment was the mid-range, low-priced
category of outlets.
The national fast food chains and stalls that were slowly gaining ground were
Stardog, Teremok, Russkie Blini etc. Street food vendors like Kroshka
Kartoshka were also very popular in Russia. However, in 2007, the Mayor of
Moscow prohibited the street vendors from doing business, in a bid to clean up the
city. Some of them were allowed to rent space in the malls and shopping centers,
but analysts pointed out that not all the vendors would be able to afford these places
because of high rentals. Further, analysts also said that the high rents paid by the
vendors would lead to an increase in the prices of the food items. In order to bear
the increasing operational costs, Kroshka Kartoshka, joined hands with Polands
AmRest Holding, a franchisee of Pizza Hut, KFC, Burger King, etc., in eastern
Europe.
Among the fast food chain operators, the food court format was slowly becoming
popular as of 2008. People visited the food courts not just for the food but also to
socialize with friends and families. Most of the leading chains such as RosticksKFC, Chaynaya Lozhka, Sbarro, and Baskin-Robbins had outlets in many malls,
shopping centers, and hypermarkets.72
For the foreign fast food chains, franchising was a popular option to enter the
country. As of 2008, Baskin Robbins was one of the largest franchises, which
capitalized on the Russians fondness for ice-cream. Among the drive-in
restaurants, Rostiks was considered the market leader. In popularity, it stood
second to McDonalds, which was among the most popular fast food chains since
1990.
One of the major challenges for the restaurant industry in Russia was
underdeveloped distribution and logistics in most parts of the country, other than
large urban cities. It was also difficult to find experienced and efficient distributors.
Moreover, in Russia, restaurants offering traditional Russian cuisine were widely
popular, while fast food joints were not. This was due to the fact that to Russians,

71
72

Euromonitor Plc is a London, UK-based provider of information services.


Russian Federation HRI Food Service Sector-2008, www.fas.usda.gov, July 28, 2008.

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

McDonalds and Burger King Kill Russian Bistro, http://english.pravda.ru, November 9,


2009.
The Fast Deteriorating State of Russias Economy, www.economist.com, December 14,
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.
Vladimir Kozlov, McDonalds Supersize Profits Conquer Moscow, www.mnweekly.ru,
January 25, 2010.
McDonalds and Burger King Kill Russian Bistro, http://english.pravda.ru, November 9,
2009.
McDonalds Set for 20% Expansion in Russia, www.sptimes.ru, June 10, 2005
McDonalds Set for 20% Expansion in Russia, www.sptimes.ru, June 10, 2005

346

McDonalds Russia: A Jewel in the McDonalds Emerging


largest among McDonalds markets in terms of average number of consumers per
restaurant.81
In 2006, more than 20 new restaurants were added to the Russian operation. Even in
2006, after 16 years of operations, the first restaurant at Pushkin Square was the
busiest McDonalds in the world.82
By the end of 2007, there were more than 180 McDonalds restaurants present in
around 40 cities of Russia.83 The Russian venture was one of the most lucrative
businesses for McDonalds, fueled by the ever increasing quest for American products
and brands among the growing middle class in Russia. However, the company
decided to concentrate on increasing the quality and to extract more sales from the
existing stores, instead of going in for rapid expansion. Some analysts pointed out the
high real estate prices of the prime locations was the main reason for McDonalds
deciding to go slow on its expansion (Refer to Table II for new outlets opened in
Russia: 2005-2009). We would like to open more restaurants in Russia, but,
unfortunately, the procedure for receiving permission is not becoming any easier,84
said Khasbulatov. The company also intended to introduce new forms of accessibility
to its products in Russia, such as the 24-hour express windows and drive-thru
windows.

Table II: New McDonalds Outlets Opened in Russia: 2005-2009


Restaurants opened

2009

2008

2007

2006

2005

33 (Planned)

22

21

23

18

Compiled from various sources.


By mid-2009, McDonalds had more than 220 restaurants in over 50 cities in Russia
and had served more than 2 billion customers.85

McDonalds Strategies in Russia


The company faced stiff operational hurdles from time to time because of the strong
bureaucracy that was present in Russia. According to analysts, opening a single store
required the sanction signatures from about 200 different officials. The government
issued guidelines running into 40 pages instructing the restaurants on numerous dos
and donts, while operating in the country. Nevertheless, the company went ahead,
implementing several strategies that eased its difficulties and paved the way for
smooth operations. The menu was kept similar to the one in the US, with the addition
of cabbage pie and a few popular Russian dishes.

The Human Factor


McDonalds faced some difficulties in getting the right talent, especially in the bigger
cities like Moscow and St.Petersburg, as there was a low rate of unemployment in
these places. However, it gave the best training to the local recruits, who were familiar
with neither customer service nor the hamburger. Moreover, molding them in the
81

82
83

84
85

Chris Mercer, McDonalds Plans to Double Russian Presence, www.foodnavigator.com,


February 3, 2005.
Top 10 Consumer Trends in Russia, www.euromonitor.com, May 7, 2008
Janet Adamy, As Burgers Boom in Russia, McDonalds Touts Discipline,
http://online.wsj.com, October 16, 2007.
McDonalds to Open 40 Restaurants in Russia in 2008, www.cdi.org, April 22, 2008.
George Cohon, Founder of McDonalds Canada and McDonalds Russia, Honored in
Washington, D.C., www.marketwire.com, October 6, 2009.

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

Helen Deresky, International Management: Managing Across Borders and Cultures,


(Pearson Prentice Hall, 2006).
Ann Blackman, Moscows Big Mak Attack, www.time.com, February 5, 1990.
Ann Blackman, Moscows Big Mak Attack, www.time.com, February 05, 1990.
Helen Deresky, International Management: Managing Across Borders and Cultures,
(Pearson Prentice Hall, 2006).
McDonalds Russia Named Best Employer, www.crmcdonalds.com, January 16, 2007.
Hewitt Associates is a leading global human resources consulting and outsourcing company.
George Cohon, Founder of McDonalds Canada and McDonalds Russia, Honored in
Washington, D.C., www.marketwire.com, October 6, 2009.

348

McDonalds Russia: A Jewel in the McDonalds Emerging


purchase them since these goods could usually be bought in foreign currencies only.93
However, at 5.5 rubles for a Big Mac, fries, and Coke, only the higher-income
segment could afford it as this was twice the cost of a meal in state-run outlets.
According to analysts, the company in Russia maintained the profit margins
somewhere around the mid 20 percent range. It was considered to be much higher
than the global average profit margins that the company earned. The same store sales94
were also considered to be higher than in other markets.
In 2007, the prices of the food items in the menu were increased around four times in
the year, in order to maintain the desired profit margins, keeping up with the rising
inflation. However, the percentage increase was different for different items. For
instance, the price of less expensive items like ice-cream cones, was raised at half the
rate of the inflation at that time, whereas for more expensive items, like the Big tasty
burger, the price rise was above the inflation rate.
According to Khasbulatov, despite a 35 percent devaluation of the ruble against the
dollar in late 2008 and early 2009, McDonalds had lowered some prices to gain from
bigger turnover. The companys endeavor was to not increase prices above annual
inflation rates of between 13 percent and 14 percent. However, in mid-2009, the price
of the Big Mac in Russia grew by 13.5 percent to 67 rubles, but it became less
expensive in dollar terms - US$0.5 (19.7 percent).95 Consumers in Russia are really
price sensitive . . . weve been very careful in managing our menu prices,96 said
Khasbulatov.

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

Helen Deresky, International Management: Managing Across Borders and Cultures,


(Pearson Prentice Hall, 2006).
Foster, P, McDonalds Excellent Soviet Venture? Canadian Business, Vol. 64, Issue 5,
May 1991.
Anatoly Vereshchagin, McDonalds Rules Russian Fast Food Market, www.cdi.org,
October 29, 2001.
Rulog had a distribution center in Moscow and was planning to open similar facilities in
St. Petersburg, Kazan, the Urals, and in southern Russia.
McDonalds to Open 40 Restaurants in Russia in 2008, www.cdi.org, April 22, 2008.
Janet Adamy, As Burgers Boom in Russia, McDonalds Touts Discipline,
http://online.wsj.com, October 16, 2007.

McDonalds Russia: A Jewel in the McDonalds Emerging


In 2004, McDonalds sales growth of 18 percent in Russia was the first time that its
sales growth was below 20 percent since the year of its launch, but it still emerged as
McDonalds leading market in comparable sales and total sales growth. 105 By the time
the company celebrated the 15th anniversary of the opening of its first restaurant in
Russia in January 2005, it had served over one billion customers and was serving
more than 500,000 customers every day. According to Mike Roberts, President and
COO, McDonalds, Russia ranked second in the entire McDonalds system for
average guest counts per restaurant. 106 The company was also credited with having
made significant contributions to the development of Russias foodservice and
processing industries, agriculture, and business practices. Customers view
McDonalds as a company that builds in Russia with a pioneer spirit. It is now viewed
as an international brand, run by local people and supplied by local people. Its part of
Russias history,107 said Khasbulatov.
In 2005, McDonalds turnover in Russia grew by 26 percent. According to
Khasbulatov, with a growth rate of more than 20 percent per year, it was comparable
to China. The Russian state backed Russian Bistro that was set up in 1995 to directly
compete with McDonalds too could not match it, and in 2005, the government
transferred the managerial tasks to Arpikom Company, which started leasing the
snack shops out.108
In 2006, the direct investment in the development of the McDonalds chain was more
than 1 billion rubles and the company said that this figure was set to rise in subsequent
years.109 Analysts felt that few of McDonalds markets could boast of more activity
than Russia, which, on an average, served 850,000 diners annually. The figure was
twice the store traffic in McDonald's other markets. In 2007, McDonalds President
Ralph Alvarez commented, Itd be very easy today to go in and say, Khamzat,
youve got to build 100 restaurants, because were getting phenomenal returns. 110
By 2007, McDonalds turnover in Russia was growing 30% annually, and the rate of
growth was the fastest in the world. It was also opening more stores in Russia
annually than any other country with the exception of China. 111 In terms of turnover, it
was among the top ten markets of McDonalds.112 According to analysts, the
companys profit margins in Russia were in the mid-20% range, much higher than the
global average of McDonalds.113

105

106

107
108

109

110

111

112
113

Chris Mercer, McDonalds Plans to Double Russian Presence, www.foodnavigator.com,


February 3, 2005.
McDonalds Celebrates its 15th Anniversary in Russia, www.prnewswire.co.uk, January
31 2005.
McDonalds Russia, Brand Strategy, November 2005.
McDonalds and Burger King Kill Russian Bistro, http://english.pravda.ru, November 9,
2009.
Number of McDonalds Restaurants in Russia to Exceed 200 by End of 2007,
http://eng.investmarket.ru, March 27, 2007.
Janet Adamy, As Burgers Boom in Russia, McDonalds Touts Discipline,
http://online.wsj.com, October 16, 2007.
McDonalds Turnover in Russia Growing 30% Annually, Russia & CIS Business and
Financial Newswire, October 24, 2007.
McDonalds to Open 40 Restaurants in Russia in 2008, www.cdi.org, April 22, 2008.
Janet Adamy, As Burgers Boom in Russia, McDonalds Touts Discipline,
http://online.wsj.com, October 16, 2007.

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.

McDonalds Russia: A Jewel in the McDonalds Emerging

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

Ann Blackman, Moscows Big Mak Attack, www.time.com, February 5, 1990.


Ann Blackman, Moscows Big Mak Attack, www.time.com, February 5, 1990.
McDonalds and Burger King Kill Russian Bistro, http://english.pravda.ru, November 9,
2009.
Helen Deresky, International Management: Managing Across Borders and Cultures,
(Pearson Prentice Hall, 2006).
Janet Adamy, As Burgers Boom in Russia, McDonalds Touts Discipline,
http://online.wsj.com, October 16, 2007.
Youngme Moon, Kerry Herman, McDonalds Russia: Managing a Crisis,
http://harvardbusinessonline.hbsp.harvard.edu, October 21, 2002.
Angela Charlton, Natalya Gracheva is Giving McDonalds Heartburn,
www.mcspotlight.org, June 23, 1999.

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

Explosion Hits McDonalds Restaurant in St. Petersburg; 6 injured, www.iht.com,


February 18, 2007
McDonalds Russia Fights $6.5 mln Tax Claim, www.flex-news-food.com, December 5,
2007.
Shaun Walker, McDonalds Faces 3m Back-tax Bill in Russia, www.independent.co.uk,
December 5, 2007.
Starbucks Corporation was started in 1971, at Seattle, the US. It is regarded as one of the
leading coffee chains in the world. As of 2008, it was present in 43 countries across the
world with 7,087 company operated stores and 4,081 licensed stores.
Vladimir Kozlov, McDonalds Supersize Profits Conquer Moscow, www.mnweekly.ru,
January 25, 2010.
Moscow Wants to Up Rent on its Two McDonalds, www.dailyherald.com, July 10,
2009.
Vladimir Kozlov, McDonalds Supersize Profits Conquer Moscow, www.mnweekly.ru,
January 25, 2010.

McDonalds Russia: A Jewel in the McDonalds Emerging

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.

McDonalds Russia: A Jewel in the McDonalds Emerging


However, he added that Russia would remain one of its most dynamic markets despite
the economic downturn and that McDonalds Russia would continue to be the
companys fastest growing and most profitable market.

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

Month ended November 30


McDonalds Corporation

Year-to- Date November 30


McDonalds Corporation

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

Vladimir Kozlov, McDonalds Supersize Profits Conquer Moscow, www.mnweekly.ru,


January 25, 2010.
Maria Kiselyova and Maria Plis, McDonalds to Target Stay-at-home Russians,
www.reuters.com, December 17, 2009.

McDonalds Russia: A Jewel in the McDonalds Emerging

References and Suggested Readings:


1. Ann Blackman, Moscows Big Mak Attack, www.time.com, February 05, 1990.
2. Foster, P, McDonalds Excellent Soviet Venture? Canadian Business, Vol. 64,
Issue 5, May 1991.
3. Angela Charlton, Natalya Gracheva is Giving McDonalds Heartburn,
www.mcspotlight.org, June 23, 1999.
4. Alf Nucifora, Russians Learn to Smile-for Profit, Business News, September 27,
1999.
5. Natalia Olynec, Big Mac Blues in Russia, Bloomberg News,
www.bellybuttonwindow.com, 1999.
6. Amy Zuber, McDonalds 10th Anniversary in Russia Brings Future Confidence
Despite Struggles, National Restaurant News, http://findarticles.com, February 21,
2000.
7. US Fast Food Firm Expanding in Russia, Interfax, CDi Russia Weekly #136,
www.cdi.org, January 05, 2001.
8. The McDonalds Effect, http://web-japan.org, August 20, 2001.
9. Dmitry Dobrov and Kommersant Vlast
www.russiajournal.com, October 26, 2001.

Food

Industry

1991-2000,

10. Anatoly Vereshchagin, McDonalds Rules Russian Fast Food Market,


www.cdi.org, October 29, 2001.
11. Vladimir Kozlov, Fast-Food Profits Offer Food for Thought,
www.russiajournal.com, November 29, 2001.
12. Daniel Rogers, Can Mac Fight Back? www.marketingmagazine.co.uk, October
17, 2002.
13. Youngme Moon and Kerry Herman, McDonalds Russia: Managing a Crisis,
http://harvardbusinessonline.hbsp.harvard.edu, October 21, 2002.
14. Dmitry Babich, Yulia Ignatyeva Big Mac does not Give Up, Foreign InvestmentCDI Russia Weekly, www.cdi.org, February 26-March 4, 2003.
15. McDonalds Celebrates its 15th Anniversary in Russia, www.prnewswire.co.uk,
January 31, 2005.
16. Chris Mercer, McDonalds Plans to Double Russian Presence,
www.foodnavigator.com, February 3, 2005.
17. Geoffrey Jones, Multinationals and Global Capitalism, (Oxford University Press,
February 2005).
18. Erin E. Arvedlund, McDonalds Gobbles up Russian Real estate, www.iht.com,
March 18, 2005.
19. McDonalds Becoming Largest Corporate
www.organicconsumers.org, March 22, 2005.
20.

Land

Owner

in

Russia,

McDonalds Set for 20% Expansion in Russia, www.sptimes.ru, June 10, 2005.

21. McDonalds Russia, Brand Strategy, November 2005.


22. Tony Royle, The Union Recognition Dispute at McDonalds Moscow FoodProcessing, Industrial Relationship Journal, Blackwell Publishing Ltd., 2005.
23. Helen Deresky, International Management: Managing Across Borders and Cultures,
(Pearson Prentice Hall, 2006).
24. McDonalds Russia Named Best Employer, www.crmcdonalds.com, January 16,
2007.

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,

27. Number of McDonalds Restaurants in Russia to Exceed 200 by End of 2007,


http://eng.investmarket.ru, March 27, 2007.
28. The Taste of Pace: Situating Fast Food Restaurants in Russias Agrifood
System, http://ageconsearch.umn.edu, May 18, 2007.
29. Janet Adamy, As Burgers Boom in Russia, McDonalds Touts Discipline,
http://online.wsj.com, October 16, 2007.
30. Russia Loves the Golden Arches, www.newser.com, October 16, 2007.
31.

McDonalds Russia Fights $6.5 mln Tax Claim, Reuters, www.flex-newsfood.com, December 5, 2007.

32. Vladimir Kvint Russias Surging Economy, www.forbes.com, January 8, 2008.


33. McDonalds to Open 40 Restaurants in Russia in 2008, www.cdi.org, April 22,
2008.
34. Top 10 Consumer Trends in Russia, www.euromonitor.com, May 7, 2008.
35. Yuri Mumchur, Obama in Moscow: True Reset or Just Walking in Circles?
www.russiablog.org, July 8, 2008.
36. Kerry Capell, A Golden Recipe for McDonalds Europe, www.spiegel.de, July
18, 2008.
37. Russian Federation HRI Food Service Sector-2008, www.fas.usda.gov, July 28,
2008.
38. Diane Francis Russia Good for Business: McDonalds,
http://network.nationalpost.com, September 11, 2008.
39. McDonalds Delivers another Month of Strong Global Comparable Sales November Up 7.7%, www.mcdonalds.com, December 8, 2008.
40. The Fast Deteriorating State of Russias Economy, www.economist.com,
December 14, 2008.
41. Crisis Will not Affect McDonalds in Russia, www.realestatelife.org, December
24, 2008.
42. Food & Drinks Industry Day Converting Opportunities to Business: Russian
and Ukrainian, www.bordbia.ie, 2008.
43. McDonalds Corporation, 2008 Annual Report, www.mcdonalds.com.
44. McDonalds to Invest in New Restaurants in Russia, http://bbjonline.hu,
February 26, 2009.
45. Benjamin Scent and Natallie Cai, To Russia with Love, www.thestandard.com.hk,
June 29, 2009.
46. Moscow Wants to Up Rent on its Two McDonalds, www.dailyherald.com, July
10, 2009.
47. Russian Ruble 43 Percent Underestimated, According to Big Mac Index,
http://newsfromrussia.com, July 21, 2009.
48. George Cohon, Founder of McDonalds Canada and McDonalds Russia,
Honored in Washington, D.C., www.marketwire.com, October 6, 2009.
49. McDonalds and Burger King Kill Russian Bistro, http://english.pravda.ru,
November 9, 2009.

360

McDonalds Russia: A Jewel in the McDonalds Emerging


50. Maria Kiselyova and Maria Plis, McDonalds to Target Stay-at-home Russians,
www.reuters.com, December 17, 2009.
51. Jenny Wiggins, Growing Taste for Quality Goods Lures Big Brands,
www.ft.com, January 20, 2010.
52. Burger King Opens First Outlet in Russia, http://abcnews.go.com, January 21, 2010.
53. McDonalds Delivers Another Year of Strong Results in 2009,
www.chainleader.com, January 25, 2010.
54. Vladimir Kozlov, McDonalds Supersize Profits Conquer Moscow,
www.mnweekly.ru, January 25, 2010.
55. McDonalds in Moscow, http://goldenessays.com
56. McDonalds Corporation, www.fortune500news.com.
57.

McDonalds Corporation, Company History, www.answers.com.

58. Eating out in Moscow & St. Petersburg, www.gateway2russia.com.


59. McDonalds History, www.mcdonalds.ca.
60. www.mcdonalds.com
61. www.mcdonalds.ca
62. http://finance.yahoo.com.
63. www.yumbrands.com.

361

Carrefours Misadventure in Russia


The case examines the entry and exit strategies of French retailer Carrefour in the
Russian market. The company opened its first store in Russia in June 2009, after
spending over two years in studying the country's retail markets.
However, within four months, in October 2009, it announced its exit from the market,
citing lack of growth and acquisition opportunities. The case discusses Carrefour's
entry into Russia, its failed acquisition attempts and the factors that forced it to make
a quick exit from the country.
It also examines the business environment in the Russian retailing industry.

Carrefours Misadventure in Russia


In the space of just four months, Russia has gone from a strategic priority to an
afterthought at Carrefour, the giant French retailer.1
- New York Times, in October 2009.
Carrefours pending exit underlines the fact that Russia remains a highly
challenging market despite its fundamental draw. Although MGR (Mass Grocery
Retail) sales are forecast to strengthen by a dynamic 66.4% to RUB 1,423bn (US$
48.53bn) through to 2014, the countrys business environment is among the least
forthcoming in emerging Europe. Despite topping our Q110 food and drink regional
business environment ratings, Russias market risks score (encompassing regulatory
environment and barriers to entry) is the regions second lowest behind Ukraine.2
-

Business Monitor International3, in October 2009.

Carrefour Exits Russia


On October 15, 2009, just four months after opening its first store in Russia, Francebased Carrefour SA (Carrefour), the second largest retailer in the world, announced
that it planned to exit the Russian market. The company announced, Carrefour has
decided to sell its activities in Russia and pull out of the market, given the absence of
sufficient organic-growth prospects and acquisition opportunities in the short- and
medium-term that would have allowed Carrefour to attain a position of leadership.
This decision is consistent with the Groups strategy which aims at building
leadership positions that will ensure strong and lasting profitable growth. 4
Carrefour started the groundwork to enter the Russian market in 2007, looking out for
suitable locations for opening its stores. It opened its first store in the country, a
hypermarket, in June 2009. Its second store was opened soon after. It also procured a
location for its third store, which was to open by the end of the year. However, in a
move that took industry analysts and observers alike by surprise, Carrefour announced
its exit from the country in October 2009.
Analysts opined that Carrefours failure to acquire Russia-based grocery chain
Sedmoi Kontinent5 (Seventh Continent) and shareholders pressure on the company to
focus on its core business were the main reasons for the exit decision. They were of
the view that the bureaucracy, complicated legislative framework, corruption, and red
tape that existed in the country were factors that could have influenced Carrefours
decision to quit Russia. Some of them opined that Carrefour had not given enough
time for its operations to stabilize in the market. Viktoria Sokolova, Senior Analyst at
Troika Dialog6, said the companys strategy was flawed and had come too late. She
1

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

Carrefours Misadventure in Russia


said, Carrefour simply failed with its strategy to enter Russia. There is plenty of
growth opportunities out there. Its nearest competitor, Auchan, has opened its 34th
hypermarket in Russia, and continued its opening program, even during the crisis
times. Carrefour came to Russia a little bit too late, and was talking, perhaps, not to
the best operator in the market, without the distribution reach, to acquire them, as a
means of an entry point.7
Industry analysts, who had observed the Russian market closely, said that Carrefours
exit could affect the entry of other international retailers like Wal-Mart and Tesco,
which had plans to enter the country. According to New York Times, It also indicates
that a good deal of the shine has come off the Russian retail market, in recent years
one of the fastest growing in the world because of trickle-down oil wealth that helped
lead a consumer boom built on decades of pent-up demand from the bleak Soviet
era.8

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

Wal-Mart Stores Inc.

Carrefour SA

Tesco Plc

UK

94,740

Metro AG

Germany

88,189

The Home Depot Inc.

USA

77,349

The Kroger Co.

USA

70,235

Schwarz Unternehmens Treuhand KG

Germany

69,346

Target Corp.

USA

63,367

Costco Wholesale Corp.

USA

63,088

10

Aldi GmbH & Co OHG

Germany

54,847

Source: Deloitte, Global Powers of Retailing, 2009.


* For the fiscal year ended June 2008.
10

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

Carrefours Misadventure in Russia


As of 2008, Carrefour was the second largest retailer in the world and the largest
retailer in Europe (Refer to Exhibit II for the list of global powers of retailing). By the
end of 2008, it was operating 15,430 stores globally. It operated through different
store formats like hypermarkets, supermarkets, convenience stores, hard discount
stores, and cash & carry outlets (Refer to Exhibit III for Carrefours store formats).
Carrefours revenues were at 108.629 billion for the year ending December 2008
(Refer to Exhibit IV for Carrefours country wise sales).

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

South Korea*, Thailand, Hong Kong*

1997

Singapore, Poland

1998

Chile*, Colombia, Indonesia

1999

Czech Republic*, Slovakia*

2000

Japan*, Dominican Republic

2001

Romania, Switzerland**

2002

Egypt

2004

Saudi Arabia

2005

Algeria

2006

Cyprus

2007

Jordan, Kuwait

2008

Bahrain

2009

Iran, Syria, Morocco,


Bulgaria, Russia,

* By 2006, Carrefour had exited from these countries.


**By 2007, Carrefour exited Switzerland.
Compiled from Carrefours Annual Reports and other sources.
367

International Business

Exhibit III

Carrefour Store Formats


FORMAT

DESCRIPTION
Offers a wide range of food and non-food products
Offers about 80,000 items.

Hypermarkets

Floor area of 5,000 square meters to 20,000 meters.


Services like Carrefour travel, Carrefour insurance, Carrefour
bookings
Banner: Carrefour, Atacado
Offers a wide selection of mostly food products
Offers about 10,000 items

Supermarkets

Floor area of 1,000 to 2,000 square meters


Banner: GS, GB, Carrefour Express, Carrefour Market,
Carrefour Bairro
Offers products at low prices.

Hard Discount
Stores

About 800 retail branded food products


Floor Areas of 300 to 800 square meters
Banner: Dia, Ed, minipreco
District or village shops

Convenience
Stores

Products covering all the food requirements


Offers a wide range of services like home delivery and ATMs
Banner: Shopi, Marche Plus, 8 a Huit, DiperDi, Proxi, Carrefour
City, Carrefour Express, Carrefour 5 minut

Cash-andCarry
and
Food Service

Wholesale and retail self-service


Food products for businesses.
Banner: Promocash, Docks, Super Gross.

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

Greece & Cyprus

2,944

888

989

498

Portugal
368

Sales (In Million)

Carrefours Misadventure in Russia

Country

Sales (In Million)

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

Source: Annual Report, Carrefour, 2008.

Carrefours Plans for Russia


In every international market in which Carrefour operated, it essentially focused on
becoming one of the top three players in terms of market share. Commenting on the
criteria for entering new markets, the Chairman of the Management Board of
Carrefour, Jos Luis Duran, said, Well look toward new markets. That means local
acquisitions in countries where we currently operate, but it also includes the
possibility of establishing a presence in new countries, such as Russia and India.
However, any such store openings will have to satisfy three criteria: we must be able
to capture a leading market position within the medium term, establish our brand
quickly, and secure a return on investment. It is only under these conditions that we
will expand our scope of operations. 13
Carrefour initially showed an interest in operating in Russia during the mid-1990s and
opened a representative office in Moscow. It also finalized two prime locations, one in
the center of the city and the other on the outskirts. However, during the 1998
financial crisis14, it exited from the country.
In June 2006, Carrefour again started contemplating an entry into the Russian retail
market. A delegation from Carrefour toured across Russia looking for locations, met
local officials, and interacted with other retailers. After spending considerable time
studying the markets, Carrefour announced its intention of entering the Russian
13
14

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

Carrefours Misadventure in Russia


Table A: Major Retailers in Russia and their Turnover (2008)
RETAILER

TURNOVER (In US$ Billion)

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

Russias Retail Revolution, www.managementtoday.co.uk, June 01, 2008.

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

Carrefours Misadventure in Russia


But before Carrefour could conclude the deal, the owner of Seventh Continent ran into
financial problems. The company defaulted on bond payments in June 2009 and went
in for debt restructuring. Ultimately, Valdimir Gruzdev who controlled a10% equity in
Seventh Continent, decided not to sell the company, citing that the time was not right
to sell well-performing assets.

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.

. And pulls out


In September 2009, a report in Le Monde31 mentioned that Carrefour was under
pressure from top shareholders to pull out of emerging markets. Carrefour, on its part,
denied the report. According to a Reuters report, French retailer Carrefour is
seriously considering exiting Latin America, one of its most lucrative markets, under
pressure from top shareholders, Le Monde newspaper reported. But the board of the
worlds second-biggest retailer has rejected the idea of abandoning all emerging
markets including Asia as this would give the impression the company was being
broken up, the newspaper said.32
However, on October 15, 2009, Carrefour announced that it had decided to close
down its Russian operations. The company cited inadequate growth and acquisition
opportunities as the reasons for its exit. It did not reveal details of total investments in
Russia and said that the losses due to the exit were not significant. Carrefour also said
30

31
32

Carrefour Says Looking at Acquisitions in Russia, www.ibtimes.com, September 10,


2009.
Le Monde is a French newspaper.
Carrefour Mulls Exit from Latin America Le Monde, http://uk.reuters.com, October 07,
2009.

374

Carrefours Misadventure in Russia


that there were no prospects of its being among the top three retailers in the country,
as it had planned.
Carrefour also announced that the stores in Russia would continue to remain open till
the company found a buyer for them, and that it would also open the third one as
planned. This was done in order to cut the costs of exit and also to reduce the penalties
that it could attract for severing the contracts with suppliers and landlords. Carrefour
also looked around for a franchising partner to operate the stores and to develop the
brand in the country.
Industry experts opined that it took retailers several years to establish themselves in
new markets, especially emerging markets like Russia which had high growth
potential. They were surprised that Carrefour did not stay long enough to test the
market. According to them, four months was too short a time to gauge the potential of
the market. They said that Carrefours justification about lack of acquisition and poor
sales targets appeared more like excuses. The exit also made analysts question
Carrefours commitment to countries with high potential, but short-term difficulties
and problems. According to Jaime Vazquez, an analyst at JPMorgan Chase & Co. in
London, Turning around the hypermarkets in a deflationary environment and with a
weak price image is not going to be easy. Stores in emerging markets are the only
ones doing well and offering good growth prospects, so selling them makes no sense
other than making short-term financial gain. 33
Analysts also said that Carrefour had spent more than three years studying and
understanding the market and this time was sufficient to understand the difficulties
associated with the retailing industry in Russia and also about the potential acquisition
targets. As it knew the market well, it was not right for Carrefour to expect positive
results within such a short span of time, that too when Russia was in the midst of
recession, they said. The analysts said Carrefour could have halted expansion and
waited in the market for a few more years before taking a final decision on its
operations in the country.
According to industry observers, Carrefours failure to acquire Seventh Continent was
the main reason for its exit. They said that without Seventh Continent, Carrefour did
not find enough scope to grow in the country, though the market was highly lucrative.
The retail industry in Russia was concentrated mainly around Moscow and St
Petersburg, and in these locations, retailers like X5 and Auchan were firmly
established and the markets were also oversaturated. With the retail space in limited
supply, it was not possible to establish a significant presence in these markets without
acquisitions (Refer to Exhibit VI for major retailers in Moscow and St Petersburg).
In spite of its high growth potential, there were several obstacles which international
retail companies had to face in the Russian retailing industry. A complicated
legislative framework, bureaucracy, along with corruption hampered the operations of
several companies in Russia. Analysts said red tape, poor economic conditions, etc.
could have influenced Carrefours decision to exit the market.
Carrefour was also caught up in bureaucratic hassles as its first store in Moscow could
not get a license to sell alcohol, which cost it almost 15% of the stores revenues.
Legislation in Russia that aimed at increasing the competition in the country 34 was
also cited as one of the main reasons for Carrefours plan to exit.
33

34

Ladka Bauerova, Carrefour Replaces Head of French Superstores, Exits Russia,


www.bloomberg.com, October 15, 2009.
The new retail trade law in Russia was passed in December 2009. According to the law, the
government can impose price ceilings on specific products (whose prices have grown by
30% in a span of 30 days) for a specific timeframe (not more than 90 days). Limitations were

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

Cash & Carry

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

Cash & Carry

11

Real

Real

Hypermarket

Alye Parusa

Alye Parusa

Supermarket

16

ABC of Taste

ABC of Taste

Supermarket

25

Sellgross

Sellgross

Cash & Carry

Spar

Spar

Supermarket

Seventh
Continent

Nash Hypermarket

Hypermarket

Seventh Continent

Corner Shop

30

Seventh Continent

Supermarket

54

Seventh Continent 5 Stars

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

Carrefours Misadventure in Russia


Due to volatile economic conditions in the Russian market, acquiring a Russian
retailing company also proved to be a tough task for Carrefour. Though due to the
global financial crisis35, the share prices of Russian retailers were down making them
an ideal target for acquisition, the lack of credit to the retailers for carrying out the
acquisitions and the high debt burden of the local retailers, proved to be unattractive
for Carrefour. The acquisitions were also priced high. For example, X5 with a share of
4% in the food retail market in Russia was valued at US$ 7 billion. According to
Datamonitor, Facing these challenges, Carrefour has probably made the right call in
making an early withdrawal from the market. A dire macroeconomic environment and
the strength of domestic discounters in the current climate make breaking into Russia
organically a significant challenge. Furthermore, the difficulties in acquiring a local
player and other market hindrances would have made Carrefours quest to gain scale
and leadership in the country a costly uphill struggle.36
There were also reports that the company was under pressure from key shareholders
like Colony Capital LLC37 and Bernard Arnault38, a French investor and Chairman of
LVMH, who insisted that Carrefour concentrate on its French operations and exit
from the emerging markets including China and Latin America after its global sales
dropped by 2.9% in the third quarter ending September 2009 to 24 billion. Reports
in Le Monde suggested that the top investors were insisting on Carrefour exiting
China and Brazil too, in order to regain their investment, after Carrefour lost 30% of
its market value between March 2007 and September 2009.
However, at the same time, other retailers in Russia were performing well. The X5
Retail Group reported that its profits had grown by 38% between January and
September 2009, as compared to the corresponding period the previous year. The
store count in 2009 was expected to increase by 25%. The net revenues of another
leading retailer Magnit increased by 31% in the first nine months of 2009. As of
September 2009, it had 2981 stores in operation.
Many analysts opined that the withdrawal from Russia meant that Carrefour remained
committed to its goal of attaining a leadership position in the markets in which it
operated and exiting the countries where it did not find the opportunity to be among
the top retailers in a span of few years.
Earlier, in 2005, Carrefour had exited from four countries namely, Japan, Mexico, the
Czech Republic, and Slovakia, where it failed to make a mark, and decided to focus
on Eastern Europe and Latin America. Analysts pointed out that as far as the Russian
market was concerned, it had realized soon that there were not enough opportunities
for it to become the top player in the country. According to Pierre Bouchut, Chief
Financial Officer, Carrefour Group, It is precisely because we are adopting a longterm stance that we are exiting from Russia.39 Carrefour, however, maintained that it
would remain committed to its expansion plans in other emerging markets where it
already had a significant presence.

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

Suggested Readings and References:


1. Carrefour to Approach from Regions, www.kommersant.com, November 09, 2006.
2. Carrefour or Perekrestok What will Russians Prefer? www.freshplaza.com,
January 11, 2007.
3. Russias Retail Revolution, www.managementtoday.co.uk, June 01, 2008.
4. Carrefour Starts the Investment Programme in Krasnodar Region (South
Russia), www.carrefour.com, September 22, 2008.
5. Jess Halliday, Russian Regions Present New Possibilities for Food Firms,
www.foodnavigator.com, October 21, 2008.
6. Carrefour to Open at Least Three Russian Stores in 2009, www.reuters.com,
April 15, 2009.
7. Javier Espinoza, Carrefour Flirts with Seventh Continent, www.forbes.com, April
20, 2009.
8. Carrefour Looks East to Russia, Checkout, April 2009.
9. Javier Espinoza, Carrefour Wants a Piece of Russia, www.forbes.com, May 05,
2009.
10. Javier Espinoza, Carrefour May be Moving to Russia Soon, www.forbes.com, May
05, 2009.
11. Lionel Laurent, Carrefour's Mission to Moscow, May 29, 2009.
12. Carrefour Starts Business Operations in Russia and Moves Forward with its
International Expansion, Press Release, Groupe Carrefour, June 18, 2009.
13. Javier Espionoza, Carrefour May be Stumbling with Russian Dreams,
www.forbes.com, June 18, 2009.
14. Carrefour Opens First Russian Store, www.russianamericanchamber.com, June 19,
2009.
15. Carrefour Opens up in Moscow for the Longer Term, http://rt.com, June 19, 2009.
16. Maria Antonova, Carrefour Opens First Russian Store, www.straightstocks.com,
June 19 2009.
17. Carrefour Says Looking at Acquisitions in Russia, www.ibtimes.com, September
10, 2009.
18. Carrefour Mulls Exit from Latin America Le Monde, http://uk.reuters.com,
October 07, 2009.
19. Carrefour Says Looking at Acquisitions in Russia, www.reuters.com, October 09,
2009.
20. French Hypermarket Chain Carrefour Leaves Russian Market, http://en.rian.ru,
October 15, 2009.
21. Ladka Bauerova, Carrefour Replaces Head of French Superstores, Exits Russia,
www.bloomberg.com, October 15, 2009.
22. Carrefour to Exit Russia, Hit by Challenging Markets, www.reuters.com, October
15, 2009.
23. Scheherazade Daneshkhu, Jonathan Birchill Carrefour Beats Hasty Russian
Retreat, www.ft.com, October 15, 2009.
24. French Hypermarket Chain Carrefour Leaves Russian Market, http://en.rian.ru,
October 15, 2009.

378

Carrefours Misadventure in Russia


25. Lionel Laurent, Robin Paxton, Carrefour to Exit Russia, Hit by Challenging
Markets, www.reuters.com, October 15, 2009.
26. Ladka Bauerova, Carrefour Replaces Head of French Superstores, Exits Russia,
www.bloomberg.com, October 15, 2009.
27. Matthew Saltmarsh, Andrew E. Kramer, French Retailer to Close Its Russia Stores,
www.nytimes.com, October 16, 2009.
28. Carrefour to Quit Russia, http://store.businessmonitor.com, October 16, 2009.
29. Carrefour Reports Challenging Q3, Exits Russia, www.igd.com, October 16,
2009.
30. Carrefour Abandons Russia, www.fis.com, October 16, 2009.
31. Carrefour to Quit Russia, ehttp://store.businessmonitor.com, October 16, 2009.
32. Retail Market Fight too Tough for Carrefour, http://rt.com, October 16, 2009.
33. Carrefour to Exit Russia, Hit by Challenging Markets, www.reuters.com, October
16, 2009.
34. Jennifer Creevy, Carrefour to Pull out of Russia, www.retail-week.com, October
16, 2009.
35. Retail Market Fight too Tough for Carrefour, http://rt.com, October 17, 2009.
36. Carrefour: Abandoning Russia, Datamonitor, October 19, 2009.
37. Carrefour Turns its Back on Russias Promise Fast, www.worldfinance.com,
October 19, 2009.
38. Carrefour to Keep Operating in Russia Until Selloff Complete, http://en.rian.ru,
October 19, 2009.
39. Maria Antonova, Carrefour to Leave Russia 4 Months after Opening, The St.
Petersburg Times, October 20, 2009.
40. Jason Bush, Russia's Foreign Investment Revival? www.forbes.com, October 20,
2009.
41. Greg Hodge, Carrefours Retreat from Russia a Mysterious Move, www.retailweek.com, October 23, 2009.
42. Carrefour Abandons Russian Food Retail Market, www.stat-usa.gov, November
03, 2009.
43. Tim Gosling, Russian Supermarket Chains - Seats Reserved at the Top Table,
http://businessneweurope.eu, November 3, 2009.
44. Deloitte Global Powers of Retailing, 2009.
45. Carrefour Annual Reports, 2005-09.
46. www.carrefour.com.

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
-

JB McNeil, vice-president, ExxonMobil Development Company in 2008.

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

Sakhalin 1- A New Frontier,


http://www.exxonmobil.com/Corporate/Files/Corporate/SakhalinEnglish_Intro.pdf.
Based in Irving, Texas, ExxonMobil Corporation is one of the worlds largest oil & gas
companies. It is involved in the exploration, production, transportation, and sale of crude oil
and natural gas. The company markets fuels and lubricants under three brands Esso,
Exxon and Mobil. For the year ended 2008, the companys revenues were US$ 477.35
billion.
Prior to 1991, Russia was the largest republic in the Soviet Union (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 the Ukraine and
Belarus formed the Commonwealth of Independent States which was later joined by other
Soviet republics.
The IPTC Excellence in Project Integration Award recognizes companies which
successfully execute multi billion oil and gas industry projects. The International Petroleum
Technology Conference (IPTC) is an international oil & gas conference and exhibition. IPTC
addresses key challenges and issues plaguing industry specialists in the gas sector world
over. The third edition of the IPTC was held from 3-5 December 2008 at the Kuala Lumpur
Convention Center and was hosted by PETRONAS, the national petroleum corporation of
Malaysia. About 7,568 participants from 57 countries attended the event.
Sakhalin-1 Project Receives Award for Excellence from International Petroleum
Technology Conference, www.sakhalin1.com, December 3, 2008.

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Sakhalin-1 Project: Delivering Excellence in Project Execution


reserves of the fields are estimated to be about 307 million tons (2.3 billion barrels) of
oil and 485 billion cubic meters (17.1 trillion cubic feet) of natural gas. The project is
operated by Exxon Neftegas Limited 6 (ENL), a subsidiary of ExxonMobil, on behalf
of an international consortium comprising Russian, Indian, Japanese, and US oil and
gas companies. The project was declared commercial in October 2001, and the
development of oil and gas from the fields began in 2005.
In the first phase of development of the project, oil was produced from the Chayvo
field using both onshore and offshore facilities. These facilities included the
construction of one of the worlds largest land-based drilling rigs, an offshore drilling
platform, an onshore oil and gas processing facility, a crude oil pipeline, and an oil
export terminal. Initially, the project produced up to 50,000 barrels of oil and 60
million cubic feet of natural gas per day. The oil was exported to the Asian markets
whereas the natural gas was supplied to domestic customers in the Khabarovsk Krai7
region. The subsequent phases were to involve development of oil and natural gas
from the Odoptu and Arkutun-Dagi fields. In 2008, the development of the Sakhalin-1
Project was put on hold for about two months as it awaited budget approval from the
Russian government for the years 2008 and 2009. After the budget was approved by
the Russian Energy Ministry in April 2009, the project resumed with the development
of the second phase of the project.
According to experts, the multi-billion dollar Sakhalin-1 Project was one of the largest
foreign investment projects in Russia. The investment was expected to reach US$ 12
billion over the life period of the project. In addition to oil and gas development, the
project was expected to bring in significant economic as well as social benefits to the
Russian community. Economic benefits included improved transportation and medical
facilities and other infrastructure developments. Besides generating revenues to the
government, the contracts awarded to Russian companies as part of the development
of the project were estimated to be more than US$ 3.2 billion. More than 13,000 jobs
were created for Russian nationals during the initial development of the project.
Experts opined that though the project brought in significant benefits, it was replete
with challenges. The project had to deal with multiple problems including a harsh subArctic climate, a remote location with minimum infrastructure, logistic problems,
limited availability of skilled labor, and a complex regulatory system. Despite these
challenges, it was successful in completing the initial development phase and was
reportedly prepared to address the future challenges too. Experts were of the view that
with global energy demand expected to increase by almost 50% by 2030, the
Sakhalin-1 Project would become a vital link in the global energy supply and in
meeting the worldwide energy demand. Talking about the benefits of the project,
Steve Terni (Terni), president of ENL, said, Working together, Russians, Americans,
and our international partners have overcome great challenges to accomplish what
many previously doubted was even possible. Forty years from now, Sakhalin-1 is
expected to still be reaping benefits for Russia, the Asia-Pacific, and an energy hungry
world. Equally important, it has created opportunities for people to enjoy a better
quality of life. With support from the Russian local, regional, and federal
governments, the Sakhalin-1 consortium will continue to work to make this people
achievement even greater.8
6

Exxon Neftegas Limited (ENL) is a subsidiary of ExxonMobil Corporation. It is the operator


of the Sakhalin-1 Project and holds an interest of 30% in the project.
Khabarovsk Krai is a Russian federation located in the Russian Far East along the coastline
of the Sea of Okhotsk.
The administrative center of the Krai is the city of Khabarovsk.
Sakhalin 1- A New Frontier,
http://www.exxonmobil.com/Corporate/Files/Corporate/SakhalinEnglish_Intro.pdf.

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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

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Sakhalin-1 Project: Delivering Excellence in Project Execution


Sakhalin Island. The government along with the local Sakhalin Oblast
administration14 divided the Sakhalin continental shelf into six blocks and named
them Sakhalin 1-6 (Refer to Exhibit I for a snapshot of the Sakhalin blocks). The
contracts for developing the oil reserves in each of these blocks were allocated to
various consortiums comprising foreign as well as Russian multinational oil
companies. Besides the six blocks, the government planned to develop three more
blocks on the Sakhalin continental shelf. The new blocks which were yet to be
awarded would be called Sakhalin 79. As of 2008, all the six Sakhalin projects were
in different stages of development. Of the six blocks, Sakhalin-1 and Sakhalin-2 were
the front-runners as the oil and gas produced from these regions was expected to meet
a significant percentage of energy demands in the Asian continent.
The Sakhalin-1 Project area comprised the Chayvo, Odoptu, and Arkutun Dagi fields.
These fields were estimated to contain 2.3 billion barrels of oil (307 million tons) and
17 trillion cubic feet of gas (485 billion cubic meters). Initially the contract to develop
the Sakhalin-1 oil fields was awarded to a consortium comprising US, Russian, and
Japanese oil and gas companies. ENL and SODECO held a 30% interest each in the
project. The other investors were Russian oil companies Sakhakinmorteneftegas
(23%), and RosneftSakahalin (17%). In 2001, the ownership pattern changed as
Indian oil and gas company ONGC Videsh Limited15 joined the Sakhalin-1
consortium with a stake of 20% while the subsidiaries of Russian oil company
Rosneft, Sakhalinmorneftegas-Shelf, and RN-Astra had an 11.5% and 8.5% stake in
the project respectively. The responsibility of the consortium was to manage the
construction of the projects oil and gas extraction and transportation facilities. Capital
investment over the life of the project was estimated to reach US$ 12 billion, making
it one of the largest foreign direct investments in Russia.

Exploration and Project Documentation


In late 1993, the five-member consortium signed a Memorandum of Understanding
with the Russian government to formulate the Sakhalin-1 production-sharing
agreement16 (PSA).The PSA, considered as the governing document for the Sakhalin1 Project, required about two years to negotiate. Finally in October 1996, the PSA
was approved and executed. It established a clear set of guidelines related to the
operational, financial, and administrative aspects of the project. Under the PSA, the
Russian government was to retain ownership of the oil and gas resources in the state
while the consortium would invest the capital required to develop the fields.

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.

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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

KaiganskoVasyukansk (KV), E. Schmidt

Pogranichny

Oil Reserve
Estimate

975 million
bbl*

1.0-1.2 billion
bbl

4-5 billion bbl

880 million
bbl.

E. Schmidt -2.98
bill. bbls). K-V 8.5 billion bbls

600 million bbl

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-1 Project: Delivering Excellence in Project Execution

Sakhalin I

Current & Expected


Production Level

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.

* bbl stands for barrels


**tcf stands for trillions of cubic feet
Source: www.eoearth.org/article/Energy_profile_of_Sakhalin_Island,_Russia

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Sakhalin-1 Project: Delivering Excellence in Project Execution


The Russian government was to receive a proportion of revenues from production as
the project progressed. As per the PSA, the oil derived from the Sakhalin shelf would
be shipped to Asia and other markets while the natural gas would be sold exclusively
in the domestic market. The PSA stipulated that all the members of the
consortium would proportionally share income from the sale of oil and natural gas
generated from the project.
Upon the execution of the PSA in 1996, a five-year exploration period began. A
commercial development plan for the Sakhalin-1 Project was also formulated during
this period. The exploration period involved delineation of the three oil fields,
assessment of hydrocarbon volumes in the region, and identification of the best
resource location from where oil could be developed. As part of the exploration
process, seven appraisal wells17 were drilled and three-dimensional seismic data was
collected covering more than 1,200 square kilometers area. ENL used advanced 3D
seismic technology18 to map the Sakhalin-1 fields. With continuous 3D surveys and
evaluation drilling, the consortium discovered crude oil on the western flank of the
Chayvo field. This was a major discovery for the project to proceed further.
Finally, in September 2000, the exploration period ended with the demarcation of the
Chayvo 6 well which confirmed the presence of a 150-meter oil column in the Chayvo
reservoir. Talking about the discovery of oil reservoirs in the Chayvo field, Richard
Powell (Powell), ExxonMobils Geoscience project manager for the Caspian, Russia,
and the Middle-East, said, We now had found what could be a 150 million-metric ton
(1 billion barrel) oil development that was previously unknown. This became the
centerpiece to the dining room table we had been searching for. But in the end, it
really was about more than just new technology. It truly came down to the teams
creativity, innovation, and determination to find and deliver that first step for Sakhalin
1.19
After successfully completing the exploration period, the Sakhalin-1 consortium
declared the project commercial on October 29, 2001. It was approved by the Russian
Federation on December 3, 2001. The declaration formally ended the exploratory
phase and marked the commencement of the 20-year development period of the
project. The project was subjected to over one hundred agency inspections and audits
to ensure that it complied with Russian regulatory and project documentation
procedures. In July 2002, the project was given the green signal by the State
Ecological Expert Review20 (SEER) for use of Extended Reach Drilling 21 (ERD)
technology to drill wells in the region. In October 2002, the technical expertise bureau
17

18

19
20

21

Appraisal wells are drilled to assess characteristics of a hydrocarbon source accumulated in


a reservoir
3D seismic technology constructs models of underground rock formations based on threedimensional models. Earlier, 2D models were used but they were difficult to read. 3D
techniques significantly reduced the number of dry holes drilled, thereby increasing the
number of productive wells.
The Quest Begins, www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish4.pdf.
The State Environmental Expert Review (SEER) is an independent body which assessed
Sakhalin-1 Projects design, waste management, and water protection measures, disaster
management, economic and social impact as well as the measures taken by the project to
protect marine and land biological resources.
Extended Reach Drilling (ERD) is an evolved form of simple directional drilling and
employs both directional and horizontal drilling techniques. It is defined as a type of
directional drilling in which the horizontal well departure is at least twice that of its total
vertical depth-to-deviation (TVD). ERD is cost effective as it does not require installation of
additional offshore facilities or pipelines. Production from ERD wells which run through
long distance reserves is much greater than output from conventional wells.

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

Justification of Investment (JOI) is a document that addresses the feasibility of a proposed


project. It analyzes the returns from an Investment by demonstrating the proposed projects
goals and capabilities.
Authorized State Body (ASB) is a constituent of the Russian Industry and Energy Ministry.
It is the governing authority of the Sakhalin 1 Project and oversees the implementation of the
PSA on behalf of the Russian Federation. It includes representatives of the Federal
Ministries of Economic Development and Trade, Taxes and Levies and Energy, and the
Sakhalin Oblast Administration.
The Development Program and Budget (DP&B) is a strategic plan which provides cost
estimates of activities related to the oil and gas development production in the Sakhalin
region. It also lists the benefits the project would bring to Russia and provides details of
environmental protection measures undertaken as part of the project.
Exxonmobil Announces Production Start-Up from Sakhalin-1 Project in Russia,
www.sakhalin1.com, October 2, 2005.

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Sakhalin-1 Project: Delivering Excellence in Project Execution

Exhibit II
List of Contracts Awarded for Sakhalin-1 Project
Contract Project
Area

Scope of Work

Contractor

DeKastri

Material Supply, Transportation


and General Services at DeKastri

ACCESS - Amur
Services Co., LLC.

Orlan, Chayvo,
DeKastri, Yuzhno

General Maintenance and


Mechanical Services for
Production Facilities

ECC-VECO, LLC.

Orlan, Chayvo,
DeKastri, Nogliki,
Odoptu, Yuzhno

General Instrument, Control &


Automation, Electrical,
Telecommunication Maintenance
and Construction Services

OOO Kentech
Sakhalin Technical
Services

Orlan, Chayvo,
DeKastri, Nogliki,
Odoptu, Yuzhno

General Engineering and


Procurement Services for
Sakhalin-1 Facilities

OOO Sakhalin
Technical Services
Network

Chayvo

Fleet Management, Fuel Depot


and General Services at Chayvo

Pacific Rim
Constructors

Orlan, Chayvo,
DeKastri, Nogliki,
Yuzhno

Camp Management and Catering


Services at various Sakhalin-1
sites

Remote Project
Services Group
Global, LLC.

Orlan, Chayvo,
DeKastri, Nogliki,
Odoptu, Yuzhno

Misc. Personal Protective


Equipment

ZAO Vostok-Service
Sakhalin

Kholmsk, Korsakov

Shorebase Services (facility,


manpower, equipment)

Sakhalin Shelf
Services

*Data as of 2007
Source: www.sakhalin1.com/en/contracting/opportunities.asp

Phase I - Development of Chayvo Field


The first phase of the Sakhalin 1 Project focused on oil and limited natural gas
production from the Chayvo field. The development costs of this phase were expected
to be about US$ 4 billion. The initial phase was expected to produce 50,000 barrels
(6,300 metric tons) of oil per day by the end of 2005. By 2006, the production was
expected to reach 250,000 barrels (33,000 metric tons) of oil per day. The
development of oil from the initial phase of the Sakhalin-1 Project began on October
2, 2005. The time period of Phase I of the Project was about five years.
The harsh Arctic weather and the remote location of Sakhalin Island presented
significant challenges for the execution of the initial phase. Experts opined that the
development of infrastructure amidst such climatic conditions was a herculean task.
However ENL, which had developed some of the major oil fields in the world, was
able to overcome these barriers. Despite the adverse climatic conditions, phase I of the

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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.

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Sakhalin-1 Project: Delivering Excellence in Project Execution

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.

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CIDS platform was towed to Russia using three super-class tugs. The renovation of
the platform was completed in 2004 after which it was taken to Ulsan, South Korea,
where top side modules weighing nearly 12,000 metric tons and a fully automated
drilling rig were installed. After installation of the support equipment, the platform
was tugged to Russia and was ready for offshore drilling. Talking about the advantage
of the platform, Plugge said, A major advantage of the gravity-based platform is that
its self contained. Crews can live onboard and get the platform ready for drilling
while its still in the shipyard. Then, when you are ready, you essentially just deballast
and go offshore.41 The Orlan drilled its first extended reach well in December 2005.
A total of 18 extended wells were drilled using the Orlan offshore drilling platform.

Onshore Processing Facility


In order to separate the oil and gas produced from the drilling operations, an onshore
processing facility (OPF) was installed at the Chayvo field. The OPF was designed to
process up to 34,000 metric tons (250,000 barrels) of oil and 23 million cubic meters
(800 million cubic feet) of gas per day from the Chayvo field.42 An off-site modular
construction approach was followed to build the OPF instead of a stick build
approach. Talking about the importance of the facility, the project manager of
Sakhalin-1, Jim Flood (Flood), said, Its truly the heartbeat of this project. All of the
pieces of the project were ancillary to some extent to the successful completion of the
OPF. Any delays in the OPF construction and start-up would greatly impact the
overall economics of the project. Yet with a scheduled construction cycle of only 36
months and the major limitations on the productivity due to the highly remote subArctic location, we were not confident that a conventional stick-build approach would
get the job done in time.43
The construction of the OPF began in 2003 and the contract to design the facility was
awarded to Fluor Corporation44. The modules of the OPF were fabricated at the
Hyundai Heavy Industry yards in Ulsan, South Korea. The platform contained 36
modules weighing 40,000 tons. The heavy modules were unloaded at Sakhalin
through two sea lifts and moved to the OPF site through the Chayvo Bay Bridge45.
The offsite construction of the OPF helped the project in saving 18 months of time
and more than US$300 million in cost. Our execution strategy for the OPF included
using 36 pre-assembled and pre-commissioned modules for a majority of the plant
facilities. This helped offset the productivity impacts of working in a remote Arctic
environment with a short construction window, 46 said Flood.
Until the OPF became fully operational, the project team decided to install an interim
processing facility (IPF) in order to process the crude oil obtained as a result of
drilling at Yastreb and Orlan. In 2004, an IPF comprising 60 modules was built in the
41

42

43

44

45

46

The Hawk and the Sea Eagle,


www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish5.pdf.
From Design to Loading Tankers in 34 Months,
www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish6.pdf.
From Design to Loading Tankers in 24 Months,
ww.exxonmobil.com/Corporate/Files/.../SakhalinEnglish6.pdf.
Fluor Corporation is a US-based engineering, construction, and maintenance services
company.
The Chayvo Bay bridge, completed in 2003, links the Chayvo well site with the OPF. Built
by Dalmostostroi, a Khabarovsk Krai construction company, the bridge is 830 meters (2,700
feet) long.
ExxonMobil-40 Years of Arctic,
www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish3.pdf.

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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.

Oil Export System


The oil export system of the Sakhalin-1 Project included a pipeline which was of 24
inch diameter and about 225 kilometers long, valve stations, an oil export terminal, a
single point mooring (SPM) facility, and oil tankers.
From the OPF, the pipeline transported oil across the western Sakhalin Island and the
Tatar Strait47 to an oil export terminal located at De Kastri in the Khabarovsk Krai
region. The construction of the pipeline began in 2004. The design and location of
each pipeline was approved in advance by the Russian environmental protection
agencies and the construction was carried out during winters when the streams were
frozen to reduce possible impacts on the marine life. Adequate measures were taken to
ensure the safety of endangered species during construction of the pipeline. For
instance, on discovering a nest of an Orlan sea eagle during construction, the project
team rerouted the pipeline. The project operators installed eight remotely operated
valve stations to shut down the pipeline in case of a leak or any emergency. To
facilitate communications across the entire pipeline route, the team installed a fiber
optic cable along the length of the pipeline and a microwave tower on each side of the
Tatar Strait. The pipeline could transport approximately 250 thousand barrels of oil
per day (12 million tons of oil a year).
The construction of the oil export terminal at De Kastri began in December 2003. A
Russian construction company JST Trust Koksokhimmontazh (KXM) designed,
manufactured, and built two 100,000 cubic meter (650,000 barrel) storage tanks for
the De Kastri oil terminal. By June 2006, the oil terminal became operational. The De
Kastri oil export terminal had oil storage facilities and a single point mooring (SPM)
tanker loading facility to load crude oil onto tankers for export to world markets. The
SPM facility located 5.7 kilometers offshore was fully automated with a conical base
built to withstand heavy loads. It weighed 3,200 tons and was 210 feet above sea
level. The facility was installed by J. Ray McDermott, a US-based supplier of offshore
field development products. The oil was transferred from the oil terminal through a
subsea loading line to the SPM facility. The SPM, considered as the worlds largest
fixed tower, allowed emergency shutdown and released tankers during unfavorable
weather conditions. It was considered as the safest, most environmentally sound, and
cost-effective method of tanker loading in an Arctic environment as it eliminated the
need for a jetty48 for tankers.

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.

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additional needed energy supplies to the expanding economies of Asia and to other
global customers. This project is another example of a long-lead time, technology
intensive development brought to fruition this past year to help address the
world's ever-growing energy demand,49 said Stuart McGill, senior vice
president of ExxonMobil.
On August 29, 2006, SPM received the Sokhol crude oil from the De Kastri terminal
for loading onto tankers. On September 30, 2006, the first tanker loading of the crude
oil started. Aframax class tankers50 were supplied to the project by Russias Primorsk
Shipping Corporation (PRISCO)51. Each tanker carried up to 720,000 barrels (100,000
tons) of crude. According to Les Carter, sub-project manager at DeKastri terminal,
Our pumps at the terminal are designed to move 6,100 metric tons (45,000 barrels) of
oil an hour into the subsea loading line, through the SPM, and onto the tankers. With
the loading operations gradually ramped up to full project capacity, tankers began
departing De-Kastri on average every three to four days in early 2007.52
In the first quarter of 2007, the Sakhalin-1 Project achieved its production goal as it
reached production rate of 34,000 metric tons (250,000 barrels) of oil per day. The oil
was supplied to refineries throughout the Asia-Pacific region while the natural gas
was supplied to domestic consumers in the Khabarovsk Krai region. In December
2007, the Sakhalin-1 Project achieved a production milestone of 100 million barrels of
crude oil from the Chayvo field. Commenting on the achievement, Stuart McGill,
Senior Vice President of ExxonMobil, said, ExxonMobil, through the operatorship of
Exxon Neftegas Limited, is pleased that the Sakhalin-1 Consortium achieved its
production goal for peak crude oil operations in a timely manner. Achieving this
production milestone is a significant example of how the energy industry and
exporting nations can work together to provide needed energy supplies to global
markets.53
The domestic sales of natural gas began in 2005 and totaled 575 million cubic meters
(20.3 billion cubic feet) in 2006. Experts opined that the supply of natural gas from
the Sakhalin-1 Project to customers in the Khabarovsk Krai was a significant step in
the Russian Far East Gasification Program54. By February 2007, the natural gas supply
to the Khabarovsk Krai region had reached 35 billion cubic feet (one billion cubic
meters). In 2007, the average gas supplies to Khabarovsk Krai were 115 million cubic
feet (3.27 million cubic meters) per day.
In January 2008, local natural gas sales were above 200 million cubic feet/day (5.85
million cubic meters) per day. 55 As of August 2008, domestic gas sales totaled 105
billion cubic feet (3 billion cubic meters). According to experts, the gas supply from
the Sakhalin- 1 Project was expected to fulfill the demand in the Khabarovsk Krai
region until 2025. According to governor of Khaborovsk Krai Viktor Ishaev, This
gas has helped bring fuel stability to our region and represents a major step in support
49

50
51

52

53
54

55

ExxonMobil Announces Start of Sakhalin-1 Exports; Newest Milestone in


Company's Effort to..., www.allbusiness.com, September 7, 2006.
Aframax tankers are small oil tankers which carry oil through narrow harbors and canals.
Primorsk Shipping Corporation (PRISCO) is a Russian shipping company involved in the
transportation of various oil and liquid cargos.
From Design to Loading Tankers in 24 Months,
ww.exxonmobil.com/Corporate/Files/.../SakhalinEnglish6.pdf.
Sakhalin-1 Project Production Goal Achieved, www.sakhalin1.com, February 14, 2007.
The gasification of Russian regions was started in 2001 by state-owned oil company,
Gazprom. As part of the program, Gazprom finances construction of gas pipelines and
ensures gas supply for regional consumers.
http://www.sakhalin1.com/en/project/marketing.asp.

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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

To Full Production and Beyond,


www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish7.pdf.
http://www.sakhalin1.com/en/news/project/pnw_03152002_lamp.asp.
www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish3.pdf.

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Russian suppliers for contracts and procurement. It was reported that over the life of
the project, the Russian state would receive more than RUB59 1.250 trillion (US$50
billion) as taxes, royalties, and the states share of hydrocarbons from the Sakhalin-1
Project. As of August 2008, the Russian government had received approximately US$
1.1 billion (RUB 28 billion) in royalties and the states share of oil production. Since
the inception of the project, the Sakhalin Oblast administration received RUB 5.3
billion (US$ 211 million) in revenues.
The Sakhalin-1 Project also brought significant benefits to the people of Russia,
particularly to those in the Sakhalin region. In 2005, the project employed
approximately 8,000 workers, including direct employees and contractors. Nearly 500
Russians worked directly for ENL. To enhance their skills, many of them received
professional training in Russia, the US, and Canada. The value of these training
programs was estimated to be about US$ 12 million. For instance, a workshop at the
Sakhalin-Alaska College helped 60 Sakhalin welders to improve their professional
skills and obtain international certificates. According to ENL, More than 13,000 direct
and indirect jobs would be created for Russian nationals as part of the initial
development of the project. It was expected that the number of Russian nationals
working on the project would reach 90% within 10 years. (Refer to Exhibit IV for
some of the achievements of the Sakhalin-1 Project).

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

Denise Allen Zwicker, Multi-national Project to Represent Record Foreign Investment in


Russia, http://www.sakhalin1.com, 2002.

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Sakhalin-1 Project: Delivering Excellence in Project Execution

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.
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Sakhalin-1 Project: Delivering Excellence in Project Execution


Another noteworthy initiative launched by the Sakhalin-1 Project was a regional small
business development program launched in 2004 in the northern Sakhalin districts of
Nogliki and Okha in association with USAID.61 The program launched with an
investment of US$ 500,000, created about 180 small businesses and more than 500
local jobs in the region. It provided financial support to small business units which
were unable to obtain commercial bank loans. The project also contributed about US$
100 million to the Sakhalin Development Fund over a five-year period (2003-2008)
and offered production bonuses of about US$ 60 million.

Safety and Environment


Besides offering multiple benefits to Russia, the project paid attention to operational,
environmental, and safety performance. The Sakhalin-1 project ensured the safety of
people, the environment, and the local community through effective application of the
safety system and tools. With support from the consortium and the Russian
government, the project applied best safety and environmental practices in a phased
development approach. The lost-time incident62 (LTI) rate reported by the project was
significantly better than the average for the worldwide oil and gas construction
industry. From the first quarter of 2005 to January 2006, the project operated for 26
million work hours without an LTI. By the end of 2006, the projects LTI rate was
nine times better than the worldwide oil and gas construction industry average. The
total recordable injury index of the Sakhalin-1 Project was 0.21, three times better
than the index of 0.59 for all projects operated globally by ExxonMobil. When you
take into account a multinational workforce operating in a harsh sub-Arctic
environment and amassing more than 75 million work hours since the start-up of
drilling and construction activity in 2003, this was an incredible accomplishment.
Making these safety records even more impressive was the fact that the workers
achieved them while keeping the project moving ahead on schedule,63said Tim
Murphy, lead safety advisor of Sakhalin 1 Project.
One of the primary reasons for the safety success of the project was an ExxonMobil
business plan called the Operations Integrity Management Systems (OIMS). The
Sakhalin-1 Project fully adopted and implemented the OIMS. Jim Reisz, the OIMS
safety manager, described the OIMS as defining everything we do and how we do it.
It takes the randomness out of your approach to business, safety, and the environment
and makes it predictable. Just as you develop a business plan, you also develop a
safety plan and an environmental plan. And, most importantly, every employee is
accountable.64
According to experts, besides achieving excellence in safety, the Sakhalin-1 Project
also ensured environmental protection. For instance, the oil export pipeline was
designed to run east-west rather than north-south to reduce the number of stream
crossings and lessen environmental impact. While carrying out drilling and
construction activities, care was taken to protect fish and endangered wildlife. To
protect endangered marine species, the construction of jetties along the shoreline north
of Chayvo was eliminated from the development plan as that construction might
61

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

Denise Allen Zwicker, Multi-National Project to Represent Record Foreign Investment in


Russia, http://www.sakhalin1.com, 2002.
The name World Conservation Union was used in conjunction with the International
Union for Conservation of Nature (IUCN), an international organization dedicated to the
conservation of natural resources.
Champions for the Safety and Environment,
www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish8.pdf.

404

Sakhalin-1 Project: Delivering Excellence in Project Execution


Sakhalin Island, situated between Russia and Japan in the North Pacific, is a
mountainous region with a harsh Arctic environment. The region is covered by a pack
of ice three to five feet thick about six to seven months in a year. As a result, the
project could operate only during the months of summer. The region is seismically
active and earthquakes occur frequently. Moreover, the geology of the region is
complex, leading to exploration problems. The remote location of the site made travel
difficult. An extensive network of helicopters, trains, and vehicles was required to
reach the work site.
Besides climate-related problems, another important challenge confronting the project
was environmental protection. The region was characterized by abundant flora and
fauna. Developing oil and gas in an ecologically sensitive area would lead to protests
from environmentalists. Environmentalists pointed out that that increasing seismic
surveys, constant drilling, and oil spills from rigs and tankers and movement of
vessels and helicopters at the production site affected the marine environment present
in the Sea of Okhotsk. To protect the marine life, the Russian Ministry of Natural
Resources restricted seismic testing and drilling in some areas of the island. Due to
environment restrictions, drilling of some of the wells was carried out from onshore
instead of offshore. This resulted in a delay in the project and increased costs. Due to
the delay, the payback period of the project could get extended, analysts said.
In October 2008, a group of NGOs filed a lawsuit, appealing against the verdict of the
State environmental appraisal for the Sakahlin-1 Project. According to them, the
projects appraisal required a thorough investigation as some significant changes had
been recorded in the distribution and number of Western Pacific grey whales in the
Piltun spit. They attributed the changes in the number of grey whales to the activities
related to the Sakhalin-1 Project in the region. According to them, the pipeline
between the Odoptu drilling platform on the Piltun spit and the Sakhalin Island was
dangerous for the whales. They demanded that the pipeline construction across Piltun
bay be stopped. According to Alexey Knizhnikov, head of the The World Wildlife
Fund (WWF) - Russia68 Program on environmental policies of the oil and gas sector,
Sakhalin 1 project must immediately halt its pipeline construction across Piltun
Bay, before the formal Court consideration. It is also important to identify the exact
reasons for the changes in the whales distribution observed in the summer 2008. 69
A court ruling was awaited in the lawsuit.
In addition to physical and environmental challenges, the Sakhalin-1 Project also
faced workforce related problems. There was no skilled labor in the region. ENL had
to invest significantly in training the workers but they were not very adept with the
latest construction and drilling procedures. To minimize training expenses, the project
operators imported manpower from other regions. The Sakhalin regional
administration alleged that most of the workers participating in the project were
foreigners. According to them, the project should maximize Russian content by hiring
contractors and workers from the region as stipulated in the PSA.
Analysts were of the view that though the project faced some harsh challenges, ENL
through the application of leading-edge technologies such as 3D seismic and ERD,
visualization analysis, simulations, and field studies had managed to successfully
complete the first phase of the Sakhalin-1 Project. Commenting on the challenges of
the project, Terni said, People ask me if ExxonMobil with its 100-plus years of
global exploration and development has ever been involved in a project that offered so
68

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

World-Class by Any Measure,


www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish1.pdf.
OVL's Sakhalin-1 project faces roadblocks, www.financialexpress.com, February 25,
2009.
Gazprom is a global energy company involved in the exploration, production, transportation,
storage, processing, and marketing of gas and other hydrocarbons as well as electric power
and heat energy production and distribution. The Russian Ministry of Oil and Gas holds
a 50 per cent controlling stake in Gazprom.

406

Sakhalin-1 Project: Delivering Excellence in Project Execution

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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International Business

References & Suggested Readings


1.

Exxon Deal Pending on Sakhalin-1 Gas? (XOM), http://247wallst.com, May 7,


2009.

2.

OVLs Sakhalin-1 Project Faces Roadblocks, www.financialexpress.com,


February 25, 2009.

3.

Environmentalists Appeal to Halt Sakhalin 1 Project Before any Formal


Court Ruling, www.wwf.ru, January 12, 2009.

4.

Sakhalin-1 Project Receives Award for Excellence from International


Petroleum Technology Conference, www.sakhalin1.com, December 3, 2008.

5.

Sakhalin-1 Beyond the Controversy, www.offshore-technology.com, July 27,


2007.

6.

Sakhalin-1 Project Production Goal Achieved, www.sakhalin1.com, February


14, 2007.

7.

ExxonMobil Announces Start of Sakhalin-1 Exports; Newest Milestone in


Company's Effort to..., www.allbusiness.com, September 7, 2006.

8.

ExxonMobil Announces Production Start-Up from Sakhalin-1 Project in


Russia, www.sakhalin1.com, October 2, 2005.

9.

Sakhalin-1 Launches Oil Pipeline Construction, www.indianexpress.com,


November 10, 2004.

10.

Denise Allen Zwicker, Multi-national Project to Represent Record Foreign


Investment in Russia, http://www.sakhalin1.com, 2002.

11.

Sakhalin 1- A New Frontier,


http://www.exxonmobil.com/Corporate/Files/Corporate/SakhalinEnglish_Intro.pdf.

12.

World-Class by Any Measure,


ww.exxonmobil.com/Corporate/Files/.../SakhalinEnglish1.pdf.

13.

ExxonMobil-40 Years of Arctic,


www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish3.pdf.

14.

The Quest Begins,


www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish4.pdf.

15.

The Hawk and the Sea Eagle,


www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish5.pdf.

16.

From Design to Loading Tankers in 34 Months,


www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish6.pdf

17.

To Full Production and Beyond,


www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish7.pdf.

18.

Champions for the Safety and Environment,


www.exxonmobil.com/Corporate/Files/.../SakhalinEnglish8.pdf.

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

Volkswagens Marketing Strategy in India


The case examines the marketing strategies of Volkswagen Group India, the Indian
subsidiary of German automobile manufacturer, Volkswagen AG (Volkswagen).
Volkswagen entered the Indian passenger car market in 2001 by launching its car
brand Skoda. In 2007, two of its other brands Audi and Volkswagen, were also
launched in India. Volkswagen Group India emphasized on all aspects of marketing
mix including product, price, place and promotion. The company offered three brands
including Audi, Skoda and Volkswagen that together comprised of 15 different models
as of late 2009. Volkswagen Group India mainly catered to the luxury segment of the
Indian car market. The company had established presence in India through separate
distribution channels for each of its brands.
In its initial years, Volkswagen Group India primarily used the print media to
promote its products. However, considering the growth potential of India's
automobile market, the company started using electronic, digital and out of home
media along with print media. In November 2009, the company launched an
integrated marketing campaign to strengthen its brand image. The case describes the
marketing campaign and ends with a discussion on the growth prospects of the
company in future.

Volkswagens Marketing Strategy in India


We are fairly new in the Indian market. The brand awareness of Volkswagen is low.
We have to raise awareness, create and improve the brand. 1
-

Lutz Kothe, Chief General Manager, Marketing and Public Relations,


Volkswagen India, in November 2009.

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
-

Jochem Heizmann, Member of the Management Board, Volkswagen


AG, in August 2009.

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

Volkswagen Launches First Brand Campaign in India, www.afaqs.com, November 10,


2009.
Volkswagen Group India Holds A Positive Outlook, http://machinist.in, August 29, 2009.
Volkswagen Aims to Sell over 300 Beetles in 2010, www.business-standard.com,
December 21, 2009.
Volkswagen India Plans to Double Distribution Network,
http://economictimes.indiatimes.com, September 25, 2009.

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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

Volkswagens Marketing Strategy in India


As of 2009, Volkswagen was the largest car manufacturer in Europe. In the third
quarter of 2009, the company generated revenues of 25, 956 million and reported a
profit after tax of 161 million (Refer to Exhibit I for Volkswagens Financial
Highlights). The company had eight brands Volkswagen, Audi, Bentley, Bugatti,
Lamborghini, SEAT, koda, and Volkswagen Commercial Vehicles (Refer to Table
I for Volkswagens Third Quarter Results in 2009 and 2008).

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

Profit before Tax

6,608

6,543

1,793

Profit after Tax

4,688

4,122

1,955

Net Cash Flow

-2,679

7,109

5,631

8,039

13,478

7,133

Sales Revenue

Net Liquidity on December 31


Source: www.volkswagenag.com.

Table I: Volkswagens Third Quarter Results


(In millions)
Q3 2009

Q3 2008

25956

28932

-10.3

Operating profit

278

1485

-81.3

Profit before tax

262

1481

-82.3

Profit after tax

161

1161

-86.1

Net Cash flow

791

-2408

13391

11767

+13.8

Sales Revenue

Net Liquidity on September 30

% Change

Source: www.volkswagenag.com.

Marketing Strategy in India


Volkswagen entered the Indian market in 2001 by setting up its Indian subsidiary
Volkswagen Group India. As of 2009, Volkswagen Group India had two group
companies Volkswagen India Private Limited (Volkswagen India) and Volkswagen
Group Sales India Private Limited (VGSIPL). Volkswagen India focused on the
manufacturing and sales of Volkswagen branded cars in India. Skoda Auto India
Private Limited (Skoda Auto India)7 and Audi India8 both were divisions of VGSIPL.
7
8

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).

Table II: Car Models Offered By the Volkswagen Group India


(December 2009)
Brand

Car Models

Audi

Audi A4, Audi A6, Audi A8, Audi Q5, Audi Q7, Audi TT, Audi
R8.

koda

New Superb, New Laura, Octavia, Fabia.

Volkswagen

Passat, Jetta, Beetle, Touareg.

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.

Audi Bullish on India; Sees Metropolitan Strategy as the Way Forward,


www.blonnet.com, April 20, 2009.

414

Volkswagens Marketing Strategy in India


Audi India had seven models with prices ranging from Rs. 2,900,000 to Rs
12,300,000. Volkswagen India had four models which were available in the price
range of Rs. 1,240,379 to Rs. 5,185,000 (Refer to Table III for Volkswagen Group
Indias Car Prices).

Table III: Volkswagen Group Indias Car Prices


(Ex-Showroom Delhi Price as of December 2009)
Brand

Price Range

Audi A4

Rs. 29,00,000 to Rs. 36,00,000

Audi A6

Rs. 39,80,000 to Rs. 49,75,000

Audi A8

Rs. 61,21,717 to Rs. 1,23,00,000

Audi Q5

Rs. 38, 29, 000

Audi Q7

Rs. 52,00,000 to Rs. 73,01,771

Audi TT

Rs. 46,19,693 to Rs. 47,51,424

Audi R8

Rs. 1,17,00,000

koda New Superb

Rs. 19,39,705 to Rs. 25,76,383

koda Laura

Rs. 13,05,207 to Rs. 17,68,528

koda Octavia

Rs. 10,19,845 to Rs. 12,10,023

koda Fabia
Volkswagen Passat
Volkswagen Jetta
Volkswagen Beetle
Volkswagen Touareg

Rs. 4,90,043 to Rs. 7,63,274


Rs. 21,61,458 to Rs. 25,77,860
Rs. 12,40,379 to Rs. 16,38,251
Rs. 20,45,000
Rs. 51, 85,000

Compiled from various sources.

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

Nirmal D. Menon, The Skoda Score, www.blonnet.com, January 13, 2005.

415

International Business

Exhibit II
Skoda Auto Indias Print Ads

Source: www.skoda-auto.co.in.

Figure I: An Image of koda Fabias TVC

Source: http://www.bigadda.com.
416

Volkswagens Marketing Strategy in India


As of 2009, Law & Kenneth11 handled the creative duties for Skoda Auto Indias four
brands the Fabia, the Octavia, the Laura, and the Superb.
Since its launch in India, Audi Indias focus had been on establishing itself as a luxury
car brand in India. According to Birkner, As a group, we have presence in almost
every segment. We are in no hurry to launch Audis compact cars. Our focus is
currently on establishing our luxury brand image.12

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

Volkswagens Marketing Strategy in India

Exhibit III
Volkswagen Indias Print Roadblock

Source: Volkswagen India Road Block: Blitzkreig! www.lbhat.com, November 11,


2009.
419

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).

Figure II: An Image of Volkswagen Indias TVC to Promote the Brand

Source: Volkswagen Launches First Brand Campaign in India, www.afaqs.com,


November 10, 2009.
25

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

Volkswagens Marketing Strategy in India

Exhibit IV
Volkswagen Indias OOH Campaign

Source: Anushree Bhattacharyya, Portland Drives German Auto Brand Volkswagen


to 23 Cities in India, www.network.media.com, December 01, 2009.
On December 04, 2009, Volkswagen India launched the Beetle. The company planned
to import the car, priced at Rs. 2.045 million, for sale in India. It launched a marketing
campaign to support the launch of the Beetle. Before the launch of the car, the
company started a teaser outdoor campaign including hoardings with the tagline,
Curves are back. Commenting about the campaign, Kothe said, Recreate a legend
that was the brief that we gave to the agency. It addresses a non-existent segment
because no other car in the world can compare with the Beetle. We are very confident
that the Beetle will make its way in India.30
On December 05, 2009, the first TVC to promote the Beetle was launched by DDB
Mudra. In the TVC, a couple was shown riding a Beetle. The TVC continued as the
couple reached their destination and the man asked how much he had to pay the valet.
Instead of taking money from the man, the valet paid him Rs. 200, put on a pair of
sunglasses, and took away the car in style to park it. The TVC ended with the tagline
German Engineering. Recreating Legends. Commenting on the rationale for
launching the campaign, Pawar said, The launch campaign was in keeping with the
continuation of the Beetles brand values. It remains among the worlds most beloved
cars; the old Beetle was the original love bug. The newly designed Beetle is the love
bug with aphrodisiac added. The idea was to showcase the reaction to a Beetle as one
where the brain is disconnected; those who buy the Beetle are buying into an
emotional promise, that of a fantastic design innovation. So the reaction when one
30

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.

The Road Ahead


In November 2009, Audi India announced that it had achieved 59 percent year to date
sales growth. In the period between January and November 2009, it sold 1,550 cars as
compared to 974 cars in the same period in 2008. The company aimed to achieve a 50
percent sales growth in 2010.34 It announced that it aimed to capture a 30 percent
share in the Indian luxury car market by 2011 from 20 percent in June 2009. 35Skoda
Auto India was set to launch its sports utility vehicle (SUV), the Yeti, in January 2010.
On December 04, 2009, Volkswagen India also showcased its next launch in India,
the Touareg, an SUV. The vehicle was priced at Rs. 5.185 million. According to
Garg, The launch of the Touareg is our marketing debut in the SUV segment. India
has a great demand for SUV. The Touareg has been successful across countries and
the entry will further enhance our presence in the market.36

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

Volkswagens Marketing Strategy in India


Volkswagen India planned to launch its small car, the Polo, in the first half of 2010.
The company wanted to build its brand image before launching its new car in India.
According to Kothe, By the time Polo is launched, we would want to be ready and
make sure there is enough brand awareness. While our target group is essentially
premium and upper premium, we want to be warm and appealing and a part of the
masses.37
On December 12, 2009, the production of Volkswagens Polo started at its Chakan
plant near Pune, Maharashtra. According to analysts, Volkswagen Indias market
share in India would largely depend on the success of the Polo. According to Umesh
Karne, a Mumbai-based analyst at BRICS Securities Limited38, The Polo is a key
model for Volkswagen as they have created a big capacity in India. India will continue
to be a small-car market for at least the next five or six years and every company
needs a compact car to get market share.39
However, some analysts were of the opinion that Volkswagen Group India would
have two compact cars once the Polo was launched in 2010, as it already had the
koda Fabia. They were of the view that, the two cars would compete with each
other.
To further improve its presence in the Indian car market, Volkswagen India also
planned to roll out a low-priced car named UP! in India by the fiscal 2010-11. The car
was expected to be priced at about Rs 0.3 million. The company also planned to
launch a sub-B segment car with a price tag of between Rs. 0.35 million and Rs. 0.45
million in India. According to Jochem Heizmann, Member of the Board of
Management of Volkswagen, It is clear we need a car below the Polo and are looking
at different options and working on it. That maybe the Up, or another car. However,
no decision has been made yet.40
With the new launches from all its three brands, Volkswagen Group India aimed to
capture an eight percent market share of Indias car market by 2013 to 2014.
According to Mueller, We are looking to have 8 per cent market share of the Indian
car market in the next 4-5 years by the Volkswagen Group which includes
Volkswagen, Audi, and koda. The market has recovered and we are firmly on a
growth track. Our plan is to increase our sales every month.41

37

38

39

40

41

Volkswagen Launches First Brand Campaign in India, www.afaqs.com, November 10,


2009.
BRICS Securities Limited is an India based financial services company. It was founded in
2004.
Vipin Nair, Volkswagen Aims to Capture 10% of Indias Car Market (Update 1),
www.businessweek.com, December 13, 2009.
VW India Could Enter Sub-B Segment with Up Rollout, www.wheelsunplugged.com,
December 14, 2009.
Volkswagen Connects with Indian Hearts in New TVC, www.exchange4media.com,
November 10, 2009.

423

International Business

References and Suggested Readings:


1.

Volkswagen Aims to Sell over 300 Beetles in 2010, www.business-standard.com,


December 21, 2009.

2.

Volkswagen & DDB Mudra Execute a Unique OOH Roadblock in Mumbai,


www.exchange4media.com, December 17, 2009.

3.

VW
India
Could
Enter
Sub-B
Segment
www.wheelsunplugged.com, December 14, 2009.

4.

The Volkswagen Beetle Finally Comes to India, www.moneycontrol.com, December


14, 2009.

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.

Anushree Bhattacharyya, Portland Drives German Auto Brand Volkswagen to 23


Cities in India, www.network.media.com, December 01, 2009.

8.

When It Comes to India, Volkswagen Isnt Thinking Small,


http://economictimes.indiatimes.com, November 25, 2009.

9.

Byravee Iyer, Hit the Road, www.business-standard.com, November 24, 2009.

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

Volkswagens Marketing Strategy in India


24. Volkswagen Group Preparing the Ground for Sustainable Growth in India,
http://machinist.in, June 09, 2009.
25. Volkswagen Mulls Beetle Launch in India This Year, www.dnaindia.com, June 09,
2009.
26. VW India Appoints Maik Stephan as Managing Director, Lutz Kothe as CGM
Marketing and PR, www.wheelsunplugged.com, June 08, 2009.
27. Audi Bullish on India; Sees Metropolitan Strategy as the Way Forward,
www.blonnet.com, April 20, 2009.
28. Volkswagen Group Most Successful Car Manufacturer at the CNBC-Overdrive
Awards, www.indiaprwire.com, January 13, 2009.
29. Audi Weighing Options for Luxury Small Car Launch in India,
www.thehindubusinessline.com, August 31, 2008.
30. Ammar Master, We Are Of The Opinion We Are Right On Time For The India
Party, www.livemint.com, January 17, 2008.
31. Volkswagen Drives in with Mudra DDB, www.afaqs.com, September 11, 2007.
32. Nirmal D. Menon, The Skoda Score, www.blonnet.com, January 13, 2005.
33. www.bmw.in.
34. www.ifc.org.
35. www.mercedes-benz.co.in.
36. www.siamindia.com.
37. www.wpp.com.
38. http://en.wikipedia.org.
39. http://ads.economist.com.
40. http://www.bigadda.com.

425

Mylans Acquisition of Matrix


In January 2007, Mylan Inc. (Mylan), one of the largest US generic drug makers,
acquired a 71.5 percent stake in Matrix Laboratories Ltd. (Matrix), India, a leading
Active Pharmaceutical Ingredients (API) supplier globally, for a cash and stock deal
of US$736 million. The Mylan-Matrix deal was the largest acquisition in the Indian
pharmaceutical industry and was viewed by analysts as a step toward backward
integration for Mylan. The deal not only gave Mylan access to a low cost
manufacturing platform, but also immediate presence in the emerging markets of Asia
and Africa as well as the lucrative generic drugs markets in Europe.
Matrix, on the other hand, gained the much-needed scale that generic companies
required to survive in a very competitive market place. It was very important for
Indian pharmaceutical companies considering that these companies did not have
research molecules of their own.
Analysts felt that with the global generic drugs industry undergoing a consolidation
phase, large pharmaceutical companies 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 world-class manufacturing facilities. Indian pharmaceutical companies also had
a number of Drug Master Files (DMFs) and Abbreviated New Drug Application
(ANDA) filings in the US, the world's largest market for pharmaceuticals. Moreover,
some of these companies had developed a significant presence in the European and
African markets through the inorganic route.

Mylans Acquisition of Matrix


This is an extremely complementary transaction that accomplishes a number of
Mylans key objectives. Mylan is executing on its commitment to establish a global
platform and expand its dosage forms and therapeutic categories. Additionally, this
acquisition deepens Mylans vertical integration and enhances its supply chain
capabilities. The transaction will allow Mylan and Matrix to strengthen and expand
their core businesses and competencies, while creating significant opportunities for
global expansion and growth.1
- Robert J Coury, Vice Chairman and CEO, Mylan Inc. in 2006.
A player has to decide how he can stay in the field for as long as possible. Matrix, as
a significant API supplier, needed a bigger playing field. Partnering with Mylan gives
us that.2,3
- Nimagadda Prasad, Executive Chairman, Matrix Laboratories Ltd. in 2006.
Clearly, were seeing a trend in the industry toward acquisitions and consolidation...
This is a continuing trend to move more sourcing and manufacturing overseas and to
own it as opposed to just contracting it.4
- Martha Freitag, an industry analyst at Argus Research Corp. 5, in 2006.

Benefits beyond Global Expansion


Mylan Inc. (Mylan), one of the largest US generic drug 6 makers, acquired a 71.5
percent stake in Matrix Laboratories Ltd. (Matrix), India, a leading API supplier,
globally in January 2007 for a cash and stock deal of US$736 million. The MylanMatrix deal was the largest acquisition in the Indian pharmaceutical industry and was
viewed by analysts as a step toward backward integration for Mylan. 7 On completion
of the deal, Robert J Coury (Coury), Vice Chairman and CEO of Mylan, said,
Todays announcement marks the successful closing of the transformational Matrix
transaction, and it also 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.8

3
4

5
6

Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories,


www.matrixlabsindia.com, August 28, 2006.
API (acronym for Active Pharmaceutical Ingredients), also known as bulk drugs, are active
chemicals used in the manufacturing of drugs.
Gina S Krishnan, Matrix Unloaded, www.businessworldindia.com, September 11, 2006.
Mylan Laboratories Mylan to Have Majority of Indias Matrix, www.advfn.com, August
29, 2006.
Argus Research Corp. is an independent research firm.
Generic drugs (or Generics) are either copies or the basic form of a proprietary drug (or
brand-named) drugs produced by large multinationals. For example, Lipitor is the brand
names for the drug Atorvastatin that was patented by Pfizer Inc. Any other drug with the
same composition manufactured and marketed by other companies is called generics.
Surojit Chatterjee, Mylan Buys Majority Stake in Indias Matrix Lab for $ 736 Million,
www.in.ibtimes.com, August 30, 2006.
Mylan Laboratories Inc. Completes Matrix Laboratories Limited Transaction,
www.devicespace.com, January 9, 2007.

428

Mylans Acquisition of Matrix


According to analysts, the deal was a winning proposition for both the parties to the
transaction. Where Mylan was concerned, Matrixs takeover helped it to enter the
global generic markets beyond the US market. In particular, this acquisition helped
Mylan to enter the emerging pharmaceutical markets of India, China, and South
Africa, given Matrixs presence in these regions. Second, the deal would also aid
Mylan enter the high-margin European markets through Matrixs subsidiary
Docpharma NV9 (Docpharma), which was already operating in the European markets.
In addition to this, Matrix would also act as a low-cost product sourcing platform for
Mylan given Matrixs strong pipeline of APIs. Jim Miller, president of PharmSource
Information Services, Inc. 10, noted, What is most striking about the deal is that
although Mylan is the buyer, Matrix is clearly the more sophisticated global player.
Matrix has built a sophisticated supply chain that sources early-stage intermediates in
China, converts them to APIs in FDA-approved plants in India, formulates the APIs
into finished dosage forms, and sells them in Asian and European markets. Mylan, by
contrast, manufactures only drug products and operates largely in the United States.
Matrixs global capabilities are likely to have much greater value to Mylan in the
generics and branded generics markets than they are in contract manufacturing. 11,12
The tie-up with Mylan would benefit Matrix in terms of providing it with a bigger
playing field. Moreover, it would be able to leverage on Mylans existing
manufacturing and sales network in the US to penetrate deeper into the US market and
benefit from economies of scale. Besides, given Mylans financial resources, Matrixs
subsidiary Docpharma could consolidate its position in the European market and in
the medium term use Mylans knowledge to enter the US generics market.
Commenting on the deal, Nimagadda Prasad (Prasad), the Executive Chairman of
Matrix, said, Mylan, a proven industry leader, is an ideal partner for Matrix. Our
strategic vision remains unchanged and we believe this transaction creates greater
growth opportunities for Matrix and its employees and also will allow us to accelerate
our existing expansion plans in India and abroad.13
Analysts felt that with the global generic drugs industry undergoing a consolidation
phase, large pharmaceutical companies such as Teva Pharmaceutical Industries Ltd. 14
(Teva), Sandoz15, Barr Pharmaceuticals, Inc. 16 (Barr), the Actavis Group17 (Actavis),

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

Mylans Acquisition of Matrix


were more affordable than the branded prescription drugs that were marketed by
research-based pharmaceutical companies. Mylan Pharmaceuticals Inc., Mylan
Technologies Inc., Bertek Pharmaceuticals Inc., and UDL Laboratories Inc. were its
four principal subsidiaries.
Mylans history dates back to 1961 when Milan Pharmaceuticals (Milan) was founded
by Milan Mike Puskar (Puskar) and his friend Don Panoz in White Sulphur Springs,
West Virginia, as a pharmaceutical distribution company. In 1970, Milan became
incorporated as Mylan Inc. and the company was listed in 1973. In 1980, under Puskars
leadership, the company achieved a milestone by introducing its own brand of Mylan
drugs. This laid the platform for its future growth. The year 1984 marked the approval of
Mylans first proprietary drug, Maxzide, an anti-hypertensive drug. With this, Mylan
became the first generic drug maker to get a patent for its own product.24
In the next ten years i.e. by 1995, Mylan had the most dispersed line of
pharmaceuticals in the US, be it generic or branded. Mylan also made some notable
acquisitions during 1993 to 1999 (Refer to Exhibit I for Mylan: A Timeline) to
consolidate its market size and to emerge as a stronger pharmaceutical player. These
included Bertex Inc, which was recognized for its transdermal drug delivery,
Penederm Inc renowned for dermatology products, and B. Hickman Inc. that was
acknowledged for its skilled workforce. The acquisition of these three companies laid
the foundation of Bertex Pharmaceuticals Inc. By 2002, the Mylans revenues had
crossed the US$1 billion mark and in 2004 the company was included in S&P 500 25.26

Exhibit I
Mylan: A Timeline
Event

24
25

26

Remark/ Rationale

1961

Milan Pharmaceutical is
incorporated

Principal business is of distribution


of drugs.

1965

Starts manufacturing vitamins

First product to be manufactured


under Milan banner.

1973

Mylan becomes a public limited


company

Milan Pharma is incorporated as


Mylan Inc. and the company gets
listed.

1984

It starts marketing its first


proprietary drug Maxzide, an
antihypertensive drug

Becomes the first generic drug


maker to get a patent for its product.

1987

Opens a new manufacturing unit


at Caguas, Puerto Rico

To enhance its manufacturing


capacity in order to move toward a
bigger platform.

1989

Acquires a 50 percent stake in


Somerset Pharmaceuticals Inc, a
US-based a proprietary research
and development pharmaceutical
company.

To acquire the rights to market a


new medication for the treatment of
Parkinsons disease called Eldepryl.

Mylan History, www.mylan.com.


The S&P 500 is an index containing the stocks of 500 Large-Cap corporations. It is
maintained by a leading publisher of financial research and analysis on stocks and bonds,
Standard & Poors.
Mylan History, www.mylanpharms.com.

431

International Business
Event

Remark/ Rationale

1991

Acquires another US-based


pharmaceutical company, Dow B.
Hickam Pharmaceuticals

To acquire its skilled workforce and


marketing
and
manufacturing
facilities of wound and burn care
pharmaceutical products.

1993

Acquires Bertek Inc. US-based


manufacturer and innovator of
transdermal (patch) drug delivery
systems

Addition of Bertek gives Mylan


five worldwide and seven domestic
patents for transdermal drug
delivery technology.

1996

Acquires UDL Laboratories Inc, a


US-based supplier of unit dose
multi source pharmaceuticals

To gain its supplying capabilities of


unit dose to the institutional and
long-term care market place.

1996

Establishes Bertex
Pharmaceuticals as its main
branded pharmaceuticals
subsidiary

To increase participation in the


branded drug segment, which
offered higher profits than the
generic sector

1998

Acquires Penederm Inc., a USbased pharmaceutical company


recognized in the dermatology
segment, and merges it with
Bertek.

To
acquire
Topicare27.

its

technology

Adapted from Company History, www.mylan.com and www.fundinguniverse.com.


In mid-2004, Mylan made a bid to acquire King Pharmaceuticals 28 in a deal valued at
US$4 billion to enhance its business in the brand drug segment.29 However, the deal
was aborted in February 2005, as the two companies could not arrive at an agreement.
Since then, the company was trying to bolster its business in generics. With the global
generic drugs industry already in a consolidation phase, Mylan was on the lookout for
an M&A deal that would help it remain competitive (Refer to Exhibit II for a note on
the global generic drugs industry).
As of 2007, Mylan Pharmaceuticals Inc. and UDL Laboratories Inc. looked after the
generic drugs operations of Mylan while Bertek Pharmaceuticals Inc. and Mylan
Technologies Inc. looked after the branded segment. The companys pharmaceutical
basket had 150 products including antibiotics, antidepressants, anti-inflammatory
drugs, beta-blockers, and laxatives that catered to various therapeutic segments. The
company also enjoyed a global presence and had a strong marketing and distribution
network stretching from North America to Europe, the Middle East and Africa
(EMEA), as well as the Asia Pacific region (APAC). For the fiscal year ended 2007,
Mylans total revenue has increased by 28 percent year-on-year from US$1257
million in 2006 to US$1611 million (Refer to Exhibit III for selected financials of
Mylan).

27

28

29

Topicare is a proprietary delivery technology of Penederm Inc in which it markets patented


topically administered prescription product.
King Pharmaceuticals, headquartered in Bristol, Tennessee, USA, is a pharmaceutical
company that was founded in 1994. In 2006, its revenues were US$2 billion.
Mylan Buys Matrix for $736 Million: Buys Indian Firm to Enter Asian and European
Markets, www.levinassociates.com, 2006.

432

Mylans Acquisition of Matrix

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

Consolidation in the Generic Pharmaceutical Industry: An Evolving Landscape, Urch


Publishing, October 2007.
Merck KGaA, headquartered in Darmstadt, Germany, is one of the oldest chemical and
pharmaceutical companies. Its history dates back to the 17 th century. In 2006, Merck
KGaAs generic unit had total sales of US$1.8 billion.
Tova Cohen and Steven Scheer, Teva Pharma Seen Best Placed to Win Merck Generics,
www.reuters.com, May 8, 2007.
IMS Health is the worlds leading provider of business intelligence and strategic consulting
services to the pharmaceutical and healthcare industries.
Visiongain, headquartered in London, UK, is a company that provides analysis of the
worldwide telecom and pharmaceutical industries.

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

Cost of Sales (B)

768.15

629.55

629.83

612.15

597.76

Gross Profit (A-B)

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

Selling, general and


administrative

215.54

225.38

259.48

201.61

173.07

Total Revenues (A)

Operating Expenses:

35
36
37

38

39

40

The Worlds Top Ten Generic Companies, www.leaddiscovery.co.uk, November 2005.


Brian Lawler, The Coming Generic Drug Boom, www.fool.com, October 16, 2006.
Mylan Outbids Teva and Private Equity Investors to Acquire Merck KGaAs Generics
Unit, www.globalinsights.com, 2007.
Ivax Corporation was a US-based generics drugs major and one of the worlds top ten
generics drugs company.
Hexel AG (Hexel) was a Germany-based generics drugs major and one of the leading
generics drugs companies.
Eon Labs, Inc., an affiliate of Hexel, was a US-based generic drugs company.

434

Mylans Acquisition of Matrix


Litigation settlements,
net

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

Other income, net

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

Provision for income


taxes

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

Mylans fiscal year ends March 31.


Source: Mylan Inc., Annual Report-2007, www.mylan.com

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

Form 8-K for MYLAN INC, www.yahoo.com, November 7, 2007.


N Prasad was then the CEO and Managing Director of Vorin Laboratories Ltd. (Vorin), a
Hyderabad-based subsidiary of one of the leading Indian pharmaceutical companies,
Ranbaxy Laboratories Ltd. C Satyanarayana was the R&D chief at Vorin. M Ravinder was a
successful pharmaceutical trader, distributor, and an investor entrepreneur.
Herren Drugs and Pharmaceuticals was a Rs.450 million company then.
H. Lundbeck A/S (Lundbeck) is a Danish international pharmaceutical company.
Gina S Krishnan, The Matrix Evolution, www.businessworldindia.com, Debember 29,
2003.

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

Fifteen: Antibacterial, antiasthma & antivirals

Markets and
customers

Europe

North America and Japan

India, Middle
East, Africa and
South Africa

Facilities

TGA and
European
norms

USFDA, TGA and MICA

ISO 9000

Regulatory
compliance

----

DMFs filed in developed


markets

----

Source: Annual Report: 2002-03, www.matrixlabsindia.com


Continuing with its policy of sustained growth through the M&A route, Matrix under
the leadership of Prasad struck some major deals during 2004 and 2005 (Refer to
Exhibit V for Matrix: A Timeline). These deals helped Matrix to expand its market
from a single country to five countries by the end of fiscal year 2006. In addition to
being an international API company, it started competing as a manufacturer of
finished dosage forms (FDF) in Europe and China and also ventured into medical
devices. This also helped the company to diversify its risks considerably.

46
47
48

Matrix Laboratories Ltd., 2001-02 Annual Reports, www.matrixlabsindia.com


Anti-retroviral drugs (ARV) are used in the treatment of HIV infection.
Para IV filing provided the company with exclusive rights of 182 days to market the generic
version of a drug in US market, once the patent for the proprietary drug expired.

436

Mylans Acquisition of Matrix

Exhibit V

Matrix: A Timeline
Event

Impact/ Benefit

February 2001

Herren renamed as Matrix.

February 2002

Process Patent for Citalopram


is filed by Matrix on February
27.

To gain the preferred supplier


status in global generic market.

May
2002

Acquires 54.89 percent stake in


Medicorp

To gain a large customer base,


presence in regulated market
and also access to sophisticated
technologies.

May
2003

Amalgamation of Medicorp
and Vorin into Matrix
Laboratories Ltd.

Reduced time cycle of its


market and product
development helped in
increasing its profit and
sustainability in the competitive
business environment.

November
2003

Decides to launch two joint


venture companies, Medikon
Galenicals in India and CEM
Pharma Life Science in Ireland
with two German companies
having a total capital outlay of
3.90 million.

Backward integration for the


supply of IPPs (generic APIs
business) and R&D support.

March 2004

FDA approves the


manufacturing facility of
Matrix at Jeedimetla,
Hyderabad.

Gains clearance for supplying


APIs to the US market.

March 2004

Vera Laboratories Ltd, Fine


Drugs and Chemicals Ltd,
Medikon Laboratories Ltd. and
Caliber Engineering Private
Ltd. merge with Matrix
Laboratories Ltd.

To enhance transparency and


corporate governance practices
and to move toward a more derisk business model.

January 2005

Acquires Finished Dosage


Facility situated near Nashik .

In order to integrate forward


into formulations
manufacturing.

February 2005

Acquires a 60 percent stake in


Mchem, China

Backward integration for the


manufacture of intermediates
and to help consolidate its
position as a major supplier of
APIs

April
2005

Floats two 50:50 joint venture


with South Africa based Aspen
Pharmacare Holdings Ltd.
having largest FDA approved
API manufacturing facility.

To manufacture and market


anti-HIV drugs in South Africa.

437

International Business
Event

Impact/ Benefit

June
2005

Acquires controlling stake in


Docpharma, a Belgium-based
generic drug distributor.

To gain generics marketing


expertise in the underpenetrated markets of Europe
such as Belgium and other
markets of Southern Europe.

September
2005

Matrix acquires a 43 percent


stake in Explora Laboratories
SA, a Switzerland-based
pharmaceutical company
engaged in R&D for high
potency API manufacture

To gain access to technology


platforms and product
portfolios such as corticosteroid
and anti-cancer therapeutic
segment. Opportunity to
leverage on technology
platform to project itself as a
partner to research based
pharmaceutical companies in
the area of contract research
and contract manufacturing.

Matrix acquires up to 55
percent controlling interest in
Concord Biotech Ltd., a USFDA approved biotechnology
company in India.

Gains fermentation & Biocatalytic technology


capabilities for manufacture of
APIs.

December
2005

Compiled from various sources


In addition to its core business of API manufacturing, the company had also identified
contract research and manufacturing as a potential growth opportunity. In this regard,
it decided to supply APIs and to make product dossiers49 of products going off patent
in the mature markets of the West. These comprehensive product dossiers, which
Martix then licensed to different companies for different markets, helped it to obtain
the contract for supplying the API in addition to the license fee. For this, Matrix
launched two joint venture companies in November 2003 Medikon Galenicals in
India and CEM Pharma Life Science in Ireland with two German companies.50 It
also signed a deal with Niche Generics Ltd.51 (UK) for the dossier for Perindopril, a
US$400-million per annum product.
Analysts felt that Matrixs global presence had resulted in it having a more de-risked
business model and also enabled it to achieve a more predictable growth in the long
run. As of 2007, the company operated in five key business segments (Refer to
Exhibit VI for the five segments and their contribution). It had 10 API intermediate
manufacturing facilities, six of which were FDA approved. These facilities are located
in India (6), China (3), and South Africa (1). Its manufacturing facility of FDFs had
the capacity to produce 2 billion tablets and 300 million capsules on a two-shift basis
per annum. It had a total workforce of 2000 which included more than 300 R&D
49

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

Mylans Acquisition of Matrix


scientists. The company had five key business segments viz. Generic APIs, ARVs,
FDF, hospital business, and contract manufacturing services (Refer to Exhibit VI to
see their Contribution to Matrixs Sales). For the fiscal year ended 2007, Martixs
total sales had increased by 42 percent year-on-year from Rs.11.59 billion in 2006 to
Rs.16.48 billion (Refer to Exhibit VII for the key financials of Matrix).
Exhibit VI

Contribution of Matrixs Business Segments


2006-07
Rs.(Mn)

% to
total
sales

2005-06
Rs.(Mn)

% to
total
sales

Year-onyear
Growth
%

Generic APIs

5,505

33

3,859

33

43

Anti-retro Virals (ARVs)

3,390

21

2,797

24

21

Finished Dosage Forms

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

Source: Matrix Laboratories Ltd., Annual Report: 2006-2007,


www.matrixlabsindia.com.

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

Profit before tax

1,021.42

2381.72

756.53

2005.63

Profit after tax before share of Associate


Matrixs fiscal year ends March 31.

Source: Matrix Laboratories ltd., Annual Report-2007, www.matrixlabsindia.com


With the generic drugs industry in a consolidation phase, leading companies were
targeting Indian generic drugs companies for M&A deals. Matrix was one of the
prime candidates for such a deal. Analysts felt that entering into such deals would be
beneficial for the Indian generic drugs companies as well, as these companies lacked
the scale that was vital for survival in the highly competitive generics drugs market.
With India bringing its patent law in line with the patent laws in mature markets such
as the UK and the US in 2005, a majority of the 3,000-odd Indian pharmaceutical
companies were in a precarious position52 (Refer to Exhibit VIII for a note on the
Indian pharmaceutical industry).

52

Gina Krishnan, The Sell-Out Begins, www.businessworldindia.com, September 11, 2006.

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

The Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPs) is an


international treaty administered by the World Trade Organization (WTO) which sets down
minimum standards for most forms of intellectual property (IP) regulation within all
member countries of the World Trade Organization.

440

Mylans Acquisition of Matrix


research/manufacturing. However, to attract such global contracts, these companies
have to achieve a critical mass or economies of scale to be viewed as a suitable
partner.
Therefore, in order to diversify risks, leading pharmaceutical companies in India
were looking for growing through M&A in foreign markets. The fact that the
patents for a large number of drugs in the US and Europe were due to expire in the
next few years, also added to the attractiveness of these markets to Indian
pharmaceutical companies. Since Indian pharmaceutical companies specialize in
manufacturing low cost and good quality generic drugs, they were in a position to
make the most of this opportunity. However, analysts believe that in order to be
more competitive the companies had to develop scale. Scale was very important
for companies considering that these companies did not have research molecules of
their own and relied on reverse engineering of drugs developed by research-based
pharmaceutical companies.
Compiled from various sources.

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

Mobis Philipose, Matrix Unloaded? www.dnaindia.com, June 22, 2006.


Pharmaceuticals, www.ibef.org, November 15, 2007
Mylan Lab Acquires Stake in Matrix, www.ciol.com, January 9, 2007.
Merrill Lynch & Co. Inc. (ML), headquartered in New York, USA, is a leading wealth
management financial services, and advisory company.
DSP Merrill Lynch Ltd. (DSPML), headquartered in Mumbai, India, is a leading financial
service provider in India. ML holds a 90 percent stake in DSPML.
ABN AMRO Holding NV, Amsterdam, the Netharlands, is a leading European bank with a
global presence.
UBS AG, headquartered in Basel & Zrich, Switzerland, is a leading financial services
company.

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

Mylans Acquisition of Matrix

Exhibit IX
Shareholding Pattern of Matrix

12%

1% 5%

1%
10%

71%

Indian Promoters

Foreign Promoters

Institutional Investors

NRIs

Indian Public

Foreign Nationals

* As on March 31, 2007.


Source: Matrix Laboratories Ltd., Annual Report: 2006-07,
www.matrixlabsindia.com.

Rationale behind the Acquisition


Benefits for Mylan
Mylan acquired the majority stake in Matrix primarily to establish a global
distribution network for its generic drug portfolio. This acquisition acted as an entry
window for Mylan to tap the huge potential of emerging pharmaceutical markets such
as India, China, and Africa, where Matrix already had a significant presence through
its various strategic alliances. Analysts felt that its presence in emerging markets
would be profitable for Mylan in the long term. 70
Matrix, in addition to having full-fledged facilities in India, had tie-ups with Aspen
Pharmacare Holdings Ltd., South Africa, and Mchem Group, China. The deal
provided Mylan with the opportunity to expand its market for generic drugs to these
emerging markets, where the generic drug turnover was greater than that of branded
drugs. With the mature markets of the West showing signs of saturation, these
emerging markets provided pharmaceutical companies with the next opportunity for
growth. For instance, in 2006, the Indian pharmaceutical market grew at the rate of
17.5 percent to US$7.3 billion while the pharmaceutical market in China grew by 12.3
percent to US$13.4 billion.71 This was much higher than the 5-6 percent growth
experienced by the pharmaceutical industry as a whole in the mid-2000s.
70

71

Mylan Signs US$736-million takeover Deal for Indias Matrix Laboratories,


www.globalinsights.com, 2006.
Robust Growth in Specialist-Driven Products, Including Oncology Treatments, Reflect
Changing Market Dynamics, www.imshealth.com, March 20, 2007.

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

Benefits for Matrix


The Mylan Matrix merger was expected to benefit Matrix as well. Experts felt that the
merger would help in accelerating Matrixs expansion plans in India and abroad. As a
part of Mylan, Matrix would benefit from Mylans predominant presence in the US
and their combined expanded production capabilities and manufacturing capacity,
which would result in economies of scale. The additional financial resources from
Mylan would help Matrix in enhancing its manufacturing capabilities and product
development activities and also to expand Docpharmas portfolio and European
presence, thereby helping Matrix strengthen its position in the European market.
Commenting on the deal, Prasad said This transaction offers significant benefits for
our customers. Together, our companies will be able to compete more effectively,
while delivering cost savings to our customers. The additional financial resources
Mylan brings us also will allow us to further enhance Matrixs capabilities in
72
73

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

Mylans Acquisition of Matrix


manufacturing and product development and expand Docpharmas portfolio and
presence across Europe. We look forward to drawing on Mylans strengths to advance
our anti-viral initiatives, as we believe bringing these products to patients at lower
costs is critical.75
Viswanathan Vasudevan, a fund manager at Aquarius Investment Advisors 76, said,
There will definitely be a broadening of the market of Matrix and it will give more
depth, reach, and coverage for the company, 77 For instance, the Mylan-Matrix
combine, with its global presence, would further augment Matrixs ARV sales.
Matrixs ARV business comprised 25 percent of its total revenues in 2005 and it
continued to be its focus area. It was one of the few players globally that offered
complete integration for ARV drugs right from the intermediate stage to the finished
dosage stage. The combined entity was well placed to partner with international HIV
programs to bring low-cost anti-AIDs drugs to HIV patients across the globe.
Analysts felt that the merger with Mylan would provide Matrix with the much-needed
scale that generic companies required to survive in a very competitive market place. It
was very important for Indian pharmaceutical companies considering that these
companies did not have research molecules of their own. Some analysts said that since
2004, Matrix had been facing considerable pricing pressures in the US and European
markets.78
Both the companies said that they did not expect any problems in cultural integration
post-merger. Prasad said that the culture of Matrix would remain intact as the culture
at Mylan was a mirror image of Matrix,79 Coury too felt that Matrix was a good
culture fit for Mylan. We are very excited about the transaction and expect, based on
our time together thus far, a smooth and effective integration. We have found that
Matrix and Docpharma have cultures and values that are extremely consistent to our
own at Mylan,80 he said.

The Other View


Though overall, the deal was expected to be a win-win proposition for both the
parties, analysts were cautious about the long-term sustainability of Matrixs existing
supply chain arrangements with other US generic players who would now become its
direct competitors. Further, as Matrix had already been the second largest API
supplier to Mylan since 2003, transfer pricing of drugs between Mylan and Matrix
was also expected to be an issue of concern which would affect the potential top-line
synergies expected from this deal in the near term. Moreover, as per Mylans press
release in December 2006, accretion to earnings would be mild in the short term.
Significant top-line synergies resulting from the combined operations would only flow
in the long term (by 2009-10) when Mylan and Matrixs subsidiary Docpharma, were
able to list their respective drugs in the Europe and the US market respectively.
75

76

77
78
79

80

Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories,


www.matrixlabsindia.com, August 28, 2006
Aquarius Investment Advisors is a Singapore-based company which provides financial
advisory services.
Mrinalina Datta, Mylan Labs to Acquire India Rival, www.iht.com, August 28, 2006.
Atul Sathe, How Mylan Can Turn around Matrix, www.rediff.com, September 18, 2006.
J.Padmapriya, Matrix Founder Prasad Set to Get into the Groove at Mylan,
www.economictimes.indiatimes.com, September 9, 2006.
Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories,
www.matrixlabsindia.com, August 28, 2006.

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

Post Deal Developments


After the deal was completed, Coury and Prasad were appointed as the Non-executive
Chairman and Non-executive Vice Chairman of the board of Matrix respectively.
Mylan also established its Asian headquarters in Singapore for Prasad and his team. 83
It was decided that Rajiv Malik (Malik) would continue to head Matrix, while Stijn
Van Rompay, the co-founder of Docpharma, would continue to manage Docpharma.
In the restructuring that followed at Mylan, Malik was appointed the Head of Global
Technical Operations at Mylan. In the new position, he was expected to look after the
global R&D, manufacturing, supply chain management, and regulatory affairs. 84 S
Srinivasan, Senior Vice President of Matrix, was promoted as COO of Matrix.
Mylans Senior Vice President of Strategic Corporate Development and Chief
Integration Officer was promoted to head Mylans North American operations.
Mylans Vice President of Facilities was promoted as head of Global Manufacturing.
The company also announced that its Chief Scientific Officer John ODonnell would
retire on April 1, 2007. During the past several months leading up to the successful
closing of this transformational transaction weve had the opportunity to carefully
evaluate all aspects of our organizations and we are realigning to allow us to realize
the full benefit, efficiencies, and growth potential of our new global platform. I am
very pleased at how quickly and efficiently we have brought these organizations
together and this reorganization will further enhance and accelerate the benefits to
Mylan and Matrix,85 explained Coury.
Mylan also increased its fiscal 2007 adjusted earnings per share guidance to US$1.50US$1.55 from the earlier projection of US$1.35-US$1.55 per share.86 The company
had cited the successful acquisition of the Matrix as a reason for this increase.

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

Mylans Acquisition of Matrix


Shortly after the acquisition of Matrix, Mylan further consolidated its position in the
global arena by acquiring Merck KgaAs generic unit for US$6.8 billion in October
2007. This acquisition catapulted Mylan to the position of the worlds third largest
generic company behind Teva and Sandoz87, employing around 12,000 people
globally in more than 90 countries. As of end 2007, Mylans broad product offering
included more than 570 products and the worlds second largest portfolio of APIs and
126 US DMFs. The mood at Matrix was also upbeat. Becoming a Mylan subsidiary
has opened up new opportunities for Matrix and the recent announcement of the
acquisition of Merck KgaAs generic business by Mylan provides additional
opportunities for Matrix. These developments would provide a global scale for
achieving very efficient utilization of R&D, manufacturing, and other resources of the
company. We are proud that Matrix will become part of one of the worlds leading
global generics companies,88 said Malik.

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

Sandoz, headquartered at Holzkirchen, Germany, is the generics subsidiary of Swiss


multinational pharmaceutical company Novartis AG.
Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix Laboratories,
Press Release, www.matrixlabsindia.com, May 23, 2007.
ChrysCapital Management Company is an investment firm headquartered in Mauritius with
its prime focus on Indian market.
Javed Sayed, Matrix Deal to Trigger M&As in Pharma Sec,
www.economictimes.indiatimes.com,
August 30, 2006.
Goldman Sachs Group is headquartered in New York and it is a global investment banking,
securities, and investment management firm that provides a wide range of services
worldwide to a substantial and diversified client base.

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

Rick Stouffer, Generics Deal a Shot in Arm for Mylan, www.pittsburglive.com,


December 9, 2007.
Mylan Laboratories Inc Completes Acquisition of Generic Business of Merck KGaA,
www.biospace.com, October 2, 2007.

448

Mylans Acquisition of Matrix

References & Suggested Readings:


1.

Gina S Krishnan, The Matrix Evolution, www.businessworldindia.com, Debember 29,


2003.

2.

The Worlds Top Ten Generic Companies, www.leaddiscovery.co.uk, November


2005.

3.

Mobis Philipose, Matrix Unloaded? www.dnaindia.com, June 22, 2006.

4.

Mrinalini Datta, Mylan Labs to Acquire India Rival, www.iht.com, August 28,
2006.

5.

Mylan Laboratories to Acquire Up to 71.5% Controlling Interest in Matrix


Laboratories, www.prnewswire.co.uk, August 28, 2006.

6.

Mylan Targets Indian Drugs Firm, www.news.bbc.co.uk, August 28, 2006.

7.

Mylan Laboratories Mylan to Have Majority of Indias Matrix, www.advfn.com,


August 29, 2006.

8.

US-Based Mylan Buys Majority Stake in Matrix, www.indiatimes.com, August 29, 2006.

9.

Brian Gorman, Mylans Biogeneric Play, www.fool.com, August 30, 2006.

10.

Joshua Owide, Mylan Laboratories: Entering the Matrix, www.pharmaceuticalbusiness-review.com, August 30, 2006.

11.

Javed Sayed, Matrix Deal to Trigger M&As in Pharma Sec,


www.economictimes.indiatimes.com, August 30, 2006.

12.

Mylan in Indias Biggest Pharmaceutical Takeover as it Enters the Matrix,


www.in-pharmatechnologist.com, August 30, 2006.

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.

Gina S Krishnan, Matrix Unloaded, www.businessworldindia.com, September 11,


2006.

17.

Gina Krishnan, The Sell-Out Begins, www.businessworldindia.com, September 11, 2006.

18.

Atul Sathe, How Mylan Can Turn around Matrix, www.rediff.com, September 18, 2006.

19.

Jim Miller, Will Delivery Technologies


www.pharmtech.com, October 2, 2006.

20.

Brian Lawler, The Coming Generic Drug Boom, www.fool.com, October 16, 2006.

21.

Nath Balakrishnan,
December 3, 2006.

22.

Mylan Buys Part of Drug Maker, www.pittsburgh.bizjournals.com, December 21,


2006.

23.

Mylan Signs US$736-million Takeover Deal for Indias Matrix Laboratories,


www.globalinsights.com, 2006.

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.

Lee Brodie, Mylan, World Leader in Generic Drugs, www.cnbc.com, January 9,


2007.

27.

Mylan Lab Acquires Stake in Matrix, www.ciol.com, January 9, 2007.

28.

Mylan Laboratories Inc. Completes Matrix Laboratories Limited Transaction,


www.devicespace.com, January 9, 2007.

29.

UPDATE 1-Mylan Reorganizes Management


www.today.reuters.com, January 31, 2007.

30.

Mylan Laboratories Announces Strategic Global Reorganization to Maximize


Growth Opportunities and Leverage Efficiencies Provided by New Global
Platform, www.drugnewswire.com, February 1, 2007.

31.

Mylan Laboratories Ups 2007 Outlook, www.businessweek.com, February 1, 2007.

32.

Robust Growth in Specialist-Driven Products, Including Oncology Treatments,


Reflect Changing Market Dynamics, www.imshealth.com, March 20, 2007.

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.

Mylan Reportedly Wants Stake in Matrix, www.pittsburghlive.com, August 26, 2007.

36.

Mylan Laboratories Inc Completes Acquisition of Generic Business of Merck


KGaA, www.biospace.com, October 2, 2007.

37.

Consolidation in the Generic Pharmaceutical Industry: An Evolving Landscape,


Urch Publishing, October 2007.

38.

Pharmaceuticals, www.ibef.org, November 15, 2007.

39.

Rick Stouffer, Generics Deal a Shot in Arm for Mylan, www.pittsburglive.com,


December 9, 2007.

40.

Mylan Laboratories Completes Acquisition of 51.5% in Matrix Laboratories,


www.equitybulls.com, January, 2007.

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,

Troubled Times for the


Chinese Toy Industry
The history of modern Chinese toy industry dates back to the early 1900s. By the early
1980s, the Chinese toy industry was developed enough to compete in the international
market. By 2006, benefiting from economies of scale and cheap labor, the Chinese toy
industry had come to dominate the global market for toys, accounting for around 75%
of the world's output. However, in 2006-07, the Chinese toy industry faced a series of
product recalls, adversely affecting its global image.
The case discusses the development of Chinese toy industry over the years.
It discusses the problems facing the toy industry in China, with specific emphasis on
the issue of recalls in 2007 and the reason behind the recalls.
The case examines some of the other challenges that the Chinese toy industry faces
such as increasing labor costs, technological inferiority of Chinese toys and the
growing demand for high tech toys, and the Chinese toy manufacturers' lack of brand
power. The case ends with a discussion on the actions taken in response to the series
of recalls and the possible impact of these recalls on the Chinese toy industry.

Troubled Times for the


Chinese Toy Industry
If this flood of dangerous products continues and retailers are forced to pull toy
after toy from their shelves, China will become the Grinch that steals Christmas this
year.1
- Richard J. Durbin, Democrat Senator from Illinois, commenting on the
recalls of Made in China toys, in August 2007
This is the last warning. If there is an unsatisfactory report in October [2007] we
will [impose] the next layer of measures. Among them is a ban on products. 2
- Meglena Kuneva, the EU commissioner responsible for consumer
protection, in response to recalls of Chinese toys
Its quite urgent that we re-construct the Chinese toy industry. Otherwise, we will
not only lose the domestic market, but also the global market in the long term. 3
- Shi Xiaoguang, president of the China Toy Association4, in 2002.

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

Troubled Times for the Chinese Toy Industry

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.

Source: Another Huge Recall of Chinese made Toys, www.cbsnews.com, October


4, 2007.
The recalls had a limited impact on toy sales in the US and the EU but they severely
dented the Chinese toy industrys image in international markets.
The possible long-term impact on its reputation, however, was only one of the many issues
confronting the toy industry in China. With costs of raw materials and labor increasing, the
toy companies were seeing an erosion in margins. Also, the growing popularity of high-tech
electronic toys was a challenge to Chinese toy companies as they were not very strong in this
field. Furthermore, even in the traditional toy markets, Vietnam and Thailand were beginning
to pose a threat.

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

Troubled Times for the Chinese Toy Industry


special economic zones, especially in Shenzhen, attracted several international toy
makers.
Several of these factories were very large. Scale economies, together with cheap labor,
helped the Chinese toy-making firms to compete with toy producers from other
countries, who were mostly small or medium-sized.
Besides cheap labor, China was able to attract international toy companies also
because of an efficient network of supporting industries such as component industries
and services such as logistics, communication, etc. This helped international toy
makers to strengthen their competitiveness in terms of productivity, reliability, and
delivery.
In 1987, the countrys first toy design institute was set up at Tianjin Science and
Technology University. Around this period, toy makers in China started incorporating
modern technology like battery-operated controls, magnetic controls, and sound and
light controls in their products.
Chinas accession into the World Trade Organization (WTO)14 strengthened the
domestic toy industry, with a sharp rise in exports.
China organized its first international toy exposition in October 2002. Held between
October 8 and 11 in Guangzhou, the capital of Guangdong province, the expo was
hosted by China Toy Association (CTA) in cooperation with its counterparts in Hong
Kong and Taiwan and Spielwarenmesse, a Germany-based toy exhibition company
that hosts the International Toy Fair. 15 Toy producers and dealers form Germany,
Britain, Russia, Spain, Mexico, the Republic of Korea, and other countries attended
the expo.
As of 2006, there were about 7,000 toy factories in and around the cities of Shenzhen,
Dongguan, and Guangzhou (Refer Exhibit II for information on some toy
manufacturing centers in China). In 2006, China exported 22 billion units of toys
worth more than $7.5 billion (Refer Exhibit III for statistics on Chinese toy exports
and imports). According to the China Chamber of Commerce for Import and Export
of Light Industrial Products and Arts-Crafts (CCCLA),16 as of end 2006, Chinese toys
constituted 75% of world toy output. 17

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.

Compiled from various sources


In addition to rising costs, and demands from foreign clients to keep prices low, there
was increasing pressure on Chinas toy companies from clients in the US and the EU
to meet their high labor standards. Chinese toy factories had long been branded as
sweatshops20 and toy factory owners had been accused of denying workers their legal
rights. Violations allegedly included forced overtime, wage payment below the
minimum standard, failure to provide social insurance, restriction of workers
personal freedoms, etc. However, Chinese toy manufacturers shifted the blame onto
Western retailers and toy companies, saying they were squeezing their margins,
leaving them with little money to improve working conditions. Liu Kaiming,
Executive Director of the Institute of Contemporary Observation (ICO), 21 said, There
are more serious problems in the [Chinese] toy industry than any other sector as the
prices are too low.22 Bama Athreya, Director, International Labor Rights Forum, also
18

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

Troubled Times for the Chinese Toy Industry


shared the same view. In her testimony23 to the Congress, she said, Wal-Mart bears a
lion share of responsibility for pushing the [Chinese] toy industry to a place where
worker health and safety are basically nonexistent.24

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

Bicycles not larger


than
16,
not
elsewhere specified
or included

174,573,263

44,643

214,011,194

64,672

Baby carriages and


parts

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

Dolls garments and


accessories,
footwear,
and
headgear

66,734,251

9,980,431

72,254,540

3,436,787

Other dolls parts


and accessories

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

Other toys, put up


in sets or outfits

226,013,097

3,111,896

307,838,064

4,501,503

Other toys and


models,
incorporating a
motor

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

Video games used


with a television
receiver

3,888,966,084

46,635,371

5,077,008,358

189,892,142

Other video games

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

Other festival and


entertainment
articles, including
conjuring tricks

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

Troubled Times for the Chinese Toy Industry


manufacturers secured the International Council of Toy Industries (ICTI)29 Code of
Business Practices certification by January 1, 2006 (Refer Exhibit IV to know more
about the ICTI code). Alan Hassenfeld, President, CARE Foundation30 at the ICTI,
said What we need to do is to set up unified factory inspection standards before
NGOs make allegations against us.31

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

Troubled Times for the Chinese Toy Industry


toys including indoor Christmas lights, decorative string lights, fruit-shaped erasers,
toy telescopes, toy air guns, and toy rifles. 39
In 2007, the Chinese toy industry faced a series of product recalls and import bans
with importing countries raising numerous consumer safety issues. In fact, the year
recorded a sharp rise in the number of recalls, with some analysts referring to 2007 as
the year of recalls40.
In February 2007, the CPSC and Hasbro recalled about 985,000 China-made EasyBake Ovens41. The stated reason for the recall was that the door of the toy oven could
trap childrens fingers and cause burns. The CPSC said it had received 29 reports of
children getting their hands or fingers caught in the oven door, including five reports
of burns.42
In June 2007, the CPSC and RC2 Corporation43 announced a recall of 1.5 million
Thomas & Friends wooden railway toys manufactured in China. The products were
recalled because the surface paint on these products was found to contain lead. Under
US regulations, childrens products containing more than .06% of lead 44 were subject
to recalls.45
In July 2007, the CPSC and Hasbro again recalled China-made Easy-Bake Ovens
(about 1 million) citing the same reason as they had in February 2007.46 The CPSC
said that it had received 249 fresh reports of children getting their hands or fingers
caught in the ovens opening and getting burnt. Out of the 77 reported cases of burns,
16 cases were reported as second and third-degree burns. It said it had also received
one report of a five-year-old girl suffering a serious burn that required amputating her
fingers.
In August 2007, Mattel recalled China-manufactured toys twice as the paint used on them
contained more than the permissible levels of lead. The first recall of almost one million
toys was on August 1, 2007, and the second on August 14, 2007. Nancy A. Nord, Acting
Chairwoman, CPSC, said, These recalled toys have accessible lead in the paint, and
parents should not hesitate in taking them away from children.47 Mattel also recalled
magnetic toys manufactured in China as they had small but powerful magnets that could
come loose and be swallowed by children. On September 4, 2007, Mattel again recalled
844,000 toys that contained excessive levels of lead paint.
The successive recalls seemed to have seriously eroded the confidence of US companies
in China-based manufacturers. Soon after the August recalls, Jim Walter, Senior Vice
President for worldwide quality assurance, Mattel, reportedly visited Mattels contract
39
40

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

Toy Recalls between 1988 and 2007

48

49

Year

Total Number
of recalls

Recalls of toys made


in China

Percent of recalled toys


that were made in
China

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

Troubled Times for the Chinese Toy Industry


2003

15

10

67

2004

15

13

87

2005

19

16

84

2006

33

26

79

2007

40

38

95

Toy Recalls by Type of Flaws between 1988 and 2007


Year

Total number of recalls

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.
487

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

Mattel Apologizes to China, Pledging to Take Responsibility for Defective Toys,


http://news.xinhuanet.com, September 21, 2007.
Media Statement September 21, 2007, www.shareholder.com.
Mattel Apologizes to China, Pledging to Take Responsibility for Defective Toys,
http://news.xinhuanet.com, September 21, 2007.
Rachel Konrad, Chinese Toy Recalls Benefit U.S. Firms, www.courierpostonline.com, October
15, 2007.
Phthalates or phthalate esters are a group of chemical compounds that are mainly used as
additives to plastics to increase their flexibility. Some researchers believe that phthalates
pose no health risks while others believe that significant exposure to some kinds of
phthalates cause allergies, asthma, cancer, etc.

488

Troubled Times for the Chinese Toy Industry


Europe.55 The appreciation of the yuan56 against the dollar, though gradual, was further
reducing the already thin margins of Chinese toy manufacturers.
In an attempt to cut costs, some toy companies shifted operations to lower-cost areas
within China. The [stringent labor] standards and rising labor costs are forcing an
exodus of downstream manufacturing out of Shenzhen57 to second border locations
and even the hinterland of China said Apo Leung, Director of the Asia Monitor
Resource Center (AMRC)58 in Hong Kong.59 The Chinese Ministry of Commerce
further predicted that the toy industry would restructure, with larger and more
organized companies eventually acquiring smaller and sub-standard factories.
A major challenge for the Chinese toy industry, despite its dominance in the global
market, was that it lacked brand power. The Chinese companies acted merely as
original equipment manufacturers (OEMs) who manufactured products for foreign
companies. These products were then sold under foreign brands. In addition, Chinese
toy factories were weak in market knowledge and product promotion. Apart from
marketing, design was another weak area. There was moreover a severe shortage of
international quality designers. China needs lots of talented toy designers to turn
itself from a big toy maker into a powerful one, 60 said Liang Mei, secretary-general
of the China Toy Association. Though China had established some design institutes,
the demand for designers often outstripped supply. I really dont know how to
distribute this small number of graduates for such a big demand, said Jin Guifang,
director of the design institute at Tianjin Science and Technology University.
Another challenge was technology. Though many China-made traditional toy products
such as stuffed toys and dolls had taken a substantial share of markets in the EU as
well as in the US, Chinese toymakers were unable take advantage of the growing
demand for high-tech toys including electronic games and educational toys (Refer
Exhibit VI for trends in the toy industry). This was because the business model of a
large majority of China-based toy companies was one of cheap labor and a low level
of technology. Most toy factories are small or middle-sized, with limited staff and
budgets for toy innovation. Besides, developing new products requires a large
investment and long-term payback, said Mei Meng, general manager of the Nantong
Eurofield Arts Toy Company. Among toys China exported to the EU in 2006, more
than 80% were traditional toys; high-tech toys were less than 5%.
By competing on price, the Chinese toy industry also faced the danger of losing orders
to other emerging manufacturing hubs. However, the authorities were aware of the
downside to following a processing model. Shi Xiaoguang, president of the China
Toy Association, said, The toy processing model is highly risky for the Chinese toy
industry. About 60 to 70 per cent of exported toys are produced in Guangdong
Province (in South China). If they lose overseas orders, they could lose their whole
market.61
55

56
57
58

59

60

61

Chinas Lockhold on Global Toy Industry Set to Ease, www.taipeitimes.com, February


12, 2006.
As on October 26, 2007, US$ 1 was equal to 7.4976 yuan.
Shenzhen is a city in the Guangdong province in southern China.
The Asia Monitor Resource Center (AMRC) was founded in 1976. It is an independent nongovernment organization which focuses on Asian labor concerns. (Source:
www.amrc.org.hk)
Calum MacLeod, Chinas Toy Industry Feels Growing Pains, www.usatoday.com,
December 21, 2006.
Barbie Doll Poses a Challenge to Mammoth Chinese Toy Industry,
http://english.peopledaily.com.cn, January 06, 2003.
Toying with the Future, http://app1.chinadaily.com.cn, 2002.

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

Troubled Times for the Chinese Toy Industry

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

Troubled Times for the Chinese Toy Industry

References and Suggested Readings:


1.

Tim Johnson, Chinese Toy Factories Retool after Recalls, www.mcclatchydc.com,


October 23, 2007.

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.

Anne Dinnocenzio, Despite Recalls, Chinese Toys Still Sell, www.theledger.com,


October 2, 2007.

5.

Media Statement-September 21, 2007, www.shareholder.com.

6.

Mattel Apologizes to China, Pledging to Take Responsibility for Defective Toys,


http://news.xinhuanet.com, September 21, 2007.

7.

Kelly Marshall and Rob Kelley, Mattel Announces Third Toy Recall, www.money.
cnn.com, September 5, 2007.

8.

Hari Bapuji and Paul W. Beamish, Toy Recalls


www.asiapacific.ca, September, 2007.

9.

Consumers: Mattel Expands Recall of Chinese Toys, http://europa.eu. August 16,


2007.

10.

Anne DInnocenzio, Toy Industry Challenged by Disposal Plan, www.boston.com,


August 15, 2007.

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.

Lead Paint Prompts Mattel to Recall 967,000 Toys, www.nytimes.com, August2,


2007.

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.

Nearly 1 Million Hasbro Toy Ovens Recalled, www.money.cnn.com, February 6,


2007.

19.

Calum MacLeod, China's Toy Industry Feels Growing Pains, www.usatoday.com,


December 21, 2006.

20.

April Mei, Playtime is over for Chinas Toy Industry, www.atimes.com, June 21,
2006.

21.

Toy Industry Gets Improved Regulation, http://english.peopledaily.com.cn, April 1,


2006.

22.

Liu Songjie, Mainland Toy Companies


www.chinalaborwatch. org, February 15, 2006.

23.

Chinas Lockhold on Global Toy Industry Set to ease, www.taipeitimes.com, February 12,
2006.

Benefit

U.S.

Firms,

Is China Really the Problem?

Facing

the

ICTI

Dilemma,

493

International Business
24.

Tin Toys Tradition Lives On, www.tinmantintoys.com.

25.

Conquering Chinas Consumer Market Example: Toy Industry, www.fiduciachina.com.

26.

Keith Bradsher, Wages Up in China as Young Workers Grow Scarce,


www.nytimes.com, August 29, 2007.

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

The European Union and Immigration from


New Member Countries
The case focuses on the issue of immigration from the new member states who joined
the EU in 2004 into the older member states of the European Union. It traces the
process of European integration from the period after the Second World War, and the
formation of the European Union and its subsequent expansions.
The case further discusses the different approaches adopted by the older member
states of the EU to deal with the expected flood of job seekers from the newly
independent states from Central and Eastern Europe, which joined the EU after the
disintegration of the Soviet Union.
While Ireland, the United Kingdom and Sweden were fairly open to immigrants from
these countries, the other EU members imposed many restrictions on the movement of
workers from the new member states. The case then compares the impact of
immigration on the three EU member states that chose to allow immigrants in, with
the countries which followed a more restrictive approach. It ends by examining the
issue of the expected eventual decrease in the EU's population in the coming
years/decades and the need for these countries to supplement their indigenous labor
markets with immigrants.

The European Union and Immigration


from New Member Countries
The [European] Union has today set itself a new strategic goal for the next decade:
to become the most competitive and dynamic knowledge-based economy in the world
capable of sustainable economic growth with more and better jobs and greater social
cohesion.1
Presidency Conclusions, Lisbon European Council, in March 2000
The old EU owes them [the new members] a welcome. In practical terms, this
means that West European politicians should stop exploiting populist resentment of
low-wage competition. They should explain to their voters that economic reforms
would be necessary even in the absence of enlargement and that, on the whole, the
addition of ten new members has been good for the EU economy. 2
Katinka Barysch, Chief Economist, Centre for European Reform, 3 in 2005.

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

The European Union and Immigration from New Member Countries

Exhibit I
Map of European Union in 2005

Source: www.ezilon.com/ eu_map_europe.jpg.


A year later, these three economies reported that they had not experienced any
upheavals or disruptions in their labor markets. Instead, they claimed, the immigrants
had helped fuel their economic growth by filling in the gaps in their labor markets
be it in construction, health & hospitality, or in other areas, while making few claims
on the welfare system or public services.

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
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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.

The European Community (EC)


After the end of the Second World War, Europe was divided into two opposing blocs
the US-led free-market oriented Western Europe and the Soviet Union-led socialist
Central and East Europe. The West European countries, devastated by the war,
realized that economic protectionism and chauvinistic nationalism were factors that
could lead to war among various nations. Jean Monnet, considered by many as the
architect of the European Union, felt that if Europe was to avoid the scourge of
destructive wars, the European states must come together. He declared, There will be
no peace in Europe, if the states are reconstituted on the basis of national
sovereignty...The European states must constitute themselves into a federation. 7
Accordingly, the European Coal and Steel Community (ECSC) was founded in 1951
by Belgium, the Netherlands, Luxembourg, France, Italy, and West Germany, in order
to pool their all-important steel and coal resources. The process of integration was
further strengthened with the signing of the Treaty of Rome in 1957 establishing the
European Economic Community (EEC), which came into effect on January 1, 1958.
6
7

Emigration, http://en.wikipedia.org/wiki/Emigration
Jeremy N. Smith, The Father of Europe,
http://www.worldtrademag.com/CDA/Articles/Column/
0489bc5ec5499010VgnVCM100000f932a8c0__

524

The European Union and Immigration from New Member Countries


The EEC was established with the aim of creating a Customs Union (CU) among the
six member states based on the four fundamental freedoms: the freedoms of
movement for goods, services, capital, and people. The CU was finally established in
1968. The EEC was later renamed the European Community (EC).

Enlargement of the EC and the Creation of the European Union


The success of the EC in stimulating trade, growth, and development among the
member states prompted Britain, Denmark, and Ireland to apply for the EC
membership in 1961.8 A series of negotiations followed in which the EC members and
the prospective members evaluated a number of proposals and counter-proposals.
Finally, Britain joined the EC along with Denmark and Ireland in 1973. This was the
first enlargement of the EC. In 1981, six years after its application for membership,
Greece acceded to the EC.
When Spain and Portugal applied for EC membership in 1977, the existing EC
members were forced to face the problem of immigration associated with the
enlargement of the EC. Although Portugal and Spain eventually gained membership
in 1986, the people of these two countries were restricted for a period of 10 years from
moving freely within the EU in search of work. One of the reasons for these
restrictions was the fear that there would be a large influx of Portuguese and
Spaniards looking for work into the more prosperous countries of the EC if the
borders of these countries were opened up fully. 9
In 1993, the Maastricht treaty, signed a year earlier, modified the Treaty of Rome and
established the European Union (EU). The EC became an integral part of the new EU.
The EU was enlarged in 1995 to include Austria, Finland, and Sweden.

The Collapse of the Socialist BLOC and the Copenhagen Criteria


Meanwhile, the collapse of the socialist bloc in Central and Eastern Europe in 198990 released many countries from the control of the Soviet Union. During this period,
Poland, Hungary, Bulgaria, Romania, and Czechoslovakia became free of Soviet
control. In 1991, the disintegration of the Soviet Union led to the emergence of
several new states on the international stage -- the Russian Federation, Lithuania,
Latvia, Estonia, Ukraine, Belarus, Moldova, Georgia, Armenia, Azerbaijan,
Kazakhstan, Kyrgyzstan, Uzbekistan, Tajikistan, and Turkmenistan. Having been
severely constrained for decades by centralized planning, many of these newly
independent states looked eagerly toward the EC for the development of their
economies. It also provided an opportunity for the EC to further the process of
European integration.
Therefore, as initial steps to future integration, the EC concluded Europe Agreements
with Hungary and Poland in December 1991, Romania, Bulgaria, the Czech Republic,
and Slovakia in February 1995, Estonia, Latvia and Lithuania in February 1998, and
Slovenia in February 1999. The aim of these agreements was to liberalize trade
between these countries and the EU.10

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

The Accession of New Members


Following the formulation of the Copenhagen Criteria, many of the CEE countries
applied for EU membership. Hungary applied in March 1994, Poland in April 1994,
Romania and Slovakia in June 1995, Latvia in October 1995, Estonia in November
1995, Lithuania and Bulgaria in December 1995, the Czech Republic in January 1996,
and Slovenia in June 1996. Turkey had already announced its desire to become a
member in April 1987. Cyprus and Malta had done likewise in July 1990 12.
The applicants had to go through painful transitions of their polities, economies, and
societies so as to conform to the eligibility criteria. It was not easy for these countries,
which for decades had been planned socialist economies with strict policing and
almost no concern for human rights, to undergo the democratization process and move
toward becoming market-oriented economies. The prospective candidates were to
incorporate all the existing laws of the EU into their domestic legal framework and
work for their active application.
The EU continuously monitored the progress of the candidate countries with respect
to the Copenhagen Criteria to determine their eligibility. In 1997, the EU decided to
open accession negotiations with Cyprus, Hungary, Poland, Estonia, the Czech
Republic, and Slovenia. Romania, Slovakia, Latvia, Lithuania, Bulgaria, and Malta
were added to the list in 1999. In December 2002, leaving Bulgaria and Romania
aside for further negotiations, the EU concluded access negotiations with the
remaining ten candidates. The Treaty of Accession with these ten countries was
signed in Athens on April 16, 2003, and the treaty came into effect on May 01, 2004.
Bulgaria and Romania were slated to accede to the EU in 2007.
Thus, ten new countries became members of the EU on May 01, 2004. These
countries, when compared to the old members, were very small in terms of GDP, but
quite large in terms of population and labor force. While the new member states
combined GDP was 5% of the GDP of the old EU, their labor force amounted to 25%
of that of the latter. Moreover, there were huge differences in wage rates between the
old and new members. The new members were erstwhile socialist countries which
gave their citizens full employment at the expense of economic health and
competitiveness. Dismantling of these economic systems in the early 1990s led to
huge lay-offs and high levels of unemployment in these countries.
With accession, the new member countries gained the right to participate on an equal
basis in the institutions and committees of the EU. The market for their goods and
services expanded and the free movement of goods, introduced as per the Europe
Agreements of the early 1990s, was to be complete. Membership of the EU also
provided full freedom of movement for persons from one country to another within
the EU. Citizens of both the old and new members could travel freely anywhere in the

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-

The European Union and Immigration from New Member Countries


enlarged EU.13 However, for a transition period of seven years, the old members were
allowed to impose restrictions on the movement of labor from the new members, if
they so wished. This provision was made out of fear that people from some of the new
member states would swamp the labor markets of the old members. However, the
citizens of Cyprus and Malta did not face this restriction.
Only three of the old members opted not to apply these restrictions on the free
movement of workers. The UK, Ireland, and Sweden opened their labor markets to
people from the new member states. However, there were fears even in these
countries, especially in the UK, that the workers from the new member states would
chase local jobs and strain the economy by seeking welfare benefits.

The Demographic and Economic Profile of the EU


To understand the issue of migration in the EU, it is essential to understand certain
important characteristics of the demography and economy of the EU member states.
These issues were interlinked, and, individually and in combination, had a significant
impact on the growth rates in these countries. The old EU economies, especially, had
been struggling with low growth rates for many years. Between 2000 and 2004, the
growth rates of GDP of the old EU countries had ranged between 1.0% and 3.8%
(Refer to Exhibit II for growth rates in the EU between 2000 and 2004).
Exhibit II

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

The European Union and Immigration from New Member Countries

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

Area and Population Statistics of the EU and its Member States


Member State

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

EU needs immigration to support ageing population,


http://www.workpermit.com/news/2005_10_25/ europe/eu_needs_immigration
Europe in figures: Eurostat yearbook 2005, European Commission, Luxembourg.

530

The European Union and Immigration from New Member Countries

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.
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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).

Table I: Immigration Regimes in the Old EU Member Countries after the


Enlargement
A restrictive immigration regime in which workers from
the new member states are treated in the same way as nonEEA* citizens and are required to apply for a work permit,
which is to be issued only in cases where neither nationals
nor other EU-15 nationals can fill the position.

Belgium, Finland,
Germany, Greece,
France, Luxembourg,
Spain

Restrictive immigration regime but with a quota for


workers from the new member states

Austria, Italy, the


Netherlands, Portugal

General access to the labor market, however with limited


welfare benefits. Unemployment might also constitute
grounds for the withdrawal of the residence permit.

Ireland, the UK

Community rules on the free movement of workers are


fully applied.

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.

Immigration in Post Enlargement EU


While other countries imposed various kinds of quotas and restrictions, the UK,
Ireland, and Sweden allowed workers from the new member countries access to their
labor markets. The UK implemented a Worker Registration Scheme, and required all
immigrants from the new member countries to obtain a work permit.
Since the accession, till December 31, 2005, nearly 345,000 applicants from the new
member countries registered with the Worker Registration Scheme to work in the UK.
Of these, around 329,000 applicants were issued worker registration certificates and
cards. The Polish were the largest group of all (204,895) followed by the Lithuanians
532

The European Union and Immigration from New Member Countries


(44,715). More than 80% of the immigrant workers were aged between 18 and 34
(Refer to Exhibit VIII for details on immigrants to the UK between May 2004
and December 2005).

Exhibit VIII

Total

Other

Slovenia

Slovakia

Poland

Lithuania

Latvia

Hungary

Estonia

Period

Czech Rep

Nationality of Applicants by Quarter Applied in the UK May 2004


December 2005

Q2
2004

2,520

660 1,090 2,930 7,720 23,465

3,730

50

30 42,200

Q3
2004

3,510

770 1,315 3,660 7,595 28,070

5,240

65

40 50,260

Q4
2004

3,020

615 1,430 2,770 5,360 23,920

4,875

55

30 42,075

Q1
2005

2,840

730 1,460 3,150 5,915 23,805

4,950

55

35 42,940

Q2
2005

2,825

740 1,650 4,340 7,685 33,700

6,025

30

30 57,030

Q3
2005

2,980

630 1,720 3,455 5,985 39,375

6,545

35

50 60,775

Q4
2005

2,310

535 1,670 2,720 4,460 32,560

4,995

55

45 49,355

20,005 4,680 10,345 23,030 44,715 204,89 36,355


5

340

265 344,63
5

Total
As %
of
Total

6%

1%

3%

7%

Source: Accession Monitoring


www.ind.homeoffice.gov.uk.

13%

Report

59%

May

11% <0.5 <0.5


%
%
2004

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

Sectors in which Registered Workers are Employed in the UK, by


Quarter Applied May 2004 December 2005
Q2
2004

Q3
2004

Q4
2004

Q1
2005

Q2
2005

Q3
2005

Q4
2005

Total

Admin, bus &


man services

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

Retail & related


services

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

Ent. & leisure


services

790

950

450

890

1,195

1,135

430

5,840

Education &
cultural act

460

545

490

445

480

510

485

3,400

Real est. & prop


services

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

Sec. & protect


services

534

The European Union and Immigration from New Member Countries

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

Source: Accession Monitoring Report May 2004 December 2005, www.ind.homeoffice.gov.uk.


The report also mentioned that very few immigrants had actually applied for taxrevenue funded welfare benefits. Even from the limited number of applications for
welfare benefits, only a few had been approved for further processing. During May
2004 and December 2005, there were 992 applicants for Income Support, 2,232
applicants for income-based Jobseekers Allowance, and 46 applicants for state
Pension Credit. Out of these, only 194 applications (or 5.9% of the total) had been
shortlisted for further processing. The remaining 94.1% of applications had been
disallowed on the grounds of Right to Reside and Habitual Residence Tests (Refer to
Exhibit X for the number of applications for income related benefits May 2004
December 2005).
Similarly, Irelands booming economy and especially its construction industry
absorbed a large number of immigrants from the new member countries. Among the
immigrants, the Poles and the Lithuanians constituted the largest numbers, followed
by the Latvians. The Latvians, in particular, earned a good name for themselves as
hard workers. Alfie Lambert, the owner of a firm that makes door frames for the
booming Irish building trade, said, We can't live without the Latvians. We can't grow
without them. He added, Our young Irish don't want to do these jobs any more. 18
Between May 2004 and December 2005, Latvia sent 14,000 workers to Ireland, and in
all, Ireland received close to 160,000 immigrants from the CEE 19. Like Ireland,
Sweden, which too opened its doors to the new members, did not report any
disruptions in its labor market.
18

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

Applications for Income Support


Disallowed

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

Applications for Income-based Jobseekers Allowance


Disallowed

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

Applications for State Pension Credit


Disallowed

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

Source: Accession Monitoring


www.ind.homeoffice.gov.uk.

Report

May

2004

December

2005,

All the three economies


UK, Ireland, and Sweden
had been experiencing strong
economic growth before the enlargement and they continued to do so even after the
arrival of the immigrants after the enlargement (Refer to Exhibit XI for growth
rates of select EU members between 2000 and 2004).
536

The European Union and Immigration from New Member Countries

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.

The Other Economies


Germany and Austria, which shared common borders with some of the new member
countries, estimated that around four million people would move into their countries
from the CEE by the year 2030. This high estimate prompted both countries to apply
severe restrictions on the movement of labor from the CEE, through the imposition of
quotas on immigration. In August 2005, Austria announced that it would continue to
apply restrictions on labor movement till 2007. In the same month, it also announced a
proposal for a bilateral agreement with Slovenia, easing restrictions and permitting
free movement for Slovene nationals.
In France, while nearly 2.5 million French workers remained unemployed, 250,000
job vacancies remained vacant. Between May 01, 2004, and March 31, 2005, only a
little more than 700 Polish nationals were granted temporary work permits in France.

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

Spain, Portugal and Finland


Migration from the new to the old EU countries was watched closely by all the member
states. Many member states realized that in spite of imposing severe restrictions, some
countries were facing large-scale illegal immigration. They realized that it would be better
to legalize immigration and integrate the immigrants with the mainstream, instead of
leaving them to live on the fringes of society.
Spain experienced a heavy flow of illegal immigration from the North African
countries. The fact that labor migration did not lead to labor market disruptions in the
host economies led Spain, Portugal, and Finland to contemplate the idea of opening up
their labor markets. In February 2006, all the three countries gave indications that they
were willing to consider the issue of opening up their labor markets to the new
members. And on March 9, 2006, the Spanish Prime Minister Zapatero announced
that Spain would open up its labor markets to the new members effective from May
01, 2006. The announcement was welcomed by the EU, which advised other member
countries to follow suit. However, Germany and Austria along with Italy and France,
the main economies in the rest of the EU, declared that they had no intention of doing
so.

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

The European Union and Immigration from New Member Countries


below 1.5 since 1995 through 2003,23 making an eventual decrease in the EU
population inevitable. This decrease in population is expected to have serious
consequences for EUs future in terms of growth rates and development. The fiscal
burden of financing pension systems for a large number of people and providing
healthcare for the elderly, as well as serious gaps in labor markets, are other concerns.
A large number of elderly people will mean that young workers will have to pay
higher taxes to finance the state pension systems. Increasing taxation on a relatively
smaller working population is likely to lead to a flight of human capital the
migration of workers to countries with lower taxes.
The fears regarding migration are expected to fade over time. Additionally, as
immigrants from the new member countries earn higher incomes and send remittances
back to their home countries, the CEE countries will begin to provide better
employment and income opportunities to its citizens. As the income gap between the
old and new member countries converge over a period of time, people will have less
incentive to move out of their own countries. As migration entails a lot of costs
tangible and intangible
people will tend to prefer to stay in their own countries,
other factors being favorable. In fact, it is expected that with the development of the
new member countries, many of the immigrants will return to their home countries.
Some of the EU countries are also looking at other options, such as increasing the
birth rates, to overcome the looming problems in their labor markets. How far these
efforts will be successful is anyones guess, given the fact that it takes at least two
decades for a baby boom to impact the labor market.
However, one thing most analysts are clear on is that if the EU wants to become a
knowledge-based dynamic economy as enunciated in its Lisbon European Council, it
cannot afford to have serious labor gaps in its market. How well the different
countries manage to meet that challenge is something that only time will tell.

23

Europe in Figures: Eurostat Yearbook 2005, European Commission, Luxembourg.

539

International Business

Additional Readings & References:


1. Mark J. Miller, Western European Strategies to Deter Unwanted Migration: Neither
New Barbarian Invasions Nor Fortress Europa, US Commission on Immigration
Reform, June 1994.
2. Marek Oklski & Dariusz Stola, Migration between Poland and the European Union:
the perspective of Polands future membership of EU, Institute for Social Studies,
University of Warsaw, March 1999
3. Michel Poulain and Nicolas Perrin, Is the measurement of international migration
flows improving in Europe, Statistical Office of European Communities, May 16, 2001.
4. Migration Policies and EU Enlargement: The Case of Central and East Europe, OECD,
2001.
5. Paul Levine, Emanuela Lotti, Joseph Pearlman & Richard Pierse, The Economic Impact
of East-West Migration in an Enlarged European Union, Hamburg Institute of
International Economics, 2003.
6. Stephen Drinkwater, Paul Levine & Emanuela Lotti, The Labour Market Effects of
Remittances, Hamburg Institute of International Economics, 2003.
7. Stephen Drinkwater, Go West? Assessing the willingness to move from Central and
Eastern European Countries, Hamburg Institute of International Economics, 2003.
8. David Mackie & Michael Marrese, EU enlargement: opportunities grasped by the
east, missed by the west, JPMorgan Research, New York, April 27, 2004.
9. The
Enlargement
of
the
European
Union,
http://www.auswaertigesamt.de/www/en/eu_politik/vertiefung/erweiterung_html, May 2004.
10. Antonio Vitorino, The Challenges of Global Migration: An EU View,
http://www.carnegiecouncil.org/viewMedia.php/prmID/4985, May 14, 2004
11. Fredrik Bergstrom & Robert Gidehag, EU VERSUS USA, Timbro, Stockholm, June
2004.
12. Controlling our borders: Making migration work for Britain, Secretary of State for
the Home Department, United Kingdom, February 2005.
13. John Salt, Types of Migration in Europe: Implications and Policy Concerns,
European Population Committee, Strasbourg, April 2005
14. Tito Boeri & Herbert Brcker, Migration, Co-ordination Failures and EU
Enlargement, Institute for the Study of Labor, Bonn, Germany, May 2005.
15. Migration and the Millennium Development Goals, United Nations Population Fund,
Marrakech, Morocco, May 2005.
16. Ellen Lammers, Global Migration Perspectives, Global Commission on International
Migration, September 2005.
17. Julianna Traser, Whos afraid of EU enlargement? ww.ecas.org/file_uploads/1009.pdf,
September 2005.
18. EU needs immigration to support ageing population,
http://www.workpermit.com/news/ 2005_10_25/europe/eu_needs_immigration, October
25, 2005.
19. Katinka Barysch, East versus West? The European economic and social model after
enlargement, www.cer.org.uk, October 26, 2005.
20. Kevin Sullivan, East-to-West Migration Remaking Europe,
www.washingtonpost.com/wpdyn/content/article/2005/11/27/AR2005112700950_2.html, November 28, 2005.

540

The European Union and Immigration from New Member Countries


21. Nicholas Watt, Migrant workers from east helping to boost EU's fortunes, says
report, http://www.guardian.co.uk/eu/story/0,,1705656,00.html, February 9, 2006
22. 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.
23. Europe in Figures: Eurostat Yearbook 2005, European Commission, Luxembourg.
24. www.workpermit.com
25. www.imf.org
26. www.oecd.org
27. www.guardian.co.uk
28. www.eiro.eurofound.eu.int
29. www.finfacts.com
30. www.euractiv.com

541

The Indian Rupee-US Dollar Exchange


Rate: The Economic Impact of a
Strengthening Currency
In 2007, India experienced rapid appreciation of its currency against the US dollar.
The reasons for the appreciation of the rupee were a generally weak dollar in
international currency markets and sharp increase in dollar inflows into the country,
partly due to India's increasing attractiveness to foreign investors. Although India
had been seeing a steady rise in dollar inflows into the country for quite some time, on
earlier occasions, the Reserve Bank of India (RBI) had intervened in the foreign
currency market and purchased excess dollars so as to prevent any appreciation in
the value of the rupee. Now, the RBI decided not to intervene, mainly to control
inflation which was around 6 percent in early 2007.
The case discusses the reasons for the appreciation of the rupee and its possible
impact on the Indian economy. It also discusses the measures taken by the RBI and
the government to control rupee appreciation and to try offset the negative impacts of
a strong currency on the economy. The case ends with some views on the future
movement of the rupee.

The Indian Rupee-US Dollar Exchange


Rate: The Economic Impact of a
Strengthening Currency
The profitability of exporters has been wiped out and constant appreciation is
threatening the competitiveness of our product. If we lose the market, aggressive
competitors are just sitting on the fence to occupy the market. 1
- G.K. Gupta, President of the Federation of Indian Export Organizations
(FIEO),2 in October 2007
The government is concerned over the rapid appreciation of the rupee against the
US dollar and the central bank may have to intervene if there is disorderly movement
in the exchange rate.3
- P Chidambaram, Finance Minister of India, in September, 2007
The objective of the exchange rate management has been to ensure that the external
value of the rupee is realistic and credible as evidenced by a sustainable current
account deficit and manageable foreign exchange situation. Subject to this
predominant objective, the exchange rate policy is guided by the need to reduce
excess volatility, prevent the emergence of destabilizing speculation activities, help
maintain adequate level of reserves, and develop an orderly foreign exchange
market.4
- RBIs Policy in the Foreign Exchange Market

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

Exporters Seek Government Intervention on Rupee Rise, www.newspstindia.com,


October 1, 2007.
The Federation of Indian Export Organizations (FIEO) is a non-profit organization set up by
the Ministry of Commerce, Government of India in 1965, to coordinate and focus the efforts
of organizations engaged in export promotion in the country. (Source: http://fieo.org)
Rapid Rupee Appreciation is a Matter of Serious Concern: FM, www.newindpress.com,
September 27, 2007.
T.C.A. Ramanujam, Currency Crossfires, www.thehindubusinessline.com, June 27, 2003.
Dollar ($) denotes US dollars in this case study.
An investment made to acquire lasting interest in enterprises operating outside the economy
of the investor is called foreign direct investment (FDI). (Source: http://en.wikipedia.org)
Foreign institutional investment is a part of foreign portfolio investment which involves
holding securities such as stocks, bonds, or other financial assets by foreign investors. In
India, foreign institutional investors have to register with the Securities and Exchange Board

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

*GDP based on exchange rate in 2006.


India, together with Russia, became a trillion-dollar economy in early
2007
Source: World Bank, 2006
Although India had been witnessing strong dollar inflows for some time, the rupee had not
appreciated as steeply as it did between September 2006 and July 2007 mainly because on
earlier occasions, strong dollar inflows into India usually saw the Reserve Bank of India
(RBI)9, Indias central bank, intervene in the foreign exchange market and purchase excess
dollars so as to minimize volatility in the value of the rupee. This time around, the RBI
chose not to intervene, in order to keep domestic inflation, which had been hovering
around 6 percent in early 2007, in check.
While the RBI and the finance ministry were able to tame the inflation rate (inflation
fell to 3.52% in August, 2007), the rupees appreciation affected Indian exporters as
Indian goods became more expensive for foreign buyers. Information technology (IT)
and textiles industries were particularly hard-hit, as they were the most dependent on
the US. Leather, sugar, and plantation crops were some of the other sectors that were
starting to lose competitiveness. The Indian Micro, Small and Medium Enterprises
(MSMEs) were also affected. It was feared that falling export competitiveness would
cause substantial job losses.

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

The Indian Rupee-US Dollar Exchange Rate:

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

The Indian Rupee-US Dollar Exchange Rate:


In June 1966, the rupee was devalued by 57.5 percent and its exchange rate against
the dollar was set at 7.50, compared to 4.76 prior to the devaluation. In August
1971, with the Bretton Woods System (The Bretton Woods system involved
member countries agreeing to an exchange rate system where each currency traded
within defined parities with the US dollar) breaking down, the rupee was pegged to
the dollar, with the rupee-dollar exchange rate continuing at 7.50. However, after
the dollar devalued on December 18, 1971, the rupee was again pegged to the
pound on December 20, 1971, with Rs 18.967 equal to one pound. When the pound
was floated on June 23, 1972, the rupee depreciated again. In 1975, the rupee was
linked to a basket of currencies of Indias major trading partners the dollar, the
pound, the yen, the Deutsche mark, and the Italian lira. To express the value of the
rupee, the pound was used by the RBI as reference currency. The RBI declared the
official rate of the rupee against the pound on a daily basis.
In 1978, the Indian rupee was given the official ISO 4217 abbreviation of INR IN
for India and R for Rupee.
In March, 1992, the government of India announced full convertibility of the rupee
in the current account. As of 2007, the government was considering full
convertibility of the rupee in the capital account as well.
Compiled from various sources
In March, 1992, the Liberalized Exchange Rate Management System (LERMS) was
introduced under which a dual exchange rate 15 was adopted. In March 1993, the
LERMS was replaced by the unified exchange rate system and the system for setting
exchange rates changed from a controlled system to a managed float system.16 In
1993-94, the rupee was made freely convertible for trading, but not for investment
purposes.
After liberalization, Indias exchange rate policy focused on managing the fluctuation
of the rupee-dollar exchange rate and at the same time allowing the demand and
supply conditions to determine the exchange rate. Post-1991, the RBI intervened in
the foreign exchange market whenever it deemed necessary and took suitable
measures to counter speculative pressures on the rupee and maintain stability in the
foreign exchange market, also with an eye to maintaining Indias external
competitiveness. It purchased or sold dollars in order to reduce the excess supply of or
excess demand for dollars.
From 1991 to 2002, the rupee depreciated steadily against the dollar, from Rs 17.94 to
Rs 48.15. This happened despite foreign exchange inflows that increased the foreign
exchange reserves of the country from $ 5.8 billion to $ 51.05 billion during the
period. The reserves grew in large part due to a healthy increase in exports (from $
18.48 billion to $ 44.91 billion 17). Growth in private transfers, especially remittances
from migrant workers, increased manifold from $ 2.08 billion to $ 12.19 billion.

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.

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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

*As on last day of every month.


Source: www.economagic.com.

Reasons behind the Appreciation of the Rupee in 2006-07


Toward the end of 2006, foreign exchange inflows, especially of dollars, into India
started rising sharply. This put upward pressure on the rupees exchange rate against
the dollar. Indias steady economic growth offered several opportunities for foreign
companies. Between April 2006 and March 2007, FDI of $ 16 billion flowed in to
India. This was around three times the preceding years figure. More than 50 percent
of these inflows arrived between December 2006 and March 2007. By August 24,
2007, Indias foreign exchange reserves had increased to a record $ 228.8 billion
(Refer Exhibit V for Indias foreign exchange reserves between 1991 and 2006).
Indias booming stock market contributed to the foreign exchange inflows. In 200607, FII inflows increased by 61 percent (year-on-year) to touch $ 105.8 billion. The
net FII inflows for the year were $ 7.99 billion. In the first five months of 2007-08, net
FII inflows crossed $ 8.4 billion. Portfolio capital inflows also came from overseas
254

The Indian Rupee-US Dollar Exchange Rate:


equity issues of Indian companies via global depositary receipts (GDRs) 18 and
American depositary receipts (ADRs). 19 Inflows from GDRs and ADRs amounted to $
3.8 billion in 2006-07 with a year-on-year increase of 48 percent.

Exhibit V
Indias Foreign Exchange Reserves between 1990-91 and 2005-06

Source: Report on Foreign Exchange Reserves, www.rbi.org.in, July 14, 2006.


Apart from the equity issues, several Indian companies borrowed massive amounts of
money, mostly in dollars, from abroad to fund investments and acquisitions in India,
and this also contributed to the dollar inflows. The first quarter of 2007-08 (AprilJune) recorded ECBs of $ 48.3 billion, an increase of 12.9 percent compared to the
first quarter of the previous year.20
Another major source of capital inflows was non-resident Indian (NRI) deposits in
bank accounts in India. As Indian banks offered higher interest rates on deposits than
overseas banks, NRIs preferred to invest in India. The NRI deposits stood at $ 42.6
billion as of June 2007.21 Remittances from Indians working overseas also saw an
increase to reach $ 27.2 billion in 2006-07 compared to $ 24.1 billion in 2005-06
(Refer Exhibit VI for remittances to India between 1990-91 and 2005-06, and
Exhibit VII for the source regions of remittance flows to India in November
2006).
18

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

Source: Muzaffar A. Chishti, The Phenomenal Rise in Remittances to India:


A Closer Look, www.migrationpolicy.org, May 2007.

Exhibit VII
Source Regions of Remittance Flows to India in November 2007

North America

Europe

East Asia

Others

Africa

Gulf countries

South America

Source: Muzaffar A. Chishti, The Phenomenal Rise in Remittances to India: A


Closer Look, www.migrationpolicy.org, May 2007.
256

The Indian Rupee-US Dollar Exchange Rate:


Export growth also contributed to Indias increasing foreign exchange reserves. IT
and business-process outsourcing (BPO) exports increased rapidly in 2006-07 to cross
$ 31.9 billion, a year-on-year increase of around 32 percent.
Some analysts were of the view that the slowdown in the US economy was the primary
reason for the dollar inflow into emerging economies, including India. According to
Avinash Vashistha, MD, Tholons, a global services and investment consulting firm, This
scenario will continue considering that India is booming and interest rates are high here,
while the US economy is facing a slowdown and interest rates are falling.22 The dollar
also depreciated against other major currencies. Between August 2006 and August 2007,
the euro appreciated against the dollar from 0.78 to 0.73, the British pound appreciated
from 0.53 to 0.49, and the yen appreciated from 117.35 to 115.83.
The sub prime mortgage crisis in the US was another reason for the large dollar
inflows in to India. While the U.S. has managed such monetary fluctuations in the
past (sub prime crisis), in the present context, there are impacts on India and other
emerging markets and the government will carefully study the rupee movement and to
what extent we can stand the current liquidity surge and hot capital inflow, with
overseas financial institutions looking here for better returns, said Parthasarathi
Shome, Advisor to the Union Finance Minister. 23 The increase in oil prices resulted in
increased liquidity in the Gulf countries, and some of this was also believed to be
being diverted to India.
The increased inflow of dollars into the Indian market certainly put upward pressure
on the rupee. This upward pressure was not neutralized, because the RBI, which till
late 2006 had been following the policy of managed float in the foreign currency
market, decided in September 2006 to stop intervening in the foreign exchange
market. Apparently, the RBIs decision not to intervene was taken in order to control
the inflation rate, which had begun to be a cause of concern to the central bank as well
as the government. In early 2007, the inflation rate, as measured by the wholesale
price index (WPI)24, hovered around 6-6.8 percent, well above the level of 5-5.5
percent acceptable to RBI. On February 15, 2007, inflation reached a two year high of
6.73 percent (Refer Exhibit VIII for the inflation rates between August 2006 and
August 2007). By allowing the rupee to appreciate, the RBI hoped to control inflation
by making imported goods cheaper. Also, the rise in the value of the rupee was
expected to make some Indian export items, especially food products, less competitive
in overseas markets, thus forcing exporters of these products to release them in the
domestic market. This was expected to increase the supply of goods and bring down
domestic prices.
Previously, whenever there had been upward pressure on the rupee, the RBI would
buy dollars from the market. This resulted in an equivalent amount of rupees being
released into the domestic market (as domestic money supply is related to the RBIs
reserve holdings). To absorb this oversupply of rupees, the RBI had been selling
government bonds under the market stabilization scheme (MSS). However,
sterilization, as this process was called, led to the oversupply of government bonds in
the market thus bringing down their prices. As bond prices share an inverse relation
with interest rates on bonds, any fall in bond prices would translate to higher interest
22

23
24

Mini Joseph Tejaswi, Rupee Appreciation to Hit Software Cos,


www.economictimes.indiatimes.com, March 29, 2007
Tackling U.S. Sub-prime Crisis in India, www.hindu.com, October 6, 2007.
The Wholesale Price Index (WPI) is the index that is used to measure the change in the average
price levels of goods (both agricultural and industrial) traded in the wholesale market (compared
to the base year 1993-94). In India, the WPI is taken as the indicator of the rate of inflation and
includes in all 435 items.

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

Inflation rate* (In %)

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

* As of last week of the month


Source: http://finmin.nic.in.
The trend of steady month-on-month appreciation of the rupee began in September
2006 and continued through the first eight months of 2007. By August 2007, the
rupee-dollar exchange rate reached 40.63, from 46.45 in August 2006.

Effects on the Economy


The rupees appreciation against the dollar was seen to be beneficial to the Indian
economy in some ways, and detrimental in other ways. The rise in the value of rupee
meant that inflation was curbed. The inflation rate in India declined from 6.73 percent
in February 2007 to 4.10 percent in August 2007. A strengthening rupee brought
down the price (in rupee terms) of food products. A serious supply shortage of food
products was believed to be the primary reason behind the inflation rate increasing in
the first half of 2007. The rupees appreciation also cushioned the impact of
increasing crude oil prices in the international market.
The rupees appreciation also benefited importers as well as manufacturers who
depended on imported raw materials. Companies in sectors such as oil and gas,
automobile, engineering and aviation were able to import items at much cheaper rates
(in rupee terms) than before. As the procurement prices of oil companies depended on
international crude oil prices, which were denominated in dollars, the rupees
appreciation absorbed some of the international price escalation. This was a welcome
development as the public sector oil companies had been incurring losses 25. The dent
25

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

The Indian Rupee-US Dollar Exchange Rate:


would have been larger had not the rupee appreciated,26 a senior oil company official
said.
Similarly, companies importing cement saw their net payments (in rupees) for imports
reduce. The capital goods sector also benefited.
As with oil, in the case of some other commodities too, the rupees appreciation
reduced the impact of increases in their international prices. The currency appreciation
was also a positive for the governments financials. The rupees appreciation reduced
Indias external debt. As on December 2006, India had an external debt of $ 142.65
billion which decreased to $ 132.66 billion following the rupees appreciation.
Companies that had borrowed in dollars from international banks also benefited from
the rupees appreciation as the rupee value of the loans decreased.
As a result of the rupees appreciation, Indian tourists traveling abroad saw their
rupees stretch a bit further than before. Vishal Suri, COO of Thomas Cook India, said,
Though no immediate effect is seen in travel packages, it (rupee appreciation) will
give Indians the freedom to spend more while traveling. The overall sentiment is
going to be positive for all markets, be it the US, Far East or Europe, as most
destinations have dollar as a common currency for conversions. 27
However, the rupees rise against the dollar was beginning to have an adverse impact
on the Indian export sector. Around 86 percent of Indian exports and 89 percent of
imports were denominated in dollars (2005-06 data)28 and with the rupee
strengthening against the dollar, Indian products were becoming more expensive in
overseas markets, thus adversely affecting their international competitiveness. The
cumulative export growth for the period April-August 2007 declined to around 18
percent, compared to around 24 percent in the corresponding period in 2006. The
RBIs deputy governor, Rakesh Mohan, referred to the effects of the rupees
appreciation on the countrys export sector as a case of Dutch disease. 29
According to an Associated Chambers of Commerce and Industry of India
(ASSOCHAM) study,30 the export sectors affected most as a result of the appreciation
of the rupee were IT and IT-enabled services, textiles, leather, and sugar. 31 The
rupees appreciation also affected the profitability of exporters of meat and spices.
The pharmaceutical sector was also moderately affected.

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

Exchange rate against dollar


August 2006

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

Sri Lankan Rupee

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

Source: www.x-rates.com and www.gocurrency.com.


In the 11th Five Year Plan, the Indian government had set an apparel export target of 6
billion pieces at $ 34.02 billion by 2011-2012. However, according to Amit Goyal,
President of Confederation of Indian Apparel Exporters (CIAe) 35, with the rupee
appreciating against the dollar, India would not be able to reach the export level of
even the previous year.36 He also said that considering the fact that employment in the
sector depended directly on export orders, the decline in export orders would
adversely affect employment in the sector. Prakash Thakkar, Managing Director of Jal
32
33

34

35

36

Infosys Technologies Ltd. is a leading provider of consulting and IT services globally.


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.
Sanjeev Choudhary, Rise in Rupee, Sluggish Sales Take Toll on Apparel Exports to US,
www.economictimes.indiatimes.com, August 27, 2007.
The Confederation of Indian Apparel Exporters or CIAe is an industry association of
garment exporters, set up in 2001.
India: Apparel Exporters Reel under Severe Order Crunch, CIAe, www.fibre2fashion.com,
October 11, 2007.

260

The Indian Rupee-US Dollar Exchange Rate:


Exports, said, I am willing to close down. In fact, I have started to reduce my
business, reduce my staff to ensure a smooth exit from the apparel export businessI
believe the worst is yet to come.37
The strengthening of the rupee against the dollar also affected exporters of plantation
crops. Monthly tea exports declined from 106.6 million kg in January 2007 to 86.1
million kg in July 2007. Coffee exports also fell from 199,761 tons in JanuarySeptember 2006 to 176,699 tons in January-September 2007. Ashok Kurian,
Chairman of the Specialty Coffee Association of India, said, Nearly 80 percent of 3
lakh (300,000) ton coffee produced annually in India is exported. We do not have a
strong domestic market and our dependence on the export market exposes us to
currency fluctuations.38
The rupees appreciation made Indian cashew exporters vulnerable to competition
from Vietnam and Brazil; and Indian sugar companies lost export orders to companies
based in China and Thailand. With the rising rupee, Indian pharmaceutical companies
too were expected to lose their competitiveness to Chinese and East European
companies.
The rupees appreciation also affected the export competitiveness of the MSMEs,
which accounted for around 34 percent of national exports. According to the
Confederation of Indian Industrys (CII) 39 19th Business Outlook Survey, more than
50 percent of the respondents from MSMEs expected a negative impact on their
business because of the appreciation of the rupee. 40
Employment in various export sectors was expected to decline. According to the study
commissioned by the commerce ministry, the rupees appreciation resulted in 11,000
job losses in the textiles and garment sector and 1,900 job losses in the leather sector
in March-June 2007.41
However, companies that were both importers and exporters were not hurt by the
appreciation of the rupee. For example, the gems and jewelry sector, which imported
unpolished gems and bullion metals and exported polished gems and jewelry, seemed
to have withstood the impact of rupee appreciation.
With the rise in the value of the rupee, foreign tourists found it more expensive to
come to India. This was expected to have a negative impact on the tourism industry.
According to Himmat Anand, Chief Operating Officer of SITA42 in India & South
Asia, The weak dollar is bound to affect the inbound travel, which can become less
attractive for travelers.43
37

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

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.
Confederation of Indian Textile Industry (CITI) is a trade association of cotton, blended and
man-made yarn spinning mills and fabric manufacturers. (Source: www.citiindia.com)

262

The Indian Rupee-US Dollar Exchange Rate:


markets and trying to do business in other currencies. 46 Still others advised exporters
to go for hedging in order to minimize impact of a sharp rise in the exchange rate.
Puneet Chaddha, Country head Commercial Banking, HSBC, 47 said, The time has
finally come that companies need to respond with interesting hedging strategies which
would benefit them, in an appreciating rupee environment. 48

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

India: Textile Industry Must Cope with Rupee Appreciation CITI,


www.yarnsandfibers.com, October 2, 2007.
HSBC is one of the largest banking and financial services organizations in the world.
Firms Look at Ways to Control Effects of Re Appreciation,
www.economictimes.indiatimes.com, October 4, 2007.

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)

Source: www.x-rates.com and www.gocurrency.com.


Some were of the view that Indian companies as well as the government could ease
the upward pressure on the rupee by investing in assets abroad. The central bank had
been easing restrictions on outward investment, with total international assets of India
in the last five years (between 2001-02 and 2006-07) increasing at an annual
compound rate of 24.2%. However, there was room for further liberalization of
norms. Others felt that as the continued appreciation of the rupee was expected to
make ECBs more attractive for Indian companies, even at an unchanged interest rate
differential, the RBI should impose tighter restrictions on ECBs so as to control dollar
inflows.

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

The Indian Rupee-US Dollar Exchange Rate:

Exhibit XII
The Measures taken by the Government
1.

Increasing the number of Services for refund/exemption of Service Tax in


respect of Exports.

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.

Provision to pay Interest on EEFC balances.

The government decided to allow interest to be paid on Exchange Earners Foreign


Currency (EEFC) accounts.
Interest should be permissible on outstanding balances to the extent of $ 1
million per exporter
Rate of interest may be determined by the banks.
This measure would be valid up to October 31, 2007.
Such accounts should be in the form of term deposits with a maturity of up
to one year.
3.

Interest on pre-shipment and post-shipment credit (extension of period &


widening of coverage of sectors).
The applicable interest rate on pre-shipment credit up to 180 days and postshipment credit up to 90 days was Benchmark Prime Lending Rate (BPLR) minus
2.5%. In July 2007, the government announced a reduction of this maximum rate to
BPLR minus 4.5% in respect of the outstanding amount for the period April 1 to
December 31 in 2007. The government agreed to provide the requisite interest
subvention of 2% points to scheduled commercial banks. This dispensation was
made available to the sectors of textiles including handlooms and readymade
garments, leather products, handicrafts, engineering products, processed
agricultural products, marine products, sports goods, toys and all exporters from the
SME sector. Now, it was decided that the coverage would be expanded to the
sectors of jute and carpet, processed cashew, coffee and tea, solvent extracted deoiled cake and plastics and linoleum. The period for which the reduction in the
interest rate is applicable, is now extended from December 31 to March 31, 2008.
The amount of subvention will be calculated on the amount of export credit from
the date of disbursement up to the date of repayment or up to the date beyond
which the outstanding export credit becomes overdue i.e. for pre-shipment credit
up to 180 days and post-shipment credit up to 90 days, whichever is earlier.
4.

Rs 3 billion more for Vishesh Krishi and Gram Udyog Yojana (VKGUY).

The product coverage under VKGUY, a scheme to promote export of agricultural


and village industry products, was expanded to include additional products. For this
purpose, the revenue ceiling fixed for 2007-08 was raised by Rs 3 billion (from Rs
2 billion to Rs 5 billion).
Source: Govt Steps to Counter Rupee Appreciation, www.tradeindia.com, October
8, 2007.
In response to the demand for government intervention, Nath said, The rising rupee
is a matter of concern. The government is very much looking at it and it needs a new
response.53 Chidambaram also said that if the package offered to exporters did not
53

Steps Soon to Address Rupee Appreciation: Kamal Nath, www.andhracafe.com,


September 20, 2007.

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

The Indian Rupee-US Dollar Exchange Rate:

References and Suggested Readings:


1.

India: Apparel Exporters Reel under Severe Order Crunch, CIAe, www.fibre2fashion.
com, October 11, 2007.

2.

India Unlikely to Meet Export Target, www.tradeindia.com, October 10, 2007.

3.

Anoop Agrawal, Indian Rupee Rises as Stocks at Record Lure More Global Funds,
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4.

Rupee Hits 9-1/2 Yr High, Stocks Support, www.livemit.com, October 10, 2007.

5.

Rupee Gains on Buoyant Local Bourses, www.myiris.com, October 9, 2007.

6.

Shobha Kannan, Strong Re, Overpricing Likely to Hurt Inbound Tourism,


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7.

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8.

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9.

Hina Mahgul Rind, Rupee Stands Firm against Dollar, www.thenews.com, October 7, 2007.

10.

Gayatri
Nayak,
Dollar
Inflows
Put
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11.

RBI
Intervention
Pulls
Re
Down
www.economictimes.indiatimes.com, October 6, 2007.

12.

India
Wont
Miss
$60-B
Software
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13.

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October 6, 2007.

14.

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16.

TB
Kapali,
Rupee
Appreciation
Upsets
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17.

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indiatimes.com, October 4, 2007.

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Panel Outlines Rupee Rise Solutions, www.economictimes.indiatimes.com, October 4, 2007.

19.

Managing the Rupee Rise on the Front Foot, www.economictimes.indiatimes.com,


October 4, 2007.

20.

US Dollar Ends Sharply Cheaper against Rupee, www.outlookindia.com, October 4,


2007.

21.

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2007.

22.

BPOs to Bear Brunt of Re Appreciation, www.economictimes.indiatimes.com, October 3,


2007.

23.

India: Rupee Appreciation Unable to Stem MSME Export, www.fibre2fashion.com,


October 2, 2007.

24.

India: Textile Industry Must Cope


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27.

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with

Govt

Rupee

in

From

Bind,

9-Yr

High,

Export

Export

Appreciation

Target,

Arithmetic,

CITI,

267

International Business
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30.

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31.

Indias External Debt as at the End of June 2007, http://rbidocs.rbi.org.in, September 28,
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Rapid Rupee Appreciation is a Matter


www.newindpress.com, September 27, 2007.

of

Serious

Concern:

FM,

33.

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Re Rise Threatens Existence of Punjab Inds, www.economictimes.indiatimes.com,


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37.

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IT Faces Brunt of Rupee Appreciation, www.econmictimes.indiatimes.com,


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39.

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40.

Gary Singh, RBI has been Struggling to Work out a Way, www.nriinternet.com,
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Rupee
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Dents
Export
Growth
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Jayashankar,
No
Model
Can
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Rupee Appreciation to Result $15


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268

bn

Fall

for

in

Outbound

to

Tackle

Re

Sharply

9%

in

Re

Herbal

Exports

Tourism,

Rise,

June,

Rise,
Products,

in

2007-08,

The Indian Rupee-US Dollar Exchange Rate:


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Alok
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The
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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

Coca-Colas Business Practices:


Facing the Heat in a Few Countries
The case discusses some of the alleged controversial business and labor practices of
The Coca-Cola Company (Coca-Cola) and its bottlers in a few countries.
The case discusses in detail about the allegations made against Coca-Cola's labor
practices in Columbia, environmental and product issues in India, and trade practices
in Mexico.
The case also highlights the rise in consumer activism as it includes details of the ban
imposed on Coca-Cola's products by some university campuses in the US and Europe
on account of pressure by student unions and other activist organizations. CocaCola's responses to these allegations have also been presented in the case .

Coca-Colas Business Practices:


Facing the Heat in a Few Countries
The University of Michigan has said it is committed to working only with companies
that have ethical and responsible practices, yet the Coca-Cola Company is in obvious
violation of these standards. Coca-Cola needs to be accountable for their actions, and
until they are, we demand that they are taken off our campus. We refuse to support
businesses that are unable to promote basic human rights amongst their employees
and the public.1
- Kristin Purdy, The Coke Coalition, University of Michigan, in 2005.
Coca-Cola is a frequent violator of union rights and thats why several universities
in the United States have decided to protest their conduct. 2
- Fabio Arias, Vice President, CUT Trade Union Confederation, Colombia, in
2006.
It is a very unfortunate. The actual volume in terms of sales is small but it is the
larger issue of our reputation. These allegations are false but we do share the
concerns with issues.3
- Kari Bjorhus, Spokeswoman for the Coca-Cola Company, in 2006.

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.

Students campaign to ban Coca-Cola products on campuses, www.indiaresource.org, April


19, 2005.
Colombian workers support U.S. universities ban on Coca-Cola, www.timesleader.com, January
02, 2006.
Univ in US to toss Coca-Cola, www.financialexpress.com, January 02, 2006.

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

Kerala is a state in the southern part of India.


The British Broadcasting Corporation (BBC) is a publicly-funded radio and television
broadcasting
corporation
of
the
United
Kingdom.
(Source:
http://en.wikipedia.org/wiki/BBC)
Center for Science and Environment (CSE) is an independent, non-governmental
organization which aims to increase public awareness on science, technology, environment,
and development. CSE was established in 1980 and is based in New Delhi.
Carbonation, which involves dissolving carbon dioxide, is used in aqueous solutions like soft
drinks to make them effervescent.
Caramel is a food which has a brown colour and a sweet toasted flavour. Caramel can be
made from sugar by heating it slowly to around 170C.

672

Coca-Colas Business Practices: Facing the Heat in a Few Countries


extracts of Coca leaves and Kola nuts 7. Frank M. Robinson (Robinson),
Pembertons book-keeper and partner, who came up with the name for the drink,
suggested that it be spelt Coca-Cola rather than Coca-Kola because he thought the
two Cs would look better while advertising. Robinson designed the now world
famous Coca-Cola trademark as well.
Pemberton later sold the business to a group of businessmen, one of whom was Griggs
Candler (Candler). By 1888, several forms of Coca-Cola were in the market
competing against each other. Candler acquired these businesses from the other
businessmen and established The Coca-Cola Company in 1892. He aggressively
marketed the product through advertising, distribution of coupons and souvenirs, and
promoted the brand name Coca-Cola. Sales grew rapidly and by 1895, the product
was being sold across the US.
In the initial years, Coca-Cola was sold through soda fountain8 wherein the Coca-Cola
syrup, carbon dioxide, and water were mixed and given to customers. In 1894, a
fountain seller named Joseph A. Biedenharn introduced the concept of selling the
prepared drink in bottles. He thus became the first bottler for Coca-Cola. In 1899,
large scale bottling of Coca-Cola began when Benjamin Thomas and Joseph
Whitehead won a contract from Candler to sell Coca-Cola throughout America in
bottles. They started sub-contracting the task of bottling and distribution and this led
to easy availability and rapid growth of sales. The Coca-Cola bottling system grew to
become one of the largest, widest production and distributions networks in the world.
However, the rapid increase of Coca-Colas popularity led to many counterfeits
flooding the market and Coca-Cola had to spend huge sums of money on educating its
customers on how to recognize the genuine product. The company realized that it
needed a uniquely designed bottle that the customer would instantly recognize. In
1916, the hobble-skirt design bottle was designed by Root Glass Company, Indiana 9,
and was approved by the bottlers (Refer to Exhibit I for a photograph of the hobbleskirt design bottle). The design of the bottle was so distinctive that it would be
instantly recognizable as a Coca-Cola bottle by the customer even it was felt in the
dark or even if the bottle was broken. The design of the Coca-Cola bottle became as
famous as the Coca-Cola trademark.
In 1919, a group of investors headed by Ernest Woodruff and W. C. Bradley
purchased Coca-Cola for US$ 25 million. In 1923, Robert Winship Woodruff
(Woodruff), son of Ernest Woodruff was elected as the company president. He was
widely credited with making Coca-Cola, one of the worlds most recognized brands
and a multinational company with huge revenues and profits. Woodruff believed in
product quality and started a Quality Drink campaign using a staff of highly trained
service people. The main focus of the campaign was to encourage and assist fountain
outlets in aggressively selling and correctly serving Coca-Cola. To make the
campaign more successful, a distinctive bell shaped fountain glass was introduced on
the lines of the popular Coca-Cola bottle. This design also became very famous (Refer
to Exhibit II for a photograph of the bell shaped fountain glass). In 1933, Coca-Cola
introduced automatic fountain dispensers that automatically prepared the finished
drink.

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

Coca-Colas Business Practices: Facing the Heat in a Few Countries


Woodruff also initiated steps to increase sale of Coca-Cola in bottles. With the
assistance of the bottlers, he established quality standards for every phase of bottling.
Advertising and marketing support was also increased and by the end of 1928, CocaColas bottle sales exceeded fountain sales for the first time. Innovative
merchandising concepts were introduced for bottles. Six-bottle cardboard cartons
were introduced to make it easier for the consumer to take Coca-Cola home. A metal,
open-top cooler was introduced to serve ice chilled Coca-Cola at retail outlets. The
coolers were later modified and became self-operated automatic coin control
machines. They were installed at factories, offices, railway stations, and other
institutions.
Under Woodruffs leadership, Coca-Cola took several initiatives to expand rapidly
into international markets. Earlier Coca-Colas international operations had not been
properly organized. In 1926, Woodruff established the Foreign Department to
organize the international operations and this later became a subsidiary known as The
Coca-Cola Export Corporation. Coca-Cola sponsored the Amsterdam Olympic Games
in 1928 to promote its product in other countries. From then on, it regularly sponsored
the Olympic Games.
During the World War II, there was difficulty in shipping the Coca-Cola syrup to
Germany and this led to the birth of the brand Fanta in Germany, which was
manufactured locally. Coca-Cola also positioned itself as an American drink when it
supplied Coca-Cola for a nominal price of five cents to American soldiers during the
War and later identified with the American way of life. The War also provided an
ideal platform for Coca-Cola to expand to other countries by setting up bottling plants
to serve the American soldiers stationed there. After the War, these plants were
utilized to establish its operations in those countries.
The period 1940 to 1970 was one of rapid international growth and Coca-Cola became
a symbol of friendliness and refreshment across the world. In 1955, Coca-Cola
became the first company to introduce the sale of the soft drinks in metal tins, a
concept originally developed for the American soldiers. In 1960, Coca-Cola acquired
the Minute Maid Corporation to add fruit juices to its product portifolio. In 1977, PET
(Polyethylene Terephthalate)10 bottles were introduced. During this time, the company
also introduced various brands like Sprite and TAB, which went on to become
bestselling soft drink brands.
In 1980, Roberto Goizueta11 became the Chairman and CEO of Coca-Cola. Business
analysts described him as a man with a global vision and credited him with taking
steps that made Coca-Cola popular across the world. In 1985, Coca-Cola changed its
old formula to make its product taste sweeter and to compete more effectively with
Pepsi. This new formula was launched with a lot of publicity and was marketed as the
New Coca-Cola. However the new product was a commercial failure and was
described as one of the biggest marketing blunders ever. Customers were vociferous
in their demand for the original taste and demonstrations were held against the
company. Coca-Cola reintroduced the original taste as Coca-Cola Classic. In 1982,
Diet Coke was introduced as a low calorie soft drink for health conscious customers.

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

Pause that Refreshes

1936

Its the Refreshing Thing to do

1942

Its the Real Thing

1944

Global High Sign

1950s

Sign of Good Taste

1950s

Be Really Refreshed

1950s

Go Better Refreshed

1963

Things Go Better with Coke

1969

Its the Real Thing (revived from 1942)

1971

Id like to buy the world a Coke

1979

Have a Coke and a smile

1985

Weve got a taste for you (New Coke)

1985

Americas real choice (Coca-Cola Classic)

1993

Always Coca-Cola

1999

Enjoy Coca-Cola

2001

Life tastes Good

2005

Make it real

Note: The list is not exhaustive.


Compiled from various sources.

676

Coca-Colas Business Practices: Facing the Heat in a Few Countries

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

Compiled from various resources.

Coca-Colas Business Practices


Coca-Cola had always believed that it conducted its business with responsibility and
ethics. The companys business practices were aimed at creating value at the
marketplace, providing excellent working conditions, protecting the environment, and
strengthening the communities in the places of operation. Commitment to quality and
a code of business conduct were evolved to ensure good business practices.
According to Coca-Cola, its commitment to quality was reflected in every facet of its
business. These included commitment to product quality, quality in business
processes, and in its relationships with suppliers and retailers. The quality system was
reviewed constantly so that the performance bar for these standards was always kept
high. The quality guidelines were communicated to all business units and their
implementation reviewed. The company introduced the Coca-Cola Quality System
(TCCQS) to achieve these quality objectives (Refer to Exhibit V for details on
TCCQS).

Exhibit V

The Coca-Cola Quality System (TCCQS)


The Coca-Cola Quality System (TCCQS) was developed by a global team of
professionals and approved by the senior management of top franchise bottling
partners. The quality system reflected the integrated approach to managing quality,
the environment, and health and safety. The system formed the guiding principles
encompassing all the business processes and activities, helped the management in
decision making, and drove the company toward continuous improvement and
quality.
Based on the quality system, four guideline books were published in the key areas
of quality, environment safety and suppliers. They were Quality Management
System Standard, Environmental Management System Standard, Safety
Management System Standard, and Supplier Expectations. TCCQS was found to
be on a par with ISO in quality standards (ISO 9001:2000), environmental
standards (ISO 14001:1996), and occupational health and safety standards
(OHSAS 18001:1999).

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

Coca-Colas Business Practices: Facing the Heat in a Few Countries


Coca-Cola also laid out extensive policies and procedures with respect to labor
relations. The companys policy was to comply with all applicable labor and
employment laws of the countries in which it operated. In its labor policies, the
company said that it respected the workplace human rights of its employees in
accordance with international labor standards. The company was also committed to its
employees right to form unions and their right to join the union or not. The company
said that it ensured these rights were exercised without fear of retaliation, repression,
or any other form of discrimination from the management.
Coca-Cola also believed that any disputes relating to labor relations were best solved in
the place of origin. Through experience, it had learnt that labor relations were matters
that were best handled at the place of origin because the best capability and knowledge
to manage such issues existed at that level. However, any local issues having broader
implications (both nationally and internationally), would be reviewed at the higher
management levels depending on the merit of the case.
However, while Coca-Cola held that it was completely committed to ethical practices,
there were several moderate to severe allegations made against it regarding trade
practices, and labor relations over the years. The allegations about Coca-Colas
business practices ranged from monopolistic and anti-competitive trade practices,
discriminatory employment practices, depletion of groundwater tables, and
environmental pollution. In 2005, the campaign against Coca-Colas business
practices became intensified with more student activists, labor unions, and
environmental organizations actively supporting a campaign to ban Coca-Colas
products at various colleges, schools and organizations in Europe and North America.

Labor Practices in Colombia


Colombia is widely considered as one of the most dangerous countries in the world
for trade union activists and union leaders. The country was in the midst of a fourdecade-old civil war involving leftist guerrillas, 13 right-wing paramilitary groups,14
and government forces. The civil war claimed approximately three thousand lives a
year including those of many trade union leaders and workers. It was reported that in
2000, three out of every five trade unionists killed in the world were from Colombia.
In 2001, SINALTRAINAL, 15 a Colombian labor union, charged that Coca-Cola and
its bottlers Panamerican Beverages (Panamaco), Bebidas y Alimentos De Uraba, and
Coca-Cola Femsa, were linked to the violence against its union members in Colombia.
Around eight union leaders of Coca-Colas plants in Colombia had been murdered
since 1989, and many others had been abducted and tortured. Coca-Cola was accused
of hiring paramilitary death squads to kidnap, torture, or kill union leaders and
intimidate worker union activists at its bottling plants.
Of the total of eight murders, four occurred at one bottling plant of Bebidas y
Alimentos De Uraba at Carepa City between 1995 and 1996. Of these four, the most
widely publicized one was the killing of Isidro Segundo Gil (Isidro), a member of the
union executive board, on December 5, 1996, at the entrance of the plant. It was
alleged that after killing Isidro, paramilitary squads had kidnapped another union
leader from his home and torched the union offices.
13

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.

Trade Practices in Mexico


Mexico was a very important market for Coca-Cola as the country was second, after
the US, in terms of per capita consumption of soft drinks in the world. The Mexican
market for soft drinks was estimated at US$ 6.6 billion for the year 2004. Over the
years, some of the highest profit margins for Coca-Cola in its overseas operations
came from Mexico. Coca-Cola was the number one seller of soft drinks in Mexico
with a 70% market share. Coca-Colas largest bottler in Mexico was Coca-Cola
Femsa (CCF) in which Coca-Cola had a 40% stake. Its stock was listed on the New
York Stock Exchange.
The chief competitor for Coca-Cola in Mexico was Pepsi. However, Coca-Cola also
faced stiff competition from Big Cola, a beverage manufactured by the Ajegroup 17.
Big Cola was priced very low when compared to the price of Coca-Cola. This low
16

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

Coca-Colas Business Practices: Facing the Heat in a Few Countries


pricing strategy made a big impact on the Mexican soft drink market because half the
population was poor and had low purchasing power. By 2004, it was estimated that
Big Cola had cornered around 5% of the market and was growing rapidly. To counter
Big Colas rising popularity, Coca-Cola resorted to lowering its prices and this led to a
fall in its profit margins.
It was alleged that CCF resorted to monopolistic and anti-competitive trade
practices to deal with the threat of Big Cola. Small retail operators were warned to
stock and sell only Coca-Colas products failing which supplies would be stopped.
These retailers would also stand to lose freebies like refrigerators and other gifts
that they otherwise received. Operators who did not heed these warnings were
lured to exchange their Big Cola stock for Coca-Cola. CCF was accused of
insulting Big Cola and its customers, most of whom belonged to the poorer
sections, with advertisements like, You are not ugly, you have personality, drink
Coca-Cola.18 CCF was also accused of bribing local government officials with
gifts to get permissions for setting up bottling plants.
On July 4, 2005, the Federal Competition Commission 19 (FCC) in Mexico charged
Coca-Cola and its bottlers for violation of anti-monopoly laws and indulging in anticompetitive business practices. Fines of US$ 15 million and US$ 53 million were
imposed in two separate cases which amounted to one of the largest fines ever
imposed in Mexico. The US$ 15 million fine was imposed in response to a complaint
by a small retail operator, Raquel Chavez (Raquel) when Coca-Cola refused to sell her
its products because she was selling Big Colas products. FCC investigated her
complaint and found evidence in similar incidents, some of which were documented
by Big Cola, which supported the lawsuit against Coca-Cola in the later stages.
Raquels victory was hailed as the victory of David over Goliath.

Environment & Product Issues in India


In India, Coca-Cola was accused of draining the underground water table, of releasing
improperly treated industrial effluents, and of selling products containing pesticide
residues above standard limits. The focal point of the environmental accusations in
India was the Coca-Cola plant located in Kerala. Coca-Cola, through its subsidiary in
India, The Hindustan Coca-Cola Beverages Pvt. Ltd., had established a bottling plant
at Plachimada locality in Palakkad district in Kerala. The unit was established in
1998-99 in a 40-acre plot that had previously been used for irrigation of paddy and
other food crops.
The factory site was located in the proximity of a main irrigation canal that drew
water from a nearby barrage and reservoir. It was alleged that Coca-Cola had dug
more than 65 bore-wells in the plot to extract the groundwater for production and
operations. The daily production was estimated at 85 truck loads of beverages wherein
each load contained 550-600 cases and each case contained 24 bottles, each of 300 ml
volume. It was estimated that every day, 15 million liters of groundwater were
extracted free of cost and used for production and bottle washing. 20

18
19

20

Coca-Cola in Chiapas labour rights, www.ciepac.org/bulletins, January 13, 2005.


The Federal Competition Commission (FCC) created in 1993, is an agency in the Ministry of
Economy with technical and operational autonomy, which is responsible for the
implementation of the Federal Economic Competition Law in Mexico.
Struggle against Coca-Cola in Kerala, www.zmag.org, September 10, 2002.

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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).

Boycott of Coca-Cola Products


In July 2001, SINALTRAINAL, with the help of United Steelworkers of America 26
(USWA) and the International Labor Rights Fund 27 (ILRF), filed a lawsuit against
Coca-Cola and its Colombian bottlers at a court in Miami, Florida, under the Alien
Tort Claims Act (ATCA)28 of the American Judicial System. It accused them of being
responsible for a campaign of murder and intimidation against its unionized workers
and charged that it was using right wing paramilitary groups for the purpose. The US
judge dismissed these charges against Coca-Cola in Colombia but approved the
charges against the local bottlers in Colombia.
21

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

Coca-Colas Business Practices: Facing the Heat in a Few Countries

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

World Social Forum is an annual meeting against globalization. It is a platform for


information exchange on anti-globalization movements and campaigns around the world.
UNISON is the largest trade union in the United Kingdom, with over 1.3 million members. It
was formed in 1993 by the merger of three previous public sector trade unions - the National
and Local Government Officers Association (NALGO), the National Union of Public
Employees (NUPE), and the Confederation of Health Service Employees (COHSE).
ECOSY or Young European Socialists is an association of socialist and social democratic
youth organizations in the European Union. It is the youth arm of the Party of European
Socialists (PES) and is a member of the International Union of Socialist Youth (IUSY) based
in Brussels, Belgium.

684

Coca-Colas Business Practices: Facing the Heat in a Few Countries


Commissions findings would be admissible in the earlier lawsuit against Coca-Cola
in Florida. While Coca-Cola did not want the findings to be admissible, the plaintiffs
of the lawsuit insisted that they should be admissible.

Exhibit VIII
List of Organizations that Boycotted Coca-Cola
Name of the Organization

Membership

UNISON (United Kingdom)

1.3 million

Service Employees International Union (SEIU)

1.7 million

Communications Workers of America (CWA)

0.7 million

American Postal Workers Union (APWU)

0.27 million

Labor Council for Latin American Advancement (LCLAA)

1.7 million

American Federation of Teachers (AFT)

1.3 million

International Longshore and Warehouse Union

0.06 million

Northern Ireland Public Services Association

Not Available

Note: The list is not exhaustive.


Adapted from http://www.educationnews.org/for-christmas.htm.
Coca-Cola spokeswoman Kari Bjorhus said, Although we have reached an impasse
on the Commissions assessment protocol, we are exploring other ways that we might
be able to conduct an additional credible, objective, and impartial independent, thirdparty assessment in Colombia without incurring legal risks. 33 The negotiations
between the Universities Commission and Coca-Cola reached a deadlock and hence
Coca-Colas products were banned from those universities in America.
The boycott of Coca-Cola also had an impact in Canada. In October 2005, the
students union of McMaster University voted to reject a renewal of the US$ 6 million
a year exclusive deal the university had with Coca-Cola. Coca-Cola sent senior
executives for negotiations with the student union but they failed in the effort.
Similarly, students at the University of British Colombia, University of Guelph, and
Ryerson University started their campaign against Coca-Cola and were considering a
boycott.
Coca-Cola tried to contain the campaign by saying that it could lead to a loss of local jobs
due to lack of demand. Kerry Kerr, public relations co-ordinator for Coca-Cola, said,
Were always concerned that these allegations could continue to spread. One of the main
concerns, especially for our bottlers in areas like Canada, is that these boycotts are actually
affecting workers in the local area.34
The City Council of Turin, Italy, took a controversial decision when it approved a
boycott of Coca-Cola products. The city of Turin hosted the February 2006 Winter
Olympic games. The decision created a controversy because Coca-Cola had donated
33

34

University of Michigan gives Coca-Cola the boot, www.billingsgazette.com, December


31, 2005.
Colin Perkel, Coca Cola hits back as boycott over alleged human-rights abuses gathers
steam, www.cbc.ca, December 27, 2005.

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 Business Practices: Facing the Heat in a Few Countries

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

Florida is a state in the Southeastern region of the US.


Cal Safety Compliance Corporation (CSCC), based in Los Angeles, is a global provider of
socially responsible supply chain consulting services, which include monitoring, training and
education, program development and management, and research capabilities. The company
has operations in 110 countries.
Geri Smith, Inside Coca-Colas labor struggles, www.businessweek.com, January 23,
2006.
Geri Smith, Inside Coca-Colas labor struggles, www.businessweek.com, January 23,
2006.
Mexican woman battles Coke, wins, www.english.aljazeera.net, November 15, 2005

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

Coca-Colas Business Practices: Facing the Heat in a Few Countries

Exhibit X
Awards Won by Coca-Cola in India
Category

Award

Community
Development

Coca-Cola received the Bhagidari Award from Chief Minister of


Delhi Sheila Dikshit for the companys efforts and contributions
toward community development programs.
The World Environment Foundation (WEF) awarded the
prestigious Golden Peacock Environment Management Award
2005 (GPEMA) to the bottling plant at Kaladera, near Jaipur,
India, in recognition of its world-class environment practices.
Coca-Colas Dasna45 plant in India received the Golden Peacock
Environment Management Award 2004.

Environment

Coca-Cola received a water conservation and pollution control


award from the Andhra Pradesh Government on World
Environment Day in June 2003.
The Golden Peacock Award was given by the World
Environment
Foundation
for
effective
environmental
management at the plant at Ameenpur Village, near Hyderabad,
India.

Health

Coca-Cola was recognized by the Rajiv Gandhi Foundation


(RGF)46 for participation in a motorized tri-wheeler scheme for
the disabled.

Note: The list is not exhaustive.


Adapted from http://www.cokefacts.org.

45
46

Dasna is a city in the state of Uttar Pradesh in North India.


The Rajiv Gandhi Foundation (RGF), established in 1991, aims to work and act as a catalyst
in promoting effective, practical, and sustainable programs in areas of national development
in India.

689

International Business

Additional Readings and References:


1.

World: Europe Belgium considers lifting Coke ban, http://news.bbc.co.uk, January 16, 1999.

2.

Coca-Cola to pay out $192.5 million to employees, www.wndu.com, November 16,


2000.

3.

Struggle against Coca-Cola in Kerala, www.zmag.org, September 10, 2002.

4.

Toxic pesticides found in Indian soft drinks, www.ens-newswire.com, August 05,


2003.

5.

Pepsi, Coke contain pesticides: CSE, http://in.rediff.com, August 05, 2003.

6.

Coke, Pepsi India fight pesticide residue claims in court, www.ens-newswire.com,


August 08, 2003.

7.

John F. Borowski, For Christmas, will Coca-Cola stop acting like Big Tobacco?
www.educationnews.org, December 22, 2004.

8.

Coca-Cola in Chiapas labour rights, www.ciepac.org, January 13, 2005.

9.

Students campaign to ban Coca-Cola products on campuses, www.indiaresource.org,


April 19, 2005.

10.

US: Coke to examine overseas labor practices, www.corpwatch.org, June 20, 2005.

11.

Did Coca-Cola torture and kill workers in Latin America? www.straightdope.com,


November 04, 2005.

12.

Mexican woman battles Coke, wins, http://english.aljazeera.net, November 15, 2005.

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.

University of Michigan gives Coca-Cola the boot, www.billingsgazette.com,


December 31, 2005.

18.

School bans Coca-Cola, www.chicagotribune.com, December 31, 2005.

19.

Gaurav, Coca-Cola banned from University of Michigan, http://gbytes.gsood.com,


December 31, 2005.

20.

US varsity suspends Coke sale, http://inhome.rediff.com, December 31, 2005.

21.

Colleges boycott Coke over labor concerns, www.taipeitimes.com, January 01, 2006.

22.

Univ in US to toss Coca-Cola, www.financialexpress.com, January 02, 2006.

23.

Colombian workers support U.S.


www.timesleader.com, January 02, 2006.

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.

Killer Coke or innocent abroad? Controversy over anti-union violence in Colombia


has colleges banning Coca-Cola, www.businessweek.com, January 23, 2006.

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,

Coca-Colas Business Practices: Facing the Heat in a Few Countries


29.

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

The South African Economy: Coping with


the Legacy of Apartheid
The South African economy is characterized by extreme income disparity along racial
lines. Many blacks are unemployed and poor, while most whites are better off. This
uneven distribution of wealth is the direct result of the apartheid system that was
followed by the government between 1948 and 1994. The case chronicles the state of
the South African economy from the 1950s, when many apartheid laws were passed,
till the mid-2000s, when the economy was showing good growth. It discusses some of
the policy initiatives taken by the ANC government after coming to power in 1994 and
the implications of these policies for the South African economy.
It also discusses the criticisms against the government's policies. The case ends with a
discussion on the future prospects of the South African economy.

The South African Economy:


Coping with the Legacy of Apartheid
It is going to take decades to correct many of the wrongs. 1
- Rev. Motlalepula Chabaku, a legislator in Free State Province.
The general consensus is that there has not been an improvement in equality, 2
- Matthew Stern, former economist, South Africa Country Office, World Bank,
in 2004.

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).

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The South African Economy: Coping with the Legacy of Apartheid

Exhibit I

Information on South Africa


The Republic of South Africa is located at the southern tip of the African
continent. It is surrounded by Namibia, Botswana, Zimbabwe, Mozambique, and
Swaziland and the South Atlantic ocean and the Indian Ocean.
South Africa covers an area of 1.2 million sq. kms and has a long coastline
stretching for more than 2,500 kms. While the northwest is arid, the region along
the eastern coast is tropical. Only around 12% of the land is arable. The country is
prone to long droughts.
South Africa has an abundant supply of natural resources. The mining industry is
one of the important industries of the country. Apart from gold and diamonds, the
country is endowed with copper, tin, platinum, chromium, manganese, antimony,
coal, iron ore, and nickel reserves.
The countrys political system is based on proportional representation. It has a
bicameral parliament consisting of the National Council (upper house) and the
National Assembly (lower house). Elections are held every five years and the
government is formed in the lower house, with the leader of the party in majority
becoming the president.
In 1994, the government replaced the former provinces of Cape, Natal, Transvaal,
and Orange Free State with nine integrated provinces Northern Cape, Western
Cape, Eastern Cape, North West, Free State, KwaZulu-Natal, Gauteng, Limpopo,
and Mpumalanga.
The country has a population of around 45 million. Blacks form the majority (see
figure below).
% of Blacks, Whites, Indians, and Coloreds in the South African Population
(2001)
Colored
9%
White

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,
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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.

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The South African Economy: Coping with the Legacy of Apartheid


and the waterboers (descendants of European and native Africans) staked a claim to
the diamond-rich regions. However, the British forces took control of the region and
brought it under the Cape Colony.
In the later part of the 19th Century, the British attempted to annex Zulu-held
territories. Much of Zulu territory was brought under British-ruled Natal by the end of
the century. The British settlers brought people from India to work in the sugarcane
fields in Natal. Many of them stayed on, and went on to form an influential part of
South African society.
The Witwatersrand goldfield in Transvaal was discovered in 1886. The gold attracted
the British, who came in large numbers. The Transvaal region, which had been
granted full internal autonomy by Britain in 1884, had been financially strapped and
the discovery of gold revived its economy.
Toward the end of the 19th Century, the British attempted to annex the Free States,
which led to the Anglo-Boer wars. The British emerged victors and the whole of
South Africa came under their control. The Union of South Africa came into being in
May 1910. Even under the Union, the black majority was deprived of the right to
franchise in the former Boer republics. Though they had voting rights in the Cape
Colony, they were barred from becoming legislators. The South African Party (SAP),
which came into power, enacted laws that restricted the role of non-whites in the
economy. The Masters and Servants Act (reserving skilled work for whites), the
Native Poll Tax, the Land Act, 1913 (reserving 90% of the land for whites) all served
to keep most non-whites economically weak.
The African National Congress (ANC) was established in Bloemfontein in 1912, with
the goal of eliminating restrictions based on color (Refer Exhibit II for the aims and
objectives of the ANC). In 1914, conservative whites formed the National Party. The
National Party, in alliance with the Labour Party, came to power in 1924. The 1920s
and 1930s saw the government strive to secure greater independence from British
control and greater job security for whites in South Africa. In 1931, South Africa
became a self-governing dominion under the British crown. In 1933, the SAP and the
National Party merged to form the United Party and in the elections that were held
that year, the merged party came to power. However, a breakaway faction consisting
of former National Party members, who represented extreme nationalists, formed a
new National Party (NP). In 1936, the blacks in the Cape were disenfranchised and
they were forced to live in separate areas away from white colonies.
In 1943, the ANC Youth League was formed under the leadership of Anton Lembede,
A.P. Mda, Oliver Tambo, and Nelson Mandela (Mandela).
In 1948, the NP came to power and immediately started implementing an even stricter
race-based policy called apartheid (derived from apart and hood), which was to
continue till the early 1990s. In 1961, South Africa declared itself a republic. The
1960s, 1970s, and the 1980s saw the South African government committed to
apartheid, even in the face of international opposition and isolation. The 1990s,
however, saw the government deciding to take steps to democratize the country.
South Africas first democratic election was held in April 1994. The ANC won a
majority and came to power, with Mandela as the president. Through negotiations
with other political parties, the ANC wrote out a new constitution, which abolished
apartheid. In the countrys second democratic election in 1999, the ANC was able to
increase its majority, albeit marginally, and Thabo Mbeki (Mbeki) was made the
president. South Africas third democratic election was held in 2004 and the ANC
returned to power with Mbeki as the president.
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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.

The South African Economy in the Apartheid Era


Apartheid was a system of racial segregation. The NP government devised apartheid
as a means for the white minority to control the economic and social system of South
Africa.
In the apartheid era, the government excluded the blacks from the mainstream
economy, with development efforts largely concentrated toward the whites. The early
1950s saw a spate of repressive laws being passed. Among them, the Population
Registration Act (calling for the classification of the population on the basis of race),
the Group Areas Act (leading to the creation of separate residential areas for each
race), the Bantu Building Workers Act (resulting in blacks being prohibited from
performing skilled work in urban areas excepting designated sections), Prevention of
Illegal Squatting Act (removing blacks from public and private lands and establishing
resettlement camps), Pass Laws (restricting the movement of blacks), and the
Reservation of Separate Amenities Act (prohibiting non-whites from using public
amenities such as buses, beaches, post offices, restrooms, etc., meant for whites)
resulted in the complete subjugation of non-whites.
In 1959, the Promotion of Bantu Self-Government Act was passed. This was inspired
by the divide and rule policy that the British had perfected over the years in their
colonies. It led to the classification of blacks into eight ethnic groups and the creation
of homelands, where each ethnic group was allowed to govern itself independently.
This was also referred to as separate development. The blacks were allotted only
13% of the land even when they formed around 80% of the population. And they had
to secure passes to enter or work in the white areas.

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The South African Economy: Coping with the Legacy of Apartheid


The Extension of University Education Act prohibited blacks from studying in
white universities, and led to the creation of separate educational institutions for the
blacks, coloreds, and Indians. The educational infrastructure and quality for nonwhites were inferior to those for whites with the result that the non-whites were
unable to upgrade their skills.
Despite the social inequalities, the annual average growth rate of the economy in the
1950s was around 4%. However, the laws barring blacks from entering white South
Africa had a negative impact on industry. Since the passes allotted were fewer than
required, companies had to deal with labor shortages on a regular basis. However,
whenever the labor shortages became particularly acute, white employers imported
laborers from central Africa. This also ensured that the wages for blacks remained
low. The whites, on the other hand, earned incomes that were, on an average, five to
fifteen times the incomes of blacks, which exacerbated the economic disparities.
In the early years of apartheid, there was little opposition from the rest of the world to
South Africas apartheid policies. This was partly due to the importance of South
Africa as a mineral-producing nation and partly because of its strategic location on the
vital trade routes to Asia. Also, many countries saw white South Africa as a force
against communism in the region. They also felt that engagement was a better option
than isolation. South Africa received foreign capital, especially in the form of loans,
from Canadian, American, European, and Japanese banks, and in the form of
investments from multi-national companies based in the US and in other countries.
In the 1960s, the South African economy rivaled that of Japan, with the average
annual growth touching 6%. Strong growth was observed in the mining and
agriculture sector. Inflation was as low as 3%. However, starting from the 1960s,
South Africa became increasingly isolated at international forums. The country had
significant trade links with other Commonwealth7 states till the early 1960s. However,
owing to severe opposition from some members, it decided to withdraw from the
Commonwealth.
In the 1970s, the manufacturing and agriculture sectors stagnated while the services
sector, especially financial and transport services, showed good growth. In 1973, the
Arab members of OPEC8 instituted an oil embargo9 on South Africa. The government
then sourced oil from Iran. However, the oil crisis of the mid-1970s led to a recession
in the economy. There was also a sharp rise in prices with average annual inflation in
the mid-1970s crossing 10%. With gold prices increasing in the late 1970s, the
economy recovered but only for a brief while. In this period, several countries ordered
their traders and investors to stop dealing with South Africa. Iran too severed relations
with South Africa in 1979.
7

Commonwealth of Nations or The Commonwealth is a voluntary association of 53 independent


sovereign states all of which were former colonies of the United Kingdom, except for
Mozambique and the UK itself.
The Organization of the Petroleum Exporting Countries (OPEC) is a permanent, intergovernmental organization, established in 1960. OPECs objective is to coordinate and
unify petroleum policies among member countries in order to secure fair and stable prices
for petroleum producers and an efficient, economic, and regular supply of petroleum to
consuming nations.
After the Arab-Israeli war, the Arab members of the OPEC along with Egypt and Syria
placed an embargo on crude oil exports to countries that supported Israel in the war, initially
targeting the US and The Netherlands. The embargo was extended to Portugal, Rhodesia
(now Zambia and Zimbabwe), and South Africa in November 1973.

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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

Share of national income

<20 percent

75 percent

Minimum taxable income

360 Rand

750 Rand

Doctors/population

1/44,000

1/400

Infant mortality rate


(per thousand)

20 (urban)
40 (rural)

2.75

Annual expenditure on education per pupil

$ 45

$ 696

Teacher/ pupil ratio

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.

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The South African Economy: Coping with the Legacy of Apartheid


While several analysts felt that sanctions and international isolation had led to the
eventual fall of the apartheid system, others felt that the system had collapsed also due
to the inefficiencies it created. While apartheid succeeded in allowing the whites to
subjugate the blacks, the economy, as a whole, suffered. By suppressing the majority
of the population, the government severely hampered the growth of the economy. The
apartheid system limited the size of the markets available to domestic companies,
while the labor market regulations caused the inefficient utilization of human
resources; the distorted education policies caused skill shortages. Further, the
administrative cost of implementing apartheid was a burden on the economy.

The Economy in the Post-Apartheid Era


In 1994, the ANC was elected to power. With political control going out of the hands
of the white minority, the deprived sections of the population were hopeful that their
problems would finally start being addressed. The government was faced with huge
disparities in income and living conditions between the population groups. While the
majority of the whites were well off, most of the blacks lived in penury. The
government, therefore, had on its hands the difficult task of bridging the income gap
between the races, bringing better education, health care, and other amenities to the
deprived people as well as achieving sustained growth.
The ANC government began by assessing the living conditions of the poor. It was
estimated that 4.3 million families (most of them black) did not have adequate
housing, 12 million people lacked access to clean drinking water, and 4.6 million
adults were illiterate. Most schools and hospitals in the black areas did not even have
electricity.

The Policy Initiatives


In 1994, the government introduced the Reconstruction and Development Programme
(RDP), which primarily aimed to reduce poverty and improve the living conditions of
the poor. Attacking poverty and deprivation will be the first priority of the
democratic Government declared the white paper on RDP. The document added
Our income distribution is racially distorted and ranks as one of the most unequal in
the world. Women are still subject to innumerable forms of discrimination and bias.
Rural people are marginalized. Throughout, a combination of lavish wealth and abject
poverty characterizes our society.12

The Reconstruction and Development Programme


The RDP was an integrated socio-economic policy framework that sought to gather
together the people and the resources of the country to eliminate the inequalities
caused by the apartheid system and build a democratic, non-racial, non-sexist
republic.
The white paper on RDP identified four key programs. They were:13
Meet the basic needs of every South African
Develop South Africas human resources
Develop a prosperous, balanced regional economy and
Democratize the state and society.

12
13

RDP White Paper, www.anc.org.za, September 1994.


Prof. B. C. Chikulo, Development Policy in South Africa: A Review, DPMN Bulletin,
Volume X, Number 2, www.dpmf.org, April 2003.

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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

Socio-Economic Objectives under the RDP


The creation of 2.5 million jobs over a ten-year period;
The building of one million houses by the year 2000;
The connection to the national electricity grid of 2.5 million homes by 2000;
The provision of running water and sewerage to one million households;
The distribution of 30% of agricultural land to emerging black farmers;
The development of a new focus on primary health care;
The provision of ten years of compulsory free education for all children;
The encouragement of massive infrastructural improvements through public
works;
The restructuring of state institutions by 1997 to reflect the broader race, class
and gender composition of society.
Source: Prof. B. C. Chikulo, Development Policy in South Africa: A Review, DPMN
Bulletin, Volume X, Number 2, www.dpmf.org, April 2003.
Despite its good intentions, the implementation of the RDP was far from satisfactory.
Ineffective governmental control and lack of inter-departmental coordination resulted in
slow progress in 1995 and 1996. Also, the local governments did not have the capacity to
successfully implement the RDP.
For the first two years after the ANC government came to power, the economy grew
by only around 2.3% (average annual rate). The government was, however, able to
bring down the annual inflation rate from around 20% to around 10%. Though the
economy in 1996 was in better shape than in 1993, when there had been negative
growth and soaring inflation, the government was only too aware that low growth
would not help in solving the huge unemployment issue, which had worsened in the
14

Rand is the currency of South Africa. US$ 1 = Rand 6.76 (as of 2006)

552

The South African Economy: Coping with the Legacy of Apartheid


period. A growing current account deficit and currency depreciation were other
factors that were worrying the government. The lower-than-expected performance of
the economy also impacted negatively on the implementation of the RDP. The
government realized that it would have to create the right environment for the
economy to achieve high growth, low deficits, a stable exchange rate, and more jobs.
The government announced a new policy in 1996.

The Growth, Employment, and Redistribution Policy (1996-2000)


The Growth, Employment, And Redistribution (GEAR) policy was introduced by
Finance Minister Trevor Manuel in June 1996. The policy primarily aimed to achieve
a 6% annual growth rate, increase exports by 8% per annum, and create 400,000 new
jobs every year by 2000. The policy document stated It is Governments conviction
that we have to mobilize all our energy in a new burst of economic activity. This
[would require] breaking current constraints and catapulting the economy to the
higher levels of growth, development, and employment needed to provide a better life
for all South Africans.15 Though the GEAR was a new policy initiative, the
government saw it as a tool that would help achieve the objectives of RDP. It was also
to assimilate several important elements from the RDP.
The new policy was to help develop a competitive, fast-growing economy through
fiscal and monetary discipline. The government aimed to control the deficit, check
depreciation of the currency, and rein in inflation. Despite certain sections demanding
nationalization, the ANC government resisted the urge to nationalize and instead
decided to privatize several sectors of the economy (See Table 1 for more
information on the GEAR policy).

Table I: The Core Elements of the Gear Policy


A renewed focus on budget reform to strengthen the redistributive thrust of
expenditure;
A faster fiscal deficit reduction program to contain debt service obligations,
counter inflation, and free resources for investment;
An exchange rate policy to keep the real effective rate stable at a competitive
level;
A consistent monetary policy to prevent a resurgence of inflation;
A further step in the gradual relaxation of exchange controls;
A reduction in tariffs to contain input prices and facilitate industrial
restructuring, compensating partially for the exchange rate depreciation;
Tax incentives to stimulate new investment in competitive and labor absorbing
projects;
Speeding up the restructuring of state assets to optimize investment resources;
An expansionary infrastructure program to address service deficiencies and
backlogs;
An appropriately structured flexibility within the collective bargaining system;
A strengthened levy system to fund training on a scale commensurate with
needs;
An expansion of trade and investment flows in Southern Africa; and
A commitment to the implementation of stable and coordinated policies.
Source: Growth, Employment, and Redistribution: A Macroeconomic Strategy,
www.treasury.gov.za, June 14, 1996.
15

Growth, Employment, and Redistribution: A Macroeconomic Strategy, June 14, 1996.

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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.

The GEAR Effect


The ANC-led government promised a better life for all when it launched the RDP.
However, in 1996, with the implementation of the GEAR policy, the government
appeared to have shifted its focus from social welfare to fiscal discipline and
liberalization. When asked to respond to criticism regarding governments change in
focus from addressing social problems to wooing foreign investment, Pundy Pillay,
head of RDP policy unit within the presidents office, insisted that the RDP remained
a vital component of government policy. It (RDP) is not at all incompatible with
GEAR. The two policies require each other to work, 18 he said.
However, irrespective of whether RDP and GEAR were compatible or not, under the
GEAR policy, i.e. between 1996 and 1999, South Africas GDP grew in real terms by
an average of only 2.1 per cent annually, which was even lower than the population
growth rate. Some analysts ascribed this lack of growth to the monetary policy
followed by the South African Reserve Bank (SARB). Chris Stals, the governor of the
SARB, was of the opinion that keeping interest rates high was necessary to control
inflation. Therefore, even when the government had recommended lowering the
interest rates under GEAR so as to boost private investments, the SARB continued to
maintain19 high interest rates.
While the GDP grew at 4.3% in 1996, the growth rate fell to 2.6% in 1997, and further
to 0.5% in 1998. In 1999, the economy recovered (from the Asian crisis) and grew by
2.4%. With the economy posting low growth rates, the unemployment situation in
South Africa worsened. Whatever little growth the country witnessed during the
period was jobless growth (Refer Table II for unemployment figures in the 1990s).

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%.

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The South African Economy: Coping with the Legacy of Apartheid

Table II: Unemployment in South Africa


Year
Broad definition* (%)

1993
31.2

1994
31.5

1996
35.6

1998
38.6

2000
36.9

Narrow definition^ (%)

13.0

20.0

21.0

26.1

25.8

* wanting work, ^ actively searching for jobs


Source: South African Labor and Development Research Unit, University of Cape
Town, and Labor Force Survey, Statistics South Africa.
Though foreign exchange reserves increased between 1996 and 2000, the FDI inflows
were not satisfactory. Despite some successes, with a few big businesses such as
BMW and Mercedes setting up automobile manufacturing plants in South Africa, the
GEAR period did not see FDI levels increasing. On the other hand, analysts such as
Padraig Carmady, Professor, University of Vermont, criticized the South African
governments view of considering FDI as a panacea for the ills plaguing the South
African economy. Also, a closer look at the FDI that did come in revealed that much
of it went toward acquiring existing assets rather than building new plants or creating
new jobs resulting, in most cases, in displacing domestic manufacturers. Under
GEAR, the South African economy became even more dependent on natural resources
such as metals, diamonds, and gold rather than on new economy industries.
However, the government was able to control the budgetary deficit, which also was one of
the objectives of the GEAR policy. The deficit went down from 4.6% of GDP in 1996, to
2.4% of GDP in 1999. Inflation too was brought under control. In 1999, the inflation rate
was around 5%, down from 7.4% in 1996 (Refer Exhibit V for major economic
indicators between 1995 and 1999).

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.

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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

A Comparison of Incomes (in 2001)


Color
edBlack
Indian
2% 10%
4%

Colore
Indiand
3% 9%
White
21%
Black
67%

Individual Monthly Income Less Than Rand


200 by Race Group*

White
84%

Individual Monthly Income More


Than Rand 30,000 by Race Group

* Amongst the employed aged 15-65 years


Source: www.statssa.gov.za.
20

21
22
23
24

25

COSATU or Congress of South African Trade Unions, established in 1985, is a union of


trade unions. It has a membership of around two million workers. Its objectives include
improving the material conditions of its members, organizing the unorganized, and ensuring
worker participation in the struggle for peace and democracy.
Richard Knight, South Africa: Economic Policy and Development, http://southernafrica.
homestead.com, July 2001.
Operation Hunger is a South Africa registered not-for-profit organization which is
concerned with the problems of chronic malnutrition and poverty.
Ernest Harsch, South Africa Tackles Social Inequities, Africa Recovery, www.un.org,
January 2001.
Wharton Econometric Forecasting Associates or WEFA was founded in 1963 by Lawrence
R. Klein, a Nobel Laureate in Economics, under the Economic Research Unit at the
University of Pennsylvania to provide forecasting services. It became part of Global Insight,
Inc. in 2001.
Ernest Harsch, South Africa Tackles Social Inequities, Africa Recovery, www.un.org,
January 2001.

556

The South African Economy: Coping with the Legacy of Apartheid


Several analysts criticized the governments moves to privatize public utilities such as
water, electricity, etc. According to Trevor Ngwane, an organizer in the Anti
Privatization Forum (APF)26 said, The ANC has bought into the idea that the best
way forward for economic development is to let the private sector take over services
and assets that prior to this were controlled by the government. 27

Subsequent Policy Initiatives


By 2000, the government was able to achieve many of the goals set under the RDP
(Refer Exhibit VII for achievements of the RDP between 1994 and 2000);
however, unemployment and poverty continued to remain high and threatened to
negate the progress made.

Exhibit VII
RDP Achievements between 1994 and 2000
Water

4 million more people given access to clean running water

Housing

900,000 units completed, 1.1 million housing subsidies


allocated

Electrification

1.5 million new connections

Telephones

4.2 million new connections

Poverty relief

Rand 3 billion allocated

Health

600 new clinics, free health care for pregnant women and
children under 6

Public works

1,500 kilometers of roads built

Land

68,000 families resettled on farming land

Source: RDP Development Monitor.


While a majority of whites continued to live in prosperity, a large section of the blacks
remained below the poverty line. In fact, in 2001, it was estimated that 57% of the
blacks in South Africa lived below the poverty line, while only 2.1% of the whites
were poor. In other words, the economic disparities had not lessened significantly
from the apartheid era. A Finance Ministry budget review document, released along
with the 2000-01 budget in February stated South Africa remains one of the most
unequal countries in the world, with the poorest 40 per cent of households still living
below the minimum household subsistence level. 28
Also, under the RDP, the government had promised to redistribute 30 percent of all
land seized during the apartheid period. However, even a decade after the dismantling
of apartheid, only two percent of the land had been returned to the blacks.

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

Black here referred to Africans, coloreds, and Indians.(Source: www.bwasa.co.za)


Broad Based Black Economic Empowerment Act 1953 of 2003, http://bee.sabinet.co.za.
The codes referred to qualification criteria for preferential purposes of procurement and any
other economic activity, indicators to measure broad-based black economic empowerment
and weighting to be attached to these indicators, etc.
Lucy Jones, Risks Remain for South Africas Economy, www.bbc.co.uk, April 14, 2004.

558

The South African Economy: Coping with the Legacy of Apartheid


The government too realized that accelerating the economic growth should be its
priority. Therefore, in July 2005, Mbeki launched the Accelerated and Shared Growth
Initiative South Africa (ASGISA). The ASGISA document said, we need to
ensure that the fruits of growth are shared in such a way that poverty comes as close
as possible to being eliminated, and that the severe inequalities that still plague our
country are considerably reduced. Our vision of our development path is a vigorous
and inclusive economy where products and services are diverse, more value is added
to our products and services, costs of production and distribution are reduced, labor is
readily absorbed into sustainable employment, and new businesses are encouraged to
proliferate and expand.33
The primary goal of the ASGISA was to halve unemployment and poverty by 2014.
Under the ASGISA, the government targeted a growth rate of at least 4.5% between
2005 and 2009, and above 6% between 2010 and 2014. The government also
identified areas where improvement would have to be made in order for the economy
to achieve the set targets. For example, the volatility of the currency, the poor
infrastructure, the shortage of skilled labor, limited investment opportunities, the
regulatory environment, and deficiencies in state organization were listed as binding
constraints. The government then developed initiatives under six categories
Macroeconomic issues; Infrastructure programs; Sector investment strategies; Skills
and education initiatives, Second economy34 interventions; and Public administration
issues.
Deputy President Phumzile Mlambo-Ngcuka (Ngcuka) said, We believe that we have
built the basis for a national program of shared economic growth. With this program
we can achieve our social objectives, and we can more than meet the Millennium
Development Goals35.36

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

Media Briefing by Deputy President Phumzile Mlambo-Ngcuka, Background Document,


A Catalyst for Accelerated and Shared Growth - South Africa, www.pmg.org.za, February
06, 2006.
Second economy here refers to the informal economy of South Africa.
The Millennium Development Goals (MDGs), which included eradicating extreme poverty
and hunger, achieving universal primary education, promoting gender equality, reducing
child mortality, improving maternal health, combating HIV/AIDS, malaria, and other
diseases, ensuring environmental sustainability, and developing global partnership for
development, were agreed on at the United Nations Millennium Summit in September 2000.
Nearly 190 countries have subsequently signed up to them as a blueprint for building a
better world in the 21st century.
Media Briefing by Deputy President Phumzile Mlambo-Ngcuka, Background Document,
A Catalyst for Accelerated and Shared Growth
South Africa, www.pmg.org.za,
February 06, 2006.

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International Business

Exhibit VIII
Economic Indicators in the 2000s
S.
No.

Economic Indicators

2001

2002

2003

2004

2005

2006

Real GDP growth (%)

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

US$ exchange rate


(in rands)

12.13

8.64

6.64

5.64

6.33

Unemployment (in %)

30.5

26.2

26.7

25.6

* Consumer price index


Source: IMF Country Report and other sources.
An EPI37 economic snapshot in 2006 showed that South Africas Gini coefficient 38
had actually worsened in the period between 1994 and 2002. South Africa had
become the most unequal country in the world in terms of income distribution in the
early 1990s, surpassing Brazil, which had held the dubious distinction till then (Refer
Exhibit IX for the Gini coefficients of South Africa and Brazil). The snapshot
concluded Both Brazil and South Africa have a long way to go to reduce the
extreme inequality in their societies, but one country (Brazil) seems headed in the
right direction while the other (South Africa) is headed in the wrong one. 39
The wide prevalence of HIV/AIDS was a major threat to the economic growth and
development of South Africa. The country had one of the highest numbers of HIV
positive people in the world
about five million out of a population of 45 million
(Refer Exhibit X for HIV/AIDS prevalence in South Africa and some other
countries). Though different estimates cited different figures, it was feared that
around 10 per cent of all young people were infected. As a result, the average life
expectancy of South Africans was predicted to fall further by 2008. South Africas
general health system too was inadequate, ranking 40 175th among the 191 UN member
states. The poor health infrastructure was expected to exacerbate the situation.

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

The South African Economy: Coping with the Legacy of Apartheid

Exhibit IX
GINI Coefficients for South Africa and Brazil, 1995-2002

Source: www.naledi.org.za, www.dieese.org.br.

Exhibit X
Ranking of Countries on the Basis of Number of People Living with
HIV/Aids
Rank

Country

People living with HIV/AIDS


(as of 2003)

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%

* 2001 data, ^ among adults (15-59)


Source: www.cia.gov.

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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

The South African Economy: Coping with the Legacy of Apartheid

References and Suggested Readings:


1.

Background Note: South Africa, Bureau of African Affairs, www.state.gov, April


2007.

2.

Mary Alexander, South Africa: Black Economic Empowerment, www.allafrica.com,


March 23, 2007.

3.

Economic Policy and South Africas Growth Strategy, www.treasury.gov.za, March 19,
2007.

4.

Dani Rodrik, Understanding South Africas Economic Puzzles, Working Papers,


Center for International Development at Harvard University, www.cid.harvard.edu,
August 2006.

5.

Josep Maria, Resistance to Neo-liberalism, www.alternatives-international.net, July 24, 2006.

6.

Good Times in SA, Financial Times, www.southafrica.info, June 12, 2006.

7.

Tony Avirgan, South Africas economic gap grows wider while Brazils narrows
slightly, www.epi.org, April 19, 2006.

8.

Asgi-SA: Accelerated Growth for All, www.southafrica.info, 2006.

9.

Lynne Thomas and Jonathan Leape, Foreign Direct Investment in South Africa,
CREFSA, London School of Economics, www.lse.ac.uk, October 2005.

10.

Edmond J. Keller, The Challenge of Enduring and Deepening Poverty in the New
South Africa, www.international.ucla.edu, May 2005.

11.

Ernest Harsch, South Africa Marks a Decade of Freedom, Africa Renewal,


www.un.org, July 2004.

12.

Poverty in Post Apartheid South Africa, www.waronwant.org, July 23, 2003.

13.

Prof. B. C. Chikulo, Development Policy in South Africa: A Review, DPMN Bulletin,


Volume X, Number 2, www.dpmf.org, April 2003.

14.

Tim Bucknell, Hannah Lee, Patty Skuster and Mary Thornton, Changing Gears: South
Africa and the Growth Employment and Redistribution Strategy of 1996, wwwpersonal.umich.edu, April 15, 2002.

15.

Ernest Harsch, South Africa Tackles Social Inequities, Africa Recovery, www.un.org,
January 2001.

16.

Ernesto Hernandez-Cata, Sub-Saharan Africa Economic Policy and Outlook for


Growth, Volume 36, Number 1, www.imf.org, March 1999.

17.

IMF Concludes Article IV Consultation with South Africa, www.imf.org, September, 1998.

18.

Reconstruction and Development Programme (RDP) White Paper, University of


Pennsylvania-African Studies Centre, www.africa.upenn.edu, September 1994.

19.

African National Congress Constitution, www.anc.org.za.

20.

www.stassa.gov.za.

21.

www.southafrica.info.

22.

www.reservebank.co.za.

23.

www.mbendi.co.za.

24.

www.cia.gov.

25.

www-cs-students.stanford.edu.

26.

www.nationsencyclopedia.com.

563