Executives of multinational companies could be excused for wondering what to make of Latin America as a place to do business today. On the upside, they see sound economic growth, increasing opportunities to serve a maturing consumer base, and a world-class commodity sector. On the downside, Latin America’s growth is much slower than Asia’s, and companies must deal with political uncertainties, regulatory constraints, and infrastructure shortcomings. The following questions and answers address some of the current concerns of executives working in the region or considering investments there.

To what extent should multinational companies be concerned about the recent political movement to the Left, particularly in Bolivia and Venezuela?

Care is needed to characterize the political shift in Latin America correctly. The continent-wide free-market measures of the 1990s were often not applied as successfully as might have been hoped. They failed to generate sufficient investment, while consumers found that they were not always the direct beneficiaries of the changes.

After the 2001–02 economic downturn, there was a backlash against the “neoliberal” reforms of the previous decade and a movement to restore the protectionist policies of the past. Even so, with the exception of a few countries, fiscal prudence, macro-economic controls, open borders, and an understanding of the need to attract foreign direct investment will still be the order of the day.

Of course, the political changes in some countries have certainly caused problems for investors—in Bolivia’s energy sector, for example. There are also clearly issues in Venezuela. Looking at Latin America as a whole, however, the economies of Brazil and Mexico alone account for two-thirds of the gross domestic product. Not surprisingly, most of the foreign direct investment has been focused there.

In Brazil and Mexico, political developments have not put off investors in recent years. Quite the opposite: capital markets and investors seemed unconcerned by the results of Brazil’s recent presidential election and by the disputed outcome of Mexico’s presidential election in 2006, eventually won by the conservative candidate Felipe Calderón. In Brazil, the stability of the financial markets after the reelection of President Luiz Inácio Lula da Silva, in October 2006, stands in marked contrast to the volatility following his initial election, four years ago.

In Latin America, as in most emerging markets, local knowledge makes all the difference when companies decide whether to invest: local partners can help much more than lawyers or advisers. In Argentina, for example, leading multinationals have successfully coinvested with local private investors both in the energy and the telecommunications sectors. Investment decisions depend on the specific industry—heavily regulated sectors such as telecommunications may be more vulnerable to changes in government policy than, say, steel. Overall, higher risks require higher returns. Invest-ments must be carefully evaluated with that in mind.

Why has Latin America recently been growing so much more slowly than Asia? Could this change?

From the end of the Second World War through the early 1980s, when the debt crisis hit, Latin America had a high growth rate. The region’s economies as a whole grew by 5.5 percent a year compounded annually from 1950 to 1980, compared with 5.2 percent in China, 3.7 percent in India, and 3.5 percent globally.

Latin America’s economy grew through industrialization, which generated a huge movement from agriculture to modern economic activities. The same thing is happening in China and India today. But from 1980 to 2005, Latin America grew by only 2.3 percent a year, compared with 8 percent in China, 3.7 percent in India, and 4.7 percent in the rest of the world. To return to high growth, the region must overcome a number of barriers that national governments have so far avoided addressing:

• overregulation and high taxes, which foster illegal and informal markets, leading in turn to reduced productivity; overregulation and high taxes were obstacles before 1980 as well but were less of an issue because of strong investment
• the incomplete liberalization of markets, resulting in weaker productivity, growth, and innovation, as well as fewer benefits for consumers
• economic instability—too many changes in direction—leading to a perception that some Latin American countries are risky, a higher cost of capital, lower levels of investment, and less developed capital markets
• underinvestment in infrastructure
• a failure, despite significant expenditures, to improve education and health, to prevent crime or fight it effectively, and to create an effective judicial system
• low productivity in public services

These barriers limit productivity growth and investment because companies think that for any given level of return they must accept a higher level of risk and because the barriers create inefficiencies that raise costs. Overcoming some of these barriers could boost growth considerably. In Brazil per capita GDP growth could reach 7 percent a year, McKinsey analysis shows (see “Five priorities for Brazil’s economy,” available late March).

Indeed, no structural features prevent Latin America from growing at Asian rates, but there is a fundamental need for strong and well-informed political leadership. It is not clear, in many countries, whether the political will to attack these problems exists. Change will occur when the electorate demands that politicians become accountable for the fact that Latin America’s economies continue to lag behind some other developing ones.

What about Chile? Hasn’t it moved ahead?

The proof that countries can address structural barriers is Chile, which represents a real exception to the region’s growth doldrums. The country has already addressed many of the barriers noted above and has recorded a high, Asian-style growth rate over the past 25 years. Chile’s GDP rose by 4.7 percent annually from 1980 to 2005—double Latin America’s average and even more than the average for India. Chile privatized and liberalized its economy early on and established stable regulations. The informal sector is small. There also seems to be a consensus that Chile’s economy should be independent of political direction, most likely because the results to date have been so favorable.

However, the 2006 figures are expected to show that Chile’s economy grew by less than 5 percent, even with the tremendous boost of record-high copper prices and a budget surplus of more than 1 percent. Within this context, economists increasingly ask why Chile isn’t growing at a rate of 7 or 8 percent a year as it did in the early 1990s. Some argue that, despite excelling in the macroeconomic sphere, Chile has fallen behind in microeconomic policy—a shortcoming that has prevented many sectors (other than mining) from growing faster. The barriers include relatively inflexible labor laws and a poor performance in education compared with competing countries. In fact, the total level of investment, including foreign direct investment, has fallen to its lowest level since the country returned to democracy, in 1990.

Chile is a clear example of the need for Latin America’s economies to complement their excellent natural resources and production of commodities with high-value-added, knowledge-based activities to build global businesses underpinned by technology.

How concerned should executives be about the informal economy?

The informal economy is a persistent and serious challenge to Latin America’s economic performance and growth. Its impact, which varies by industry, is particularly severe in consumer goods and services. In Latin America, the informal economy makes up 38 percent of GDP, on average—and 42 percent in Brazil—compared with 16 percent in China and 26 percent in India. Informality means many things: tax evasion, lack of adherence to product regulations, and avoidance of social-security taxes, for instance. It thus reduces the income of governments, leading to higher taxes on the formal sector and lower standards of public services.¹ Furthermore, productivity and investment are stifled by a large informal economy, which creates unfair competition with a formal sector that in turn makes fewer investments than it might have otherwise. And by definition, the informal economy requires some level of corruption—the gray zone extends all the way to organized crime.

Countries with large informal economies cannot build or maintain institutions with enough integrity for societies and economies to thrive. However, governments do not understand (and largely disregard) the issue of informality because, in the populist view, “big business” is fighting the “little guys.” This is a fundamental misunderstanding of the informal economy’s impact on economic development. The little guys actually suffer most by having to live in a world without rules and without much access to credit. The cost and complexity of going formal are too high for the little guys, yet the penalties and limitations of informality are substantial as well.

Broad-based reforms to make formality significantly less expensive and much simpler to achieve are necessary, along with sector-specific strategies to encourage the formal economy’s growth. In retailing, for example, taxes might be based on supermarket shelf space rather than sales because size is easy to measure and hard to hide. One successful example of an effort to fight informality comes from the beverage industry in Brazil, where industry leaders were instrumental in promoting the installation of meters on bottling lines in order to discourage informal production.

Why should a company focus on Latin America when China and India present so many opportunities and demand so much attention from management?

Latin America is a large and growing region with extremely attractive investment opportunities. If you are in a resource-based industry, Latin America is typically at the top of potential areas for profitable growth. As for consumer markets, the region has to be part of the footprint of all major international corporations, which derive some of their economies of scale and scope from global operations. The region’s total estimated GDP is $2.6 trillion for 2006, roughly the same as China’s and three times India’s. External trade balances have improved, leading to greater macro-economic stability and declining political risk in most countries. The challenge remains—many of the region’s economies are not growing fast enough, but that could change quite rapidly if the appropriate policies were applied.

Even though growth, on average, has been slower in the region than in some other developing markets, this does not mean that it has no high-growth sectors. The revenues and returns of commodity-based industries, for example, have risen quickly in recent years—a trend that will probably sustain itself over the long term through demand from Asia, and China in particular. In some other sectors, such as financial services, greater economic stability has also led to profitable growth in Latin America. The key is to be selective and to understand the opportunities.

Finally, Latin America has abundant talent to tap as a source of competitive advantage for companies growing overseas.

How is China’s business and economic relationship with Latin America evolving?

Chinese companies see Latin America primarily as a supplier of raw materials, which they obviously need, and secondarily as a rather small market for their industrial products. Imports from China—mostly manufactured goods such as electric motors and appliances, textiles, and toys—have certainly grown, from $2.8 billion in 1995 to $33.4 billion in 2005. That is a big jump but still represents only 3.8 percent of Latin America’s total imports.

In fact, China’s economy could complement Latin America’s, but the region must evolve from its current competitive advantages, based largely on natural resources and cheap labor, to higher-value-added offerings. One of Latin America’s chief competitive advantages for Chinese companies is its geographic location—the easy accessibility of North America and the European Union, which combined still hold almost 60 percent of world GDP. The other advantages include low energy costs, an increasingly skilled labor force for manufactured goods, and entrepreneurial spirit.

Although cost-competitive Chinese exports partly compete with (and replace) Latin American exports to Europe and the United States, Latin America should abandon the idea that China is the enemy. Chinese and Latin American companies can work together to serve developed markets. Some already do: for example, a significant proportion of China’s $18 billion in exports to Mexico—mainly electrical machinery and equipment, as well as manufactured goods—is intended not for local consumption but to provide components for higher-value-added manufactured goods that are then exported to the United States and Canada.

Meanwhile, China can be a major market for Latin America’s goods beyond simple commodities. A new generation of Latin American entrepreneurs increasingly understands this. An example is the aggressive investment in China by Gruma, Mexico’s largest corn- and wheat-based tortilla manufacturer, which seeks to dominate this segment of the Chinese consumer market.

What are the other opportunities for investment in Latin America today?

Much of the massive foreign direct investment of the 1990s was linked to privatization, by definition a onetime event. Particularly in telecommunications and energy, there has been a prolonged hiatus in privatization following the big wave. Overall foreign direct investment in Latin America dropped from 48 percent of the total for emerging markets in 1990 to 31 percent in 2005. (In absolute terms, foreign direct investment in Latin America first peaked, at more than $100 billion, in 1999 and had returned to that level by 2005.) Although privatization improved productivity, the picture for investors was mixed. Some investments of that period, particularly in infrastructure, were very public failures, which created a misleading picture of the overall situation.

A market is now forming for privatized assets, however. Investors who moved in during the past decade are thinking about selling out as they revise their global strategies or decide that their returns have been disappointing—or both. So we do see opportunities for investors to buy assets at attractive prices eventually; it is no accident that private-equity business is now reviving in the region. One interesting example of the deals being done was the sale of the French energy company EDF’s electricity holdings in Argentina and Brazil to private investors.

We advise caution: investors should place their bets countercyclically. We still see many investors entering when equity prices are high and currencies strong and then getting out when equities and currencies are weaker. As an illustration, in 2002 and 2003 equity prices were very low, but these were also the years with the lowest levels of foreign direct investment. Latin America is and will remain a volatile region, and returns depend on the timing of entry. But capital markets and foreign direct investment seem to accentuate the cycle instead of using it to advantage. Local investors are much more savvy in this respect.

The restructuring and consolidation of many industries is a good bet. For long periods, many of Latin America’s economies were largely closed and inefficient, so industry structures in sectors such as light manufacturing are still suboptimal. What’s more, some export opportunities, such as forwardly integrating into higher-value-added products, have yet to be well exploited. Agricultural producers, for example, could consider moving into biofuels—10 percent of world gasoline consumption could be replaced by Brazilian ethanol if the potential was fully developed.

What kind of improvement can we expect in Latin America’s infrastructure?

The development of the region’s infrastructure has lagged behind that of many other countries, and there is a need for major investments. Asia’s high-growth economies are investing about 6 percent of their annual GDP in infrastructure, Latin America only 3.5 percent. Major investments are needed in logistics, transportation, sewage and water systems, and in every type of energy.

With public-sector finances stretched, private investment is necessary. Given the liquidity of global markets, there is no lack of capital. The question is how to mediate between supply and demand; that will require appropriate regulation, enforceable contracts, and, especially, risk-taking entrepreneurship. Governments are mostly aware of these needs, and some are already addressing them. We see private-equity investors, among others, entering the region with infrastructure funds. Foreign investors will have to recognize that it is better to accept the imperfectly developed regulations that prevail in the region now and to mitigate this risk by relying on the insider know-how of local partners than to wait for the perfect investment scenario.

Several countries have instituted public-private partnerships, and the first pilots are seeing the light of day. Brazil recently approved a new legal frame-work for such partnerships, with provisions that are in line with global best practice, including limits on the participation of public capital, procedures for resolving conflicts efficiently, and acceptance of future revenue as a guarantee for debt financing. Plans have been approved slowly under the new framework, however, though some are in the pipeline, such as rail and highway projects. Investors are waiting to see success stories before acting; thus it’s important to make sure that the first few projects are implemented carefully to build credibility.

Commodity-related infrastructure presents clear opportunities given the sector’s export orientation. If the infrastructure improves, the transactional costs of serving major global markets can fall. Many projects are long overdue, and plenty of long-term international financing is available to execute them. It is extremely important that governments change their role for such projects from “owner-builder-operator” to facilitator, quality insurer, and market maker.

To what extent should we expect Latin American companies to expand regionally or globally?

Given the expansion of the capital markets, high profitability, and relatively low domestic growth rates, many local Latin American companies are bound to become important regional and global players. This is already true for a few commodity companies, such as Cemex, the Mexican cement maker, which is pursuing a long-term global acquisition strategy in building materials, and the Brazilian mining house Companhia Vale do Rio Doce (CVRD), which recently acquired Inco, the world’s leading nickel miner. Younger companies, such as Cosan in Brazil, are growing rapidly as well. Cosan may develop into a global leader in biofuels.

In general, we expect more Latin American companies to become major players or even global consolidators in some commodity industries. Local companies—such as Brazil’s Banco Itaú, Mexico’s packaged-goods maker Bimbo, and Chile’s retailers Cencosud and Falabella—could become regional leaders in finance, consumer goods, and retailing, respectively. From this position, they could also develop into global players, leveraging advantages such as an understanding of how to operate in volatile environments and to deal with low-income customers.² Foreign multinationals might well see the growing strength of Latin American companies as a threat, but there is also an opportunity—for example, forming joint ventures to serve regional and global markets.