Mc Donald has restaurants across world serving 47 million customers daily and is a brand name that qualifies to establish anywhere in the world1. Mc Donald's started operations in Iceland as a franchise with Lyst Hr. However, in October 2009, upon advice of Magnus Ogmundsson Mc Donald's operation in Iceland is closed.
This case study presents an analysis of financial crisis in Iceland, investment climate in Iceland (pre and post crisis), and risks associated with investments by foreign MNC (FDI). This Presentation also appraises Benson, Executive Vice President and Chief Financial Officer of Mc Donald, on the reasons for the failure of Mc Donald's in Iceland and provides risk mitigation plan to guide Benson on future investments in small countries like Iceland.
Solution to case problems
Risk and returns faced by McDonald's in investing in Iceland
Iceland is 2nd largest island of Europe and its economy is based on the Scandinavian type capitalistic system, also known as the Nordic Tiger because of its rapid growth3. Mc Donald's is ubiquitous and successful in almost every country in which it had its business however franchisee in Iceland failed warranting study on the reasons for failure and the prevailing conditions in Iceland for any future prognosis towards investments in smaller countries .
The primary reason for the failure of Mc Donald in Iceland is observed from a statement mentioned by Ogmundsson "Our competitors all use domestic meat and lettuce and so on, while we are flying in these materials, which is extremely expensive,"4. All produces that Mc Donald's uses are imported but inflation and collapsing currency of Iceland reduced profit margin for Mc Donald's and ultimate closure.
Secondly, After October 2008, Iceland's banking system collapsed and lost its international reputation. This led to a crisis. To build its credibility Iceland entered negotiations with the IMF initiating a program to stabilize the economy. However this Iceland went into recession5 & 6. The financial crisis has had detrimental effect on Iceland's economy. Effects of Iceland's financial crisis:
The national currency has fallen sharply in value,
Foreign currency transactions were virtually suspended for weeks6
Market capitalization Iceland stock exchange dropped by more than 90%22.
Thirdly, as a consequence of failed banking system government intervened and provided support however this led to currency of Iceland to collapse (Krona) from 60 to 140 (7).
Chart courtesy of ino.com
Having studied the prevalent market conditions in 2007 in Iceland, I will provide the risk and returns faced by Mc Donald's in Iceland.
With a failed banking system, loss of trust by foreign investors, with a global recession in place and improper government policies towards investment investors felt Iceland is a risky bet and Mc Donald's faced it extremely. Following are risks for Mc Donald's:
Risk from failed banking system - Banking and financial system transformed in 2007 from a small-scale, low-risk deposit money banks to an international banking system with high-risk leveraged investments and depending heavily on foreign financing5. Major Banks capitalizing on this change in perspective invested across world their by improving their balance sheets and Iceland's GDP. In 2008 failure in banking system had led Iceland into collapse. Thereby reducing the investor's confidence. Risk associated with foreign exchange transactions has increased a lot for Mc Donald's.
Risk from policies - Lyst was bound by McDonald's requirement that it imports all the produces - from packaging to meat and cheeses - from Germany8. The prices of imports into Iceland are high and increased prices at McDonald's. Additionally, risk associated with foreign exchange rate transactions is high. In this case the imports of products became expensive. Because of global economic crisis currency of Iceland is affected dropping its value by half.
Risk from inflation - With the overall economy of Iceland in doldrums prices of goods increased as most of the goods are imported into Iceland. For Mc Donald's Inflation reduced the competitiveness.
Additionally, some of the general risks towards investing in Iceland are
Risk from global crisis - 2008 sub-prime Global Crisis is a cause of misguided policies and these troubled polices created exhaustive imbalances in the world economy. These imbalances affected already troubled Iceland because of Foreign investors loosing confidence.
Iceland's debt: Iceland's internal and external debt increased during the crisis9. Higher debts bring in a negative sentiment and thereby stalling the overall growth and future investments.
Iceland's global purchasing power in 2007 versus 2009; causes and impact on Iceland's purchasing power
Purchasing power parity by definition is based on the belief that identical products and services in different countries should cost the same in different countries. This is based on assumption that exchange rates will adjust to eliminate the arbitrage opportunity of buying a product or service in one country and selling it in another country10.
There is sea change in Iceland's Global Purchasing power pre 2007 and after 2009 due to the financial crisis. PPP is required to understand because purchasing power parity should be a guiding factor for Benson towards his future investments in countries like Iceland.
Iceland is primarily a fishing based export oriented economy but because of changes in policies described in Question 1 Iceland's economic profile changed. FDIs started pouring into Iceland and economy grew by 4.0% p.a in 20th century. This increased investment has to be financed by domestic savings or foreign investors. In Iceland most of the investments is financed by foreign investments and thereby opening capital market in which foreign investments banks played crucial roles. This change in perspective in 2007 remarkably improved assets of the Icelandic banking system that grew to more than ten times the GDP. In 2007 with high foreign investments inflation was low. A low inflation means an increase in comparable (between 2007 and 2009) currency value. Additionally, exchange rates are low in 2007. With strong economy foreign investors investing in Iceland would get profits.
However in 2009, after the crisis, inflation is high and thereby exchange rates are high and foreign investments reduced in Iceland (due to loss in leverage of currency fluctuation and other factors).
Inflation peaked in 2009.
Chart courtesy of http://www.statice.is/ and tradingeconomics.com
key Economic Indicators 2005-2012
2005
2006
2007
2008
2009
2010
2011
2012
GDP growth, %
7.5
2.6
4
-0.1
-9.6
0
2.8
2.9
Current Account Balance, % of GDP
-16.1
-27.4
-15.4
-22.2
6.1
5.6
-5.7
-5.2
Inflation rate, %
4
6.8
4
12.8
13.1
2.7
2.5
2.7
Unemployment, % of labour force
2.1
1.3
1
7.8
8.6
3.2
3
3
Source: Ministry of Finance, autumn 2006, winter 2007, summer 2007, winter 2009.
24
Iceland's financial crisis is part of global turmoil and primary causes are
Failed banking system thereby leading to liquidity crisis
Large size of banking sector when compared to economy 11
Loss of Iceland's international creditworthiness
Dangers of cross currency risk as in 2007 bank assets and liabilities primarily denominated in foreign currencies, creating a dangerous currency crisis. If there is a liquidity crisis then central banks cannot print currency to rescue banks.
Pre-crisis real estate boomed and spending increased creating a financial bubble like the sub-prime crisis in 2008 in the United States of America.
Extent to which local versus global factors has impacted Iceland's purchasing power:
Factors:
Economical / Financial Factors (12)
There are local and global economical and financial factors that lead to the crisis. The local factors such as deregulation, liberalization of banking system, uncontrolled banking system with an inexperience management are reasons for crisis. These factors lead to external factors such as reduced investment, loss of confidence in investing in Iceland, low purchasing power parity etc. In comparison, the internal factor played crucial role in the financial crisis than the external factors.
Political Cultural Factors (12)
Iceland has a very high nexus between state and people running the business i.e., nexus between politics and business. The privatization of banks and state owned enterprises is supposed to end this relationship however this processed failed due to some crony policies of the government leading to crisis. This factor is purely internal and because of the phenomenal growth in banking system (10 times GDP) the global purchasing power increased however a sudden failure in the banking system created a crisis of insurmountable amount.
Hedging Strategies in Iceland and Lyst's investment in Mc Donald
Hedging is done to reduce risk of exposure to fluctuations in financial prices13. Mc Donald's is exposed to the following risks due to the franchisee.
Hedging strategies for each risk are:
Risk from interest rate changes: Post crisis the central bank of Iceland has increased interest rate to 18% (reduce to 17%). To mitigate risk associated with interest rate fluctuation Mc Donald's could have followed the following hedging strategies
CAP
SWAP
CAP would have limited the exposure to raising interest rate. However, CAP benefits borrowers when rates fall. Using a corridor and knockout feature of CAP reduces the risk associated with interest rates further down.
SWAP is an agreement to exchange interest payments in a single currency for a stated time period and this can be customized to meet user specific time requirements.
During the crisis there is a huge change in the exchange rate and it is also known that most of the purchases in Mc Donald's are from Germany. It could have helped Mc Donald's if it had hedged against the exchange rates while transacting with German.
In addition to the above, Mc Donald's should have taken care of its currency by hedging against credit risk and currency risk. Credit Risk is the risk that money owing will be paid by an obligator. Additionally, currency risk reduces the risk of investing in foreign countries.
Currency exposure can be reduced by trade-over-counter (OTC) market currency forwards and options, exchange-traded futures and options on futures.
Lyst's investment in Mc Donald's franchise could have been saved if he had followed the following hedging strategies.
Lyst should have hedged primarily because the crisis increased prices of produce, imports become expensive, and inflation effected Lyst's portfolio. Additionally, Lyst should have also hedged for currency risks as Lyst pays franchisee fee to Mc Donald's on a regular basis.
Lyst could also have had a cash flow hedge, if Lyst plan to purchase inventory in future.
MNC investment risk in small countries
From your analysis of the Iceland situation, and drawing on other examples that you feel are useful, outline and discuss all of the risks of an MNC investing in small markets, and ways in which MNCs can mitigate such risks.
Competition among firms, technology development, and availability of market access are potential factors for an MNC to invest in foreign markets. In this framework, small countries such as Iceland, Greece etc are emerging as key players15.
As in Iceland, MNC could face political risk. Political risk is becoming exposed to a range of political risks such as adverse political developments, changes in policies, tax laws for FDI etc. These political risks are further classified as country specific risk, firm specific risk and global risk (as seen in 2008 crisis). Apart from political risks firms also face following risks17 :
Economic risk
Transfer risk
Exchange rate risk
Sovereign risk
Economic risk is the risk of projects output not generating sufficient revenues and profits to cover operating costs. Economic risk is generally due to change in policy goals (fiscal, monitory, international, or wealth distribution or creation) or a significant change in company's comparative advantage. Economic risks are generally measured by studying fiscal and monitory policies of a country.
Transfer risk is the possibility of loss due to currency conversion (exchange) restrictions imposed by foreign government that make it possible to move money out of the country18. It is difficult to quantify this risk because the policies of government is unpredictable however for smaller countries such as Greece, Iceland the possibility of Transfer risk is low because these countries are pro-growth and have requested for foreign investments.
Exchange Risk is exposure or uncertainty that is inherent in dealing with two or more currencies that do not have fixed-parity values. Also called currency risk19. For Iceland the failure of banks had lead to currency of Iceland to collapse (Krona) from 60 to 140. Typically, investors hedge to mitigate exposure to exchange risk.
Sovereign risk is a risk associated with governments unwilling or unable to meet its loan obligations or reneges on loans it guarantees. This generally arises due to unfavorable developments in its balance of payments. A classic example is the 2001 crisis of Argentina.
MNCs typically investing in small countries would have all the risks mentioned above.
Following are ways to mitigate each of the risk.
Political risk mitigation20 is understanding political uncertainties of the operating environment and risks faced by all business operations in individual countries. Political risk can be mitigated by political risk insurance.
Exposure to economic risk can be mitigated by using financial instruments, especially credit risk and market risk. Financial instruments are cash instruments (securities) and derivatives (exchange traded derivatives and over-the-counter OTC derivatives)21 and for foreign exchange risk spot and currency features can be used..
Sovereign risk can be mitigated by studying the government policies, government role in financial policies, openness of government in executing financial rules etc. A country with a judicious and lay abiding financial system typically could have a low sovereign risk.
Conclusion:
Mc Donald's franchisee failed in Iceland because of prevailing fiscal policies. Iceland's financial crisis is a result of failed banks, improper financial regulation and government policies and lack of investor's confidence. The risks associated with investment in countries like Iceland are discussed to develop an insight into future investments of MNC. Benson should study risks associated with small countries as mentioned in this case study before venturing into a country and additionally develop strategies to mitigate risks after starting a business in a country
