The Potential and Pitfalls of Doing Business in Cuba

The Potential and Pitfalls of Doing Business in Cuba
Pablo González Alonso Alec Lee
MARCH 16, 2016

When President Obama visits Cuba on March 21, it will have been a little
more than 57 years since the end of the Cuban revolution and slightly
less than 55 years since the initial implementation of the U.S. embargo.

Amid this historic trip and the flood of regulatory and diplomatic
changes (including a new decision to ease some additional travel rules)
that have occurred since President Obama's first meeting with Cuban
President Raul Castro last fall, it is important for American business
leaders considering investing in Cuba to understand the current status
of its economy, as well as the key factors that will influence its future.

For the vast majority of American companies, doing business with Cuba
remains illegal. The economic embargo still stands (though companies
such as Caterpillar and Colgate-Palmolive have spent hundreds of
thousands of dollars lobbying for an opening of Cuba). That said, the
Obama administration has made a few changes. In addition to lifting some
travel restrictions, American financial institutions can establish
accounts with their Cuban counterparts and telecommunication firms can
export to and install equipment on the island.

While these recent policy changes are important, they are unlikely to
significantly alter the face of the Cuban economy. Cuba has been mired
in stagnation for nearly two decades, with the regime unable to generate
higher productivity. This has been driven by three factors:

Lack of capital investment. Fixed capital investment in Cuba represents
just 10% of GDP, which is half the regional average. This likely won't
change until the embargo is lifted, as that would facilitate the arrival
of significant new foreign capital. Cuba currently requires billions of
dollars in investment in communication infrastructure, an update to its
dilapidated transportation network, and significant capital inflows into
key productive sectors.
Stalled state economy. Cuba's large and inefficient public sector
severely constrains the country's ability to expand output. Lacking a
true price mechanism to drive resource allocation, many state-run
enterprises are unprofitable and kept afloat with implicit subsidies.
While the Cuban government has made an effort to gradually shift workers
out of the public sector (it has closed 24 state-owned enterprises for
failing to meet output targets), only 25% of the Cuban workforce is
currently employed in the private sector.
Currency confusion. Cuba desperately needs to do away with its dual
currency system. It uses two currencies, the convertible Peso (CUP)
valued on par with the dollar and fully tradeable, and the Cuban Peso
(CUC) valued at a rate of 24:1 with the dollar, which creates severe
constraints for the development of Cuba's export sector. While
calculations would suggest the convertible peso is over valued, Cuban
firms will need to see considerable devaluation to gain greater
competitiveness.
To deflect attention from these challenges, the Cuban government has
introduced various distortions into the country's official economic
statistics, which are used largely unaltered by entities such as the
World Bank and CEPAL. To guard against possible revenue losses, American
business leaders must also be attentive to how currently available data
on this economy tends to overstate the sales opportunity.

Let's look at the two largest of those distortions. The first is in
regards to wages in the public sector, which as reported by the Cuban
government stand at an average rate of over $7,000 USD per year. In
fact, when paying local workers, the government uses the country's
non-convertible currency, or the CUP, in contrast to the convertible
currency, the CUC, but reports these wages as if they were paid in CUC.
This effectively means that these wages are overvalued by as much as
2400%.

A further overrepresentation of the actual market size is determined by
methodological inconsistencies. Between 2003 and 2007, the Cuban
government enacted a series of methodological changes that produced a
jump in GDP of approximately 15%. For instance, the government decided
to assign an arbitrary value to the free social and medical services
provided to its citizens. This is why U.S. healthcare companies, among
the first to do business in Cuba, have told us that official statistics
regarding the healthcare sector just don't match the demand they see in
reality.

Forecasting Cuba's Future
My company, Frontier Strategy Group, is now forecasting expansion for
Cuba to be 3.1% in 2016. While this figure might look especially
attractive when compared to the average Latin America regional growth
rate of -0.4%, there are still various challenges making Cuba's untapped
sales potential largely inaccessible.

That said, Cuba's potential to present new sales opportunity is high,
and could be realized very rapidly under the right conditions. The two
main signposts that we will be watching for are the eventual lifting of
the economic embargo and the unification of the country's two
currencies. While we expect the first to occur by 2018, the Cuban
government has already begun to slowly move toward unifying its two
currencies. The government itself has suggested that it may make further
announcements towards this end later this year.

These two events would serve to drive greater capital inflows to Cuba
(we estimate that foreign direct investment could climb from $700
million USD to above $3 billion USD annually), and thus allow the
government to continue the process of shifting workers from the public
to the private sector, where productivity and innovation is
significantly higher.

Under such a scenario, multinationals would see expanded opportunity
across diverse sectors. While more American tourists would boost the
hospitality businesses, higher productivity would permit higher wages
for Cuban and thus increased private consumption. Likewise, new
infrastructure projects and new local businesses (helped by increased
capital inflows) would generate demand for various products and
services. Furthermore, continued liberalization could drive higher
productivity in Cuba's agriculture sector, where participation by the
public sector continues to be significant, stimulating higher demand for
farm equipment and other agricultural inputs.

These scenarios are not a given. Many risks remain. Likewise, for most
foreign companies, doing business in Cuba will require working hand in
hand with the Cuban government. Forming a joint venture can involve
giving up final control over the import, distribution, and final sale of
your product. While the government is making a concerted effort to be a
more reliable partner, so far very few infrastructure projects been
approved, and payment has often been delayed because of the government's
limited access to foreign currency.

American companies should familiarize themselves with these multiple
challenges, while identifying potential business partners, sizing the
market potential for the company's product, and understanding the
challenges of operating alongside the Cuban government. The key to
winning in Cuba will be to prepare with rigorous scenario planning in
order to avoid being left on the sidelines once the market begins to bloom.

Pablo González Alonso is Director of Latin America Research at Frontier
Strategy Group (FSG), the leading information and advisory services
partner to senior executives in emerging markets. Access his latest
report, "Sizing the Cuban Opportunity."
Alec Lee is a research analyst at Frontier Strategy Group (FSG), the
leading information and advisory services partner to senior executives
in emerging markets. Access his latest report, "Sizing the Cuban
Opportunity."

Source: The Potential and Pitfalls of Doing Business in Cuba -
https://hbr.org/2016/03/the-potential-and-pitfalls-of-doing-business-in-cuba