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mar16-16-163230196

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 (CUC) valued on par with the dollar and fully tradeable, and the Cuban Peso (CUP) 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.

Editor's note: This article has been updated to reflect the correct Cuban currency abbreviations.