Impacts of Rising Illegal Tobacco Trade in Latin America
The latest Euromonitor global research for the tobacco industry has unveiled a subtle but important milestone: the value of the global cigarettes category as a proportion of total tobacco sales fell slightly below 90% in 2016 for the first time. This milestone highlights the growing importance of the factors affecting cigarettes retail sales worldwide. In Latin America, one of these factors is the rise of illegal tobacco. However, the rise of illegal trade is also tied to government initiatives seeking to raise taxes, an easy and correct policy option in light of issues concerning public health, as well as the continued erosion of consumer’s purchasing power due to current unfavorable macroeconomic scenarios in the region.
During the last 10 years, retail volume sales of cigarettes in Latin America have showed declines of 4% in compound annual growth rate, the equivalent of losing 94 billion sticks sales in that period. The negative trend has accelerated in the last five years (-5.6%), as sales per capita have decreased in more than 90 sticks in that same period. Leading volume declines are from Ecuador, Brazil, and Colombia, while Uruguay, Argentina and Chile show greater resilience in cigarette consumption, although on the negative side as well.
This grim picture concerning retail volume sales is defied and partly neutralized, at least until now, by the healthy profits and value growths reported by the main global players. This is due to their ability to push premiumization through innovation and is why we see product launches in Latin America concentrated in flavor capsule developments which have a much higher added value for companies. In virtually every market across the region this technology, which adds options to mix different flavors and intensities into the smoking experience, has been rolled out by global brands such as Luck Strike (Click&Roll or Indigo), or Marlboro (Double Fusion or Red Capsule).
Nevertheless, this strategy may soon dry out as the Latin American consumer´s purchasing power, as measured in USD of disposable income per capita, has decreased by 9% in the last three years, suffering strong impacts from a series of global and local macroeconomic problems. This is reducing the industry´s option to continue profit gain from premiumization in cigarettes, and will eventually force competition for value into low and medium price ranges, as consumers tend to trade down. Good examples of this are the recent launches of brands such as Rothmans by British American Tobacco in Argentina or Winston by Japan Tobacco in Brazil. As well, illegal cigarettes are starting to play an important role as access to cheap smuggle and counterfeit products allow the base of pyramid consumers to keep up the frequency of smoking, in spite of inflation or rising prices.
In fact, strongly rising prices well over the national inflation rates, are due to the huge increases in specific tax burdens for tobacco products in various countries such as Chile, Argentina, Peru, and Colombia. This constitutes another overarching regional development indirectly fueling illegal cigarettes. The remarkable specific tax increases seen in the last five years across Latin America generally mix two different objectives: those aimed at increasing state revenue, and those aimed at public health benefits. In both cases, the general public has a rather positive perception because it shows commitment to public health. Therefore specific tobacco tax increases are unique in the fact that while they hurt the wallet of the many consumers of cigarette products, they do not hurt the popularity of the implementing government.
Paradoxically, the resulting higher prices have benefitted illicit trade by increasing supply and demand of smuggled and counterfeit products which do not report tax benefits to governments. Euromonitor International research shows that total illicit sales of cigarettes in Latin America have jumped from 19% to 25% of total trade in the last five years, reaching over 57 billion sticks. In this period, large increases as a proportion of internal market volume have occurred in Ecuador, Chile, Peru, Argentina, and Brazil, which are well correlated with price hikes, strong tax increases and economic downturns. Alternatively, Mexico, Colombia and Bolivia have managed to keep more at bay the growth illegal trade. In the case of Bolivia it is mainly a conduit country for smuggling production from Paraguay into other countries, as has the lowest legal retail unit prices which helped protect its internal legal market. In the case of Mexico and Colombia, efforts from authorities and price stability have helped make illegal trade not gain a stronger foot.
Tax avoiding products coming from cross border contraband are the main source of illicit cigarettes in the region. These are sourced mostly from original quality legal production in their country of origin, but are smuggled without paying duties or taxes into a neighboring country. Paraguay appears to be a main source of contraband cigarettes through its triple frontier with Argentina and Brazil. Nevertheless, contraband brands from China, India and Panama are also present. Additionally, but in much less significant volumes, illegal products in the region originate from small scale production made directly for illegal trade with artisanal or falsified brands, as has started happening in Brazil.
There is a systemic relationship of illicit trade with other fundamental factors that shape Latin American cigarette markets, such as taxes and regulations, consumer driven trends such as healthier lifestyles, and consumers simply adjusting their spending priorities in difficult macroeconomic times. The most interesting case can be seen in Brazil, where illicit trade has become relevant in spite of efforts to combat it.
Competition in Brazil gets fiercer – and winners are unexpected
Today, Brazil represents more than 29% of Latin America’s retail volume of cigarettes sticks. However, in 2011, it represented almost 39%. The last two years have been particularly challenging for the country, with sales of legal cigarettes reducing significantly, while illicit products continued to emerge and consolidate.
While there is an irreversible trend of pursuing a healthier lifestyle – that for many consumers might translate into abandoning smoking, among other habits – the unfavorable economic situation was definitely the main driver for the reduction of retail volume demand. Sales of legal cigarettes volume in Brazil declined by more than 14% in 2016. This decline is particularly driven by consumers’ reduced available income and higher unemployment rates combined with increasing unit prices and taxation on cigarettes in Brazil.
Nevertheless, this decline does not mean that crisis forced Brazilians to smoke less because while sales of legal cigarettes decline, illicit products continued to grow. In 2016, illicit cigarettes registered 8% increase in volume terms, reaching 38 billion sticks. This growth is the highest in the last 14 years. These products tend to cost less than half of the price of a legal brand, so they appear as very attractive for consumers with limited budgets and not willing to reduce the purchasing frequency of these products. In Brazil, more than 41% of total cigarettes sales are from illicit brands, against a global average of 11%. Brazil is the second country with the highest percentage of illicit cigarettes globally and it ranks first in Latin America.
A large part of the illicit cigarettes comes from neighbor country Paraguay. The country has a large number of “tabacaleras”, which produce a great deal of the illicit cigarettes sold in Brazil. More than that, most recently, as the Brazilian government has been attempting to improve surveillance over the country’s frontiers, some local production spots have also been found. These products are not legally allowed by ANVISA, the National Agency for Sanitary Surveillance in the country. However, they are widely available in some regions of the country, especially those which border Paraguay or receive high volume of imports from China. The Federal Police monitors these issues.
These brands’ are spreading so fast that, if public and private initiatives do not slow them down, Brazil might soon have an illegal brand among the top brands in the country. When talking about the impact on legal brands, the “economy” price segment was the most affected, especially because they target lower income consumers, who are highly impacted by the economic situation. In 2011, these brands represented 60% of legal cigarettes sales. In 2016, however, their share dropped to 48%, losing space to illicit cheaper brands.
As a consequence, competition is increasingly fierce for cigarette manufacturers in Brazil who compete not only against other producers, but also with illegal companies and other categories of smoking products, such as electronic cigarettes, which are not legally allowed, but can still be found in many regions of the country. The cigarettes market is pretty consolidated between two major manufacturers: Souza Cruz who is part of the global group British American Tobacco and Philip Morris. The first, accounted for 71% of retail volume sales in 2016, followed by Philip Morris with 20%. Both companies suffered from the current economic scenario and its implications for cigarette sales. Most recently, Japan Tobacco International also entered the Brazilian market with Winston and Camel brands, and has been registering high growth rates over the last years. The current market is not very attractive for manufacturers to launch new products or innovate, so most launches are made around the expansion of existing product lines towards flavor or capsule editions.
The scenario for the upcoming years is not very optimistic. There is an irreversible trend of pursuing a healthier lifestyle and according to a survey conducted by Euromonitor International, 81% of Brazilians consider extremely important to quit smoking. In addition to this, the current economic crisis should play an important role in turning the situation worse. Even with an expected economic recovery, sales of legal cigarettes in Brazil are expected to register a negative 4% CAGR until 2021, while illicit ones are set to shrink by a 2% CAGR in the same period.