Country Risk Assessment
Methodologies: the Qualitative,
Structural Approach to Country Risk
–The Welfare and Social Dimension-

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The globalisation of the world’s trade, financial and technology markets and the emergence of new economies have created a new world environment, full of
opportunities, but fraught with uncertainty and spill-over risks.

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It’s the possibility that a foreign country’s:

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 borrower (financial investment);
Importer/producer (trade and sub-contracting)
Corporate partner (FDI)
May be UNABLE or UNWILLING to fullfill its contractual obligations toward a:
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Foreign lender;
Exporter;
Investor.

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Two possible way to include Risk in our investment decision (NPV):

Expected Value of Profit (EV)  probability of a negative event;

Adjust the Discount Rate  risk premium.
Which are the sources of risk?
How can we measure it?

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Natural Disasters;
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Tsunami;
Earthquake;
Socio-Political Risks:
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Social Risk;
•
Boycott;
•
Terrorism;

• Strikes;
• Religion and racial problems;
Government Policy Risk:
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Trade restrictions;
•
Legal enforcement;

•
Loan repudiation;
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Foreign exchange controls;
•
Expropriation.
Political Risk:
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War;
•
Nationalisation.

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Country-Specific Economic risk
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Macroeconomic Risks:
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Exchange rate;
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Hyperinflation;
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Terms of Trade;
•
Debt Service.
Microeconomic Risks:
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Market Failure;
•
Market Inefficiency.
Supranational Level  risk of contagion!

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The Quantitative Approach (Lecture VII):
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Ratio, indices and ratings;
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Reduces a complex situation into a number/letter;
Cross-country and cross-time comparison;
Shortcomings:
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Similar ratio and financial indicators BUT different socio-economic structure;
Quantitative data not available on time, incomplete, wrong or distorted;
Interpretation is difficult;
SOL: integrate with qualitative data to account for volatility and regional contagion.

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Qualitative Approach (SWOP):
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Assessment of the economic, financial and socio-political fundamentals that can affect the investment return prospects in a foreign country;
Describes/identifies the structure of a country’s development strategy/process by shedding light on:
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Strengths and opportunities;
Weaknesses and threats.

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A robust qualitative approach leads to comprehensive country risk report that includes the following six elements:
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Social and welfare dimension of the development strategy;
Macroeconomic fundamentals;
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External indebtedness evolution, structure and burden;
Domestic financial system situation;
Assessments of the governance and
transparency issues;
Evaluation of the political stability.

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Development:
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Definition;
Measurement;
Poverty:
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Definition;
Measurement;
Inequality:
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Definition;
Measurement;
✔ Impact on Country Risk Assessment

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Adam Smith (1774)  “Wealth of
Nations”;
Recent years  distinctive analytic and methodological identity:
NARROW  INCOME
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Def
BROADER  BASIC NEED

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“The capacity of a national economy, whose initial economic condition has been more or less static for a long time, to generate and sustain an annual increase in its gross national product (GNP) at rates of perhaps 5% to 7%”;
OR “ rates of growth of income per capita or per capita GDP”.
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ADVANTAGES: easily to measure and understand
DISADVANTAGES: experience 1950s 1960s:
“growth without human development”

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Three basic components:
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Ability to meet basic needs;
(food, shelter, health and protection)
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Self-esteem;
(self respect and cultural identity)

Human Freedom
(emancipation from material conditions, ignorance, misery)

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Increase the availability and distribution of basic goods;
Raise the living standards:
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 higher income; better jobs;
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 better education; cultural and humanistic values.
More economic and social choices.

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GDP = Gross Domestic Product;
 final output
GNP = Gross National Product;
 total income
GDP and GNP per capita;
Purchasing Power Parity (PPP):
DEF: This purchasing power rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods .
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Different purchasing power of US$1 in different countries; better than Exchange Rate (underestimate real value of income in LDC).

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Low-Income:
< 755 US$
Lower Middle Income:
[$756 - $2995]
Upper Middle Income
[$2996 - $755]
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High Income OECD and other Countries
> $ 9265
Developing
Countries

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A long and Healthy Life
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Life expectancy at birth (age);
Knowledge:
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Adult Literacy Rate (% aged 15 and above);
Gross enrollment ratio in education (%)
A decent Standard of Living:

GDP per capita (PPP US$)
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Composite Indicator  UNDP Human
Development Index:
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Low Human Development [0.00 – 0.49];
Medium [0.5 – 0.799];
High [0.8 – 1].

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Are there other useful development indicators?
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Urban population % (urbanisation)
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Percentage under 15 years old (age structure);
Gender structure;
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Gender-Related Development Index (GDI);
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Gender Empowerment Measure (GEM)
Number of computers per 1,000 inhabitants;
Health care.

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Economic Growth VS Development
Not only GDP growth but also:
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Self-sustaining development;
Enlarging people’s choice/rights;
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Democracy;
Robust and stable institutions;
Decent standard of living:
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Access to education;
Nutrition and health;
Political and cultural freedom.
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Basic components of country risk and close correlation between HDI and country risk (ex.
Sierra Leone) but not the reverse (ex. Cuba!)

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Poverty is a complex and multi-
dimensional concept:
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Material aspects;
Non material aspects;
Personal features (age, gender, race);
Location cannot be fully captured by the income level!

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Income Need Perspectives:
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Being below a defined poverty line;
Basic Need Perspective:
 no minimal acceptable fulfilment of human needs;
Capability Perspective
 physical; non-physical needs and functionings.

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1 st STEP: IDENTIFICATION
2 nd STEP: AGGREGATION i.e. how identify the poor people in society and once identified how summarise
(aggregate) the information on them into an useable and meaningful measure of poverty
(Amartya Sen)

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A) Objective indicators of poverty:
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Income or Expenditure?
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Unit of analysis: Household, Families or
Individuals?
Adjusting for differences in household size and composition: equivalence of scale

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Basic needs: adequate clothing, food and shelter, health and education;
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Measure: Human Poverty Index (HPI):
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Decent Standard of Living:
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% of pop not using an improved water source;
% of chinldren under weight for age;
Knowledge/Adult Illiteracy Rate:
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% of illiterate people aged > 15;
A long and healthy life:
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Prob at birth of not surviving to age 40 (60 in OECD countries); HDI  Achievements
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Weak relationship between objective indicator of poverty and HPI.

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1° step: choose and indicator of wellbeing;
2° step: define a threshold or poverty line;
3° step: population below the PL are poor.
Absolute
(Sen)
Poverty as an concept
Relative
(Atkinson)

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Growth reduces poverty;
BUT it depends on two factors:
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The type of growth;
The initial level of inequality
(share of population just below the poverty line
VS extreme poverty).

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Poverty may be a barrier to growth:

Vicious circle and poverty traps: high poverty leads to low growth and low growth leads to high poverty!
Which channels?
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Poverty deters investment and growth especially where the degree of financial development is limited;
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But also through a negative impact on education, health and innovation!


Bouchet, Clark and Groslambert (2003): “Country
Risk Assessment”, Wiley finance (Chapter 4).
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Human Development Report –UNDP web site-
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McCulloch, N.; Winters, A. and Cirera, X. (2002):
“Trade Liberaliation and Poverty: an Handbook”,
Chapter3 “Poverty and the poor”, eds. CEPR

Perry, G. et all (2006): ”Poverty Reduction and
Growth: Virtuous and Vicious Circles”, World Bank
Report