Lecture VI
Country Risk Assessment
Methodologies: the Qualitative,
Structural Approach to Country Risk
- The Macroeconomic Fundamentals -
The Qualitative Approach

A robust qualitative approach leads to
comprehensive country risk report that tackle
the following six elements:
 Social and welfare dimension of the
development strategy;
 Macroeconomic fundamentals;
 External indebtedness evolution, structure
and burden;
 Domestic financial system situation;
 Assessments of the governance and
transparency issues;
 Evaluation of the political stability.
Global GDP Contraction

Country-Specific Economic risk

Macroeconomic Risks:
•Inflation and Hyperinflation;
•Exchange rate;
•Terms of Trade;
•Debt Service.
GDP in value and in volume
The Inflation Rate


Inflation = increase in the general level of prices;
How to measure inflation?




Consumer Price Index;
Producer’s input and output prices Index;
GDP deflator.
Causes of Inflation:

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Demand Pull  the Economic Cycle!
Supply Shocks;



OPEC I (1970s)  oil prices from 3$ a barrel to
11.65$;
OPEC II (1980s)  over 36$ a barrel;
Nowdays.
The Inflation Rate (2)
The Inflation Rate (3)
The Cost of Inflation


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Real Interest Rate;
Inflation tax;
Menu costs;
Relative Price VS General Price Level  ↓
Economic Efficiency;
Volatitlity of Inflation:



Reduces investment;
Income Redistribution.
Nominal Illusion.
Deflation


DEF: Decrease in the general level
of prices  Japan since 1999
The Cost of Deflation:


Effect on Real Interest Rate, Savings
and Investment;
Effect on the real burden of debt.
Hyperinflation



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Inflation is running at more than 50% at
month;
CAUSE: large fiscal deficit that, without
tax or bond issues, led govs to finance
their activities through the inflation tax
and by printing money.
Unless the gov reforms its fiscal position
it has to print money and create inflation.
It has origin in fiscal policy (government’s
decision about spending and taxation)
and not monetary policy (gov’s decision
for investing and loaning money);
Hyperinflation (2)


WHERE: Latin America and Central East
Europe (1920s and 1914-1918);
Government issues to finance the debt:

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Hungary = 48%;
Poland = 62%;
Germany = 88%.
End of Hyperfinflation when:

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New currency issue;
Fiscal reform;
Return to fiscal surplus;
Establishment of an indipendent central bank
 ignore the demand of the fiscal authority!
The Qualitative Approach

Country-Specific Economic risk

Macroeconomic Risks:
•Inflation and Hyperinflation;
•Exchange rate;
•Terms of Trade;
•Debt Service.
Exchange Rate

Types of Exch rates:



Nominal Exchange rate
determinats:




Bilateral and effective Exch rate
Nominal VS real Exch rate.
CIP
UIP
Risk Adverse Investor
Currency Crisis and the Exchange
Rate System
Exchange Rate: different Types

BILATERAL: rate at which you can
swap the money of one country for
that of another:

Indirect Approach: how many yen
(amount foreign currency) to get 1$
(unit of local currency);
Example: yen*/dollar = 93.01 yen
 Devaluation if we need less yen to buy 1$
 the value of the ER decreases;
 Appreciation if we need more yen to buy
1$  the value of the ER increases;

Exchange Rate: different Types (2)

Direct Approach: how many dollar
(amount local currency) to get 1 yen
(unit of foreign currency)!
Example: dollar/yen*=0.0107 $;
 Devaluation if we need more dollar to buy
1yen  the value of the ER increase;
 Appreciation if we need less dollar to buy
1yen  the value of the ER decreases.


We would follow the INDIRECT
APPROACH!
Exchange Rate: different Types (3)

EFFECTIVE: measure the average
appreciation/depreciation of a
currency in comparison to different
countries!

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Trade weighted basis (see charts pag
498);
EX: Jap yen appreciate by 1% against
the $ and 1% againt the Thai Baht and
remain unchanged versus other
currency = increase in the yen EER;
Usually expressed using an index =
100.
Exchange Rate: different Types (4)
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NOMINAL ER: rate at which you
can swap two currencies (as
above);
REAL ER: how expensive
commodities are in different
countries and reflect the
competitiveness of a country’s
export.
Exchange Rate: different Types (5)

Example:
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Cup of coffee = 200 yen in JPN and 1$
in USA;
Nominal Exchange rate = 100 yen per
$ (Yen/$);
BUT real exchange rate = 0.5  you
can only buy half as much with your
money in Japan as you can in the US;
Yen-US dollar RER is low! Goods in the
US are cheaper than in Japan!
Exchange Rate: different Types (6)

RER is based on a basket of commodities and not just
1!!!
RER=NER * domestic price level
overseas price level;
Example:
- 1$ in US buy the same amount of goods as 3 pesos in
Argentina;
- NER: 3 pesos/$
 RER = 3 * 1US$/3pesos = 1
If price increases in Argentina (1$ in US buy the same
amount of goods as 5 pesos in Argentina):
 RER = 3 * 1US$/5pesos = 0.6
 i.e with 1$ in Argentina you can buy only the 60% of
goods that you could buy in US.
Nominal Exchange rates Determinants

Converted Interest Parity:

Value of foreign investment (yen) in local
currency (dollar) at the end of the period:
Yen(1+r*)(F(0)/S(0))


S(0) = spot exchange rate (current exchange
rate);
F(0) = forward exchange rate (exchange rate
in the future)  forward exchange rate is
prefectly forecast in the CIP;
Nominal Exchange rates Determinants
(2)

Equilibrium (i.e the investor is indifferent between
yen and dollar investment):
 Yen(1+r*)(F(0)/S(0)) = $(1+r)
 If we put F(0)/S(0) = 1+ fp
 Where fp is the forward premium (proportion
by which a country’s gorward exchange rate
exceeds its spot rate) we get:

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(1+iJPN)(1+fp) = (1 + iUSA)
= iJPN - iUSA = fp
OR iJPN +fp = iUS
i.e. as a result of arbritage, the return on the dollar
investment will equal the return on the yen
investment when evaluated using the forward
rate!
Nominal Exchange rates Determinants
(3)

Uncovered Interest Parity:

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The investor takes a risk because he doesn’t
cover his position by a forward transition F(0)
= Se(1);
Expected Appreciation of the dollar = interest
rate gap;
[Se(1) – S(0)]/S(0)=iJPN- iUS
What drives the Exhange rate?
 Change in the overseas interest rate;
 Change in the domestic interest rate;
 Change in expectation of the dollar.
Nominal Exchange rates Determinants
(4)

Risk Adverse investor:

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Premium at risk;
US return = iUS+expected dollar apprec
= ijpn+ risk premium
Change in the risk premium would
impact on the NER!
Reference
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Bouchet, Clark and Groslambert (2003): “Country
Risk Assessment”, Wiley finance (Chapter 4).
Colombo, E. and Lossani, M. (2009): “Economia
dei Mercati Emergenti”, Carocci Editore.
Miles, D. and Schott, A. (2005):
“Macroeconomics. Understanding the Wealth of
Nations”, eds. Wiley (Chapter 11,19, 20).
The Economist (2009): “Guide to Economic
Indicators. Making Sense of Economics”, eds. The
Economist.