INTERNATIONAL FINANCE
COUNTRY RISK
ANALYSIS
LECTURE 9
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ANALYSING COUNTRY RISK
Introduction:
* Identifying countries that offer the best prospects of sound
investments
* Need for MNCs to constantly assess the host country
business environment
* Assessing potential risks and rewards of making
investments and doing business in a foreign country
* Studying political factors behind economic policies
* Political economy, the key subject matter: the interaction
between, and interface of, politics and economics
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POLITICAL RISK CHECK LIST
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Expropriation (the most obvious and extreme form)
Currency controls
Capital controls
Barriers at the border
Barriers behind the border
Changes in tax / labour / investment laws
Regulatory restrictions
Statutory requirements
In short, MNCs watch out for government intervention into the
workings of the economy that would affect the value of the
firm positively or negatively
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POLITICAL STABILITY
Measures of Political Stability
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Frequency of changes of government
Number of armed insurrections
Level of violence in the country
Extent of conflicts with other states
Key Concerns
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How long the current regime will last
Whether regime change will be smooth
Ability of the civil service to stay neutral
Neutrality of the police force and the military
Enforcement of foreign investment guarantees
Continuity of key policies towards foreign trade and investment
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INSTITUTIONAL ASPECTS
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Rule of law
Independence of judiciary
Property rights
Freedom of press
Economic freedom
Respect for human rights
Governance
Transparency
Accountability
Integrity
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SUBJECTIVE FACTORS
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Quality of government bureaucracy
Attitude towards private enterprise
Friendly or hostile towards businesses
Issues relating to local vs foreign enterprises
Issues relating to public vs private enterprises
Treatment of migrant workers
Levelness of the playing field
Perception of corruption
Security (law & order) considerations
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ECONOMIC FACTORS
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Macroeconomic management
Policy consistency and predictability
GDP growth trends and sustainability
Price stability
Monetary prudence
Fiscal discipline
External balance
Exchange rate volatility
Central bank reserves
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BUSINESS RISK IN ADVANCED
COUNTRIES
Western Europe
Japan
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• Rigid and highly regulated
business system
• Too much power in the hands of
the state and lack of flexibility
• Huge public debt
• Inefficient banking system
• Selective state patronage
Economic stagnation
Overregulated economies
Inflexible labor markets
Expensive welfare states
Tax disincentives
United States
• Systemic litigation risks
• Arbitrary changes in
employment and environment
laws
• Living beyond means
• Huge household debt
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BUSINESS RISK IN DEVELOPING
COUNTRIES
• Fiscal Irresponsibility. Monetization of budget deficit (e.g.
Zimbabwe)
• Monetary Instability. Increased money supply (e.g. Vietnam)
• Controlled Exchange Rate System. Over-valued currencies
(e.g. Papua New Guinea)
• Wasteful Government Spending. Questionable spending on
show-case projects (e.g. Malaysia)
• Curse of Resources. Abundant resources a recipe for disaster
– Dutch Disease (e.g. Nigeria)
• Vulnerability to External Shocks. Smaller economies are
more vulnerable (e.g. Mauritius)
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BUSINESS RISK IN DEVELOPING
COUNTRIES (CONT’D)
• Statist Policies. Markets combined with heavy
government intervention: top-down approach (e.g.
China)
• Lack of Economic Freedom. Limited personal choice,
difficult voluntary exchange, obstacles to enter and
compete in markets (e.g. Myanmar)
• High Cost of Doing Business. Bureaucratic red tapes,
poor infrastructure, etc. raise transaction costs (e.g.
India)
• Crony Capitalism. Collusion between the govt. and
vested interests: picking winners (e.g. The Philippines)
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HIGH RISK FACTORS
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Large budget deficit relative to GDP
High rate of monetary expansion
Exchange controls
Govt. expenditures yielding low rates of return
Price controls
Interest rate ceilings
Trade restrictions
Rigid labour laws
Large BOP deficit relative to GDP
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HIGH-RISK FACTORS (CONT’D)
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Large external debt
Large debt-servicing ratio
Low central bank reserves
High tax rates (disincentive, tax evasion)
Inefficient state-owned enterprises
Pervasive corruption
Flawed legal system
Too much or too little regulation
Poor enforcement of regulations
Bloated civil service
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LOW-RISK FACTORS
• A structure of incentives that rewards risk taking
in productive ventures
• A legal structure that stimulates the
development of free markets
• Minimal regulations and economic distortions
• Clear incentives to save and invest
• An open economy
• Stable macroeconomic policies
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MEXICAN ECONOMY: THEN & NOW
Old Mexican Model
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Large budget deficit
Rapid money supply growth
Nationalizations
Restrictions on FDI
High tax rates
Import substitution
Controlled currency
Price and int. rate controls
Govt.-dominated economy
New Mexican Model
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Fiscal restraint
Monetary discipline
Privatizations
Liberalization of FDI rules
Tax reform
Trade liberalization
No currency controls
Mkt-driven prices/ int. rates
Slimmer govt.
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SOVEREIGN DEBT
• Sovereign debt burden measured as % of debt
relative to GDP: the smaller, the better
• High external debt/GDP ratio is a high-risk factor
• Large short-term debt is particularly dangerous
• Caveat: some countries can cope with debt
burden better than some others
• Adequacy of reserves relative to short-term
external debt
• Debt servicing ratio also matters: the lower, the
better
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COUNTRY RISK ANALYSIS
INTERNATIONAL
BANKING
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COUNTRY RISK FOR INT’L BANKING
Main Concerns
• Borrowers unwilling or unable to service or repay their
debts to foreign lenders: the accent is largely on the ability
rather than willingness.
• Access to regional/international lender of last resort
• Political and economic factors of interest to foreign banks
are very similar to those for the MNCs.
• Default cases point overwhelmingly to home-grown risk
rather than external risk.
• Lending to a private sector borrower exposes a bank to
commercial risks (similar to those in domestic lending), in
addition to country risk.
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COUNTRY RISK & TERMS OF TRADE
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Nation’s ability to generate USD and other hard currencies – based on terms of
trade
TOT = price of exports / price of imports
TOT is largely independent of NER (TOT can’t be artificially raised by revaluing the
currency)
Much depends on export commodity composition (LDCs’ primary products) and
import dependence (OECD nations’ dependence on oil imports)
TOT improvement suggests better credit risk
TOT deterioration suggests poorer credit risk
TOT fluctuations affect living standards (the wealth effect)
Efforts to avoid a drop in living standard when TOT declines lead to maintaining
the old and now-overvalued exchange rate (futile and disastrous)
• Loans made when TOT were strong are doubly at risk, if TOT weakens
and HC is overvalued (reduced FC inflows)
Key issue in assessing country risk: can the country cope with its new wealth position
caused by TOT decline?
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EXTERNAL DEBT: COST-BENEFIT
CALCULUS
• A nation’s foreign debt can be met by austerity measures
which includes sacrificing consumption.
• The cost of austerity depends primarily on the size of the
nation’s external debt relative to its GDP: the lower the
ratio, the smaller the amount of consumption to be
sacrificed.
• Bail-outs by IMF, BIS, the Fed or ECB, depending on the
nation’s geopolitical importance to the big economic
powers, so as to avoid unacceptable political turmoil
• Bail-outs prevent adjustments, rewards inefficiency, and
breeds moral hazard.
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INTERNATIONAL DEBT CRISIS
• August 1982: Mexico, Chile, Brazil and Argentina
• Early 1983: About 25 LDCs, accounting for 2/3 of loans to
LDCs, caved in
• Loan re-scheduling
• Defaulting on several hundred million dollars of debt
• Debt relief: reducing the principal or int. payments or both
• Debt forgiving: write-offs
• Consequently, foreign loans to LDCs dried up
• The decade-long Latin American debt crisis ended in July
1992
• Economic reforms led to revival of loans to LDCs in the 1990s
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ASIAN FINANCIAL CRISIS 1997-98
• Hardest hit: Korea, Thailand and Indonesia
• Massive capital outflow & currency meltdown
• Causes: Economies overheating: rising inflation, soaring
BOP deficit; financed by short-term capital; borrowing
short, lending long; overvalued home currencies; fragile
banking system
• From financial crisis to economic crisis to political crisis
• Private sector debt was the main culprit, but government
policies to be blamed: crony capitalism: unholy trinity
among the government, the private sector and the
banking industry – a lethal combination with disastrous
consequences
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GLOBAL FINANCIAL CRISIS 2008-09
• The US as the epicenter, beginning with subprime fiasco
• Total loss estimated at $1.7 – 3.6 trillion (IMF)
• Transmitted to the rest of the world through trade and
financial channels
• Writedowns by banks worldwide: $850-900 b
• Economic causes: overconsumption, low savings, huge BOP
and fiscal deficits, soaring sovereign debt (US foreign policy)
• Financial causes: excessive credit expansion; securitization of
debts; highly leveraged banking system; lack of oversight
• The US lost its AAA rating
• Severe social impact: 15% of US population (46m) below the
poverty line; >9% unemployment
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ONGOING EURO DEBT CRISIS
• Greece as the epicenter, the govt. regime to
blame for reckless spending: populist policies
• PIIGS also in hot soup, with mountains of
sovereign debt
• Fiscal indiscipline the root cause: 17 fiscal policies
with single monetary policy; EUR under pressure
• Rescue package: EUR 1.3 t by ECB and IMF;
private banks taking 50% haircut; bailouts don’t
mean injection of funds into the ailing economies
• Catch 22 situation: fiscal austerity necessary but
it cannot help economic recovery
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CAN ISLAMIC FINANCE HELP?
• The root cause of all these problems is DEBT
arising from excessive consumption financed by
credit
• Moderation in consumer behavior and good
governance as propagated by Islam can provide a
long-term solution
• Replacing interest-based debt system with risksharing IF modes
• Unanswered questions: disconnect bet theory
and practice? Is IF a silver bullet? Is risk sharing
always fair and just?
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ECONOMIC REFORM
Lessons from Mexico, Chile and Argentina point to the
importance of the following:
• Strong political will and enlightened leadership
• Home-grown reform package with proper
sequencing
• Well motivated and competent economic team
• Integrated program to sell the plan to all levels of
society
• Taking ownership of reform agenda
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SUMMARY & CONCLUSIONS
* Country risk analysis helps MNCs/ foreign banks in
ensuring healthy foreign investment
* Although the main concern centers on exchange risks
which may wipe out profits in HC terms, other factors
that impact on profits are just as important
* A stable political and economic system is of
paramount importance
* Risks associated with top-down approach, picking
winners frighten foreign investors
* Direct govt. involvement in business is inimical
* “The business of the government is to govern, not to
be in business”
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SUMMARY & CONCLUSIONS
(CONT’D)
* Desirable outcomes require institutions of a free
society, limited government, rule of law, independent
judiciary, protection of private property (including
intellectual property), free markets and free speech.
* Foreign banks providing external loans face country
risk in addition to commercial risk
* Credit risk is largely determined by the real cost of
repaying the loan: depends on the variability of the
nation’s TOT and the flexibility in living standards
* There is no substitute for prudent policies
* Excessive debt is the mother of all financial crises
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END OF LECTURE 9
BE CARING, KEEP SMILING!
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