26 Country Risk Analysis

Vishal Kumar

 

1.  Learning Outcome

 

After completing this module, you will be able to:

 

i.  Understand the meaning of Country Risk Analysis

ii. Understand the types of country risk

iii. Know about how to manage country risk

iv. Understand the Country Risk Strategies

 

 

2.  Introduction

 

All business transactions involve some degree of risk. When business transactions occur across international borders, they carry additional risks which is not present in domestic transactions. These additional risks, called country risks, typically include risks arising from a variety of national differences in economic structures, policies, socio-political institutions, geography, and currencies. Country risk refers to the risk of investing in a country, dependent on changes in the business environment that may adversely affect operating profits or the value of assets in a specific country.

 

Country risk analysis (CRA) attempts to identify the potential for these risks to decrease the expected return of a cross-border investment. Country risk can be defined and measured in many different ways. In general, it refers to the risk associated with those factors which determine or affect the ability and willingness of a sovereign state or a borrower from a particular country ‘to fulfill their obligations towards one or more foreign lenders and/or investors’.

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Shapiro (1999) defines country risk as the general level of political and economic uncertainty in a country affecting the value of loans or investments in that country. Thus country risk analysis consists of the assessment of political, economic, and financial factors of a ‘borrowing country’ or an FDI host country which may interrupt timely repayment of principal and interest or may adversely affect returns on foreign investment. To the extent that the borrowers have little control over these factors, country risk may represent a ‘non diversifiable systematic risk’. This would particularly be the case when the borrowers are mostly private parties.

 

3. Types of Country Risk

 

Analysts have tended to separate country risk into the six main categories of risk shown below. Many of these categories overlap each other, given the interrelationship of the domestic economy with the political system and with the international community. Even though many risk analysts may not agree completely with this list, these six concepts tend to show up in risk ratings from most services.

I.   Economic Risk

II.  Transfer Risk

III. Exchange Rate Risk

IV. Location or Neighbourhood Risk

V.  Sovereign Risk

VI. Political Risk

 

I. Economic Risk is the significant change in the economic structure or growth rate that produces a major change in the expected return of an investment. Risk arises from the potential for detrimental changes in fundamental economic policy goals (fiscal, monetary, international, or wealth distribution or creation) or a significant change in a country’s comparative advantage (e.g., resource depletion, industry decline, demographic shift, etc.). Economic risk often overlaps with political risk in some measurement systems since both deals with policy.

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Economic risk measures include traditional measures of fiscal and monetary policy, such as the size and composition of government expenditures, tax policy, the government’s debt situation, and monetary policy and financial maturity. For longer-term investments, measures focus on long-run growth factors, the degree of openness of the economy, and institutional factors that might affect wealth creation.

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II. Transfer Risk is the risk arising from a decision by a foreign government to restrict capital movements. It is the core risk under country risk, arises on account of the possibility of losses due to restrictions on external remittances. Consequently, an obligor may be able to pay in local currency, but may not be able to pay in foreign currency. This type of risk may occur when foreign exchange shortages either close or restrict a country’s cross border foreign exchange market. Restrictions could make it difficult to repatriate profits, dividends, or capital. Because a government can change capital-movement rules at any time, transfer risk applies to all types of investments.

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Transfer risk measures typically include the ratio of debt service payments to exports or to exports plus net foreign direct investment, the amount and structure of foreign debt relative to income, foreign currency reserves divided by various import categories, and measures related to the current account status. Trends in these quantitative measures reveal potential imbalances that could lead a country to restrict certain types of capital flows. For example, a growing current account deficit as a percent of GDP implies an ever-greater need for foreign exchange to cover that deficit. The risk of a transfer problem increases if no offsetting changes develop in the capital account.

 

III. Exchange Risk is an unexpected adverse movement in the exchange rate. Exchange risk includes an unexpected change in currency regime such as a change from a fixed to a floating exchange rate. Economic theory guides exchange rate risk analysis over longer periods of time. Short-term pressures, while influenced by economic fundamentals, tend to be driven by currency trading momentum best assessed by currency traders. In the short run, risk for many currencies can be eliminated at an acceptable cost through various hedging mechanisms and futures arrangements. Currency hedging becomes impractical over the life of the plant or similar direct investment, so exchange risk rises unless natural hedges can be developed.

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Many of the quantitative measures used to identify transfer risk also identify exchange rate risk since a sharp depreciation of the currency can reduce some of the imbalances that lead to increased transfer risk. A country’s exchange rate policy may help isolate exchange risk. Managed floats, where the government attempts to control the currency in a narrow trading range, tend to possess higher risk than fixed or currency board systems. Floating exchange rate systems generally sustain the lowest risk of producing an unexpected adverse exchange movement. The degree of over- or under-valuation of a currency also can help isolate exchange rate risk.

 

IV.  Location or Neighborhood Risk includes spillover effects caused by problems in a region, in a country’s trading partner, or in countries with similar perceived characteristics. While similar country characteristics may suggest susceptibility to contagion (Latin countries in the 1980s, the Asian contagion in 1997-1998), this category provides analysts with one of the more difficult risk assessment problems.

 

Geographic position provides the simplest measure of location risk. Trading partners, international trading alliances (such as Mercosur, NAFTA, and EU), size, borders, and distance from economically or politically important countries or regions can also help define location risk.

 

V.  Sovereign Risk concerns whether a government will be unwilling or unable to meet its loan obligations, or is likely to renege on loans it guarantees. Sovereign risk can relate to transfer risk in a way if a government may run out of foreign exchange due to unfavorable developments in its balance of payments. It also relates to political risk, if a government may decide not to honor its commitments for political reasons. The CRA literature designates sovereign risk as a separate category because a private lender faces a unique risk in dealing with a sovereign government. Should the government decide not to meet its obligations, the private lender realistically cannot sue the foreign government without its permission. Sovereign-risk measures of a government’s ability to pay are similar to transfer-risk measures.

 

VI.  Political Risk concerns risk of a change in political institutions stemming from a change in government control, social fabric, or other no economic factor. This category covers the potential for internal and external conflicts, expropriation risk and traditional political analysis. Risk assessment requires analysis of many factors, including the relationships of various groups in a country, the decision-making process in the government, and the history of the country. Insurance exists for some political risks, obtainable from a number of government agencies and international organizations.

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Few quantitative measures exist to help in assessing political risk. Measurement approaches range from various classification methods (such as type of political structure, range and diversity of ethnic structure, civil or external strife incidents), to surveys or analyses by political experts. Most services tend to use country experts who grade or rank multiple socio-political factors and produce a written analysis to accompany their grades or scales. Company analysts may also develop political risk estimates for their business through discussions with local country agents or visits to other companies operating similar businesses in the country. In many risk systems, analysts reduce political risk to some type of index or relative measure.

 

A multinational enterprise (MNE) that builds a plant in a foreign country faces different risks than a bank lending to a foreign government. The MNE must consider a longer time horizon and risks from a much broader spectrum of country characteristics. Some categories pertinent to a plant investment contain a much higher degree of risk simply because the MNE remains exposed to risk for a much longer period of time.

 

4. Managing Country Risk

 

Evaluating country risks is a crucial exercise when choosing sites for international business, particularly if investment is to be undertaken. Certain risks can be managed through insurance, hedging and other types of financial planning, but other risks cannot be controlled through such financial mechanisms. Some of these latter risks may be measured in a risk return analysis, with some countries’ risks requiring higher returns to justify the higher risks. The study of country risks is also necessary in order to develop alternative scenarios: Uncertainty may remain, but it can be transformed into planned uncertainty, with no surprises and with contingency plans in place.

 

Each corporation confronts a unique set of country risks. As a result, we can say that there are many issues and analytical frameworks a business should examine as it develops its own evaluation of country risks and creates its own strategy to manage the uncertainties those risks entail.

 

POLITICAL RISKS

 

Prior to the 1990s, the political risks associated with interventionist governments were considerable. They included government regulations that imposed inefficiencies, and foreign-investment restrictions. Many countries pursued the goal of economic self-sufficiency through extensive tariff and non-tariff barriers to both trade and investment. In many countries today, such political risk has been reduced and replaced by a new acceptance of free markets and a belief that international trade and investment are the bases for economic growth. Nevertheless, political risks still remain.

 

For natural resource sectors, in particular, political risk may still be a showstopper, since the risk of nationalization, special taxes or new regulations is particularly severe. Managers in these sectors must consider whether the risks may be too high to justify investment. It remains helpful to seek the views of local political experts. One technique involves circulating a questionnaire to these experts, compiling the results, and returning them to the respondents for further commentary. This “Delphi” technique facilitates the development of a consensus view on the political risks that a potential investor faces.

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Managing Political Risk

 

Analyzing and managing political risks has become important even when doing business in one’s home country. International investment agreements attempt to limit political risks. Here we can take the example of Canada and the United States. Both the countries have signed investment agreements with many other countries that promise financial compensation for corporations based in Canada or the U.S. if their assets are expropriated. These agreements promise that the amount of compensation will be determined in a fair and just manner. Under NAFTA’s Chapter 11, corporations can sue a NAFTA government on the grounds that they have been denied “fair and equitable treatment” in a way that is tantamount to expropriation. However, it is not clear how far Chapter 11 or other investment agreements go in protecting corporations from new government regulations that increase costs or restrict prices. The Enron dilemma in India illustrates the potential seriousness of political risks. Political risk insurance may be purchased as additional protection against specific outcomes such as capital repatriation difficulties, expropriation, or war and insurrection. Canada’s Export Development Corporation offers credit insurance for many such risks.

 

ECONOMIC RISKS

 

Economic risks may be particularly important in regard to exchange rates, economic volatility, industry structure and international competitiveness.

 

Managing Exchange Rate Risks

 

In recent years, the risk of foreign exchange rate movements has become a paramount consideration, as has the risk that a government may simply lack the economic capacity to repay its loans. Many countries have been experiencing ongoing fiscal deficits and rapid money-supply growth. Consequently, inflation rates remain high in these countries, and devaluation crises appear from time to time. A devaluation of one country’s exchange rate automatically creates pressure for devaluation in other countries’ exchange rates.

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Today exchange rates may be maintained at unrealistically high levels as a result of considerable inflows of foreign capital. Yet, these capital inflows may slow or even reverse abruptly. Foreign investors now recognize these risks of foreign exchange volatility. In the future, capital flows will be more sensitive to changes in each country’s financial system and general economic conditions than they have been in the past. Future surges in capital flows may translate into increased volatility of foreign exchange rates for some countries. But how can foreign investors protect themselves from these exchange rate risks? Hedging mechanisms offer some hope for reducing foreign exchange risks, though generally not without some cost. Here are some other ways managers can cope with these country risks:

 

1) Consider the timing of investments: Investors should restrict capital transfers to a country to those times when the foreign exchange rate is in equilibrium. The theory of “Purchasing Power Parity” provides a guide to likely exchange rate changes. Compare a country’s cumulative inflation over a number of years with the cumulative inflation rate of its major trade partners. If the difference in cumulative inflation rates exceeds the percentage change in the foreign exchange rate, then devaluation is a real possibility.

 

2) Borrow domestically to do business in the domestic country and avoid foreign exchange rate exposure: Keep in mind that this approach does expose the business to the possibility of interest rate increases as a result of a central bank’s response to foreign exchange rate devaluation. For a foreign-owned financial institution, this approach also involves the possibility of a “run” on deposits, as the depositors seek to withdraw funds in order to transfer them abroad.

 

3) Focus on the devaluation risk when choosing among countries as investment sites: From this perspective, Chile is currently a less risky region for investment than Argentina or Mexico.

 

4) Consider the amount of capital required by those activities that are being developed in a country subject to devaluation risk: The significance of a foreign exchange risk may be relatively low for a business that requires little capital investment, like one in the service sector or fast-food industry; it may be high for a firm in the manufacturing and natural resource sectors, where considerable capital is required.

 

5) Spread the purchase price over as long a time period as possible: This allows domestic currency to be purchased at a lower cost if devaluation occurs. Alternatively, gear the purchase price to a weighted average of the exchange rate over future years, with projected future payments adjusted in accordance with the exchange rate.

 

RISK OF ECONOMIC VOLATILITY

 

Economic stability depends upon a strong banking sector; without it, a foreign exchange crisis may have a particularly severe impact. An ongoing challenge for financial institutions everywhere is that the time profile for liabilities is not the same as the one for assets. Banks borrow short term from depositors and lend long-term. This exposes the banks to the risks that fixed assets may fall quickly in price and that depositors may make sudden withdrawals. With dramatic reductions in land and stock prices, bank loans made on the security of real estate and stocks suddenly may be at a major risk of default, further exacerbating the effects of a foreign exchange crisis, and transforming it into a general crisis in the economy.

 

Managing Industry Risks

 

Managers must analyze the domestic situation for industry risks such as the strength of competitors, the potential for substitutes, the capabilities of suppliers and customers, and the risk of new entrants. It may be helpful to determine the risk level by developing a matrix in which each industry risk is evaluated as minor, serious or “show-stopping,” and in which the various ways of mitigating each risk are analyzed.

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For many foreign corporations, one example of industry risk may be the difficulty in finding suppliers who can offer the required level of quality and service. Public utility disruptions may also be risky, especially for firms dealing in perishable commodities. (In some countries, for example, electricity outages are common.) For some Canadian corporations, one solution has been to encourage other Canadian or U.S. suppliers to open a business in the same locality. For others, the construction of one’s own utilities, such as power supply, is a solution to the risk of electricity outages. Such actions may serve to strengthen a corporation’s domestic competitive advantage. Further, the process of developing a matrix of industry risks leads to strategies and solutions unique to each country and, indeed, to regions within countries as well.

 

5.  COUNTRY RISK STRATEGIES

 

For corporations that are searching for foreign suppliers and customers, as well as those that are evaluating investment opportunities, the analysis of country risks has attained a new importance and a new complexity. More careful differentiation among countries and business sectors is now required. For example, instead of viewing Southeast Asia as a group of tigers that have been involved in an economic miracle and subsequent downfall, it is now necessary to carefully analyze the situation that each individual country faces.

 

Managers should prepare themselves accordingly, with an analysis of interest rates and stock prices, the country’s balance of payments, projections of probable macroeconomic policies, and fiscal and current-account deficits. It is important to examine alternative potential scenarios and projections, and assign probabilities to each scenario in order to determine the risks and rewards connected with particular business opportunities. Price water house Coopers has developed an index that indicates how one may quantify the impact of country risks in terms of equivalent tax rates and rates of return.

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The relative significance of various country risks differs from one corporation to another, depending on features such as the type of business activity, experience in managing a certain risk, and financial strength. Hence, each corporation has to develop its unique country risk strategies. In the context of globalization, the New Economy and the changing role of governments, the analysis and management of country risks is now of paramount importance.

 

6.  Summary:

 

There is an old expression, which says “no one is an island”. This means that none of us can live or lives without being effected by or affecting other people. So it is with business also. No company can operate business by completely ignoring the rest of the community. International business is a transaction between different countries. It acquires a large portion of the continuously growing business of the world. The rapid increase in economy is one of the reasons for the vast growth of international business. Businesses expand internationally to increase their market and profits. When a business is flourishing well, the domestic market seems too small. Companies start international business to expand their sale, make foreign contact and reduce the local competitive risk. When companies are operating abroad, they must adapt a more professional way of handling business. They should be aware that international business is far different from the domestic business. When entering the international business community, these risks become greater and the person required to deal with them should be fully equipped with knowledge of business administration. If we look at the financial risks of any international business, we should keep in mind when a company accepts a foreign customer, not only is he assuming the foreign companies risk, but also the risk of the country. A company can mitigate country risk by having a full research on the company he would be working internationally in the future. This is done by country risk assessment.

 

Suggested Reading

  1. Sundharam K.P.M. and Datt Ruddar (2010). Indian Economy, S. Chand & Sons, New Delhi.
  2. Sharan Vyptakesh (2003). International Business: Concept, Environment and Strategy. Pearson Education, New Delhi
  3. Cullen. (2010). International Business. Routledge.
  4. Bennett Roger (2011). International Business. Pearson Education, New Delhi
  5. Paul Justin (2010). Business Environment-Text and Cases. Tata McGraw Hill, New Delhi.
  6. Cherunilam Francis (2010). International Business. Prentice Hall of India Private Limited. New Delhi.
  7. Cherunilam Francis (2013). Global Economy and Business Environment. Himalaya Publishing House, New Delhi.
  8. Levi MauriceD. (2009). International Finance. Routledge.
  9. Conklin David w. (2011). The Global Environment of Business. Sage Publications.
  10. Mithani D M. (2009). Economics of Global Trade and Finance. Himalaya Publishing House New Delhi.
  11. Cherunilam Francis (2011). International Business Environment. Himalaya Publishing House, New Delhi.
  12. Saleem Shaikh (2010). Business Environment. Pearson Education, New Delhi.