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Country Risk Analysis
2
Certainty, risk and uncertain situations
Uncertain situations
Risk
Certain
Managers know all the events that could affect their decisions and they
can evaluate the impact on the results
Managers have no any information about
future events that can affect their
decisions and they can’t appreciate the impact on the results
3
Identified risks / Assumed risks
Identified risks
Not identified
risks
Risks involuntary
not assumed
Risks voluntary
not assumed
Risks voluntary assumed
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Risks in international businessEnvironment risks
(macro - risks)
RM
Project risks (micro-risks)
Company risks (micro-risks)
RF
RP
No control on further events
Imperfect information
Limited time for decisions
Sources of risks in international
business
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I. Country risk• it is a new concept introduced by Milton Friedman in 1975 when
Citibank grant a credit to a foreign government;• it was initially connected with the capacity of a government to repay a
loan• today we use this concept in different decisions related to international
business:• international finance (private and public debt)• FDI’s• portfolio investments (bond valuation, stock valuation)• cash flows projections – discounted rate
• we make now a distinction between country risk assessment in case of international financing and international investment
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Country risk – credit or investment risk ?
International Credit International Investment
Indicators Different Different
Methodology Similar Similar
Time horizon 1 - 3 years 1-5 years
Utility Cost of debt Expected return
Risk management Before Before / After
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Role of country risk assessment
- To locate the credit / business (risk map); - To take the decision to be involved on international markets (“go / no go decision”); - To establish the level of your involvement; - To develop strategies for your company (ex. strategies to fight against your competitors); - To adapt your further decision related to an international credit or investment in accordance with the latest evolutions on a foreign market.
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Country risk determinants
Country risk – international credit
Current account balance, external debt, BP deficit, economic structure, economic development, the level of export concentration, the import dependency, the convertibility of national currency, GDP, international reserves, inflation, internal capital accumulation, political stability, corruption, credibility and independence of Central Bank, government orientation etc.Educational level of labor force, wages, internal market dimension, internal competition, infrastructure, country accessibility, market accessibility, interest rate, investment facilities, property and transfer regulations, taxation.
Country risk – international investment
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Different types of country risk
International credits International business
Late paymentsDebt service default; External debt repudiationRenegotiation of external debtRescheduling external debt serviceExternal debt moratorium;Temporary default caused by chronic deficit in BP, budgetary deficit, shortfall in exportation incomes, major disturbances on foreign exchange markets, social and internal/external political disturbances ;
ConfiscationNationalization;Expropriation ;Indigenization;Limitations/restrictions on capital repatriationTotal/partial destruction of foreign investment caused by political and social events (strikes, social riots, military conflicts, elections)Profit losses caused by economic crises, shortfall of internal market, legislative instability, corruption etc.
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Country risk management - investmentsBBefore:· - gathering more host country specific information · - avoidance of higher country risk locations· - insurance policies (provided by insurance companies)·- negotiating the environment· - adapting the investment project· - geographical or sectorial diversification of investment portfolioAAfter:· - permanent supervision of country risk level;· - adaptation of investments in order to reduce the exposure to risk;· - promoting good relations with local operators and institutions;· - disinvestments; profit maximization; sectorial diversification.
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Country risk management – creditsBefore:• floating interest rate instead fixed rate;• interest rate adjusted to country risk by using a risk
premium in accordance with risk profile of the debtor;• imposing a restrictive use of lend funds;• financial consultancy for debtors;• loan maturity adjusted to risk;• credit condition;• credit insurance (ex: export credit insurance);• direct participation to the project financed (ex: E.B.R.D. or
I.M.F. credits);• require a set of measures that must be applied by the
debtor as a condition to obtain the credit (ex: structural credits
• additional collaterals or guaranties. After:• debt - by - debt swap;• debt - by - equity swap;• rescheduling debt or interest payments in the case of
default;• renegotiations of debt or interest.
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Country risk profiles - EEC
Country Rating (S&P)
Rating (Moody) Spread Cost of
DebtBulgaria BB B1 4.50% 9.50%Croatia BBB- Baa3 1.40% 6.40%Czech Republic A- A1 0.80% 5.80%Hungary A- A1 0.80% 5.80%Poland BBB+ A2 0.90% 5.90%Romania B+ B1 4.50% 9.50%Russia BB- Ba3 4.00% 9.00%Slovak Republic BBB- A3 0.95% 5.95%Slovenia A Aa3 0.60% 5.60%Ukraine B B2 5.50% 10.50%
Source: S&P, Moody's
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Country risk assessment1. Selecting group of countries;
2. Selecting the set of indicators (qualitative and quantitative)
3. Grouping indicators;
4. Weighting indicators
5. Selecting the source of information
6. Collecting data
7. Establishing the checking lists
8. According marks and points
9. Calculate the country risk indicator
10. Country risk maps
11. Using country risk in your decisions
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Different risk models
Micro - models
Macro - models
Large number of countries
Small number of countries
Delphi models (BERI; PRS)
Econometric models
Financial models (Euromoney)
Banking models
In House Models(DOW CHEMICAL)
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“Institutional Investor” Country Risk Model
Products: ratings for credit risk;
Information: qualitative indicators;
Source of information: information provided by international banks;
Indicators: economic environment (10p), external debt service (10p), international reserves / current account balance (10p), fiscal policy (10p), political environment, capital market accessibility (10p), commercial balance (10p), international portfolio investment (10p), FDI’s (10p);
Significance: credit risk measured on a scale between 0 and 90.
Methodology: scalar indicator calculated as total amount of points mentioned above for each country
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“Standard & Poor’s” Country Risk ModelProducts: sovereign risk, international bond rating (public or privateInformation: qualitative and quantitative information;Source of information: published source, internal source;Indicators (sovereign risk):
- political environment (stability, government changing, political system flexibility, political support, political parties orientation) - social environment (life standard, income distribution, labor conditions, relations with neighbor countries, social conflicts) - economic environment (international investment position, GDP, exports, economic structure, natural resources, currency regimes, taxation level;
Significance: ordinal indicator by risk classes (using letters such as BB-)Methodology: weighted indicator.
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“Political Risk Services - PRS” Country Risk Model Products: country risk Information: qualitative and quantitative information;Information: qualitative and quantitative information;Indicators: economic evolution (6%), political parties (5%),
external conflicts (5%), corruption (3%), invimplicarea of the religion in politic (3%), involvement of the army in politic (3%), racial or nationalist tensions (3%), terrorism (3%), civil wars (3%), historical evolution of the external debt (5%), transfer control (5%), expropriations (5%), inflation (5%), country’s financial leverage (5%), international liquidity (5%), current account (8%), FX market (5%).
Significance: scale indicator expressed by a numberMethodology: weighted average indicator using different weights for
indicators groups: political (50%), financial (25%) and economical indicators (25%).
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“The Economist” Country Risk Model
Products: country risk
Information: qualitative and qualitative indicators;
Source of information: experts (political indicators), internal sources published sources (economic indicators);
Indicators: GDP growth, inflation, external debt, exports, neighbor countries, government, army’s involvement in politics, corruption, ethnical conflicts, internal conflicts.
Significance: scale indicator
Methodology: weighted indicator using different points: economic (33 p), social (17 p) and politic (50 p).
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II. Currency risk in international finance
Currency risk = possible losses caused by un unfavourable evolution
of exchange rate in case of an international financing denominated in
other currency
Currency risk:
A. Transaction exposure: possible losses in case of a specific
transaction (such as export, import or credit);
B. Translation exposure: possible losses in case of translation for a
subsidiary’s balance sheet in mother company one;
C. Economic exposure: possible losses of cash flow in case of a
company involved on international business
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Transaction exposure
• Very easy to asses this type of particular risk;• The exposure degree can be measured by the
variation of current yield in case of a credit using different estimation for FX rate:
1
0
s
sTR
CY
CYE credit
Example: Credit for 100.000 USD, interest rate of 10% p.y., paid at the end of the year, maturity 4 year, reimbursement yearly in equal payments.
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Translation exposure
• More difficult to asses (than transaction exposure);• Specific for MNC’s with many subsidiaries that requires
periodically a consolidation for the balance sheets of this subsidiaries into mother company one;
• The translation could be made using:• Current rate method;• Current / non - current method;• Monetary method;• Temporal method (for inventories we use a current
exchange rate for translation).
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Translation exposure
Example:Balance US GER (Euro) UK Jap
Assets 500 700 1000 1500 Fixed Assets 200 300 450 700 Current Assets 300 400 550 800 Liabilities 500 700 1000 1500 Stocks 150 200 350 800 Short Term debt 250 275 300 300 Long Term Debt 100 225 350 400
Historical rate: 1 USD= 2 Euro= 3 Pounds= 4 YenCurrent rate: 1 USD= 3 Euro= 6 Pounds= 8 Yen
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Economic exposure
• It is the most complex form of the currency risk;
• The assessment is based on the profit & loss account of a
company involved on international business;
• The exposure degree is measured by the variance of the cash
flow in case of the exchange rate variance;
• To asses this type of risk you should estimate cash flow using
exchange rate in order to transform the inflows and outflows
denominated in other currencies
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Economic exposure – example
Cash flow calculation An I An II An IIIInflows
Sales from exports 1540000 1670000 1890000Investments 100000
Credits 200000Outflows
Current Expenditures 300000 350000 310000Wages 110000 120000 100000
Comercial Expenditures 340000 320000 310000Administrative expenditures 50000 50000 50000
Financial Expenditures 45000 45000 45000Amortization 40000 60000 80000
Cash Flow 955000 725000 995000Taxes 238750 181250 248750
Net Cash Flow 756250 603750 826250
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Exchange risk managementA. Contractual measures:
• simple currency clause;• simple currencies basket clause;• weighted currencies basket clause;• netting
B. Non – contractual measures:• Parallel loans;• “Back to back” loans;• Swaps;• Forward;• Futures;• Options;• Insurance Contracts.
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II. Interest rate risk
Interest rate risk = possible loss caused by an unfavorable evolution of the interest rate in case of a international credit.• This risk affects the debtor and the creditor too;• Interest risk can affect a credit in which is used a
fixed interest rate or a variable one too;• The assessment is based on specific indicators:
• Loan maturity;• Loan sensitivity;• Loan duration.
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Interest rate risk - example
Indicator Credit Euro - bonds
Maturity 3,7 years 3,66 years
Sensitivity 1,09 1,14
Duration - -
- Duration 2,85 years 3 years
- Discounted duration 2,66 years 2,81 years
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Interest rate risk managementA. Contractual measures:
• Non - financial clauses• “Parri pass” clause (equal treatment for creditors);• “Cross default” clause;• “Material adverse change” clause
• Financial clauses• Conditions on different indicators (net working capital,
global financial leverage, long term financial leverage, liquidity, solvability);
B. Non - contractual measures:• Debt renegotiation;• Floating rate notes;• Swap, forward, futures, options;• Collar, cap, floor (synthetic instruments).
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III. Default riskDefault risk = possible loss caused by the payment incapacity of a debtor;• It is a risk exclusive for creditors• The assessment is based on a lot of indicators:
• Liquidity ratios • Profitability ratios and activity ratios • Financial leverage ratios • Return ratios and the Du Pont system• Shareholders ratios