Country Risk Analysis Cra Write Up r n Zhasa

8/12/2019 Country Risk Analysis Cra Write Up r n Zhasa

1/12

School of Management Studies, Nagaland University

MFM 301 International Financial Management

1

Country r isk is expos ure to a loss in a cross-border lend ing, caused by

events in a part icular coun try. These events mus t be, at least to som e

extent, un der the contro l of the gov ernmen t of that country ; they are

def in i te ly not un der the contro l of a private enterprise or indiv id ual.

COUNTRY RISK ANALYSIS

By

Rokov N. ZhasaNU/MN-22/11NU Reg. No. 111291 of 2011-2012

Keywords:Country Risk Analysis

Content

1.0 Introduction

1.2 What is at Risk?

1.3 Country Risk and Political, Social and Economic Risks

1.4 Time horizon

1.5 Need for Risk Evaluation

1.6 Geographical location of risks

1.7 Classification of Country Risk

1.8 Qualifications needed for proper assessment of country risk

1.9 Quantifying Country Risk

1.10 Use of Country Risk Assessment

1.11 Incorporating Country Risk in Capital Budgeting

1.12 Conclusion

Reference

1.0 INTRODUCTION

The Oxford English Dictionary defines risk as exposure to a perils. From an

investors point of view, risk is exposure to a loss.

Country risk applies to assets and not to liabilities, although there may exist

a cross country liability risk of branch banking abroad. Among foreign assets, the

definition of country risk includes only foreign loans.


2/12



2

1.2 WHAT IS AT RISK?

All cross-border lending in a country-whether to the government, a bank, a private

enterprise or an individual-is exposed to a country risk. Country risk is thus a

broader concept than sovereign risk, which is the risk of lending to thegovernment of a sovereign nation. Further, only events that are, at least to some

extent, under the control of the government, can lead to the materialization of

country risk. A default caused by bankruptcy is country risk if the bankruptcy is the

result of mismanagement of the economy by the government; it is commercial risk

if it is the result of the mismanagement of the firm.

An interesting case is that of natural calamities. If they are unforeseeable,

they cannot be considered as country risks. But if the past experience shows that

they have a tendency to recur periodically-such as typhoons in Southeast Asia-

then the government can minimize their effects. Prudent analysts also make

allowance for them in their assessment of country risk.

Control by the government is understand in the broad sense. If the

government can to some extent control at least the impact of an adverse

development, even though it cannot control the event itself, the possibility of that

event is country risk.

1.3 COUNTRY RISK AND POLITICAL, SOCIAL AND ECONOMIC RISKS

The most frequent events that can lead to the materialization of country risk can

be classified as:

1.3.1 Political Components

War, occupation by foreign power, riots, disorders caused by territorial claims,

ideological differences, conflict of economic interests, regionalism, political

polarization, etc. are the many of the critical factors of country risk analysis of

political nature. Some of the Political factors are listed in Table-1. Depending on

the particular type of project for which the country risk analysis is being performed,

the analyst should consider more specific subcategories in some of these areas

and some other important categories.

1.3.2 Socio-Cultural Components

When a company operates in a foreign country, it must consider the possible

effects of many socio-cultural variables such as civil war, riots, disorders caused


3/12


4/12



4

A. L ikel ihood of s ystem disrupt ing con f l ic t ar is ing f rom o uts ide the count ry

1. Due to countrys own problems

2. Due to treaty or other obligations

B. Relat ions w ith major trading p artners

C. Relations of the companys home country with other countries

Table-2 Socio-Cultural Factors Affecting County RiskI. DOMESTIC

A. Socia l Group s

1. Homogeneity of population

a. Ethnic

b. Religious

c. Linguistic

d. Class.

2. Extent of cohesiveness or divisiveness

B. General psycho logy of popu la tion w ork eth ic

C. Unemployment

D. Pol i t ica l act iv ism of po pulat ion

E. Extent of Soc ia l unrest

1. Strikes

2. Riots

3. Insurgency

II. INTERNATIONAL

A. Cross-border t ies

a. Ethnic

b. Religious

c. Linguistic

d. Historical

B. Cross-border antagon ism

a. Ethnic

b. Religious

c. Linguistic

d. Historical


5/12



5

Table-3 Economic Factors Affecting Country Risk

I. DOMESTICA. Economic grow th, investment t rends

B. Cycl ical i ty of econ omy , economic d ivers i ficat ion

C. Inflationa. Momentary policyb. Fiscal policy, budget deficits

D. Strength of local f inancial m arkets, por t ion o f total investment f inanced loc al ly

II. INTERNATIONALA. Balance of p ayments

B. Internat ion al trade

1. Importance of trade in GNP2. Stability of trade earnings

a. Diversity of exportsb. Elasticity of export demandc. Elasticity of import demand

i. capital equipmentii. necessities

-Degree of self-reliance in food-Reliance on imported energy

iii. luxuries3. International trade ties, proximity to major markets4. Extent if trade controls

C. Internat ion al Capital

1. Currencya. Strengthb. Stabilityc. Quality of exchange marketsd. Depth of exchange marketse. Extent of controls over exchange markets

2. Debta. Totalb. Short-term as share of totalc. Debt service ratiod. Debt-service schedule

3. International Financial Resourcesa. International reservesb. International borrowings capacity

i. History of debt repayment

ii. Credit ratingc. Autonomous capital inflows4. Share of total investment financed from abroad

1.4 TIME HORIZON

Loans are made from one day to maximum of 10-12 years, and country risk

evaluation encompasses these periods. It is extremely rare to contemplate a

direct investment for less than five years. This is thus the minimum time horizon

for risk assessment. The maximum is around 30 years, for example for oilexploration, plantations, or mining.


6/12



6

1.5 NEED FOR RISK EVALUATION

Events of the last decade have demonstrated that, just as the stock market, the

international financial market can in the short term be disastrously wrong in itscollective evaluation of country risk. Individual banks can be ahead of the market

in their evaluation of country risk if they have insight based on information and its

interpretation as well as analytical ability superior to the market average. The

purpose of country risk evaluation is to improve the individual bank sperformance

relative to the market average. If the bank can in the short term assess country

risk more accurately than the market and can anticipate changes in the risk

situation ahead of the market, it can move with countries where the risk is better

than the markets perception, or where the bank perceives an improvement before

its competitors, it can fund at the most favorable rates, and have smaller losses

and wider average spreads than its competitors.

1.6 GEOGRAPHICAL LOCATION OF RISKS

The risk of a loan is usually located in the country of domicile of the borrower. But

if the loan is guaranteed, should it be the country of the guarantor? What about

the brass plate domiciles, where the head office is legally domiciled in a tax

haven and the assets of the company are elsewhere?

As a general rule, the risk should belong to the country on which the

principal protection as the repayment of the loans depends. The risk of each loan

can only be located after careful scrutiny of the overall situations, covering

safeguards against loss and country jurisdiction.

1.7 CLASSIFICATION OF COUNTRY RISK

Much of the conceptual confusion that surrounds country risk arises from the

different criteria according to which risks can be classified. These include:

1. By the side of the balance sheet which is exposed to risk, whether assets

or liabilities

2. In case of assets, by type of asset which is at risk: loans (country risk) vs.

direct investment;

3. Geographically: Austrian, Brazilian, Chilean, etc. risk;


7/12



7

4. Within each country, by the nature of events that may lead to its

materialization: political, social, economic, etc;

5. Regarding country risk, by type of borrower: government (or soverign) risk,

private sector risk, corporate risk, individual risk;6. For each type of borrower, by the action taken by the borrower that causes

a loss: repudiation, default, renegotiation, rescheduling, etc.

7. For each of these, by degree, i.e. high, low, moderate risk.

1.7.1 Classification by action taken by borrower

Among the various classifications, the type of action taken by the borrower is

probably the most important.

Repudiat ion or d efault

In this case, the debtor notifies the creditor that he will definitely cease making any

further service payments because he cannot or does not want to pay (default), or

because he does not recognize the debt (repudiation). As the distinction between

repudiation and default has little relevance to the lender, and because repudiation

is extremely rare, we are concerned here only with default.

Renegot iat ion

Renegotiation here indicates that the lender will receive less than originally agreed

because the interest rates is lowered, the spread narrowed and/ or because part

of the principal will not be repaid. Refinancing not covered by a penalty clause has

similar consequences to the lender.

Reschedul ing or m orator ium

This implies that the terms of the loan are lengthened either because annual

repayments of principal are lowered and spread over a great number of years

than originally agreed (rescheduling) or because there will be a grace period for

the repayment of principal (moratorium). The interest (or spread) remains the

same as originally agreed.

There may be an opportunity loss if the lender could have relent the the

principla at a higher rate interest rate or wider spread had it been repaid as


8/12



8

originally scheduled. There may alternatively be an opportunity gain, if the market

has become more liquid in the meantime.

There will also be a loss of convenience as the schedule of the actual cash

flow will be different from that of the expected cash flow. There are extraadministrative costs, such as the cost of negotiating the rescheduling or the

moratorium. This is usually the only measurable loss that the lender suffers as a

aresult of rescheduling or moratorium, but even that may be recovered through a

one percent penalty interest on re-scheduled amounts.

Technical default

Technical default arises when the borrower fails to meet one or several terms for

debt service payments because of, for example, temporary inability (or

unwillingness) to pay, administrative delays, or inefficiency. The accent is on the

word temporary usually there is little doubt that the debtor will eventually meet

his debt servicing obligations. Usually he also pays interest-sometimes at a

penalty rate-on service payments due, In that case the impact from the lenders

point of view is similar to that of a moratorium; there is a possibility of opportunity

loss and there will be a convenience loss as well as the extra costs incurred in

prompting the debtor to meet his debt servicing obligations.

Transfer risk

If prohibitive exchange restrictions have been imposed by the government, it may

become impossible to transfer payments. This type of country risk can only

materialize for private borrowers; if the government cannot service its own debt

because it does not have the required amount of foreign exchange, the risk would

come under default, renegotiation, rescheduling, moratorium, or technical default.

A so called improductive loan-a loan that is not serviced-may be a case of

technical default or transfer impossibility. Depending upon how the issue is

eventually resolved, it may also belong to any of the other categories.

1.8 QUALIFICATIONS NEEDED FOR PROPER ASSESSMENT OF COUNTRY

RISK

At least six qualifications are required for proper assessment of country risks:


9/12



9

1. Conceptual awareness of factors that have a bearing on country risk

2. Analytical ability to assess how these factors interact in affecting debt

servicing ability.

3. In-depth knowledge of the country under scrutiny; its political and economicstructure, the institutional and regulatory framework, recent political and

economic developments, economic policies, strength and determination of

the government to implement policies, etc.

4. Specialized expertise to predict political variables

5. Familiarity with economic forecasting techniques to make short and lonf-

term projections of relevant variables; real GDP growth, inflation, balance

of payments, external debt, debt service payments.

6. Experience and skills to draw conclusions regarding debt servicing ability

from observed and predicted variables, and combine these into a risk

rating.

The acquisition of these qualifications requires considerable learning, training and

experience. Few individuals are likely to combine all the qualifications, so country

risk analysis should be the result of cooperation , drawing on all the available

expertise within, and accessible to, the bank, and should under no circumstances

be left to amateurs.

1.9 QUANTIFYING COUNTRY RISK

To develop an overall country risk rating, it is necessary to first construct separate

ratings for political and financial risk which depend on variety factors. First the

political factors can be assigned values within some arbitrarily chosen range,

which should add up to 100 percent. The assigned values of the factors times the

respective weights can then be summed up to derive a political risk rating.

The process described for deriving the political risk rating can then be

repeated to derives the financial risk rating. That is, values can be assigned (from

1 to 5, where 5 is the best value/ lowest risk) to all financial factors. The assigned

values of the factors times their respective weights can be summed up to derive a

financial risk rating.


10/12



10

Once the political and financial ratings have been derived, a countrys

overall country risk rating as related to a specific project can be determined by

assigning weights to the political and financial ratings according to the perceived

importance. The political and financial ratings multiplied by their respectiveweights would determine the overall country risk rating for a country as related to

a particular project.

In a realistic setting, many more factors might be included. Political risk

factor A might reflect the degree of political tension of the country with its

neighboring countries, and so on. Financial risk factors A might reflect potential

internal economic growth, and so on.

The number of relevant factors comprising both the poltitical risk and the

financial risk categories will vary with the country being assessed and the type of

corporate operations planned for the country. The assignments of values to the

factors, along with the degrees of importance (weights) assigned to the factors,

will also vary with the country being assessed and type of corporate opearations

planned for the country.

It should be emphasized that country risk assessors have their own

individual procedures for quantifying country risk. Most procedures are similar,

though, in that they somehow assign ratings and weights to all individual

characteristics relevant to country risk assessment.

1.10 USE OF COUNTRY RISK ASSESSMENT

The first step for a firm after it has developed a country risk rating is to determine

whether that rating suggests the risk is tolerable. If the country risk is too high,

then the firm does not need to analyse the feasibility of the proposed project any

further. Some firms may contend that no risk is too high when considering a

project. Their reasoning Is that if the potential return is high enough, the project is

worth undertaking. However, there are cases in which the degree of country risk

could be too high regardless of the projects expected return.

If the risk rating of a country is in the tolerable range any project related to

that country deserves further consideration. Capital budgeting analysis would be

appropriate to determine whether the project is feasible.


11/12



11

1.11 INCORPORATING COUNTRY RISK IN CAPITAL BUDGETING

Country risk can be incorporated in the capital budgeting analysis of a proposed

project by adjustment of the discount rate, or by adjustment of the estimated cash

flows. Each method is discussed below:

Adjustm ent of the Discoun t Rate:

The discount rate of a proposed project is supposed to reflect the required rate of

return on that project. Thus, the discount rate could be adjusted to the amount for

the country risk. The lower the country risk rating, the higher is the perceived risk,

and the higher is the discount rate applied to the projects cash flows. This

approach is convenient in that one adjustment to the capital budgeting analysis

can capture country risk. However, there is no precise formula for adjusting the

discount rate to incorporate country risk. The adjustment is somewhat arbitrary,

and may therefore cause feasible projects to be rejected or unfeasible projects to

be accepted.

Adjustm ents of the est imated Cash Flows

If there is a chance that the host government takeover will occur, the foreign

projects NPV under these conditions should be estimated. Each possible form of

risk has an estimated impact on the foreign projects cash flows, and therefore on

the projects NPV. By analysiny each possible impact, the MNC can determine the

probability distribution of NPVs for the project will generate a positive NPV, as well

as the size of possible NPV outcomes. While this procedure may seem somewhat

tedious it directly incorporates forms of country risk into the cash flow estimates

and explicitly illustrates the possible results from implementing the project. The

more convenient methos of adjusting the discount rate in accordance with the

country risk rating does not indicate the probability distribution of possible

outcomes.

1.12 CONCLUSION

As sovereign lending increases with each passing year, the risk of operating

across ones national borders is increasingly given more attention. The need to

estimate the risks involved and thereafter putting in place appropriate measures


12/12

Documents

Country Risk Analysis Cra Write Up r n Zhasa