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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• 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• Frequency of changes of government• Number of armed insurrections• Level of violence in the country• Extent of conflicts with other states

Key Concerns• 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

• 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

• 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

• 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• 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

Japan• 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

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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

• 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)

• 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• 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• 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

• 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 risk-sharing 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!