COUNTRY RISK ANALYSIS

DEFINITION

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. For example, financial factors such as currency controls, devaluation or regulatory changes, or stability factors such as mass riots, civil war and other potential events contribute to companies' operational risks. This term is also sometimes referred to as political risk, however country risk is a more general term, which generally only refers to risks affecting all companies operating within a particular country.

Political risk analysis providers and credit rating agencies use different methodologies to assess and rate countries' comparative risk exposure. Credit rating agencies tend to use quantitative econometric models and focus on financial analysis, whereas political risk providers tend to use qualitative methods, focusing on political analysis. However, there is no consensus on methodology in assessing credit and political risks.

Introduction

All business transactions involve some degree of risk. When business transactions occur across international borders, they carry additional risks 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 analysis (CRA) attempts to identify the potential for these risks to decrease the expected return of a cross-border investment.

"Risk" implies that an analyst can identify a well-defined event drawn from a large sample of observations. A large sample contains enough observations to develop a statistical function amenable to probability analysis. An event that lacks these requirements moves toward uncertainty on the continuum between pure risk and pure uncertainty. For example, the probability of death from an auto accident classifies as a risk; the probability of death from a nuclear meltdown falls into uncertainty, given a lack of nuclear meltdown observations. Many of the individual events investigated by country risk analysis fall closer to uncertainties than well-defined statistical risks. This forces analysts to construct risk measures from theoretical or judgmental, rather than probabilistic, foundations.

Uncertainty makes CRA more similar to a soft art than a hard science. Analysts deal with the soft nature of CRA in different ways, which can result in widely varying views of the risk level of a country. For this reason, users of risk measures developed from commercial country-risk services must understand analysts' construction methods if they wish to analyze a company investment risk appropriately. As demonstrated in the sections below, company analysts should be able to improve upon outside measures by adapting risk systems to their specific company investments.

Theory vs. Practice

Country risk analysis rests on the fundamental premise that growing imbalances in economic, social, or political factors increase the risk of a shortfall in the expected return on an investment. Imbalances in a specific risk factor map to one or more risk categories. Mapping all the factors at the appropriate level of influence creates an overall assessment of investment risk. The mapping structure differs for each type of investment, so an imbalance in a given factor produces different risks for different investments.

This fundamental premise provides a simple theoretical underpinning to CRA. Unfortunately, no comprehensive country risk theory exists to guide the mapping process. [1] In practice, most country-risk services create risk measures using an eclectic mix of economic or sociopolitical indicators based on selection criteria arising from their analysts' experiences and judgment. The services usually combine a variety of factors representing actual and potential imbalances into a comprehensive risk assessment that applies to a broad investment category. Most CRA literature emphasizes a number of common points, then slips into a detailed discussion of ways the respective authors enumerate risk for various investments. The best authors emphasize the necessity to adapt their analyses for a specific investment decision given the judgmental nature of their methods.

Country Risk Categories and Measurements

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 Neighborhood Risk

V. Sovereign Risk

VI. Political Risk

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 deal with policy.

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.

Transfer Risk: - It is the risk arising from a decision by a foreign government to restrict capital movements. 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. It usually is analyzed as a function of

a country's ability to earn foreign currency, with the implication that difficulty earning foreign currency increases the probability that some form of capital controls can emerge. Quantifying the risk remains difficult because the decision to restrict capital may be a purely political response to another problem. For example, Malaysia's decision to impose capital controls and fix the exchange rate in the midst of the Asian currency crisis was a political solution to an exchange-rate problem. Quantitative measures typically used to assess transfer risk provided little guidance to predict Malaysia's actions.

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.

Exchange Risk: - It 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 (more than one to two years). 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 (alignment of revenues and costs in the same currency) can be developed.

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.

Location or Neighborhood Risk: It 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.

Sovereign Risk : - It is concerned with 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 that a government may run out of foreign exchange due to unfavorable developments in its balance of payments. It also relates to political risk in that 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. Measures of willingness to pay require an assessment of the history of a government's repayment performance, an analysis of the potential costs to the borrowing government of debt repudiation, and a study of the potential for debt rescheduling by consortiums of private lenders or international institutions. The international setting may further complicate sovereign risk. In a recent example, IMF guarantees to Brazil in late 1998 were designed to stop the spread of an international financial crisis. Had Brazil's imbalances developed before the Asian and Russian financial crises, Brazil probably would not have received the same level of support, and sovereign risk would have been higher.

Political Risk concerns risk of a change in political institutions stemming from a change in government control, social fabric, or other noneconomic 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 (such as the Overseas Private Investment Corporation in the United States) and international organizations (such as the World Bank's Multilateral Investment Guarantee Agency).

Few quantitative measures exist to help assess 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. Unfortunately, little theoretical guidance exists to help quantify political risk, so many "systems" prove difficult to replicate over time as various socio-political events ascend or decline in importance in the view of the individual analyst.

Why Country Risk Analysis Is Important

Country risk is the potentially adverse impact of a country environment on an MNC's cash flows. Country risk analysis can be used to monitor countries where the MNC is currently doing business. If the country risk level of a particular country begins to increase, the MNC may consider divesting its subsidiaries located there. MNC can also use country risk analysis as a screening device to avoid conducting business in countries with excessive risk. Events that heighten country risk tend to discourage U.S. direct foreign investment in that particular country.

Country risk analysts are not restricted to predicting major crises. An MNC may also use this analysis to revise its investment or financing decisions in light of recent events. In any given week, the following unrelated international events might occur around the world:

A terrorist attack

A major labor strike in an industry

A political crisis due to a scandal w within a country

Concern about a country's banking system that may cause a major Outflow of

Funds

The imposition of trade restrictions on imports

Any of these events could affect the potential cash flows to be generated by an MNC or the cost financing projects and therefore affect the value of MNCs.

Even if an MNC reduces it exposure to all such events in a given week, a new vet of events will occur in the following week. For each of these events, an MNC mull consider whether

its cash flows will be affected and whether there has been a change in policy to which it should respond. Country risk analysis is an ongoing process.

Most MNC will not be affected by every event, but they will pay close attention to any events that may have an impact on the industries or countries in which they do business. They also recognize that they cannot eliminate their exposure to all events but may at least attempt to limit their exposure to any single country specific event.

Political Risk Factors

An MNC must assess country risk not only in countries where it currently does business but also in those where it expects to export or establish subsidiaries. Several risk characteristics of a country may significantly affect performance, and the MNC should be concerned about his likely degree of impact for each. The September 11, 2001, terrorist on the United States heightened the awareness of political risk.

As one might expect, many country characteristics related to the environment can influence an MNC. An extreme form of political risk is the possibility that the host country will take over a subsidiary. In some cases of expropriation, some compensation (the amount decided by the host country government) is awarded. In other cases, the assets are confiscated and no compensation is provided. Expropriation can take place peacefully or by force. The following are some of the more common forms of political risk:

Attitude of consumers in the host country

Actions of host government

Blockage of fund transfers

Currency inconvertibility

War

Bureaucracy

Corruption

Each of these characteristics will be examined.

Attitude of Consumers in the Host Country

A mild form of political risk (to an exporter) is a tendency of residents purchase only locally produced goods. Even if the exporter decides to set up a subsidiary in the foreign country, this philosophy could prevent its success. All countries lend to expert some pressure on consumers to purchase from locally owned manufacturers. (In the United States, consumers are encouraged to look for the "Made in the U.S.A." label.) MNC's that consider entering a foreign market (or haw already entered that market) must monitor the general loyalty of consumers toward locally produced products. If consumers are very loyal to local products, a joint venture with a local company may be more feasible than an exporting strategy. The September 11, 2001, terrorist attack caused some consumers to pay more attention to the country where products arc produced.

Actions of Host Government

Various actions of a host government can affect the cash flow of an MNC. For example, a host government might impose pollution control standards (which affect costs) and additional corporate taxes (which affect after-tax earnings) as well as withholding taxes and fund transfer restriction (which affect after-tax cash flows sent to the parent).

Some MNCs use turnover in government members or philosophy as a proxy for a country's political risk. While this can significantly influence the MNC’s future cash it alone does not serve does not suitable representation of political risk. A subsidiary will not necessarily be affected by changing governments. Furthermore subsidiary can be affected by new policies of live host government or by a changed attitude toward the subsidiary's home country (and therefore the subsidiary), even when the host government has no risk of being overthrown.

A host government can use various means to make an MNC's operations coincide with its own goals. It may, for example, require the use of local employees for managerial positions at a subsidiary. In addition, it may require social facilities (such as an exercise room or nonsmoking areas) or special environmental controls (such as air pollution controls). Furthermore, it is not uncommon for a host government to require special permits, impose extra uses, or subsidize competitors. All of these actions represent political risk in that they reflect a country's political characteristics and could influence an MNC's cash flows.

Example: In March 2004 antitrust regulators representing the European Union countries decided to fine Microsoft about 500 million euro’s (equivalent to about $610 million at the time)

For abusing its monopolistic position in computer software. They also imposed restrictions on how Microsoft can bundle its Windows Media player (needed to access music or videos) in its personal computers sold in Europe. Microsoft argued that the line is unfair because it is not subject to such restrictions in its home country, the United States. Some critics argue, however, that the European regulators are not being too strict, but rather that the US regulators are being too lenient

Lack of Restrictions

In some c, MNCs arc adversely affected by a lack or" restrictions in host country, which allows illegitimate business behavior to take market share. One of the most troubling issues tor MNCs is the failure by host government!* to enforce copyright law* against local firms- that illegally copy the MNCs product. For example, local firms in Asia commonly copy software produced by MNCs and sell it to customers at lower prices. Software producers lose an estimated S3 billion in sales annually in Asia for this reason. Furthermore, the legal systems in tome countries Jo not adequately protect a (inn against copyright violations or other illegal means of obtaining market share.

Blockage of Fund Transfers

Subsidiaries of MNCs often send funds back to the headquarters for loan repayments, purchases of supplies, administrative tires, remitted earnings, or other purposes. In some cases, a host government may block fund transfers, which could force subsidiaries to undertake projects that are not optimal (just to make use of the funds). Alternatively, the MNC may invest the funds in local securities that provide some return while the funds arc blocked. But this return may be inferior to what could have been earned on funds remitted to the parent.

Currency Inconvertibility

Some governments do not allow the home currency to be exchanged into other currencies. Thus, the earnings generated by a subsidiary in these countries cannot be remitted to the parent through currency conversion. When the currency is inconvertible, an MNCs parent may need to exchange it for goods to extract benefit from projects in that country.

Bureaucracy

Another Country risk (actor is government bureaucracy, which can complicate an MNCs business. Although this factor may seem irrelevant, it was a major deterrent for MNCs that considered projects in Eastern Europe in the early 1990s. Many of the Eastern European governments were not experienced at facilitating the entrance of MNCs into their markets.

Corruption

(Corruption can adversely affect a MNCs international business, because it can increase the cost of conducting business or it can reduce revenue, various forms of corruption can occur between firms or between firms and the government. for example, an MNC may loss revenue because a government contract is awarded to a local

Main points to be considered are As Follows.

It can be used by MNCs as a screening device to avoid countries with excessive risk.

It can be used to monitor countries where the MNC is presently engaged in international business

Assess particular forms .of risk for a proposed project considered for a foreign country.

Types of Country Risk Assessment

Although there is no consensus as to how country risk can best be assessed, some guidelines have been developed. The first step is to recognize the difference between (1) an overall risk assessment of a country without consideration of the MNC’s business and (2) the risk assessment of a country is it relate to the MNC's type of business. The first type can be referred to as macro assessment of country risk and the latter type as a micro assessment. Each type is discussed in turn.

1. Macro assessment of country Risk.

2. Micro assessment of country Risk.

Macro assessment of Country Risk

A macro assessment involves consideration of all variables affect country risk except those unique a particular firm or industry. This type of assessment is convenient in that it remain the same for a given country, regardless of the firm or industry of concern; however, it excludes relevant information that could improve the accuracy of the assessment. Although a macro assessment of country risk is not ideal for any individual MNC, it serves as a foundation that can then be modified to reflect the particular business of the MNC.

Any macro assessment model should consider both political and financial characteristics of the country being, assessed.

•Political factor- Political factors include the relationship of the host government with the MNC’s home country government, the attitude of people in the host country toward the MNC's government, the historical stability of the host government, the vulnerability of the host government to political takeovers, and the probability of war between the host country and neighboring countries. Consideration of such political factors will indicate the probability of political events that may affect an MNC and the magnitude of the impact. The September

11, 2001, terrorist attack on the United States caused more concern about political risk tor U.S. based MNCs became of all the factors cited here.

Financial factor- The financial factors of a macro assessment model should include GDP growth. Inflation trends, government budget levels (and the government deficit), interest rates, unemployment, the country’s reliance on export income, balance of trade, and foreign exchange control. The list of financial factors could easily be extended several pages. The factors listed here represent just .subset of the financial factor considered when evaluating the financial strength of a country.

Uncertainty Surrounding a Macro assessment-

There is clearly a degree of subjectivity in identifying the relevant political and financial factors for a macro assessment of country risk. There is also some subjectivity in determining the importance of each factor for the overall macro assessment for a particular country For instance, one assessor may assign a much higher weight (degree of importance) to real GDP growth than another assessor. Finally, there is some subjectivity in predicting these financial factors. Because of these various types of subjectivity, it is not surprising that risk assessors often arrive at different opinions after completing a macro assessment country risk.

Micro assessment of Country Risk

While a micro assessment of country risk provides an indication of the country’s overall status it does not assess country risk from the perspective of the particular business of concern. A in it reassessment of country risk is needed to determine how the country risk relates to the specific MNC.

Example: Country Z has been assigned a relatively tow macro assessment by most experts due to its poor financial condition. Two MNCs ore deeding whether to set up subsidiaries In Country Z. Carco, Inc. is considering developing a subsidiary Dial would produce automobiles and sell them locally. While Mlico.inc, plans to build a subsidiary that would produce military supplies. Caro’s plan to build an automobile subsidiary does not appear to be teasable unless Country Z does not have a sufficient number of automobile producers already.

Country Z's government may be committed to purchasing a given amount of military supplies, regardless of how weak the economy is. Thus, Miico’s plan to build a military supply subsidiary may still be feasible, even though Country Z's financial condition is poor.

It is possible, however, that Country Z's government will order its military supplies from a locally owned firm because it wants its supply needs to remain confidential. This possibility is an element of country risk because it is a country characteristic tor attitude that can affect the feasibility of a project. Yet, this specific characteristic is relevant only lo Milo. Inc., and not to Carco, Inc.

In addition to political variables, financial variables must also be included in a micro assessment of country risk. Micro factors include the sensitivity of the firm's business to real GDI growth, inflation trends, interest rates, and other factors. Due to differences in business characteristics, some firms are more susceptible to the hurt country's economy than others.

In summary, the overall assessment of country risk consists of following pans:

1. Macro political risk

2. Macro financial risk

3. Micro political risk

4. Micro financial risk

Techniques to assess country risk

Once a firm identifies all the macro assessment and micro assessment that deserve consideration in the country risk assessment, it may wish to implement a system for evaluating these factors and determining a country risk rating.

The following are some the more popular techniques.

1. Checklist approach.

2. Delphi Technique.

3. Quantitative analysis.

4. Inspection visits.

5. Combination of techniques

Each technique is briefly discussed in turn.

Checklist Approach

A checklist approach involves making a judgment on all the political and financial factors (both macro and micro) that contribute to a firm's assessment of country risk. Ratings are assigned to a list of various financial and political factors, and these ratings are then consolidated to derive an overall assessment of country risk. Some factors (such as real GDP growth) can be measured from available data, while others (such as probability of entering a war) must be subjectively measured.

A substantial amount of information about countries is available on the Internet. This information can be used to develop ratings of various factors used to assess country risk. The factors are then converted to numerical rating in order to assess a particular country. Those factors thought to have a greater influence on country risk should be assigned greater is weights. Both the measurement of factors and the weighting scheme implemented are subjective.

Delphi Technique

The Delphi technique involves the collection of independent opinions without group discussion. As applied to country risk analysis, the MNC could survey specific employees, or outside consultant who has some expertise in assessing a specific country's risk characteristics. The MNC receives responses from its survey and may then attempt to determine some consensus opinions (without attaching names to any of the opinions) about the perception of the country’s risk. Then, it sends this summary of survey back to the survey respondents and asks for additional feedback regarding, it’s summary of the country's risk.

Quantitative Analysis

Once the financial and political variables have been measured for a period of time, models for quantitative analysis can attempt to identify the characteristics that influence the level of country risk. For example, regression analysis may he used to assess risk, since it can measure the sensitivity of One variable to other variables. A firm could regress a measure of its business activity (such as its percentage increase in sales) against country characteristics (such as real growth in GDIP) over a series of previous months or quarters. Results from such an analysis will indicate the susceptibility of particular business- to a country's economy. This is valuable information to incorporate into the overall evaluation of country risk.

Although quantitative models can quantify the impact of variables on each other, they do not necessarily indicate a country's problems before they actually occur (preferably before the firm's decision to pursue a project in that country). Nor can they evaluate subjective data that cannot be quantified. In addition, historical trends of various country characteristics are not always useful for anticipating an upcoming crisis.

Inspection Visits

Inspection visits involve traveling lo a country and meeting with government officials, business executives, and/or consumers. Such meeting* can help clarify any uncertain opinions the firm has about a country.

Combination of Techniques

A survey of corporations heavily involved in foreign business found that about half of them have no tenant method of assessing country risk. This does not mean that they neglect to assess country risk, but rather that there is no proven method to use. Consequently, many MKCs use a variety of techniques, possibly using a checklist approach to identify relevant factors and then using the Delphi technique, quantitative analysis and inspection visits to assign ratings to the various factors.

Measuring Country Risk

Deriving an overall country risk rating using a checklist approach requires separate ratings for political and financial risk. First, the political factors are assigned values within some arbitrarily chosen range (such as values from 1 to 5, where 5 is the best value/ lowest risk). Next, these political factors are assigned weights (representing degree of Importance), which should add up to 100 percent. The assigned values of the factors times their respective weights can then be summed to derive a political risk rating.

Variation in Methods of Measuring Country Risk

Country Risk assessors have their own individual procedure for quantifying country risk. The procedure described here is just one of many. Most procedures are similar, though, in that they somehow assign ratings and weights to all individual characteristics relevant to country risk assessment.

The number of relevant factors comprising both the political risk and financial risk categories will vary with the country being assessed and the type of corporate operations planned for the country. The assignment of values to the factors, along with the degree of importance (weights) aligned to the factors, will also vary with the country being assessed and the type of corporate operations planned for that country.

Using the Country Risk Rating for Decision Making

If the country risk is too high, then the firm does not need to analyze 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. When employee safety is a concern, however, the project may he rejected regardless of its potential return.

Even after a project is accepted and implemented, the MNC must continue to monitor country risk. With a labor-intensive MNC, the host country may feel it is benefiting from a subsidiary's existence (due to the subsidiary's employ men: of local people), and the chance of expropriation may be low. Nevertheless, several other forms of country risk could suddenly make the MNC consider divesting the project. Furthermore, decisions regarding subsidiary expansion, fund transfers to the parent, and sources of financing can all be affected by any changes in country risk. Since country risk can change dramatically over lime, periodic reassessment is required, especially for less stable countries.

Regardless of how country risk analysis is conducted, MNCs are often unable to predict crises in various countries. MNCs should recognize their limitations when assessing country risk and consider ways they might limit their exposure to a possible increase in that risk.

Comparing Risk Ratings among Countries

An MNC may evaluate country risk for several countries, perhaps to determine where to establish a subsidiary. One approach to comparing political and financial ratings among countries, advocated by some foreign risk managers, is a foreign investment risk matrix (FIRM), which displays the financial (or economic) and political risk by in ten all ranging across the matrix from "poor" to "good." Each country can position in its appropriate location on the matrix based on its political rating and financial rating.

Country Risk Assessment

Recently, Ben Holt Blades, chief financial officer, has assessed whether it would be more beneficial for Blades ("establish a subsidiary in Thailand to manufacture roller blades or to acquire an existing manufacturer, Skates'n'Stutf. Which has offered to sell the business to Blades for 1 billion Thai baht? In Holt's view, establishing a subsidiary in Thailand yields a higher net present value {SI'V) than acquiring the existing business. Furthermore, the Thai manufacturer has rejected an offer by Blades, Inc for 900 million baht. A purchase price of 900 million baht lot Skates’n’Stutf would make the acquisition as attractive as the establishment of a subsidiary in Thailand in terms of XPV. Skates’n’Stutf has Indicated that it is not willing to accept less than 950 million baht.

Although Holt is confident that the NPV analysis was conducted correctly, he is troubled by the fact that the same discount rate, 25 percent, was used in cash analysis. In his view, establishing a subsidiary in Thailand may be associated with a higher level of country risk than acquiring Skates’n’Stutf. Although either approach would result in approximately the same level of financial risk, the political risk associated with establishing a subsidiary in Thailand may be higher than the political risk of operating Skates’n’Stutf. If the establishment of a subsidiary in Thailand is associated with a higher level of country risk overall, then a higher discount rate should have been used in the analysis.

Country Risk Premiums

The concept of a country risk premium refers to an increment in interest rates that would have to be paid for loans and investment projects in a particular country compared to some standard. One way of establishing the country risk premium for a country is to compare the interest rate that the market establishes for a standard security in the country, say central government debt, to the comparable security in the benchmark country, say the United States. For the securities to be comparable they must have the same maturity and involve payment in the same currency, say U.S. dollars. The reason the payments must be the same is that otherwise

the differential in the interest rates would reflect the differential rates of inflation in the two countries instead of solely the market-perceived risk of nonpayment. The interest rate that is relevant is the market-determined yield to maturity rather than the coupon interest rate. The coupon interest rate is valid only if the issuers are careful to set the coupon rate so that it is equal to the yield to maturity of the security.

For example, suppose the U.S. government has a currently issued five year bond that has a yield to maturity of 6 percent and the government of Poland borrows dollars by selling a five year bond that pays in dollars and the yield to maturity of that bond is 8 percent. The country risk premium for Poland would be 2 percent or, as such premiums are often expressed, 200 basis points. The two percent is the correct value providing the yields to maturity are expressed as instantaneous rates. If they are expressed as effective annual rates then the correct computation of the risk premium ρ is as follows: 1+ρ = (1+0.08)/(1+0.06) = 1.01887and thusρ = 0.01887  

Country Risk Classification

The objectives of the Knaepen Package, as reflected in Article 23 of the Arrangement, are to ensure that Participants to the Arrangement charge premium rates in addition to interest charges that cover the risk of non-repayment of export credits (i.e. credit risk) and are not inadequate to cover long-term operating costs and losses associated with the provision of export credits. Another stated purpose of the Knaepen Package is premium rate convergence, which, although not easily measured or

defined, is a general outcome that can be expected when the two above-mentioned objectives are met.

One of the key elements of the Knaepen Package, which came into effect in 1999, is a system for assessing country credit risk and classifying countries into eight country risk categories (0 - 7).The Country Risk Classification Method measures the country credit risk, i.e. the likelihood that a country will service its external debt. The classification of countries is achieved through the application of a methodology comprised of two basic components: (1) the Country Risk Assessment Model (CRAM), which produces a quantitative assessment of country credit risk, based on three groups of risk indicators (the payment experience of the Participants, the financial situation and the economic situation) and (2) the qualitative assessment of the Model results, considered country-by-country to integrate political risk and/or other risk factors not taken (fully) into account by the Model The details of the CRAM are confidential and not published. The final classification, based only on valid country risk elements, is a consensus decision of the sub-Group of Country Risk Experts that involves the country risk experts of the participating Export Credit Agencies.

The sub-Group of Country Risk Experts meets several times a year. These meetings are organized so as to guarantee that every country is reviewed whenever a fundamental change is observed and at least once a year. Whilst the meetings are confidential and no official reports of the deliberations are made, the list of country risk classifications is published after each meeting.

A number of Multilateral/Regional Financial Institutions are also classified in relation to Article 26 of the

Arrangement.

The Country Risk Classifications are produced solely for the purpose of setting minimum premium rates for transactions covered by the Export Credit Arrangement. Neither the Participants to the Arrangement nor the OECD Secretariat take any responsibility if these classifications are used for other purposes. Please note that historical Country Risk Classification (see below) only exist for the period since the Knaepen Package was agreed in 1999; the OECD Secretariat does not therefore have any old historical data.

Evaluating Country Risk For International Investing.

Many investors choose to place a portion of their portfolios in foreign securities. This decision involves an analysis of various mutual funds, exchange-traded funds (ETF), or stock and bond offerings. However, investors often neglect an important first step in the process of international investing. When done properly, the decision to invest overseas begins with a determination of the riskiness of the investment climate in the country under consideration. Country risk refers to the economic, political and business risks that are unique to a specific country, and that might result in unexpected investment losses. This article will examine the concept of country risk and how it can be analyzed by investors.

COUNTRY RISK RATINGS have been heavily used by international companies for years. In the era of globalization, the ratings are used as the basis for travel

policies, insurance premiums, calculation of hardship allowances, or simply to gain context as to how the risks in one nation stack up against those of another. While the use of these ratings is broadly consistent, the way they are determined by risk management companies is not.

Credit Rating Agencies measuring country risk

Bank of America World Information Services

Business Environment Risk Intelligence

Control Risk Information Services

Economic Intelligence Unit

Euro Money

Institutional Investor

Standard and Poor Rating Group

Political risk Services: International Countries Risk Guide

Political risk Services: Coplin –O’Leary Rating System

Measuring country risk

Deriving an overall country risk rating using a checklist approach requires separate ratings for political and financial risk. First, the political factors are assigned values within some arbitrarily chosen range(such as values from 1to 5, where 5 is the best value/lowest risk). Next, these political factors are assigned weights (representing degree of importance), which should add up to 100 percent. The assigned values of the factors times their representative weights can be summed to derive a political risk rating.

Variation in methods of measuring Country Risk

Country risk assessors have their own individual procedures for quantifying the country risk. The procedure described here is just of many. Most procedures are similar, though in that they somehow assign ratings and weights to all individual characteristics relevant to country risk assessment.

The number of relevant factors comprising both the political risk and financial risk will vary with the country being assessed and the type of corporate operations planned for the country. The assignment of values, along with the degree of importance (weights) assigned to the factors, will also vary with the country being assessed and the type of corporate operations planned for the country.

Comparing risk ratings among countries

An MNC may evaluate country risk for several countries, perhaps to determine where to establish a subsidiary. One approach to comparing political and financial ratings among countries, advocated by some foreign risk managers, is a foreign investment risk matrix (FIRM), which displays the financial (or economic) and political risk by intervals ranging across the matrix from “poor “ to “ good “. Each country can be

positioned in its appropriate location on the matrix based on its political rating and financial rating.

Actual country risk ratings across countries

Country risk ratings are not necessarily applicable to a particular MNC that wants to pursue international business because the risk assessment here may not focus on the factors that are relevant to that MNC. Nevertheless, the risk rating can vary substantially among countries. Many industrialized countries have high ratings, indicating low risk. Emerging countries tend to have low ratings. Country risk ratings change over time in response to the factors that influence a country’s ratings.

Using the country risk rating for decision making

If the country risk is too high, the firm does not need to analyze 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. The employee safety is concerned; however, the project may be rejected regardless of its potential returns.

Even after a project is accepted and implemented, the MNC must continue to monitor country risk. With a labor –intensive MNC, consider divesting the project. Furthermore, the

decisions regarding subsidiary expansion, fund transfers to the parent, and sources of financing can all be affected by any changes in country risk. Since country risk can change dramatically over time, periodic reassessment is required, especially for less stable countries.

Regardless of how country risk analysis is considered , MNC’s are often unable to predict crisis in various countries .MNC’s should recognize their limitations when assessing country risk and consider ways they might limit their exposure to a possible increase in that risk.

How country risk affects financial decisions?

When incorporating country risk into the capital budgeting analysis, some projects are no longer feasible, and MNCs reduced their involvement in politically tense countries.

Asian crisis:

As a result of the 1997-1998 Asian crisis, MNCs realized that they had underestimated the potential financial problems that could occur in the high growth Asian countries. Country risk analyst had concentrated on the high degree of economic growth, even though the Asian countries had high debt levels

and their commercial banks had massive loan problems. The loan problems were not obvious because commercial banks were typically not required to disclose much information about their loans. Some MNCs recognized the potential problems in Asia, though, and discontinued their exports to those Asian businesses that were not willing to pay in advance.

Terrorist attack on United States:

Following the September 11, 2001, attack on the United States, some MNCs reduced their exposure to various forms of country risk by discounting business in countries where U.S. firms might be subject to more terrorist attacks. Some MNCs also reduced employee travel to protect employees from attacks. MNCs recognize that some unpredictable events will unfold that will affect their exposure to country risk yet, they can at least be prepared to revise their operations in order to reduce their exposure.

Governance over the assessment of country risk

Many international projects by MNCs last for 20 years or more. Yet, an MNC’s managers may not expect to be employed for such a long period of time. Thus, they do not necessarily feel accountable for the entire lifetime of a project. There are many

countries that may have low country risk today, but that are very fragile. Some governments could easily experience a major shift in the government regime from capitalist to socialist or vice versa. In addition, some countries rely heavily on the production of a specific commodity (such as oil) and could experience major financial problems if the world’s market price of that commodity declines. When managers want to pursue a project because of its potential success during the next few years, they may overlook the potential for increased country risk surrounding the project overtime. In their minds, they may no longer be held accountable if the project fails several years from now. Consequently, MNCs need a proper governance system ensures that managers fully consider country risk when assessing potential projects. One solution is to require that major long term projects use input from an external source ( such as a consulting firm ) regarding the country risk assessment of a specific project and that this assessment be directly incorporated in the analysis of the project. In this way a more unbiased measurement of country risk may be used to determine whether the project is feasible. In addition, the board of directors may attempt to oversee large long-term projects to make sure that country risk is fully incorporated into the analysis.

Case studies

Political risk analysis assists with strategy decisions and situation monitoring

An aerospace company was about to sign a major contract with a Central Asian government to supply equipment and training.  The contract was for six years and, given the high value of it, the company considered the political risks they might face. 

The company bought a subscription to Country Risk Forecast to use as a tool to help them monitor the political situation and look for risks in the country that could affect their contract.  These included a shift in policy away from defense expenditure, a change in political leadership or government ideology that could lead to arbitrary contract termination with foreign companies, the cancellation of all government defense contracts following evidence of major corruption in their negotiation and signing or signs of currency collapse or government inability to pay that could affect the agreement. With the assistance of Control Risks’ daily updated online information service, the client is able to keep abreast of developments in the country during the course of the contract and used this information in their strategic development process.

Easily accessible information empowers employees to make informed decisions

A large multinational company had over 500 staff travelling to a number of high risk and safer destinations. It wanted all staff to have the necessary information to allow them to make informed decisions about where they could travel safely on company business. The company selected to subscribe to Control Risks' travel security services because of the wide-ranging world coverage, the regularly updated analysis and the breadth of political, security and travel risk information in a user-friendly format.

The availability of the information via the company's intranet meant that no password was required to access the online services and all staff could have direct access to the daily updated information at their fingertips. Staffs that travel regularly to specific regions are able to receive updates via email and Control Risks' analysts are available to respond to questions about travel to specific destinations.

The client also uses the travel risk ratings that Control Risks assigns to each country as a basis for their travel policy and a separate feed from the service was set up to allow the company to use the travel risk ratings on the intranet site itself as part of the travel policy.

 Conclusion

The importance of country risk is underscored by the existence of several prominent country risk rating agencies. These agencies combine information regarding alternative measures of economic, financial and political risk into associated composite risk ratings. As the accuracy of such country risk measures is open to question, it is necessary to analyses the agency rating systems to enable an evaluation of the importance and relevance of agency risk ratings. The book focuses on the rating system of the international country risk guide. "Time" series data permit a comparative assessment of risk ratings for 120 countries, and highlight the importance of economic, financial and political risk ratings as components of a composite risk rating. The book analyses various univariate and multivariate risk returns and corresponding symmetric and asymmetric models of conditional volatility, as well as conditional correlations.