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Wednesday, February 9, 2011

What we understand by Country Risk Analysis?

Country risk analysis (CRA) attempts to identify imbalances that increase the risk of a shortfall in the expected return of a cross-border investment. This paper describes the general process used to create risk measures and discusses some of the weaknesses of this process. It then examines the degree of association of six measures and analyzes the ability of these measures to predict returns for a manufacturing investment. The paper concludes that company analysts may improve the performance of risk measures available from commercial services by adjusting risk measurement to fit the company's specific type of foreign direct investment.
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.  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 deals 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 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 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 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 concerns whether a government will be unwilling or unable to meet its loan obligations, or is likely to renege on loans it guarantees. Sovereign risk can relate to transfer risk in 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 no economic factor. This category covers the potential for internal and external conflicts, expropriation risk and traditional political analysis. Risk assessment requires analysis of many factors, including the relationships of various groups in a country, the decision-making process in the government, and the history of the country. Insurance exists for some political risks, obtainable from a number of government agencies (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.
Conclusion
Country risk analysis in the 197Os and 1980s tended to focus on the risk a private lender such as a bank incurred when it made a hard currency loan to a sovereign government outside its home country. Risks were segmented to identify potential shortfalls in either the foreign currency value of the investment or in the investor's home currency (returns hold up in local currency, but decline when measured in the investor's own currency). Quantitative risk analysis generally focused on factors related to a country's ability to earn foreign currency to repay the debt. Qualitative analysis attempted to ascertain a country's willingness to repay the debt. This type of analysis tended to focus on the sovereign, transfer, and short-term exchange rate risk categories. With minor adjustments, this analytical approach also was used to assess risk in short-term investments in foreign private financial assets.
A multinational enterprise (MNE) that builds a plant in a foreign country faces different risks than a bank lending to a foreign government. The MNE must consider a longer time horizon and risks from a much broader spectrum of country characteristics. Some categories pertinent to a plant investment contain a much higher degree of risk simply because the MNE remains exposed to risk for a much longer period of time.
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