CHAPTER-06: COUNTRY RISK ANALYSIS
PART I. MEASURING POLITICAL RISK
A. Country-specific perspective There are two basic approaches to viewing political risk: a country-
specific (macro) perspective and a firm-specific (micro) perspective. The country-specific
perspective focuses on macro indicators to quantify the level of political risk within a nation as a
whole.
B. Political Stability Measured by: Measures of political stability are used to determine how long a
current regime might remain in power and its ability to enforce foreign investment guarantees. These
measures include:
a. Frequency of government changes: How often the leadership or administration of the country
shifts.
b. Level of violence: Quantifiable data such as the number of violent deaths per 100,000 population.
c. Number of armed insurrections: The frequency of internal uprisings or rebellions.
d. Conflict with other states: The extent to which the nation is involved in external disputes or
warfare.
C. Economic Factors: Indicators of political unrest Economic indicators are frequently used to
determine if a country's economy is in "good shape" or if it might require a "quick fix"—such as
expropriation or currency inconvertibility—to improve its financial position. A poor economic outlook
increases the likelihood of social turmoil. Key indicators include:
a. Rampant inflation: High and volatile inflation often results from large government deficits that are
"monetized" (financed by printing money), leading to monetary instability.
b. Balance of payment deficits: Persistent deficits may lead a government to impose price and interest
rate controls or result in a significant devaluation of the local currency.
c. Slowed growth of per capita GDP: This reflects the overall economic health and the standard of
living; for instance, Venezuela experienced a 47% decline in per capita income over a six-year period,
coinciding with significant political shifts.
D. Subjective Factors
1. Profit Opportunity Recommendation (POR): This is an index developed by Business
Environment Risk Intelligence (BERI) that incorporates economic, social, and political factors into a
single measure of a country's business climate. The rankings are based on the subjective assessments
of a panel of experts.
2. Political Risk and Uncertain Property Rights: Economically, political risk refers to uncertainty
over property rights. If a government has the power to expropriate legal titles or change laws (such
as tax laws) in a way that alters the income a property generates, political risk exists. This uncertainty
can also stem from constrained use of property or laws that favor state-owned companies over private
competitors. Examples of such risks include the erosion of the rule of law, unpredictable court systems,
and arbitrary changes in tax or export laws.
3. Capital Flight
Definition: the export of savings by a nation’s citizens because of safety-of-capital fears.
capital flight is inherently difficult to measure accurately because it is usually not directly observed.
However, it can be inferred using balance-of-payments figures through the following methods:
• Errors and Omissions: One common way to estimate capital flight is to look at the entry in
the balance-of-payments account labeled "errors and omissions". Large, unexplained
negative figures in this category often represent unreported capital outflows.
• World Bank Methodology: The World Bank uses a specific formula to estimate capital flight.
It is calculated as the sum of gross capital inflows and the current account deficit, minus
any increases in foreign reserves.
These measurements are significant because capital flight represents an enormous outflow of funds,
particularly from developing countries, and serves as a key indicator of the seriousness of a nation's
political risk.
capital flight is the export of savings by a nation's citizens driven by fears regarding the safety and
future value of their capital. It is often used as a key indicator of the seriousness of political risk in a
country.
The three causes you identified are elaborated upon in the source material as follows:
1) Inappropriate Economic Policies
• Discouraging Investment: Capital flight often occurs due to government regulations, controls,
and high taxes that lower the return on domestic investments.
• Fiscal Irresponsibility: Large government deficits, often financed by "monetizing" the debt
(printing money), signal economic instability.
• Wasteful Spending: When a government uses capital from abroad to subsidize consumption
or wasteful "showcase" projects rather than productive ventures, it reduces the nation's ability
to repay debts and encourages citizens to move their money elsewhere.
• Statist Policies: Policies such as import-substitution, which involves heavy regulation and
state ownership, can lead to long-term economic inefficiency and trigger capital flight.
2) Expectation of Devaluation
• Inflation Hedging: In countries with rampant inflation, hedging against domestic price
increases is often difficult. Investors may shift their savings to foreign currencies deemed less
likely to depreciate.
• Artificially Low Interest Rates: When governments keep domestic interest rates artificially
low, residents often anticipate a devaluation of the local currency and move funds abroad to
preserve their purchasing power.
• Overvalued Currencies: Governments that maintain an overvalued currency, often through
controlled exchange rate systems and price controls, virtually invite citizens to ship their money
elsewhere before the exchange rate inevitably falls.
3) High Political Risk
• Security of Wealth: This is considered the most powerful motive for capital flight. In unstable
political regimes, citizens fear their wealth is not secure from government seizure.
• Anticipated Regime Changes: Significant capital flight often occurs in advance of anticipated
changes in government, as seen when citizens of Hong Kong moved large sums of money
abroad before the 1997 transfer to Chinese rule.
• Lack of Trust: At its core, capital flight reflects a lack of trust in the government. If residents
believe the legal and political environment is unsafe for investment, they will move their capital
to more stable foreign markets.
• Uncertain Property Rights: Political risk is fundamentally defined as uncertainty over
property rights. If a government has the power to arbitrarily change tax laws or expropriate
legal titles, it creates a high-risk environment that drives capital away.
PART II. ECONOMIC AND POLITICAL FACTORS
Economic and Political Factors
The primary focus of this analysis is how well the country is doing economically, as better economic
performance generally lowers the likelihood that a government will take actions that adversely affect
the value of private companies.
A. Fiscal Irresponsibility A key indicator of country risk is a large government deficit relative to
GDP. Excessive government spending indicates an "insatiable appetite for money," which often leads
the state to extract more resources from its citizens through high taxes, printing money, or
expropriating property.
B. Monetary Instability When a government "monetizes" its deficit by printing money to finance
spending, it leads to monetary instability. This results in high and volatile inflation, high interest
rates, and currency depreciation. Zimbabwe is cited as a prime example where voiding property rights
and monetizing a massive budget deficit led to hyperinflation and economic collapse.
C. Controlled Exchange Rate System A controlled rate system often goes hand-in-hand with an
overvalued local currency. This effectively taxes exports and subsidizes imports. Such systems lack
the flexibility to respond to changing relative prices and often encourage capital flight as residents
anticipate a future devaluation.
D. Wasteful Government Spending Unproductive spending, such as subsidies for consumption or
"showcase" projects, leaves a government with fewer resources to service its foreign debt.
Furthermore, capital diverted to purchase assets abroad (capital flight) does not add to the nation's
productive capacity unless investors feel safe repatriating those earnings.
E. Resource Base A nation’s resource base includes natural, human, and financial resources. However,
having abundant natural resources is not a guarantee of success; instead, a highly skilled and
productive workforce and a free-market system that rewards ingenuity (like that seen with Steve Jobs
and Apple) are essential for prosperity. Nations that lack these "modern industrial" values, such as
meritocracy and the rule of law, are less likely to succeed.
F. Country Risk and Adjustment to External Shocks Nations vary in how they respond to external
shocks like rising interest rates or falling commodity prices.
• Successful Responses: Many Asian nations successfully coped with shocks in the 1980s by
promoting timely internal adjustments, manifest in low inflation and small current-account
deficits.
• Failed Responses: Many Latin American nations used "import-substitution" strategies
involving state ownership and heavy regulation, which led to long-term inefficiency and an
inability to adapt to the global marketplace.
Key Indicators of Country Risk and Economic Health
The sources identify specific characteristics that signal whether a country is a high-risk environment
or a healthy economy.
Key Indicators of High-Country Risk:
a. Relative size of government debt: Large deficits relative to GDP.
b. Money expansion: High rates of money supply growth.
c. Government-imposed barriers: Price controls, interest rate ceilings, and trade restrictions that
prevent market adjustment.
d. Level of tax rates: High rates that destroy incentives to work, save, and invest.
e. Government-owned firms: Vast state-owned enterprises run for the benefit of managers and
workers rather than efficiency.
f. Political and fiscal responsibility: A citizenry that demands public sector spending without regard
for the state's ability to pay.
g. Corruption: Pervasive corruption that acts as a "tax" on business and breeds’ distrust.
Key Indicators of Long-Run Economic Health:
a. Structural incentives: An incentive structure that rewards risk-taking in productive ventures.
b. Legal structure: A stable legal system with an independent judiciary and protected property
rights.
c. Clear incentives to save: Low taxes on investment returns and minimal regulatory distortions.
d. Open economy: A commitment to free trade and competition.
e. Stable macroeconomic policies: Policies that promote monetary stability, leading to lower inflation
and interest rates.
PART III. COUNTRY RISK ANALYSIS IN INTERNATIONAL
BANKING
1. Country Risk and the Terms of Trade
From a lender's perspective, what ultimately determines a nation’s ability to repay foreign loans is its
ability to generate U.S. dollars and other hard currencies. Because most foreign lenders
denominate loans in currencies like the dollar, euro, or yen, a country's ability to repay is based on its
terms of trade—the weighted average of its export prices relative to its import prices.
A key factor in assessing this risk is the speed of adjustment—how quickly a country can adjust its
standard of living to its new wealth position when its terms of trade decline. Governments often attempt
to avoid this necessary adjustment by fixing exchange rates or borrowing more, which can lead to
capital flight and further economic deterioration.
2. The Government’s Cost/Benefit Calculus
A government’s decision to stay current on its debt involves a cost/benefit analysis:
• Debt to Wealth Ratio: The cost of "austerity" (reducing consumption to pay debt) is
determined by external debt relative to wealth, measured by Gross Domestic Product (GDP).
The lower this ratio, the less consumption must be sacrificed to meet obligations.
• Cost of Default: This is the likelihood of being cut off from international credit. Most
nations view default as a last resort and may seek bailouts from the IMF or World Bank first.
• Fluctuations in the Terms of Trade: If a nation's terms of trade are highly volatile (often due
to limited diversification, like relying on one or two primary exports), the government is more
likely to be tempted to delay necessary economic adjustments, increasing the risk of default.
3. Lessons from the International Debt Crisis of 1982
The crisis began in August 1982 when Mexico announced it could not meet its scheduled payments,
followed by other major debtor nations like Brazil and Argentina. By late 1983, the crisis eased as
world economic activity picked up and countries began rescheduling loans and implementing reforms.
Economic Reforms That Work: Successful reforms in countries like Mexico and Chile showed that
effective programs typically meet five criteria:
• Strong head of state: A leader who demonstrates strong will and political leadership.
• Viable economic plan: A comprehensive plan implemented in the proper sequence.
• Competent economic team: A motivated team working in harmony.
• Support “at the top”: Strong belief in the plan from the head of state, the cabinet, and other
senior officials.
• Sell the program to all levels of society: An integrated program to communicate the plan to
the public through the media.
Ultimately, even with the best intentions, economic reform is painful, and these programs only succeed
if all levels of society are convinced that free-market policies will bring long-term growth.