Norbert Gaillard

Country
Risk
The Bane of Foreign Investors
Country Risk
Norbert Gaillard

Country Risk
The Bane of Foreign Investors
Norbert Gaillard
NG Consulting
Paris, France

ISBN 978-3-030-45787-7    ISBN 978-3-030-45788-4 (eBook)

[Link]

© Springer Nature Switzerland AG 2020

This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of
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To Milena
Acknowledgments

I am grateful to Juan Flores, Andy Hira, Edward Luttwak, and Roger Nye for their
comments. I thank Christopher Hajzler, Jonathan Rosborough, Jonathan Powell,
Clayton Thyne, and Credendo for sharing their databases.

vii
Abbreviations

AR Accuracy ratio
BA Business activity
BERI Business Environment Risk Intelligence
BIS Bank for International Settlements
BIT Bilateral investment treaty
CAP Cumulative accuracy profile
CFB Corporation of Foreign Bondholders
Comecon Council for Mutual Economic Assistance
CR Country risk
CRA Credit rating agency
CSP Center for Systemic Peace
DJIA Dow Jones Industrial Average
ECR Euromoney Country Risk
EEC European Economic Community
EFSF European Financial Stability Facility
EFW Economic Freedom of the World
EM-DAT Emergency Events Database
ERP European Recovery Program
ESM European Stability Mechanism
EU European Union
Exim Bank Export-Import Bank of the United States
FC Foreign currency
FCPA Foreign Corrupt Practices Act
FCSC Foreign Claims Settlement Commission
FDI Foreign direct investment
G7 Group of Seven
GATT General Agreement on Tariffs and Trade
GCI Global Competitiveness Index
GDP Gross domestic product
GNP Gross national product
HIPC Heavily indebted poor country

ix
x Abbreviations

IaDB Inter-American Development Bank

IBRD International Bank for Reconstruction and Development
ICC International Chamber of Commerce
ICJ International Court of Justice
ICRG International Country Risk Guide
ICSID International Centre for Settlement of Investment Disputes
ICT Information and communications technology
IEF Index of Economic Freedom
IFC International Finance Corporation
IIA International investment agreement
IIF Institute of International Finance
IMF International Monetary Fund
IPCC Intergovernmental Panel on Climate Change
ISI Import substitution industrialization
ITT International Telephone and Telegraph
LC Local currency
LDC Less developed country
MIGA Multilateral Investment Guarantee Agency
Moody’s Moody’s Investors Service
MNC Multinational corporation
NIC Newly industrialized country
NTB Non-tariff barrier
OCC Office of the Comptroller of the Currency
OECD Organisation for Economic Co-operation and Development
OPEC Organization of the Petroleum Exporting Countries
OPIC Overseas Private Investment Corporation
RTA Regional trade agreement
S&P Standard & Poor’s
SDR Special Drawing Right
SEC Securities and Exchange Commission
TIP Treaty with investment provisions
TNI Transnationality Index
UN United Nations
UNCTAD United Nations Conference on Trade and Development
USAID United States Agency for International Development
USSR Union of Soviet Socialist Republics
WEF World Economic Forum
WTO World Trade Organization
WWI World War I
WWII World War II
Contents

1 Introduction������������������������������������������������������������������������������������������������    1
1.1 Business Activities and Country Risk����������������������������������������������    2
1.2 Genealogy and Definitions of Country Risk ������������������������������������    3
1.2.1 Genealogy of Country Risk��������������������������������������������������    3
1.2.2 Notable Definitions of Country Risk������������������������������������    4
1.3 Outline of the Book��������������������������������������������������������������������������    6
References��������������������������������������������������������������������������������������������������    7

Part I Understanding Country Risk

2 Two Centuries of Country Risk, 1816–2016��������������������������������������������   11
2.1 Foreign Investment During the Pax Britannica��������������������������������   11
2.1.1 Overall Risks������������������������������������������������������������������������   12
2.1.2 International Business Environment for Exporters��������������   13
2.1.3 International Business Environment for Foreign Direct
and Equity Investors��������������������������������������������������������������   14
2.1.4 International Business Environment
for Foreign Creditors������������������������������������������������������������   15
2.2 Deglobalization and Threats to Foreign
Investment: 1914–1945��������������������������������������������������������������������   16
2.2.1 The World War I Shocks ������������������������������������������������������   16
2.2.2 Nationalism, Isolationism, and Lack of International
Cooperation��������������������������������������������������������������������������   18
2.2.3 The Slide Toward Protectionism������������������������������������������   19
2.2.4 The Increasing Vulnerability of Foreign-Owned
Property��������������������������������������������������������������������������������   20
2.2.5 Foreign Creditors in Turmoil������������������������������������������������   22
2.2.6 World War II ������������������������������������������������������������������������   23
2.3 International Business in a Bipolar World: 1945–1991��������������������   23
2.3.1 Reconstructing the World Economy ������������������������������������   23
2.3.2 The Geopolitical Context������������������������������������������������������   25

xi
xii Contents

2.3.3 A Precarious International Monetary System Based

on the US Dollar ������������������������������������������������������������������   30
2.3.4 Growth of International Trade and New Export Risks ��������   34
2.3.5 Foreign Direct Investment at Risk����������������������������������������   37
2.3.6 A Long Debt Cycle That Leads to a Major Financial
Crisis ������������������������������������������������������������������������������������   44
2.4 The Globalization Years, 1991–2016������������������������������������������������   53
2.4.1 A New Paradigm: Free-Market Capitalism��������������������������   53
2.4.2 Financial Globalization: Opportunities and Dangers������������   55
2.4.3 The Boom of the Chinese Economy ������������������������������������   60
2.4.4 A New Sovereign Debt Landscape ��������������������������������������   61
2.4.5 The New World Economy: Between Interdependence
and Competition��������������������������������������������������������������������   68
References��������������������������������������������������������������������������������������������������   75
3 Taxonomy of Country Risk ����������������������������������������������������������������������   89
3.1 International Political Risks��������������������������������������������������������������   90
3.1.1 Bilateral Relations Between the Host Country
and the Investor’s Country����������������������������������������������������   90
3.1.2 International Sanctions and Embargoes��������������������������������   91
3.1.3 International Tensions and Warfare��������������������������������������   93
3.2 Domestic Political and Institutional Risks����������������������������������������   95
3.2.1 Institutional and Political Instability������������������������������������   95
3.2.2 Domestic Violence and Warfare�������������������������������������������� 101
3.2.3 The Two Paradoxes of Political Risk������������������������������������ 103
3.3 Jurisdiction Risks������������������������������������������������������������������������������ 104
3.3.1 Expropriation������������������������������������������������������������������������ 104
3.3.2 Risks Related to Legal, Regulatory,
and Judicial Environment������������������������������������������������������ 107
3.3.3 Corruption Practices������������������������������������������������������������� 109
3.4 Macroeconomic Risks���������������������������������������������������������������������� 110
3.4.1 Foreign Currency and Monetary Issues�������������������������������� 111
3.4.2 Financial and Private Debt Issues ���������������������������������������� 112
3.4.3 Fiscal and Public Debt Issues ���������������������������������������������� 114
3.4.4 Trade Issues�������������������������������������������������������������������������� 116
3.5 Microeconomic Risks ���������������������������������������������������������������������� 118
3.5.1 Supply-Side Risks���������������������������������������������������������������� 118
3.5.2 Demand-Side Risks�������������������������������������������������������������� 121
3.6 Sanitary, Health, Industrial, and Environmental Risks �������������������� 122
3.6.1 Sanitary and Health Risks���������������������������������������������������� 122
3.6.2 Industrial Risk���������������������������������������������������������������������� 123
3.6.3 Environmental Risk�������������������������������������������������������������� 124
3.7 Natural and Climate Risks���������������������������������������������������������������� 124
3.7.1 Natural Risk�������������������������������������������������������������������������� 124
3.7.2 Climate Risk ������������������������������������������������������������������������ 125
Contents xiii

Appendix 1: International Political Risks Perceived

by DJIA Firms, 2016–2017������������������������������������������������������������   126
Appendix 2: Domestic Political Risks Perceived
by DJIA Firms, 2016–2017������������������������������������������������������������   127
Appendix 3: Jurisdiction Risks Perceived
by DJIA Firms, 2016–2017������������������������������������������������������������   128
Appendix 4: Macroeconomic Risks Perceived
by DJIA Firms, 2016–2017������������������������������������������������������������   129
Appendix 5: Microeconomic Risks Perceived
by DJIA Firms, 2016–2017������������������������������������������������������������   131
Appendix 6: Sanitary, Health, Industrial, Technological,
Environmental, Natural, and Climate Risks Perceived
by DJIA Firms, 2016–2017������������������������������������������������������������   132
References�������������������������������������������������������������������������������������������������� 133

Part II Sovereign and Country Risk Indicators

4 Sovereign Risk Indicators ������������������������������������������������������������������������ 143
4.1 Sovereign Rating Methodologies������������������������������������������������������ 143
4.1.1 Sovereign Ratings Issued by Moody’s
and Standard & Poor’s���������������������������������������������������������� 144
4.1.2 Institutional Investor Ratings������������������������������������������������ 149
4.1.3 Euromoney Country Risk Ratings���������������������������������������� 150
4.2 Performance of Sovereign Risk Indicators �������������������������������������� 153
4.2.1 The Debt Crisis of 1982��������������������������������������������������������  154
4.2.2 The Eurozone Crisis of 2009–2013��������������������������������������  160
4.2.3 The Sovereign Bond Years (1995–2013)������������������������������ 166
4.3 General Comments���������������������������������������������������������������������������� 174
4.3.1 Redrafting Sovereign Rating Methodologies������������������������ 174
4.3.2 Evolution of Sovereign Ratings during
the Globalization Era������������������������������������������������������������ 178
4.3.3 Ratings Convergence and Divergence���������������������������������� 180
Appendix: Ratings Assigned by Institutional Investor,
Euromoney Country Risk, Moody’s, and S&P
as of 1 September 2016������������������������������������������������������������������   183
References�������������������������������������������������������������������������������������������������� 188
5 Country Risk Indicators���������������������������������������������������������������������������� 191
5.1 Country Risk Rating Methodologies������������������������������������������������ 192
5.1.1 ICRG Methodology�������������������������������������������������������������� 192
5.1.2 Credendo’s Country Risk Methodologies���������������������������� 198
5.1.3 OECD’s Country Risk Classification������������������������������������ 199
5.1.4 The Heritage Foundation’s Index of Economic
Freedom�������������������������������������������������������������������������������� 200
xiv Contents

5.1.5 The Fraser Institute’s Economic Freedom

of the World Index���������������������������������������������������������������� 202
5.1.6 The World Economic Forum’s Growth Competitiveness
Index and Global Competitiveness Index ���������������������������� 206
5.2 Country Risk Shocks������������������������������������������������������������������������ 210
5.2.1 Methodology ������������������������������������������������������������������������ 210
5.2.2 Major Episodes of International Political Violence�������������� 211
5.2.3 Major Episodes of Domestic Political Violence ������������������ 212
5.2.4 Expropriation Acts���������������������������������������������������������������� 213
5.2.5 High-Inflation Peaks ������������������������������������������������������������ 214
5.2.6 Deep Economic Depressions������������������������������������������������ 215
5.2.7 Significant Restrictions on Capital Flows���������������������������� 216
5.2.8 Sovereign Debt Crises���������������������������������������������������������� 217
5.2.9 Exceptional Natural Disasters���������������������������������������������� 218
5.2.10 Comments on the Country Risk Crises Identified���������������� 218
5.3 Performance of Country Risk Indicators������������������������������������������ 219
5.3.1 Methodology ������������������������������������������������������������������������ 219
5.3.2 Performance of Euromoney’s Country Risk Ratings������������ 220
5.3.3 Performance of ICRG’s Country Risk Ratings�������������������� 223
5.3.4 Performance of Credendo’s Country Risk Ratings�������������� 225
5.3.5 Performance of OECD’s Country Risk Ratings������������������� 226
5.3.6 Performance of IEF’s Country Risk Ratings������������������������ 228
5.3.7 Performance of EFW’s Country Risk Ratings���������������������� 231
5.3.8 Performance of the Growth CI and the GCI ������������������������ 235
5.4 General Comments���������������������������������������������������������������������������� 236
5.4.1 Country Risk Indicators and Types of Risks������������������������ 237
5.4.2 Improving Country Risk Methodologies������������������������������ 239
5.4.3 Evolution of Country Risk Ratings During
the Globalization Era������������������������������������������������������������ 243
5.4.4 Ratings Correlations������������������������������������������������������������� 247
Appendix: List of the 272 “Country Risk Crises,” 1985–2014 ��������������   248
References�������������������������������������������������������������������������������������������������� 255
6 Concluding Remarks �������������������������������������������������������������������������������� 257
References�������������������������������������������������������������������������������������������������� 259
Chapter 1
Introduction

“Country risk” is a protean term that has long confused scholars. It is easy to grasp
but comprehending the concept’s multidimensional nature requires proficiency in a
wide array of fields—including (among others) economics, finance, and political
science.
With any attempt to define country risk, one problem that arises is that definitions
are contingent on the profiles of country risk experts. For a risk manager in an
exporting firm, country risk includes mainly protectionist threats but also political
and economic events that could reduce demand for the firm’s products and/or ser-
vices abroad. A foreign creditor is primarily concerned about the likelihood that
debtors will pay back the entire amount of cash borrowed, and with the interest due,
in a timely manner. A foreign direct investor fears expropriation risk and political,
social, economic, and tax shocks that could affect his business operations. In con-
trast, an external analyst (e.g., an economist working for a think tank that is not
involved in any form of investment abroad) may adopt a less parochial approach to
assessing country risk.
A second problem is related to the components of country risk. In particular, they
cover many academic fields and present dissimilar features. A component may con-
sist of a shock or a latent threat; may affect a firm in the very short term or in the
medium–long term; may result in various types of damages to investors (e.g., from
financial losses to reputational damage); and so forth.
A third problem involves country risk indicators. These have flourished since the
1980s, placing greater emphasis on particular aspects of country risk (e.g., political
risk, sovereign risk) or combining various components. Country risk experts and
raters have published their methodologies, reports, and ratings; however, investors
have no clear idea about the consistency or accuracy of these indicators.
This book is the first research work to address these three issues and thus to
deliver a novel analysis of country risk.1

1
When it is italicized, the term “country risk” designates the concept. Otherwise, it refers to the
threats to foreign investments.

© Springer Nature Switzerland AG 2020 1

N. Gaillard, Country Risk, [Link]
2 1 Introduction

The rest of the Introduction is organized as follows. Section 1.1 establishes a

typology of business activities that underpins a correct understanding of country
risk. Section 1.2 documents the genealogy of country risk and provides several
­definitions of this concept. Finally, Sect. 1.3 outlines the book’s structure.

1.1 Business Activities and Country Risk

Business activities mainly include trade and investment. Trade is the “action of
­buying and selling goods and services,”2 and investment can be defined as “the
action or process of investing money for profit.”3 The two basic types of investment
are lending and ownership investments.
At the international level, trade consists of importing and exporting goods and/or
services. Lending involves a bond purchase or loan agreement with a (public or
private) foreign borrower. Ownership investment includes equity and direct invest-
ments abroad. It is thus possible to classify business activities into six categories:
BA1–BA6. To each type of business activity, there corresponds a set of “country
risks” labeled CR1–CR6 (see Table 1.1).
The concept of risk refers to “a situation involving exposure to danger.”4 Note
that risk differs from uncertainty (see Knight 1921) because the former entails some
measurement of such exposure (i.e., it involves “risk assessment”).
In short: country risk is a set of measurable dangers (CR1–CR6) likely to affect
a business (BA1–BA6) abroad.5 That said, numerous definitions of country risk
have emerged since the 1960s.

Table 1.1 Investments and risks: Classification and codification

Business activities Business activities Country risk
classification codification codification Description of country risk
Export BA1 CR1 Risks faced by an exporter
Import BA2 CR2 Risks faced by an importer
Lending to a foreign BA3 CR3 Risks faced by a creditor to
sovereign borrower a foreign government
Lending to a foreign BA4 CR4 Risks faced by a creditor to
corporate borrower a foreign firm
Foreign equity BA5 CR5 Risks faced by a shareholder
investment of a foreign firm
Foreign direct BA6 CR6 Risks faced by a direct
investment investor in a foreign country
Source: Author’s classification and codification

2
See [Link]
3
See [Link]
4
See [Link]
5
The terms “businessman” and “investor” are used interchangeably in the rest of this book.
1.2 Genealogy and Definitions of Country Risk 3

1.2 Genealogy and Definitions of Country Risk

1.2.1 Genealogy of Country Risk

It is difficult to determine exactly when the concept of country risk was forged. The
expression was used as far back as 1967 by Frederick Dahl—then assistant director
of the Division of Examinations at the Board of Governors of the US Federal
Reserve System—in a research paper addressing the international operations of
American banks. Dahl (1967, p. 116) states that “an appraisal of the so-called
­country risk inherent in any foreign credit is the major distinction between domestic
and international lending. Besides assessing the creditworthiness of the individual
­borrower, the bank has to exercise a judgment on political, economic, and social
conditions in the country of the borrower as they are likely to affect foreign exchange
availabilities at the time of repayment of the loan.”
It was not until 1975–1977 that the notion of country risk began to permeate the
economic literature and media. What happened, exactly? Between 1970 and 1975,
the external public debt of low- and middle-income countries soared by 144%,
while the share of that debt financed by Western banks climbed from 7.5% to 25%.6
This growing exposure to sovereign debt began to worry the US Office of the
Comptroller of the Currency (OCC), which sought to ensure that long-term lending
was supported by adequate long-term deposits.7 By 1977, country risk had become
a buzzword among bankers and investors. In March of that year, Henry Wallich—a
member of the Board of Governors of the Federal Reserve System—used the term
in a statement before the Committee on Banking, Finance, and Urban Affairs of the
US House of Representatives (Wallich 1977). A few weeks later, in an interview
with the New York Times, Citibank vice-chairman G. A. Costanzo gave assurances
that only a minor part of the loans granted to less developed countries (LDCs)
“involved any significant ‘country risk’.”8 In its annual report released in June, the
Bank for International Settlements (BIS 1977) explained that “country risks [did]
add new dimensions to private banking in many ways”; this international institution
added that it was “necessary to appraise a country’s overall economic and political
development and to relate the data on the amount and the structure of its external
indebtedness to a number of macro-economic figures, such as current and prospec-
tive foreign exchange earnings.”
Starting in 1977, however, policy makers and academics offered different defini-
tions of country risk (e.g., Friedman 1977; see below). Confusion spread in the
following years and remains to this day. The main reason is that country risk experts
do not all monitor the same risks; instead, they focus on those risks that impinge on

6
Author calculations based on World Bank (1975, p. 91; 1983, p. 140).
7
Charles Stabler, “U.S. Banks’ Foreign Activities Will Face More Federal Control, Officials
Predict,” Wall Street Journal, 9 April 1975.
8
“Banker Sees No Danger of Default by Developing Nations on Loans,” New York Times, 7 April
1977.
4 1 Introduction

their own respective institutions or clients. In addition, the various focal risks do not
systematically match one or more of the six types of country risk (CR1–CR6) iden-
tified previously.

1.2.2 Notable Definitions of Country Risk

The first definition, in line with Dahl’s (1967) approach, includes all the risks that
are likely to disrupt lending activities abroad—namely, the risks experienced by
creditors of foreign sovereign and corporate borrowers (i.e., CR3 and CR4, respec-
tively). For Wallich (1977, p. 5), country risk can be divided into two categories: (1)
“balance-of-payments difficulties resulting from external or internal economic
causes that can lead to devaluation, foreign exchange controls, or some form of debt
rescheduling or even default” and (2) “risks arising from social or political upheav-
als.” In the same vein, the Federal Reserve Bank of New York (1978, p. 2) states that
country risk “encompasses the whole spectrum of risks that arise from the ­economic,
social, legal, and political conditions of a foreign country and that may have poten-
tial favorable or adverse consequences for loans to borrowers in that country.” This
definition was adopted by the General Accounting Office (1982, p. i) and Young
(1985, p. 32).
A second group of scholars has equated country risk with sovereign risk (CR3).
This proclivity—widespread in the midst of the LDC debt crisis during the 1980s—
is evident in Carvounis (1982, p. 17), Shapiro (1985, p. 881), Eaton et al. (1986,
p. 482), Cosset and Roy (1991, p. 135), Edwards (1997, p. 99), and Qian and Strahan
(2007, p. 2811). From a variant perspective, country risk “comprises the default risk
of sovereign external debt (sovereign risk), and of private external debt when the
credit risk is due to circumstances unrelated to the solvency or liquidity status of the
private debtor” (Iranzo 2008, p. 12); a typical instance is transfer risk, which occurs
when there is a lack of foreign currencies in which the external debt is contracted
(see Norel et al. 1988, pp. 857–858; Keizer 1993, p. 346).
A third set of researchers and practitioners promotes a broader definition of
country risk. F. T. Haner—a prominent consultant who worked on political and
country risk issues as early as the 1960s (see Sect. [Link])—establishes that “the
risks confronting business operations in a foreign country fall into four categories:
(1) those concerning the host government and its policies, programs, and practices;
(2) economic factors, such as real growth, inflation, unemployment levels, and
­similar criteria; (3) financing and other dealings in the local currency; and (4)
administrative and production factors, such as left-wing labor unions, corrupt
bureaucracies, and so on” (Haner and Ewing 1985, p. 7). Bouchet et al. (2003, p. 4)
provide an extensive definition of country risk, arguing that it includes “all the addi-
tional risks induced by doing business abroad, as opposed to domestic transactions.”
Meunier and Sollogoub 2005 (p. 7) view country risk as the myriad risks driven by
the ­vulnerability of business operations inherent to a specific macroeconomic,
­political, and financial environment.
1.2 Genealogy and Definitions of Country Risk 5

Two heterodox definitions deserve examination. Irving Friedman (1977,

p. 120)—then Senior Vice President and Senior Adviser for International Operations
at Citicorp—explains that country risk “comprises the whole spectrum of risk aris-
ing from the economic, social and political environments of a given foreign country
(including government policies framed in response to trends in these environments)
having potential favorable or adverse consequences for the profitability and/or
recovery of debt or equity investments made in that country.” The risks identified
here clearly correspond to those faced abroad by Citicorp as lender and equity
investor (i.e., CR3, CR4, and CR5).9
From a purely financial perspective, Campbell R. Harvey (1991, p. 111)—then
Professor of Finance at Duke University—defines country risk as “the conditional
sensitivity (or covariance) of the country return to a world stock return.” His
­idiosyncratic approach was followed by other articles (see Erb et al. 1995, 1996).
Export credit agencies developed a particular form of analysis through their coun-
try risk assessments, and their methodologies exhibit some dissimilarities. Coface’s
country risk assessment “measures the way in which company payment behavior is
influenced by a country’s economic, financial, and political perspectives, as well as by
the business climate” (Coface 2004, p. 9; 2018, p. 6). For Atradius (2011, p. 5), “coun-
try risk includes political risks and risks related to catastrophes. Political risks include
the risks of war, hostilities, civil war, revolution, insurrection and internal disturbances.
They also include the risks of a transaction being impeded by government regulations,
such as a general debt moratorium, transfer restrictions and blocking of payments.
Transfer difficulties and foreign exchange shortages are also included in this category.
Catastrophes include epidemics, nuclear disasters and natural disasters such as storms,
earthquakes and floods.” Euler Hermes examines economic imbalances, the quality of
the business climate, the likelihood of political hazards, short-term economic fore-
casts, and the “macroeconomic indicators that can signal imminent financial crisis as
a result of a disruption to financing flows.” 10 Instead of studying country risk at large,
Credendo focuses specifically on the risks experienced by exporters (political risk and
commercial risk) and direct investors (i.e., risks related to political violence, expro-
priation, inconvertible currencies, and transfer restrictions).11
My definition of country risk is consistent with those advanced by Haner and
Ewing (1985), Bouchet et al. (2003), and Meunier and Sollogoub (2005). I view coun-
try risk as including any macroeconomic, microeconomic, financial, social, political,
institutional, judiciary, climatic, technological, or sanitary risk that affects (or could
affect) an investor in a foreign country. Damages may materialize in ­several ways:
financial losses; threat to the safety of the investing company’s employees, clients, or
consumers; reputational damage; or loss of a market or supply source (see also Gaillard
2015, p. 165). This definition includes the six types of country risk (CR1–CR6).

9
See also Friedman (1983, p. 307).
10
See [Link]/economic-research/about-economic-research/Pages/methodologies.
aspx.
11
See [Link].
6 1 Introduction

1.3 Outline of the Book

My book is divided into two parts. Part I (Chaps. 2 and 3) offers a historical and
analytical study of country risk. Part II (Chaps. 4 and 5) explores sovereign and
country risk indicators.
Chapter 2 establishes that impediments to international business preceded any
mention of the country risk concept. I investigate how country risk has evolved and
manifested since the advent of the Pax Britannica in 1816. Four distinct periods are
examined: the era of Pax Britannica (1816–1914), the 1914–1945 period, the Cold
War (1945–1991), and the globalization years (1991–2016). For each period, I
describe the international political and economic environment and identify the main
obstacles to foreign investment.
Chapter 3 documents the numerous forms that country risk may take and ­provides
illustrations of them. Seven broad components of country risk are scrutinized in
turn: international political risks; domestic political and institutional risks; jurisdic-
tion risks; macroeconomic risks; microeconomic risks; sanitary, health, industrial,
and environmental risks; and natural and climate risks. This taxonomy includes
some risks that have materialized since 1945. I also discuss how the different coun-
try risk components are factored into the business strategies of the 30 companies on
which the Dow Jones Industrial Average (DJIA) index is based.
Chapter 4 focuses on what is known as “type-3 country risk” (CR3)—that is, sover-
eign risk. This emphasis is motivated by the high likelihood of sovereign risk, which is
often equated with country risk, exacerbating all the other risks that affect international
investors. I present the sovereign rating methodologies used by Moody’s, Standard &
Poor’s, Institutional Investor, and Euromoney. Next, I measure and compare these four
raters’ performance (i.e., their ability to forecast sovereign defaults). Finally, I identify
the strengths and weaknesses of these methodologies and make recommendations.
Chapter 5 studies the various indicators used to assess type-1, type-2, type-4,
type-5, and type-6 country risks (i.e., CR1, CR2, CR4, CR5, and CR6)—in other
words, the risks likely to affect (respectively) exporters, importers, foreign creditors
of corporate entities, foreign shareholders, and foreign direct investors. In doing so,
I present the country risk rating methodologies used by six major raters: International
Country Risk Guide, Credendo, the Organisation for Economic Co-operation and
Development, the Fraser Institute, the Heritage Foundation, and the World Economic
Forum. In parallel, I discuss eight types of shocks that reflect the main components
of country risk analyzed in Chap. 3. Each type of shock has occurred a number of
times since the early 1980s, resulting in country risk crises. Next, I measure the
track records of Euromoney and the six raters in terms of anticipating these crises.12
Finally, I deliver a critical view of these indicators.
In Chap. 6, I summarize the findings and explain why globalization is now at a
crossroads.

12
Euromoney ratings were initially sovereign risk ratings, but methodological amendments trans-
formed them into country risk ratings (see Sect. 4.1.3).
References 7

References

Atradius (2011). Export credit insurance on behalf of the Dutch Government, Amsterdam.
Bank for International Settlements (1977). Annual Report, Basle.
Bouchet, M. H., Clark, E., & Groslambert, B. (2003). Country risk assessment—A guide to global
investment strategy. Chichester: Wiley.
Carvounis, C. C. (1982). The LDC Debt problem: Trends in country risk analysis and rescheduling
exercises. Columbia Journal of World Business, 17(1).
Coface (2004). Guide Risque Pays 2004, Le Moci. Paris: Coface et Dunod.
Coface (2018). Coface handbook—Country & sector risks 2018.
Cosset, J.-C., & Roy, J. (1991). The determinants of country risk ratings. Journal of International
Business Studies, 22(1).
Dahl, F. R. (1967). International operations of U.S. banks: Growth and public policy implication.
Law and Contemporary Problems, 32(1).
Eaton, J., Gersovitz, M., & Stiglitz, J. (1986). The pure theory of country risk. European Economic
Review, 30(3).
Edwards, S. (1997). Latin America’s underperformance. Foreign Affairs, 76(2).
Erb, C. B., Harvey, C. R., & Viskanta, T. E. (1995). Country risk and global equity selection.
Journal of Portfolio Management, 21(2).
Erb, C. B., Harvey, C. R., & Viskanta, T. E. (1996). Political risk, economic risk, and financial risk.
Financial Analysts Journal, 52(6).
Federal Reserve Bank of New York (1978). A new supervisory approach to foreign lending.
FRBNY Quarterly Review, 3(1).
Friedman, I. S. (1977). Evaluation of risk in international lending: A lender’s perspective. Key
Issues in International Banking, Conference Series No. 18, Federal Reserve Bank of Boston.
Friedman, I. S. (1983). The World Debt Dilemma: Managing country risk. Philadelphia: Council
for International Banking Studies, Robert Morris Associates.
Gaillard, N. (2015). Le concept de risque pays. Politique Etrangère, 80(2).
General Accounting Office (1982). Bank examination for country risk and international lending,
GAO/ID-82-52, 2 September, Washington, DC.
Haner, F. T., & Ewing, J. S. (1985). Country risk assessment: Theory and worldwide practice.
New York: Praeger.
Harvey, C. R. (1991). The world price of covariance risk. Journal of Finance, 46(1).
Iranzo, S. (2008). Delving into country risk. Banco de España: Documentos Ocasionales. No. 0802.
Keizer, B. (1993). La gestion des risques dans les banques. Revue d’économie financière, No. 27.
Knight, F. H. (1921). Risk, uncertainty and profit. Boston and New York: Houghton Mifflin Company.
Meunier, N., & Sollogoub, T. (2005). Economie du risque pays, collection Repères. Paris: La
Découverte.
Norel, P., Quenan, C., & Sarry, M.-C. (1988). Stratégies bancaires et risque-pays. Economie
Appliquée, XLI(4).
Qian, J., & Strahan, P. E. (2007). How laws and institutions shape financial contracts: The case of
bank loans. Journal of Finance, 62(6).
Shapiro, A. C. (1985). Currency risk and country risk in international banking. Journal of Finance,
40(3).
Wallich, H. C. (1977). Statement Before the Subcommittee on Financial Institutions Supervision,
Regulation and Insurance of the Committee on Banking, Finance and Urban Affairs of the
U.S. House of Representatives, 23 March, Washington, DC.
World Bank (1975). Annual report. Washington, DC.
World Bank (1983). Annual report. Washington, DC.
Young, J. E. (1985). Supervision of bank foreign lending. Economic Review, Federal Reserve Bank
of Kansas City, 70(5).
 Part I
Understanding Country Risk
Chapter 2
Two Centuries of Country Risk, 1816–2016

This chapter investigates the international business environment as well as the most
salient threats to foreign investment since 1816. I examine four distinct periods: the
era of Pax Britannica (1816–1914) in Sect. 2.1; the years 1914–1945 in Sect. 2.2;
the Cold War (1945–1991) in Sect. 2.3; and the globalization years (since 1991) in
Sect. 2.4. A greater emphasis is placed on the postwar decades.

2.1 Foreign Investment During the Pax Britannica

The Napoleonic regime’s collapse opened an era of relative political stability and eco-
nomic growth that lasted until World War I (WWI). Between 1820 and 1913, world
GDP growth increased by 1.5% annually—five times the rate during 1500–1820.1
This period of economic growth was inextricably connected to the emergence of
a new geopolitical paradigm under which European and North American powers
elaborated strategies to strengthen their status, in the eyes of the world, as major
international investors (Lipson 1985, pp. 9–12). As Miles (2013, p. 23) states, these
strategies included “the securing of ‘friendship, commerce and navigation’ treaties,
[and] the acquiring of concessions, diplomatic pressure, capitulation treaties, extra-
territorial jurisdiction, military intervention, and colonial annexation of territory.
Significantly, this process of Western commercial and political expansionism was
facilitated by international law.”
Although Western business interests were generally promoted and protected by
their respective governments, business people faced various challenges when
investing abroad. I start by examining the challenges that affected all types of
investors; then I turn to the risks that specifically affected merchants, direct and
equity investors, and lenders.

1
Author calculations based on Angus Maddison’s historical statistics, available at [Link]/
maddison/historical_statistics/horizontal-file_02-[Link].

© Springer Nature Switzerland AG 2020 11

N. Gaillard, Country Risk, [Link]
12 2 Two Centuries of Country Risk, 1816–2016

2.1.1 Overall Risks

Contrary to common belief, the Pax Britannica era was punctuated by many interstate
wars.2 Several of them disturbed the activities of foreign enterprises. An instructive
case is that of the Ottoman Empire during the second half of the nineteenth century.
The Crimean War (1853–1856) dramatically increased the Empire’s borrowing needs;
the response of Sultan Abdülmecid I was to initiate the printing and circulating of
paper money, which aggravated inflation (Pamuk 2004, p. 25). After two wars against
Montenegro during 1858–1862, Ottoman finances continued to deteriorate. Several
loans were arranged in London but in 1875 the Turkish government had to declare a
moratorium on its outstanding debt (Pamuk 1984, p. 113). The decade that followed
was, in terms of financial viability, a lost cause for the Ottoman Empire as well as for
all types of foreign investors there.
During 1879–1887, Ottoman imports declined 0.8% yearly, as compared with
the 5.5% annual growth in the decade preceding the Crimean War (Pamuk 1984,
p. 109). Moreover, the annual flows of net foreign direct investment (FDI) to the
Ottoman Empire tumbled during 1876–1887, accounting for only a third of the
annual inflows recorded during the two previous decades (Pamuk 1984, p. 113).
Following the Muharrem Decree of December 1881, European creditors “accepted”
a 45% haircut on the Ottoman bonds issued between 1858 and 1874.3
Civil wars were the second type of impediment to all types of businesses abroad.
Consider, for instance, the period of civil unrest that hit Venezuela during 1898–1899
(Dixon and Sarkees 2015, pp. 187–188). Caracas stopped repaying its foreign debt
as early as 1898 (Corporation of Foreign Bondholders 1903, p. 419) and subse-
quently expropriated the properties of several American and European investors
(Maurer 2013, pp. 80–85; Miles 2013, p. 67).4 In addition, Venezuelan imports fell
by 19% in 1898 and by 16% in 1899 and 1900.5
Third, economic backwardness also hindered international business. In the
nineteenth century, Spain suffered from both a structural fiscal deficit (Carreras
and Tafunell 2005, p. 951) and a lack of industrialization (Simpson 1997). These
two persistent weaknesses resulted in massive defaults on its sovereign debt
(Suter 1989, p. 27) and led the country to expropriate holdings of the few foreign
investors that had ventured there (Keefer 1996, pp. 171–173). After gold convert-
ibility was suspended in 1883, the Spanish economy became even more isolated
(Martín-Aceña et al. 2012, p. 146).
Economic and financial contagion was yet another overall threat to foreign
investments. Two aspects of contagion in particular are noteworthy. The first is the

2
A total of 74 interstate conflicts can be identified based on Goldstein (1992). The period under
consideration is 1816–1913.
3
Author calculations based on Agoston and Masters (2009, p. 182).
4
The terms expropriation, nationalization, takeover, and forced divestment are used interchange-
ably in the rest of this book.
5
Author calculations based on Department of Commerce and Labor (1905, p. 625).
2.1 Foreign Investment During the Pax Britannica 13

spread of risk aversion from one asset class to another. Starting in 1889, when
Argentina proved unable to exploit its accumulated capital inflows, British banks
stopped lending to Buenos Aires. Finding itself short of foreign currencies, the
Argentinean government defaulted in 1890; GDP then fell dramatically and imports
plummeted by 53% within a year.6 By 1891, the crisis also affected direct invest-
ments to Argentina (Ford 1956). The second aspect of contagion is its geographical
dimension. Argentina’s turmoil drove up the bond yields of other Latin American
economies (Mitchener and Weidenmier 2008) and was the catalyst for Uruguay’s
debt restructuring in 1891 (Corporation of Foreign Bondholders 1903, p. 395).

2.1.2 International Business Environment for Exporters

During the period 1820–1830, Great Britain was by far the world’s leading industrial
economy (Bairoch 1982). As a result, the British Empire needed to stimulate inter-
national trade in order to export its manufactured goods and consolidate its hege-
mony. Such “stimulation” took various forms that ranged from diplomatic discussions
to military threats (O’Brien and Pigman 1992). One of the most commonly used
coercive tools for converting foreign countries to free trade was the signing of
“unequal treaties,” which prevented peripheral states (e.g., China, the Ottoman
Empire, Siam, and countries in Latin America) from adopting high tariffs (Bairoch
1999, pp. 64–65). Other European powers followed suit, leading to the “first era of
trade globalization” by the turn of the twentieth century (Estevadeordal et al. 2003).
However, exporters still had to overcome high tariffs in some other parts of the
world. For instance, the United States retained protectionist trade policies through-
out the nineteenth century, and both Japan and Russia significantly increased their
tariffs in the decades preceding WWI (Bairoch 1999, pp. 44, 63). The most protec-
tionist policies were implemented in Latin America: during 1865–1913, the abso-
lute gap between Latin American and world average tariffs was about 25 percentage
points (Coatsworth and Williamson 2004, p. 211).7
The other major hurdles in importing countries were nationalism (Wilkins 1970,
pp. 101–103), subsidization of domestic industries, and foreign exchange risk
(Kirchner 1981, pp. 273–274).8

6
Here the values compared are those for 1891 and 1890; author calculations based on Ford (1956,
p. 149).
7
A fundamental reason is that customs duties were relatively easy to levy in countries where tax
collection was inefficient and that were waging interstate and/or civil wars (Coatsworth and
Williamson 2004, p. 216).
8
Foreign exchange risk was a serious threat to investors engaged in trade with peripheral econo-
mies. Bear in mind that, during 1880–1913, peripheral countries were either intermittent in their
adherence to the gold standard or opted for floating–exchange rate regimes. In contrast, core econ-
omies never wavered from the gold standard (Flandreau and Zumer 2004, p. 129).
14 2 Two Centuries of Country Risk, 1816–2016

2.1.3 I nternational Business Environment for Foreign Direct

and Equity Investors

There were many drivers of foreign direct and equity investment. The most basic
ones involved firms (e.g., mining and plantation companies) seeking to exploit
resources that were unavailable in their home country. Other drivers were the needs
to circumvent high tariffs, to avoid damage when shipping perishable products, to
counter nationalistic biases, to lower production costs, to obtain better access to
local markets, and to learn more about competitors (Phelps 1936, pp. 43–89; Wilkins
1970, pp. 52–79; Godley 1999).
Foreign-owned property enjoyed a high level of protection during the Pax
Britannica. Such safety was consistent with the imperialistic strategies followed by
European powers. Thus, as these powers took possession of various countries and
territories and transformed them into colonies or protectorates, it remained abun-
dantly clear that no violation of the property rights of their nationals abroad would
be tolerated.
International investment law was shaped by capital-exporting nations, especially
Great Britain, for the express purpose of promoting the interests of their respective
domestic businesses (Lipson 1985, pp. 37–40). This legal structure relied on two
key principles: the “extraterritoriality” rule for foreign investors (Miles 2013,
p. 27),9 and the obligation of governments to pay prompt, adequate, and effective
compensation after expropriating an alien’s property (Herz 1941). If the host coun-
try failed to do so, European powers were likely to employ coercion or “gunboat
diplomacy” (Lipson 1985, pp. 14–15).
Until 1914, this framework of international law helped limit the number of
confiscations. Most expropriating governments were either Latin American (e.g.,
Brazil, Paraguay, and Venezuela) or peripheral European states (e.g., Greece,
Portugal, and Spain). In some cases, foreign investors managed to obtain compen-
sation promptly or through international arbitration. In other cases, they con-
vinced their respective government to deploy military force (Macchione Saes
2013, p. 248; Miles 2013, pp. 52–69). However, the main sources of concern
among foreign direct and equity investors during the nineteenth century were
actually the lack of information about the host country as well as political insta-
bility and inadequate commercial law (Phelps 1936, pp. 90–126).

9
Under “extraterritoriality,” foreign property rights were guaranteed by the extraterritorial applica-
tion of European and US laws.
2.1 Foreign Investment During the Pax Britannica 15

2.1.4 I nternational Business Environment for Foreign

Creditors

The main reason why investors lent to foreign entities was that they expected higher
returns than were available in their home country. Even the latter part of the finan-
cial globalization era witnessed significant return spreads between peripheral and
core countries. An examination of sovereign risk premia reveals that the average
spread between Argentina, Brazil, Greece, Portugal, and Spain, on the one hand,
and Belgium, France, Germany, the Netherlands, and the United Kingdom, on the
other hand, reached 226, 594, and 106 basis points in (respectively) 1883, 1898,
and 1913.10
Consider, as another example, the investment strategy of a famous British fund
of that time: the Foreign and Colonial Investment Trust (FCIT). In their study of the
period 1880–1912, Chambers and Esteves (2014) find that the FCIT delivered aver-
age real returns in excess of 5% (vs. 2.2% offered by the risk-free British consols).
This profitability mainly reflected the Trust’s extensive purchases of North and
South American railroad bonds, thus demonstrating the attractiveness of certain for-
eign corporate securities.
Contrary to other types of investments, foreign lending was often discouraged by
the governments of capital-exporting nations because such lending tended to
increase domestic interest rates while underwriting foreign competitors at the
expense of domestic industries (Hobson 1914, pp. xiii–xix). That is one reason why,
in the event of default, the holders of foreign bonds could expect little help from
their own government. In this respect, Lord Palmerston’s circular published in 1848
is telling. Though it asserted the right to use force when seeking to recover foreign
government debts, Great Britain was more inclined to adopt a policy of noninter-
vention because (i) lenders were aware that the chance to earn higher returns
required that they assume more risk and (ii) British authorities preferred to avoid
disputes with foreign states regarding matters on which they had not been consulted
(Cairncross 1935, pp. 67–68).
Such reluctance was justified also in light of the frequency and magnitude of
nineteenth-century debt crises. During the 1830s and in the second half of the 1870s,
no fewer than 15 sovereign borrowers were in default (Suter 1989, p. 26).11 Some
countries (e.g., Argentina, Ecuador, El Salvador, Greece, Guatemala, Honduras,
Liberia, Peru, and Spain) remained insolvent for several consecutive decades, while
others (e.g., Brazil, Colombia, Costa Rica, the Dominican Republic, Mexico,
Nicaragua, Portugal, and Venezuela) can fairly be described as “serial defaulters.”12
The riskiness of foreign government debt led to the creation of bondholders’
associations in creditor countries—for instance, the 1868 establishment in London

10
Author calculations based on Flandreau and Zumer (2004, p. 125). These results are consistent
with Lehfeldt’s (1913) analysis.
11
The defaults could take various forms; for details, see Gaillard (2014b, pp. 3–12).
12
Author classifications based on Suter (1990, p. 283).
16 2 Two Centuries of Country Risk, 1816–2016

of the Corporation of Foreign Bondholders (CFB). These institutions were designed

to inform private bondholders and to coordinate their actions in cases of default
(Winkler 1933, pp. 153–157).

2.2  eglobalization and Threats to Foreign Investment:

D
1914–1945

Factors that had ensured the prosperity of foreign investors during the Pax
Britannica—namely, international investment law, unequal trade treaties, gunboat
diplomacy, and the relative cooperation among Great Powers on international mon-
etary and financial issues—faded with the outbreak of World War I.

2.2.1 The World War I Shocks

[Link] The Legal Shock

So that they could strike at their enemies (and, to a lesser extent, wage war), European
belligerent countries broke the long-standing tradition of respect for foreign inves-
tors’ rights that they had defended so ferociously during the previous century.
In the first weeks of WWI, Austria-Hungary, France, Germany, Great Britain,
and Russia enacted legislation that not only prohibited trade with the enemy but also
confiscated—and, in some cases, liquidated—the businesses owned by enemy
aliens located on their territory (Caglioti 2014).13 In doing so, combatant nations
violated the principle of “immunity of private enemy property” established by the
Hague Conventions of 1899 and 1907. Retaliatory measures also affected the hold-
ers of some bonds. In December 1914, Austria-Hungary announced that its 4.5%
Treasury notes would be redeemable only when accompanied by an affidavit stating
that they were not the property of an alien whose country was at war with Vienna
and Budapest (Moody’s Investors Service 1918, p. 909).
The violation of foreign investors’ rights by capital-exporting powers was a land-
mark in the history of international business because it led to the establishment of a
legal basis for debt repudiation and expropriation. With regard to the former,
Alexander Sack (1927) forged the doctrine of “odious debt” whereby a government
could repudiate its public debt under certain conditions. With regard to the latter,
Article 297 of the Treaty of Versailles (1919)14 paved the way for the large-scale

13
In the United States, the so-called Alien Property Custodian confiscated German and Austrian
properties during 1917–1918 (Potterf 1927, pp. 460–469).
14
Article 297 stipulates that “the Allied and Associated Powers reserve the right to retain and liq-
uidate all property, rights and interests belonging at the date of the coming into force of the present
Treaty to German nationals, or companies controlled by them, within their territories, colonies,
possessions and protectorates, including territories ceded to them by the present Treaty.”
2.2 Deglobalization and Threats to Foreign Investment: 1914–1945 17

expropriations that occurred during the following decades (for a discussion, see
Sects. 2.2.4 and 2.3.5 as well as Borchard 1946b).

[Link] The Economic Shock

The economic consequences of World War I were unprecedented. First, waging war
obliged the belligerent countries to siphon domestic savings through war loans and
tax increases and also to abandon gold convertibility.15 This development ushered in
the breakdown of the gold standard, a monetary system that until then had eased
capital flows worldwide. The depreciation of major currencies (e.g., the French
franc and the German mark), when combined with the inflationary pressures due
mainly to the circulation of paper money, prevented restoration of the gold standard
at the end of hostilities.
Second, international trade declined dramatically—although this contraction pri-
marily affected the Continent. Between 1913 and 1918, European exports declined
by 69% even as non-European exports increased by 27%.16 With its share of world
exports falling from 56% in 1913 to 24% in 1918,17 Europe lost its previously unas-
sailable leadership in trade.
Finally, the massive public debts accumulated by European economies weak-
ened their credit position.18 One group of combatants, including France and the
United Kingdom, remained solvent but endured skyrocketing ratios of public debt
to GDP.19 Another group, which included Austria-Hungary and Germany, managed
to repay their debt but experienced episodes of high inflation (if not hyperinflation)
after 1918. A third set of nations consists of those that defaulted during the war;
among these were Bulgaria, the Ottoman Empire, and Russia (Suter 1990, p. 283).
The foreign holders of bonds issued by governments in this last category suffered
major losses. The ruin of French savers who had purchased Russian bonds is a noto-
rious illustration (Oosterlinck 2016).

15
The United Kingdom was an exception; it was formally committed to the gold standard until
March 1919 (Bordo 2005, p. 211).
16
Author calculations based on Federico and Tena-Junguito’s (2016) database, available at https://
[Link]/bitstream/handle/10016/22230/wp1601_data.xlsx. Export values are in 1913
constant prices.
17
Idem.
18
Moody’s Investors Service, “The Credit of Foreign Governments,” Moody’s Investment Letter,
3 April 1919.
19
See Reinhart and Rogoff ’s (2011) database (available at [Link]/data/browse-
by-topic/topics/9).
18 2 Two Centuries of Country Risk, 1816–2016

2.2.2  ationalism, Isolationism, and Lack of International

N
Cooperation

The business climate’s deterioration during the interwar years was driven mainly by
the lack of cooperation among major capitalist nations, especially the victors in
WWI. By failing to build an enduring international monetary and financial architec-
ture, these countries—France, the United Kingdom, and the United States (the new
leader in exporting capital)—impeded the activities of investors abroad.

[Link] A Short-Lived Monetary System

The Genoa Conference of 1922 resulted in a partial return to the gold standard.
Governments willing to adopt this monetary system could achieve that end in one of
two ways: by implementing a deflationary policy and setting a high exchange rate;
or by devaluating and then stabilizing their currency. In order to maintain London’s
role as a major international financial center, Great Britain imposed austerity mea-
sures and passed the Gold Standard Act in 1925.20 In contrast, France struggled
against speculation until 1926 and was then forced to devaluate its currency
(Einzig 1935).
Notwithstanding these governmental efforts, lenders considered the new gold
standard system to be less credible than its pre-1914 predecessor; hence lenders,
when assessing a government’s credit position, were mainly concerned with its
terms of trade and public debt (Obstfeld and Taylor 2003).21 As the Genoa system’s
sustainability came into question, threats soon materialized. Once the French franc
was officially stabilized in 1928, the Bank of France reduced its reserves of British
pounds and accumulated gold (Accominotti 2009, p. 354). The US Federal Reserve
followed suit until mid-1931 (Board of Governors of the Federal Reserve System
1943, p. 537). These gold-hoarding policies increased the pound’s vulnerability, and
its overvaluation became obvious. In September 1931, the MacDonald government
bowed to the inevitable and left the gold standard. The Genoa system’s disintegra-
tion accelerated in the following years. President Roosevelt abandoned convertibil-
ity of the US dollar in 1933 and refused to coordinate with other governments
(Einzig 1935); these actions dealt the death blow to international monetary coopera-
tion. Thereafter, the world was fragmented into monetary zones and blocks (Feiertag
and Plessis 2000).

20
This decision favored British bankers, as well as direct and equity investors abroad, at the
expense of exporters.
21
The criteria for such risk assessment contrasted with those that prevailed before 1914, when
adherence to the gold standard was viewed as a signal of financial robustness (Bordo and Rockoff
1996).
2.2 Deglobalization and Threats to Foreign Investment: 1914–1945 19

[Link] The Rise and Fall of the League of Nations

The League of Nations fared no better than the Genoa monetary system. As estab-
lished by Part I of the Treaty of Versailles (1919), the League’s primary mission was
to maintain world peace. Yet it also aimed, through its Economic and Financial
Organization (EFO), to promote economic cooperation (Clavin 2013, pp. 11–46).
The EFO enabled the recovery of many countries—especially in Central and Eastern
Europe—and helped them access capital markets. During 1923–1928, for example,
the organization arranged international loans for Austria, Bulgaria, Danzig, Estonia,
Greece, and Hungary (Flores Zendejas and Decorzant 2016). These loans, which
were typically secured by domestic taxes and duties, contributed to restoring the
credit position of economies in financial distress during the early 1920s.
Following the outbreak of another world crisis in 1930, investors tended to grant
the League loans a de facto senior status—most likely because they hoped the orga-
nization would act as the “lender of last resort” in cases of default.22 Yet because the
League was not backed by major capital-exporting nations, it was in no position to
bail out distressed economies. This loss of the EFO’s credibility foreshadowed the
League’s failure to preserve peace in the second half of the 1930s.
The collapse of both the Genoa monetary system and the League of Nations in
the 1930s were natural outcomes of increased nationalism and isolationism. This
fraught landscape was anything but conducive to international business. Furthermore,
there were other factors that handicapped foreign investors during the inter-
war period.

2.2.3 The Slide Toward Protectionism

In 1918, world trade (imports plus exports) amounted to only 68% of its 1913
level.23 In order to stimulate their exports, some governments took unprecedented
measures. For example, Great Britain passed the Overseas Trade (Credits and
Insurance) Act and the Trade Facilities Act in 1920 and 1921, respectively. The
purpose of this legislation was to authorize the undertaking of insurance and the
granting of credits to domestic exporters; another aim was to guarantee foreign
loans whose proceeds would be used to purchase British goods (James 1926).
Such interference in the economic life of corporations, which disadvantaged
non-British exporting firms, was emulated in other countries and led to the creation
of export credit agencies (Hanna 1931; Dietrich 1935; Bonin 2002) and export–
import banks (see Patterson 1943 on establishment of the US Exim Bank).

22
For a given sovereign bond issuer, this preferred creditor status was mirrored in the lower yields
observed for its League loans as compared with other bonds (Flores Zendejas 2017).
23
Author calculations based on Federico and Tena-Junguito’s (2016) database, available at https://
[Link]/bitstream/handle/10016/22230/wp1601_data.xlsx.
20 2 Two Centuries of Country Risk, 1816–2016

The emergence of these novel institutions was indicative of the difficulties experi-
enced by exporting companies at the time.
Trade barriers were actually erected as early as the 1920s, when Central and
Eastern European countries increased tariffs and implemented import quotas and
export licensing requirements (Liepmann 1938). Soviet Russia shifted to an autar-
kic economic model (Hough 1986, p. 495). More importantly, the Fordney–
McCumber tariff of 1922—enacted in response to the 1919–1920 American farming
crisis—increased duties on foreign agricultural products and commodities
(Berglund 1923).
The Smoot–Hawley Act of 1930 triggered an ultimately fatal vicious cycle:
protectionism fed the abandonment of the gold standard, competitive devalua-
tions, and exchange controls, which in turn prompted even higher tariffs
(Eichengreen and Irwin 1995). Great Britain passed its Import Duties Act in
1932; this legislation introduced a general tariff of 10% on most imports, albeit
with some exemptions for products from members of the British Empire. Under
these isolationist conditions, where trade blocs constantly vied with one another,
exporters were forced either to skirt or to comply with a host of antibusiness
policies: import quotas, a greater number of regulations and formalities, and the
need to bargain bilaterally on matters of compensation, clearing, and payments
agreements (for an exhaustive analysis, see Condliffe 1940, pp. 178–294).

2.2.4 The Increasing Vulnerability of Foreign-Owned Property

The development of trade barriers convinced multinational corporations (MNCs) to

open even more subsidiaries abroad (Jones 2005, p. 84). This largely explains why
FDI increased 81% during 1914–1938 while world trade was increasing by only
39%.24 The establishment and acquisition of plants in foreign countries had far-
reaching consequences for manufacturers, enabling them to boost their market
shares (e.g., General Motors in Europe; see Foreman-Peck 1982), diversify their
production in a context of capital controls (e.g., Unilever in Germany; see Wilson
1954), imitate local firms (Wilkins 1974), and export from their foreign units (e.g.,
GM’s Opel subsidiary in Germany; see General Motors Corporation 1937, p. 17).
However, these nascent strengths were offset by three major risks: adverse eco-
nomic conditions, political instability, and large-scale expropriations.
The Great Depression was certainly the most serious macroeconomic
impediment to international business during the interwar years. The GDP
growth of the top 15 recipient countries of US direct investment in 1929 fell

24
Author calculations based on Jones (2005, p. 82) and on Federico and Tena-Junguito’s (2016)
database, available at [Link]
2.2 Deglobalization and Threats to Foreign Investment: 1914–1945 21

by 15% (on average) during 1929–1932,25 reflecting the collapse of consump-

tion. Price volatility was another challenge: after inflationary pressures in the
early 1920s, most host countries struggled with deflation in the first half of the
1930s and with inflation shortly before World War II.
Political risk also shaped the interwar period. Among the 15-country sample,
only Australia, Canada, France, and the United Kingdom managed to avoid being
hit by a coup, a revolution, or an interstate war or being run by a dictator during
1919–1938.26 Businessmen who followed the financial and economic press during
1936–1937 could reasonably predict that the increased nationalism and expendi-
tures for rearmament would eventually plunge Europe into another major conflict.27
A more diffuse aspect of political risk stemmed from the sentiment among local
population and politicians that foreign firms perpetuated colonialism and extracted
undue profits (Coudert and Lans 1946). Such frustration was likely to engender
xenophobic regulations and legislation—as observed in the early 1930s regulation
of Argentina’s meatpacking industry (Phelps 1936, pp. 166–193)—or, more radi-
cally, large-scale expropriations.
The most striking nationalization episode followed the Soviet Revolution of
1917, when the communists seized all property belonging not only to foreigners
(mainly British, French, and German firms) but also to its own citizens and busi-
nesses (Root 1968, p. 70). Other significant expropriations occurred in Bolivia and
Mexico in 1937 and 1938, respectively. These latter nationalizations affected
American and British oil companies: Jersey Standard, Consolidated Oil Corporation,
and Royal Dutch Shell.28
It is worth noting that the Bolivian and Mexican expropriations did not trigger
military intervention or even strong diplomatic pressures. The passivity of British
authorities reflected that country’s political and economic decline, while the “good
neighbor” diplomacy embraced by President Roosevelt was used to justify the non-
interventionist US posture (Gellman 1979, pp. 49–53).
This geopolitical retreat contributed to a deteriorating international business
climate at a time when the legal position of foreign direct investors (and especially
American ones) was weakening. Perhaps the best illustration of this trend is the
Convention on the Rights and Duties of States, which was signed at Montevideo
in 1933 and consecrated the “equality of treatment” rule at the expense of the
“extraterritoriality” rule (for a discussion, see Borchard 1940).29

25
Author calculations based on Zettler and Cutler (1952, p. 8) and on Angus Maddison’s historical
statistics, available at [Link]/maddison/historical_statistics/horizontal-file_02-[Link].
This 15-country sample consists of Argentina, Australia, Brazil, Canada, Chile, China, Colombia,
Cuba, France, Germany, Italy, Mexico, Peru, the United Kingdom, and Venezuela.
26
Author classification based on [Link].
27
See “Economic Consequences of Rearmament,” Barron’s, 25 May 1936; Standard Statistics,
“Foreign Trade Outlook Despite War Dangers,” Standard Trade and Securities, 1 January 1937.
28
For an exhaustive analysis, see Maurer (2013, pp. 260–278).
29
Article 9 of the Convention states that “nationals and foreigners are under the same protection of
the law and the national authorities and the foreigners may not claim rights other or more extensive
than those of the nationals.”
22 2 Two Centuries of Country Risk, 1816–2016

2.2.5 Foreign Creditors in Turmoil

The countries involved in WWI saw their public debt increase dramatically. Two of
them went bankrupt, imposing heavy losses on their foreign creditors. The Ottoman
Empire, dismantled by the Treaty of Sèvres (1920) and the Treaty of Lausanne
(1923), did not resume payment on its external debt until 1928 (Wynne 1951,
pp. 485–510). Soviet Russia repudiated its debt in 1918 and remained insolvent
until the end of the twentieth century (Oosterlinck 2016). Despite these setbacks,
three factors contributed to reduce sovereign risk in the 1920s: the international
recovery, the positive role played by the League of Nations (see Sect. [Link]), and
a new debt cycle that enabled local and central governments to borrow abroad—
especially on the New York Stock Exchange.
During 1915–1917, J. P. Morgan had lent extensively to support British and
French governments (Moody’s Investors Service 1918, pp. 924, 981; 1920,
pp. 1241–1242, 1312–1313). Once the war ended, American bankers continued to
profit from the enhanced creditor position of the United States and from the US dol-
lar’s strength. From 1919 to 1929, the average annual amount of foreign govern-
ment bonds and foreign corporate bonds issued in the United States reached
(respectively) $700 million and $300 million, compared with $37 million and $8
million in 1914.30
However, American creditors failed to perceive the deterioration in the quality of
these foreign bonds, especially sovereign bonds (Mintz 1951, pp. 29–43). In the
second half of the 1920s, smaller and less prestigious banks began to underwrite
foreign government securities whose ratings were increasingly low (Flandreau et al.
2009). The US economic downturn and the Smoot–Hawley Act of 1930 depressed
commodities prices, which shook Latin American economies. Most of them
defaulted during 1931–1933 (Gaillard 2011, pp. 191–192).
The spread of protectionism and the establishment of capital controls worldwide
exacerbated the international debt crisis. The fraction of foreign government bonds
that Moody’s rated as “speculative” soared from 21% in 1931 to 64% in 1938
(Gaillard 2011, pp. 40–41). On the eve of World War II, one-fourth of all countries
were in default on their external debt—a proportion that rose to one-third in 1942
(Gaillard 2011, p. 7).
The losses incurred by American foreign bondholders in the 1930s and 1940s
turned out to be abnormally high. Several reasons can be identified. First, American
investors—unlike their British counterparts, who could rely on the CFB—were not
well organized. And even after the US Foreign Bondholders Protective Council
was created in 1933, it was too intransigent to reach any debt restructurings with
defaulting governments (Adamson 2002). Second, some Latin American debtors
anticipated that they would not face sanctions; hence they shunned debt negotia-
tions and launched buyback programs at discounted prices (Jorgensen and Sachs
1989, pp. 65–68). Third, the outbreak of WWII further postponed resumption of

30
Author calculations based on Young (1930, pp. 12–13).
2.3 International Business in a Bipolar World: 1945–1991 23

debt payments, especially in Central and Eastern Europe (Suter 1990, p. 283). The
confluence of these factors led to realized internal rates of return being persistently
lower than the contractual rates for all foreign government bonds, excepting French
ones, denominated in US dollars (Eichengreen and Portes 1989, pp. 32–34).

2.2.6 World War II

World War II was the inevitable outcome of a decade of nationalism and

isolationism. On narrow economic grounds, the costs of trade destruction
during WWI and WWII were comparable (Glick and Taylor 2010), but the
collapse of GDP and consumption was much more pronounced during the
latter conflict (Barro and Ursúa 2008, pp. 271–274). 31 When GDP growth
finally rose (e.g., in Great Britain and the United States), it did so mainly
because of the boom in military expenditures. At the same time, the wide-
spread confiscation of enemy private property further undermined the sanc-
tity of foreign private property (Borchard 1946b). Moreover, the Soviet
Union’s ascension to “great power” status jeopardized the future of liberal-
ism and capitalism.

2.3 International Business in a Bipolar World: 1945–1991

2.3.1 Reconstructing the World Economy

Reconstruction of the world economy took several years and was largely shaped by
the United States. Four steps can be identified: establishing a durable peace, laying
the foundation of a new monetary system, stimulating international trade, and accel-
erating the economic recovery of Western Europe.

[Link] The United Nations

In the spring of 1945, representatives of 50 countries met in San Francisco at the

United Nations Conference on International Organization to draw up the United
Nations (UN) Charter. The UN officially came into existence in October 1945 upon
ratification of its Charter by China, France, the Soviet Union, the United Kingdom,
the United States, and other signatories.
The UN’s purposes, as presented in Article 1 of the Charter, are: (i) “to maintain
international peace and security,” especially through “collective measures for the

31
The exceptions were Latin American economies, which actually prospered during WWII.
24 2 Two Centuries of Country Risk, 1816–2016

prevention and removal of threats to the peace, and for the suppression of acts of
aggression or other breaches of the peace”; (ii) “to develop friendly relations among
nations based on respect for the principle of equal rights and self-determination of
peoples”; (iii) “to achieve international co-operation in solving international prob-
lems of an economic, social, cultural, or humanitarian character, and in promoting
and encouraging respect for human rights and for fundamental freedoms for all”;
and (iv) “to be a centre for harmonizing the actions of nations in the attainment of
these common ends.”32
Under Article 24 of the Charter, the Security Council—which consisted of ten
nonpermanent and five permanent members (China, France, the Soviet Union, the
United Kingdom, and the United States)—has primary responsibility for maintain-
ing international peace and security. In effect, the preservation of peace devolved to
the two superpowers (i.e., the Soviet Union and the United States) and depended on
their averting a war between each other.

[Link] The Bretton Woods Monetary System

Following the Bretton Woods Conference of July 1944, the United States and its
allies established the International Bank for Reconstruction and Development
(IBRD) and the International Monetary Fund (IMF). These two institutions began
their operations in 1946 (see IBRD 1946; IMF 1946).33
The IBRD’s mission was to assist in reconstructing and developing the territories
of its members and to promote international investment by guaranteeing or partici-
pating in loans and acquisitions made by private investors (IBRD 1946, pp. 4–5).
The IMF was responsible for maintaining the new international monetary system
(IMF 1946, pp. 9–16). The guiding philosophy of this system involved fixing a for-
eign par value for a currency by using gold—or a currency tied to gold—and then
keeping the exchange rate within 1% of its par value. Toward that end, exchange
rates remained adjustable in the medium term (with IMF assistance, as need be) and
the Fund facilitated loans to countries experiencing temporary balance-of-payments
deficits (for an overview, see McKinnon 1993, pp. 11–15).

[Link] The General Agreement on Tariffs and Trade

The Havana Charter of March 1948 established a multilateral trade agreement

known as the General Agreement on Tariffs and Trade (GATT).34 This agreement’s
objective was to fight protectionism by promoting “most favored nation” treatment,
dismantling trade barriers and discriminatory practices, limiting export subsidies,

32
[Link]/en/sections/un-charter/chapter-i/[Link].
33
The IBRD is commonly referred to as the World Bank.
34
[Link]
2.3 International Business in a Bipolar World: 1945–1991 25

and allowing countries to levy duties to counteract dumping. The GATT did include
some exceptions to free-trade principles, however. For instance, quantitative restric-
tions were authorized for addressing balance-of-payments issues and for other spe-
cific purposes. Note that the GATT’s signatories were required to cooperate with the
IMF (for an exhaustive analysis of this agreement, see Hexner 1950–1951).

[Link] The European Recovery Program of 1948

The Cold War and the perceived risk that communist parties might come to power
in France and Italy induced the United States to provide massive economic assis-
tance to European nations. This goal was formalized in April 1948 by the European
Recovery Program (ERP), more widely known as the “Marshall Plan” after its chief
proponent, George C. Marshall.35
The objectives of the ERP were (i) to promote “industrial and agricultural pro-
duction in the participating countries,” (ii) to further “the restoration or maintenance
of the soundness of European currencies, budgets, and finances,” and (iii) to facili-
tate and stimulate “the growth of international trade of participating countries with
one another and with other countries by appropriate measures including reduction
of barriers which may hamper such trade” (Title I, Sec. 102(b)).
The 16 Marshall Plan countries were Austria, Belgium, Denmark, France, Great
Britain, Greece, Iceland, Ireland, Italy, Luxembourg, the Netherlands, Norway,
Portugal, Sweden, Switzerland, and Turkey. A total of $27 billion was authorized
for the four-year period 1948–1952. The aid consisted of grants and loans, and the
US Exim Bank served as the official lending agency.36 Thanks in no small part to
this assistance, Western European economies were in a position to thrive again by
the early 1950s.

2.3.2 The Geopolitical Context

During the Cold War, several geopolitical factors affected the development of inter-
national investments. I focus here on four major factors: the Soviet bloc, the US
financial assistance policy aimed at containing communism, the decolonization pro-
cess, and the new role played by oil-exporting countries.

35
[Link]
36
[Link]
the-european-recovery-program.
26 2 Two Centuries of Country Risk, 1816–2016

[Link] The Communist Bloc

In 1949, the communist bloc led by the Soviet Union (and including Albania,
Bulgaria, Czechoslovakia, East Germany, Hungary, Mongolia, the People’s
Republic of China, Poland, Romania, and Yugoslavia) comprised more than 800
million inhabitants, accounting for a third of the world’s population.37 Some Western
experts doubted that planned economies would adopt multilateral free trade and
free-enterprise principles or would become significant business partners (Condliffe
1947, pp. 33–42). The bloc’s 1949 creation of the Council for Mutual Economic
Assistance (Comecon), a response to the Marshall Plan, seemed to support
this view.38
Yet those doubts proved not to be well founded. In the 1960s, annual growth in
exports of the developed economies to Comecon members exceeded that of intra-
Comecon trade (Familton 1970, p. 31). An explanation for this trend was that com-
mercial exchanges between the two spheres evidenced a certain complementarity:
the West exported manufactured products while importing fuels, raw materials, and
food. Furthermore, the 1970s context of “peaceful coexistence” led to the West’s
increased participation in—and financing of—Russian and Eastern European indus-
trial projects (Zwass 1976, p. 5). As might be expected, credit risk materialized
shortly thereafter: in 1981, both Poland and Romania defaulted on their foreign
currency (FC) bank loans.39 The perestroika reforms implemented by Russian
President Mikhail Gorbachev in the second half of the 1980s allowed for the devel-
opment of Western direct investment in Czechoslovakia, Hungary, and Poland
through the creation of joint ventures (Michalak 1993). This shift presaged the col-
lapse of planned economies and their conversion to capitalism.
In sum, it was reasonable in 1950 for Western investors to view communist
countries as lost markets. Yet through succeeding decades, European and American
businesses became increasingly involved in Comecon economies and coped with
much the same risks as those present in free-market economies.40

37
Author calculations based on Angus Maddison’s historical statistics, available at [Link]/
maddison/historical_statistics/horizontal-file_02-[Link].
38
The founding members of the Comecon were Bulgaria, Czechoslovakia, Hungary, Poland,
Romania, and the Soviet Union. In the following months, Albania and East Germany joined the
organization.
39
See Beers and de Leon-Manlagnit’s (2019) database.
40
Even so, the Coordinating Committee for Multilateral Export Controls (CoCom)—established
shortly after WWII by the United States and its allies—restricted technological transfers to the
East. See Mastanduno (1992) for an exhaustive study of the CoCom.
2.3 International Business in a Bipolar World: 1945–1991 27

[Link]  oreign Loans and Grants as the Continuation of Politics by

F
Other Means

One of the chief objectives of US diplomacy was to contain both communism and
the variety of threats to international investments around the world. Three years
after passage of the Marshall Plan, the Mutual Security Act of 1951 extended US
assistance abroad—especially toward developing countries. The US foreign aid
program was reorganized by the Foreign Assistance Act of 1961; this legislation set
up the United States Agency for International Development (USAID), which is still
active today.41
Not surprisingly, the economic assistance provided by the United States during
1946–1991 was directed mainly to allies and strategic countries. Consider the top
ten recipient nations, which received 52% of all funds.42 Two of them (South Korea
and the Philippines) had each signed a mutual defense treaty with Washington in the
early 1950s. Three others (Germany, Turkey, and the United Kingdom) were mem-
bers of the North Atlantic Treaty Organization, and one (Pakistan) was part of other
US-led collective defense treaties. The US financial support of the four remaining
states (Egypt, India, Israel, and Vietnam) was driven by their geopolitical signifi-
cance (for a concise analysis of the Egyptian-Israeli Peace Treaty’s economic impli-
cations, see Korn 1979; for the US administration’s role in helping India become
self-sufficient with respect to food production, see Goldsmith 1988).43
The US Exim Bank’s policy was consistent with USAID programs in the sense
that loans were granted to friendly or strategic nations (Feinberg 1982, pp. 59–68).
In September 1978, ten countries account for 58% of the Bank’s exposure: Algeria,
Brazil, Iran, Japan, Mexico, the Philippines, South Korea, Spain, Taiwan, and
Yugoslavia (Exim Bank 1979, pp. 12–15). However, the pro-Western alignment of
the Exim Bank’s debtors hardly guaranteed that they were risk free. During
1980–1984, five nations (Brazil, Iran, Mexico, the Philippines, and Yugoslavia)
defaulted on their FC sovereign debt.44 In addition, Iran and Mexico expropriated
assets of foreign investors (Kobrin 1984, p. 346; Minor 1994, p. 181). The Exim
Bank was itself severely affected by the economic crisis that hit these LDCs (General
Accounting Office 1982b).
In total, US overseas economic assistance during 1946–1991 exceeded $250
billion.45 The Exim Bank lent some $76 billion, and the amounts covered by its
guarantee and insurance operations reached $137 billion.46 Although these capital

41
See [Link] for more information.
42
Author calculations based on USAID data (available at [Link]).
43
The bulk of the US assistance to Vietnam was remitted before the country’s pro-American
regime’s fall in 1975. Egypt and Israel obtained 95% of their funds after 1970. Author calculations
based on USAID data (available at [Link]).
44
See Beers and de Leon-Manlagnit’s (2019) database.
45
Author’s calculations based on USAID data, available at [Link].
46
Author’s calculations based on Becker and McClenahan Jr. (2003, pp. 306–314).
28 2 Two Centuries of Country Risk, 1816–2016

flows fell short of their objectives in some cases (most spectacularly, Iran and
Vietnam), they stimulated world demand and foreign investment.

[Link] The Decolonization Process

Former British dependencies were decolonized over a period of five decades. In

contrast, France and Belgium lost most of their colonies during (respectively)
1945–1962 and 1960–1962. Portugal did not grant independence to Angola, Cape
Verde, Guinea Bissau, Mozambique, or São Tomé and Príncipe until 1974–1975.47
By the mid-1970s, more than half of the UN’s members were countries that had
gained their independence in the preceding 35 years.48
This new international landscape engendered diverging analyses. An illustrative
case is that of African nations in the early 1960s.49 On the one hand, US diplomat
Kenneth T. Young Jr. (1961) believed that those countries were driven by national-
istic forces and would remain aloof from the West and the East alike. And according
to journalist Walter Kolarz (1962), African nationalism had “entered into a working
agreement with Marxism” that would inevitably scare off foreign investors. On the
other hand, in a propitious report on investment laws and regulations, the UN
Economic Commission for Africa (1963) documented that two thirds of African
countries had an integrated law or code on investments, and it pointed out that sev-
eral of them (e.g., Ghana, Guinea, Libya, Nigeria, and Sudan) had passed laws
protecting foreign private property and guaranteeing fair compensation in case of
expropriation. Thus the UN report suggested that business opportunities did, in fact,
exist in Africa.
A brief look at the investment policy (i.e., with regard to loans and equity) that
was followed by the International Finance Corporation (IFC)50 clarifies the business
climate in countries that gained independence after 1939. Those countries accounted
for 25–39% of IFC commitments in 1964, 1969, 1974, 1979, and 1984.51 More
importantly, the return on assets posted by the IFC ranged from 1.7% to 2.4%—
which compares favorably with the 0.4–0.6% range earned by Wells Fargo, a San
Francisco–based bank whose activities were based essentially within the United
States.52 Although it is impossible to assess the precise contribution made to IFC
income by investments in young nations, the high level of observed profitability
strongly suggests that those countries offered fruitful business opportunities.

47
[Link]
48
Author calculations based on [Link].
49
In the history of decolonization, 1960 was a milestone because 17 African nations became inde-
pendent in that year ([Link]).
50
The IFC is a member of the World Bank Group.
51
Author calculations based on IFC (various reports).
52
Author calculations based on IFC (various reports) and on Wells Fargo & Company (various
reports).
2.3 International Business in a Bipolar World: 1945–1991 29

[Link] The New Role of Oil-Exporting Countries

The Organization of the Petroleum Exporting Countries (OPEC) was established in

1960 by Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. Its objective was to “co-
ordinate and unify petroleum policies among Member Countries, in order to secure
fair and stable prices for petroleum producers.”53 The baseline price of crude oil was
maintained below $3 (US) per barrel until the 1973 Arab–Israeli War. In October of
that year, OPEC unilaterally raised the per-barrel price of crude oil from $3 to $5.10;
a second increase, to $11.65/barrel, was announced in December 1973.
This near quadrupling of the oil price within three months had wide-ranging and
drastic effects. In the short term, it led to a recession and double-digit inflation in
most Western industrialized economies and to a contraction of world trade volume
in 1975 (IMF 1977). In the medium–long term, the consequences were far more
complex.
The total current account surplus earned by oil exporters during 1974–1981
exceeded $400 billion.54 A large portion of these “petrodollars” was invested through
major Western commercial banks, which lent funds to oil-importing LDCs (for a
banker’s perspective on this phenomenon, see Safer 1978). Yet the loans neither
enabled those countries to offset their growing current account deficits, which came
to more than $420 billion during 1974–1981,55 nor prevented their terms of trade
from deteriorating. Instead, the credit position of Third World countries weakened,
especially after oil prices shot upward and the Federal Reserve decided to raise its
federal funds rate in 1979. It is therefore not surprising that most developing coun-
tries defaulted on their external debt in the first half of the 1980s (see Sect. 2.3.6).
It is important to highlight the paradoxical and pernicious scope of OPEC’s
policy. The oil price increases during October–December 1973 occurred amid a
growing debate about the “new international economic order” (for an overview, see
White 1975). The UN resolution adopted on this matter in May 1974 insisted, inter
alia, on the “right of every country to adopt the economic and social system that it
deems the most appropriate for its own development” and on the “full permanent
sovereignty of every State over its natural resources and all economic activities”
(United Nations General Assembly 1974). In 1973, LDCs could certainly argue
that the OPEC’s pricing move opened the way to “full permanent sovereignty” and
that they had no choice but to follow suit. As it turned out, those expectations faded
and these countries broadened their economic and financial dependence.
The two oil shocks also eroded the competitiveness of many manufacturing firms
in most Western capitalist economies as well as in the planned economies of Eastern
Europe. Protectionist measures, subsidies, and bailouts all failed to curb the dein-
dustrialization process that accelerated unemployment. In the West, welfare capital-

53
See [Link] During 1961–1991, OPEC expanded
to include Algeria, Ecuador, Gabon, Indonesia, Libya, Nigeria, Qatar, and the United Arab
Emirates.
54
Author calculations based on IMF (1978, p. 18; 1984, p. 23).
55
Idem.
30 2 Two Centuries of Country Risk, 1816–2016

ism’s crisis in the late 1970s and early 1980s prompted a shift from the Keynesian
to the “neoliberal” paradigm (for an archetypal criticism of Keynesian policies, see
Buchanan and Wagner 1977). In the East, planning inefficiencies led the Soviet bloc
to collapse.

2.3.3  Precarious International Monetary System Based

A
on the US Dollar

The Bretton Woods system relied fundamentally on the US dollar. Yet even after this
monetary system collapsed in 1973, the US currency continued to play a key role in
international economic and financial relations.

[Link] 1946–1959: The Dollar “as Good as Gold”

In the late 1940s, the US dollar was the only major currency offering gold con-
vertibility. The currencies of most countries could not be converted into gold, into
dollars, or even into other currencies. As a result, non-US economies had to
obtain US dollars in order to pay for their imports. Doing so required that they
obtain financial assistance from Washington and/or increasing their volume of
exports.
In 1949, the currency devaluation of several major European countries—includ-
ing France, (West) Germany, and Great Britain—boosted their exports, brought
back US dollars, and provided some basis for progress toward the goal of convert-
ibility (IMF 1950, p. 28). After a prolonged series of efforts—which included import
restrictions, disinflationary policies, and even additional devaluations (especially in
France)—14 Western European countries established convertibility for their curren-
cies in January 1959 (IMF 1959, p. 125).56 This decisive step made possible a revival
of capital movements among industrial economies, although imbalances in pay-
ments appeared soon thereafter.

[Link] 1959–1967: An Unstable System

The frailty of the Bretton Woods system was presciently described by Robert Triffin
as early as 1959 (see Triffin 1978). He forecast that the United States would eventu-
ally face an unresolvable dilemma. On the one hand, if Washington managed to
balance its payments then the US dollar would continue to be the world’s preferred
reserve currency but would be not be able to support the expansion of international

56
The parties to this agreement were Austria, Belgium, Denmark, Finland, France, (West) Germany,
Ireland, Italy, Luxembourg, the Netherlands, Norway, Portugal, Sweden, and the United Kingdom.
2.3 International Business in a Bipolar World: 1945–1991 31

trade and financial flows. On the other hand, increasing balance-of-payments defi-
cits would keep the world economy liquid but would undermine the dollar’s credi-
bility and thus end its gold convertibility.
Deterioration in the US balance-of-payments deficit was accelerated mainly by
three factors. First, exports from Japan and the European Economic Community57
grew more rapidly than did US exports during the 1960s (IMF 1971, p. 51).
Second, the Vietnam War (see Dudley and Passell 1968) and the increase in US
direct investments abroad substantially increased capital outflows. The latter point
merits closer examination. Cutler (1971) estimates that US direct investment out-
flows between 1950 and 1966 rose by a factor of 7. He also finds that more than half
of the flows for 1966 went to foreign affiliates established or acquired during
1963–1966, which suggests that direct investments were not only expanding but
also intensifying. The implication of this pattern was that the US balance-of-pay-
ments deficit was likely to increase even more significantly in the following years.
Third, policies implemented by President Kennedy and President Johnson, which
aimed to preserve the US monetary position, were counterproductive. For instance,
the interest equalization tax, established in 1963 to discourage long-term US lend-
ing to foreign entities, resulted in non-US borrowers raising funds in Europe and not
in the United States (IMF 1964, pp. 94–95). Also, the mandatory direct investment
program of 1968, which imposed a partial moratorium on US direct investment and
the repatriation of some earnings and financial assets held abroad (IMF 1968, p. 58),
ended up convincing US businesses to give their foreign subsidiaries more
responsibilities.
In fact, these capital control measures encouraged offshore markets to use
eurodollars,58 which attracted both bankers and multinational firms. The former
could obtain higher returns than in the United States, while the latter could circum-
vent restraints on international capital movements. At the macroeconomic level, the
growth of euromarkets increased the US balance-of-payments deficit.

[Link] 1967–1973: The Agony of Bretton Woods

Both the US payments imbalances and the November 1967 devaluation of the
British pound were accompanied by a strong demand for gold. In March 1968, the
governors of the central banks of Belgium, Germany, Italy, the Netherlands,
Switzerland, the United Kingdom, and the United States announced that gold would
henceforth be used only to effect transfers among monetary authorities (IMF 1968,

57
The European Economic Community (EEC) was established in 1957 and included Belgium,
France, (West) Germany, Italy, Luxembourg, and the Netherlands. In the 1970s and 1980s, the
EEC expanded to include Denmark, Greece, Ireland, Portugal, Spain, and the United Kingdom.
58
The Bank for International Settlements (BIS 1964, p. 127) defines a eurodollar as “a dollar that
has been acquired by a bank outside the United States and used directly or after conversion into
another currency for lending to a non-bank customer.” Eurodollars are traded on offshore markets
(initially in London) known as euromarkets.
32 2 Two Centuries of Country Risk, 1816–2016

p. 87). The IMF’s creation of Special Drawing Rights (SDRs) was intended to pro-
vide a supplementary international reserve asset.59
The 1969 devaluation of the French franc and revaluation of the German mark,
combined with the increasing mobility and volatility of capital flows and the sharp
deterioration in the US balance of payments, were clear indicators that the monetary
system could no longer be sustained (see IMF 1970, 1971). When the dollar’s gold
convertibility ended and the dollar was devalued in 1971, the collapse of the Bretton
Woods system was complete.60 Hence one can view “the floating–exchange rate
era” as beginning in February 1973, when the US dollar was devalued with no mar-
gins for fluctuation (IMF 1973, pp. 5–6).

[Link] 1973–1991: The Era of Floating Exchange Rates

The Jamaica Accords of January 1976 sanctioned the shift to a regime of flexible
exchange rates. At this time, the IMF’s Articles of Agreement were amended as fol-
lows. First, members agreed to collaborate with the Fund and with other members
in order to assure exchange arrangements and to promote a stable system of
exchange rates. Second, gold’s function as the SDR’s unit of value was eliminated—
as was its role as the common denominator of currency par values. Third, the SDR
replaced gold as a means of payment by the Fund. Fourth, the Fund’s financial
operations and transactions were simplified and expanded (IMF 1976, pp. 43–46).
This new era was characterized by large swings in exchange rates. The extensive
use of eurodollars, which accounted for more than 25% of official foreign exchange
reserves between 1974 and 1977,61 and the increasing US trade deficit resulted in
the dollar depreciating against the currency of major exporters: the US dollar
declined 32% and 16.5% against the German mark and the Japanese yen, respec-
tively, between 1973 and 1980.62 This trend reversed at the turn of the 1980s, when
demand for US dollars was boosted by a surge in US interest rates in 1979 and the
Third World debt crisis starting in 1982. Between 1980 and 1985, the US currency
appreciated by 62% against the German mark and by more than 100% against the
French franc and the Italian lira.63 Following the Plaza Accord of 1985, the dollar
depreciated again until 1987. During 1987–1991, exchange rates among the curren-
cies of major industrialized countries generally stabilized (IMF 1986, 1991).

59
The SDR was initially defined as the equivalent of 0.888671 g of fine gold. Following the Bretton
Woods system’s collapse, the SDR was redefined as a basket of currencies (see [Link]
org/en/About/Factsheets/Sheets/2016/08/01/14/51/Special-Drawing-Right-SDR).
60
After stabilizing at more than $20 billion in the 1950s, US gold reserves declined from $19.5
billion in 1959 to less than $11 billion in March 1971 (IMF 1960, p. 60; 1971, p. 28).
61
Author calculations based on IMF (1979, p. 59).
62
Author calculations based on the Pacific Exchange Rate Service (available at [Link]
[Link]).
63
Idem.
2.3 International Business in a Bipolar World: 1945–1991 33

The volatility of exchange rates within the EEC declined notably over this period.
In 1979, the countries of Belgium, Denmark, France, (West) Germany, Ireland,
Italy, Luxembourg, and the Netherlands established the European Monetary System
(EMS). These countries then maintained maximum margins of 2.25% (6% for the
Italian lira) on exchange rates for transactions involving their currencies. Their cen-
tral banks cooperated closely in order to ensure the EMS’s stability, and they orga-
nized devaluations and revaluations when a significant inflation gap and/or current
account imbalance became evident.64
The collapse of the Bretton Woods system complicated international business.
Consider the case of US investors conducting business with a country whose cur-
rency was floating. Exporters could take advantage of the dollar’s relative weakness
until 1979–1980, but they were adversely affected when the dollar subsequently
appreciated.65 Investors eager to acquire assets abroad were in the opposite position.
Lenders faced a dilemma. Although they needed a strong dollar to preserve the
long-term credibility of their activities, the credit position of their foreign debtors
was undermined by excessive appreciation of the US currency.66
Relatively high risks were encountered also by US investors exporting goods,
services, or capital to any country that “pegged” its currency’s exchange value at a
fixed rate. The main reason is that some currency pegs were not sustainable. When
such economies experienced a balance-of-payments deficit, they were prone to
speculative attacks that could force devaluation (for a seminal theoretical analysis,
see Krugman 1979).67 Irrespective of such external threats, a government might be
tempted to devalue simply to increase the competitiveness of its exporting firms. In
their study of exchange rate pegs in 17 Latin American economies during the post–
Bretton Woods era, Klein and Marion (1994) found that devaluation was more likely
following appreciation in the real exchange rate, increased trade concentration, and/
or reduced openness of trade.
This unstable international monetary system spurred academic research on for-
eign exchange risk and the tools to manage it (Shapiro and Rutenberg 1976; Giddy
1977; Soenen 1979). In particular, meticulous investigations of hedging techniques
reflected the growing importance of accounting and financial strategies among mul-
tinational companies.

64
In the 1980s, the currencies of France, Italy, and Ireland were frequently devalued and those of
Germany and the Netherlands were often revalued (IMF, various years).
65
Between June 1975 and June 1980, the US dollar depreciated against two-fifths of the currencies
that were floating at the start of this period. Between June 1980 and June 1985, however, the US
dollar appreciated substantially against almost all floating currencies. Author calculations based on
IMF (1975, pp. 68–70; 1980, pp. 106–109; 1985, pp. 92–95).
66
This risk was concomitant with the sovereign debt crisis of 1982; see Sect. 2.3.6.
67
See Kaminsky et al. (1997) for a review of the literature on currency crises.
34 2 Two Centuries of Country Risk, 1816–2016

2.3.4 Growth of International Trade and New Export Risks

[Link] The Role of the GATT and Its Limits

During 1947–1991, world exports increased (on average) by more than 6% annual-
ly.68 This expansion of international trade was spurred by the GATT and was
achieved through a series of multilateral negotiations known as “trade rounds.”
Until the early 1960s, these GATT rounds concentrated mainly on reducing tariffs.
The so-called Kennedy Round (1964–1967) led to an average tariff cut of 35% on
industrial products and included an antidumping code (Miles 1968). The Tokyo
Round (1973–1979) brought the average tariff on industrial products down to 4.7%.
Several agreements and arrangements were reached to fight non-tariff barriers
(NTBs), but not all GATT members subscribed to these agreements.69 The Uruguay
Round (1986–1994) covered even more aspects of international trade—including,
among others, services and intellectual property—and tackled most of the impedi-
ments to such trade (e.g., domestic subsidies, safeguard measures, etc.).70
Although the GATT managed to reduce tariffs dramatically in the postwar
decades, it was unable to curb the rise of NTBs. Hiscox and Kastner (2002,
pp. 33–35) use “gravity” model–based estimates of trade policy orientations, includ-
ing all forms of trade restrictions, to show that all developed nations (excepting
Portugal, Spain, and Switzerland) were more protectionist in 1990 than in 1960. By
the same token, more than half (58%) of the top three economies in each of four
areas—Africa, East Asia, Latin America, and the Middle East—had a less liberal
trade policy in 1990.71
It is not surprising that the resurgence of protectionism in the 1970s led to more
trade disputes. For example, the number of disputes settled within the GATT system
rose from 28 during 1948–1969 to 72 during 1970–1991.72 The fierce criticisms
lodged against this system in the latter period (for discussions, see Hudec 1980;
Davey 1987) mirrored the frustration and persistent difficulties experienced by
exporters.
The financial support of export–import banks and the insurance contracts pro-
vided by export credit agencies against an increasing array of risks73—from basic

68
Author calculations based on IMF (various reports).
69
[Link]
70
The number of countries participating in GATT rounds increased from 23 for the first round (in
1947) to 123 for the Uruguay Round ([Link]
fact4_e.htm).
71
Author classification based on Hiscox and Kastner (2002) and on Angus Maddison’s historical
statistics, available at [Link]/maddison/historical_statistics/horizontal-file_02-[Link].
The selection criterion for these estimates is GDP in 1960. The 12 countries included in the sample
are Egypt, Nigeria, and South Africa; China, India, and Indonesia; Argentina, Brazil, and Mexico;
and Iran, Iraq, and Turkey.
72
Author calculations based on [Link]
73
See Sect. [Link] for analysis of the enhanced role of export credit agencies since the 1960s.
2.3 International Business in a Bipolar World: 1945–1991 35

commercial risk in the 1950s to political risk in the 1960s and exchange rate risk in
the 1970s (Greene 1965; Archives de l’Etat en Belgique 2008)—were helpful in this
challenging trade environment. However, they were not enough to render it gener-
ally profitable.

[Link] New Export Risks in LDCs

In the postwar years, several influential ideologies drove some LDCs to follow pro-
tectionist policies. These policies had the effect of impeding export activities.
The autarkic policy followed by Maoist China left very few opportunities for
Western businesses until economic reforms were instituted in 1978. Until then, only
exporters from Australia, Canada, Japan, New Zealand, and communist countries
had trade relationships with Beijing (Perkins 1971–1972). After stagnating in the
1960s and growing considerably in the 1970s, the volume of Chinese trade increased
by a factor of 6 during 1978–1990 (Park 1993, p. 52).74 Yet despite the open-door
policy promoted by Deng Xiaoping, China remained among the most closed econo-
mies in the world in 1990 (Hiscox and Kastner 2002, p. 33).
One of the most pervasive risks faced by exporters was the implementation of
“import substitution industrialization” (ISI) policies,75 which were widespread
among Latin American economies (Baer 1972). A striking illustration is the auto-
mobile industry’s development in the 1960s (Munk 1969). European, Japanese, and
US automakers had difficulties exporting to Latin America, yet setting up branches
there would enable them to take advantage of the subsidies and tax rebates offered
by host governments. However, the shift to direct investment created several prob-
lems. On the one hand, it induced additional risks—for example, the possibility of
expropriation. On the other hand, it undermined profitability because the cost of
producing cars locally turned out to be higher than simply exporting them (Munk
1969, pp. 91–94).
However, ISI could succeed provided it involved the production of nondurable
consumer goods and was complemented by export-promotion policies, such as
those adopted in Hong Kong, Singapore, South Korea, and Taiwan (Balassa 1971,
1978).76 These countries managed to reduce their dependence on imports and to
stimulate the development of a domestic industry through “backward integration.”
Their firms reached economies of scale and expanded production capacity to enable
the export of manufactured goods with increasing value added. This economic

74
The integration of China into world trade and business is analyzed in Sect. 2.4.3.
75
The advocates of ISI strategies assumed that the income elasticity of demand for imports of
LDCs’ nonindustrial products by developed countries was lower than the income elasticity of
demand for imports of industrial products. If so, then ISI could probably correct the disparity in
income elasticities (Prebisch 1959)—an outcome that supported the establishment of tariffs and
quotas as well as the subsidizing of domestic producers or foreign direct investors. The ISI policies
were also intended to preserve foreign exchange.
76
These economies were commonly referred to as newly industrialized countries (NICs).
36 2 Two Centuries of Country Risk, 1816–2016

model posed two threats to Western exporters: In the short term, it reduced the
demand for some of their goods, and in the longer term, it led to the emergence of
new competitors (e.g., the Korean chaebols).
Another manifestation of country risk in LDCs stemmed, somewhat paradoxi-
cally, from the growing importance of export credit schemes. In this respect, the US
Exim Bank played a leading role until the 1970s. The huge amounts lent to foreign
entities for the purpose of buying US products distorted competition and handi-
capped non-US exporters. In particular, it was difficult for European manufacturers
to sell their airplanes and tractors in the countries where Boeing and Caterpillar—
two firms that benefited mightily from US Exim Bank credits—exported under the
aegis of that Washington-based institution.

[Link] New Export Risks in Developed Countries

Starting in the 1970s, the growing competition of Japan’s and NICs’ exporters com-
bined with the oil shock to slow down economic growth in North America and
Western Europe. A typical response of old capitalist countries would be to imple-
ment new norms and regulations—in addition to traditional NTBs—with the aim of
discriminating against foreign firms. These measures, broadly referred to as “regu-
latory protectionism” (Sykes 1999), include technical barriers, sanitary barriers, and
national preference policies.77
Technical barriers—such as regulations covering electrical equipment, electronic
devices, motor vehicles, and so forth—became a major protectionist tool of policy
makers in the United States, in the EEC, and even in Japan (Drifte 1983; Schoenbaum
1984). These measures reflected the efforts of US and European authorities to pro-
tect uncompetitive industrial firms as well as the “mercantilist” policy followed
by Tokyo.
Discriminatory sanitary norms resulted from countries resolving to preserve
domestic agriculture. A memorable example dates to the mid-1980s, when the EEC
prohibited beef imports from nations that permitted the injection of growth hor-
mones into cattle destined for human consumption. Because this policy penalized
US farmers, President Reagan ordered retaliatory tariffs against some European
exporters (Sykes 1999, pp. 1–3).78
National preference measures include imposition of “local content” require-
ments and the prohibition of foreign companies from bidding on government con-
tracts in some sectors. An illustration of national preference in a highly sensitive
area was the Bayh–Dole Act of 1980, which reformed the US patent and trademark
system. Section 204 of this legislation stipulates that no entity that patents any

77
See Messerlin (1981, 1982) for analysis of the political economy of protectionism.
78
The US retaliation proceeded under Section 301 of the Trade Act of 1974, which authorized the
president to take all appropriate steps to disallow any foreign government’s policy that restricted
US commerce. The thrust of this section illustrated Washington’s awareness of the need for a
prompt response to protectionist policies adopted by trade partners.
2.3 International Business in a Bipolar World: 1945–1991 37

invention with federal assistance can “grant to any person the exclusive right to use
or sell any subject invention in the United States unless such person agrees that any
products embodying the subject invention or produced through the use of the sub-
ject invention will be manufactured substantially in the United States” (for an analy-
sis, see Coriat 2002, p. 182).
These aspects of “regulatory protectionism” were so inconvenient that they were
addressed during GATT’s Uruguay Round. Several formal agreements were
reached: one dealing with technical barriers to trade, a second on the application of
sanitary and phytosanitary measures, and a third on trade-related aspects of intel-
lectual property rights.79

2.3.5 Foreign Direct Investment at Risk

No type of investment was ever more hazardous than foreign direct investment in
the decades following World War II. Various political and economic factors com-
bined to disturb international business. Despite these impediments, US direct invest-
ment abroad soared from $7.2 billion in 1946 to $467.8 billion in 1991—an annual
growth rate that exceeded 9.5%.80 This paradox can be explained by the myriad
business opportunities worldwide and by the array of tools that capital-exporting
nations and foreign investors deployed to reduce country risk, especially expropria-
tion risk.81

[Link] Hostile Business Environment of the Postwar Decades

The treatment of enemy property in the aftermath of WWII was tough and foreshad-
owed the fragility of foreign direct and portfolio investments during the Cold War,
especially in LDCs. The Potsdam Declaration of 1945 regarding German repara-
tions and the peace treaties concluded in 1947 with Bulgaria, Hungary, Italy, and
Romania provided that the Allies had the right to seize and liquidate all properties
within their territory and belonging to the enemy State or its nationals (for discus-
sions, see Borchard 1946a; Martin 1948).

79
See [Link] and [Link]
org/english/thewto_e/whatis_e/tif_e/agrm7_e.htm.
80
Author calculations based on Pizer and Cutler (1956, p. 15) and [Link]
tional/di1usdbal.
81
There are three reasons why this section focuses on nationalization risk. First, starting in the
1950s, that threat became a major concern among MNCs operating in LDCs. Second, other risks
(e.g., subsidies to local producers, exchange controls, other macroeconomic risks) were addressed
in Sects. 2.3.3 and 2.3.4. Third, and as described in what follows, expropriation risk turned out to
be a driver of political and country risk analysis.
38 2 Two Centuries of Country Risk, 1816–2016

In the meantime, the Bulgarian, Czechoslovakian, Hungarian, Polish, Romanian,

and Yugoslavian governments—already within the Soviet zone of influence—
enacted nationalization laws inspired by socialist and communist doctrines. It is
interesting that compensation policies differed considerably across countries, with
the Hungarian regime being much more favorable to foreign investors than the
Bulgarian (Doman 1948, pp. 1152–1158).
In subsequent years, other newly communist powers undertook expropriation
acts. The most striking cases were observed in mainland China (1949–1950), Cuba
(1959–1960) and Ethiopia (1975) as well as in Angola and Mozambique during the
second half of the 1970s (see US House of Representatives 1963, p. 16; Johnson
1965; Kobrin 1984; Maurer 2013, pp. 347–348). These large-scale nationalizations
affected most economic sectors.
A second driver of the expropriation of foreign ownership was the extensive
interpretation of every State’s right to dispose of its wealth. This principle—pro-
moted by UN General Assembly Resolution 626 (VII) of 21 December 1952 on the
right to exploit freely natural wealth and resources and Resolution 1803 (XVII) of
8 December 1962 on permanent sovereignty over natural resources—convinced
several countries (including those that had just gained independence) to nationalize
their own petroleum and mining sectors.
Major takeovers of foreign oil companies’ properties occurred in Iran (during
1951), Iraq (1961), Ceylon (1962), Argentina (1963), Algeria (1967), Peru (1968),
Bolivia (1969), Libya (1970), Nigeria (1971), Arab oil-exporting countries (1972),82
and Venezuela (1975) (US Department of State 1972; Genova 2010, pp. 120–121;
Maurer 2013, pp. 304–305, 358–361, 382–384).83 Mining companies that operated
abroad were also vulnerable to expropriation risk. For example, Bolivia national-
ized the tin and zinc sectors in 1952 and 1971, respectively. The Democratic
Republic of the Congo, Zambia, and Chile followed a similar strategy with copper
in (respectively) 1966, 1969, and 1971 (US Department of State 1972; Maurer
2013, pp. 297–301).84 It is noteworthy that the agrarian reforms implemented in
many LDCs led to significant forced divestments of foreign landowners (US
Department of State 1972; Kobrin 1980; Bandyopadhyay 1996).
Nationalizations were sometimes driven by more idiosyncratic political motives.
Thus, the 1951 takeover of the Anglo-Iranian Oil Company by Iran’s Prime Minister
Mossadegh, and that in 1956 of the Suez Canal by Egypt’s President Nasser,
reflected the eagerness of these two leaders to enhance the geopolitical status of
their respective countries and to counter Western influence. The expropriation of
foreign firms operating in Indonesia during 1960–1965 was part of a massive attack
against US interests that was likely to spill over into Southeast Asia (Van der Kroef
1965). Furthermore, the MNCs despoiled by the new Iranian regime in 1979–1980

82
The Arab oil-exporting countries referenced here are Kuwait, Saudi Arabia, and the United Arab
Emirates.
83
Only the starting year of the nationalization process is indicated.
84
For information on other minerals that were nationalized, see US Department of State (1972) and
Rood (1976).
2.3 International Business in a Bipolar World: 1945–1991 39

paid the price of a complex revolution that mixed religious fundamentalism, state
intervention, and anti-US sentiments (Halliday 1982).
During 1960–1979, a total of 79 LDCs engaged in 559 expropriation acts against
1,705 foreign firms (Kobrin 1984). International investors had several options for
protecting their ownership and preserving their interests. They could act preven-
tively by using guarantees or insurance contracts; and once nationalization occurred,
they could mobilize political, arbitrational, and judicial means to secure adequate
compensation. At the same time, these investors could improve their decision-mak-
ing by enhancing their knowledge about the investment climate abroad.

[Link] Foreign Investment Guarantees

The Investment Guaranty Program, which originated with the European Recovery
Program of 1948, was a milestone in the history of capital export because it offered
guarantees—against convertibility risk—to new US direct, equity, and loan invest-
ments in ERP countries. The coverage was expanded in 1950 and 1956 to include
(respectively) expropriation risk and war damage risk. The Mutual Security Act of
1959 shifted the set of recipient countries from Western Europe to underdeveloped
nations exclusively (von Neumann Whitman 1959, pp. 36–37). Following the Cuban
deprivations of US-owned wealth, the Foreign Assistance Act of 1961 revised the
guaranty program in order to include risks of insurrection, revolution, and accom-
panying civil unrest and to provide arbitration procedures for settling investor
claims. Guaranty schemes were reorganized and reinvigorated with the establish-
ment of the Overseas Private Investment Corporation (OPIC) in 1971. As a self-
sustaining US government agency, OPIC had considerable autonomy. For instance,
it could insure joint ventures and grant loans (Lipson 1978, pp. 361–366).85 During
1971–1991, OPIC’s insurance claims settlements totaled $509 million, 77% of
which involved expropriation claims.86
European countries—primarily through their export credit agencies—started
offering political risk guarantees to their investors in the late 1950s. Germany moved
forward as early as 1959; Switzerland, Belgium, France, and the United Kingdom
followed suit in 1970–1972 (Laviec 1985, pp. 215–217; Ducroire 2006). Private
insurance companies (e.g., Lloyds and AIG) did not play a significant role in this
field until the 1980s (Williams 1993, pp. 96–97).
It is noteworthy that, after a quarter century of laborious efforts (see Broches
1962), the Multilateral Investment Guarantee Agency (MIGA) was ultimately estab-
lished in 1988. The seminal objectives of this World Bank agency were to issue
guarantees against political risks and to stimulate the flow of capital to developing
countries (MIGA 1989, pp. 1–6).

85
See also [Link]
86
Author calculations based on O’Sullivan (2005, pp. 51–64).
40 2 Two Centuries of Country Risk, 1816–2016

[Link] Compensation from Expropriating States

The Western doctrine stating that the nationalization of foreign properties must be
balanced by “prompt, adequate, and effective” compensation (Hyde 1939) was not
a “general rule of law applicable in all circumstances” (Schachter 1984). In light of
the diverging interpretations of what “prompt, adequate, and effective” (or just)
compensation should be, the prospects for foreign investors receiving at least satis-
factory indemnification depended on their ability to (i) negotiate directly with host
governments, (ii) settle disputes by means of arbitrational or judicial recourses, and/
or (iii) prevail upon their home government to exert diplomatic or economic
pressure.87
In some expropriation acts, direct and prompt negotiations enabled aggrieved
foreign investors to settle agreements with host countries. Such agreements were
underpinned by different motives. In 1969, the US copper mining company
Anaconda accepted the Chilean government’s acquisition of 51% of its properties
because political pressure for complete expropriation was high (Central Intelligence
Agency, 1969, pp. 4–5). The following year, Roan Selection Trust (another copper
mining company) settled with Zambia. Although the compensation amount for the
takeover of majority ownership was underestimated, the firm was satisfied with the
agreement’s other provisions, such as sales and management contracts and the
absence of tax increase for a ten-year period (US Department of State 1972, p. 110).
In 1975, Venezuela anticipated the expiration of oil concessions—scheduled in
1983—and announced a nationalization program. This decision relieved US oil
companies, facilitated negotiations, and led to relatively just compensations (Maurer
2013, pp. 382–383).
A second set of remedies included recourse to judicial, quasi-judicial, and arbi-
tration tribunals. International investors might seek redress in the host country’s
courts—but with little chance of success because litigation before those courts was
constrained by state doctrine and the principle of sovereign immunity. Even the
trend toward a restrictive approach to immunity, especially after the European
Convention on State Immunity of 1972 and the US Foreign Sovereign Immunities
Act of 1976, did not ensure the processing and adjudication of claims (for a discus-
sion on the US legal landscape, see Leigh 1990). The International Court of Justice
(ICJ) was a potential forum provided that the investors’ claims were supported by
their home government (Snyder 1963, p. 1099).88 Ad hoc tribunals might also
be formed.
In fact, three ways of recourse were effective in resolving disputes: the Court of
Arbitration of the International Chamber of Commerce (ICC); the International

87
These avenues of redress are designed to resolve a large set of investment disputes and not exclu-
sively those arising out of expropriation acts. However, it is their capacity to deal with nationaliza-
tion problems that is studied here.
88
For instance, in the 1977 dispute between Texaco and the Libyan government, the ICJ arbitrator
delivered an award on the merits in favor of the company (see Von Mehren 1978).
2.3 International Business in a Bipolar World: 1945–1991 41

Centre for Settlement of Investment Disputes (ICSID); and, in the case of US inves-
tors, the Foreign Claims Settlement Commission (FCSC).
Established in 1923,89 the Court of Arbitration of the ICC is entitled to settle
commercial disputes in cases where the parties had included ICC arbitration clauses
in their contract (for a thorough analysis, see Craig et al. 2000).90 Created in 1954 as
a quasi-judicial, independent agency within the US Department of Justice, the
FCSC administered the War Claims Act of 1948 and the International Claims
Settlement Act of 1949. The Commission adjudicated claims of US nationals against
Maoist China, Communist Eastern Europe, and other expropriating countries (Re
1962; FCSC 2018). The ICSID was established in 1966 under the auspices of the
World Bank. Its objective is to depoliticize investment disputes between states and
private investors by providing facilities for conciliation and arbitration;91 however,
the parties must have previously consented to submitting the dispute to the Centre
(see Broches 1965; Shihata 1992).
A third set of recourse for foreign investors was to request the support of their
home government to foster settlements providing for just compensation. What fol-
lows is a brief recounting of the initiatives carried out by the administrative appara-
tus of the United States.
First, MNCs were likely to resort to traditional diplomatic channels to advance
their claims as International Telephone & Telegraph (ITT) did in Brazil in 1962–1963
(US House of Representatives 1963). Diplomatic pressure could be stronger.
Following the expropriation of US tin companies in Bolivia in October 1952, the
incoming Eisenhower administration committed to endorsing its businesses and
reminded Bolivia that its tin had to be smelted in Texas. An agreement was reached
in June 1953 (Maurer 2013, pp. 298–300).
In some cases, Washington exerted more coercive measures to protect its MNCs.
In 1962, the increasing hostile investment climate in Latin America convinced
Congress to modify the Foreign Assistance Act via the Hickenlooper Amendment,
which provided for the suspension of assistance to countries that took over
US-owned properties without making prompt, adequate, and effective compensa-
tion. This amendment was first applied to Ceylon in 1963; in response to the result-
ing capital flight, Ceylon’s economy suffered dramatically. However, a new
government in 1965 enabled the parties involved to secure a satisfactory agreement
(Maurer 2013, pp. 332–336). In fact, US presidents frequently threatened to sus-
pend aid—sometimes by recalling the Hickenlooper Amendment provisions—
rather than cut it off immediately. This strategy proved successful during
1971–1976 in the cases of Benin, the People’s Republic of the Congo, and Guyana

89
[Link]
90
Although the ICC Court of Arbitration’s work is confidential, some information is available
regarding the disputes stemming from expropriation; see, for example, the ICC award made in
Case no. 2139 in 1974: [Link]
220-et-seq-
91
For an early ICSID award in connection with an expropriation case, see AGIP S.p.A. v. People’s
Republic of the Congo (ICSID Case no. ARB/77/1); for additional details, see Baker (1999, p. 76).
42 2 Two Centuries of Country Risk, 1816–2016

(Akinsanya 1981, p. 782; Maurer 2013, p. 356, n. 7).92 The combination of suspend-
ing US aid and reducing bilateral and multilateral lending was tried out against
Bolivia and Peru in 1968–1971. Although the efficiency of this policy is debatable,
it seems to have prevented significant losses to Gulf Oil and the International
Petroleum Company (Olson 1975; Maurer 2013, pp. 363–379).
The most radical measures in favor of US firms took the form of covert actions.
Chile is a tragic example of such efforts. Once elected in 1970, President Allende
expropriated US copper mining companies and industrial firms but did not offer
adequate compensation. Fearing the spread of hard leftist policies in Latin America
and encouraged by ITT, the Nixon administration and the Central Intelligence
Agency approved a covert operation. President Allende was overthrown in
September 1973. His successor, General Pinochet, reached agreements on compen-
sation with the copper companies as early as 1974 (US Senate 1975; Sigmund 1977,
p. 261).
However, these attempts to constrain expropriating governments to settle agree-
ments with aggrieved investors did not systematically guarantee just indemnifica-
tion. In many cases, compensation was not “prompt, adequate, and effective”
because negotiations took excessive time,93 settlements required reinvestment in the
host country, payouts consisted of annual installments or long-term bonds, and/or
enforcement was poor.
Another option to reduce expropriation risk abroad involved collecting informa-
tion and using country risk indicators.

[Link] Investment Climate and Country Risk Analyses

In the decade that followed WWII, news on the investment climate was the main
resource at the disposal of MNCs seeking to assess country risk. Such news included
data, notes, and reports published by international institutions (e.g., the United
Nations, the IMF, the World Bank); the Bureau of Foreign Commerce of the
U.S. Department of Commerce (viz., Foreign Commerce Weekly) and its counter-
parts in capital-exporting nations; trade and industry associations; chambers of
commerce; leading international banks; trade commissioners; and commercial
attachés.94
A few firms specialized in providing information and advice to international
investors; these included the Economist Intelligence Unit (EIU), S. J. Rundt &

92
The United States passed additional laws that provided for retaliation against expropriating coun-
tries. Examples include the González Amendment of 1972 ([Link] and Section
502(b) of the Trade Act of 1974.
93
Some formal claims agreements were settled several decades after the expropriation occurred;
see FCSC (2018).
94
See, for instance, National Industrial Conference Board (1951) and United States Council of the
International Chamber of Commerce (1953).
2.3 International Business in a Bipolar World: 1945–1991 43

Associates, and Business International.95 It is worth mentioning also that Norman

M. Littell, who served as Assistant Attorney General of the United States during
1939–1944, published three prominent articles in the Virginia Law Review that sum-
marized the legal climate for investment abroad (Littell 1950, 1952, 1954).
The risks experienced by MNCs were not addressed by the academic community
until the creation in the late 1950s of several journals dealing with international
business: Business Horizons, California Management Review, The International
Executive (continued as Thunderbird International Business Review), and
Management International (continued as Management International Review).96
Political scientists added their contribution by undertaking cross-national compari-
sons (see Deutsch 1960; Banks and Textor 1963). In one noteworthy article,
Feierabend and Feierabend (1966) used 30 variables to establish an index of politi-
cal stability for 84 countries.
Starting in the late 1960s, three complementary strands of research grew and
enabled international businesses to monitor the investment climate much more
accurately.
A first set of academic works focused on the assessment of political risk. This
discipline was concerned with the systematic identification, analysis, and manage-
ment of political and socioeconomic restraints on foreign investments (see e.g.
Stobaugh 1969; Nehrt 1970; Robock 1971; Zink 1973; Kobrin 1977, 1982; Overholt
1982; Simon 1982).
A second group of articles conducted in-depth studies on specific threats. For
example, investigations of expropriation risk proliferated (e.g., Root 1968; Truitt
1970; Knudsen 1974; Williams 1975; Hawkins et al. 1976; Rood 1976; Kobrin
1980, 1984).
A third group of studies implemented methodologies designed to evaluate politi-
cal and economic risk and to rate countries.97 Some models were established by aca-
demics (e.g., Coplin and O’Leary 1972; Hibbs 1973; Green 1974; Haendel et al.
1975) and others by Business Environment Risk Intelligence (BERI) and Business
International, two influential consulting firms.98 Although the accuracy of such rat-
ings was questioned—especially after the Iranian revolution in 1979 (see Kennedy Jr.

95
These three entities were established in 1946, 1952, and 1954, respectively; see EIU (2006, p. 3),
Howell (2001, p. 185), and E. McDowell, “Spotlight; Orville Freeman, Businessman,” New York
Times, 14 September 1980.
96
Two important reviews emerged a few years later: the Columbia Journal of World Business in
1965 (continued as Journal of World Business) and the Journal of International Business Studies
in 1970.
97
The increasing threat of nationalization in LDCs may explain the development of these ratings.
Yet one could advance another reason—namely, the growing share of manufacturing in total US
investments abroad. Because industrialists generally had more options (than did mining and oil
companies) when selecting a host country, they needed some tools to discriminate among potential
recipients.
98
F. T. Haner founded BERI in 1966 after working several years for US companies; [Link].
com/Dr.-F.T.-[Link]. For a thorough analysis of BERI methodologies, see Haner and Ewing
(1985).
44 2 Two Centuries of Country Risk, 1816–2016

1984)—their use spread and new raters emerged in the 1980s, such as Nord Sud
Export and the International Country Risk Guide.99
Between the 1950s and the 1980s, the number of available means for reducing
country risk mushroomed. Guarantee and insurance schemes as well as judicial and
arbitrational recourse contributed to limit financial losses, while political and busi-
ness risk ratings helped investors anticipate (to some extent) political and economic
shocks. At the onset of financial globalization, MNCs were undoubtedly better pre-
pared than ever to run their businesses abroad.

2.3.6  Long Debt Cycle That Leads to a Major Financial

A
Crisis

Sovereign lending went through dramatic changes during 1945–1991. Contrary to

what occurred in the 1920s, foreign government bond markets did not rebound after
WWII and bondholders failed to reach debt restructurings with several defaulting
countries. Also, the nature of sovereign lending evolved substantially. Suppliers’
credits and bilateral and multilateral loans accounted for the bulk of the capital
flows to LDCs until commercial banks became major creditors in the 1970s. The
debt crisis that erupted in 1982 led the IMF to steer the most important debt negotia-
tions in history. It is noteworthy that the high debt levels of the late 1970s and the
financial turmoil of the 1980s stimulated sovereign risk analysis. By 1991, creditors
had many indicators that could be used to anticipate debt crises.

[Link]  nfortunate Foreign Bondholders and Dormant Sovereign Bond

U
Markets

There was little activity on sovereign bond markets during the Cold War. Several
reasons can be advanced: creditor countries enacting capital controls, which are
intended to direct domestic savings into domestic investments and to avert payments
imbalances; the importance of bilateral and multilateral loans; and the stigma of the
painful bond restructuring processes conducted since the 1930s.
At the end of 1945, 52% of outstanding foreign government bonds remained in
default. Seven years later, this percentage had declined slightly to 42% (IBRD 1955,
p. 2). The most recalcitrant debtors (whose defaulting bonds exceeded $200 million
in December 1952)100 were the Soviet Union, Romania, Yugoslavia, Greece, China,
and Hungary. These six distressed countries were still in default in 1960 (Corporation
of Foreign Bondholders 1961).

99
See Bouchet et al. (2003, pp. 82–83) and Howell (2001, p. 19).
100
Author calculations based on IBRD (1953b, 1955).
2.3 International Business in a Bipolar World: 1945–1991 45

In the 1950s–1960s, most of the sovereign borrowers that tapped capital markets
were industrialized countries, not LDCs. In 1963–1965, publicly issued bonds
accounted for less than 2% of the total debt incurred by LDCs (World Bank 1967,
p. 34). The profile of issuers was not fundamentally changed either by the develop-
ment of offshore markets in the 1970s or by the foreign bond market’s revival in the
United States following expiration (in 1974) of the interest equalization tax.
Venezuela was the sole LDC that managed to offer both medium-term notes and
long-term bonds.101

[Link] A Long Indebtedness Cycle Fed by Various Types of Creditors

During 1946–1950, capital flows to the underdeveloped world reached $6.4 billion;
of this amount, 57% took the form of grants and 43% were loans. About 83% (resp.,
17%) of the loans came from governments and international organizations (resp.,
from private entities).102
The LDCs’ indebtedness cycle—driven by urgent infrastructure needs and weak
export volumes—began in the 1950s and lasted nearly three decades. During
1955–1981, the external public debt of a set of 34 LDCs103 increased (on average)
by more than 18% annually; during 1962–1981, that of 22 newly independent
African countries104 increased by more than 25% annually. Several types of institu-
tions lent to LDCs.
The 1950s featured a predominance of bilateral and multilateral loans. In this
respect, two institutions played leading roles: the US Exim Bank and the World
Bank. During 1950–1959, the former lent $3.7 billion and the latter $2.5 billion to
LDCs’ central and local governments, their agencies, and private firms with a public
guarantee.105 A third important source of fresh capital was officially guaranteed pri-
vate export credits (mainly from France, Germany, Italy, and the United Kingdom),
which totaled $1.3 billion for the period 1956–1959 (United Nations 1966, p. 65).

101
See Moody’s Bond Survey, 31 January 1977 and 27 April 1981.
102
Author calculations based on IBRD (1953a, pp. 26–27).
103
Author calculations based on Avramovic et al. (1964, pp. 104–105) and World Bank (1985). The
34 countries in the sample are: Argentina, Bolivia, Brazil, Chile, Colombia, Costa Rica, Ecuador,
Egypt (formerly United Arab Republic), El Salvador, Ethiopia, Greece, Guatemala, Honduras,
India, Israel, Jordan, Lebanon, Liberia, Mexico, Myanmar (formerly Burma), Nicaragua, Pakistan,
Panama, Paraguay, Peru, the Philippines, Portugal, Sri Lanka (formerly Ceylon), Syria, Thailand,
Turkey, Uruguay, Venezuela, and Yugoslavia.
104
Author calculations based on Avramovic et al. (1964, pp. 104–105) and World Bank (1985). The
22 countries in the sample are: Benin (formerly Dahomey), Burkina Faso (formerly Upper Volta),
Burundi, Cameroon, the Central African Republic, the Democratic Republic of Congo (formerly
Zaire), Gabon, Ghana, Guinea, Ivory Coast, Mauritania, Morocco, Niger, Nigeria, the Republic of
Congo, Rwanda, Senegal, Sierra Leone, Somalia, Sudan, Togo, and Tunisia.
105
Author calculations based on Exim Bank and World Bank annual reports for fiscal years 1950–
1960. A small part of the credits authorized by the Exim Bank went to LDCs’ private firms but with
no public guarantee.
46 2 Two Centuries of Country Risk, 1816–2016

Commercial banks in the United States developed their sovereign lending activi-
ties step by step. After underwriting part of the World Bank’s obligations in 1950
(World Bank 1950, p. 40), they began participating in the loans granted by that
international institution in 1954 (World Bank 1954, p. 2). The commercial banks’
policy consisted of taking up the loans with shorter maturities but without the
Bank’s guarantee (World Bank 1955, p. 14). In the meantime, some banks lent
directly to sovereign governments. For example, the Chase National Bank of
New York granted a $5 million loan to Peru; this loan complemented a US Treasury
stabilization credit line and an IMF standby arrangement (IMF 1954, p. 107).
Between 1955 and the early 1980s, US commercial banks increased the number of
their foreign branches by a factor of 8 and expanded the volume of their foreign
assets from $1.1 billion to $242.8 billion (OCC 1956, 1981).
These developments resulted in a dramatic change in the contribution of different
creditors to financing of the Third World. Between 1967 and 1981, the share of
official bilateral lending and non-bank credits (including suppliers’ credits) in total
LDCs’ external public debt outstanding fell, respectively, from 54% to 29% and
from 23% to 9%. In contrast, the percentage of official multilateral106 and commer-
cial banks’ loans increased (respectively) from 17% to 23% and from 6% to 39%.107
The indebtedness cycle of 1955–1981 was characterized by several multilateral
debt relief episodes. The associated debt negotiation meetings were organized under
the auspices of the “Paris Club,” an informal group established in 1956 and com-
posed of representatives from major Western creditor countries. During 1956–1973,
nine countries reached debt rescheduling or refinancing agreements: Argentina,
Brazil, Chile, Ghana, India, Indonesia, Pakistan, Peru, and Turkey (Klein 1973,
pp. 17–20). The type of external debt most frequently subject to consolidation
involved suppliers’ credits—primarily because their shorter maturities and higher
interest rates burdened debt service payments. These first debt restructuring deals
established the senior creditor status of international financial institutions, espe-
cially the World Bank (see IBRD 1969, pp. 35–38).
In the context of an oil crisis, a global economic slowdown, and the external
imbalances of 1974–1981, Paris Club creditor countries conducted debt relief oper-
ations with 14 debtor countries: the Central African Republic, Chile, the Democratic
Republic of Congo, Liberia, Madagascar, Pakistan, Peru, Poland, Senegal, Sierra
Leone, Sudan, Togo, Turkey, and Uganda.108
Yet the most distinguishing aspect of this period was the restoration, by com-
mercial banks, of its distressed debtors’ creditworthiness. One example is the treat-
ment of the Democratic Republic of Congo (formerly Zaire) in 1975–1976.
Commercial banks accepted the Mobutu regime’s refinancing proposals provided it
reached an agreement with the IMF. The latter would end up arranging a standby

106
Multilateral loans were driven by the activities not only of the World Bank but also of, among
others, the Inter-American Development Bank and the Asian Development Bank (established in
1959 and 1966, respectively).
107
Author calculations based on World Bank (1975, p. 91; 1983, p. 141).
108
See [Link].
2.3 International Business in a Bipolar World: 1945–1991 47

credit line in return for strict control over the country’s fiscal policy (Beim 1977,
pp. 726–727).109
Commercial banks relied on the IMF to impose harsh conditions on sovereign
borrowers, conditions that would presumably enhance their capacity to repay debts.
This strategy was clearly expressed by Irving Friedman (Senior Vice President and
Senior Adviser for International Operations at Citicorp, and former top officer at the
IMF and the World Bank) in testimony to the US Senate in October 1977 (US
Senate 1978, pp. 147–148). In fact, all the countries for which a bank debt restruc-
turing or refinancing scheme was approved during 1978–1981 had already signed
such an agreement with the IMF (see Dillon et al. 1985, p. 6; IMF various years).
Coordination between the IMF and private creditors strengthened as both
increased their exposure to LDCs.110 On the one hand, the banks’ claims in non-oil-
developing countries—though they were already a source of concern in 1977—
grew by more than 20% annually during 1978–1981 (Brau et al. 1983, p. 5; see also
Wallich 1981). On the other hand, the IMF liberalized existing loan facilities, and
also established new ones, to support structural reforms and to compensate coun-
tries for the increase in oil prices and the volatility of food prices (Boughton 2001,
pp. 705–733).
For example, the IMF supplementary financing facility of 1977 (a.k.a. the
“Witteveen facility”) was praised by some famous economists—for example,
Fishlow (US Senate 1978, p. 61) and Von Neumann Whitman (1978)—who consid-
ered it a necessary “bailout of the international financial system.” Yet when the
sovereign debt crisis erupted in 1982, other experts (e.g., Vaubel 1983) blamed the
IMF lending policy and regarded it as a source of moral hazard. However, the tight
relationships between the Washington-based institution and private banks turned
out to be essential when LDC debts had to be restructured.

[Link] The Debt Crisis of the 1980s and Its Resolution

The catalyst for the sovereign debt crisis was the August 1982 announcement by
Mexican authorities of a moratorium on the repayment of its bank debt due in 1983.
With an exposure to Mexico amounting to $25 billion—the highest among LDCs
(Federal Financial Institutions Examination Council 1982)—US banks had reason
to worry.
The IMF’s Managing Director, Jacques de Larosière, affirmed in November
1982 that the Fund would commit to arranging a $1.2 billion facility for Mexico and
that official creditors could lend $2 billion –provided the private sector would come
up with complementary financing of $5 billion and consent to a debt restructuring

109
See also Charles N. Stabler, “Zaire’s Lenders Hope Accord to Restore Creditworthiness Will Be
Model to Others,” Wall Street Journal, 9 November 1976. The private creditors affected by the
default organized themselves into an informal group called the London Club.
110
Extensive meetings and exchanges of information between the IMF and commercial banks were
also an important aspect of their cooperation (see Sgard 2016).
48 2 Two Centuries of Country Risk, 1816–2016

package. Despite some initial reluctance, US commercial banks accepted this

“offer” after domestic regulators assured them that the fresh loans would be deemed
“performing” (Mendelsohn 1983; Sgard 2016).
In fact, President Ronald Reagan and US regulators viewed the interests of Wall
Street as converging with those of Washington (see Cohen 1986). More importantly,
the US administration reckoned that a well-endowed IMF was a convenient option
for supporting its banks (Cohen 1985); this reasoning paved the way to an IMF
quota increase in 1983.
One should bear in mind that the Mexican crisis was resolved through a novel
burden-sharing agreement based on informal rules, whereby each party (bilateral
and multilateral official creditors, private financial institutions, and debtor coun-
tries) had an implicit veto right. This “ad hoc machinery” shaped many subsequent
debt restructuring and refinancing packages (Dillon et al. 1985; Alvarez and Flores
2014; Sgard 2016). During 1983–1989, no fewer than 55 countries reached a debt
restructuring deal with their foreign private creditors and/or the Paris Club.111 An
examination of just the bank debt restructurings reveals that $390 billion was
involved. The total weighted average haircut exceeded 15%, accounting for nearly
$60 billion. More than 90% of the total haircut was concentrated in ten countries:
Mexico, Brazil, Argentina, Poland, Nigeria, Venezuela, the Philippines, Chile,
South Africa, and Yugoslavia.112
However, collective action incentives started to wane in the mid-1980s.
Confronted with an intrusive IMF conditionality—especially in the realm of fiscal
policy (see Polak 1991, pp. 39–40)—and a severe recession in 1982–1983, several
Latin American countries established the Cartagena Group in 1984. This debtors’
cartel sought to coordinate negotiating positions and to reduce debt burden, but
creditors viewed it as a threat (Central Intelligence Agency 1986). Hence, US com-
mercial banks reacted by increasing their loan-loss reserves and securitizing part of
their claims (Monteagudo 1994, pp. 62–73).113 This “exit strategy” reflected that the
percentage of debt restructuring agreements including previously restructured debt
jumped from 0% in 1983 to 42% in 1985 and then to 58% in 1987.114 The consen-
sual approach set up during the Mexican debacle loosened in 1989 when the IMF
gave up on its “no lending into arrears” doctrine (i.e., the IMF accepted lending to
countries that were still in default to private creditors; Sgard 2016).

111
Author calculation based on Cruces and Trebesch’s (2013) database and [Link].
112
Author calculation based on Cruces and Trebesch’s (2013) database.
113
Securitization paved the way for implementation of the Brady deals in the 1990s (see Sect.
[Link]).
114
Author calculation based on Cruces and Trebesch’s (2013) database.
2.3 International Business in a Bipolar World: 1945–1991 49

[Link] Development of Sovereign Risk Assessment

This section begins by examining the sovereign risk analyses performed by major
creditors: the World Bank, the US Exim Bank, and some commercial banks. It then
focuses on related external indicators and academic research.

The World Bank

Following WWII, one of the first tasks of creditors was to gather data for the pur-
pose of estimating the external debt of LDCs. As a result, the World Bank estab-
lished the Debtor Reporting System (DRS) in 1951. Although it excluded short-term
debt and remained dependent on the capacity and willingness of developing coun-
tries to report their debt data accurately, the DRS was instrumental in setting up the
World Debt Tables.115
The World Bank played a pioneering role also in terms of credit risk assessment.
This multilateral lender identified and assessed criteria believed to reflect the bor-
rowing country’s creditworthiness: its foreign exchange earnings (driven mainly by
its exporting capacity), annual debt service, inflation rate, level of exchange reserves,
and attitude toward creditors in the event of debt restructuring (IBRD 1960, pp. 4–7).
World Bank economists also attended to the factors affecting a country’s balance of
payments and its capacity to service debt in the short and medium term; however,
they did not point to a single indicator capable of predicting a sovereign default or
restructuring (Avramovic et al. 1964, pp. 13–37, 85–94).
Because the proceeds of its loans were used for specific purposes, the World
Bank was also required to implement project appraisals (IBRD 1960, pp. 12–22).
The fundamental issue was that of assessing the “economic rate of return” on every
project—that is, comparing “the measurable costs and benefits of the project to the
economy as a whole” (King 1967, p. 6). The goals of such assessment were to limit
substantial time delays and cost overruns. These project performance audits were
conducted on a regular basis by the bank and enhanced economic returns (World
Bank 1975, pp. 3–13; 1982, pp. 174–178). In fact, the institution’s “senior status”
convinced its own experts to place even greater emphasis on microeconomic risk
analysis.116

115
See [Link]
debt-reporting-system-drs and World Bank (1985, p. ix).
116
The defaulted debt owed to the World Bank was negligible until the mid-1980s. Thereafter, it
increased but remained significantly lower than that owed to the IMF; see Beers and de Leon-
Manlagnit’s (2019) database.
50 2 Two Centuries of Country Risk, 1816–2016

The US Exim Bank

The US Exim Bank’s lending policy was contingent on three criteria. First, the bank
evaluated the borrower’s status and its capacity to obtain preferential treatment—
such as a state guarantee, a complementary state loan, subsidies, and/or tax conces-
sions. Second, “self-liquidating” projects (i.e., those generating adequate foreign
exchange) were prioritized. Third, the bank rated countries on a 4-notch scale.117
The key determinants of the sovereign rating methodology were the global level of
indebtedness, the risk of balance-of-payments problems, and the repayment perfor-
mance of previous loans, especially Exim Bank loans (Feinberg 1982, pp. 69–82).
Nonetheless, the Exim Bank’s risk assessment policy was extremely lax. In sev-
eral annual reports, the bank stated that “because of the unpredictable nature of
future economic and political conditions throughout the world, the risk of loss on
Exim Bank’s loans, guarantees, and insurance [was] not susceptible to accurate
measurement” (Exim Bank 1969, p. 21). It is therefore not surprising that the share
of outstanding loans classified as delinquent or rescheduled increased inexorably in
the 1970s and exceeded 10% in 1981 (General Accounting Office 1982b, p. 6). The
1982 debt crisis undermined the Exim Bank’s credibility and expedited its decline.

Commercial Banks

Starting in the mid-1970s, the increasing commitment of commercial banks to

LDCs was mirrored in the more extensive use of the term “country risk” (see Sect.
1.2). A study investigating the country evaluation systems developed by 37 US
banks exposed the rudimentary nature of those systems (Exim Bank 1976). For
example, most of the surveyed banks did not back-test their country risk methodolo-
gies and used them primarily to set maximum exposure limits for each country.
Smaller banks’ foreign lending policies relied on analyses conducted by the World
Bank, the IMF, the OECD, the Exim Bank, the US State Department, or such promi-
nent institutions as Morgan Guaranty and Bank of America.118
During 1977–1979, top officers at Citicorp, First National Bank of Boston, Bank
of Montreal, and Bank of America disclosed their country risk methodologies (see,
respectively, Friedman 1977; Thornblade 1978; Nagy 1978; Wilson 1979). Their
rating systems were unexpectedly dissimilar. The systems used by Citicorp and
First National Bank of Boston relied on checklists, whereas those of the two other
establishments were more sophisticated. Bank of Montreal estimated the likelihood
of debt not being serviced as well as the loss that would be incurred; Bank of

117
The rating system was discontinued in 1977 but resumed ten years later (Feinberg 1982, p. 46;
“Ratings by Ex-Im Bank,” New York Times, 9 March 1987).
118
David R. Francis, “Banks Tighten Credit Ratings to Identify Overseas Risks,” New York Times,
15 May 1977.
2.3 International Business in a Bipolar World: 1945–1991 51

America used “analytical” ratings based on an economic stability index and an

external debt servicing capacity index.119
In 1978, the three Federal bank regulatory agencies (the Office of the Comptroller
of the Currency, the Federal Reserve Board, and the Federal Deposit Insurance
Corporation) adopted a uniform examination procedure for evaluating country risk
factors involved in international lending by US banks. In addition, this procedure
limited the concentration of exposure to any individual country (Federal Reserve
Bank of New York 1978). The system consisted of “identifying countries with
actual or potential debt-servicing problems, calling loans to these countries to the
attention of bank management in examination reports, and evaluating bank internal
country exposure management systems” (General Accounting Office 1982a, p. i).
Despite this new regulatory framework, banks’ country risk methodologies failed to
anticipate the sovereign debt crisis of 1982–1985.

External Indicators

Mounting concerns about the ability of major commercial banks to assess sovereign
risk convinced two business magazines, Institutional Investor and Euromoney, to
publish their own risk analyses and ratings in (respectively) September and October
1979. The paradox is that these supposedly external country risk ratings reflected
bankers’ own opinions and lending strategies.
The Institutional Investor ratings were based on a survey of 50 leading interna-
tional banks and interviews with 40 bank executives. Bankers were asked to grade
countries on a scale that ranged from 0 to 10, with 0 representing the least credit-
worthy countries.120 Euromoney ratings were a function of the weighted average
spread between the interest rate charged to a particular country and the London
Interbank Borrowing Rate (LIBOR). Next, Euromoney divided borrowers into seven
categories: the countries with the lowest weighted average spreads were awarded
seven stars; those with the highest spreads, just one.121 The Institutional Investor and
Euromoney rating methodologies have been amended regularly and have gained
influence since the 1980s (see Sects. 4.1.2 and 4.1.3).

Academic Research

The most significant progress in terms of sovereign risk analysis was driven by
academic research. A vast set of studies were published in the 1970s. Their purpose
was to measure the debt-servicing capacity of LDCs and then to identify the vari-
ables that could have enabled the anticipation of past debt restructurings. The statis-

119
For complementary analyses, see Basagni (1981, pp. 81–94) and Heffernan (1986, pp. 66–72).
120
Institutional Investor, September 1979, p. 243.
121
Euromoney, October 1979, p. 130.
52 2 Two Centuries of Country Risk, 1816–2016

tical procedures used, which were much more sophisticated than those employed by
major banks, included discriminant analysis (e.g., Frank and Cline 1971; Sargen
1977), principal components analysis (Dhonte 1975), logit models (Feder and Just
1977; Feder et al. 1981), and probit models (Kharas 1981). The ratio of debt service
payments to exports was a key determinant of debt restructurings, yet also other
indicators turned out to be significant: the GDP per capita, the inflation rate, and the
ratios of external debt to exports and of reserves to imports.122
Some economists have offered alternative approaches to these empirical studies.
For example, Aliber (1980) stresses the need to distinguish between liquidity and
solvency risks. The persistent appreciation of a country’s currency in real terms may
signal liquidity problems, whereas a recession and a contraction of exports may lead
to a solvency crisis in the medium term. Gasser and Roberts (1982) emphasize the
“vulnerability indicator,” which was based on imports of goods and services plus
bank claims maturing within one year less international reserves, the result then
weighted by exports of goods and services. Although this indicator was not intended
to measure the probability of default or of debt restructuring, it did reflect sensitivity
to unexpected shocks.
Research dealing with sovereign risk assessment evolved substantially after the
Mexican debt crisis of 1982. The failure of private lenders to discriminate between
good and bad borrowers naturally induced some practitioners and academics to
compare sovereign risk analyses (see Haner and Ewing 1985; Heffernan 1986).
A second strand of literature proposed a rethinking of sovereign risk methodolo-
gies. Bird (1986) and Norel et al. (1988) argue that more attention should be given
to structural economic features (e.g., terms of trade, productivity of capital, evolu-
tion of real exchange rates). In a different vein, Citron and Nickelsburg (1987) and
Simon (1992) state that political risk does affect a country’s creditworthiness.
A third set of articles investigated the determinants of Euromoney and Institutional
Investor ratings. Feder and Uy (1985) show that the key explanatory variables are
GNP per capita, average GDP, average rate of export growth, and the ratios of debt
to GNP and of international reserves to imports. In a subsequent paper, Cosset and
Roy (1991) conclude that there are three fundamental determinants of country risk
ratings: GNP per capita, the propensity to invest, and the ratio of foreign debt to
exports. Brewer and Rivoli (1990) find that the frequency of governmental regime
change affects country creditworthiness more significantly than does armed conflict
or political legitimacy indicators. These studies laid the groundwork for an exten-
sive sovereign ratings literature, which flourished in the following decades (for an
overview, see Gaillard 2011, p. 40).

122
See McDonald (1982) and Heffernan (1986) for a complementary review of the literature.
Kosmidou et al. (2008) present a more recent quantitative analysis of the methodologies designed
to develop country risk assessment models.
2.4 The Globalization Years, 1991–2016 53

2.4 The Globalization Years, 1991–2016

The collapse of the Soviet Union in 1991 marked the utter failure of planned econo-
mies. The spread of capitalism around the world boosted international trade and
cross-border capital flows, enabling MNCs to thrive as never before. Yet fierce eco-
nomic competition between nations, China’s emergence, and the greater instability
of financial markets have engendered new risks that jeopardize globalization.123

2.4.1 A New Paradigm: Free-Market Capitalism

The process of financial and trade globalization that shaped the 1991–2016 period
was largely based on the free-market capitalist principles established by the
Washington Consensus.124 Implementation of those principles was facilitated by an
extensive use of risk indicators.

[Link] The Washington Consensus

The term “Washington Consensus” was coined by economist John Williamson in

1989 and popularized the following year. Williamson (1990) identifies ten policy
instruments designed to ensure macroeconomic stabilization and restore growth.125
These ten points, which are akin to policy recommendations, are fiscal discipline,
new public expenditure priorities, reform of the tax system, liberalization of interest
rates, achievement of a competitive exchange rate, free trade, liberalization of
“inward” FDI, privatization, deregulation, and enforcement of property rights.126
Fiscal discipline is considered necessary for countries that ran chronic fiscal defi-
cits and defaulted on their external debt during 1982–1985. Public infrastructure,
education, and health must be prioritized over the use of indiscriminate subsidies.
An efficient tax system should combine a broad tax base with moderate marginal
tax rates. Interest rates should be not only determined by market forces but also
significantly higher than the inflation rate. The real exchange rate must be suffi-

123
This section is deliberately abbreviated because many of the issues addressed here are developed
in Chaps. 3, 4, and 5.
124
Globalization refers to “the growing interdependence of the world’s economies, cultures, and
populations, brought about by cross-border trade in goods and services, technology, and flows of
investment, people, and information” (see [Link]
what-is-globalization).
125
The term “Washington” refers to the US Congress, the Federal Reserve Board, US economic
agencies, and Washington-based international financial institutions and think tanks that agreed
with Williamson’s proposals.
126
The Washington Consensus was not a “neoliberal” agenda because it did not advocate cutbacks
in social welfare programs, deregulation of the financial sector, massive tax cuts, and so forth.
54 2 Two Centuries of Country Risk, 1816–2016

ciently competitive in order to boost exports, while trade policy should eliminate
barriers to imports. Promoting inward FDI is indispensable for increasing capital,
skills, and know-how. Privatization programs are based on the belief that private
firms are managed more efficiently than state-owned enterprises. Deregulation aims
to stimulate competition, and the enforcement of property rights is crucial to reas-
sure foreign businesses.
The Washington Consensus was influenced by experiences of the IMF and the
World Bank as well as by Balassa’s works (e.g., Balassa et al. 1986). It draws from
the lessons of different policies conducted by developing countries during the three
previous decades, and it pronounces the export promotion model to be “superior.”
Since the 1990s, the ability of emerging and developing economies to attract FDI
and raise capital has depended, in large part, on their proficiency at implementing
Williamson’s recommendations. That proficiency has been tracked by an increasing
number of indicators.

[Link] From Country Risk to Attractiveness Indicators

The globalization years featured the sophistication and refinement of existing coun-
try risk ratings and, more importantly, the creation of new indicators aimed at mea-
suring a country’s “attractiveness.”
Since 1991, export credit agencies have expanded their activities beyond their
home countries and offered a wider array of services. Thus they now collect exten-
sive microeconomic data, recover unpaid receivables, offer policies to insure against
many types of risks, and provide training, advisory services, and other tailored solu-
tions.127 In addition, these agencies have enhanced their country risk rating method-
ologies. For example, Credendo has established distinct rating systems to evaluate
the risks affecting exporters and those affecting direct investors.128 Coface assigns
country risk ratings and business environment ratings; the former assesses “the aver-
age credit risk on a country’s businesses” and the latter “the quality of a country’s
private sector governance.”129
However, the preglobalization indicators that gained tremendous power in the
1990s are the credit ratings issued by Moody’s and Standard & Poor’s (S&P). The
incorporation of ratings into financial regulatory rules transformed credit rating
agencies (CRAs) into gatekeepers of capital markets (Sinclair 2005, pp. 42–46;
Gaillard and Waibel 2018, pp. 1081–1094) and required that debt issuers always
request a credit rating. For the 124 sovereign debt issuers that obtained their first

127
According to [Link], [Link], [Link], [Link].
com, [Link], and [Link].
128
[Link].
129
[Link].
2.4 The Globalization Years, 1991–2016 55

rating from either these CRAs during 1991–2016,130 fiscal discipline became the
keystone of their economic policy (see Sect. 2.4.4).
It is noteworthy that the 1990s and 2000s saw the advent of two types of indica-
tors to measure economic freedom and competitiveness. Both are the outcomes of
the globalization process: They discard the concept of country risk and postulate
that countries are now motivated to improve their attractiveness to investors.
Economic freedom indices were launched in 1994–1996 by two neoliberal think
tanks, the Heritage Foundation and the Fraser Institute. Those organizations view
economic freedom as a prerequisite for achieving growth and prosperity, and their
indices are published on a yearly basis (see Sects. 5.1.4 and 5.1.5 for more details).
Leading business newspapers (e.g., the Wall Street Journal) and several academic
reviews (especially Public Choice and The Independent Review) played a major role
in disseminating their ideas.131
Competitiveness indicators—which rate countries based on macroeconomic,
microeconomic, social, and regulatory data—flourished in the 1990s and 2000s,
aiming to support business executives and entrepreneurs in their international
investment decisions. The most prominent studies on competitiveness are the World
Economic Forum’s Global Competitiveness Report and the World Bank’s Doing
Business report.
These two publications differ in both their methodologies and their objectives.
The Global Competitiveness Report documents a country’s ability to implement
sound macroeconomic policies and to promote a stable, transparent, and innovative
business environment (see Sect. 5.1.6). Doing Business takes a more corporate-ori-
ented approach and discusses regulations that encourage (or constrain) business
activity.
Such indicators are consistent with the Washington Consensus in the sense that
they promote free-market capitalism, contribute to “discipline” emerging econo-
mies, and support the idea that all countries are involved in a global economic race
and so can be presumed (if they are not, in fact, obliged) to be “pro-business.” These
“mechanisms of governance without government” (Sinclair 1994) are studied thor-
oughly in Chaps. 4 and 5.

2.4.2 Financial Globalization: Opportunities and Dangers

Financial globalization—defined as the increasing interconnectedness between

growing cross-border capital flows—is a complex phenomenon. As pointed out by
Prasad et al. (2003), it is contingent on “pull” and “push” factors. Pull factors
include capital account liberalization, privatization programs, and policies designed
to enhance a country’s attractiveness; push factors include the macroeconomic envi-

130
Author calculations based on Moody’s and S&P’s databases.
131
Author analysis based on [Link] and [Link].
56 2 Two Centuries of Country Risk, 1816–2016

ronment in top capital-exporting nations and the factors that may lead foreign firms
to invest in (or disinvest from) a host country.
This section focuses on three drivers of financial globalization: financial liberal-
ization (a pull factor), financial innovation (a push factor), and the Federal Reserve’s
accommodative monetary policy (another push factor). With financial liberaliza-
tion, even a minor change in any pull or push factor will likely affect the quantity,
source, and/or destination of cross-border capital flows. The volatility of those flows
is exacerbated by contagion effects and, paradoxically, by certain financial tech-
niques designed to protect against risk. Such instability is magnified by the abun-
dant liquidity resulting from the Federal Reserve’s policy.

[Link] Financial Liberalization, Capital Flows, and Crises

Financial liberalization was the dominant pattern of the 1990s. A brief look at Chinn
and Ito’s (2006) updated database shows that the top three economies in Latin
America (i.e., Brazil, Mexico, and Argentina) and sub-Saharan Africa (i.e., South
Africa, Nigeria, and Sudan) significantly increased their financial openness between
1990 and 2000.132 In Europe and Asia, the top three economies underwent the same
evolution (France, Italy, and China) or witnessed a stabilization of their openness
(Germany, Japan, and India).
The dismantling of capital controls enabled emerging countries to absorb grow-
ing FDI and foreign portfolio equity and bond investments. However, the latter type
of capital flows appears to have amplified procyclicality. During boom periods, they
helped create asset “bubbles” (e.g., in housing and stock markets), fueled credit
growth, and led to overvalued exchange rates. Any sign of overheating or of doubt
concerning the short-term GDP growth could spark a confidence crisis, result in a
sudden reversal in capital flows, trigger a banking and/or currency crisis, and depress
economic activity (Kaminsky et al. 2003; Reinhart and Rogoff 2009). The greatest
crises caused by massive capital flight affected Mexico in 1994–1995, Southeast
Asia in 1997, Russia in 1998, Argentina in 2000–2001, Iceland in 2008, and Eastern
Europe (especially Hungary, Latvia, and Lithuania) during 2008–2009.133
A central feature of financial liberalization was that it accelerated the propaga-
tion of crises. In addition to existing “monsoonal” effects and spillovers,134 the phe-
nomenon of financial liberalization gave rise to the threat of “pure contagion.”
Under this threat, a surge in risk aversion—one that is disconnected from macroeco-
nomic fundamentals—may be self-fulfilling and trigger a crisis (Masson 1998).

132
Economic size is based on 1990 gross domestic product.
133
Most frequently, the magnitude of these crises obliged the IMF to intervene as lender of last
resort (see Sect. [Link]).
134
Monsoonal effects are caused by exogenous common shocks that affect several economies,
whereas spillovers involve a shock—often in an emerging country—whose effects spread to inter-
connected and neighboring countries.
2.4 The Globalization Years, 1991–2016 57

Volatility, pro-cyclicality, and contagion risks convinced economists and interna-

tional investors to develop early warning systems that would facilitate the prediction
of currency, banking, and financial crises (Kaminsky et al. 1997; Sollogoub 2001;
Bussière and Fratzscher 2006; Frankel and Saravelos 2010). Empirical analyses
conclude that an excessive appreciation of the real exchange rate and a low level of
reserves are the most relevant indicators. The use of early warning systems reflects
not only the need to anticipate sudden capital flow reversals but also the “short-
termism” of some portfolio investors.

[Link] New Financial Instruments

The deep-rooted causes of financial innovation are traditionally located in tax sys-
tems and financial regulatory frameworks. The efforts deployed by businessmen to
avoid or circumvent supposedly high taxes and detrimental regulatory rules have
often incentivized some experts, such as financiers and lawyers, to devise new
financial techniques (Miller 1986).135
However, the magnitude and pervasiveness of the financial innovation that started
in the 1980s suggest that this process was much more than a set of ploys designed
to exploit imperfections in the financial system. Instead, during the first years of
globalization, financial innovation enabled the business community to expand its
operations in a world economy crippled by major macroeconomic imbalances (see
Sect. [Link]).
The inability of the Group of Seven (i.e., Canada, France, Germany, Italy, Japan,
the United Kingdom, and the United States) and leading central banks to stabilize
exchange rates, combined with the limited resources of export credit agencies to
insure foreign ventures, paved the way for development of derivatives markets (for-
wards, swaps, and options). Thus, it became easier to hedge currency and interest
rate exposures, which fostered international capital flows. Next, in the adverse con-
text of the 1980s—characterized by the debt crisis of LDCs, the debacle of the sav-
ings and loan institutions, and the banking sector’s excess capacity—securitization
techniques helped US banks increase the marketability and liquidity of their assets.
In sum, derivatives and securitized products helped free up banks’ balance sheets,
diversify revenue sources, and restore profitability.
Yet after more than 30 years of financial globalization, one must admit that the
extraordinary variety of financial techniques failed to ensure efficient allocation of
capital, reliable information transmission, and adequate risk management. Several
abuses and dangers can be identified.
Financial instruments were frequently used for speculative purposes. For exam-
ple, the development of “naked” credit default swaps (i.e., a swap in which the
buyer does not own the underlying debt) worsened the 2008 financial debacle and

135
The study of financial innovation is beyond the scope of this book, but the factors that drove the
creation of new financial instruments—and led to their extensive use by international investors—
certainly merit further examination.
58 2 Two Centuries of Country Risk, 1816–2016

the European sovereign debt crisis in 2009–2011 (see, respectively, Murdock 2013;
Gaillard 2011, pp. 173–183, 2014a, pp. 220–223). Securitization fed opaque off–
balance sheet activities and enabled risky firms to issue high-rated securities, thus
misleading investors about their true credit position (Hill 1996; Gaillard and
Harrington 2016). Note also that the widespread application of new computer tech-
nology to financial transactions since the 2000s (e.g., algorithmic trading) has mag-
nified stratification in markets at the expense of smaller investors; it has also
increased information asymmetry and encouraged short-termism (Mattli 2019).
The incommensurate size of the US financial sector (see Rethel and Sinclair
2012; Greenwood and Scharfstein 2013) transformed liberal capitalism into finance
capitalism in the United States.136 This shift concentrated risks on financial interme-
diaries and magnified cross-border contagion effects. A dramatic illustration was
the US subprime crisis, which triggered a spectacular reversal of portfolio equity
flows to low- and middle-income countries: from +$134 billion in 2007 to −$61
billion in 2008.137 This episode evidenced the world economy’s dependence on the
US domestic business cycle. That dependence increased in response to the Federal
Reserve’s monetary policy.

[Link] An Accommodative US Monetary Policy

The financial globalization process intensified as a result of the policies imple-

mented by major central banks, especially the Federal Reserve.
Under Alan Greenspan’s tenure (1987–2006), the US central bank opted for per-
sistently low Fed Funds rates in order to reduce business cycle volatility and to
compensate for insufficient GDP growth. This “great moderation” was perpetuated
and amplified by successor chairs Ben Bernanke and Janet Yellen who (respec-
tively) launched and maintained quantitative easing138 measures to counter the
2007–2009 recession and preserve the ongoing economic recovery.
The accommodative monetary policy resulted in US real interest rates being
lower than the GDP growth rate during 1991–2016; they were even negative about
half the time (see Fig. 2.1). This development encouraged excessive borrowing and
leverage among US investors, which fed asset bubbles in the United States (Mian
and Sufi 2014) as well as in emerging economies (Bhattarai et al. 2018).
The US federal government itself borrowed huge amounts: its total debt increased
fivefold during 1991–2016. However, this increase was considered to be a balancing
factor for the international financial system because it allowed Washington to con-

136
In “finance” capitalism, the role and influence of financial institutions are so disproportionate
that they tend to affect the interests of other economic sectors and taxpayers.
137
These figures are based on the World Bank’s World Development Indicators.
138
Quantitative easing consists of purchasing government securities (and possibly other securities)
in order to increase the money supply and to stimulate lending.
2.4 The Globalization Years, 1991–2016 59

-1

-2

-3

-4
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
U.S. real interest rate U.S. GDP growth rate

Fig. 2.1 US GDP growth rate and US real interest rate, 1991–2016. Note: The US real interest rate
is calculated as the effective Federal Funds rate minus the growth rate of the consumer price index.
Source: [Link]

tinue ensuring the world economy’s liquidity without jeopardizing the US dollar’s
status as primary reserve currency. This capacity to overcome the Triffin dilemma
(see Sect. 2.3.3) was made possible because major exporters such as China and
Japan sought to avert any appreciation in their national currency. Toward that end,
these countries accumulated US assets—especially risk-free Treasury bonds. In
return, the United States dramatically increased its volume of imports.139
The Federal Reserve’s lax monetary policy was essential for the intensification
of cross-border financial flows and the expansion of international trade,140 but it
bears some responsibility for the increasing speculation and financial instability
since observed worldwide.141

139
In 1991, Washington balanced its current account. Twenty-five years later, it posted a $452 bil-
lion deficit while Tokyo and Beijing reported an aggregated $383 billion surplus (World Bank’s
World Development Indicators).
140
China adopted an accommodative monetary policy following the East Asian crisis but did not
significantly raise its benchmark interest rate thereafter (Bell and Feng 2013, pp. 178–208). This
new pattern’s effects on financial globalization were limited owing to the Chinese economy’s rela-
tively small extent of financial openness.
141
Crotty (2009) and Gaillard and Michalek (2019) show how the Federal Reserve and other US
financial regulatory bodies failed to reduce risk taking and leverage among US investors.
 60 2 Two Centuries of Country Risk, 1816–2016

2.4.3 The Boom of the Chinese Economy

The rise of China was certainly the biggest “game changer” of the globalization
years. The reforms launched by Deng Xiaoping, embodied in the 1979 promulga-
tion of the Joint Venture Law and in the establishment that same year of the China
International Trust Investment Corporation (see, respectively, Richdale and Liu
1991, pp. 125–128; Collier 2017, pp. 74–77), led to four decades of sustained GDP
growth—nearly 10% during 1979–2016—and propelled China to its position as the
world’s second-largest economy.
Beijing learned from the success of newly industrialized countries yet followed
its own path. It attracted FDI, managed to obtain technology transfers, and moved
up in the manufacturing value chain. In addition, Chinese authorities opted for
financial repression measures in order to channel growing savings toward domestic
firms and to facilitate the undervaluation of its currency. These policies yielded
spectacular results: between 1991 and 2016, the share of China in world trade,
inward FDI stock, and outward FDI stock rose by a factor of 9, 5, and 23, respec-
tively (see Fig. 2.2).142 The country is now a major capital exporter, and, for the first
time ever, its outward FDI stock exceeded its inward FDI stock in 2016.
This emergence of “the Middle Kingdom” reshaped the world economy as well.
Several structural trends can be observed. Chinese demand led to a boom in com-
modity markets during the 2000s (e.g., crude oil, aluminum, copper, iron ore, soy-
beans), which supported economic growth in emerging countries as well as in

16
14
12
10
Percentage

8
6
4
2
0

China in world GDP China in world inward FDI stock

China in world outward FDI stock China in world trade of goods & services

Fig. 2.2 China in the world, 1991–2016. Source: Author calculations based on [Link]
and the World Bank’s World Development Indicators

Author calculations based on [Link] and the World Bank’s World Development
142

Indicators.
2.4 The Globalization Years, 1991–2016 61

Australia and Canada (World Bank 2009, pp. 51–73; Roberts et al. 2016).143
Moreover, China’s capacity to produce and export a massive quantity of low-priced
manufacturing goods had deflationary effects on the rest of the world; this dynamic
has depressed the profitability of its foreign competitors and in some cases has led
to their bankruptcy (Qiu and Zhan 2016, pp. 49–51).
The combination of these trends entails that emerging economies risk losing part
of their industrial capabilities and also risk being confined to the production of agri-
cultural and mining products. These downsides are a major challenge for countries
seeking to diversify their economy (see Costa et al. 2016, who examine the case of
Brazil).
Another aspect of China’s success was the rapid ascent of its firms in the global
value chain: some of them managed to upgrade their status from subcontractor (to
Japanese, US, or European MNCs) to international leader in certain sectors. Lenovo
and BYD are two examples. Lenovo was Hewlett-Packard’s distributor in China in
the 1990s before acquiring IBM’s personal computer segment in 2005.144 Established
in 1995, BYD started out manufacturing rechargeable batteries but expanded its
activities to become the world’s third leading seller of plug-in electric vehicles in
2016—trailing only Tesla and Renault-Nissan.145
The Chinese growth model provided an alternative to liberal capitalism and thus
restored the status of state capitalism in the eyes of some foreign policy makers.
Beijing promoted this model and developed training programs for Asian and African
officials (Kurlantzick 2016, pp. 108–114). However, such initiatives were limited
by the failure of state capitalism in most countries (especially in Algeria, Argentina,
Iran, and Venezuela).

2.4.4 A New Sovereign Debt Landscape

Three prominent changes affected international lending during the globalization

era: the increasing debt accumulated by developed economies, the resumption of
emerging sovereign bond markets, and the greater capacity of private creditors to
cope with sovereign risk.

143
See [Link]
144
See “Legend in the Making,” The Economist, 13 September 2001, and Sumner Lemon, “Lenovo
Completes Purchase of IBM’s PC Unit,” PC World, 2 May 2005.
145
See M. Gunther, “Warren Buffett Takes Charge,” CNN Money, 13 April 2009 (available at https://
[Link]/2009/04/13/technology/gunther_electric.fortune), and J. Cobb, “China’s BYD
Becomes World’s Third-Largest Plug-in Car Maker,” Hybrid Cars, 7 November 2016 (available at
[Link]
62 2 Two Centuries of Country Risk, 1816–2016

[Link] Growing Concerns About High-Income Countries’ Public Debt

The general government debt of the Group of Seven rose by 6% annually during
1991–2016.146 This debt burden became a source of concern among business circles
and was reflected in sovereign ratings. In January 1991, the seven economies were
assigned the top rating (Aaa) by Moody’s. Twenty-six years later, four of them
(France, Italy, Japan, and the United Kingdom) had a lower credit rating. In the case
of Italy, the magnitude of the downgrade reached 8 notches.
The vulnerability of some high-income countries became evident during the
2008 financial crisis and the European sovereign debt crisis. The financial and eco-
nomic difficulties experienced in Cyprus, Greece, Iceland, Ireland, Portugal, and
Spain necessitated intervention by the IMF and the creation of ad hoc mechanisms
in the European Union (viz., the European Financial Stabilisation Mechanism, the
European Financial Stability Facility, and the European Stability Mechanism)147 to
support and bail out these governments or their respective banking systems.
Economic history teaches that even some high-income countries have defaulted
on their sovereign debt. However, such episodes were usually driven by political
upheaval and not, as during the European debt crisis, by economic disruption
(Gaillard 2014d).
Several factors can be posited to explain the weakened credit position of some
high-income countries. First, the accommodative monetary policies of many OECD
economies fed asset bubbles and kept “zombie” firms alive, thus misallocating capi-
tal and hampering economic performance (Banerjee and Hofmann 2018). Second,
financial and banking crises obliged most governments to guarantee or bail out fail-
ing firms and banks to avert a systemic crisis. Such interventions crippled public
authorities with contingent liabilities (Gaillard 2017). Third, southern European
governments proved unable to reform their costly and inefficient welfare states
(Hemerijck 2013). Fourth, eurozone membership depressed economic activity in
countries that had traditionally relied on currency depreciation to boost their exports
and preserve their domestic industry; examples include Greece, Italy, Portugal,
Spain, and (to a lesser extent) France.148
Now more than ever, creditors must pay attention to the sustainability of public
debt in rich countries and scrutinize their debt ratios. The decision by the Institute
of International Finance (IIF) to launch its Quarterly Global Debt Monitor in
2015—in response to growing demand from IIF members—reflected the increased
riskiness of public debt in both emerging and developed economies.149

146
Author calculations based on [Link]
147
For an exhaustive analysis of the EU’s financial mechanisms, see Bianco (2015).
148
Greece is a dramatic illustration. Prior to its joining the eurozone in 2001, the drachma had
depreciated by some 14% annually against the Deutsche mark during 1973–1994 (author computa-
tion based on Frieden 2015, p. 154).
149
Established in 1983, the IIF is one of the financial industry’s leading associations. “Its mission
is to support the financial industry in the prudent management of risks; to develop sound industry
practices; and to advocate for regulatory, financial and economic policies that are in the broad
2.4 The Globalization Years, 1991–2016 63

[Link]  esumption of Markets for Sovereign Bonds of Emerging

R
Economies

A remarkable feature of the globalization era was the enhanced credit position of
many emerging economies. This development is perhaps best captured by the mod-
est growth of external debt. During 1991–2016, the public and public-guaranteed
external debt of 34 major emerging countries increased (on average) by 4% annual-
ly.150 This rate was much lower than that observed during the 1960s and 1970s (see
Sect. 2.3.6).
This positive evolution was driven by the relative efficiency of the macroeco-
nomic policies implemented in these economies. Measures designed to increase
domestic savings, attract FDI, boost exports, and curb inflation enabled reductions
in payments imbalances and mitigated the problem of “international original sin”
(Eichengreen et al. 2005).151
Figure 2.3 plots the composition of public and public-guaranteed external debt.
After accounting for almost a third of lending to emerging economies in the 1990s,
bilateral loans saw their share decline dramatically during the subsequent two
decades. In the meantime, the percentage of multilateral loans stabilized. Yet the
most prominent development was the resumption of sovereign bond markets.
During 1991–2016, the volume of bonds issued by major low- and middle-income
governments increased by a factor of 11 and their share in total public external debt
quadrupled.152
The boom in sovereign bond markets can trace its roots to the financial disinter-
mediation of the 1980s, but it was catalyzed by the Brady Plan. This initiative—
which was launched in 1989 and amounted to transforming commercial bank loans
into bonds (see Vásquez 1996)—resolved the public debt crisis and encouraged an
increasing number of emerging countries to tap capital markets. The growth of for-
eign government bond markets was accompanied by development of a new “busi-
ness ecosystem” (Buckley 1997, 2006).
The most prominent feature of this trend was the inordinate power of credit rat-
ing agencies. Ever since credit ratings were incorporated into regulatory rules and

interests of its members and foster global financial stability and sustainable economic growth”
([Link]
150
Author calculation based on the World Bank’s World Development Indicators. The countries
under consideration are the low- and middle-income economies whose total public and public-
guaranteed external debt exceeded $10 billion (US) in 2016. Six countries are excluded because of
insufficient data for 1991. The 34 countries included in this data set are: Angola, Bangladesh,
Brazil, Bulgaria, China, Colombia, Costa Rica, the Dominican Republic, Ecuador, Egypt, Ethiopia,
Ghana, India, Indonesia, Jordan, Kenya, Lebanon, Mexico, Morocco, Myanmar, Nigeria, Pakistan,
Peru, the Philippines, Romania, Russia, Sri Lanka, Sudan, Tanzania, Thailand, Tunisia, Turkey,
Venezuela, and Vietnam.
151
For example, the so-called BRIC countries (Brazil, Russia, India, and China) were especially
successful in cutting the share of their public debt denominated in foreign currency or indexed to
a foreign currency.
152
Author calculations based on the World Bank’s World Development Indicators.
64 2 Two Centuries of Country Risk, 1816–2016

100

90

80

70

60

50

40

30

20

10

0
1991 1996 2001 2006 2011 2016

Multilateral debt Bilateral debt Bond debt Other private debt

Fig. 2.3 Composition of public and public-guaranteed external debt, 1991–2016. Notes: The data
set’s 40 countries have low- and middle-income economies whose total public and public-guaran-
teed external debt exceeded $10 billion (US) in 2016. Those countries are Angola, Azerbaijan,
Bangladesh, Belarus, Brazil, Bulgaria, China, Colombia, Costa Rica, the Dominican Republic,
Ecuador, Egypt, Ethiopia, Ghana, India, Indonesia, Jordan, Kazakhstan, Kenya, Lebanon, Mexico,
Morocco, Myanmar, Nigeria, Pakistan, Peru, the Philippines, Romania, Russia, Serbia, South
Africa, Sri Lanka, Sudan, Tanzania, Thailand, Tunisia, Turkey, Ukraine, Venezuela, and Vietnam.
The data set for 1991 excludes Azerbaijan, Belarus, Kazakhstan, Serbia, South Africa, and Ukraine
because of insufficient data. Source: Author calculations based on World Bank’s World
Development Indicators.

investors’ prudential guidelines, bond issuers have been obliged to obtain a rating—
and the higher, the better. Higher ratings corresponded to greater investor confi-
dence and lower borrowing costs. Credit ratings are lagging indicators, not leading
indicators (Gaillard 2011, pp. 175–183; 2014b; Nye 2014, pp. 39–40). Yet a down-
grade, a review for possible downgrade, or a negative outlook is likely to exacerbate
risk aversion and trigger sell-offs.153
It is noteworthy that S&P and Moody’s methodologies compel borrowers to
remain solvent on their bond debt: Any missed payment or (even minor) debt
restructuring is considered a sovereign default and results in a downgrade to the
bottom of the rating scale. In addition, CRAs frequently use the FC sovereign rating
as the ceiling for FC ratings of other debt issuers domiciled within that country;

The pro-cyclical effects of rating downgrades were obvious in November–December 1997 dur-
153

ing the East Asian crisis (Ferri et al. 1999) and between December 2009 and April 2010 during the
Greek debt crisis (Gaillard 2011, pp. 173–185). Sinclair (2005, pp. 160–167) analyzes how the
East Asian crisis undermined the CRAs’ legitimacy.
2.4 The Globalization Years, 1991–2016 65

hence, a reduction in the former rating leads to downgrading the latter.154 This pol-
icy—which aims to account for the risk of a government restricting access to for-
eign exchange—highlights the importance of sovereign ratings for all borrowers.
Major financial institutions took advantage of this propitious environment to
expand their operations in emerging financial markets. An illustrative example is
that of JP Morgan. In 1991, the New York–based bank created a special “emerging
markets” group to provide an array of services to these economies (JP Morgan
1992). Later, it launched a series of indices that track foreign currency–denomi-
nated bonds—the Emerging Markets Bond Index (EMBI), the EMBI+, and the
EMBI Global—as well as local currency–denominated debt instruments (JP Morgan
1995, 1996, 1999). More importantly, JP Morgan was the most active underwriter
of emerging government bond issues during 1993–2007 (Flandreau et al. 2009).
Another group of organizations gained ground during the globalization: bond-
holders’ associations.155 In addition to the IIF and the International Securities
Market Association (ISMA, established in 1969), new organizations—such as the
Emerging Markets Traders Association (EMTA) and the Emerging Markets
Creditors Association (EMCA)—were set up to monitor sovereign bond market
activity and to promote creditors’ rights (see EMTA 2015). The IIF is certainly the
most influential among these associations; its members include investment and
commercial banks, insurance companies, sovereign wealth funds, asset manage-
ment firms, hedge funds, and central banks.

[Link] Coping with Sovereign Risk

Both the number and the percentage of countries in default reached record highs
during the globalization years. In 1994, 114 sovereign debtors—accounting for
54% of all countries in the world—had failed to repay debt to their public or private
creditors. This figure fell 10 percentage points by 2016, but it remained higher than
any year during 1960–1981.156 Yet unlike what occurred in the 1930s and 1980s, no
massive wave of sovereign bond or bank defaults was observed during 1991–2016.
The explanation for this paradox involves (a) official creditors and China agreeing
to restructure more sovereign debts and (b) private creditors managing to cut their
losses by exploiting the new international financial architecture and a more secure
legal environment.

154
Increased financial globalization prompted Moody’s and S&P to relax their policy on this matter
in the 2000s. In 2011, however, very few debt issuers were assigned a FC rating higher than that of
their government (see S&P 2011).
155
The Council of the Corporation of Foreign Bondholders (arguably the most important associa-
tion of bondholders in history) was liquidated in 1988, a few months prior to the resumption of
sovereign bond markets.
156
See Beers and de Leon-Manlagnit’s (2019) database.
66 2 Two Centuries of Country Risk, 1816–2016

How Official Creditors and China Absorbed Losses

In 1996, the international financial community launched the Heavily Indebted Poor
Country (HIPC) Initiative in order to reduce the external debt of low-income econo-
mies. The Paris Club—as well as multilateral, non–Paris Club official bilateral, and
private commercial creditors—all participated in this program. The initiative’s eli-
gibility criteria required that candidate countries have an unsustainable debt burden
(even after obtaining traditional debt relief); a track record of sound policies through
IMF- and World Bank–supported programs; cleared any arrears with the IMF, the
World Bank, and the African Development Bank (AfDB); and prepared a credible
“poverty reduction strategy” (see IMF 2019, pp. 7–8).
In 2005, the Multilateral Debt Relief Initiative (MDRI) complemented the HIPC
Initiative.157 Under the MDRI, several agencies—including the IMF, the International
Development Association (IDA),158 the African Development Fund (AfDF), and
later the Inter-American Development Bank (IaDB)—committed to alleviating the
debt burden of low-income economies. By the end of 2017, the total costs of debt
relief to creditors under the HIPC Initiative and the MDRI were estimated at $76
billion and $43 billion, respectively (IMF 2019, pp. 12–14).
In addition to these specific programs, the Paris Club continued to reschedule
and cancel the external debt of low- and middle-income economies. For all types of
treatments, the Paris Club signed 248 agreements involving 79 countries during
1991–2016.159
The high proportion of defaulting sovereign debt issuers in the 1991–2016 period
was driven also by the many debt restructurings and write-offs negotiated by China
and its state-owned banks, especially since 2000 (Horn et al. 2019, pp. 30–32). This
pattern reflects both the weak credit rating system used by Beijing and the poor
credit position of its debtors (Gaillard 2016)—an interpretation supported by the
massive defaults in 2016 of Angola, Cuba, and Venezuela on their debt to China.160

How Private Creditors Limited Losses

Several of the sovereign debt crises that arose during 1991–2016 involved major,
“systemic” economies. In the context of financial globalization, these shocks threat-
ened not only private creditors but also the international financial community as a
whole. In order to prevent a systemic crisis, policy makers instigated a new interna-
tional financial architecture that proved to be a boon for private creditors.

157
See [Link]
158
A member of the World Bank Group, the IDA lends money on concessional terms to the world’s
poorest countries.
159
See [Link].
160
See Beers and de Leon-Manlagnit’s (2019) database.
2.4 The Globalization Years, 1991–2016 67

This new architecture was shaped around the IMF. It became manifest in 1994
when that Washington-based institution—supported by the US Treasury, the World
Bank, and the IaDB—intervened to stop capital outflows from Mexico, thereby pre-
venting a default and, quite possibly, a serious international financial crisis
(Camdessus 1995).161 These same players were at work in 1997 to resolve the East
Asian crisis.162 The total last-resort lending for these two rescue packages reached
$117 billion (Kindleberger and Aliber 2005, p. 271). In the following years, other
bailouts were secured for major emerging countries (e.g., Brazil, Colombia, and
Turkey) so that they could remain solvent.
These last-resort loan interventions reduced the number of governments in
default on their bond debt163 and cut the percentage of distressed debt owed to pri-
vate creditors (i.e., among the total sovereign debt in default) from 65% in 1992 to
22% in 2011.164 Nonetheless, IMF economists admitted that such bailouts were
likely to encourage both debtor and creditor moral hazard. Debtor moral hazard was
identified in the loans to Argentina in 2000–2001 (Jeanne and Zettelmeyer 2005,
pp. 79–80), and creditor moral hazard seems to account for the massive private
capital inflows to Russia before its bankruptcy in 1998 (Mussa 1999, pp. 228–229).
The IMF conditionality required that distressed countries accept restrictions
minimizing the problems associated with debtor moral hazard. However, a side
effect of both financial globalization and the new international financial architecture
is that creditor moral hazard remains a fundamental challenge for policy makers.
Another factor that strengthened creditors’ position was the enhanced legal and
contractual protection of their rights. Thus, for example, the Foreign Sovereign
Immunities Act of 1976 and the US Supreme Court’s statement that the issuance of
debt was a commercial act (see Republic of Argentina v. Weltover, 1992) virtually
consecrated the restrictive theory of sovereign immunity. This new paradigm
spurred the insertion of clauses favorable to creditors in sovereign bond contracts.
So starting in the 1990s, contracts were more likely to include a waiver of the sov-
ereign’s immunity from suit and execution. Other clauses (e.g., “consent to jurisdic-
tion” and governing law clauses) were inserted to facilitate the enforcement of
sovereign debt contracts (Choi et al. 2012; Weidemaier 2014).
Such enforcement became uncertain when creditors doubted their status or dis-
agreed over how best to cope with a distressed sovereign debtor. The fear of legal
subordination in favor of another creditor led to a proliferation of pari passu clauses
(see Buchheit and Pam 2004; Cohen 2011). By the same token, the need to expedite

161
Michel Camdessus (2014, p. 309), then Managing Director of the IMF, reports that Stanley
Fischer (then First Deputy Managing Director) feared the Mexican crisis endangered Western
civilization.
162
The Asian Development Bank replaced the IaDB in resolving the East Asian crisis.
163
Only 29 countries lapsed into default on their FC bond debt during 1991–2016; some of them
defaulted several times (author calculations based on the database of Beers and de Leon-Manlagnit
2019).
164
Author calculations based on Beers and de Leon-Manlagnit’s (2019) database.
68 2 Two Centuries of Country Risk, 1816–2016

debt restructuring deals favored the insertion of so-called collective action clauses
(e.g., collective modification provisions and collective acceleration provisions).
Despite these protections, bondholders have suffered some setbacks in the recent
years. For instance, they were forced to accept haircuts exceeding 50% after the
debt restructurings of Argentina and Greece in 2005 and 2012, respectively (Gaillard
2014c, pp. x, 11). Bondholders have also encountered some coordination problems.
The successful strategies followed by certain holdout creditors (e.g., the lawsuits
brought by Elliott Management against Argentina) suggest that a creditor’s most
dangerous opponent might well be another creditor.165

2.4.5  he New World Economy: Between Interdependence

T
and Competition

Globalization contributed to blur the lines between exporters and foreign direct
investors as well as between capital-exporting and capital-importing nations. At the
same time, it accelerated the transformation of capitalism and generated a new set
of risks.

[Link] The New Dynamics of Free Trade and FDI

International trade went through unexpected and paradoxical changes during the
globalization era. Multilateralism waned, but the process of trade liberalization con-
tinued. For instance, the average tariff rate for the Group of Twenty (G20) fell from
13% during 1991–1994 to 5% during 2013–2016.166 How can this evolution be
explained?
After the General Agreement on Tariffs and Trade was superseded by the World
Trade Organization (WTO) in 1995, several challenges arose that rendered multilat-
eral trade talks increasingly complex and lengthy (Baldwin 2016a; Jean 2019).
First, under the WTO regime, tariff rates and market-opening commitments are
binding, which deters members from further liberalizing their trade policy. Second,
the WTO’s admission of China in 2001 stirred mistrust among other WTO mem-
bers, whatever their income level. Third, as industrialized countries had reduced
their tariffs substantially during the previous GATT rounds, they had little maneu-

165
It is worth mentioning that commercial creditors also sued sovereign debtors, including HIPCs
(see IMF 2019, p. 51). For a study of litigation against defaulting sovereigns, see Schumacher et al.
(2015).
166
Author calculations based on the World Bank’s World Development Indicators. The G20 com-
prises Argentina, Australia, Brazil, Canada, China, the European Union, France, Germany, India,
Indonesia, Italy, Japan, Mexico, Russia, Saudi Arabia, South Africa, South Korea, Turkey, the
United Kingdom, and the United States. It accounted for more than 80% of merchandise trade in
2016 (author calculation based on [Link]
2.4 The Globalization Years, 1991–2016 69

vering room left to obtain trade liberalization in emerging countries—with regard to

financial services, for example. Fourth, the sustained growth of international trade
in the 1990s and 2000s called into question the relevance of new multilateral talks.
In this context, it is not surprising that the Doha Round, launched in 2001, failed
to achieve any trade liberalization agreements (see Cohn 2007). However, some
minor progress was observed with the Nairobi Package of 2015, which removed
subsidies for farm exports.167 In fact, other means were employed to effect trade
liberalization during 1991–2016: unilateral actions, regional trade agreements
(RTAs), and international investment agreements (IIAs).
Unilateral tariff cuts by several emerging countries (e.g., China, India, and
Indonesia) were part of offshoring-led development strategies designed to attract
foreign investments. These countries’ final objectives were to integrate themselves
into global value chains, absorb knowledge and technologies, and export an even
wider range of products and services.
The signing of RTAs was another feature of globalization. The number of RTAs
in force rose by a factor of 5 within 25 years.168 However, the nature of those agree-
ments changed significantly during that time span. Contrary to what was observed
at the dawn of globalization, the bulk of RTAs signed in the 2010s were “deep”
agreements. Thus, they transcend traditional tariff cuts to cover multiple policy
areas: competition policy, antidumping measures, environmental laws, labor market
regulations, and so forth (see Mattoo et al. 2017).
The boom in IIAs was certainly the most salient feature of the past three decades.
These agreements, which include treaties with investment provisions (TIPs) and
bilateral investment treaties (BITs), have contributed to reshaping international
business relations and increasing the levels of protection enjoyed by foreign inves-
tors. A typical IIA’s main provisions include protection against expropriation risk,
convertibility risk, and arbitrary or discriminatory measures; they may also ensure
“protection and security”, and/or “most favored nation” treatment.169
These new trends in international investment rule-making merit comment. First,
they reflect the outright triumph of globalization. Second, they enabled developing
countries to gain credibility. Vashchilko (2011) shows that risky economies that
signed BITs managed thereby to reassure international investors, which stimulated
FDI inflows. Third, the growing proportion of BITs involving exclusively low- and
middle-income countries evidenced the ongoing enlargement of the group of capi-
tal-exporting nations.170 Such evolution went hand in hand with the mutation of
capitalism.

167
See [Link]
168
See [Link]
169
The “protection and security” provisions require that host countries take measures to prevent the
destruction of an investor’s property.
170
About 33% of the BITs that entered into force during 2016 did not involve a high-income econ-
omy, compared with less than 12% in 1991 (see [Link]
investment-agreements/advanced-search).
70 2 Two Centuries of Country Risk, 1816–2016

[Link] Untrammeled Capitalism

The transformation of international, liberal capitalism into what I call “untram-

meled capitalism” was a complex and incremental process. This transformation was
driven by five sets of factors.
1. The first group includes all the factors that contributed to enhance the capacity of
countries, especially emerging and developing ones, to host FDI. Once commu-
nism collapsed, governments worldwide had little choice but to integrate them-
selves into the world economy. Beyond the Washington Consensus, which
offered some macroeconomic guidelines (see Sect. [Link]), it was necessary for
low- and middle-income nations to identify and explore their competitive advan-
tages (Porter 1990). Doing so would increase their attractiveness to investors.
2. Adequate specialization and enhanced attractiveness, combined with the infor-
mation and communication technology (ICT) revolution of the 1990s, catalyzed
what Baldwin (2016b) refers to as the “second unbundling”.171 This phenomenon
consists of offshoring some production stages to economies that offer decisive
advantages to foreign investors. These advantages include a low-cost workforce,
proficient engineers, experience in business process outsourcing, government
support for the ICT sector, and favorable tax and regulation systems. Offshoring
enabled many emerging countries to boost their FDI inflows,172 and it led to a
new international division of labor (UNCTAD 2004, pp. xxiv–xxv).
This new international division of labor mirrored much more than a world
economy in which developed countries produce goods and services with higher
value added while developing countries specialize in labor-intensive activities.
In particular, the division was also the result of value chains being extensively
reorganized by multinational firms.
3. The reorganization of value chains, which Gerlach (1992) and Dunning (1995)
label “alliance capitalism,” casts transborder activities as being “increasingly
affected by the collaborative production and transactional arrangements between
firms” (Dunning 1995, p. 462). Cooperative strategies may take various forms,
from wholly owned foreign affiliates and joint ventures to licensing, franchising,
and contractual alliances (Dunning and Lundan 2008, pp. 260–262). The major
goals of such strategies are to cut costs, incorporate new technologies, upgrade
manufacturing methods, and improve R&D performance.
Japanese MNCs pioneered these types of interfirm alliances and networks
(see Gerlach 1992). Mitsubishi Corporation is an illustration. Its 1991 annual
report listed its foreign partners in different sectors; its 2015 annual report went
further and included statements by some of its key partners (Mitsubishi
Corporation 1991, pp. 14–21; 2015, pp. 51–75).

171
The “first unbundling” was the separation of production and consumption locations that occurred
in the nineteenth century.
172
A. T. Kearney Global Services Location indices show that India, China, and Malaysia were the
top three beneficiaries of offshoring strategies during 2004–2016 (A. T. Kearney 2004, 2016).
2.4 The Globalization Years, 1991–2016 71

The spread of this alliance capitalism pattern made value chains global, which
amplified the interdependence not only of participating firms but also of their
contractors and subcontractors. In addition, it helped expand the international
presence of MNCs. For example, the average Transnationality Index (TNI) for
the world’s top 100 nonfinancial MNCs rose from 55% in 1996 to 66% in
2016.173
4. The participation in global value chains and the increasing internationalization
of MNCs were not limited to firms located in traditional capital-exporting coun-
tries. Starting in the 1990s, emerging economies globalized their businesses as
well—with a remarkable surge in MNCs. The number of emerging countries
hosting the world’s top 100 nonfinancial MNCs increased from two in 1996 to
ten in 2016. The average TNI of these ten mega-firms (CK Hutchison Holdings
Ltd., Hon Hai Precision Industries, CNOOC, Teva Pharmaceutical Industries
Ltd., Samsung Electronics, Broadcom Ltd., Petronas, China COSCO Shipping
Corp. Ltd., Vale SA, and América Móvil) was comparable to that of other leading
MNCs.174
5. The fifth feature of untrammeled capitalism is the trend of multinational firms
registering outside their home country—usually in a tax haven (e.g., the Cayman
Islands) or a territory offering a favorable tax regime (e.g., Luxembourg). These
strategies were designed to enhance profitability, and they convinced some coun-
tries (e.g., Ireland) to engage in “tax-dumping” policies (Hira et al. 2019).
The advent and development of untrammeled capitalism revealed that MNCs
were able to offshore most of their business segments and support functions.

[Link] Country Risk During to the Globalization Era

Three categories of risks are examined here: the “traditional” but “manageable”
risks; the “traditional” but growing risks, especially creeping protectionism; and a
new type of threat inherent to untrammeled capitalism.
1. International investors managed to cope with some traditional risks simply
because such risks materialized much less frequently than during the Cold War.
Expropriation and convertibility risks are two examples. The collapse of the
Soviet Union considerably reduced the likelihood that a government might shift
to a socialist economic policy and expropriate foreign holdings. The few coun-
tries that followed this path (e.g., Bolivia, Ecuador, and Venezuela) accounted for
most of the expropriation cases (see Sect. 3.3.1). By the same token, emerging
countries were much more reluctant to implement capital controls. The imposi-

173
This ranking is based on the total value of foreign assets. The TNI is calculated as the average
of the following three ratios: foreign assets to total assets, foreign sales to total sales, and foreign
employment to total employment; author calculations based on UNCTAD (1998, pp. 36–38) and
[Link]
174
Author calculations based on UNCTAD (1998, pp. 36–38) and [Link]
72 2 Two Centuries of Country Risk, 1816–2016

tion of nonconvertibility was most often a desperate measure driven by an eco-

nomic or political crisis, as observed in Argentina, Iceland, and Cyprus in 2001,
2008, and 2012, respectively (see Sects. [Link] and 5.2.7).
Next, some traditional risks were controlled by the increased ability of inves-
tors to insure against them. Political risk was mitigated through the guarantees or
insurance contracts provided by an increasing number of institutions (see MIGA
2014): export credit agencies, insurance companies, MIGA, and OPIC. During
1992–2016, 62% of OPIC’s insurance claim settlements arose from damages
caused by episodes of political violence (OPIC 2017). The countries involved
were Afghanistan, Chad, the Central African Republic, Colombia, the Dominican
Republic, the Democratic Republic of Congo, Ethiopia, Haiti, Liberia, Mali,
Rwanda, Sierra Leone, South Sudan, Yemen, the former Yugoslavia, and Zambia.
Note also that derivative financial instruments enabled international investors to
hedge risks stemming from foreign currencies, interest rates, and commodity
prices.
Foreign currency and interest rate risks were a major concern among all
MNCs. For example, the Indian rupee, the Brazilian real, and the Russian ruble
fell by (respectively) 47%, 69%, and 91% against the US dollar between January
1997 and December 2016.175 Because these depreciations were concentrated in
specific periods (1997–1998, 2008, and 2012–2013 for India; 1998–1999, 2001–
2002, 2008, and 2014–2015 for Brazil; 1998–1999 and 2014–2015 for Russia),
they required that domestic central banks hastily tighten their monetary policy;
this dynamic made financing abroad even more difficult.
Meanwhile, the extensively fluctuating exchange rates of major currencies
remained a serious impediment to international business, as it was in the 1970s
and 1980s (for an analysis of the global monetary disorder, see Cohen 2013).
Hence hedging became indispensable for most MNCs (for an illustration of the
extensive use of hedging techniques in the commercial airplane industry, see
Airbus 2017, p. 16; Boeing 2017, p. 98).
Commodity price volatility was especially challenging for oil and mining
companies and manufacturing firms. Chevron (1999, p. 27) and Glencore (2017,
p. 182) indicate that they hedged against commodity price risk when, respec-
tively, the price of crude oil reached record lows in 1998–1999 and the price of
copper and nickel plunged between 2014 and 2016. Manufacturing firms behaved
likewise when seeking to offset the commodity price boom of the 2000s (see e.g.
Reliance 2007, p. 160; Ford Motor Company 2008, p. 50).
2. A growing risk for exporters and foreign direct investors was the development of
“creeping protectionism.” This trend, already underway in the 1980s, has accel-
erated since then.

Author calculations based on the Pacific Exchange Rate Service; available at [Link]
175

[Link].
2.4 The Globalization Years, 1991–2016 73

During 2009–2016, more than 56% of the new protectionist measures took
the form of nontariff barriers.176 Such NTBs include subsidies (e.g., financial
grants, state loans, bailouts, loan guarantees, production subsidies, and tax or
social insurance relief), import controls (e.g., quotas and licensing require-
ments), export controls (e.g., export subsidies and trade finance), public procure-
ment policies, localization measures, capital controls, and currency depreciation.
Nontariff barriers were rife in the United States, India, and Russia; the sectors
most affected were electric energy, domestic appliances, and products of iron or
steel (Bertelsmann Stiftung 2017).
By discriminating against foreigners, NTBs distort competition and unravel
what the WTO, BITs, and TIPs had previously accomplished. The surge in NTBs
nurtured trade defense measures and more than doubled the number of disputes
brought to the WTO from 239 cases during 1970–1994 (under the GATT system)
to 518 during 1995–2016. Moreover, the number of investment disputes settled
by the ICSID increased dramatically—from 26 during 1967–1991 to 584 during
1992–2016.177
In this neo-mercantilist environment, MNCs need the support of their home
country as well as a top-flight legal department to counter the anti-business prac-
tices implemented by importing and host countries. However, such safeguards
may not be effective for investors in the world’s two largest economies: the
United States and China.
In China, both the low-interest loans granted to strategic MNCs and the trans-
formation of state companies into “weapons of trade policy” are extremely det-
rimental to the interest of foreign firms (Kurlantzick 2016, pp. 89–91, 203–204).
And the negative real interest rates prevailing in the United States unfairly
advantage US companies, especially the largest ones. Furthermore, US courts
play a relatively active economic role. For instance, prosecutors generally com-
promise with domestic firms, which pay far smaller fines (on average) than do
their foreign competitors (Garrett 2014, pp. 218–249).
The protectionist policies followed by the two economic superpowers extend
beyond NTB measures and include such heterodox macroeconomic measures as
financial repression. This tendency suggests that free-market capitalism might be
waning. Instead, the world economy may reach the apex of what Luttwak (1990,
p. 19) calls geo-economics, or “the admixture of the logic of conflict with the
methods of commerce.”
3. The third category of threats includes all the risks inherent to untrammeled capi-
talism. Most of them are microeconomic risks characteristic of global value
chains, but some are political in nature.
The first set of risks is related to the host country’s business and regulatory
environment. These risks are analyzed in the World Bank’s Doing Business
reports, which present data—for nearly all of the world’s economies—on eleven

176
Author calculations based on [Link]
177
Author calculations based on [Link]
74 2 Two Centuries of Country Risk, 1816–2016

areas of business regulation: starting a business, dealing with construction per-

mits, obtaining electricity, registering property, securing credit, protecting
minority investors, paying taxes, trading across borders, enforcing contracts,
resolving insolvency, and regulating the labor market (World Bank 2016, p. 20).
The risks identified in Doing Business reports consist mostly of the extra time,
cost, and procedures required in these eleven areas.178
Another set of risks reflects the need for MNCs to monitor their partners, sup-
pliers, and contractors by checking their respective credit positions, ownership,
and reputations as well as the quality and ethics of their managers and employ-
ees. Firms that specialize in business data and information (e.g., Dun &
Bradstreet) help MNCs perform these duties by offering services designed to
make global value chains safer and to avoid supply disruptions.179
The third set of risks stems from (a) the potential delinquent behavior of
MNCs and of their partners, suppliers, and/or contractors and (b) the negative
externalities generated during the production process. Fraud, violating laws and
regulations, allowing poor labor conditions, and polluting are likely to tarnish
the MNC’s reputation and could lead to significant financial losses. So in order
to preserve their interests and improve their social, environmental, and ethical
performance, MNCs have developed corporate social responsibility standards.
Such standards, which serve as “international private business self-regulation”
(Sheehy 2015), are increasingly scrutinized by the media and the public.
The last group of threats associated with untrammeled capitalism involves not
microeconomic but rather political risks. The globalization process described
here has troubled Western societies in the sense of rising inequality (Piketty
2013) and increased deindustrialization (Nickell et al. 2008). These destabilizing
trends have exacerbated frustration among European and American citizens
while nurturing populism and isolationism—especially since the Great
Recession.180 Populism is a complex challenge for international investors because
it renders economic policies less certain and may well undermine the rule of law
(as in Viktor Orban’s Hungary).
It is interesting that globalization’s negative effects on developed economies
were clearly identified, more than two decades ago, by Rodrik (1997) and
Luttwak (1999). However, their warnings were largely ignored by policy
makers.

178
These issues are partly addressed by the World Economic Forum’s Global Competitiveness
Report and A. T. Kearney’s Foreign Direct Investment Confidence Index.
179
See [Link]
180
The Brexit vote and the election of Donald Trump in 2016 are two illustrations.
References 75

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Chapter 3
Taxonomy of Country Risk

This chapter investigates the numerous forms that country risk may take and also
provides illustrations of them. Seven broad components of country risk are scruti-
nized in turn: international political risks; domestic political and institutional risks;
jurisdiction risks; macroeconomic risks; microeconomic risks; sanitary, health,
industrial, and environmental risks; and natural and climate risks. Each of these risks
consists of various “subrisks” that have specific features. Their effects may be direct
or indirect (or both) and may become manifest in the short, medium, or long term.
These “subrisks” may be latent or constitute a shock that affects all or only some
investors. For instance, environmental risks are much more likely to affect foreign
bondholders of corporate debt, shareholders, and especially direct investors—cor-
responding to type-4, type-5, and type-6 country risks (CR4, CR5, and CR6)—than
to affect exporters, importers, and foreign bondholders of sovereign debt, which
correspond to type-1, type-2, and type-3 country risks (CR1, CR2, and CR3).
My analysis focuses on the postwar years, with a greater emphasis on the global-
ization era (i.e., since the 1990s). Various sources are used: academic works, profes-
sional publications, press articles, and corporate annual reports. I also discuss how the
30 companies included in the Dow Jones Industrial Average (DJIA) index1 factored
the different country risk components into their 2016–2017 business strategies.2

1
As of 1 April 2017, the 30 companies listed on the DJIA were 3M Company (3M), American Express
Company (American Express), Apple Inc. (Apple), The Boeing Company (Boeing), Caterpillar Inc.
(Caterpillar), Chevron Corporation (Chevron), Cisco Systems, Inc. (Cisco), The Coca-Cola Company
(Coca-Cola), The Walt Disney Company (Disney), E. I. du Pont de Nemours and Company (DuPont),
Exxon Mobil Corporation (Exxon Mobil), General Electric Company (General Electric), The Goldman
Sachs Group, Inc. (Goldman Sachs), The Home Depot, Inc. (Home Depot), International Business
Machines Corporation (IBM), Intel Corporation (Intel), Johnson & Johnson (Johnson & Johnson),
JPMorgan Chase & Co. (JPMorgan Chase), McDonald’s Corporation (McDonald’s), Merck & Co.,
Inc. (Merck), Microsoft Corporation (Microsoft), Nike, Inc. (Nike), Pfizer Inc. (Pfizer), The Procter &
Gamble Company (Procter & Gamble), The Travelers Companies, Inc. (Travelers), United
Technologies Corporation (United Technologies), UnitedHealth Group Incorporated (UnitedHealth),
Verizon Communications Inc. (Verizon), Visa Inc. (Visa), and Wal-Mart Stores, Inc. (Walmart).
2
I examine “Item 1A. Risk Factors” of the US Securities and Exchange Commission (SEC) Form
10-K as filed by the 30 DJIA companies for the fiscal year ended between April 2016 and March 2017.

© Springer Nature Switzerland AG 2020 89

N. Gaillard, Country Risk, [Link]
90 3 Taxonomy of Country Risk

3.1 International Political Risks

This section explores three aspects of international political risk: the bilateral
­relations between the host country and the investor’s country (Sect. 3.1.1), interna-
tional sanctions and embargoes (Sect. 3.1.2), and international tensions and warfare
(Sect. 3.1.3).

3.1.1 B
 ilateral Relations Between the Host Country
and the Investor’s Country

Bad or deteriorating diplomatic relations between the host country and a business’s
home country is alarming. This is a crucial issue for firms headquartered in a nation
whose foreign policy is regarded as excessively proactive or interventionist.
After his coup in January 1959, Fidel Castro gave up the pro-American diplo-
macy of his predecessor Fulgencio Batista.3 Castro’s “anti-imperialistic” stance
foreshadowed the expropriation measures announced in the following months
(Johnson 1965). The Cuban episode shows that diplomatic rows between the United
States and various Latin American countries may result in the expropriation of US
direct investors there. Two examples are illustrative: the 1970 election of Salvador
Allende in Chile and the 1998 election of Hugo Chavez in Venezuela. In both cases,
the newly elected president criticized US foreign policy4 and promoted a Marxist
agenda that ended up with industries being nationalized. The first US firms affected
were Bethlehem Steel5 in Chile and Williams (a company operating in the oil and gas
industry) in Venezuela.6
Firms with a subsidiary in a territory that gained independence from their home
nation may also suffer from the bad relations between the former colonial power and
the former colony. For example, after years of mistrust with Belgium, the Congo’s
government announced in 1966–1967 that it intended to “Congolize” Belgian com-
panies.7 By the same token, Algeria seized 51% of the oil fields of French firms in
1971 (Grimaud 1972).

3
R. H. Phillips, “Castro Rules Out Any Foreign Hand in Cuban Affairs,” New York Times, 4 July
1959.
4
J. Novitski, “Chile Restores Formal Ties with Cuba; End of Alignment with U.S. Policy Seen,”
New York Times, 13 November 1970; “‘Back Off’ Says Venezuela in Light of Bad Economy,”
Orlando Sentinel, 6 February 2000.
5
See J. de Onis, “Chile to Buy Bethlehem Mines in First Major Take-Over Pact,” New York Times,
27 March 1971.
6
See The Williams Companies, Inc. (2003, pp. 23–24; 2004, p. 22) and Hajzler and Rosborough’s
(2016) database.
7
C. H. Farnsworth, “Belgium and the Congo,” New York Times, 7 January 1967.
3.1 International Political Risks 91

With the number of such expropriation acts declining since the 1980s (see Sect.
3.3.1), bad diplomatic relations between a host country and the United States have
been reduced to a minor concern among US firms. In 2016–2017, American Express
was the only DJIA company that referred explicitly to this risk (see Appendix 1).
This multinational financial services corporation fears that “a negative perception of
the United States arising from its political or other positions” could harm the percep-
tion of the company and its brand (American Express 2017, p. 22). This reputational
concern partly echoes that of Wyndham Worldwide Corporation—one of the world’s
largest hospitality companies—which has repeatedly worried about the “potential
adverse changes in the diplomatic relations of foreign countries with the United
States” (Wyndham Worldwide Corporation 2008, p. 33; 2012, p. 33; 2016, p. 26).
It is noteworthy that bad relations between two countries will likely affect credi-
tors as well. In 1960, Cuba suspended the interest payments on its 4.5% external US
dollar bond.8 It is safe to assume that the sole objective of this default was to steal
from American bondholders.9 A more recent illustration involves Russia’s seizure of
the Crimean Peninsula from Ukraine in 2014; that action led Kiev not only to with-
hold payment on $3 billion worth of bonds owed to Moscow but also to declare, in
2015, a moratorium on any repayment of that debt (Moody’s 2015b; Ukraine 2016).

3.1.2 International Sanctions and Embargoes

I examine here the international sanctions and embargoes that hit foreign investors
in countries where they could, until then, do business on a regular basis.10
South Africa is an instructive case. Adopted unanimously in November 1977,
United Nations Security Council Resolution 418 imposed a mandatory arms embargo
against the apartheid regime.11 Resolution 418 caused the last-minute cancellation of
certain contracts signed with the South African authorities. Thus, the sale of two A69
avisos built by the French shipyard Dubigeon-Normandie was suspended, which
obliged the French parties to compensate Pretoria (Sada 1990, p. 291).
In October 1986, the US Congress passed the Comprehensive Anti-Apartheid
Act; this legislation prohibited US firms from either granting loans to or investing in
South Africa.12 Some of them (e.g., Emhart and PepsiCo) divested from South

8
P. Heffernan, “Bonds: Prices of Prime Securities Tend to Decline,” New York Times, 4 April 1961;
see also Suter (1990, p. 283).
9
The trading range of this bond plummeted from 102–106 in 1958 to 23–37 in 1962 and then to
18–27 in 1969 (Moody’s 1963, p. a4; 1970, p. a3).
10
The two embargoes imposed by the United States on Cuba in October 1960 and February 1962
are not studied because they were announced after the wave of expropriations. For the chronology
of events, see Peterson Institute for International Economics (2011).
11
See [Link]
12
See [Link]
92 3 Taxonomy of Country Risk

Africa,13 and Rank Xerox South Africa Pty. Ltd. was sold to a local company (Xerox
Corporation 1988, p. 7). However, other US firms (e.g., Citibank and Mobil)
remained in the country.14 In 1989, Colgate-Palmolive Company (1990, p. 17) still
had a subsidiary there.
During 1993–1996, 35 countries were subject to US unilateral economic sanc-
tions. The promotion of human rights and democratization was the most frequently
cited purpose, followed by “anti-terrorism” (National Association of Manufacturers
1997). As of March 10, 2017, more than 30 nations were affected by a variety of
US restrictions and sanctions. Most of them were subject to restrictions regarding
defense articles and services (Thompson Coburn LLP 2017). Of these, 17 coun-
tries were—to a greater or lesser degree—“blacklisted” by the United States both
during 1993–1996 and in March 2017: Afghanistan, Burundi, China, Cuba, the
Democratic Republic of the Congo (formerly Zaire), Haiti, Iran, Iraq, Libya,
Myanmar, North Korea, Qatar, Russia, Saudi Arabia, Sudan, Syria, and the United
Arab Emirates.15
Losman (1998, p. 40) investigates the cost of international economic sanctions.
Direct costs may include loss of current earnings, sale of properties at distressed
prices, and loss of a major supplier or customer. Indirect costs may entail additional
expenses for marketing, administration, and compliance. For instance, Section 219
of the Iran Threat Reduction and Syria Human Rights Act of 2012 added new Section
13(r) to the Securities Exchange Act of 1934, which imposed new reporting require-
ments on US companies (see American Express 2017, p. 15; Boeing 2017, p. 47).16
Another indirect cost is the possible “imposition of retaliatory sanctions against
U.S. multinational corporations by countries that are or may become subject to
U.S. trade sanctions” (Coca-Cola 2017, p. 16).
In a different connection, the willful violation of US economic sanctions can be
much more disastrous. In 2015, BNP Paribas was sentenced for conspiring to vio-
late the Trading with the Enemy Act and the International Emergency Economic
Powers Act by processing billions of dollars of transactions through the US finan-
cial system on behalf of Sudanese, Iranian, and Cuban entities subject to US

13
D. Kneale, “Sullivan Urges Firms to Quit South Africa—Principles’ Author Calls for Broader
Sanctions,” Wall Street Journal, 4 June 1987.
14
Ibid.
15
It is worth remarking that the countries included in this list considerably outnumber those that
can be viewed as “rogue states.” For a thorough analysis of this latter concept and the countries it
includes, see Saunders (2006).
16
The main objective of the Iran Threat Reduction and Syria Human Rights Act was to strengthen
Iran sanctions laws for the purpose of compelling that country to abandon its pursuit of nuclear
weapons and other threatening activities. See [Link]
[Link].
3.1 International Political Risks 93

­economic sanctions.17 The French financial institution was ordered to forfeit $8.8
billion to the United States and to pay a $140 million fine.18

3.1.3 International Tensions and Warfare

Interstate wars can be the most disastrous events for any investor. Section 2.2.1
documented how World War I not only depressed international trade and destroyed
the global integration of capital markets but also led capitalist powers to break their
long-standing tradition of respect for foreign individual property.
However, this section does not review the interstate conflicts that occurred in
recent decades (but for a remarkable work on this topic, see Goldstein 1992). Neither
does it classify interstate wars nor discusses the relevance of “low-­intensity,” “mid-
intensity,” and “high-intensity” conflicts; these two issues have been addressed by,
respectively, Vasquez and Valeriano (2010) and Bellamy (1998). Instead, I focus on
the period 1975–2015 and analyze how foreign investors suffered from this type of
international political risk.
Figure 3.1 presents the major episodes of international political violence (e.g.,
interstate wars, occupations of disputed territories, and invasions) as assessed by the
Center for Systemic Peace. The number of international conflicts has significantly
declined since 1975. At the beginning of the period, East Asia, Middle East, and
North Africa were the riskiest areas. The most recent war episodes involved Iraq and
the United States.
The interstate conflicts that occurred during 1975–2015 seem to have had rela-
tively limited consequences for major foreign direct investors. Several reasons can
be advanced for this surprising result.
First, three major military powers—Russia, the United Kingdom, and the United
States—were involved in wars outside their own borders.19 As a result, these interven-
tions did not affect the foreign firms that had commercial or financial interests in
these three countries. Second, some governments were embroiled in interstate
conflicts after years of civil war; examples include Zimbabwe (formerly Rhodesia)
during 1975–1979, Cambodia and Vietnam during 1975–1989, and Rwanda during
1996–2002. Thus, the business climate in these areas was already gloomy when

17
The Trading with the Enemy Act of 1917 restricts trade with countries hostile to the United
States. The International Emergency Economic Powers Act of 1977 authorizes the President to
regulate commerce after declaring a national emergency in response to any unusual and extraordi-
nary threat to the United States that has a foreign source. See [Link]
trading-with-the-enemy-act-twea and [Link]
economic-powers-act.
18
Department of Justice, “BNP Paribas Sentenced for Conspiring to Violate the International
Emergency Economic Powers Act and the Trading with the Enemy Act,” Office of Public Affairs,
Press Release No. 15-549, 1 May 2015.
19
The three governments fought against (respectively) Afghanistan and Georgia; Argentina; and
Afghanistan, Iraq, and Panama.
94 3 Taxonomy of Country Risk

14

12

10

East Asia & Pacific Europe & Central Asia Latin America & Caribbean
Middle East & North Africa North America South Asia
Sub-Saharan Africa

Fig. 3.1 Major episodes of international political violence, 1975–2015. Sources: Author’s calcu-
lations based on international major episodes of political violence (MEPV) listed by the Center for
Systemic Peace; database available at [Link]

international hostilities began. Third, in a few cases, international political risk was
dwarfed by business opportunities. For example, Ethiopia’s border war with Eritrea
in the late 1990s did not prevent the former from launching a large-scale privatization
process to attract foreign firms.20 In the meantime, the International Finance
Corporation (IFC 1999, p. 73) announced its first investment in the country since 1967.
The Iraqi invasion of Kuwait in 1990 has idiosyncratic features. Most American
companies with operations in the small emirate were caught off guard. They had to
set up 24-h hotlines to inform relatives of the Americans in Kuwait, organize the
evacuation of their employees, save hostages, and so forth.21 Texaco held a conces-
sion representing a 50% undivided interest in the onshore portion of the Partitioned
Neutral Zone, an area located between Saudi Arabia and Kuwait. Because of the
invasion, its wells and related facilities were severely damaged, and all operations
were suspended (Texaco Inc. 1991, p. 67; 1992, p. 4). However, the short-term finan-
cial consequences were quite different: The firm reported a 35% jump in its fourth
quarter earnings for 1990 at $388 million, reflecting the surge in crude oil prices.22

20
“Ethiopia Set to Privatize 120 State-Owned Enterprises in Next Three Years,” BBC Monitoring
Africa—Economic, 24 April 1999.
21
C. Johnson, “Many Americans Trapped in Kuwait Escape Detection,” Wall Street Journal, 22
August 1990; D. Medina and C. Phillips, “Companies with Hostages in Persian Gulf Struggle to
Help Stateside Families Cope,” Wall Street Journal, 26 September 1990.
22
J. P. Hicks, “Earnings Jump 35% at Texaco,” New York Times, 24 January 1991.
3.2 Domestic Political and Institutional Risks 95

Chevron and Exxon posted even bigger profits over the same period.23 The first Gulf
War shows that, paradoxically, adverse political events may have positive effects for
some types of investors.
The fate of the bankers and bondholders who had lent to belligerent governments
merits some more specific comments. Only five countries (accounting for 10% of all
observations)24 defaulted in the same year or the year after they entered an interna-
tional war: Iran in 1980, Lebanon and Argentina in 1982, Kuwait in 1990, and
Croatia in 1992.25 Moreover, it is not certain whether becoming embroiled in war is
causally related to debt default (except in the case of Kuwait). In fact, the economic
difficulties experienced by the four other countries are certainly the main driver for
their inability to honor their financial obligations.
The international wars that occurred during 1975–2015 were not a major threat to
foreign investors because most were low-intensity conflicts that hit already unstable
political regimes. That said, any war of even medium intensity in Eastern Europe, the
Middle East, or East Asia could spiral out of control and have immeasurably nega-
tive consequences.

3.2 Domestic Political and Institutional Risks

This section tackles two aspects of domestic political risk: the risks stemming from
institutional organization and access to power (Sect. 3.2.1) and the various forms of
political tensions that may lead to civil unrest or war (Sect. 3.2.2). Section 3.2.3
discusses the two paradoxes of political risk.

3.2.1 Institutional and Political Instability

Any regime change or shift in a country’s executive or legislative power is a potential

threat to foreign investors. Such adverse changes may occur after an independence
proclamation, a democratic election, a nondemocratic power succession, a coup, or
a revolution.

23
“Earnings/Energy—Exxon, Chevron Profits Surge; Gulf Crisis Cited,” Los Angeles Times, 25
January 1991.
24
Author’s calculations based on the Center for Systemic Peace database. An observation is an
episode of international violence for a given country. For example, a country involved in a sus-
tained ten-year international conflict will yield one observation.
25
About 45% of the countries were already in default when the conflict began; 45% remained sol-
vent in the short to medium term.
96 3 Taxonomy of Country Risk

[Link] Independence Proclamation

Between 1945 and 2002, more than 80 territories gained independence from a
­colonial power.26 The leaders of these newly independent states were frequently con-
sidered nationalists or, at least, politicians willing to unify their nation (Young Jr.
1961). Many of them embraced economic policies that were not especially friendly
to foreign exporters (e.g., import–substitution industrialization and protectionist
measures) or that overtly discriminated against foreign direct investment (e.g.,
expropriation; see Sect. 3.3.1). Such options were rife in the 1950s–1970s and
involved countries that had just emancipated themselves from France (e.g., Guinea
in 1958), Belgium (e.g., the Republic of the Congo—now Democratic Republic of
the Congo—in 1960), the United Kingdom (e.g., Ghana in 1960), and Portugal (e.g.,
Mozambique in 1975). This pattern is observed also with regard to the territories that
became sovereign in the aftermath of the Soviet Union’s dissolution in 1991.

[Link] Democratic Election

Democratic elections enabled politicians who were poorly perceived by investors to

come to power (e.g., Salvador Allende in Chile in 1970, François Mitterrand in
France in 1981, Hugo Chavez in Venezuela in 1998, Evo Morales in Bolivia in 2005,
and Rafael Correa in Ecuador in 2006). Take, for example, the case of Evo Morales.
During the 2005 presidential election campaign, this leader of the Movement for
Socialism announced that he would void all contracts allowing ­mining, gas, and oil
exploration by foreign companies.27 Anticipating Morales’s election, the head of
Repsol’s Bolivian operations initiated discussions with the public authorities at La
Paz.28 These fears materialized quickly: As early as 2006, the Spanish oil company
was among the first foreign firms to be expropriated by the Bolivian government.29
Political risk may also arise when the executive and legislative powers are at
odds (typically in a presidential regime) or when no party is able to secure a major-
ity at the parliament. The latter scenario is likely when the electoral system is based
on proportional representation and/or the political landscape is fragmented. Such
scenarios are observed in both developing and developed countries. For instance, it
took 18 months during 2010–2011 for the Belgian government to be sworn in.30 In
2015–2016, Spain had to organize two general elections before a government could
be formed—and a third general election was averted only because the party that
came in second did not vote against the leading party, allowing government forma-
tion to proceed (Lancaster 2017).

26
Author’s estimations based on [Link]
27
D. Rieff, “Che’s Second Coming?,” New York Times, 20 November 2005.
28
J. de Cordoba, “Bolivia Election Portends Foreign-Investor Clash; Outright Presidential Win
Gives Morales Clout to Push for Gas Nationalization,” Wall Street Journal, 20 December 2005.
29
See Hajzler and Rosborough’s (2016) database.
30
S. Castle, “18 Months after Vote, Belgium Has Government,” New York Times, 2 December 2011.
3.2 Domestic Political and Institutional Risks 97

An additional challenge to democratic societies is the influence of “anti-system”

parties, which traditionally undermines government stability (Taylor and Herman
1971; Hartleb 2015). The recent electoral success of the League and the Five Star
Movement in Italy suggests that “anti-system” parties can come to power.31

[Link] Nondemocratic Power Succession

Nondemocratic power successions can trigger an adverse change in the policies

implemented by the outgoing administration or government. More dramatically,
they may exacerbate political rivalries and increase instability. Following the death
of Marshal Tito in 1980, a rotating system of succession was put into operation
among the leaders of the different Yugoslavian provinces.32 This system failed to
maintain the country’s cohesion. In 1981, protests broke out in Kosovo and opened
a period of repression, which spread throughout the country and led to civil war and
the dismantling of Yugoslavia in the early 1990s. Today, succession in Arab monar-
chies remains a source of concern among foreign direct and equity investors
(Billingsley 2010).

[Link] Coup

A coup is certainly the most unexpected catalyst for institutional and political
shocks. For Luttwak (1969, p. 12), “a coup consists of the infiltration of a small but
critical segment of the state apparatus, which is then used to displace the government
from its control of the remainder.”
Figure 3.2 presents all instances of coup attempts that occurred during 1975–2015.
Their frequency has significantly declined over the past four decades. During
1975–1984, there were (on average) ten coup attempts per year, when compared to
three annually during 2006–2015. Sub-Saharan Africa has been especially afflicted
by such events; this region accounts for 55% of all coups (followed by Latin America,
with 21% of the total).
A coup is likely to have various consequences on MNCs and foreign lenders.
A few successful coups triggered bloody civil wars that eliminated most forms of
business (e.g., Afghanistan in 1978; El Salvador in 1979). However, many coups
occurred amid an episode of civil violence or civil war: Chad (seven coups during
1975–2006), Lebanon (1976), Angola (1977), Ethiopia (1977 and 1989), Mauritania
(1978), Turkey (1980), Guatemala (four coups during 1982–1989), Nigeria (four
coups during 1983–1993), Sudan (1985, 1989, and 2012), Uganda (1985), the
Philippines (four coups during 1986–1990), Iraq (1991, 1992, and 1995), Liberia

31
“Demagogues Win as Europe’s Populist Tide Sweeps Italy,” New York Times, 6 March 2018.
32
“Tito Dies at 87; Last of Wartime Leaders,” New York Times, 5 May 1980.
98 3 Taxonomy of Country Risk

16

14

12

10

East Asia & Pacific Europe & Central Asia Latin America & Caribbean
Middle East & North Africa South Asia Sub-Saharan Africa

Fig. 3.2 Coup attempts, 1975–2015. Notes: Both successful and unsuccessful coups are included.
There was no coup attempt in North America during 1975–2015. Sources: Author’s calculations
based on Powell and Thyne’s (2011) updated database.

and Rwanda (each in 1994), and Zaire (2004).33 Foreign investors were either already
leaving the host country when the coup occurred (e.g., Lebanon in 1975–1976)34 or
had contemplated doing so (e.g., the Philippines in 1989).35 The case of sub-Saharan
Africa in the late 1970s and early 1980s was even more dramatic, as US firms
became increasingly reluctant to invest there (Seymour Whitaker 1983).36
In at least two instances, a successful coup seems to have directly caused the
default of the debtor country. In 1980, after a military coup, the Bolivian government
ceased making amortization payments to foreign banks. Those banks accepted a
rescheduling of that debt while the IMF maintained a standby agreement signed with
the previous government.37 In 1999, Ivory Coast’s President Konan Bédié was over-
thrown by General Guéï. A few weeks later, the new head of state announced that the
country would default on its foreign currency bonds (Moody’s 2015a, p. 22).

33
Author’s classification based on Powell and Thyne’s (2011) updated database and the Center for
Systemic Peace’s database; see [Link].
34
J. M. Markham, “Foreign Businesses Are Casualties of Lebanon’s Strife,” New York Times, 17
October 1975.
35
D. E. Sanger, “In Manila Coup Effort, Economy Is Big Victim,” New York Times, 20 December
1989.
36
Although Seymour Whitaker was not speaking quantitatively, her analysis is corroborated by the
decline—for Sub-Saharan Africa—in the ratio of foreign direct investment inflows to GDP: from
1% in 1975 to 0.5% in 1983. This ratio exceeded 2.5% in 2015 (World Development Indicators).
37
“10 U.S. Banks Agree to New Terms on $172 Million Bolivia Debt,” New York Times, 13
September 1980.
3.2 Domestic Political and Institutional Risks 99

In some cases, foreign investors refrained from divesting from the country that
had faced a coup. Despite the coup that shocked Fiji in 2000, the Asian Development
Bank (2001, pp. 108–109; 2002, pp. 65–66) disbursed some $9 million in 2000–2001
to that Pacific state while claiming the situation there was being closely monitored.
Similarly, Attijariwafa Bank maintained its activities in Mali after the March 2012
coup there. By 2013, its subsidiary—the Banque Internationale pour le Mali—had
expanded its network and increased its total amount of loans by 16% over 2011
(Attijariwafa Bank 2012, p. 57; 2014, p. 59). It is noteworthy that neither the multi-
lateral bank nor the Moroccan financial institution mentioned the word “coup” in
their annual reports. Instead, they used (respectively) the terms “widespread civil
unrest” and “crisis” (Asian Development Bank 2001, p. 108; Attijariwafa Bank
2013, p. 62).
These results are intriguing. Therefore, I further investigate the relation between
the occurrence of coups d’état and investment decisions. I focus on the investment
strategy followed by the IFC because this financial institution has been a global
investor with a wide range of activities (including equity investment, lending opera-
tions, technical assistance, and advisory services) for a long time. In 1976, its cumu-
lative gross commitments amounted to $1.5 billion and ranged across 61 countries
(IFC 1976, p. 32). Forty years later, they reached $245 billion in 155 countries (IFC
2016, pp. 112–115). Studying the annual reports published during 1976–2006, I find
that the IFC invested in 47 countries in which a coup occurred during the previous
year.38 Much like the Asian Development Bank and Attijariwafa Bank, the IFC
reports do not refer directly to the coups and instead mention only “political uncer-
tainties” and “political instability.”
The tendency of foreign investors to downplay these political shocks reached an
extreme in the case of Thailand. There were 12 coups in Bangkok during 1950–2016.
The last two (in 2006 and 2014) were perceived in positive terms by some interna-
tional bankers, which viewed them as potentially enabling the restoration of political
stability in the medium term.39
The impact of a coup d’état on MNCs and foreign creditors varies across sectors,
countries, and periods. However, investors must bear in mind that coups led to major
expropriations (e.g., Cuba in 1959–1960), horrific civil wars (e.g., Nigeria in
1966–1970, El Salvador in 1979–1992), and transformed a regime into a “rogue
state” (e.g., Sudan in 1989).

38
The reference period is the IFC fiscal year (i.e., July 1–June 30), so I checked whether a recipient
country faced a coup the previous fiscal year. Author’s calculations are based on IFC (various
reports) and Powell and Thyne’s (2011) updated database.
39
“Coup? What Coup? Thailand’s Bond Market Is Unruffled,” Euroweek, 29 September 2006;
J. Maxwell Watts, “Thailand Investors Shrug Off Coup,” Wall Street Journal, 24 May 2014.
100 3 Taxonomy of Country Risk

[Link] Revolution

As defined by Huntington (1968, p. 264), a revolution is “a rapid, fundamental, and

violent domestic change in the dominant values and myths of a society, in its politi-
cal institutions, social structure, leadership, and government activity and policies.”40
Postwar history shows that revolutions are likely to have very different consequences
on foreign businesses. Here, I examine how the Iranian and Egyptian revolutions,
which took place in (respectively) 1978–1979 and 2011–2013, affected the hotel
industry.
After months of protestations, strikes, and civil resistance that paralyzed Iran, the
Shah exiled himself from that country in January 1979. This triumph of the revolu-
tionary groups enabled establishment of the Islamic Republic of Iran. The new
regime’s fierce opposition to Western powers obliged the Carter administration to
impose sanctions and an embargo on trade with Iran in 1979–1980.41 In the mean-
time, American firms had to leave the country. Several hotel and leisure companies
(e.g., Hilton, Hyatt, Sheraton, and Starwood) operated properties there when the
Islamic Revolution broke out.42 In fact, Hilton Hotels (1964, p. 14) had opened the
tallest building in the capital, the Royal Tehran Hilton, in 1963. In 2016, these firms
had still not returned to Iran.43
Like its precursor, the Egyptian revolution started with protestations and strikes,
and a military junta overthrew President Hosni Mubarak in February 2011. After a
series of popular elections, the Muslim Brotherhood took power and Islamist
Mohamed Morsi became head of state in June 2012. A second coup, organized by
General Abdel Fattah El-Sisi, ousted Mohamed Morsi in July 2013 (Tabaar 2013).
During this period, major hotel companies admitted that their operations in Egypt
were depressed but did not terminate them (e.g., Marriott International Inc. 2014,
p. 10; Melia Hotels International 2014, p. 106).
The respective creditors of the two countries experienced diverging fates, too.
Iran stopped repaying its debt shortly after the beginning of the Islamic Revolution.
The US Exim Bank (1981, p. 19) and Wells Fargo & Company (1980, p. 3) announced
that their loans to Iranian entities were in default. Iran proved unable and/or unwill-
ing to respect its financial obligations for two decades. In contrast, Egypt remained
solvent during the period 2011–2013 and beyond (see the database of Beers and de
Leon-Manlagnit 2019).
The political upheavals that shook Tehran and Cairo suggest that foreign inves-
tors can survive a revolution provided it does not lead to antibusiness measures,
international disputes, or major episodes of host-country violence.

40
This definition is debatable because some revolutionary processes did not entail violence—for
example, the “Velvet Revolution” in Czechoslovakia during 1989.
41
See [Link]
42
“Marriott Is First US Hotel Group to Eye Iran,” Press TV, Tehran, 7 December 2016.
43
Ibid.
3.2 Domestic Political and Institutional Risks 101

3.2.2 Domestic Violence and Warfare

Episodes of political violence have two basic dimensions: their intensity and their
length. It is with reference to these dimensions that I categorize such episodes into
two groups, as described next.

[Link] Riots and Terrorist Attacks

Sporadic riots and violent demonstrations are unlikely to affect equity and direct
investors unless they target the firms from a specific country or business sector. In
May 2014, many riots erupted in Vietnam. Hundreds of stores and factories owned
by Chinese and Taiwanese merchants were looted and torched. Foreign workers
died, and some companies suspended their operations in Vietnam indefinitely. A
Wall Street Journal investigation showed that anti-Chinese and anti-Taiwanese senti-
ment was the main motive for these riots.44
Protesters may also target specific businesses. In the 1990s–2000s, the operations
of foreign mining companies in Indonesia were frequently disturbed by human
rights defenders, environmentalists, and illegal miners. In March 2006, five
Indonesian security officers working for PT Freeport Indonesia—a subsidiary of
Freeport-McMoRan—were killed by protesters in the West Papuan capital of
Jayapura.45
Political violence may affect a single firm, as the next two examples illustrate. In
1969, on the occasion of Nelson Rockefeller’s visit to Buenos Aires as a special
envoy of President Nixon, several supermarkets located in Argentinean cities were
bombed because they were controlled by the Rockefeller family (Robock 1971,
p. 9). More recently, Centerra Gold Inc. (2015, p. 85) complains that protesters and
other groups have regularly attempted to access its Kyrgyz site. The Toronto-based
gold mining company warns that a trespass could “cause harm to employees or prop-
erty, or result in business interruption.”
Terrorist attacks constitute an even more serious risk for a foreign direct investor,
especially when their purpose is to disrupt operations or eliminate a key market or
supply source. A striking illustration is the tragedy that shocked the nuclear com-
pany Areva in Niger. In May 2013, suicide bombers attacked the Somaïr uranium
mine owned by that French firm. One employee was killed, and 14 staff members
were wounded (Areva 2014, p. 24). If the company lost this mine, then it would be
forced to rely on scarce alternative supply sources (in Kazakhstan and Canada).46

44
E. Dou, J. W. Hsu, and T. K. Vu, “World News: Vietnam Unrest Shakes Foreign Firms,” Wall
Street Journal, 17 May 2014; E. Dou and R. Paddock, “Firms Learn Business Risks in Vietnam,”
Wall Street Journal, 19 June 2014.
45
“The Fun of Being a Multinational,” The Economist, 20 July 1996; “Indonesia: Mining Looks
Good, Despite Violent Protests,” Oxford Analytica Daily Brief, 4 April 2006.
46
V. Le Billon, “Areva en terrain miné au Niger,” Les Echos, 13 June 2013.
102 3 Taxonomy of Country Risk

[Link] Political Unrest and Civil War

Political unrest and civil war are certainly the most dangerous plagues for any busi-
nessman because damages accumulate over an extended period. These damages
manifest as threats to the safety of the investing company’s employees, clients, and
consumers as well as loss of a market or supply source and massive financial losses.
Figure 3.3 presents all major episodes of domestic political violence for the
period 1975–2015. They include civil and ethnic violence and warfare. Sub-Saharan
Africa—the most violent region—accounts for one-third of all observations.47
Political violence reached a peak in 1992 and declined until 2010. Since then, there
has been a resurgence of ethnic and civil war (mainly because of the so-called Arab
Spring). The countries of Egypt, Libya, Syria, and Yemen have been especially
hard-hit.48
Close examination of these events reveals that ethnic conflicts were the main
component of domestic political violence, accounting for more than half of all obser-
vations. Furthermore, the most violent episodes (as classified by the Center for
Systemic Peace) were driven by interethnic tensions: the wars in Ethiopia in the late
1970s, Iraq in the 1980s, and India in the early 1990s and the Rwandan genocide
of 1994.
In the early 1990s, attacks conducted by Separatists of the Jammu and Kashmir
Liberation Front, insurgencies (in Jharkhand, Chhattisgarh, and Andhra Pradesh) by
the Maoist People’s War Group, and Hindu–Muslim tensions throughout the country
caused thousands of deaths and undermined political stability in India. Such vio-
lence scared some financiers but did not discourage industrialists with long-term
projects.49 Long-lasting civil wars in small territories are more likely to hamper for-
eign investments. In Burundi, ethnic violence during 1993–2005 compelled mining
companies involved in nickel and gold exploration to declare force majeure, which
allowed them to suspend or terminate the performance of their obligations (African
Mining 2002a, 2002b, 2002c).50 In some cases, anarchy and political unrest led to
the destruction of foreign factories and stores. For example, French small- and
medium-sized enterprises were severely affected by the civil war that destabilized
Ivory Coast in 2004. Losses were estimated at €60 million, and 55% of French citi-
zens living in the country were evacuated over a nine-day period (Assemblée
Nationale 2007, pp. 9, 27).

47
Here, an observation is an episode of violence for a given country a given year. For example, a
country in which a civil war lasts for ten years will yield ten observations.
48
For more information, see [Link]
five-years-on.
49
M. V. Brauchli, “India’s Violence Fuels Doubt about Course of Economic Reform,” Wall Street
Journal, 15 December 1992.
50
See K. Damsell, “Argosy Stops Work on Burundi Nickel Mine: Force Majeure Declared,”
National Post, 5 May 2000; see also [Link]
3.2 Domestic Political and Institutional Risks 103

48

40

32

24

16

East Asia & Pacific Europe & Central Asia Latin America & Caribbean
Middle East & North Africa South Asia Sub-Saharan Africa

Fig. 3.3 Major episodes of domestic political violence, 1975–2015. Note: There was no episode
of domestic political violence in North America during 1975–2015. Sources: Author’s calculations
based on domestic MEPV listed by the Center for Systemic Peace; database available at http://
[Link]/inscr/[Link]

3.2.3 The Two Paradoxes of Political Risk

Political risk is a paradoxical concept: It remains a key component of country risk, but
it is mentioned only briefly—and in general terms—in the annual reports published by
MNCs (e.g., the DJIA firms; see Appendix 2). It may be that multinationals fear local
authorities will view any extensive political analysis as interference. Nonetheless, some
major companies have developed idiosyncratic strategies to reduce this type of risk.
In 1997, Cabinda Gulf Oil (a subsidiary of Chevron) convinced the Angolan gov-
ernment to hire an American surveillance and security firm to provide protection
against guerrilla attacks from the Front for the Liberation of the Enclave of Cabinda
(O’Brien 2000, p. 57). It is often the case that a MNC’s interconnectedness with state
structures is a crucial factor in the development of business operations as with the
ties between Shell and Nigeria (Frynas 1998).51 In some cases, investors have com-
promised with a dictator in order to preserve their own interests. Bucheli and Kim
(2012) analyze how United Fruit Company thrived in Central America—until the
1954 Guatemalan coup and subsequent institutional changes in the region tarnished
the company’s reputation and reduced its profitability. This process, called “obso-
lescing legitimacy” by Bucheli and Kim (2012), supports the view that one result of
any “solution” to political risk will be yet another challenge.

51
Frynas (1998) argues that political instability may be conducive to business precisely when a
foreign firm has developed privileged ties with top politicians and civil servants.
104 3 Taxonomy of Country Risk

3.3 Jurisdiction Risks

I investigate how foreign investors may be affected by adverse, inefficient, unstable,

and arbitrary laws, regulatory rules, judicial proceedings, and business practices.
Sect. 3.3.1 analyzes the most brutal and adverse form of jurisdiction risk: expropria-
tion. Section 3.3.2 studies other legal, regulatory, and judicial risks. Section 3.3.3
focuses on corrupt practices.

3.3.1 Expropriation

According to Kobrin (1984, p. 330), expropriation is “the involuntary forced divest-

ment of foreign direct investment.” This broad definition includes any seizure of
foreign property by a government, whether or not any compensation is paid.
Figure 3.4 plots the expropriation acts that occurred during the 1960s and 1970s.
Their number increased from 136 acts in the 1960s to 423 in the 1970s. Analysis of
these two decades combined reveals that sub-Saharan Africa was the riskiest region
(accounting for 43.5% of all takeovers), followed by Latin America (27%). Ten host
countries—Algeria, Angola, Chile, Ethiopia, Indonesia, Mozambique, Peru,
Tanzania, Uganda, and Zambia—accounted for 41% of the total (Kobrin 1984,
p. 331). The manufacturing and petroleum sectors were the most affected: They
represented, respectively, 27% and 19% of all takeovers observed during 1960–1979.52

350

300

250

200

150

100

50

0
1960-64 1965-69 1970-75 1976-79

Latin America Asia Middle East & North Africa Sub-Saharan Africa

Fig. 3.4 Expropriation acts by region, 1960–1979. Sources: Author’s calculations based on Kobrin
(1984)

52
Author’s calculations based on Kobrin (1984).
3.3 Jurisdiction Risks 105

At least three reasons may be advanced to explain why forced divestments were
widespread during those two decades. First, the practice can be viewed as political
revenge by former colonies. It is interesting that, of the 17 states that undertook more
than ten expropriation acts, 13 had gained independence after WWII.53 Second, expro-
priation was part of socialist economic policies, which were still considered possible
paths for development—either on behalf of independence and sovereignty (Rood 1976)
or owing to perceived limits of capitalism, especially in light of the economic crisis that
erupted in 1973 (Weeks 1977). Third, there were some cases of new regimes seeking to
exercise state powers in the economic rather than the military realm (Nye 1974).
A large number of firms were affected by the seizure of their business properties
abroad. The nationalization of MNC subsidiaries sometimes hit the headlines; exam-
ples include International Petroleum Company (a subsidiary of the Standard Oil
Company) in Peru in 1969 and British Petroleum’s interests in Nigeria in 1979.54
However, small firms were also the targets of expropriation (Truitt 1970, p. 30; Rood
1976, pp. 432–434). In many instances, compensation was low or not even offered
(Root 1968, p. 74; Williams 1975, pp. 267–272).
The evolution of forced divestments since 1980 presents a very different picture
(see Fig. 3.5). In particular, the frequency of expropriations declined dramatically in
the 1980s. Minor (1994, pp. 180–182) argues that this trend was driven by two fun-
damental factors. First, the 1979 oil shock and the resulting economic crisis induced
many developing countries to revise their policies and take advantage of FDI. Second,
some governments realized that it could be more efficient to regulate than to nation-
alize foreign businesses.
I offer two additional explanations. First, the debt crisis of the 1980s obliged most
developing and emerging countries to adopt market-friendly policies—­including
legal security for property rights, privatization of state-owned enterprises, and the
liberalization of trade and finance. Second, the shift to this new paradigm led to
myriad bilateral investment treaties in the 1980s and 1990s (Vashchilko 2011).
The resurgence of expropriation acts since 1998 reflects policy shifts in some
countries. For example, more than 17% of forced divestments involved former
Soviet republics that became independent in the 1990s. This finding is in line with
observations following WWII and suggests that young nations may be tempted by
nationalist economic measures. Bolivia, Ecuador, and Venezuela—which together
accounted for 46% of the nationalizations during 1998–2014—opted for “Bolivarian”
policies, in which state interventionism is high.55

53
Ibid.
54
See (respectively) P. L. Montgomery, “Peru Seizing All International Petroleum Assets,” New
York Times, 7 February 1969; and “Nigerians Move to Take Over All of BP’s Interests,” Wall Street
Journal, 1 August 1979.
55
For an overview of the different strategies followed by Latin American economies since the
1990s, see Hira and Gaillard (2011).
106 3 Taxonomy of Country Risk

24

20

16

12

East Asia & Pacific Europe & Central Asia Latin America & Caribbean
Middle East & North Africa South Asia Sub-Saharan Africa

Fig. 3.5 Expropriation acts by region, 1980–2014. Notes: For the period 1980–1988, data are
from Minor (1994); for the period 1989–2014, data are from Hajzler and Rosborough’s (2016)
database. Sources: Author’s calculations based on Minor (1994) and Hajzler and Rosborough’s
(2016) database

Mining companies were the most affected businesses (24% of all takeovers),
f­ollowed by the manufacturing and petroleum sectors (14% each).56 As during the
1960s and 1970s, it was difficult for the expropriated firms to secure fair compensa-
tion (see Hajzler and Rosborough’s 2016 database).
Investors reacted very differently to such expropriation. In 2010, after Hugo
Chavez’s regime seized 11 rigs and associated real and personal property owned by
a subsidiary of Helmerich & Payne, the company announced it was leaving Venezuela
(Helmerich & Payne, Inc. 2010, p. 80).57 The following year, the drilling company
filed a lawsuit in the United States for indemnity (Helmerich & Payne, Inc. 2016,
p. 29). Yet during the same period and in the same country, Casino Group (2011,
pp. 4–5) presented the takeover of 80.1% of its subsidiary by the Venezuelan govern-
ment as a “strategic partnership”; the French retailer was to receive $622.5 million
for this “transaction.”
The expropriation of Glencore in Bolivia provides another case. The constitution
that came into effect in 2009 mandates that mining entities form joint ventures with
the government. As a result, the Anglo-Swiss company entered into negotiations
with Bolivian authorities about satisfying this requirement (Glencore 2012, p. 152).
In 2016, Glencore (2017, p. 10) was still operating in the country but now under this
new legal framework.

56
Author’s calculations based on Hajzler and Rosborough’s (2016) database.
57
See also D. Molinski, “Helmerich Warns Other Firms after Venezuela Seizes Oil Rigs,” Wall
Street Journal, 7 July 2010.
3.3 Jurisdiction Risks 107

3.3.2 R
 isks Related to Legal, Regulatory, and Judicial
Environment

There is a plethora of laws, regulatory rules, and judicial decisions that—wittingly

or not—contribute to discouraging foreign investment. This section examines some
of the most striking recent examples.

[Link] Inefficient Jurisdictional System

A basic risk for foreign investors is to operate in a country where bureaucracy, red
tape, and lack of competence at the legislative, regulatory, and administrative levels
hinder business opportunities and reduce productivity. These risks, which become
acute when they preclude adequate contract enforcement and investor protection,
have obliged corporate managers and researchers to take governance quality into
account (see Kaufmann et al. 2002).

[Link] Subsidies to Local Firms58

Laws and business practices that favor local competitors and hamper foreign inves-
tors’ operations are a major concern among MNCs (Chrysler Group 2014, p. 33;
American Express 2017, p. 19). In 2010, amid trade discussions between the
European Union and Turkey, the European Parliament urged Ankara to stop dis-
criminating against non-Turkish firms by granting a 15% price advantage to local
bidders for public procurement contracts.59 China’s support to its domestic firms was
conducted on a much larger scale. During 1985–2005, total subsidies to Chinese
manufacturing enterprises reached $310 billion (Haley and Haley 2013, pp. 2–3).
These transfers of funds prevented foreign industrialists from garnering their
expected share of the market.

[Link] Copyright and Intellectual Property Rights (IPR) Infringement

Copyrights and IPR violations are widespread in developing and emerging coun-
tries. In 2004, after the US copyright industry announced it had lost $785 million in
Brazil the previous year, a controversy arose between the US and the Brazilian
­governments. The former promoted a strict enforcement of IPR, whereas the latter
preferred “flexible” enforcement.60 In the past years, many foreign companies sued

58
This threat is part of protectionism risk; see Sect. 3.4.4.
59
“EU-Turkey Trade Relations: More Functional Customs Union without Barriers,” US Fed News
Service, 15 July 2010.
60
R. Colitt, “Brazil Warned over Copyright Violations,” Financial Times, 22 September 2004.
108 3 Taxonomy of Country Risk

local infringers in court to protect their industrial property (for summaries of the
lawsuits filed in Bulgaria and China, see Hoekman and Djankov 2000 and Ross
2012, respectively). It is noteworthy that the violation of IPR may take extreme
forms. In the early 2010s, for instance, Chinese police organized raids and copied
computer hard drives in foreign firms’ offices. These episodes convinced several
MNCs to shift headquarters from Shanghai to Singapore.61 Today, copyright and
intellectual property protection is a key issue for all business sectors (Coca-Cola
2017, p. 17; IBM 2017, p. 13; Travelers 2017, p. 67; United Technologies 2017, p. 15).

[Link] Burdensome Taxes

Multinational companies may experience discrimination due to the host country’s

tax policy. In Saudi Arabia, foreign investors are subject to corporate income tax at
the rate of 20%—when compared to 2.5% for local firms and entrepreneurs based in
Gulf Cooperation Council states62 (PWC 2015, pp. 8–10). Sometimes, an unex-
pected tax increase in a specific sector may jeopardize business operations abroad.
In 2008, Zambia introduced a new tax regime that upset the copper mining industry.
Some provisions of this law were removed after foreign companies asserted they
were likely to face a marginal tax rate exceeding 100% for high-cost mines (World
Bank 2011, pp. 16–22).

[Link] Shift in Legal Environment

A new legal framework may affect the operations of a foreign company to various
degrees. In Angola, a new mining code became effective in 2011. Despite some
business-friendly provisions, for certain contracts the code gives priority to local
firms, workers, and technicians. It also distinguishes between “ordinary” and “stra-
tegic” mineral resources, where the latter are subject to more state intervention
(Business Monitor International 2013, p. 22). On a much larger scale, Travelers
expresses concern about “Solvency II”—the capital adequacy and risk management
regulations implemented by the European Commission in 2016. This US insurance
company states that, “under Solvency II, it is possible that the US parent of a
European Union subsidiary could be subject to certain Solvency II requirements if
the regulator determines that the subsidiary’s capital position is dependent on the
parent company and the US parent is not already subject to regulations deemed
“equivalent” to Solvency II” (Travelers 2017, p. 65).

61
K. Bradsher, “Looking beyond China, Some Companies Shift Personnel,” New York Times, 10
September 2014.
62
The Gulf Cooperation Council includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the
United Arab Emirates.
3.3 Jurisdiction Risks 109

[Link] Prosecutions and Fines

Multinational firms may be sued and fined for failing to comply with all applicable
laws and regulations relevant to their operations abroad. During fiscal years 2012
through 2016, BHP Billiton failed to comply with various environmental regulations
and received 18 separate fines from outside Australia, its home country.63 In 2015,
BNP Paribas was sentenced for conspiring to violate the International Emergency
Economic Powers Act and the Trading with the Enemy Act (see Sect. 3.1.2). The
BNP Paribas case raises a tricky issue. An ineffective and unpredictable judiciary—
as is characteristic of developing countries—raises red flags among foreign investors
(Kaufmann et al. 2002). Yet a study of corporate prosecutions in the United States
reveals that corporate fines levied against foreign firms are much larger than those
against US firms (Garrett 2014, pp. 218–249). These findings suggest that the risks
related to legal, regulatory, and judicial environment are complex and not systemati-
cally correlated with poor governance indicators. As described next, MNCs may
seek to circumvent legal and judicial risks by opting for corruption.

3.3.3 Corruption Practices

Senior (2006, p. 27) offers an accurate and useful definition of corruption: “corrup-
tion occurs when a corruptor covertly gives a favour to a corruptee or to a nominee
to influence action(s) that benefit the corruptor or a nominee, and for which the cor-
ruptee has authority.” Corruption practices are a peculiar risk in the sense that they
generally aim to reduce other types of risks—for example, political and jurisdiction
risks (for discussion from a global perspective, see Svensson 2005; Senior 2006).
Corruption may threaten foreign firms in three ways.
A first problem affects the foreign investors engaged in countries, where corrup-
tion is widespread but who want to avoid any involvement with such illegal prac-
tices. In the 1990s, Procter & Gamble preferred to close a Pampers plant in Nigeria
rather than pay a bribe to a customs official (Doh et al. 2003, p. 116). The Dow Jones
Anti-Corruption Survey Results 2014 shows that 66% of companies consider that
bribery should always be reported to authorities, but only 13% report ever having
taken action against corrupt competitors (Dow Jones 2014, p. 4). A company seeking
to pursue an ethical strategy may “blow the whistle” on wrongdoers by alerting the
media or nongovernmental organizations (NGOs; e.g., Transparency International).
Foreign firms who adopt corruption practices may experience short-term gains,
but in the longer term, they risk reputational damage and prosecution in the host
country. Siemens is a good illustration. In the 1990s and 2000s, the German engi-
neering giant bribed thousands of officials in dozens of countries. As a consequence,

63
Author’s calculations based on BHP Billiton (2012, p. 166; 2013, p. 193; 2014, p. 215; 2015,
p. 203; 2016, p. 154).
110 3 Taxonomy of Country Risk

Siemens was later banned from doing business in Singapore for 5 years and was
fined by several nations (including the United States, Nigeria, and Israel).64 Amid
this turmoil, Transparency International suspended Siemens’s membership in the
nongovernmental watchdog group.65 This large-scale bribery by the Munich-­
headquartered company is now a notorious case study for law and political science
scholars (see Choudhary 2013; Klinkhammer 2013).
The third threat to a corrupt firm is the risk of being prosecuted in its home coun-
try. In the United States, for example, the Foreign Corrupt Practices Act (FCPA) of
197766 makes it illegal for American citizens, US companies, and certain non-US
foreign companies to influence foreign officials with any personal payments,
rewards, or bribes.67 In past years, many US firms have paid fines and penalties to
settle US charges for making illegal foreign payments (Sanyal and Samanta 2011,
p. 155). In most cases, the incriminated companies neither admit nor deny the com-
plaint’s allegations (Doh et al. 2003, p. 116). Compliance with FCPA provisions
appears to be a major issue for DJIA firms (see Appendix 3).

3.4 Macroeconomic Risks

All foreign investors are exposed to local or worldwide recessions or economic cri-
ses. Walmart (2017, p. 17) states that economic slowdown and other economic fac-
tors are likely to affect consumer demand for the products their stores sell in foreign
markets. Although it owns no mine in China, BHP Billiton (2012, p. 7; 2016, p. 30)
explains that reduced Chinese demand may have a negative effect on its results. The
success of Coca-Cola (2017, p.12) depends on its ability to grow in emerging and
developing markets. Doubts on that score are driven by macroeconomic uncertain-
ties. The macroeconomic risks studied here include country-­specific and interna-
tional monetary, financial, debt, fiscal, and trade risks that affect the activity of
MNCs abroad.

64
L. Kramer, “The World’s Second-Oldest Profession,” Institutional Investor, September 1998,
p. 49; S. Schubert and T. C. Miller, “Managing the Siemens Bribe Budget; Accountant Details
Secret Life Distributing $50 Million a Year,” International Herald Tribune, 20 December 2008;
T. Soniyi, “Bribe Scandal: Siemens Fined N7 Billion,” This Day, 23 November 2010; T. Pileggi,
“Ex-Power Company Execs Charged in Massive Siemens Bribery Case,” The Times of Israel, 3
May 2016.
65
M. Esterl, “Corruption Probes Threaten Germany’s Image; Siemens, DaimlerChrysler Get
Caught Up in Inquiries; A Backlog of Court Cases,” Wall Street Journal, 24 November 2006.
66
See [Link]
67
Since then, other governments have enacted similar laws (e.g., the Bribery Act in United
Kingdom). See Sanyal and Samanta (2011).
3.4 Macroeconomic Risks 111

3.4.1 Foreign Currency and Monetary Issues

[Link] Foreign Currency Risk and Foreign Exchange Controls

The most frequent and basic risk relates to foreign currency fluctuations and espe-
cially depreciation. This type of risk became a major concern following collapse of
the Bretton Woods accord in 1971–1973.68 Today, currency risk is highlighted by
almost all DJIA companies in their 2016–2017 annual reports (see Appendix 4).
This is not surprising when one considers that, in 2016, Coca-Cola (2017, p. 12)
used 72 functional currencies in addition to the US dollar.
Currency risk may stem from an excessive appreciation of the home country’s
currency. Merck (1987, pp. 3–4) reported that the foreign currencies in which its
sales abroad were made had declined an overall 40% during 1981–1985.69 A more
common disturbance to the operations of foreign investors is persistent depreciation
of the host country’s currency. After Venezuela announced the establishment of sev-
eral alternative exchange rate systems in 2014–2016, the subsidiary of 3M in Caracas
had to recast its financial statements accordingly and also carefully monitor its
access to liquidity (3M 2017, pp. 60–61). A more striking example is that of
Argentina’s 2002 currency crisis: The currency board system was abandoned, and
the peso lost 70% of its value against the dollar. Argentina simultaneously imposed
exchange controls, which restricted the ability of foreign firms to repatriate funds
(Monsanto 2003, p. 46).
It is noteworthy that, in some developing and emerging economies, exchange
control is a policy tool often used when the goal is a more stable financial system.
For example, Jaguar Land Rover’s subsidiary in China is subject to such restrictions
and so cannot freely transfer cash to other entities outside China (Tata Motors
2013, p. 79).
Foreign currency risk is also a plague for the investors who purchase corporate or
government bonds denominated in a currency that depreciates vis-à-vis their home
country’s currency.

[Link] Inflation and Risks Related to the Monetary Policy

Foreign currency depreciation is partly determined by the difference between infla-

tion rates in the home and the host countries. Inflation was a major concern of most
MNCs during the 1974–1975 world stagflation (see L’Air Liquide 1975, pp. 10, 14;
L’Oréal 1975, pp. 14–17; Wells Fargo 1975, p. 10), but it has become less feared in

68
Foreign investors have since developed foreign exchange hedging strategies to minimize cur-
rency risk.
69
Foreign currency depreciation is actually an opportunity for MNCs intending to purchase assets
in the foreign country.
112 3 Taxonomy of Country Risk

light of the disinflation trend evident since the 1980s.70 In 2015, only four
­economies—those of Venezuela, South Sudan, Ukraine, and Malawi—experienced
inflation in excess of 20%.71
Monetary policy and the communication among central bankers are increasingly
scrutinized by foreign investors (Holmes 2014). Most investors view the capacity of a
central bank to fight inflation and deflation, maintain the stability of the financial system,
provide adequate financial services, regulate banking institutions, and ­influence market
expectations about the future levels of interest rates as crucial to sustaining economic
growth in the medium-long term. Note that perceptions of the risk implied by a foreign
country’s monetary policy might diverge across business sectors. Take, for example, two
German companies that operate in the United States. In 2013–2014, after the Federal
Reserve began to normalize its monetary policy and announced that it planned to increase
interest rates soon, Daimler (2015, p. 134) expressed its fear that this move could slow
down the pace of growth. However, Munich Re (2016, p. 136) believed that the less
expansive monetary policy would benefit its long-term insurance activity.
Finally, another key issue is the credibility of top officials in charge of the host
country’s monetary policy. For instance, in 2013, those in business circles hailed the
appointment of Raghuram Rajan, former chief economist of the International
Monetary Fund, as head of India’s central bank.72

3.4.2 Financial and Private Debt Issues

Regardless of the country, regulatory bodies and the central bank must trade-off
preserving the financial system’s stability against stimulating economic growth.
Since the 1980s, however, most of the monetary policies implemented and financial
regulations passed in developed and emerging countries reflect the priority of eco-
nomic stimulus. In concrete terms, this tendency has led to a surge in private indebt-
edness and also to asset price bubbles—typically in the equity and real estate sectors.
As evidence, one may examine the evolution of the ratio of total credit to private
non-financial sector (as a percentage of GDP) in the United States, China, and
Japan—the world’s three largest economies; see Fig. 3.6. This ratio, which reflects
the importance of leverage in the economy, increased in Japan and in the United
States until a major financial crisis erupted (respectively) in the early 1990s and in
2007–2008. These two episodes suggest that the present credit boom in China could
trigger another financial and economic crisis. That the Chinese economy might over-
heat should therefore be a major concern of foreign investors, whether or not they

70
The world inflation rate dropped from 14% in 1980 to 5.6% in 1997 and 1.4% in 2015 (World
Development Indicators).
71
World Development Indicators.
72
P. Sahu, “Delhi Taps IMF Veteran to Run Central Bank; Raghuram Rajan Is Viewed as a Reform-
Minded Outsider in a Policy-Making Role Long Held by Indian Bureaucrats,” Wall Street Journal,
6 August 2013.
3.4 Macroeconomic Risks 113

350

300

250

200

150

100

50

0
1985Q4

1987Q4

1989Q4

1991Q4

1993Q4

1995Q4

1997Q4

1999Q4

2001Q4

2003Q4

2005Q4

2007Q4

2009Q4

2011Q4

2013Q4

2015Q4
China United States Japan

Fig. 3.6 Total credit to private nonfinancial sector as percentage of GDP (100 = 1985Q4). Notes:
Quarterly data for China, Japan, and the United States. Credit is provided by domestic banks, all
other sectors of the economy, and nonresidents. The “private non-financial sector” includes nonfi-
nancial corporations, households, and nonprofit institutions that serve households. Source: https://
[Link]

operate in that country. HeidelbergCement (2014, p. 117; 2016, p. 129) seems to be

among the few firms to worry officially about overheating and speculation, espe-
cially with respect to urban residential property. Other companies remain silent on
this issue, perhaps because China is a such a large market and because the excessive
lending and borrowing there mirror companies’ own respective leverage strategies.
Financial crises may have many different causes. A surge in the proportion of
nonperforming loans held by a bank, a drop in prices of a specific class of assets, and/
or bad macroeconomic news (e.g., a poor GDP forecast, a disappointing ­manufacturing
survey, a pessimistic speech delivered by a top policy maker) may lead bankers to
reduce the supply of credit. The resulting increase in interest rates may trigger an
economic slowdown or a recession. In this context, firms with greater short-term bor-
rowing needs may face a liquidity or solvency crisis. If a financial institution is
involved then strains in interbank lending markets may appear, which could well lead
to a global banking crisis (for a review of banking crises, see Reinhart and Rogoff
2009, pp. 147–155). This scenario played out in the United States during 2007–2008,
when Bear Stearns and Lehman Brothers went bankrupt. Had major central banks
and the G7 governments not intervened as lenders of last resort, systemic risk would
have materialized with consequences even more painful than those that did transpire.73

73
Systemic risk is the possibility that an event at the bank or company level could trigger the col-
lapse of an economy.
114 3 Taxonomy of Country Risk

In addition to private debt issues, certain developing and emerging countries must
cope with the risk of financial “openness.” Financial liberalization is a double-­edged
sword: On the one hand, it is needed to attract foreign investors (especially portfolio
investors), and on the other hand, it is likely to exacerbate a crisis if those investors
lose confidence in the country or become risk averse. In their study of the 20th cen-
tury’s last three decades, Kaminsky and Reinhart (1999) show that financial liberal-
ization frequently led to banking and currency crises. Such findings should encourage
investors to monitor the financial openness of host countries. Chinn and Ito (2006)
have developed and updated an index that measures the financial openness of most
economies for the period 1970–2014. It seems that the richer the country, the greater
its financial openness. However, the following low-income and lower-middle-
income economies exhibit a financial openness index equal to that of rich industrial-
ized countries and could therefore be more prone than expected to capital outflows
and financial crises: Armenia, Gambia, Guatemala, Haiti, Liberia, Micronesia,
Nicaragua, São Tomé and Principe, Uganda, Yemen, and Zambia.74
In their annual reports, multinational firms (including international banks) do not
exhaustively analyze currency or banking crises. Yet they do express concerns about
possible capital controls (Caterpillar 2017, p. 17; Goldman Sachs 2017, p. 43),
which include the freezing of deposits, foreign currency controls, restrictions on
certain transactions, tax measures, and tariffs. It is interesting that not all foreigners
are equally affected by such risk. Thus, when Cyprus introduced capital controls in
2013, some foreign banks were exempt from the restrictions.75
With the advent of financial globalization, interdependence between economies
has grown dramatically. A financial crisis in a major Latin American country may
affect a foreign investor operating in an Asian economy. Contagion risk has become
so high that it may be in the best interest of certain MNCs, especially those with
long-term strategies, to conduct business in emerging countries that impose some
(moderate) capital controls.

3.4.3 Fiscal and Public Debt Issues

The fiscal policy of a host country presents three challenges to MNCs. First, an exces-
sively tight or orthodox fiscal policy may depress consumer spending and economic
activity. The austerity programs implemented in eurozone countries during 2010–2012
were a source of concern for international investors (see Nissin Kogyo 2011, p. 1;
Johnson & Johnson 2012, p. 4; Pirelli 2012, p. 32). A second challenge arises when
fiscal policy affects the overall business climate or specific sectors through adverse
tax measures, public expenditures aimed at supporting domestic companies, and so

74
Author’s classification based on Chinn and Ito’s (2006) updated database and the World Bank list
of economies as of September 2016.
75
E. Hazou, “Call to Ease Restrictions to Stop Flight of Companies,” Cyprus Mail, 29 May 2013.
3.4 Macroeconomic Risks 115

forth (see also Sect. 3.3.2). In fact, the main risk in such circumstances is a continually
expansionist fiscal policy and chronic fiscal deficits that might jeopardize the coun-
try’s credit position and so lead to a major economic and financial crisis.
Figure 3.7 illustrates the distribution of sovereign defaults during 1975–2015.
Their increase during the early and mid-1980s reflects the first widespread public
debt crisis since WWII (see Sect. 4.2.1).76 After a peak in the mid-1990s, the cases
of distressed governments declined slowly; however, they were still nearly twice as
numerous in 2015 as in the mid-1970s. Sub-Saharan Africa accounts for 44% of all
observations, followed by Latin America and Caribbean countries (23%). The num-
ber of defaults in Europe and Central Asia increased by a factor of 6 between 1990
and 1995 because of the economic difficulties experienced by the states that gained
independence from Yugoslavia and the Soviet Union.
A total of 21 countries remained in default during the entire period: Benin,
Cambodia, Central African Republic, Chad, Democratic Republic of Congo,
Republic of Congo, Ghana, Guinea, Guyana, Jordan, Madagascar, Mali, Mauritania,
Nicaragua, Sierra Leone, Somalia, Tanzania, Togo, Uganda, Yemen, and Zambia.
Because these governments are chronic defaulters, lenders (and, perhaps to a lesser
extent, direct investors) are aware of the risks involved. Evidence spanning the past
four decades indicates that sovereign risk is greatest for borrowers that regularly tap
capital markets and thus are more likely to accumulate a large stock of debt.

120

100

80

60

40

20

East Asia & Pacific Europe & Central Asia Latin America & Caribbean
Middle East & North Africa South Asia Sub-Saharan Africa

Fig. 3.7 Number of sovereign debt issuers in default by area, 1975–2015. Notes: Observations
include all forms of default to all types of creditors; only those defaults of at least $500,000 are
included. There was no sovereign default in North America during 1975–2015. Sources: Author’s
calculations based on Beers and de Leon-Manlagnit’s (2019) database

76
The total number of defaulting governments increased by 65% between 1979 and 1986.
116 3 Taxonomy of Country Risk

During 1975–2015, the four most damaging “bankruptcies” (in terms of the total
amounts of public debt in default for the period) were those in Argentina, Brazil,
Greece, and Iraq.77 The crisis of 1982–1983 obliged Buenos Aires and Brasilia to
default on their FC bank loans. The haircuts imposed by the two governments on their
foreign creditors averaged 20% and affected, respectively, $30 billion and $62 billion
worth of debt (per Cruces and Trebesch’s 2013 database).78 The restructuring of
Argentina’s, Iraq’s, and Greece’s debts in (respectively) 2005, 2006, and 2012 led to
haircuts far deeper than 50% (Cruces and Trebesch’s 2013 database; Eurogroup 2012).
The riskiness of a sovereign “bankruptcy” is evidently linked to the domestic
political context, the simultaneous occurrence of a currency or a banking crisis, and
the form that the default takes.
If the default consists of a missed payment or a debt restructuring deal that is
promptly negotiated and concluded, then risk is lower than in case of debt repudia-
tion or unilateral debt restructuring (for a review, see Gaillard 2014, pp. 1–12). Also,
political tensions may foreshadow a deep haircut on creditors (e.g., Poland in 1982,
Iraq in 2006). Finally, a currency or banking crisis inevitably exacerbates any sover-
eign debt turmoil and vice versa: Domestic banks can no longer lend to their govern-
ment, which in turn can no longer bail out distressed banks. The resulting collapse
of the domestic currency puts both the government and banks in the position of
desperately seeking foreign currencies, whose costs continue to rise.
The economic and financial crisis that hit Argentina in 2001–2002 is an illustra-
tion of this devastating spiral. The consequences were harsh for certain foreign bank-
ers. For example, Citigroup (2003, p. 34) recorded a total of $1.7 billion in net pretax
charges (60% of which represented net provisions for credit losses) for fiscal year
2002 alone. In addition, the peso’s devaluation led to foreign currency translation
losses that reduced Citigroup’s equity by about $600 million. Foreign direct inves-
tors were also affected: The revenues of DaimlerChrysler Argentina S.A. tumbled
75%, from €698 million in 2000 to €176 million in 2002 (DaimlerChrysler 2001,
p. 116; 2003, p. 144).

3.4.4 Trade Issues

Trade restrictions and protectionism can be serious impediments to exporters and

direct investors. Under the auspices of the General Agreement on Tariffs and Trade
(during 1948–1994) and the World Trade Organization (since 1995), many rules
have been adopted to reduce tariffs and nontariff protective measures, to fight restric-
tive business practices, and to promote international investment and trade. These
rules have been complemented by the signing of regional trade agreements and bilat-

Author’s classification based on Beers and de Leon-Manlagnit’s (2019) database.

77

The percentage reported here reflects the two main restructuring plans devised in 1987 and 1988
78

by, respectively, Argentina and Brazil.

3.4 Macroeconomic Risks 117

eral investment treaties (Baldwin 2016). All such initiatives have contributed to
stimulate international trade, whose average annual growth exceeded that of GDP
for all regions during 1975–2015 (Fig. 3.8).
Despite this global evolution, many protectionist measures affecting foreign
investors are still in force around the world. These include (among others) bailouts;
state aid; competitive devaluation; consumption subsidies; export incentives; import
bans, quotas, and tariffs; intellectual property protection; expropriation; restrictions
on investment; localization requirements; “national content” preferences; sanitary
and phytosanitary rules; technical barriers to trade; funding facilities; trade defense
measures; and immigration restrictions.79
In June 2017, the economies that had implemented the highest number of protec-
tionist rules were the United States (1438 rules enacted), India (904), Russia (878),
Brazil (649), and Argentina (506). On average, there were 158 “anti-trade” measures
in high-income countries as compared with 99, 53, and 3 measures in (respectively)
upper-middle income, lower-middle income, and low-income countries.80
Protectionism is unlike most other macroeconomic risks because it is characteristic

90
80
70
60
50
40
30
20
10
0

East Asia & Pacific Europe & Central Asia

Latin America & Caribbean Middle East & North Africa
North America South Asia
Sub-Saharan Africa

Fig. 3.8 Trade as percentage of GDP, 1975–2015. Note: Trade is the sum of exports and imports
of goods and services measured as a share of gross domestic product. Source: World Development
Indicators

79
See [Link] for an exhaustive list of the different protectionist measures;
that list identifies not only the implementing governments but also the affected trading partners
(countries as well as firms).
80
Author’s calculations based on [Link] (data retrieved 16 June 2017).
118 3 Taxonomy of Country Risk

of rich countries and not poor ones. The uncertainty related to the Brexit vote and
President Trump’s economic nationalism tends to support this view (Irwin 2017).
Most multinational companies express concerns about the risks of protectionism
and potential trade disputes (see Appendix 4). For example, Caterpillar (2017, p. 10)
views itself as being exposed to the imposition of burdensome tariffs or quotas and
to changes in trade agreements. Boeing (2017, p. 10) fears that the raw materials on
which it depends (e.g., aluminum and titanium) might become unavailable or avail-
able only at very high prices.

3.5 Microeconomic Risks

Microeconomic risks are ubiquitous as befits the multitude of components involved.

Only the most significant supply- and demand-side risks are examined here. Supply-­
side risks (Sect. 3.5.1) are connected to the three basic factors of production: labor,
capital, and land. Those demand-side risks that depend mainly on macroeconomic
conditions (real income, inflation, prevailing interest rates, etc.) are addressed in
Sect. 3.4. Hence Sect. 3.5.2 focuses on the demand-side risks driven by a shift in
consumer preferences.

3.5.1 Supply-Side Risks

[Link] Social and Labor Risks

The first type of this social risk may be connected to the “obsolescing legitimacy”
problem that can affect some MNCs abroad (Bucheli and Kim 2012). Foreign firms
that violate human rights or overlook fundamental social norms are subject to labor
riots that could disrupt their operations and tarnish their reputation. After decades of
dreadful labor conditions on United Fruit Company’s Colombian plantations, social
tensions intensified throughout the country and encouraged local producers to orga-
nize and compete (successfully) with the Boston-based company (Bucheli 2004;
Chomsky 2007).
In some cases, a foreign investor did not own manufacturing facilities abroad but
stocked up at factories where workers were exploited. In the early 1990s, for exam-
ple, Nike’s general manager in Indonesia stated that it was not within the firm’s
scope to investigate allegations of labor violations in these factories.81 Yet only a few
years later, Nike had to accept the blame for those conditions and admit wrongdoing
(see Sect. [Link]).

81
A. Schwarz, “Shoe Manufacturers Accused of Exploiting Labour – Running a Business,” Far
Eastern Economic Review, 20 June 1991.
3.5 Microeconomic Risks 119

The second category of risk includes strikes and lockouts. Guillén (2000) concep-
tualizes how organized labor both responded to and shaped the presence of MNCs in
newly industrialized economies. He identifies four images of multinationals (i.e.,
“villains,” “necessary evils,” “arm’s-length collaborators,” and “partners”) that
depend on the focal country’s political regime and the economic attitudes of its orga-
nized labor segment. Authoritarian regimes, in which foreign investors are typically
perceived as “villains,” are more subject to labor riots; Argentina in the 1960s–1970s
is an illustration (Guillén 2000, p. 428). The countries where foreign businesses are
considered a “necessary evil” (e.g., Argentina in the 1990s) or “arm’s-length col-
laborators” (e.g., South Korea) may be the scene of long strikes—for instance, the
5-month strike at a South Korean Nestlé plant in 2003.82 In contrast, labor relations
are generally less confrontational in “non-populist democracies” (e.g., Spain since
the 1980s).
The third type of labor-related risk includes the cost of labor and the possibility
of being unable to attract, hire, and retain a sufficiently qualified workforce. These
fears officially top the list of social concerns among DJIA firms (see Appendix 5).

[Link] Capital-Related Risks

Insufficient access to credit and the difficulty of protecting intellectual capital are
addressed in Sects. 3.4.2 and [Link], respectively. Two additional risks are studied
here: fraud and system failure.83
Internal fraud risks include, inter alia, the misappropriation of assets and fraudu-
lent financial reporting in a foreign subsidiary. External fraud risks include (among
others) industrial espionage, racketeering, blackmail, and violations of partnership
agreements. For example, Danone discovered in 2007 that the Wahaha Group, its
Chinese partner in a joint venture, had created secret companies that siphoned off
profits. The French company filed a lawsuit in California but eventually exited the
venture by selling its 51% stake in the Wahaha Group (Danone 2009, p. 99; 2010,
p. 16).84
Two types of system failures are examined here: (1) blackouts and (2) ransom-
ware, cyberattacks, and hacking.85 Table 3.1 reports on the reliability of power sup-
ply. Electrical outages are a key constraint to doing business in South Asia, the
Middle East, and North Africa. Moreover, the time required to obtain an electrical
connection in these regions is exceedingly long.

82
S. Len, “Long Strike at a Nestlé Plant in Korea Comes to an End,” New York Times, 29 November
2003. It is remarkable that Nestlé (2004, 2005) did not mention this exceptionally long strike in its
2003 and 2004 annual reports.
83
System failure and technological risk are here viewed as equivalents.
84
D. Barboza, “Danone Exits China Venture after Years of Legal Dispute,” New York Times, 30
September 2009.
85
Ransomware, cyberattacks, and hacking are idiosyncratic in that their origins are seldom known
with certainty. Thus, they cannot constitute a systematic component of country risk.
120 3 Taxonomy of Country Risk

Table 3.1 Reliability of Electrical Connections

Number of electrical Losses due to electrical Days to obtain an electrical
outages in a typical outages (% of annual connection (after
Region month sales) application)
East Asia and 5.0 1.3 27.6
Pacific
Europe and 2.0 1.2 31.5
Central Asia
Latin American 2.8 1.2 22.3
and Caribbean
Middle East and 17.6 4.7 41.1
North Africa
South Asia 25.4 6.6 55.1
Sub-Saharan 8.3 5.2 36.8
Africa
Source: [Link]

Multinational companies are also concerned about cybersecurity incidents (see

Appendix 6). The North Korean cyberattack on Sony in 2014 illustrates this phe-
nomenon.86 There is a risk that cyberattacks experienced by a firm or group of firms
might be part of global technological warfare, referred to by Rid and Hecker (2009)
as “War 2.0.”
All these threats of business or supply chain disruptions require that foreign direct
investors expend significant resources to enhance their control environment, pro-
cesses, and practices (as advocated in DuPont 2017, p. 13).

[Link] Land

In addition to expropriation risk that may affect companies exploiting natural

resources (see Sect. 3.3.1), the lack of access to land is a considerable challenge for
foreigners who invest in small countries or territories like Dubai (Elbadawi 2016,
pp. 299–303). The waiting period for property registration and construction permits
can also complicate matters by causing expensive delays (World Bank 2016,
pp. 62–69, 78–82).

S. Sicard, “North Korean Cyber Attack on Sony Poses Tough Security Questions,” National
86

Defense, March 2015.

3.5 Microeconomic Risks 121

3.5.2 Demand-Side Risks

Beyond the changes in consumer tastes that are driven by international fashions and
technological evolution, demand for goods and services supplied by MNCs may be
jeopardized by adverse publicity and boycotts.

[Link] Adverse Publicity

Adverse publicity is often the result of content-related or quality risks.

Content-related risk usually involves public health issues. Since the 1990s, the
tobacco industry has been held responsible for the illness and death of thousands of
smokers. Tobacco firms have paid billions in fines and settlements in various coun-
tries.87 They were also affected by many public health measures whose purpose was
to reduce the consumption of tobacco products: increasing the taxes on cigarettes,
prohibiting underage access to tobacco, launching anti-tobacco campaigns, expand-
ing smoke-free areas, and so on (Britton and Bogdanovica 2013). More recently,
Coca-Cola (2017, p. 10) has admitted that obesity and other health-related concerns
could reduce demand for some of its products.
Quality risk has especially negative consequences; it is likely to tarnish a firm’s
reputation if not destroy its business altogether. During 2014–2016, several Japanese,
European, and American automobile companies were obliged to recall millions of
vehicles equipped with defective Takata airbags, which were responsible for many
serious injuries and even deaths. Following an investigation led by the US Department
of Justice, Takata—the Japanese original equipment manufacturer—paid $1 billion
in criminal penalties and restitution to automakers that purchased the airbags88
before filing, in June 2017, for bankruptcy protection in both the United States
and Japan.89

[Link] Boycotts

Boycotts stem from ideological roots and are usually a response to perceived ethical
lapses of the targeted company.
A striking illustration is the Arab League’s boycott of Israeli companies, Israeli-­
made goods, non-Arab companies that do business with Israeli companies, and Arab
entities that do business with blacklisted companies. This boycott, driven by an anti-

87
See “Excerpts from Agreement between States and Tobacco Industry,” New York Times, 25 June
1997.
88
For a chronology, see [Link]
to-know-about-the-takata-air-bag-recall/[Link].
89
J. Soble, “Takata, Unable to Overcome Airbag Crisis, Files for Bankruptcy Protection,” New York
Times, 25 June 2017.
122 3 Taxonomy of Country Risk

Zionist agenda, upsets the strategies of some Western MNCs. Shortly after opening
a bottling franchise in Israel in 1966, Coca-Cola was expelled from Egypt—where it
had been operating for decades (Labelle 2014).
Some boycotts are initiated by human rights groups. During 1996–2001, NGOs
(e.g., Oxfam) worked with consumer and labor groups (e.g., the Clean Clothes
Campaign) to organize boycotts of Nike goods after media revealed that the firm’s
production processes involved underpaid workers in Indonesia, child labor in
Cambodia and Pakistan, and poor working conditions in China and Vietnam (Locke
2002). These boycotts damaged Nike’s image and severely depressed its profitabil-
ity: The firm’s pretax income fell 36% in the United States and 98% abroad during
fiscal year 1997–1998 (Nike 1998, p. 47). In May 1998, Nike’s Chief Executive
Officer announced a series of measures to improve factory working conditions (Nike
1998, p. 56).
Business circles have developed new tools to help reduce microeconomic risks.
For example, more firms have begun to provide public statements discussing corpo-
rate social responsibility (CSR) and to codify business ethics (see Kitzmueller and
Shimshack 2012). Present-day CSR principles aim not only to prevent social wrong-
doing but also to reduce negative environmental effects.

3.6 Sanitary, Health, Industrial, and Environmental Risks

The main feature of sanitary, health, industrial, and environmental risks is that they
endanger the lives of a firm’s employees, its consumers, or a population group.
Although some such risks are beyond the firm’s control, others are the consequence
of its activities.

3.6.1 Sanitary and Health Risks

One of the most dangerous health risks in the world is the human immunodeficiency
virus (HIV), which causes acquired immune deficiency syndrome (AIDS). Firms
that hire their workforce in regions where the HIV pandemic is severe (e.g., Southern
Africa) are especially exposed.90
Ebola virus disease in sub-Saharan Africa and influenza A (H1N1) virus are
extremely hazardous because they are likely to affect people traveling in contami-
nated zones. In 2009, a pandemic crisis management team at the Asian Development
Bank (2010, p. 92) set up screening procedures and a medical hotline to respond to
the outbreak of new influenza virus.

90
See [Link]
3.6 Sanitary, Health, Industrial, and Environmental Risks 123

Sanitary risk may be closely connected to the activities of a company. In 1990,

Perrier—a French brand of natural bottled mineral water—had to recall its water in
the United States after benzene was found in bottles.91 However, some anticipated
risks do not actually materialize. In 2013, for instance, China halted imports of all
milk powder from New Zealand and Australia after dairy products were found to
contain bacteria that could cause botulism. Fonterra, the New Zealand dairy giant,
was held responsible for exporting these contaminated products. Yet it was announced
just a few weeks later that the botulism scare was a false alarm (Fonterra 2013,
pp. 10–11).92

3.6.2 Industrial Risk

Industrial risk generally reflects casualties resulting from a company’s failure to

comply with fundamental safety norms.
In April 2013, the collapse of the eight-story Rana Plaza building in Bangladesh
killed more than 1100 people and injured thousands. The building housed several
clothing factories that manufactured goods for Western retail companies (e.g.,
Benetton, Mango, Matalan, and Primark). In the months that followed, an accord
was signed by more than 200 international brands toward the end of improving fac-
tory safety and labor conditions.93
The chemical tragedy in Bhopal had even stronger political repercussions because
it affected civilian populations (and not just the firm’s own employees), led to a long
and controversial international judicial battle, and ultimately destroyed the company
at fault. In December 1984, methyl isocyanate gas leaked from a tank at Union
Carbide India Limited’s Bhopal plant. Approximately 3800 people died, and thou-
sands suffered permanent disabilities. Union Carbide Corporation (UCC) lost its
reputation, paid $470 million in fines, and ended up being purchased by rival Dow
Chemical in 1999 (Broughton 2005).94

91
G. James, “Perrier Recalls Its Water in U.S. after Benzene Is Found in Bottles,” New York Times,
10 February 1990.
92
See also L. Craymer, “Fonterra Recall: New Zealand Dairy to Plead Guilty; Company Faces
Maximum $425,000 Fine from Four Charges,” Wall Street Journal, 13 March 2014.
93
“Rising from the Rubble,” Sunday Times, 24 April 2016.
94
S. Warren, “Dow Chemical to Acquire Union Carbide—Deal, Valued at $8.89 Billion, Would
Position Firm to Challenge DuPont,” Wall Street Journal, 5 August 1999.
124 3 Taxonomy of Country Risk

3.6.3 Environmental Risk

In addition to the numerous casualties it caused, the Bhopal accident irrevocably

damaged the local environment. Two studies released in December 2009 confirmed
the presence of toxic chemicals in the soil and groundwater around the abandoned
UCC plant. Drinking water samples contained total pesticides as high as 59 times the
levels permitted by the Bureau of Indian Standards.95
Such pollution cases are not uncommon in the mining sector. In 2001, cyanide
waste contaminated the Asuman, a Ghanaian river, after a tailings dam ruptured at a
mine operated by Goldfields Ltd. (a South African company). Thereafter, those liv-
ing in the villages along the river no longer had clean drinking water and were pro-
hibited from fishing; thus, this industrial catastrophe cost that population its main
source of sustenance and revenue.96
Other environmental hazards include air pollution, oil spills, nuclear fallout, and
deforestation. The repeated occurrence of hazardous events has progressively dete-
riorated overall working conditions in some areas. The toxic smog that has cloaked
Beijing for several years documents the interconnectedness of health, industrial, and
environmental risks, which can undermine the efficient operation of MNCs (see
Appendix 6).

3.7 Natural and Climate Risks

Natural catastrophes were long overlooked by many investors until climate risk
emerged as a new threat in business circles.97

3.7.1 Natural Risk

Natural risk may materialize in various forms. These include (among others) coastal
erosion, drought, earthquake, extreme temperature, flood, insect infestation, hurri-
cane, landslide, storm, volcanic activity, and wildfire.
In 1999, the Turkish industrial center of Izmit was hit by an earthquake. Biomeks,
the Turkish distributor of Anika Therapeutics (a US firm), was obliged to postpone

95
N. Jayaraman, “Bhopal: Generations of Poison,” Special to CorpWatch, 2 December 2009, avail-
able at [Link]
96
M. Anane, “Ghana: Cyanide Spill Worst Disaster Ever in West African Nation,” Environment
News Service, 24 October 2001, available at [Link]
97
A catalyst for this changed assessment may well have been publication of the first report by the
Intergovernmental Panel on Climate Change (IPCC 1990).
3.7 Natural and Climate Risks 125

product delivery to local customers, which caused disruption in sales and profits
(Bouchet et al. 2003, p. 17).
An earthquake is likely to affect creditors, too. In 2010, the earthquake that dev-
astated Haiti constrained the IMF to cancel the country’s outstanding liabilities to
the Fund, after which it approved a credit facility to support reconstruction
(IMF 2010).
Natural disasters can also have indirect consequences. BHP Billiton (2010, p. 11)
expressed concern when the Chilean government announced an increase in the cor-
porate income tax rate and a change in the mining code to fund the reconstruction of
the areas destroyed by an earthquake.

3.7.2 Climate Risk

Climate risk has become a key component of country risk, and it is likely to worsen
the business environment for all companies regardless of sector and geographical
location.
The 2007 Fourth Assessment Report of the Intergovernmental Panel on Climate
Change (IPCC) presents empirical evidence linking human economic activities to
the emission of greenhouse gases (IPCC 2007). These conclusions are confirmed in
the 2014 Fifth Assessment Report. Climatic evolution will have negative conse-
quences on social and economic life worldwide. By 2030–2040, IPCC experts fear
reduced crop productivity associated with heat and drought stress in Africa; increased
water restrictions and extreme heat events in Europe; wildfire-induced loss of eco-
system integrity, property loss, and human mortality in North America; decreased
food production and the spread of vector-borne diseases in Central and South
America; and increased risk of heat-related mortality in Central and South Asia.
Moreover, if the global mean sea level continues to rise then low-lying coastal areas
will be threatened while biodiversity and the abundance of fisheries will decline
(IPCC 2014, pp. 21–25).
Climate-related hazards exacerbate natural risks, yet they might also affect politi-
cal stability. The IPCC (2014, p. 20) indicates that climate-induced population dis-
placement, and hence violent conflict, may spread in several regions throughout the
twenty-first century.
Although all business activities are threatened by climate risk (see Appendix 6),
the insurance and reinsurance sectors are especially vulnerable (Mills 2009; Travelers
2017, pp. 109–110). Beyond corporate concerns, a huge challenge for capitalist soci-
eties is to avert those catastrophes against which it may well be impossible to insure.
126 3 Taxonomy of Country Risk

 ppendix 1: International Political Risks Perceived by DJIA

A
Firms, 2016–2017

International
Relations between the recipient sanctions and International tensions
Firm country and the investor’s country embargoes and warfare
3M No No Yes. Reference to
“geopolitical risks”
American Yes. Concern about “a negative No Yes
Express perception of the United States”
abroad
Apple No No Yes. Reference to
“geopolitical
uncertainties”
Boeing No Yes Yes (e.g., reference to
“political unrest
involving Russia and
Ukraine”)
Caterpillar No Yes Yes
Chevron No No Yes. Reference to war
Cisco Partly. Concern about retaliations No No
to “intelligence gathering methods
of the U.S. government”
Coca-Cola Not explicit Yes Yes
Disney No No Yes, but in general terms
DuPont No No No
Exxon Mobil Not explicit Yes No
General No No Yes. Reference to
Electric “geopolitical risks”
Goldman Not explicit Yes Yes, but in general terms
Sachs
Home Depot No No Yes. Reference to war
IBM No No Yes
Intel No No Yes
Johnson & No No Yes. Reference to war
Johnson
JPMorgan No Yes Yes. Reference to
Chase “geopolitical
instabilities”
McDonald’s No No No
Merck No No Yes. Reference to war
Microsoft Not explicit Yes Yes. Reference to war
Nike No No Yes. Reference to
military conflicts
Pfizer No No Yes
Procter & No No Yes. Reference to war
Gamble
Travelers No No No
Appendix 2: Domestic Political Risks Perceived by DJIA Firms, 2016–2017 127

International
Relations between the recipient sanctions and International tensions
Firm country and the investor’s country embargoes and warfare
United Not explicit Yes Yes. Reference to
Technologies “geopolitical risks”
UnitedHealth No No No
Verizon No No Yes. Reference to war
Visa No No Yes
Walmart No Yes Yes
Sources: Author’s analysis based on “Item 1A. Risk Factors” of US Securities and Exchange
Commission (SEC) Form 10-K as filed by the 30 DJIA companies for the fiscal year ended between
April 2016 and March 2017

 ppendix 2: Domestic Political Risks Perceived by DJIA

A
Firms, 2016–2017

Firm Political instability Domestic tensions and warfare

3M Yes, but in general terms: political conditions in specific countries
American Yes Yes. Reference to “nationalism”
Express
Apple Yes. Reference to war and terrorism
Boeing Yes (e.g., “changes in non-U.S. national Yes, but in general terms
priorities and budgets”)
Caterpillar Yes Yes
Chevron Yes, but in general terms
Cisco Yes, but in general terms
Coca-Cola Yes Yes
Disney Yes, but in general terms
DuPont Yes Not explicit
Exxon Mobil Yes Yes. Reference to “civil unrest”
General Electric Yes, but in general terms Yes. Reference to “populism”
and “nationalism”
Goldman Sachs Yes, but in general terms
Home Depot Yes, but in general terms
IBM Yes, but in general terms
Intel Yes Yes
Johnson & Yes, but in general terms
Johnson
JPMorgan Chase Yes, but in general terms
McDonald’s Yes, but in general terms
Merck Yes, but in general terms
Microsoft Yes, but in general terms
Nike Yes Yes. Reference to “political
unrest”
128 3 Taxonomy of Country Risk

Firm Political instability Domestic tensions and warfare

Pfizer Yes Yes. Reference to “political
unrest”
Procter & Yes Yes. Reference to political
Gamble upheaval
Travelers Yes, but in general terms
United Yes, but in general terms
Technologies
UnitedHealth Yes, but in general terms
Verizon Yes, but in general terms
Visa Yes, but in general terms
Walmart Yes, but in general terms
Sources: Author’s analysis based on “Item 1A. Risk Factors” of SEC Form 10-K as filed by the 30
DJIA companies for the fiscal year ended between April 2016 and March 2017

 ppendix 3: Jurisdiction Risks Perceived by DJIA Firms,

A
2016–2017

Unstable legal, regulatory, or

Firm Expropriation judiciary environment Corruption
3M No Yes Yes, reference to
the FCPA
American No Yes (e.g., “laws and business Yes, reference to
Express practices that favor local the FCPA
competitors”)
Apple No Yes Yes, but in
general terms
Boeing No Yes No
Caterpillar No Yes Yes, reference to
the FCPA
Chevron Yes Yes No
Cisco Yes. Major concern Yes No
Coca-Cola No Yes Yes, reference to
the FCPA
Disney Yes. Reference to Yes Yes
“ownership restrictions”
DuPont No Yes No
Exxon Mobil Yes Yes No
General No Yes No
Electric
Goldman Yes Yes Yes, reference to
Sachs the FCPA
Home Depot No Yes Yes, reference to
the FCPA
Appendix 4: Macroeconomic Risks Perceived by DJIA Firms, 2016–2017 129

Unstable legal, regulatory, or

Firm Expropriation judiciary environment Corruption
IBM Yes. Reference to the Yes Yes
“ownership and protection
of patents”
Intel Yes Yes Yes, reference to
the FCPA
Johnson & Yes. Major concern Yes Yes, reference to
Johnson the FCPA
JPMorgan Yes Yes Yes, implicit
Chase reference to the
FCPA
McDonald’s No Yes Yes
Merck Yes Yes No
Microsoft No Yes Yes, reference to
the FCPA
Nike No Yes No
Pfizer Yes Yes Yes, reference to
the FCPA
Procter & No Yes Yes, reference to
Gamble the FCPA
Travelers Yes Yes. Major concern Yes, reference to
the FCPA
United Yes. Reference to the Yes Yes, reference to
Technologies protection of “intellectual the FCPA
property”
UnitedHealth Yes Yes No
Verizon No Yes No
Visa No Yes No
Walmart No Yes Yes, reference to
the FCPA
Sources: Author’s analysis based on “Item 1A. Risk Factors” of SEC Form 10-K as filed by the 30
DJIA companies for the fiscal year ended between April 2016 and March 2017

 ppendix 4: Macroeconomic Risks Perceived by DJIA Firms,

A
2016–2017

Trade disputes; Deposit freeze,

Foreign currency Economic or availability and cost foreign exchange
exchange rates and financial of energy and raw control, or
Firm fluctuations crisis materials sovereign default
3M Yes Yes Yes Yes
American Yes Yes Yes Yes
Express
Apple Yes Yes Yes Yes
130 3 Taxonomy of Country Risk

Trade disputes; Deposit freeze,

Foreign currency Economic or availability and cost foreign exchange
exchange rates and financial of energy and raw control, or
Firm fluctuations crisis materials sovereign default
Boeing Yes Yes Yes Unclear
Caterpillar Yes Yes Yes. Changes in trade Yes
rules are a major
concern
Chevron Not explicit Not explicit Yes Yes
Cisco Yes Yes Yes No
Coca-Cola Yes Yes Yes. Major concern Not explicit
Disney Yes Yes Yes Yes
DuPont Yes Yes Yes Yes
Exxon Mobil Yes Yes Yes Yes
General Yes Yes Yes Yes
Electric
Goldman Yes Yes Not explicit Yes
Sachs
Home Depot Yes Yes Yes Not explicit
IBM Yes Yes Yes Yes
Intel Yes Yes Yes Yes
Johnson & Yes Yes Yes Not explicit
Johnson
JPMorgan Yes Yes Yes Yes
Chase
McDonald’s Yes Yes Yes Yes
Merck Yes Yes Yes Not explicit
Microsoft Yes Yes Yes Not explicit
Nike Yes Yes Yes Yes
Pfizer Yes Yes Yes Yes
Procter & Yes Yes Yes Yes
Gamble
Travelers Yes Yes Not explicit Yes
United Yes Yes Yes Yes
Technologies
UnitedHealth Yes Yes No Yes
Verizon No Yes No No
Visa Yes Yes Yes Yes
Walmart Yes Yes Yes Not explicit
Sources: Author’s analysis based on “Item 1A. Risk Factors” of SEC Form 10-K as filed by the 30
DJIA companies for the fiscal year ended between April 2016 and March 2017
Appendix 5: Microeconomic Risks Perceived by DJIA Firms, 2016–2017 131

 ppendix 5: Microeconomic Risks Perceived by DJIA Firms,

A
2016–2017

Negative publicity
Firm Fraud or boycotts Adverse labor conditions
3M No No Yes
American Partly and indirectly: fear that third-party service Yes, but in very general
Express providers may act in ways that “could result in terms
regulatory actions, fines, sanctions or economic
and reputational harm”
Apple Yes No Yes
Boeing No No Yes (e.g., the hiring of
“non-U.S. representatives
and consultants”)
Caterpillar No Yes. “Negative Yes, major concern (e.g.,
publicity” in “business culture”
connection with problems, “union
cost reduction disputes”)
actions
Chevron No Partly. Reference No
to “societal
pressures”
Cisco Yes. Fear of counterfeit No Yes
products
Coca-Cola Not explicit Yes. Major Yes
concern
Disney Implicit reference No Yes
DuPont No No No
Exxon Mobil No No No
General No No Yes
Electric
Goldman Yes Yes, reference to No
Sachs “negative
publicity”
Home Depot Yes No Yes
IBM Yes No Yes
Intel Yes No Yes
Johnson & Not explicit No Yes
Johnson
JPMorgan Implicit reference Yes, reference to Yes
Chase “adverse publicity”
McDonald’s Not explicit Yes Yes
Merck Yes Partly. Reference Yes
to the role of
certain “social
media platforms”
Microsoft Yes No Yes
132 3 Taxonomy of Country Risk

Negative publicity
Firm Fraud or boycotts Adverse labor conditions
Nike Yes. Fear of counterfeit Yes (“negative Yes
products publicity”)
Pfizer Yes No Not explicit
Procter & Yes Yes (“negative Yes
Gamble publicity”)
Travelers Yes Yes (“negative Yes
publicity”)
United Not explicit Yes (“adverse Yes
Technologies publicity”)
UnitedHealth Yes Yes (“negative Yes
publicity”)
Verizon Not explicit No Yes
Visa Yes. Major concern No Yes
Walmart Yes No Yes
Sources: Author’s analysis based on “Item 1A. Risk Factors” of SEC Form 10-K as filed by the 30
DJIA companies for the fiscal year ended between April 2016 and March 2017

 ppendix 6: Sanitary, Health, Industrial, Technological,

A
Environmental, Natural, and Climate Risks Perceived by DJIA
Firms, 2016–2017

Technological, industrial, sanitary, Natural or climate

Firm or environmental risks risks
3M Partly: reference to “natural and other Yes
disasters” and to “cybersecurity risks”
American Yes Yes
Express
Apple Yes Yes
Boeing Yes Yes
Caterpillar Yes Yes
Chevron Yes Yes
Cisco Yes Yes
Coca-Cola Main concern relates to cyberattacks Yes. Long-term
adverse impact
Disney Yes Yes
DuPont Main concern relates to cyberattacks Yes
Exxon Mobil Yes Yes
General Electric Main concern relates to cyberattacks Not explicit
Goldman Sachs Yes Yes
Home Depot Yes Yes
IBM Yes Yes
Intel Yes Yes
References 133

Technological, industrial, sanitary, Natural or climate

Firm or environmental risks risks
Johnson & Yes Yes
Johnson
JPMorgan Chase Yes Yes
McDonald’s Yes Yes
Merck Yes Yes
Microsoft Yes Yes
Nike Yes Yes
Pfizer Yes Yes
Procter & Yes Yes
Gamble
Travelers Yes. Major concern Yes. Major concern
United Yes Yes
Technologies
UnitedHealth No No
Verizon Yes Yes
Visa Yes Yes
Walmart Yes Yes
Sources: Author’s analysis based on “Item 1A. Risk Factors” of SEC Form 10-K as filed by the 30
DJIA companies for the fiscal year ended between April 2016 and March 2017

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 Part II
Sovereign and Country Risk Indicators
Chapter 4
Sovereign Risk Indicators

Starting in the mid-1970s, an increasing number of economists began using the term
“country risk” to refer to “sovereign risk” (see Chap. 1). At the time of this writing,
that confusion has not yet completely dissipated and so the two terms are sometimes
used interchangeably. This chapter focuses on what is known as “type-3 country
risk” (CR3)—in other words, the risk that a sovereign borrower might fail to fulfill
its financial obligations to a foreign creditor.1 This emphasis is motivated by the
high likelihood of sovereign risk exacerbating all the other risks that affect interna-
tional investors.
Section 4.1 presents the sovereign rating methodologies used by Moody’s, S&P,
Institutional Investor, and Euromoney. Section 4.2 measures and compares the per-
formances of these four raters since the early 1980s. Two fundamental criteria are
examined: the consistency and the accuracy of sovereign ratings. Section 4.3 offers
three extended comments. First, it identifies some weaknesses of these sovereign
risk indicators. Next, it names the countries whose credit positions improved or
weakened most significantly during the globalization era and advances some expla-
nations for those trends. Finally, it explores on the major disagreements between
raters as of September 1, 2016.

4.1 Sovereign Rating Methodologies

This section investigates the sovereign rating methodologies implemented by

Moody’s, S&P, Institutional Investor, and Euromoney. Moody’s and S&P are the
two major CRAs, and they have rated sovereign borrowers for a century. Institutional
Investor and Euromoney are well-known monthly periodicals that focus on business
and finance; both started assessing sovereign risk in 1979.

1
See Gaillard (2014c) for an overview of sovereign risk.

© Springer Nature Switzerland AG 2020 143

N. Gaillard, Country Risk, [Link]
144 4 Sovereign Risk Indicators

4.1.1  overeign Ratings Issued by Moody’s and Standard &

S
Poor’s

Sovereign ratings first appeared in 1918 in Moody’s Analyses of Investments—

Government and Municipal Securities. By 1929, Moody’s and its three competi-
tors—Poor’s, Standard Statistics, and Fitch2—rated most of the foreign government
securities issued worldwide. Sovereign rating activity declined following the Great
Depression and did not rebound until the financial globalization of the 1980s–1990s.
The growth in borrowing needs of both developed and industrialized countries,
combined with the establishment of market-based macroeconomic policies
(Williamson 1990), reinvigorated government bond markets and spurred the
resumption of sovereign ratings. Moody’s and S&P rated (respectively) 11 and 14
countries in 1986, 89 and 87 countries in 2001, and 133 and 131 countries in 2016.3
The significance of a sovereign credit rating has not changed since 1918: it con-
sists of an opinion regarding the relative ability and willingness of a government to
meet its financial commitments in the medium term. Today, CRAs assign long-term
and short-term credit ratings with regard to both foreign currency and local cur-
rency. Table 4.1 summarizes Moody’s and S&P’s long-term rating scales.4
The methods by which these two CRAs assign their ratings have been substan-
tially revised since the interwar years.
Starting in the 1980s, Moody’s and S&P have each used committees to assign
ratings. The committee process is intended to limit the influence of a single analyst
as most such committees include four to ten analysts. Their deliberations are based
on data and information either provided by the debt issuer or gathered by the ana-
lysts themselves. In the former case, the sovereign rating assignment is solicited by
the country in question; in the latter, it is not. Today, nearly all sovereign ratings are
assigned on a solicited basis—in contrast to the interwar period, during which sov-
ereign issuers did not participate in the rating process.5
Ratings are now reviewed at least once a year,6 but a CRA may initiate a rating
review whenever it considers that economic, fiscal, financial, political, or any other
information is likely to affect the issuer’s creditworthiness. In practice, upgrades
and downgrades are not frequent. During 1987–2010, an S&P rating was modified
every 3.7 years, on average, as compared with every 5.2 years for a Moody’s rating
(Gaillard 2011, p. 125).

2
Poor’s and Standard Statistics merged in 1941 to form Standard & Poor’s (S&P).
3
Author’s calculations based on [Link] and [Link].
4
In the rest of this book, Moody’s and S&P ratings refer to Moody’s and S&P long-term FC
ratings.
5
For a more detailed analysis of the sovereign rating process, see Gaillard (2011, Chap. 4) and Nye
(2014, Chaps. 4 and 5).
6
The ratings assigned to European Union (EU) members must be reviewed at least once every six
months, per Article 8 of Regulation (EC) No. 1060/2009 as amended by Regulation (EU) No.
462/2013.
4.1 Sovereign Rating Methodologies 145

Table 4.1 Current meanings of ratings issued by Moody’s and S&P

Moody’s S&P
Category ratings ratings Significance
Investment Aaa AAA Lowest credit risk
grade
Aa1 AA+ Very low credit risk
Aa2 AA
Aa3 AA−
A1 A+ Low credit risk
A2 A
A3 A−
Baa1 BBB+ Moderate credit risk
Baa2 BBB
Baa3 BBB−
Speculative Ba1 BB+ Substantial credit risk
grade
Ba2 BB
Ba3 BB−
B1 B+ High credit risk
B2 B
B3 B−
Caa1 CCC+ Very high credit risk
Caa2 CCC
Caa3 CCC−
CC
Default Ca SD SD designates issuers that have defaulted on part of their
debt; Ca designates defaulting issuers for which there is
some prospect of recovering the principal and interest
C D D designates issuers that have defaulted on all of their
debt; C designates defaulting issuers for which there is
little prospect of recovering the principal or interest
Sources: Author’s classification based on [Link] and [Link]

In fact, the most noticeable feature involves sovereign rating methodologies. The
paradox here is that the fundamental determinants of sovereign ratings have
remained the same since the 1920s. Thus Moody’s and S&P ratings have always
been a function of the same macroeconomic and institutional variables: the ratio of
gross domestic product (GDP) per capita and of foreign currency debt to exports (or
revenues), inflation, default history, and institutional stability (Cantor and Packer
1996, pp. 39–43; Gaillard 2011, pp. 50–60). That said, sovereign rating methodolo-
gies have been refined considerably and have become more transparent and
quantitative.
The first step was Moody’s decision to open its “black box” by publishing quan-
titative models for both LC and FC ratings (Moody’s 2003, 2004). The objective of
these two studies was to alleviate criticism that the firm lacked transparency (see
146 4 Sovereign Risk Indicators

SEC 2003). In 2008, Moody’s redrafted its methodology and implemented a mecha-
nistic process to assign its sovereign ratings. The agency identified four broad deter-
mining factors: the focal country’s economic strength (Factor 1), its institutional
strength (Factor 2), its financial strength (Factor 3), and its “susceptibility to event
risk” (Factor 4). These four factors, which are assessed via various quantitative and
qualitative indicators,7 are combined to establish a rating range. Determination of
the final rating relies on the analysts’ own opinions (Moody’s 2008).
Five years later, Moody’s (2013) published an updated methodology. Each of the
four broad factors just described is now decomposed into several rating subfactors,
for which Moody’s provides at least one indicator each. After these subfactors are
calculated (or estimated), the outcomes are mapped to one of the 15 ranking catego-
ries: very high plus (VH+), very high (VH), very high minus (VH−), high plus
(H+), high (H), high minus (H−), medium plus (M+), medium (M), medium minus
(M−), low plus (L+), low (L), low minus (L−), very low plus (VL+), very low (VL),
and very low minus (VL−). These mappings are used to determine the score for the
subfactors and also for the broader rating factors. Finally, Factors 1, 2, 3, and 4 are
combined to obtain a provisional FC credit rating. It is noteworthy that Factor 4 fol-
lows a maximum function. Moody’s explains that, “as soon as one area of risk war-
rants an assessment of elevated risk, the country’s overall susceptibility to event risk
is scored at that specific, elevated level.” This approach is indicative of a more con-
servative rating policy. Moody’s (2015) subsequently revised its rating criteria but
without making any major amendments (see Table 4.2).

Table 4.2 Moody’s sovereign rating criteria, 2015

Subfactor
weighting within
Broad rating factors Rating subfactors factor Subfactor indicators
Factor 1: Economic Growth dynamics 50% Average real GDP
strength growtht−4 to t+5
Volatility in real GDP
growtht−9 to t
WEF Global
Competitiveness Indext
Scale of the economy 25% Nominal GDP (US$)t
National income 25% GDP per capita (PPP,
US$)t
Adjustment factors 1–6 scores Diversification
Credit boom
(continued)

7
For instance, economic strength is based mainly on GDP per capita, the economy’s size and
diversification, and long-term economic trends.
4.1 Sovereign Rating Methodologies 147

Table 4.2 (continued)

Subfactor
weighting within
Broad rating factors Rating subfactors factor Subfactor indicators
Factor 2: Institutional Institutional 75% World Bank Government
strength framework and Effectiveness Index
effectiveness World Bank Rule of Law
Index
World Bank Control of
Corruption Index
Policy credibility and 25% Inflation levelt−4 to t+5
effectiveness Inflation volatilityt−9 to t
Adjustment factor 1–6 scores Track record of default
Factor 3: Fiscal Debt burden 50% General gov. debt/GDPt
strength
General gov. debt/revenuet
Debt affordability 50% General gov. interest
payments/revenuet
General gov. interest
payments/GDPt
Adjustment factors 1–6 scores Debt trendt−4 to t+1
General gov. FC debt/gen.
gov. debtt
Other public sector debt/
GDPt
Public sector financial
assets or SWFs/GDPt
Factor 4: Political risk Max. function Domestic political risk
Susceptibility to
event risk
Geopolitical risk
Government liquidity Max. function Fundamental metrics
risk Market funding stress
Banking sector risk Max. function Strength of banking
system
Size of banking system
Funding vulnerabilities
External vulnerability Max. function (Current account
risk balance + FDI)/GDPt
External vulnerability
indicator (EVI)t+2
Net international
investment position/GDPt
Notes: FDI foreign direct investment, PPP purchasing power parity, SWF sovereign wealth fund,
WEF World Economic Forum
Source: Moody’s (2015)
148 4 Sovereign Risk Indicators

What about S&P? In the early 2000s, S&P stated that its analytical framework
for sovereign borrowers was divided into ten categories: political risk, income and
economic structure, economic growth prospects, fiscal flexibility, general govern-
ment debt burden, offshore and contingent liabilities, monetary stability, external
liquidity, public-sector external debt burden, and private-sector external debt burden
(S&P 2002). Each category consisted of a list of factors, and a country was ranked
on a scale of 1 (best) to 6 (worst) for each of these categories. However, S&P
acknowledged that there was no exact formula for combining the scores to deter-
mine ratings.
In 2011, this rating agency adopted a multistep analytical process (S&P 2011).
After grouping the major criteria listed in its traditional methodology into five broad
categories, S&P then assigns a score to each on a 6-point scale ranging from 1 (the
strongest) to 6 (the weakest). Next, the five scores are grouped into two profiles. The
political and economic scores are combined to form the political and economic
profile; the external, fiscal, and monetary scores are combined to form the flexibility
and performance profile. The two profiles are then combined to yield an initial sov-
ereign rating level, although exceptional adjustments may be made prior to assign-
ing the final FC rating. Thereafter, S&P (2013a, 2014) made some minor amendments
to its 2011 methodology. Table 4.3 presents the five broad categories along with
their respective key factors.

Table 4.3 S&P sovereign rating criteria, 2014

Broad
categories Key factors
Institutional Effectiveness, stability, and predictability of the sovereign’s policymaking and
assessment political institutions (primary factor)
Transparency and accountability of institutions, data, and processes as well as
coverage and reliability of statistical information (secondary factor)
Sovereign’s debt payment culture (potential adjustment factor)
External security risks (potential adjustment factor)
Economic Income levels
assessment
Growth prospects
Economic diversity and volatility
External Status of a sovereign’s currency in international transactions
assessment
External liquidity, which provides an indication of the economy’s ability to
generate the foreign exchange necessary to meet its public- and private-sector
obligations to nonresidents
External position, or residents’ assets and liabilities (in both FC and LC)
relative to the rest of the world
Fiscal Fiscal flexibility
assessment
Long-term fiscal trends and vulnerabilities
Debt structure and funding access
Potential risk arising from contingent liabilities
(continued)
4.1 Sovereign Rating Methodologies 149

Table 4.3 (continued)

Broad
categories Key factors
Monetary Ability to coordinate monetary policy with fiscal and other economic policies
assessment to support sustainable economic growth
Credibility of monetary policy, as measured by inflation trends over an
economic cycle
Market-oriented monetary mechanisms’ effect on the real economy, which is
largely a function of the depth and diversification of the country’s financial
system and capital markets
Source: Author’s classification based on S&P (2014)

4.1.2 Institutional Investor Ratings

Institutional Investor is a leading international business-to-business publisher of

magazines, newsletters, journals, research, directories, books, and maps. The
Institutional Investor magazine (hereafter simply “Institutional Investor”) debuted
in 1967 but did not publish its first country credit ratings until September 1979.
Institutional Investor ratings are updated twice a year and published in the March
and September issues. Countries were initially rated on a scale of 0–10, where 0
represents the least creditworthy countries and 10 the most creditworthy. In 1980,
the scale was modified so that the top credit rating was 100. This 0–100 scale was
still in use in 2016.
Since 1979, Institutional Investor’s country credit ratings have been based on
information provided by senior economists and sovereign risk analysts at leading
international banks and—for ratings issued since the late 1990s—at money man-
agement and securities firms. These respondents grade each country on the 0–100
scale. Participant responses are then weighted according to their respective institu-
tions’ global exposure. All participants in the surveys are assured that their opinions
will be kept strictly confidential. Starting in September 1999, however, Institutional
Investor mentioned the names of sovereign risk experts in the analyses accompany-
ing their classification, which suggested that they were part of Institutional Investor’s
panel.8 In addition to the opinions delivered by financial institutions’ experts, it is
worth mentioning the prominent role played by Harvey D. Shapiro. Mr. Shapiro—a
writer, consultant, and senior contributing editor at Institutional Investor—has
supervised most surveys since the mid-1980s.9
Institutional Investor ratings are unsolicited. The magazine rated 93 countries in
1979, 135 in 1996, and 179 in 2016. Academic research has established no clear
consensus about the determinants of these ratings. In their study of the ratings

8
Institutional Investor, September 1999, pp. 197–200.
9
See for example Institutional Investor, September 1984, p. 293; September 2002, p. 167; and
September 2016, p. 104. For more information, readers may refer to [Link]
[Link]/bio/[Link]?bioid=3099.
150 4 Sovereign Risk Indicators

p­ ublished in September 1987, Cosset and Roy (1991) find that gross national prod-
uct per capita, propensity to invest, and the ratio of net foreign debt to exports are
key explanatory variables. Haque et al. (1996) extend the coverage of ratings to the
period 1982–1993 but focus exclusively on developing countries; they conclude that
Institutional Investor ratings are driven by the ratios of current account balance to
GDP and of international reserves to imports, the three-month US Treasury bill rate,
and GDP growth. In a follow-up article, Butler and Fauver (2006) show that the
determinants of Institutional Investor ratings published in March 2004 are GDP per
capita, the ratio of foreign debt to GDP, default history, the underdevelopment
index, and the legal environment—thereby highlighting the importance of institu-
tional issues.

4.1.3 Euromoney Country Risk Ratings

Euromoney magazine (hereafter, “Euromoney”) was launched in 1969 to cover the

reemergence of international cross-border capital markets.10 Euromoney published
its first country risk survey in October 1979. The magazine showed how the interna-
tional banking community, through its lending activities, rated the countries that
borrowed that year. Euromoney pointed out that the ratings disclosed were those
“assigned” by the market. That is, they were the result of “statistical analysis of the
terms and conditions for all sovereign borrowers that tapped the Eurodollar and
floating rate Deutschemark syndicated loan market in 1979.”11 In fact, a country’s
ranking was completely driven by its weighted average interest rate spread (i.e., the
gap between a given country’s interest rate and that of a “risk-free” country). The
lower the spread, the higher the ranking. In addition, Euromoney divided borrowers
into seven categories. The best risks got seven stars and the worst received just one.
Seven-star countries had a weighted average spread no higher than 0.50%; those
that were granted six stars had a weighted average spread no higher than 0.75%, and
so forth. Borrowers suffering a spread higher than 1.75% were rated as one star. A
few months later, Euromoney replaced its seven-star rating system by a seven-grade
system under which EM-I referred to the most creditworthy countries and EM-VII
to the least creditworthy.
Euromoney amended its methodology again in 1982. Country risk ratings,
henceforth established on a 0–100 scale (equivalent to Institutional Investor’s), were
now based on three criteria: access to eurocredit and all bond markets (40% weight-
ing), terms obtained in the current year (30%), and selldown performance (30%)—
where the last criterion assesses whether loans had a successful, normal, or poor
syndication. Extra points were awarded if loans had been oversubscribed and the

10
See [Link]
11
Euromoney, October 1979, p. 130.
4.1 Sovereign Rating Methodologies 151

amounts raised were considerable.12 For the first time, Euromoney’s methodology
had not only quantitative but also qualitative features. This tendency was confirmed
in subsequent years. For instance, in 1986, the criteria and weighting were as fol-
lows: access to markets (20% weighting), access to trade finance (10%), payment
record (15%), difficulties in rescheduling (5%), political risk (20%), and selldown
(30%).13 A further step was taken in 1987 when Euromoney announced that several
experts were asked to give their opinions on each country. The number of key vari-
ables was then expanded to eight: political risk (15% weighting), economic risk
(10%), economic indicators (15%),14 payment record (15%), ease of rescheduling
(5%), access to bond markets (15%), selldown on short-term paper (10%), and
access to and discount available on forfeiting (15%).15
In March 1993, Euromoney responded to increased international volatility by
announcing that its country risk surveys would be carried out every 6 months: not
only in September but also in March. Nine criteria were identified, and the opinions
of experts were involved in assessing the first two of them (viz., economic data and
political risk). Unless these analysts wished to remain anonymous, their names were
published. Six months later, Euromoney’s methodology was updated once again.
The nine criteria were kept but the weightings of economic and political risks were
revised from 10% and 20% to 25% and 25%, respectively (see Table 4.4).
In September 2010, the survey weightings were changed to increase the influ-
ence of the focal country’s political risk and economic performance. So to obtain
the overall country risk score, Euromoney assigned a weighting to six rating catego-
ries. The three qualitative expert opinions are political risk (30% weighting), eco-
nomic performance (30%), and structural assessment (10%); the three quantitative
values are debt indicators (10%), credit ratings (10%), and access to bank finance
and/or capital markets (10%). This methodology, as summarized in Table 4.5, was
still being used in 2016.
Unlike Moody’s, S&P, and Institutional Investor, which focus solely on sover-
eign risk, Euromoney Country Risk (ECR) evaluates several aspects of a country’s
investment risk: the risk of default on a bond, the risk of losing direct investment,
the risk to global business relations, and so forth.16 This particular feature should be
borne in mind when comparing and analyzing the performance of the four raters
(see Sects. 4.2 and 4.3). The ECR ratings are unsolicited, and Euromoney rated 66
countries in 1979, 178 in 1996, and 186 in 2016.

12
Euromoney, September 1982, pp. 71–74.
13
Euromoney, September 1986, p. 364.
14
The economic indicators consisted of three ratios: debt service to exports, balance of payments
to gross national product (GNP), and external debt to GNP.
15
Euromoney, September 1988, p. 233.
16
See [Link]
152 4 Sovereign Risk Indicators

Table 4.4 Euromoney country risk criteria, September 1993

Criteria Weighting Explanation
Economic data 25% Data are taken from Euromoney global economic projections.
Political risk 25% Euromoney polls risk analysts, risk insurance brokers, and
bank credit officers, who are asked to give each country a
score from 0 to 10. A score of 10 indicates no risk of
nonpayment; a score of 0 indicates that there is no chance of
payments being made.
Debt indicators 10% Scores are calculated from the following ratios: debt service
to export, current account balance to GNP, and external debt
to GNP.
Debt in default or 10% A score from 0 to 10 based on the amount of debt in default
rescheduled or that had to be rescheduled during the last 3 years.
Credit ratings 10% Average of sovereign ratings from Moody’s and
S&P. Countries without credit ratings or with less than
BB—score 0.
Access to bank 5% Scores are calculated from disbursements of long-term private
finance nonguaranteed debt as a percentage of GNP. All OECD
countries automatically score 10.
Access to short-term 5% Score is calculated based on the OECD “consensus group” to
finance which the country belongs—i.e., whether the country is
covered by the US Export-Import Bank or by Nederlandsche
Credietverzekering Maatschappij N.V.
Access to 5% Analysis by Euromoney of syndicated loan and international
international bond bond issues since January 1989 and a judgment concerning
and syndicated loan how easy it would be for that country to tap the market now.
markets
Access to and 5% Scores are a combination of the maximum tenor available and
discount on the forfeiting spread over riskless countries such as the United
forfeiting States.
Note: Each criterion is scored on a 0–10 scale
Source: Author’s classification based on Euromoney (September 1993)

Table 4.5 Euromoney country risk methodology, September 2016

Broad rating
category Weighting Criteria
Economic 30% Bank stability/risk
assessment
Economic/GNP outlook
Employment/unemployment
Government finances
Monetary policy/currency stability
Political 30% Corruption
assessment
Government nonpayments/non-repatriation
Government stability
Information access/transparency
Institutional risk
Regulatory and policy environment
(continued)
4.2 Performance of Sovereign Risk Indicators 153

Table 4.5 (continued)

Broad rating
category Weighting Criteria
Structural 10% Demographics
assessment
Hard infrastructure
Labor market/industrial relations
Soft infrastructure
Debt indicators 10% Calculated using the following ratios: total debt stocks to GNP,
debt service to exports, and current account balance to
GNP. Developing countries that do not report complete debt
data receive a score of 0
Credit ratings 10% Nominal values are assigned to sovereign ratings from
Moody’s, S&P, and Fitch Ratings. The ratings are converted
into a score using a preestablished scoring chart; this score is
then averaged
Access to bank 10% Accessibility to international markets
finance or capital
markets
Note: Each criterion is scored on a 0–10 scale
Source: Author’s classification based on [Link]

4.2 Performance of Sovereign Risk Indicators

This section analyzes the consistency and accuracy of sovereign ratings issued by
Moody’s, S&P, Institutional Investor, and Euromoney during the globalization era.
Three specific periods are scrutinized: the wave of defaults in LDCs during
1982–1984 (Sect. 4.2.1), the Eurozone crisis during 2009–2013 (Sect. 4.2.2), and
the “sovereign bond years” during 1995–2013 (Sect. 4.2.3). The selection of the
first two periods is underpinned by the surge in total public debt in default, as shown
in Fig. 4.1.17 The third period encompasses the most recent and active years on bond
markets; it starts in 1995 because, for the first time since the interwar years, the
sovereign rating coverage by the two CRAs exceeded 50 issuers, of which more
than half were nonindustrialized countries.

Of the total sovereign debt in default in 1984 (resp., 2013), 100% (resp., 68%) had been issued
17

by emerging and developing countries (resp., eurozone members). Author’s calculation based on
Beers and de Leon-Manlagnit’s (2019) database.
154 4 Sovereign Risk Indicators

600

500

400

300

200

100

Fig. 4.1 Total sovereign debt in default (US$ bn) by year. Source: Beers and de Leon-Manlagnit’s
(2019) database

4.2.1 The Debt Crisis of 1982

Between 1973 and 1981, the total external debt of oil-importing developing coun-
tries increased from $96.8 billion to $436.9 billion (IMF 1982, p. 36). This rise was
driven by the oil crises of 1973 and 1979 and by the surge in international interest
rates that followed the 1979 shift in US monetary policy. Although US banks lend-
ing abroad had implemented specific country risk assessments in the second part of
the 1970s,18 they failed to anticipate the LDC debt crisis that erupted in 1982.
Fishlow (1978) was one of the few who raised doubts about the sustainability of
Latin American public debt. His concerns spread to international financial institu-
tions a couple of years later (BIS 1980, p. 111; IMF 1981, p. 53). A few countries
defaulted between mid-1981 and mid-1982 (see below), but the financial crisis in
LDCs was sparked in August 1982 when Mexico’s Treasury Secretary Jesus Silva
Herzog informed the country’s foreign creditors that his government had to suspend
principal payments on its debt.19 Between 1981 and 1984, the amount of sovereign
debt in default soared from $16.4 billion to $117.4 billion.20

18
See Friedman (1977) and Wilson (1979) for a presentation of the country risk rating systems
established by Citicorp and Bank of America, respectively. For an overview, see Heffernan (1986).
19
L. Rout and J. Salamon, “Bankers Tentatively Agree to Let Mexico Delay Repayment of Some
Debt Principal,” Wall Street Journal, 23 August 1982.
20
Based on Beers and de Leon-Manlagnit’s (2019) database.
4.2 Performance of Sovereign Risk Indicators 155

This section offers the first-ever analysis of the performance of sovereign risk
indicators during the debt crisis of 1982–1984. Considering that Moody’s and S&P
rated barely a dozen sovereign debt issuers in the early 1980s (Gaillard 2011,
pp. 8–9), this examination focuses on Institutional Investor and Euromoney ratings.
The performance of these ratings is assessed by observing those assigned prior to
default, computing accuracy ratios (ARs), and studying the stability of ratings.

[Link] Ratings Prior to Default

The Institutional Investor ratings examined here are those published in March 1982,
which reported the credit risk of 105 countries at the end of 1981. Euromoney ratings
are those published in February 1982; these gave the average credit risk of 69 countries
for the year 1981. I shall assess the accuracy of sovereign ratings at the 3-year horizon.
My list of sovereign defaults includes the countries that defaulted on their foreign
currency bank loans during 1982–1984. My source is Beers and de Leon-­Manlagnit’s
(2019) database. The rankings and ratings assigned by Institutional Investor and
Euromoney to countries that defaulted during 1982–1984 are shown in Table 4.6.

Table 4.6 Rankings and ratings assigned by Institutional Investor and Euromoney to countries
that defaulted during 1982–1984
Institutional Investor Euromoney
Rank Country Rating Rank Country Rating
28 Venezuela 63.3 27 Mexico EM-II
29 Mexico 62.8 33 Uruguay EM-III
43 Nigeria 52.3 34 Chile EM-III
44 Chile 52.1 37 Philippines EM-IV
48 Argentina 50.5 38 Argentina EM-IV
49 Brazil 50.3 39 Ecuador EM-IV
50 Ecuador 46.9 43 Nigeria EM-IV
59 Peru 41.0 45 Cuba EM-V
60 Panama 40.5 47 Peru EM-V
61 Yugoslavia 40.3 52 Ivory Coast EM-VI
62 Philippines 40.2 53 Morocco EM-VI
63 Uruguay 40.1 56 Panama EM-VI
64 Ivory Coast 39.8 58 Yugoslavia EM-VI
71 Morocco 33.4 61 Venezuela EM-VI
76 Dominican Rep. 23.3 62 Brazil EM-VI
78 Cuba 20.5 66 Zambia EM-VII
79 Malawi 20.2 69 Niger EM-VII
94 Zambia 12.8
95 Tanzania 11.9
105 North Korea 4.3
Notes: For Institutional Investor, rankings and ratings are those published in March 1982. For
Euromoney, rankings and ratings are those published in February 1982. Institutional Investor and
Euromoney rated then 105 and 69 countries, respectively
Sources: Institutional Investor (March 1982), Euromoney (February 1982), and Beers and de
Leon-Manlagnit’s (2019) database
156 4 Sovereign Risk Indicators

The top quarter and top third of, respectively, the Institutional Investor and
Euromoney classifications are default-free; this suggests that the two raters made no
major mistakes when ranking countries. However, the highest rating assigned to a
sovereign issuer that defaulted in the following 3 years (i.e., Venezuela for
Institutional Investor and Mexico for Euromoney) was too kind: 63.3 out of 100 for
Institutional Investor and the second highest (EM-II) of seven rating categories for
Euromoney. Other countries were also assigned excessively high ratings: the
Institutional Investor scores for Mexico, Nigeria, Chile, Argentina, and Brazil were
all above 50; and Uruguay and Chile were each rated EM-III by Euromoney.
Notwithstanding these exceptions, the majority of defaulting countries was assigned
low or very low scores.21

[Link] Accuracy Ratios

The second evaluative measure is derived by tracing cumulative accuracy profile

(CAP) curves and then computing ARs. Both CAPs and ARs are designed to estab-
lish whether raters manage to assign low ratings to issuers that default and high
ratings to issuers that do not. A CAP is constructed by sorting the countries from
lowest to highest rating and then plotting, for each rating category, the percentage of
defaults due to sovereigns with the same or a lower rating against the percentage of
all sovereigns with the same or a lower rating. The further the CAP curve bows
toward the graph’s upper left corner, the greater the fraction of all defaults that are
accounted for by the lowest rating categories (for an illustration, see Gaillard 2011,
pp. 141–142).
Figures 4.2 and 4.3 plot the 3-year CAP curves for the countries rated by, respec-
tively, Institutional Investor and Euromoney. The countries already in default in
1981 are excluded.22 Hence the two respective samples consist of 90 and 63
countries.
The two CAPs illustrated in these figures are “above” the curve that would be
plotted for a random assignment of ratings—that is, a 45° line from the origin. The
AR compresses the information encoded by a CAP curve into a single summary
statistic: the ratio of the area between the CAP curve and the 45° line to the total
area above the 45° line. Accuracy ratios range between −1 and 1, where 1 represents
maximum accuracy (all defaulters are assigned the lowest rating) and −1 represents

21
It is worth mentioning that Venezuela was the only defaulting borrower rated by Moody’s and
S&P. The country was ranked in the triple-A category by these CRAs both in 1981, which indicates
that the ratings assigned by Institutional Investor and Euromoney were reasonably accurate. See
Moody’s (1981) and S&P (2013b).
22
The countries removed from the Institutional Investor sample are Bolivia, Costa Rica, Honduras,
Iran, Jamaica, Liberia, Nicaragua, Poland, Romania, Senegal, Sierra Leone, Sudan, Turkey,
Uganda, and Zaire. Those removed from the Euromoney sample are Bolivia, Honduras, Jamaica,
Romania, Senegal, and Turkey.
 4.2 Performance of Sovereign Risk Indicators 157

100
90
80
Share of defaulters (in %)

70
60
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80 90 100
Share of issuers (in %)

Fig. 4.2 Three-year cumulative accuracy profiles (CAPs), Institutional Investor, January 1982–
December 1984. Source: Author’s computations

100
90
80
Share of defaulters (in %)

70
60
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80 90 100

Share of issuers (in %)

Fig. 4.3 Three-year cumulative accuracy profiles (CAPs), Euromoney, January 1982–December
1984. Source: Author’s computations
158 4 Sovereign Risk Indicators

the worst possible performance (all defaulters are assigned the highest rating). The
formula for calculating an AR is as follows:


AR = 2   ∑
( )(
DRi + DRi−1 N Ri + N Ri−1 )  − 0.5)
  Ri = R1 ,…, Rmax 2 DN  
  

where
D = total number of defaults;
N = total number of issuers;
Ri = rating of given rater;
DRi = total number of defaults rated Ri and less;
N Ri = total number of issuers rated Ri and less;
D0 = 0;
N0 = 0.
The 3-year ARs for Institutional Investor and Euromoney are 0.347 and 0.454,
respectively. Three comments can be made. First, ARs are significantly greater than
zero, which confirms that these two raters generally managed to distinguish between
good and bad debtors. Second, although the two ratios are not strictly comparable
(recall that the samples under consideration differ), the Institutional Investor perfor-
mance is worse than that of Euromoney. Two reasons may be advanced. On the one
hand, half of the defaults are concentrated on the bottom 33% of the issuers included
in Institutional Investor’s sample as compared with the bottom 25% of those in
Euromoney’s sample. On the other hand, there are no defaults in the top 30% of the
International Investor sample as compared with the top 38% of the Euromoney
sample. Third, Institutional Investor’s and Euromoney’s performance with respect
to the 1982 LDC crisis is somewhat worse than the performance posted by CRAs
during the interwar sovereign debt debacle (Flandreau et al. 2011, pp. 527–529). It
seems that CRAs in that earlier period were better able to rank relative risks. Perhaps
more surprising is that the Institutional Investor and Euromoney ARs are reduced
because half of all emerging and developing countries did not default in 1982–1984
despite having been assigned intermediate or low ratings. This outcome is in con-
trast with the 1930s, when more than two thirds of Latin American and Eastern
European countries lapsed into default during a single 3-year period (1931–1933).23

[Link] Ratings Stability

Given that Euromoney’s rating scale was completely changed in 1982 (see Sect.
4.1.3), the examination here of sovereign ratings stability focuses exclusively on
Institutional Investor ratings. After collecting the ratings it issued in September of

23
Author’s computations based on Gaillard (2011, apx. 1 and 3).
4.2 Performance of Sovereign Risk Indicators 159

1981, 1982, 1983, and 1984, I identified each country whose rating was lowered by
15 points or more within a year. This 15-point downgrade is roughly equivalent to a
three-notch downgrade on CRAs’ rating scales (see Table 4.7), which reflects a
major change in creditworthiness of the rated country.24
Three major downgrades are observed for 1982—Romania (−25 points), Argentina
(−19.7 points), and Costa Rica (−18 points)—and another three for 1983: Mexico
(−20.8 points), Venezuela (−16.9 points), and Chile (−16.6 points). No country lost
15 points or more between 1983 and 1984. These results indicate that only a few
Institutional Investor ratings were excessively high when the debt crisis erupted in
1982. Between September 1981 and September 1984, however, the overall adjustment
of sovereign ratings was dramatic: within 3 years, they lost on average 7.2 points.
Fourteen countries were downgraded by at least 15 points, of which seven (Ecuador,
Nigeria, Iraq, Chile, Venezuela, Mexico, and Argentina) lost 25 points or more.
The seriousness of the 1982 debt crisis is reflected not only in the lowered
Institutional Investor ratings between 1981 and 1984 but also in their subsequent
slow recovery. In 1989, none of the seven countries just mentioned had a rating
higher than it did in 1981.

Table 4.7 Equivalence table for rating scales used

by Institutional Investor, Moody’s, and S&P
Institutional Investor Moody’s S&P
100 Aaa AAA
95 Aa1 AA+
90 Aa2 AA
85 Aa3 AA−
80 A1 A+
75 A2 A
70 A3 A−
65 Baa1 BBB+
60 Baa2 BBB
55 Baa3 BBB−
50 Ba1 BB+
45 Ba2 BB
40 Ba3 BB−
35 B1 B+
30 B2 B
25 B3 B−
20 Caa1 CCC+
15 Caa2 CCC
10 Caa3 CCC− and CC
5 Ca and C SD and D
Source: Author’s classifications

24
See Gaillard (2011, p. 78).
160 4 Sovereign Risk Indicators

4.2.2 The Eurozone Crisis of 2009–2013

The eurozone debt crisis was triggered in October 2009 when the newly elected
Prime Minister of Greece, George Papandreou, revised the country’s forecasted
budget deficit upward to 12.5%—more than double the previous forecast. In the
months that followed, Greek bond yields and credit default swaps soared while the
country’s credit rating was downgraded by CRAs, Institutional Investor, and
Euromoney (see Gaillard 2011, Chap. 10, for a description of the actions under-
taken by CRAs during October 2009–June 2010). In May 2010, in the context of a
3-year program set up jointly by the European Monetary Union and the International
Monetary Fund (IMF), a €110 billion financial package was offered to help Greece
meet its financing needs.
In June 2010, the European Financial Stability Facility (EFSF) was established
to rescue two additional countries: Ireland and Portugal (in 2010 and 2011, respec-
tively). Greece was bailed out again in 2012. The European Stability Mechanism
(ESM), which was set up in October 2012 as a successor to the EFSF, rescued Spain
in 2012 and Cyprus in 2013.
This section analyzes the ability of Moody’s, S&P, Institutional Investor, and
Euromoney to anticipate these five bailout packages.25 Absent their implementation,
the countries of Ireland, Portugal, and Spain would have become insolvent and the
defaults of Greece and Cyprus would have had far more severe consequences.
Gaillard (2017) documents that bailouts undermine a government’s financial credi-
bility and therefore dictate that sovereign ratings be lowered.26 As in Sect. 4.2.1,
ratings performance is assessed by examining the ratings prior to default, comput-
ing ARs, and evaluating the stability of ratings. The time horizon for this assignment
is again 3 years.

[Link] Ratings Prior to Default

Tables 4.8 and 4.9 report eurozone sovereign ratings as of (respectively) September
1, 2009 and September 1, 2010.27 Institutional Investor and Euromoney scores are
transformed into CRA ratings via the equivalences given in Table 4.7. For example,
a score ranging between 85.01 and 90.00 would be rounded up to the higher score
in the table’s first column (i.e., 90), which is then converted to AA on the S&P rating
scale. Countries that were bailed out in the three subsequent years are printed in
boldface type.

25
The second bailout of Greece, implemented in 2012, is not accounted for here.
26
Greece’s and Cyprus’s defaults on their FC bonds have been estimated at $312.4 billion and $1.7
billion, respectively (Beers and de Leon-Manlagnit’s 2019 database).
27
Unless otherwise stated, Euromoney ratings are rounded to the first decimal place to facilitate
comparisons with Institutional Investor ratings.
4.2 Performance of Sovereign Risk Indicators 161

Table 4.8 Eurozone sovereign ratings, 1 September 2009

Institutional Institutional
Investor Investor Euromoney Euromoney Moody’s S&P
Austria 87.6 AA 88.5 AA Aaa AAA
Belgium 87.2 AA 84.8 AA− Aa1 AA+
Cyprus 74.9 A 77.9 A+ Aa3 A+
Finland 90.6 AA+ 89.1 AA Aaa AAA
France 90.2 AA+ 86.0 AA Aaa AAA
Germany 91.5 AA+ 85.7 AA Aaa AAA
Greece 74.9 A 77.4 A+ A1 A−
Ireland 80.0 A+ 83.4 AA− Aa1 AA
Italy 78.5 A+ 78.3 A+ Aa2 A+
Luxembourg 92.6 AA+ 96.3 AAA Aaa AAA
Malta 76.8 A+ 77.8 A+ A1 A
Netherlands 91.7 AA+ 88.0 AA Aaa AAA
Portugal 80.1 AA− 76.7 A+ Aa2 A+
Slovakia 75.4 A+ 75.1 A+ A1 A+
Slovenia 82.6 AA− 77.7 A+ Aa2 AA
Spain 81.6 AA− 81.7 AA− Aaa AA+
Notes: Institutional Investor and Euromoney scores are those published in September 2009.
Institutional Investor and Euromoney scores that have been converted to CRA ratings are itali-
cized. Countries that were bailed out during the period from 1 September 2009 to 1 September
2012 are shown in boldface
Sources: Author’s classifications based on Institutional Investor (September 2009), Euromoney
(September 2009), [Link], and [Link]

On the two dates in question, Moody’s assigned the highest ratings whereas
Institutional Investor followed the most conservative policy. In September 2009,
Greece was ranked in the single-A broad rating category by all four raters; however,
Euromoney was much slower to downgrade after the bailout was announced in May
2010. For all the other countries to be rescued, Moody’s posted the poorest perfor-
mance. Institutional Investor and Euromoney outperformed the two CRAs in terms
of assessing the creditworthiness of Ireland and Spain. Two distinct reasons can be
advanced. First, Moody’s and S&P realized that the credit position of the two coun-
tries was weakening yet they were reluctant to lower their ratings. In fact, the two
CRAs feared that multi-notch downgrades would trigger massive sales of sovereign
bonds and thereby exacerbate the debt crisis. That concern stemmed from the insti-
tutional overreliance on CRA ratings through their incorporation into regulatory
rules and investors’ “prudential” rules (for an exhaustive analysis, see Gaillard
2014a). This factor did not apply to the ratings issued by the two magazines. Second,
Institutional Investor and Euromoney may have benefited from the greater granular-
ity of their rating scales. As risk aversion increased in 2007–2008, for instance, they
managed to assign Germany a rating higher than Spain and Ireland. In contrast, the
20-notch rating scale used by Moody’s and S&P might have been too narrow to
enable distinguishing among different eurozone members (e.g., Germany and Spain).
162 4 Sovereign Risk Indicators

Table 4.9 Eurozone sovereign ratings, 1 September 2010

Institutional Institutional
Investor Investor Euromoney Euromoney Moody’s S&P
Austria 85.2 AA 85.8 AA Aaa AAA
Belgium 81.4 AA− 80.2 AA− Aa1 AA+
Cyprus 71.4 A 80.0 A+ Aa3 A+
Finland 88.6 AA 88.6 AA Aaa AAA
France 85.6 AA 82.0 AA− Aaa AAA
Germany 90.8 AA+ 84.5 AA− Aaa AAA
Greece 43.9 BB 60.3 BBB+ Ba1 BB+
Ireland 67.5 A− 77.9 A+ Aa2 AA−
Italy 70.4 A 74.0 A Aa2 A+
Luxembourg 90.1 AA+ 88.3 AA Aaa AAA
Malta 75.5 A+ 75.7 A+ A1 A
Netherlands 90.5 AA+ 88.2 AA Aaa AAA
Portugal 62.2 BBB+ 73.8 A A1 A−
Slovakia 71.2 A 76.3 A+ A1 A+
Slovenia 84.4 AA− 78.7 A+ Aa2 AA
Spain 66.7 A− 72.3 A Aaa AA
Notes: Institutional Investor and Euromoney scores are those published in September 2010.
Institutional Investor and Euromoney scores that have been converted to CRA ratings are itali-
cized. Countries that were bailed out during the period from 1 September 2010 to 1 September
2013 are shown in boldface. On 1 September 2010, Greece had already been bailed out but was
rescued again in 2012
Sources: Author’s classifications based on Institutional Investor (September 2010), Euromoney
(September 2010), [Link], and [Link]

[Link] Accuracy Ratios

Figures 4.4 and 4.5 present the 3-year CAP curves for eurozone countries as rated
by Institutional Investor, Euromoney, Moody’s, and S&P on September 1, 2009 and
September 1, 2010, respectively.28 Because Greece was bailed out in May 2010, it
has been excluded from the second sample. The resulting two samples comprise 16
and 15 countries.
For the two periods under consideration (i.e., September 1, 2009–September 1,
2012 and September 1, 2010–September 1, 2013), the Institutional Investor and the
Moody’s CAP curves are (respectively) the first and the last to reach the uppermost
line, which suggests that Institutional Investor performed much better than Moody’s.
The Euromoney and S&P CAP curves are fairly similar, and the performance of
these raters seems to be intermediate. The concavity of the curves is more pro-
nounced for ratings issued in September 2010, which means that the four raters
lowered the credit ratings of those countries that were about to be bailed out by the
EFSF or the ESM.

The Institutional Investor and Euromoney ratings used here are their original scores (i.e., on the
28

0–100 scale).
 4.2 Performance of Sovereign Risk Indicators 163

100
90
Share of defaulters (in %)

80
70
60
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80 90 100
Share of issuers (in %)
Institutional Investor Euromoney Moody's S&P

Fig. 4.4 Three-year CAPs: Eurozone countries as of 1 September 2009. Source: Author’s
computations

100
90
Share of defaulters (in %)

80
70
60
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80 90 100
Share of issuers (in %)
Institutional Investor Euromoney Moody's S&P

Fig. 4.5 Three-year CAPs: Eurozone countries as of 1 September 2010. Source: Author’s
computations

These results are reflected in the accuracy ratios (see Table 4.10). Moody’s ARs are
the lowest for the two periods. Two main reasons can be proposed. The firm assigned
its highest rating (i.e., Aaa) to Spain, which was bailed out in 2012. More fundamen-
tally, Moody’s failed to discriminate between creditworthy and distressed issuers in
the eurozone. S&P came in with the next-to-worst performance. For the ratings issued
in September 2009, its ARs are comparable to those of Institutional Investor and
164 4 Sovereign Risk Indicators

Table 4.10 Three-year accuracy ratios, Eurozone countries

Three-year accuracy ratio, Three-year accuracy ratio,
1 September 2009–1 September 2012 1 September 2010–1 September 2013
Institutional 0.375 0.667
Investor
Euromoney 0.375 0.500
Moody’s 0.141 0.267
S&P 0.359 0.450
Sources: Author’s computations

Euromoney; for its September 2010 ratings, however, S&P is penalized because of the
high proportion of non-distressed countries (e.g., Italy, Malta, and Slovakia) in the
lower rating categories. Euromoney exhibits better performance but suffers from its
overly optimistic scores assigned to Greece and Ireland in September 2009 and to
Cyprus in September 2010. Institutional Investor shows an impressive capacity to
assign high ratings only to creditworthy debt issuers. Moreover, its scores exhibit
efficient adjustments between September 2009 and September 2010: thus Institutional
Investor’s AR increased by 0.29 points during this period, as compared with 0.13
points for both Euromoney and Moody’s and only 0.09 points for S&P. The sharp
downgrades of Ireland, Portugal, and Spain in 2010 are emblematic of Institutional
Investor’s winning strategy.

[Link] Ratings Stability

After collecting the ratings issued in September of 2009, 2010, 2011, and 2012, I
identified the countries whose ratings were lowered—within a year—by 15 points
or more by Institutional Investor and Euromoney (Table 4.11) and by three notches
or more by Moody’s and S&P (Table 4.12).
These two tables merit several comments. First, Moody’s and S&P’s major
downgrades outnumber those made by Institutional Investor and Euromoney: nine
cases (seven countries) versus four cases (three countries), respectively. These
results suggest that the ratings assigned by the two CRAs were excessively high in
2009 and so had to be lowered dramatically. In the cases of Greece and Cyprus,
there is an additional explanation. During 2011 and 2012 (respectively), the two
countries became increasingly likely to restructure their debt in the short term. That
prospect obliged Moody’s and S&P to lower their ratings to the default level (Ca/C
and SD/D, resp.) or to near-default levels (Caa1, Caa2, Caa3 and CCC+, CCC,
CCC−, CC, resp.). Such specific categories are absent from the Institutional Investor
and Euromoney rating scales. Hence these two raters could dispense with massive
downgrades of distressed debt issuers.
Second, the more-than-two-notch downgrades announced by Moody’s and S&P
hit exactly the same set of countries: Cyprus, Greece, Ireland, Italy, Portugal,
Slovenia, and Spain. Similar comments can be made for Institutional Investor and
4.2 Performance of Sovereign Risk Indicators 165

Table 4.11 Eurozone members that experienced a major downgrade by Institutional Investor and
Euromoney, 1 September 2009–1 September 2012
Institutional investor Euromoney
Downgrade (in Downgrade (in
Country Period points) Country Period points)
Greece Sept. 2009–Sept. 31.0 Greece Sept. 2009–Sept. 17.1
2010 2010
Portugal Sept. 2009–Sept. 17.9 Greece Sept. 2010–Sept. 21.5
2010 2011
Greece Sept. 2010–Sept. 16.7 Ireland Sept. 2010–Sept. 16.8
2011 2011
Ireland Sept. 2010–Sept. 18.5 Portugal Sept. 2010–Sept. 17.7
2011 2011
Source: Author’s computations and classifications

Table 4.12 Eurozone members that experienced a major downgrade by Moody’s and S&P,
1 September 2009–1 September 2012
Moody’s S&P
Downgrade Downgrade
Country Period (in notches) Country Period (in notches)
Greece Sept. 2009– 6 Greece Sept. 2009– 4
Sept. 2010 Sept. 2010
Cyprus Sept. 2010– 4 Cyprus Sept. 2010– 3
Sept. 2011 Sept. 2011
Greece Sept. 2010– 9 Greece Sept. 2010– 9
Sept. 2011 Sept. 2011
Ireland Sept. 2010– 8 Ireland Sept. 2010– 4
Sept. 2011 Sept. 2011
Portugal Sept. 2010– 7 Portugal Sept. 2010– 3
Sept. 2011 Sept. 2011
Cyprus Sept. 2011– 5 Cyprus Sept. 2011– 4
Sept. 2012 Sept. 2012
Italy Sept. 2011– 6 Italy Sept. 2011– 3
Sept. 2012 Sept. 2012
Slovenia Sept. 2011– 6 Slovenia Sept. 2011– 3
Sept. 2012 Sept. 2012
Spain Sept. 2011– 7 Spain Sept. 2011– 5
Sept. 2012 Sept. 2012
Source: Author’s computations and classifications

Euromoney: Greece, Ireland, and Portugal were massively downgraded by the two
magazines. These observations support the view that the two CRAs and the two
magazines had converging opinions about the creditworthiness of eurozone sover-
eign issuers. Their disagreements and performance gaps mainly reflect the timing
and magnitude of the downgrades. For instance, Institutional Investor was more
prompt in downgrading Portugal and lowered Greece’s rating to a much greater
166 4 Sovereign Risk Indicators

extent than did Euromoney. Moody’s adjustments were more dramatic than S&P’s
primarily because its ratings were higher when the eurozone debt crisis began in
2009. Moody’s had rated the four countries that requested a bailout in 2010–2012
(i.e., Greece, Ireland, Portugal, and Spain) 1.5 notches higher, on average, than
S&P had.
Third, unlike Institutional Investor and Euromoney, Moody’s and S&P announced
major downgrades of two countries (Italy and Slovenia) that ultimately would not
need to be rescued. The two CRAs might have overestimated the risk of contagion
to other eurozone members, which rendered the credit ratings—especially those by
Moody’s—more procyclical during 2011–2012. This assumption is partly
­corroborated when one compares the eurozone ratings issued in September 2012
with those assigned 3 years earlier. The steepest downgrades are observed for
Moody’s: 4.3 notches as compared with 2.9 notches for S&P, 13.2 points for
Institutional Investor (the equivalent of 2.6 notches), and 15.4 points for Euromoney
(3.1 notches).
The eurozone debt crisis would have been worse if the IMF, the EFSF, and the
ESM had not intervened as lenders of last resort. Despite these bailouts, it is possi-
ble to assess the relative performance of Institutional Investor, Euromoney, Moody’s,
and S&P. The ratings published by Institutional Investor were the most accurate
essentially because the magazine refrained from assigning top scores to countries
that had to default or be rescued during the three subsequent years. At the other
extreme, Moody’s poor performance resulted from its failure to discriminate ade-
quately among eurozone countries’ creditworthiness.

4.2.3 The Sovereign Bond Years (1995–2013)

The debt crisis experienced by many emerging and developing economies in the
1980s was partly solved by the Brady Plan. Implemented in 1989 under the auspices
of US Secretary of Treasury Nicholas Brady, this plan helped distressed sovereign
borrowers to reach debt reduction agreements with their commercial bank creditors
and to exchange their discounted bank loans for so-called “Brady bonds.” Mexico
was the first country to restructure its debt. Other emerging countries followed suit
(see Vásquez 1996 for an overview). In 1992, JP Morgan created the Emerging
Markets Bond Index (EMBI), a “total return” index that tracked the traded market
for Brady bonds. The market trading volume for this type of security grew from
$247 billion in 1992 to $2.69 trillion in 1996 (Emerging Markets Traders Association
1996, 1999). These Brady deals attracted many investors and had the effect of
increasing the size of emerging bond and equity markets (Erb et al. 1999). They also
enabled many middle- and low-income countries to tap capital markets for the first
time (Grigorian 2003).
This section studies foreign government bond markets during 1995–2013. Only
two measures of ratings performance are used: the assigned ratings prior to default;
and ratings stability. As in previous sections, the time horizon considered is 3 years.
4.2 Performance of Sovereign Risk Indicators 167

Accuracy ratios are not computed because fewer than half of the countries that
defaulted on their FC bond debt were rated simultaneously by Institutional Investor,
Euromoney, Moody’s, and S&P.

[Link] Ratings Prior to Default

Using Beers and de Leon-Manlagnit’s (2019) database, I compiled a list of the

countries that lapsed into default on their foreign currency bond debt during
1995–2013; the resulting sample comprised 31 defaults.29 Several countries
defaulted twice or more.30 Tables 4.13, 4.14, and 4.15 report the ratings issued by
Institutional Investor, Euromoney, Moody’s, and S&P 1, 2, and 3 years prior to
default.31 As in Sect. [Link], Institutional Investor and Euromoney scores are trans-
formed into CRA ratings.
For the ratings assigned 3 years before default, Table 4.13 shows that three coun-
tries were rated in the investment-grade category by all four raters: Uruguay, Greece,
and Cyprus. The highest rating was given either by Euromoney or by Moody’s.
Euromoney was the only firm to rank Argentina in the investment-grade category.
Of the 27 sovereign debt issuers rated both by Institutional Investor and by
Euromoney, 25 were rated lower by the former than by the latter. The implication is
that Institutional Investor performed significantly better than Euromoney. Of the 13
sovereign debt issuers rated by both Moody’s and S&P, 6 were assigned the same
rating. Of the seven remaining defaults, S&P ratings were lower for five of them.
Once the Institutional Investor scores are transformed into CRA ratings, its perfor-
mance is seen to be worse than both Moody’s and S&P’s. On average, however, the
rating gap between Institutional Investor and S&P amounts to less than one notch.
For the period 1995–2013, then, S&P was the most accurate rater over 3-year time
horizons.
Two years prior to default (Table 4.14), Cyprus is the only country still placed in
the investment-grade category by all four raters. Institutional Investor was the first
to downgrade Uruguay’s rating to the speculative-grade category, while Euromoney
was the last to maintain Greece’s rating in the investment-grade category. Observe
also that Euromoney assigned a score above 50 points to two other countries that
defaulted 2 years later: Argentina and the newly rated Antigua and Barbuda. As
emphasized previously, Institutional Investor’s ratings are more conservative (and
hence generally more accurate) than Euromoney’s but end up being slightly less
accurate than either Moody’s or S&P’s. The ratings issued by the two CRAs 2 years
prior to default are strongly similar.

29
Saint Kitts and Nevis defaulted on its FC bond debt in 2011 but is excluded from the sample
because it was not evaluated by any of the four raters.
30
When a country is in default for at least two consecutive years, only the first year is considered.
31
Moody’s and S&P ratings are as of September 1. Institutional Investor and Euromoney ratings
are those published in their respective September issues. For a country that defaulted in year y, the
ratings studied are those published on September 1 of years y−3, y−2, and y−1.
168 4 Sovereign Risk Indicators

Table 4.13 Institutional Investor, Euromoney, Moody’s, and S&P ratings 3 years prior to default,
1995–2013
Year of Institu. Institu.
default Investor Investor Euromoney Euromoney Moody’s S&P
Moldova 1998 N.R. N.R. 27.5 B N.R. N.R.
Russia 1998 19.4 CCC+ 27.4 B N.R. N.R.
Ukraine 1998 15.7 CCC+ 28.0 B N.R. N.R.
Ecuador 1999 26.4 B 45.0 BB N.R. N.R.
Pakistan 1999 29.2 B 49.8 BB+ B1 B+
Ivory Coast 2000 20.1 B− 37.0 BB− N.R. N.R.
Argentina 2001 41.8 BB 61.3 BBB+ Ba3 BB
Nigeria 2001 16.4 CCC+ 33.6 B+ N.R. N.R.
Moldova 2002 N.R. N.R. 31.0 B+ B2 N.R.
Cameroon 2003 16.3 CCC+ 29.7 B N.R. N.R.
Dominica 2003 N.R. N.R. 38.6 BB− N.R. N.R.
Nicaragua 2003 21.8 B− 26.3 B B2 N.R.
Paraguay 2003 32.5 B+ 41.3 BB B2 B
Uruguay 2003 53.5 BBB− 56.8 BBB Baa3 BBB−
Grenada 2004 27.7 B 37.9 BB− N.R. N.R.
Moldova 2004 16.2 CCC+ 26.0 B Caa1 N.R.
Nigeria 2004 18.3 CCC+ 28.8 B N.R. N.R.
Venezuela 2004 33.3 B+ 44.7 BB B2 B
Antigua and 2005 N.R. N.R. 33.7 B+ N.R. N.R.
Barb.
Dominican 2005 38.1 BB− 47.3 BB+ Ba2 BB−
Rep.
Belize 2006 37.4 BB− 32.0 B+ Ba3 B+
Ecuador 2008 28.0 B 35.1 BB− Caa1 CCC+
Nicaragua 2008 23.1 B− 29.0 B Caa1 N.R.
Seychelles 2008 26.1 B 37.8 BB− N.R. N.R.
Zimbabwe 2009 7.0 CCC− 19.9 CCC+ N.R. N.R.
Jamaica 2010 36.2 BB− 42.6 BB B1 B
Belize 2012 28.2 B 43.2 BB B3 B
Greece 2012 74.9 A 77.4 A+ A1 A−
Cyprus 2013 71.4 A 80.0 AA− Aa3 A+
Grenada 2013 33.0 B+ 16.4 CCC+ N.R. B−
Jamaica 2013 31.1 B+ 34.1 B+ B3 B−
Notes: Institutional Investor and Euromoney scores that have been transformed into CRA ratings
are italicized. N.R. = not rated
Sources: Author’s classifications based on Institutional Investor (various issues), Euromoney (var-
ious issues), [Link], and [Link]
4.2 Performance of Sovereign Risk Indicators 169

Table 4.14 Institutional Investor, Euromoney, Moody’s, and S&P ratings 2 years prior to default,
1995–2013
Year of Institu. Institu.
default investor investor Euromoney Euromoney Moody’s S&P
Moldova 1998 N.R. N.R. 31.5 B+ N.R. N.R.
Russia 1998 21.4 B− 42.6 BB N.R. N.R.
Ukraine 1998 16.6 CCC+ 29.5 B N.R. N.R.
Ecuador 1999 26.3 B 37.1 BB− B1 N.R.
Pakistan 1999 27.2 B 44.5 BB B2 B+
Ivory Coast 2000 22.2 B− 34.0 B+ N.R. N.R.
Argentina 2001 42.4 BB 53.8 BBB− Ba3 BB
Nigeria 2001 17.9 CCC+ 31.2 B+ N.R. N.R.
Moldova 2002 15.8 CCC+ 29.2 B B3 N.R.
Cameroon 2003 17.0 CCC+ 29.7 B N.R. N.R.
Dominica 2003 N.R. N.R. 32.5 B+ N.R. N.R.
Nicaragua 2003 18.9 CCC+ 28.7 B B2 N.R.
Paraguay 2003 28.9 B 38.8 BB− B2 B
Uruguay 2003 49.5 BB+ 57.0 BBB Baa3 BBB−
Grenada 2004 37.9 BB− 33.0 B+ N.R. BB−
Moldova 2004 15.7 CCC+ 26.2 B Ca N.R.
Nigeria 2004 17.6 CCC+ 24.5 B− N.R. N.R.
Venezuela 2004 30.6 B+ 39.9 BB− B2 B
Antigua and 2005 N.R. N.R. 52.5 BBB− N.R. N.R.
Barb.
Dominican 2005 36.6 BB− 43.4 BB Ba2 B+
Rep.
Belize 2006 35.1 BB− 41.2 BB B2 B−
Ecuador 2008 30.2 B+ 34.5 B+ Caa1 CCC+
Nicaragua 2008 19.5 CCC+ 30.0 B+ Caa1 N.R.
Seychelles 2008 23.0 B− 42.5 BB N.R. N.R.
Zimbabwe 2009 8.0 CCC− 19.8 CCC+ N.R. N.R.
Jamaica 2010 37.4 BB− 40.8 BB B1 B
Belize 2012 28.7 B 44.7 BB B3 B
Greece 2012 43.9 BB 60.3 BBB+ Ba1 BB+
Cyprus 2013 65.8 A− 70.0 A− Baa1 BBB+
Grenada 2013 27.1 B 17.4 CCC+ N.R. B−
Jamaica 2013 32.0 B+ 32.2 B+ B3 B−
Notes: Institutional Investor and Euromoney scores that have been transformed into CRA ratings
are italicized. N.R. = not rated
Sources: Author’s classifications based on Institutional Investor (various issues), Euromoney (var-
ious issues), [Link], and [Link]
170 4 Sovereign Risk Indicators

In September of the year preceding a default (Table 4.15), three countries were
still rated as investment grade by at least one rater: Argentina, Antigua and Barbuda
(both scored above 50 points by Euromoney), and Cyprus (which was scored at 51
points and 59.7 points by Institutional Investor and Euromoney, respectively). All
ratings assigned by Moody’s and S&P were in the speculative-grade category, and

Table 4.15 Institutional Investor, Euromoney, Moody’s, and S&P ratings 1 year prior to default,
1995–2013
Year of Institu. Institu.
default Investor Investor Euromoney Euromoney Moody’s S&P
Moldova 1998 N.R. N.R. 36.3 BB− Ba2 N.R.
Russia 1998 27.5 B 49.7 BB+ Ba2 BB−
Ukraine 1998 19.8 CCC+ 29.7 B N.R. N.R.
Ecuador 1999 26.1 B 44.8 BB B1 N.R.
Pakistan 1999 25.3 B 35.9 BB− B3 CCC
Ivory Coast 2000 22.7 B− 31.2 B+ N.R. N.R.
Argentina 2001 45.8 BB+ 55.0 BBB− B1 BB
Nigeria 2001 18.1 CCC+ 32.1 B+ N.R. N.R.
Moldova 2002 16.2 CCC+ 26.0 B Caa1 N.R.
Cameroon 2003 19.7 CCC+ 29.6 B N.R. N.R.
Dominica 2003 N.R. N.R. 29.3 B N.R. N.R.
Nicaragua 2003 17.6 CCC+ 30.8 B+ B2 N.R.
Paraguay 2003 29.7 B 36.8 BB− B2 B
Uruguay 2003 41.9 BB 43.1 BB B3 B
Grenada 2004 33.9 B+ 48.2 BB+ N.R. BB−
Moldova 2004 18.7 CCC+ 31.5 B+ Caa1 N.R.
Nigeria 2004 20.2 B− 33.5 B+ N.R. N.R.
Venezuela 2004 27.1 B 34.6 B+ Caa1 B−
Antigua and 2005 N.R. N.R. 50.4 BBB− N.R. N.R.
Barb.
Dominican 2005 26.3 B 37.6 BB− B3 CC
Rep.
Belize 2006 31.4 B+ 39.6 BB− B3 CCC−
Ecuador 2008 33.0 B+ 34.2 B+ Caa2 CCC
Nicaragua 2008 20.9 B− 31.2 B+ Caa1 N.R.
Seychelles 2008 29.0 B 41.9 BB N.R. B
Zimbabwe 2009 7.6 CCC− 14.6 CCC N.R. N.R.
Jamaica 2010 37.1 BB− 43.6 BB B2 CCC+
Belize 2012 33.2 B+ 36.6 BB− B3 B−
Greece 2012 27.2 B 38.9 BB− Ca CC
Cyprus 2013 51.0 BBB− 59.7 BBB Ba3 BB
Grenada 2013 31.1 B+ 13.5 CCC N.R. B−
Jamaica 2013 30.1 B+ 31.1 B+ B3 B−
Notes: Institutional Investor and Euromoney scores that have been transformed into CRA ratings
are italicized. N.R. = not rated
Sources: Author’s classifications based on Institutional Investor (various issues), Euromoney (var-
ious issues), [Link], and [Link]
4.2 Performance of Sovereign Risk Indicators 171

more than three-fourths were rated B1/B+ or below (i.e., the bottom of that cate-
gory). These results suggest that the two CRAs were more prompt to reassess credit
risk as the likelihood of default increased. This finding is in line with the evolution
of ratings observed between the third and the last year preceding default. Moody’s
and S&P downgraded distressed debt issuers by 2.7 and 3.3 notches, respectively,
compared with 2.2 and 2.5 points for Euromoney and Institutional Investor. These
gaps are substantial because one notch on CRAs’ rating scale is equivalent to 5
points on Euromoney’s and Institutional Investor’s scoring scale.
A detailed analysis reveals that Moody’s and S&P ratings 1 year prior to default
were never more than those assigned 3 years prior to default. In contrast, only 61%
and 48% of the scores published by (respectively) Euromoney and Institutional
Investor 1 year prior to default were lower than those issued 2 years earlier. These
percentages reveal that the two magazines failed to realize that the credit position of
some economies was weakening. For example, the scores given by Euromoney to
Russia, Antigua and Barbuda, and Grenada were increased by 22.3, 16.7, and 10.3
points. There may have been methodological flaws behind these upgrades (see Sect.
4.3.1). A second explanation, which likely accounts for most of the untimely
upgrades announced by Institutional Investor, is that a more granular rating scale
increases the probability of a (modest) upgrade for a country that will default in the
short term.

[Link] Ratings Stability

After collecting the ratings issued on September 1 in each year from 1995 to 2012,
I identified the countries whose ratings were lowered—within a year’s time—by 15
points or more by Institutional Investor (Table 4.16) and Euromoney (Table 4.17)
and by three notches or more by Moody’s (Table 4.18) and S&P (Table 4.19).
Observe first of all that the number of major downgrades differs across raters: 14
by Institutional Investor, 25 by Moody’s, 31 by S&P, and 62 by Euromoney. These
downgrades account for (respectively) 0.5%, 1.5%, 1.9%, and 2% of all observa-
tions.32 Institutional Investor’s ratings are far more stable than those of its three

Table 4.16 Major downgrades by Institutional Investor, 1 September 1995–1 September 2012
Country Period Country Period Country Period
Indonesia 1997–1998 Latvia 2008–2009 Greece 2010–2011
South Korea 1997–1998 Ukraine 2008–2009 Ireland 2010–2011
Argentina 2001–2002 Greece 2009–2010 Libya 2010–2011
Ecuador 2008–2009 Portugal 2009–2010 Vanuatu 2010–2011
Iceland 2008–2009 Bahrain 2010–2011
Source: Author’s calculations and classifications

32
Here an observation is the evolution of a rating between year y and year y+1.
172 4 Sovereign Risk Indicators

Table 4.17 Major downgrades by Euromoney, 1 September 1995–1 September 2012

Country Period Country Period Country Period
Barbados 1996–1997 Bermuda 2009–2010 Nepal 2009–2010
Cambodia 1996–1997 Bhutan 2009–2010 Rwanda 2009–2010
Central 1996–1997 Botswana 2009–2010 Samoa 2009–2010
Afric. Rep.
Tonga 1996–1997 Brunei 2009–2010 Sao Tome and Princ. 2009–2010
Bahamas 1997–1998 Burundi 2009–2010 Solomon Islands 2009–2010
Bermuda 1997–1998 Cambodia 2009–2010 St Lucia 2009–2010
Brunei 1997–1998 Cape Verde 2009–2010 St Vincent and Gren. 2009–2010
Indonesia 1997–1998 Central Afr. Rep. 2009–2010 Swaziland 2009–2010
Malaysia 1997–1998 Dominica 2009–2010 Tajikistan 2009–2010
Mauritius 1997–1998 Dominican Rep. 2009–2010 Tonga 2009–2010
South Korea 1997–1998 Equatorial 2009–2010 Trinidad and Tobago 2009–2010
Guinea
Tonga 1999–2000 Eritrea 2009–2010 Turkmenistan 2009–2010
Zaire 2000–2001 Fiji 2009–2010 Vanuatu 2009–2010
Argentina 2001–2002 Greece 2009–2010 Bahrain 2010–2011
Estonia 2008–2009 Grenada 2009–2010 Greece 2010–2011
Iceland 2008–2009 Laos 2009–2010 Ireland 2010–2011
Mali 2008–2009 Lesotho 2009–2010 Libya 2010–2011
Niger 2008–2009 Maldives 2009–2010 Pakistan 2010–2011
Antigua and 2009–2010 Marshall Isl. 2009–2010 Portugal 2010–2011
Barb.
Bahamas 2009–2010 Mauritius 2009–2010 Yemen 2010–2011
Barbados 2009–2010 Micronesia 2009–2010
Source: Author’s calculations and classifications

Table 4.18 Major downgrades by Moody’s, 1 September 1995–1 September 2012

Country Period Country Period Country Period
Indonesia 1997–1998 Uruguay 2001–2002 Ireland 2010–2011
Moldova 1997–1998 Dominican Rep. 2003–2004 Portugal 2010–2011
Russia 1997–1998 Belize 2005–2006 Belize 2011–2012
South Korea 1997–1998 Ecuador 2008–2009 Cyprus 2011–2012
Thailand 1997–1998 Iceland 2008–2009 Italy 2011–2012
Romania 1998–1999 Latvia 2008–2009 Slovenia 2011–2012
Argentina 2000–2001 Greece 2009–2010 Spain 2011–2012
Argentina 2001–2002 Cyprus 2010–2011
Moldova 2001–2002 Greece 2010–2011
Source: Author’s calculations and classifications
4.2 Performance of Sovereign Risk Indicators 173

Table 4.19 Major downgrades by S&P, 1 September 1995–1 September 2012

Country Period Country Period Country Period
Indonesia 1997–1998 Dominican Rep. 2003–2004 Greece 2010–2011
Malaysia 1997–1998 Belize 2004–2005 Ireland 2010–2011
Pakistan 1997–1998 Cameroon 2004–2005 Portugal 2010–2011
Russia 1997–1998 Grenada 2004–2005 Belize 2011–2012
South Korea 1997–1998 Seychelles 2007–2008 Cyprus 2011–2012
Indonesia 1999–2000 Iceland 2008–2009 Egypt 2011–2012
Argentina 2000–2001 Latvia 2008–2009 Italy 2011–2012
Argentina 2001–2002 Ukraine 2008–2009 Slovenia 2011–2012
Indonesia 2001–2002 Greece 2009–2010 Spain 2011–2012
Paraguay 2002–2003 Bahrain 2010–2011
Uruguay 2002–2003 Cyprus 2010–2011
Source: Author’s calculations and classifications

counterparts. It is noteworthy that about half of Euromoney’s major downgrades

involve small states or microstates, which suggests that the credit position of such
issuers is quite unpredictable. Moreover, 60% of Euromoney’s major downgrades
occurred in 2010: this concentration reflects that year’s change in the ECR method-
ology (see Sect. 4.1.3).
Second, 28% of all major downgrades follow two events: the Asian debt crisis of
1997–1998 and the eurozone turmoil of 2009–2012. This proportion is lower than
one might expect because many countries experienced idiosyncratic economic and
financial difficulties. Several of them defaulted (e.g., Russia in 1998; Moldova in
1998, 2002, and 2004; Argentina in 2001; Belize in 2006 and 2012), but others man-
aged to remain solvent thanks to a bailout (e.g., Iceland and Latvia in 2008).
Third, these tables show that 39% of the countries that defaulted on their FC debt
bonds during 1995–2013 were not severely downgraded within the year preceding
and following their bankruptcy. In fact, these debt issuers typically had a poor credit
rating one or 2 years prior to default, which made it unnecessary for raters to issue
significant downgrades. This dynamic is evidenced in particular by Institutional
Investor and Euromoney. However, there is one puzzling exception: Antigua and
Barbuda. This twin-island country was scored at 50.4 points by Euromoney in
September 2004 and at 53.2 points in September 2005 (i.e., the year of its default).
A year later, the score was lowered by only 2.1 points. It is possible that Euromoney
overlooked Antigua and Barbuda’s default and so maintained its intermediate score.
This anomaly illustrates how Euromoney ratings may assess not strictly sovereign
risk but also—and more globally—country risk (see Sect. 4.1.3).
Finally, the profile of those countries that suffered a major downgrade evolved
during the period under consideration. During 1995–2008, high-income countries
accounted for the smallest portion of that subsample, but during 2008–2012 they
represented no less than 46% of major downgrades—a larger share than that of
either middle- or low-income countries. This shift, which was driven by the debt
174 4 Sovereign Risk Indicators

crisis that shook the eurozone, Iceland, and Bahrain, calls into question the debt
sustainability of wealthy sovereign issuers. In the medium–long term, this counter-
intuitive possibility may constitute the main challenge for Institutional Investor,
Euromoney, Moody’s, and S&P.

4.3 General Comments

This section is home to many globally applicable comments that should help foreign
creditors grasp the limits of sovereign ratings, appreciate some historical back-
ground, and assess sovereign risk more efficiently. Section 4.3.1 identifies some
flaws in Institutional Investor’s, Euromoney’s, Moody’s, and S&P’s sovereign rat-
ing methodologies, and it emphasizes some important yet overlooked factors in the
medium- and long-term creditworthiness of sovereign borrowers. Section 4.3.2
studies the evolution of sovereign ratings during the globalization era and focuses
on countries whose respective credit positions either improved or weakened the
most. Section 4.3.3 examines the main disagreements across the four raters as of
September 1, 2016 and attempts to account for those differences.

4.3.1 Redrafting Sovereign Rating Methodologies

[Link]  hy Neither Transparency Nor a Quantitative Approach Is

W
a Panacea

The first lesson that can be drawn from Sect. 4.2 is that transparency does not entail
accuracy. In this respect, the eurozone debt crisis is especially telling. Institutional
Investor, the least transparent rater, exhibited the best performance; whereas
Moody’s, which had recently opened the “black box” of its methodology, assigned
excessively high ratings to countries that defaulted or were bailed out in the follow-
ing 3 years. This finding should convince investors to keep a critical eye on sover-
eign rating methodologies or, even better, to develop their own tools for assessing
credit risk.
Sovereign rating methodologies have also become increasingly quantitative.
Euromoney opened the way to this new pattern as early as the 1980s; Moody’s and
S&P followed suit, albeit not until the late 2000s. The main problem is that rating
analysts are now ensnared in quantitative risk assessments that allow little room to
maneuver when adjusting ratings upward or downward. Furthermore, the quantita-
tive criteria do not always permit one to anticipate debt crises. The reasons are that
(a) most such indicators (e.g., the WEF Global Competitiveness Index and the
unemployment rate) assess a country’s structural strengths and weaknesses and (b)
most ratios are stated relative to GNP or GDP (e.g., current account balance to GNP,
public debt to GDP) and so are insufficiently sensitive to current events. As a result,
sovereign ratings tend to be too “sticky.”
4.3 General Comments 175

Because a credit rating is an opinion about the willingness and ability of a bor-
rower to repay its debt in the medium term, it would be hazardous to transform that
rating into an early warning indicator. A more relevant way to enhance rating meth-
odologies would therefore be to focus on the sustainability of the rated sovereign’s
public debt, of its economic framework, and of its institutional and political system.
These factors will be discussed in turn.

[Link] Sustainability of Public Debt

Despite the extensive research dealing with debt sustainability (e.g., Reinhart et al.
2003; Collard et al. 2015),33 Euromoney, Moody’s, and S&P have difficulty in
addressing this issue.
The “debt indicators” score (which accounts for 10% of the final rating) assigned
by Euromoney to sovereign borrowers 1 year, 2 years, and 3 years prior to their
default during 1995–2013 (see Tables 4.13–4.15 for the list of defaulting countries)
have systematically contributed to the inflation of final ratings. For the three
­countries that were still rated above 50 points the year prior to their default—namely,
Cyprus, Argentina, and Antigua and Barbuda—this factor was set at a high or very
high level: respectively 7.6, 7.7, and 10 out of 10. Part of the relatively poor perfor-
mance of Euromoney ratings (see Sect. 4.2.3) was driven by this “mis-scoring” of
the debt indicators.
The problem with Moody’s and S&P’s methodologies is that they have tradition-
ally placed too much emphasis on the ratio of general government debt to GDP
without distinguishing between industrialized economies, on the one hand, and
emerging and developing economies, on the other. Yet the former enjoy a higher
“debt intolerance” threshold than do the latter. Hence it is fruitless to classify coun-
tries on a risk scale that is based on this ratio, as Moody’s (2015, p. 16) currently
does. The traditional quantitative measures used by rating analysts include public
debt ratios, the maturity structure of the debt, whether it is indexed or not, whether
the debt is denominated in foreign or domestic currency, whether it has fixed or
floating rates, by whom it is held, and so forth. However, the less than stellar past
performance of these raters confirms the indispensability of also conducting quali-
tative analyses in three principal areas.
First, in the present era of moral hazard, assessing sovereign risk requires that
one examines the credit position of all borrowers that could apply for a government
bailout: local debt issuers, government-related firms, and especially “systemically
important financial institutions” (SIFIs). Growing debt and liabilities in any of these
entities may indicate an increased risk of future contingent liabilities for the central
or federal government. Rating analysts have persistently downplayed these chal-

See also the debt sustainability assessments (DSAs) of low-income countries undertaken by the
33

IMF and the World Bank since 2005 ([Link]

176 4 Sovereign Risk Indicators

lenges, which have led them to assign inflated ratings to developed countries
(Gaillard 2017).
Second, a country’s fiscal balance must be carefully monitored. A fiscal deficit or
surplus is a poor indicator unless it is analyzed over time and in relation to GDP
growth. A government that posts fiscal deficits after several years of high GDP
growth (e.g., Argentina in the late 1990s, Greece in the mid-2000s) will be vulner-
able in the event of an economic slowdown. By the same token, fiscal or primary
surpluses during a recession—which are often run to reduce the debt/GDP ratio—
may prove to be counterproductive. Austerity measures are likely to fail if they are
not accompanied by a strong social consensus and/or a significant debt restructuring
(e.g., Greece in the 2010s).
Third, an exhaustive analysis of debt sustainability requires that one focus on the
quality of public spending and the tax system’s efficiency. A high level of public
spending does not threaten a country’s credit position provided those expenditures
stimulate growth, education, and competitiveness. Scandinavian countries embody
this truism. At the same time, a tax system’s capacity to collect revenues fairly and
efficiently and to increase taxes with no risk of evasion, avoidance, or revolt is
imperative because otherwise indebtedness will almost surely follow. That China’s
ratio of general government revenue to GDP doubled between 1995 and 2015
reflects not only that country’s rapid economic growth but also its government’s
increasing ability to extract revenues from all taxpayers.34

[Link] Sustainability of a Country’s Economic Structure

The eurozone debt crisis serves as a reminder that also rich countries may default.
Between 1890 and 2010, there were 13 defaults involving high-income countries
(Gaillard 2014b). All European countries included in this sample became insolvent
for political reasons: they either entered a world war or were authoritarian regimes
that refused to meet their financial commitments. However, the debt restructurings
of Greece in 2012 and of Cyprus in 2013 did not have political roots. In this sense,
the eurozone crisis was both unprecedented and idiosyncratic. Hence it should
oblige all raters to revise their methodologies because sovereign ratings have always
been strongly correlated to income per capita and to GDP per capita (Cantor and
Packer 1996; Gaillard 2011). This correlation was still high in September 2016 (see
Table 4.20). In fact, the economic framework of industrialized countries may be
threatened by an unsustainable exchange rate and/or the creation of asset bubbles.35
First of all, exchange rate sustainability vis-à-vis major foreign currencies has
become a key factor in assessing the credit positions of emerging and developed
countries. The default of Greece in 2012 and the financial difficulties experienced

Author’s computation based on Moody’s data.

34

These two risks were leading causes in the default of emerging economies (e.g., Indonesia in
35

1999 and Argentina in 2001). Yet the 2008–2012 financial turmoil in Iceland and the eurozone
demonstrated that they could trigger a solvency crisis in developed countries as well.
4.3 General Comments 177

Table 4.20 Correlation coefficients for sovereign ratings versus GDP per capita, September 2016
GDP per capita, PPP (constant 2011 GDP per capita, PPP (current
international $) international $)
Institutional Investor 0.78 0.77
ratings
Euromoney ratings 0.75 0.75
Moody’s ratings 0.73 0.72
S&P ratings 0.76 0.75
Notes: The GDP per capita figures used are the latest available. A country is excluded from the
sample if the latest figure available is from prior to 2009. Moody’s and S&P ratings are trans-
formed into numerical values following the equivalents listed in Table 4.7. There are 174, 180, 129,
and 119 pairs for (respectively) Institutional Investor, Euromoney, Moody’s, and S&P
Sources: Author’s computations based on the World Bank’s World Development Indicators as of
November 2016, Institutional Investor (September 2016), Euromoney (September 2016), moodys.
com, and [Link]

by peripheral eurozone members were partly driven by high appreciation of the

euro, which undermined the economic competitiveness of those countries. During
the 20 years preceding their eurozone membership, the currencies of Greece,
Portugal, and Spain depreciated by (respectively) 9%, 6.5%, and 4% per annum
against the US dollar. In contrast, from 2001 to 2009 the euro appreciated, on aver-
age, 5% each year against the US dollar.36 Southern European economies suffered
from losing their monetary sovereignty because their competitiveness depended in
large part on being able to let their currency depreciate over time. The implementa-
tion of austerity measures since the early 2010s is thus the steep price they have paid
for adopting an international currency.37
Two crucial questions then arise for foreign creditors. Will peripheral eurozone
countries be able to remain in the monetary union? If not, then the exiting countries
are likely to default. If these peripheral countries do remain, the second question is:
Will they manage to stay solvent? Countries can address this challenge by improv-
ing their non-price competitiveness, diversifying their economies, rationalizing
public spending, limiting the painful effects of austerity, and—to the extent that this
is even possible—encouraging eurozone governance bodies to adopt remedies that
reflect a more Keynesian perspective.
As regards the second factor affecting economic structure, the ability of high-­
income countries to prevent credit-fueled asset bubbles from arising should be given
greater weight. Over the past three decades, homes and financial assets have increas-
ingly been acquired by means of leverage and quite often with the intention of
­selling them later at a higher price. The problem is that asset bubbles exacerbate
business cycles; thus their appearance tends to reduce risk aversion only to magnify

36
Author’s calculations based on World Bank’s World Development Indicators.
37
It is interesting that Greece’s former Finance Minister Yanis Varoufakis, who opposed German
Chancellor Angela Merkel regarding the austerity measures imposed on his country, admitted that
a “Grexit” would be too hazardous (Varoufakis 2016, pp. 205–206).
178 4 Sovereign Risk Indicators

it when they burst (Reinhart and Rogoff 2009, pp. 158–162). More dramatically,
debt—and especially mortgage debt—increases inequality and acts as “anti-­
insurance,” concentrating risks on the middle class (Mian and Sufi 2014, p. 30). In
concrete terms, these considerations dictate that specific indicators be more care-
fully examined. For instance, stock exchange indices and real estate prices that rise
at least three times as fast as GDP growth for several consecutive years are good
indicators of speculation. A prolonged surge in the ratio of average domestic private-­
sector credit to GDP (or of bank assets to GDP) is also cause for alarm. If these
indicators had been properly taken into account by Institutional Investor, Euromoney,
Moody’s, and S&P in the 2000s, then distressed eurozone countries would have
been rated lower when the Greek debt crisis broke out in 2009.

[Link] Sustainability of Institutional and Political Systems

The sustainability of a country’s institutional and political system is evidently con-

tingent on four parameters: the legitimacy of the institutional regime; its capacity to
yield stable government and administration; the absence of powerful “anti-system”
parties in the political landscape; and, more importantly, the preservation of the rule
of law. The last factor will be analyzed in Chap. 5 because it has turned out to be
even more important for country risk than for sovereign risk.

4.3.2  volution of Sovereign Ratings during

E
the Globalization Era

The world economy has changed substantially during the past 35 years. Between
1982 and 2016, world GDP and total exports of goods and services rose by factors
of 6.5 and 9.5, respectively. In the meantime, life expectancy at birth increased by
more than 8 years.38 As Deaton (2013) states, “life is better now than at almost any
time in history.” However, growth and development were accompanied by a soaring
world public debt (+2300% between 1982 and 2016).39 This context helps explain
why some countries managed to improve their credit position while others failed
to do so.

[Link] The Worst-Performing Borrowers

Table 4.21 lists the five countries whose credit position deteriorated the most during
1982–2016 (as measured by Institutional Investor and Euromoney ratings) and dur-
ing 1995–2016 (as measured by Moody’s and S&P ratings).

38
Author’s calculations based on World Bank’s World Development Indicators.
39
Author’s calculations based on Beers and de Leon-Manlagnit’s (2019) database.
4.3 General Comments 179

Table 4.21 Five worst-performing countries during the globalization era

Institutional Investor Euromoney Moody’s S&P
Downg. Downg. Downg. Downg.
Country (in points) Country (in points) Country (in notches) Country (in notches)
Venezuela −43.8 Greece −38.9 Greece −9 Cyprus −9
Greece −30.1 Libya −37.2 Portugal −6 Italy −7
Zimbabwe −17.9 Venezuela −30.5 Spain −6 Portugal −7
Japan −15.4 France −30.3 Venezuela −6 Greece −6
Papua N.G. −14.2 Fiji −29.6 Barbados −5 Spain −5
Notes: For Institutional Investor and Euromoney, the ratings published in September 2016 are
compared with those published in September 1982. For Moody’s and S&P, the ratings as of 1
September 2016 are compared with those as of 1 September 1995
Sources: Author’s calculations and classifications based on Institutional Investor (September 1982
and September 2016), Euromoney (September 1982 and September 2016), [Link], and
[Link]

I first examine the countries that were massively downgraded by Institutional

Investor and Euromoney. Only two sovereign borrowers are on both lists: Greece
and Venezuela. In total, there are eight different countries, yet only three of them
(Greece, Venezuela, and Zimbabwe) defaulted massively on their FC debt during
1982–2016. All three experienced more than a debt crisis: they were embroiled in
(and are still undergoing) major social and political crises with little hope for recov-
ery in the medium term. Papua New Guinea and Fiji share several fundamental
weaknesses, including political instability and their respective economies’ lack of
diversification. The consequence is that their sovereign ratings have traditionally
been volatile. The other three severely downgraded sovereign issuers—Libya,
France, and Japan—were solvent during the entire period. Libya’s rating fell sharply
as early as 1983–1984, although it rebounded in the late 2000s before plummeting
again during the 2011 war. In France and Japan, the ratio of general government
debt to GDP increased fourfold over the past 35 years; even so, their rating did not
decline significantly until the Great Recession. To date, neither nation has been able
to achieve fiscal deficit reduction goals or to curb public debt. Sovereign rating
analysts and investors should pay close attention not only to debt sustainability but
also to the capacity of these countries to implement reforms that will reduce unem-
ployment (in France) and cut deflationary pressures (in Japan).
Turning now to Moody’s and S&P ratings, we can see that the sovereign borrow-
ers whose credit position deteriorated the most during 1995–2016 are eurozone
countries. These downgrades, which are mainly concentrated in the period
2009–2013, were analyzed extensively in Sect. 4.2.2. The last pending case is
Barbados. After being rated in the investment-grade category for more than a
decade, this Caribbean island’s rating was subjected to multiple downgrades. The
main causes are the continued increase in government debt and the limited pros-
pects of fiscal reform. Barbados ultimately defaulted on its LC and FC debt in 2018.40

40
See Beers and de Leon-Manlagnit’s (2019) database.
180 4 Sovereign Risk Indicators

[Link] The Best-Performing Borrowers

Table 4.22 presents the five countries whose credit position improved the most dur-
ing 1982–2016 (as measured by Institutional Investor and Euromoney ratings) and
during 1995–2016 (as measured by Moody’s and S&P ratings).
In several instances, the best “performers” are countries that, at the beginning of
the period under consideration, were already in default (e.g., Costa Rica, Poland,
and Romania in 1982) or were then experiencing—or had recently experienced—a
severe economic and financial crisis (e.g., Mexico, Sweden, and Turkey in 1995).
By and large, the sovereign borrowers that enhanced their credit position enjoyed
strong GDP growth, implemented pro-business measures to attract foreign inves-
tors, and were unaffected by any political crises. In addition, the Czech Republic,
Malta, Poland, Romania, and Slovakia all took advantage (until the mid-2000s) of
the prospect of EU membership and of that membership itself in the following years.

4.3.3 Ratings Convergence and Divergence

As of September 1, 2016, the ratings issued by Institutional Investor, Euromoney,

Moody’s, and S&P were strongly correlated with one another. Table 4.23 reports the
correlation coefficients and Appendix provides the ratings lists.

Table 4.22 Five best-performing countries during the globalization era

Institutional Investor Euromoney Moody’s S&P
Upg. (in Upg. (in Upg. (in Upg. (in
Country points) Country points) Country notches) Country notches)
Poland +63.7 Malta +45.1 Mexico +6 Slovakia +6
Costa Rica +40.6 Israel +40.3 Chile +4 China +5
Israel +37.6 Poland +38.3 Poland +4 Hong Kong +5
Romania +37.1 Botswana +32.7 Slovakia +4 Czech Rep. +4
Mauritius +33.6 Romania +26.6 China +3 Mexico +4
Czech Rep. +3 Poland +4
Philippines +3
Sweden +3
Turkey +3
Notes: For Institutional Investor and Euromoney, the ratings published in September 2016
are compared with those published in September 1982. For Moody’s and S&P, the ratings as of
1 September 2016 are compared with those as of 1 September 1995
Sources: Author’s calculations and classifications based on Institutional Investor (September 1982
and September 2016), Euromoney (September 1982 and September 2016), [Link], and
[Link]
4.3 General Comments 181

Table 4.23 Correlation coefficients among sovereign risk indicators, September 1, 2016
Institutional Investor Euromoney Moody’s S&P
ratings ratings ratings ratings
Institutional Investor 1 N.R. N.R. N.R.
ratings (179)
Euromoney ratings 0.96 1 N.R. N.R.
(175) (186)
Moody’s ratings 0.97 0.95 1 N.R.
(126) (128) (133)
S&P ratings 0.97 0.96 0.98 1
(119) (119) (117) (131)
Notes: Moody’s and S&P ratings are transformed into numerical values using the equivalents given
in Table 4.7. The number of pairwise observations is reported in parentheses. N.R. = not relevant
Sources: Author’s computations based on Institutional Investor (September 2016), Euromoney
(September 2016), [Link], and [Link]

However, these strong correlations obscure some major disagreements between

raters. After transforming Moody’s and S&P ratings into numerical values (per
Table 4.7), the following pairs are evaluated: Institutional Investor–Euromoney,
Institutional Investor–Moody’s, Institutional Investor–S&P, Euromoney–Moody’s,
Euromoney–S&P, and Moody’s–S&P. Table 4.24 lists the countries with large split
ratings—that is, those countries for which the ratings gap is at least 15 points or 3
notches. There are 69 such splits, which account for 8.8% of the observations. These
data support the following conclusions.
First, Euromoney is the rater that disagrees most frequently with its competitors
(nearly 80% of all large split ratings). The most striking pattern is that Euromoney
underrates high-income sovereign borrowers and China. In particular, Euromoney’s
assigned economic performance score, structural assessment score, and debt indica-
tors all contribute to deflate the ratings of these countries (cf. Table 4.5). An econ-
omy rated Aaa/AAA or Aa1/AA+ by Moody’s or S&P is typically scored at about
80 points or less by Euromoney.
Second, Moody’s and S&P assign lower ratings to sovereign debt issuers that
defaulted during the past 5 years (i.e., Belize, Cyprus, Greece, Jamaica, and
Ukraine). These findings are in line with academic research showing that CRAs
traditionally place considerable emphasis on default history.
Finally, Table 4.24 shows that there is no major divergence—with the exception
of China—across the four raters regarding the credit position of emerging econo-
mies. Most disagreements involve developed economies, in contrast to what was
observed during the 1990s and the 2000s (Gaillard 2011, Chap. 6). These results
support the view that the credit positions of some high-income countries are more
at risk than they were a decade ago and hence the sustainability of their debt should
be questioned.
182 4 Sovereign Risk Indicators

Table 4.24 Countries with large split ratings

Institu. Institutional Institutional
Investor– Investor– Investor– Euromoney– Euromoney– Moody’s–
Euromoney Moody’s S&P Moody’s S&P S&P
Countries Cyprus, Kuwait and Kuwait and N.A. N.A. N.A.
for which Guinea-­ Botswana Hong Kong
Institu. Bissau, and
Investor Liberia
rating is
lower
Countries Djibouti, N.A. N.A. China, UK, China, N.A.
for which China, USA, Kuwait, Bermuda,
Euromoney France, and UAE, France, Kuwait,
rating is USA Saudi Arabia, France, Hong
lower South Korea, Kong, South
New Zealand, Korea,
Macau, Australia,
Australia, UK, USA,
Bermuda, Qatar,
Qatar, Germany,
Germany, Canada,
Canada, Estonia,
Mauritius, Sweden,
Botswana, Belgium,
Sweden, Denmark,
Denmark, Luxembourg,
Luxembourg, and
and Netherlands
Netherlands
Countries N.A. Barbados, N.A. Greece, N.A. Slovenia,
for which Greece, Cyprus, Greece,
Moody’s Jamaica, Barbados, Jamaica,
rating is and Belize Mozambique, Trinidad
lower Belize, and
Jamaica, and Tobago,
Ukraine and
Ukraine
Countries N.A. N.A. Barbados N.A. Cyprus and No
for which Mozambique country
S&P rating
is lower
Notes: Moody’s and S&P ratings are transformed into numerical values in accordance with
Table 4.7. N.A. = not applicable
Sources: Author’s computations based on Institutional Investor (September 2016), Euromoney
(September 2016), [Link], and [Link]
Appendix: Ratings Assigned by Institutional Investor, Euromoney Country Risk.... 183

 ppendix: Ratings Assigned by Institutional Investor,

A
Euromoney Country Risk, Moody’s, and S&P as of
1 September 2016

Institutional
Investor ECR Moody’s S&P
Country rating rating rating rating
Abu Dhabi N.R. N.R. Aa2 AA
Afghanistan 14.2 26.63 N.R. N.R.
Albania 41.0 36.28 B1 B+
Algeria 46.6 38.37 N.R. N.R.
Andorra N.R. N.R. N.R. BBB–
Angola 32.5 32.62 B1 B
Antigua and Barbuda N.R. 29.13 N.R. N.R.
Argentina 35.1 36.47 B3 B–
Armenia 35.2 43.32 B1 N.R.
Aruba N.R. N.R. N.R. BBB+
Australia 90.5 81.17 Aaa AAA
Austria 87.2 80.29 Aa1 AA+
Azerbaijan 45.3 42.89 Ba1 BB+
Bahamas 57.1 49.51 Baa3 BBB–
Bahrain 50.5 49.39 Ba2 BB
Bangladesh 33.2 30.63 Ba3 BB–
Barbados 48.1 41.76 Caa1 B
Belarus 26.0 26.04 Caa1 B–
Belgium 83.3 74.19 Aa3 AA
Belize 32.0 35.12 Caa2 B–
Benin 26.8 23.25 N.R. N.R.
Bermuda 71.2 56.92 A2 A+
Bhutan 30.0 21.89 N.R. N.R.
Bolivia 42.0 39.54 Ba3 BB
Bosnia and Herzegovina 33.9 25.20 B3 B
Botswana 58.8 58.25 A2 A–
Brazil 55.7 51.20 Ba2 BB
Brunei N.R. 57.32 N.R. N.R.
Bulgaria 55.2 52.26 Baa2 BB+
Burkina Faso 20.6 28.20 N.R. B–
Burundi 15.5 12.05 N.R. N.R.
Cambodia 29.6 21.14 B2 N.R.
Cameroon 29.4 30.75 B2 B
Canada 93.3 82.31 Aaa AAA
Cape Verde 25.5 37.07 N.R. B
Cayman Islands N.R. N.R. Aa3 N.R.
Central African Republic 10.5 10.21 N.R. N.R.
Chad 15.3 10.66 N.R. N.R.
Chile 78.0 75.80 Aa3 AA–
184 4 Sovereign Risk Indicators

Institutional
Investor ECR Moody’s S&P
Country rating rating rating rating
China 75.9 58.15 Aa3 AA–
Colombia 62.9 58.10 Baa2 BBB
Comoros 17.7 N.R. N.R. N.R.
Congo 22.7 32.65 B3 B–
Cook Islands N.R. N.R. N.R. B+
Costa Rica 54.8 47.10 Ba1 BB–
Croatia 52.3 49.34 Ba2 BB
Cuba 20.8 19.60 Caa2 N.R.
Curacao N.R. N.R. N.R. A–
Cyprus 37.8 58.30 B1 BB–
Czech Republic 78.7 71.53 A1 AA–
Democratic Rep. of Congo 15.0 26.71 B3 B–
Denmark 91.3 84.28 Aaa AAA
Djibouti 28.0 5.72 N.R. N.R.
Dominica N.R. 30.80 N.R. N.R.
Dominican Republic 43.1 37.13 B1 BB–
East Timor 23.4 N.R. N.R. N.R.
Ecuador 29.7 34.20 B3 B
Egypt 32.3 33.14 B3 B–
El Salvador 38.7 40.74 B1 B+
Equatorial Guinea 24.4 21.24 N.R. N.R.
Eritrea 13.2 10.47 N.R. N.R.
Estonia 76.5 68.38 A1 AA–
Ethiopia 22.7 35.42 B1 B
Fiji 28.9 23.88 B1 B+
Finland 90.3 81.06 Aa1 AA+
France 85.0 68.66 Aa2 AA
Gabon 36.0 43.54 B1 N.R.
Gambia 18.2 28.69 N.R. N.R.
Georgia 40.2 44.97 Ba3 BB–
Germany 94.6 82.22 Aaa AAA
Ghana 31.9 36.01 B3 B–
Greece 27.1 33.93 Caa3 B–
Grenada 20.7 34.31 N.R. N.R.
Guatemala 41.8 39.79 Ba1 BB
Guernsey N.R. N.R. N.R. AA–
Guinea 12.3 20.84 N.R. N.R.
Guinea-Bissau 14.7 32.95 N.R. N.R.
Guyana 31.5 33.59 N.R. N.R.
Haiti 16.0 16.60 N.R. N.R.
Honduras 31.2 35.78 B2 B+
Hong Kong 83.9 80.28 Aa1 AAA
Hungary 57.4 51.93 Ba1 BB+
Appendix: Ratings Assigned by Institutional Investor, Euromoney Country Risk.... 185

Institutional
Investor ECR Moody’s S&P
Country rating rating rating rating
Iceland 61.0 63.88 A3 BBB+
India 62.3 53.91 Baa3 BBB−
Indonesia 56.9 50.69 Baa3 BB+
Iran 26.3 31.97 N.R. N.R.
Iraq 21.4 28.37 N.R. B−
Ireland 74.6 66.59 A3 A+
Isle of Man N.R. N.R. Aa1 N.R.
Israel 71.2 66.29 A1 A+
Italy 66.2 55.98 Baa2 BBB−
Ivory Coast 35.6 37.24 Ba3 N.R.
Jamaica 32.1 33.90 Caa2 B
Japan 80.5 69.36 A1 A+
Jersey N.R. N.R. N.R. AA−
Jordan 41.5 44.26 B1 BB−
Kazakhstan 49.3 46.85 Baa3 BBB−
Kenya 32.6 34.93 B1 B+
Kiribati 25.1 N.R. N.R. N.R.
Kuwait 73.7 67.96 Aa2 AA
Kyrgyzstan 28.8 23.97 B2 B
Laos 23.4 19.37 N.R. N.R.
Latvia 69.0 57.68 A3 A−
Lebanon 29.8 31.95 B2 B−
Lesotho 30.0 27.22 N.R. N.R.
Liberia 17.7 34.70 N.R. N.R.
Libya 27.7 22.58 N.R. N.R.
Liechtenstein N.R. N.R. N.R. AAA
Lithuania 69.5 60.17 A3 A−
Luxembourg 93.3 84.54 Aaa AAA
Macau N.R. 66.04 Aa3 N.R.
Macedonia 43.3 38.68 N.R. BB−
Madagascar 22.0 33.00 N.R. N.R.
Malawi 20.2 33.50 N.R. N.R.
Malaysia 67.2 61.32 A3 A−
Maldives N.R. 22.97 N.R. N.R.
Mali 19.7 24.98 N.R. N.R.
Malta 71.3 69.14 A3 BBB+
Marshall Islands N.R. 5.21 N.R. N.R.
Mauritania 17.9 21.57 N.R. N.R.
Mauritius 53.5 48.07 Baa1 N.R.
Mexico 70.6 61.10 A3 BBB+
Micronesia N.R. 1.00 N.R. N.R.
Moldova 24.8 28.77 B3 N.R.
Mongolia 39.4 33.72 B3 B−
186 4 Sovereign Risk Indicators

Institutional
Investor ECR Moody’s S&P
Country rating rating rating rating
Montenegro 39.9 33.28 B1 B+
Montserrat N.R. N.R. N.R. BBB−
Morocco 50.2 46.96 Ba1 BBB−
Mozambique 18.0 30.64 Caa3 CCC
Myanmar 25.3 30.06 N.R. N.R.
Namibia 47.0 51.20 Baa3 N.R.
Nepal 24.2 24.06 N.R. N.R.
Netherlands 90.8 84.98 Aaa AAA
New Caledonia N.R. 4.00 N.R. N.R.
New Zealand 87.1 80.73 Aaa AA
Nicaragua 24.4 30.93 B2 B+
Niger 16.6 31.29 N.R. N.R.
Nigeria 35.6 37.20 B1 B+
North Korea 7.2 7.77 N.R. N.R.
Norway 93.8 88.62 Aaa AAA
Oman 62.2 60.03 Baa1 BBB−
Pakistan 29.3 31.26 B3 B−
Panama 59.6 55.67 Baa2 BBB
Papua New Guinea 28.4 30.46 B2 B+
Paraguay 41.3 43.60 Ba1 BB
Peru 65.5 59.47 A3 BBB+
Philippines 61.7 54.04 Baa2 BBB
Poland 72.5 63.70 A2 BBB+
Portugal 56.6 55.66 Ba1 BB+
Qatar 76.3 72.18 Aa2 AA
Ras Al Khaimah N.R. N.R. N.R. A
Romania 57.2 53.22 Baa3 BBB−
Russia 54.4 45.70 Ba1 BB+
Rwanda 29.9 29.40 B2 B+
Saint Lucia N.R. 34.49 N.R. N.R.
St Vincent and the Grenadines N.R. 35.11 B3 N.R.
Samoa N.R. 16.31 N.R. N.R.
Sao Tome and Principe 14.0 21.05 N.R. N.R.
Saudi Arabia 71.1 59.24 A1 A−
Senegal 33.7 37.44 B1 B+
Serbia 41.0 42.81 B1 BB−
Seychelles 30.6 43.03 N.R. N.R.
Sharjah N.R. N.R. A3 A
Sierra Leone 15.9 30.06 N.R. N.R.
Singapore 93.2 86.62 Aaa AAA
Sint Maarten N.R. N.R. Baa2 N.R.
Slovakia 73.6 69.22 A2 A+
Appendix: Ratings Assigned by Institutional Investor, Euromoney Country Risk.... 187

Institutional
Investor ECR Moody’s S&P
Country rating rating rating rating
Slovenia 66.8 63.37 Baa3 A
Solomon Islands 27.6 13.82 B3 N.R.
Somalia 5.7 13.85 N.R. N.R.
South Africa 51.9 52.26 Baa2 BBB−
South Korea 83.5 70.70 Aa2 AA
South Sudan 7.5 N.R. N.R. N.R.
Spain 65.9 58.33 Baa2 BBB+
Sri Lanka 34.5 44.96 B1 B+
Sudan 8.3 20.83 N.R. N.R.
Suriname 32.5 36.01 B1 B+
Swaziland 20.8 23.44 N.R. N.R.
Sweden 93.6 83.75 Aaa AAA
Switzerland 95.4 87.86 Aaa AAA
Syria 8.7 15.24 N.R. N.R.
Taiwan 81.6 71.49 Aa3 AA−
Tajikistan 21.7 21.07 N.R. N.R.
Tanzania 29.7 36.38 N.R. N.R.
Thailand 62.0 54.32 Baa1 BBB+
Togo 22.6 31.68 N.R. N.R.
Tonga 27.9 15.09 N.R. N.R.
Trinidad and Tobago 58.9 55.05 Baa3 A−
Tunisia 41.8 40.88 Ba3 N.R.
Turkey 51.0 51.92 Baa3 BB
Turkmenistan 29.3 26.76 N.R. N.R.
Turks and Caicos Islands N.R. N.R. N.R. BBB+
Uganda 30.4 34.27 B1 B
Ukraine 24.0 28.04 Caa3 B−
United Arab Emirates 76.1 68.50 Aa2 N.R.
United Kingdom 85.8 71.49 Aa1 AA
United States 93.3 77.06 Aaa AA+
Uruguay 57.8 56.01 Baa2 BBB
Uzbekistan 27.5 27.91 N.R. N.R.
Vanuatu 28.2 26.59 N.R. N.R.
Venezuela 16.5 24.65 Caa3 CCC
Vietnam 48.6 43.43 B1 BB−
Yemen 17.5 21.65 N.R. N.R.
Zambia 31.4 34.19 B3 B
Zimbabwe 8.3 15.82 N.R. N.R.
Notes: N.R. = not rated
Sources: Institutional Investor (September 2016), Euromoney (September 2016), [Link] and
[Link]
188 4 Sovereign Risk Indicators

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Chapter 5
Country Risk Indicators

This chapter studies the various indicators used to assess type-1, type-2, type-4,
type-5, and type-6 country risks (i.e., CR1, CR2, CR4, CR5, and CR6)—in other
words, the risks likely to affect exporters, importers, foreign creditors of corporate
entities, foreign shareholders, and foreign direct investors, respectively. The pur-
pose is to assess the extent to which country risk indicators are able to anticipate
major shocks.
Section 5.1 presents the country risk rating methodologies used by six major rat-
ers: International Country Risk Guide (ICRG), Credendo, the Organisation for
Economic Co-operation and Development (OECD), the Fraser Institute, the
Heritage Foundation, and the World Economic Forum (WEF). Section 5.2 discusses
eight types of shocks, which reflect the main components of country risk analyzed
in Chap. 3. Each type of shock has occurred a number of times since the early
1980s, resulting in country risk crises (or simply “crises”). Section 5.3 measures the
capacity of Euromoney and the six raters examined in Sect. 5.1 to anticipate these
crises. The criteria used are the ratings and rankings assigned to a country 1, 2, and
3 years before it encountered a crisis as well as the percentage of what I call crisis
countries whose scores put them in the top rating categories and were classified in
the top tier of the rankings 1, 2, and 3 years prior to their respective crises. Sect. 5.4
gives four extended comments. First, it identifies the strengths and weaknesses of
these country risk indicators and provides some comparisons between the raters.
Second, it makes recommendations to improve country risk methodologies. Third,
it names the countries whose country risk positions improved or weakened most
significantly during the globalization era and then offers some explanations for
those trends. Finally, it examines correlations among country risk scores.

© Springer Nature Switzerland AG 2020 191

N. Gaillard, Country Risk, [Link]
192 5 Country Risk Indicators

5.1 Country Risk Rating Methodologies

It would clearly be impossible to conduct an exhaustive investigation of all the politi-

cal and country risk methodologies that have flourished since the 1960s. As a result,
this section focuses on a small set of the most significant raters. Four generations of
raters are studied here. The first generation includes the external country risk asses-
sors that emerged before the globalization years—namely, Euromoney (see Sect.
4.1.3) and ICRG (Sect. 5.1.1). The second generation is represented by export credit
agencies, such as Credendo (Sect. 5.1.2), and the OECD through its “country risk
classification” (Sect. 5.1.3). The third generation comprises what I call the “neolib-
eral indicators.” Launched in the mid-1990s, the indices of the Heritage Foundation
(Sect. 5.1.4) and the Fraser Institute (Sect. 5.1.5) put considerable emphasis on eco-
nomic freedom. The fourth generation, which gained influence in the 2000s, scruti-
nizes competitiveness and the business environment; the Global Competitiveness
Reports published by the WEF are emblematic of this generation (Sect. 5.1.6).

5.1.1 ICRG Methodology

The ICRG model for forecasting political, financial, and economic risk was created
in 1980 by the editors of International Reports, the newsletter dealing with interna-
tional finance and economic issues. In 1992, ICRG analysts moved from
International Reports to The PRS Group (Howell 2001, p. 19).1 Very little informa-
tion is provided about the ICRG team. Yet it seems that Professor Howard Howell,
senior advisor to ICRG for more than three decades, played a prominent role in the
design of its rating methodologies.2
The ICRG approach incorporates 22 variables in three subcategories of risk: politi-
cal, financial, and economic. A specific index is created for each subcategory. The
political risk index is based on a 100-point scale, whereas the financial risk and eco-
nomic risk indices are each based on a 50-point scale. For the three indices, 0 repre-
sents the maximum risk. The three scores are aggregated and then divided by 2 to
yield the composite risk score. The composite scores, which range from 0 to 100, are
then broken into five categories: “very high risk” (0–49.9 points), “high risk” (50–59.9
points), “moderate risk” (60–69.9 points), “low risk” (70–79.9 points), and “very low
risk” (80–100 points); see Howell (1998, pp. 185–188; 2001, pp. 19–22) and The PRS
Group (2012, p. 15; 2014, p. 15). The scores are updated on a monthly basis.
The political risk index is composed of 12 criteria with different weightings (see
Table 5.1). “Government stability” measures a government’s ability to carry out its
program and remain in office. The “socioeconomic conditions” component assesses
“general public satisfaction, or dissatisfaction, with the government’s economic poli-
cies.” “Investment profile” reflects four risks: expropriation, taxation, repatriation,

1
The PRS Group is headquartered in East Syracuse, New York.
2
See [Link]
5.1 Country Risk Rating Methodologies 193

Table 5.1 Political risk Maximum

components Components points
Government stability 12
Socioeconomic conditions 12
Investment profile 12
Internal conflict 12
External conflict 12
Corruption 6
Military in politics 6
Religious tensions 6
Ethnic tensions 6
Law and order 6
Democratic accountability 6
Bureaucracy quality 4
Maximum total points 100
Sources: Howell (1998, 2001), The PRS
Group (2012, 2014)

and labor costs. The factors measured by the “internal conflict,” “external conflict,”
“corruption,” “military in politics,” “religious tensions,” and “ethnic tensions” com-
ponents are self-evident. “Law and order” reflect the strength and impartiality of the
legal system, on the one hand, and popular observance of the law, on the other hand.
“Democratic accountability” focuses on the government’s responsiveness to its citi-
zens, and “bureaucracy quality” measures the bureaucracy’s “strength and expertise
to govern without drastic changes in policy or interruptions in government services”
(Howell 1998, 2001; The PRS Group 2012, 2014).
The ICRG model’s financial risk index consists of five criteria with different
weightings (see Table 5.2): the ratios of foreign debt to GDP, foreign debt service to
exports of goods and services, and current account to exports of goods and services;
the net international liquidity position (measured as months of import cover); and
the country’s exchange rate stability. For each component, ICRG establishes a scale
whereby performance is transformed into a point score (see Tables 5.3, 5.4, and 5.5).
The economic risk index is determined by five criteria with different weightings
(see Table 5.6): GDP per capita, real GDP growth, annual inflation rate, and the
ratios of current account to GDP and of central government budget balance to
GDP. Here, too, ICRG establishes a scale whereby performance is transformed into
a point score (see Tables 5.7 and 5.8).
In addition to these current political, financial, economic, and composite risk scores,
ICRG also uses the same methodology to produce a “worst-case forecast” (WCF) and
a “best-case forecast” (BCF) at the 1- and 5-year horizons (The PRS Group 2012).3

3
In the early 2000s, ICRG issued a “most probable forecast” (MPF) (Howell 2001, pp. 33–34). The
MPF, which was neither the mean nor the median of the BCF and WCF, assumed that the govern-
ment would take action to reduce the risks identified by the current scores. However, the MPF was
discontinued shortly after its implementation.
194 5 Country Risk Indicators

Table 5.2 Financial risk components

Components Points (maximum)
Foreign debt as a percentage of GDP 10
Foreign debt service as a percentage of exports of goods and 10
services
Current account as a percentage of exports of goods and 15
services
Net international liquidity as months of import cover 5
Exchange rate stability 10
Maximum total points 50
Notes: ICRG indicates that figures are converted into US dollars at the average exchange rate for
the given year. The appreciation or depreciation of a currency against the US dollar (against the
German mark/Euro in the case of the United States) over a calendar year or the most recent
12-month period is calculated as a percentage change
Sources: Howell (1998, 2001), The PRS Group (2012, 2014)

Table 5.3 Foreign debt as a percentage of GDP and foreign debt service as a percentage of exports
of goods and services: Point scores
Foreign debt service as a percentage of exports of goods
Foreign debt as a percentage of GDP and services
Ratio (%) Points Ratio (%) Points
0.0–4.9 10.0 0.0–4.9 10.0
5.0–9.9 9.5 5.0–8.9 9.5
10.0–14.9 9.0 9.0–12.9 9.0
15.0–19.9 8.5 13.0–16.9 8.5
20.0–24.9 8.0 17.0–20.9 8.0
25.0–29.9 7.5 21.0–24.9 7.5
30.0–34.9 7.0 25.0–28.9 7.0
35.0–39.9 6.5 29.0–32.9 6.5
40.0–44.9 6.0 33.0–36.9 6.0
45.0–49.9 5.5 37.0–40.9 5.5
50.0–59.9 5.0 41.0–44.9 5.0
60.0–69.9 4.5 45.0–48.9 4.5
70.0–79.9 4.0 49.0–52.9 4.0
80.0–89.9 3.5 53.0–56.9 3.5
90.0–99.9 3.0 57.0–60.9 3.0
100.0–109.9 2.5 61.0–65.9 2.5
110.0–119.9 2.0 66.0–70.9 2.0
120.0–129.9 1.5 71.0–75.9 1.5
130.0–149.9 1.0 76.0–79.9 1.0
150.0–199.9 0.5 80.0–84.9 0.5
≥ 200.0 0.0 ≥ 85.0 0.0
Source: The PRS Group (2012)
5.1 Country Risk Rating Methodologies 195

Table 5.4 Current account as a percentage of exports of goods and services and net international
liquidity position as months of import cover: Point scores
Current account as a percentage of exports of Net international liquidity as months of
goods and services import cover
Ratio (%) Points Net liquidity in months Points
≥25.0 15.0 ≥15 5.0
20.0–24.9 14.5 12.0–14.9 4.5
15.0–19.9 14.0 9.0–11.9 4.0
10.0–14.9 13.5 6.0–8.9 3.5
5.0–9.9 13.0 5.0–5.9 3.0
0.0–4.9 12.5 4.0–4.9 2.5
−4.9 to −0.1 12.0 3.0–3.9 2.0
−9.9 to −5.0 11.5 2.0–2.9 1.5
−14.9 to −10.0 11.0 1.0–1.9 1.0
−19.9 to −15.0 10.5 0.6–0.9 0.5
−24.9 to −20.0 10.0 ≤0.5 0.0
−29.9 to −25.0 9.5
−34.9 to −30.0 9.0
−39.9 to −35.0 8.5
−44.9 to −40.0 8.0
−49.9 to −45.0 7.5
−54.9 to −50.0 7.0
−59.9 to −55.0 6.5
−64.9 to −60.0 6.0
−69.9 to −65.0 5.5
−74.9 to −70.0 5.0
−79.9 to −75.0 4.5
−84.9 to −80.0 4.0
−89.9 to −85.0 3.5
−94.9 to −90.0 3.0
−99.9 to −95.0 2.5
−104.9 to −100.0 2.0
−109.9 to −105.0 1.5
−114.9 to −110.0 1.0
−119.9 to −115.0 0.5
≤ −120.0 0.0
Source: The PRS Group (2012)
196 5 Country Risk Indicators

Table 5.5 Exchange rate stability: Point scores

Depreciation (%) Points Appreciation (%) Points
0.1–4.9 10.0 0.0–9.9 10.0
5.0–7.4 9.5 10.0–14.9 9.5
7.5–9.9 9.0 15.0–19.9 9.0
10.0–12.4 8.5 20.0–22.4 8.5
12.5–14.9 8.0 22.5–24.9 8.0
15.0–17.4 7.5 25.0–27.4 7.5
17.5–19.9 7.0 27.5–29.9 7.0
20.0–22.4 6.5 30.0–34.9 6.5
22.5–24.9 6.0 35.0–39.9 6.0
25.0–29.9 5.5 40.0–49.9 5.5
30.0–34.9 5.0 ≥ 50.0 5.0
35.0–39.9 4.5
40.0–44.9 4.0
45.0–49.9 3.5
50.0–54.9 3.0
55.0–59.9 2.5
60.0–69.9 2.0
70.0–79.9 1.5
80.0–89.9 1.0
90.0–99.9 0.5
100.0 0.0
Source: The PRS Group (2012)

Table 5.6 Economic risk Maximum

components Components points
Annual inflation rate 10
Real GDP growth 10
GDP per capita 5
Current account as a percentage of GDP 15
Budget balance as a percentage of GDP 10
Maximum total points 50
Notes: ICRG indicates that figures are converted into US
dollars at the average exchange rate for the given year.
GDP per capita is expressed as a percentage of the aver-
age of all the countries covered by ICRG. The annual
inflation rate is the unweighted average of the Consumer
Price Index
Sources: Howell (1998, 2001), The PRS Group (2012)
5.1 Country Risk Rating Methodologies 197

Table 5.7 Annual inflation rate, real GDP growth, and GDP per capita: Point scales
Annual inflation rate Real GDP growth GDP per capita
Change (%) Points Change (%) Points % of average Points
<2.0 10.0 ≥6.0 10.0 ≥250.0 5.0
2.0–2.9 9.5 5.0–5.9 9.5 200.0–249.9 4.5
3.0–3.9 9.0 4.0–4.9 9.0 150.0–199.9 4.0
4.0–5.9 8.5 3.0–3.9 8.5 100.0–149.9 3.5
6.0–7.9 8.0 2.5–2.9 8.0 75.0–99.9 3.0
8.0–9.9 7.5 2.0–2.4 7.5 50.0–74.9 2.5
10.0–11.9 7.0 1.5–1.9 7.0 40.0–49.9 2.0
12.0–13.9 6.5 1.0–1.4 6.5 30.0–39.9 1.5
14.0–15.9 6.0 0.5–0.9 6.0 20.0–29.9 1.0
16.0–18.9 5.5 0.0–0.4 5.5 10.0–19.9 0.5
19.0–21.9 5.0 −0.4 to −0.1 5.0 ≤9.9 0.0
22.0–24.9 4.5 −0.9 to −0.5 4.5
25.0–30.9 4.0 −1.4 to −1.0 4.0
31.0–40.9 3.5 −1.9 to −1.5 3.5
41.0–50.9 3.0 −2.4 to −2.0 3.0
51.0–65.9 2.5 −2.9 to −2.5 2.5
66.0–80.9 2.0 −3.4 to −3.0 2.0
81.0–95.9 1.5 −3.9 to −3.5 1.5
96.0–110.9 1.0 −4.9 to −4.0 1.0
111.0–129.9 0.5 −5.9 to −5.0 0.5
≥130.0 0.0 ≤ −6.0 0.0
Source: The PRS Group (2012)

Table 5.8 Current account as a percentage of GDP and budget balance as a percentage of GDP:
Point scales
Current account as a percentage of GDP Budget balance as a percentage of GDP
Ratio (%) Points Ratio (%) Points
≥10.0 15.0 ≥4.0 10.0
8.0–9.9 14.5 3.0–3.9 9.5
6.0–7.9 14.0 2.0–2.9 9.0
4.0–5.9 13.5 1.0–1.9 8.5
2.0–3.9 13.0 0.0–0.9 8.0
1.0–1.9 12.5 −0.9 to −0.1 7.5
0.0–0.9 12.0 −1.9 to −1.0 7.0
−0.9 to −0.1 11.5 −2.9 to −2.0 6.5
−1.9 to −1.0 11.0 −3.9 to −3.0 6.0
−3.9 to −2.0 10.5 −4.9 to −4.0 5.5
−5.9 to −4.0 10.0 −5.9 to −5.0 5.0
−7.9 to −6.0 9.5 −6.9 to −6.0 4.5
−9.9 to −8.0 9.0 −7.9 to −7.0 4.0
−11.9 to −10.0 8.5 −8.9 to −8.0 3.5
−13.9 to −12.0 8.0 −9.9 to −9.0 3.0
(continued)
198 5 Country Risk Indicators

Table 5.8 (continued)

Current account as a percentage of GDP Budget balance as a percentage of GDP
Ratio (%) Points Ratio (%) Points
−15.9 to −14.0 7.5 −11.9 to −10.0 2.5
−16.9 to −16.0 7.0 −14.9 to −12.0 2.0
−17.9 to −17.0 6.5 −19.9 to −15.0 1.5
−18.9 to −18.0 6.0 −24.9 to −20.0 1.0
−19.9 to −19.0 5.5 −29.9 to −25.0 0.5
−20.9 to −20.0 5.0 ≤ −30.0 0.0
−21.9 to −21.0 4.5
−22.9 to −22.0 4.0
−23.9 to −23.0 3.5
−24.9 to −24.0 3.0
−26.9 to −25.0 2.5
−29.9 to −27.0 2.0
−32.5 to −30.0 1.5
−34.9 to −32.5 1.0
−39.9 to −35.0 0.5
≤ −40.0 0.0
Source: The PRS Group (2012)

5.1.2 Credendo’s Country Risk Methodologies

In 1921, the Belgian Ministry of Economic Affairs set up the Delcredere Committee
to guarantee Belgian export transactions. Eighteen years later, this Committee was
transformed into the Office nationale du ducroire (ONDD), an autonomous public
financial body with a state guarantee. As an export credit agency, ONDD expanded
its operations in the postwar decades, providing a range of services that covered
risks worldwide (see Sect. [Link]). The ONDD became a private limited company
in 2004 and was renamed Credendo in 2013 (SA Ducroire 2006; Credendo
Group 2014).4
For export transactions, the agency has developed three rating systems that aim to
assess short-term political risk, medium/long-term political risk, and commercial risk.5
For assessing short-term political risk, Credendo uses a quantitative model based
on the host country’s short-term external liabilities, foreign exchange reserves, cur-
rent account balance, and refinancing capabilities. For medium/long-term political
risk assessment, the firm employs a quantitative model to measure the country’s sol-
vency. This model includes external debt ratios and liquidity indicators, yet it also
considers the country’s fiscal and monetary policies, external balances and structural
reforms, potential growth, export diversification, aid dependency, political situation,
and payment experience. For both political risk classifications, countries are rated on
a scale of 1 to 7, where 1 corresponds to the least risky countries and 7 to the riskiest.

4
Credendo is headquartered in Brussels.
5
See [Link]
5.1 Country Risk Rating Methodologies 199

Commercial risk assessment consists mainly of case-by-case microeconomic

assessments of the buyer/obligor, its business sector, and the country in which it is
active. The model used is based on economic and financial indicators affecting all
companies in the country (e.g., inflation, GDP growth, volatility in exchange rates,
etc.) and on the institutional context in which the companies operate. Countries are
rated on a three-grade scale: A, B, and C indicate (respectively) low, average, and
high commercial risk.
For FDI, Credendo has implemented three rating systems that assess the risk of
(i) political violence, (ii) expropriation, and (iii) currency inconvertibility and trans-
fer restrictions.6 Political violence risk includes wars, terrorist acts, and political
violence damages. Expropriation risk encompasses the quality of the country’s legal
system as well as all measures taken by a host government that discriminate against
foreign investors without adequate compensation. It seems that no quantitative
model is used to assess these two types of risk. In contrast, Credendo indicates that
the risk of currency inconvertibility and transfer restrictions is driven by essentially
the same factors underlying medium/long-term political risk. For all three risk
types, host countries are rated on a scale of 1 (least risky) to 7 (most risky).
All Credendo country risk ratings are updated on a regular basis and subject to
immediate review as circumstances warrant.

5.1.3 OECD’s Country Risk Classification

In 1997, the Participants to the Arrangement on Officially Supported Export Credits

established a methodology for assessing country credit risk and classifying coun-
tries accordingly. These classifications were produced solely for the purpose of set-
ting minimum premium rates for transactions. They reflect country risk, which
includes transfer and convertibility risk as well as what the OECD considers “cases
of force majeure”—for example, war, expropriation, revolution, civil disturbance,
floods, and earthquakes.7
Countries are rated on a scale of 0 to 7—where 0 represents the least risky coun-
tries and 7 the riskiest—via application of a two-step methodology. The Country
Risk Assessment Model (CRAM) yields a quantitative evaluation of country credit
risk that is based on a set of indicators (e.g., the country’s financial and economic
circumstances and payment experience reported by the participants). Next, the
CRAM ratings are adjusted upward or downward following a qualitative analysis by
OECD experts. Any adjustment requires a consensus among these experts.
The OECD released its first country risk ratings in January 1999. Since then, the
ratings have been updated quarterly. It is noteworthy that the rating of high-income
OECD and eurozone countries was discontinued in 2013.

6
See [Link]
7
See [Link]
200 5 Country Risk Indicators

5.1.4 The Heritage Foundation’s Index of Economic Freedom

The Heritage Foundation is a conservative think tank founded in 1973. It gained

significant influence under the Reagan administration and has since maintained a
tight relationship with the Republican Party.8 It was ranked #12 in the 2016 Global
Go to Think Tank Index Report (McGann 2017, p. 46). The mission of the Heritage
Foundation is to “formulate and promote conservative public policies based on the
principles of free enterprise, limited government, individual freedom, traditional
American values, and a strong national defense.”9
In December 1994, the Heritage Foundation launched its Index of Economic
Freedom (IEF) in collaboration with the Wall Street Journal.10 Its purpose was to
measure economic freedom in ten key areas: trade policy, tax policy, government
intervention in the economy, monetary policy, capital flows and foreign investment,
banking policy, wage and price controls, property rights, regulations, and “black
market” activity. For each category, countries are rated on a scale that ranges from
1 to 5. A score of 1 (resp. 5) indicates that the focal policy is most (resp. least)
­conducive to economic freedom. The ten categories are weighted equally to yield
the average overall score. Countries that exhibit an overall score in the 1.00–1.99
bracket are considered “free” economies; those with an overall score in the
2.00–2.99, 3.00–3.99, and 4.00–5.00 brackets are viewed as being (respectively)
“mostly free,” “mostly unfree,” and “repressive” economies.
Table 5.9 presents the key components of the ten categories used by the IEF in
year 2003. For each of these components, Heritage Foundation experts set boundar-
ies that enable them to assign specific “sub-scores.” For example, a country receives
a sub-score of 1 on the “weighted average tariff rate” component if that rate does not
exceed 4%. The sub-score falls to 2 if the rate is higher than 4% but does not exceed
9%; the next boundaries are 14% and 19% (Heritage Foundation 2002, p. 53). The
key components and their associated boundaries have changed frequently since 1995.
The methodology was amended substantially in the IEF for 2007 (Heritage
Foundation 2007, pp. 37–55). First, the ten main categories were reorganized and
renamed as follows: business freedom, trade freedom, fiscal freedom, freedom from
government, monetary freedom, investment freedom, financial freedom, property
rights, freedom from corruption, and labor freedom. Second, an equation-based
approach replaced the bracket scores for several key components. Third, the 1–5
scoring scale was converted to a 0–100 scale, with 100 representing the most free
business environment. Finally, the assessments of economic freedom were expanded
from four categories to five (Table 5.10).

8
See [Link]
and [Link]
9
See [Link]
10
K. R. Holmes, “In Search of Free Markets,” Wall Street Journal, 12 December 1994.
5.1 Country Risk Rating Methodologies 201

Table 5.9 Methodology for the 2003 IEF

Broad categories Key components
Trade policy Weighted average tariff rate
Nontariff barriers
Corruption in the customs service
Fiscal burden of government Top income tax rate and marginal rate for the average taxpayer
Corporate tax rate
Government expenditures as a percentage of GDP
Government intervention in Government consumption as a percentage of the economy
the economy Government ownership of businesses and industries
Share of government revenues from state-owned enterprises and
gov. ownership of property
Economic output produced by the government
Monetary policy Weighted average inflation rate from 1992 to 2001
Capital flows and foreign Foreign investment code
investment Restrictions on foreign ownership of business
Restrictions on the industries and companies open to foreign
investors
Restrictions and performance requirements on foreign companies
Foreign ownership of land
Equal treatment under the law for both foreign and domestic
companies
Restrictions on repatriation of earnings
Availability of local financing for foreign companies
Banking and finance Government ownership of banks
Restrictions on the ability of foreign banks to open branches and
subsidiaries
Government influence over the allocation of credit
Government regulations
Freedom to offer all types of financial services, securities, and
insurance policies
Wages and prices Minimum wage laws
Freedom to set prices privately without government influence
Government price controls and the extent to which government
price controls are used
Government subsidies to businesses that affect prices
Government role in setting wages
Property rights Freedom from government influence over the judicial system
Commercial code defining contracts
Sanctioning of foreign arbitration of contract disputes
Government expropriation of property and legally granted and
protected private property
Corruption within the judiciary and delays in receiving judicial
decisions
(continued)
202 5 Country Risk Indicators

Table 5.9 (continued)

Broad categories Key components
Regulations Licensing requirements to operate a business and ease of
obtaining a business license
Corruption within the bureaucracy
Labor regulations
Environmental, consumer safety, and worker health regulations
Regulations that impose a burden on business
Black market Smuggling
Piracy of intellectual property in the black market
Agricultural production, manufacturing, services, transportation,
and labor supplied on the black market
Source: Heritage Foundation (2002, pp. 49–69)

Table 5.10 Revised Broad rating categories Brackets

assessment categories
in the 2007 IEF Free 80.0–100
Mostly free 70.0–79.9
Moderately free 60.0–69.9
Mostly unfree 50.0–59.9
Repressed 0.0–49.9
Source: Heritage Foundation (2007, p. 3)

The methodology did not change fundamentally in subsequent years. It is worth

mentioning, however, that the 2017 IEF measured 12 broad categories: property
rights, judicial effectiveness, government integrity, tax burden, government spend-
ing, fiscal health, business freedom, labor freedom, monetary freedom, trade free-
dom, investment freedom, and financial freedom (Heritage Foundation 2017,
pp. 455–469).
The Index of Economic Freedom is published every year—during November/
December until 2002 (in each case for the following year) and during January since
2004 (in each case for that same year). Its experts and contributors have included
diplomats (e.g., Kim R. Holmes and Terry Miller) and senior economists (e.g.,
Gerald P. O’Driscoll, Jr., and Anthony B. Kim).

5.1.5  he Fraser Institute’s Economic Freedom of the World

T
Index

The Fraser Institute is an independent, Vancouver-headquartered think tank founded

in 1974. It was ranked #19 in the 2016 Global Go to Think Tank Index Report
(McGann 2017, p. 46). The mission of the Fraser Institute is to “improve the quality
of life for Canadians, their families, and future generations by studying, measuring,
5.1 Country Risk Rating Methodologies 203

and broadly communicating the effects of government policies, entrepreneurship,

and choice on their well-being.”11
The Fraser Institute launched its Economic Freedom of the World (EFW) report
in January 1996.12 Its goal was to “construct an index that is (a) a good indicator of
economic freedom across countries and (b) based on objective components that can
be updated regularly and used to track future changes in economic freedom” (Fraser
Institute 1996, p. xv). The report’s neoliberal inspiration was recounted in its
Introduction, which stated that “the current volume is the culmination of a process
which began at the 1984 meetings of the Mont Pelerin Society in Cambridge,
England” (ibid., p. 1).
The EFW index for 1996 had 17 components distributed among four major
areas: money and inflation; government operations and regulations; takings and
discriminatory taxation; and international exchange (Table 5.11). Every component
is rated on a scale of 0–10, where 10 corresponds to the most economic freedom.
The index is based on three distinct assessment methods. The first one, which is
used for 7 of the 17 components, establishes a grading scale and then transforms
indicators and qualitative assessments into specific ratings. The second method
(used for another seven components) involves arranging the data from best to worst
and then dividing them into 11 groups that each contains an equal number of coun-
tries. Countries ranked in the top 11th are assigned a rating of 10; those in the
­second eleventh, a rating of 9; and so forth. The third method is a binary assessment
whereby the country is given a rating of 10 or 0 according as whether a focal condi-
tion consistent with economic freedom is or is not present—for example, key com-
ponent #3 is evaluated by answering this question: Are citizens free to own a foreign
currency bank account domestically? The Fraser Institute provides three alternative
summary indices that assign different weights to the 17 components (Fraser
Institute 1996, pp. 11–46).
During 1997–2001, there were fluctuations in the index’s number of key compo-
nents and their respective weights (see Table 5.12). Starting in 2002, the EFW index
used a simple average to combine the key components into broad category ratings
and then to express those ratings as “summary” ratings.
In 2017, the EFW index was changed again to consist of 24 key items grouped in
five major areas. Several components themselves comprise a number of subcompo-
nents. Altogether, the index now incorporates 42 distinct variables. Each component
is still evaluated on a 0–10 scale that reflects the underlying data’s distribution. In
the case of subcomponents, their ratings are averaged to yield the main component’s
rating. The component ratings within each broad category are then averaged to

11
See [Link]
12
Several think tanks were copublishers of the report: the Cato Institute, the Centro de
Investigaciones Económicas Nacionales (Guatemala), the Centro de Investigaciones Sobre la Libre
Empresa (Mexico), the Free Market Foundation of Southern Africa (South Africa), the Hong Kong
Centre for Economic Research (Hong Kong), the Institute of Economic Affairs (England), the
Institute of Economic Affairs (Ghana), the Institute of Public Affairs (Australia), the Israel Center
for Social and Economic Progress (Israel), and the Liberales Institut (Germany).
204 5 Country Risk Indicators

Table 5.11 Methodology used to construct the EFW index: 1996

Broad categories Key components
Money and inflation Average annual growth rate of the money supply during the last
5 years minus the potential growth rate of real GDP
Standard deviation of the annual inflation rate during the last
5 years
Freedom of citizens to own a foreign currency bank account
domestically
Freedom of citizens to maintain a bank account abroad
Government operations Government general consumption expenditures as a percentage of
and regulations GDP
Role and presence of government-operated enterprises
Price controls
Freedom of private businesses and cooperatives to compete in
markets
Equality of citizens under the law and access of citizens to a
nondiscriminatory judiciary
Freedom from government regulations and policies that cause
negative real interest rates
Takings and discriminatory Transfers and subsidies as a percentage of GDP
taxation Top marginal tax rate
Use of conscripts to obtain military personnel
Restraints on international Taxes on international trade as a percentage of exports plus imports
exchange Difference between the official exchange rate and the black market
rate
Actual size of trade sector compared to the expected size
Restrictions on the freedom of citizens to engage in capital
transactions with foreigners
Source: Fraser Institute (1996, pp. 11–46)

derive ratings for each of the five broad categories. In turn, those five ratings are
averaged to obtain the summary rating for each country (Table 5.13).
The EFW is published on a yearly basis—at different times of the year until 2004
and in September since 2005. Experts and contributors include a variety of senior
economists. Since 1996, professors James Gwartney (Florida State University) and
Robert Lawson (Southern Methodist University) have served as chief editors of the
EFW annual report.
5.1 Country Risk Rating Methodologies 205

Table 5.12 Methodology used to construct the EFW index: 2001

Broad categories (overall
weighting) Key components (weighting within the broad category)
Size of government: General government consumption expenditures as a
consumption, transfers, and percentage of total consumption (50%)
subsidies (11%) Transfers and subsidies as a percentage of GDP (50%)
Structure of the economy and Government enterprises and investment as a percentage of
use of markets (14.2%) the economy (32.7%)
Price controls: extent to which businesses are free to set their
own prices (33.5%)
Top marginal tax rate (25%)
Use of conscripts to obtain military personnel (8.8%)
Monetary policy and price Average annual growth rate of the money supply during the
stability (9.2%) last 5 years minus the growth rate of real GDP during the last
10 years (34.9%)
Standard deviation of the annual inflation rate during the last
5 years (32.6%)
Annual inflation rate during the most recent year (32.5%)
Freedom to use alternative Freedom of citizens to own foreign currency bank accounts
currencies (14.6%) domestically and abroad (50%)
Difference between the official exchange rate and the black
market rate (50%)
Legal structure and property Legal security of private ownership rights (50%)
rights (16.6%) Rule of law (50%)
International exchange: freedom Revenue from taxes on international trade as a percentage of
to trade with foreigners (17.1%) exports and imports (28.2%)
Mean tariff rate (29.4%)
Standard deviation of tariff rates (28.4%)
Actual size of trade sector compared to the expected size
(14%)
Freedom of exchange in capital Ownership of banks: percentage of deposits held in privately
and financial markets (17.2%) owned banks (27.1%)
Extension of credit: percentage of credit extended to private
sector (21.2%)
Interest rate controls and regulations that lead to negative
interest rates (24.7%)
Restrictions on the freedom of citizens to engage in capital
transactions with foreigners (27.1%)
Source: Fraser Institute (2001, p. 6)
206 5 Country Risk Indicators

Table 5.13 Methodology used to construct the EFW index: 2017

Broad categories Key components
Size of government Government consumption
Transfers and subsidies
Government enterprises and investment
Top marginal tax rate
Legal system and property rights Judicial independence
Impartial courts
Protection of property rights
Military interference in rule of law and politics
Integrity of the legal system
Legal enforcement of contracts
Regulatory costs of the sale of real property
Reliability of police
Business costs of crime
Sound money Money growth
Standard deviation of inflation
Inflation: most recent year
Freedom to own foreign currency bank accounts
Freedom to trade internationally Tariffs
Regulatory trade barriers
Black-market exchange rates
Controls of the movement of capital and people
Regulation Credit market regulations
Labor market regulations
Business regulations
Source: Fraser Institute (2017, p. 4)

5.1.6  he World Economic Forum’s Growth Competitiveness

T
Index and Global Competitiveness Index

The World Economic Forum was established as a foundation by Klaus Schwab in

1971.13 The WEF is famous for organizing annual symposiums that gather top pol-
icy makers and business leaders in Davos, Switzerland.
In 1979, the Forum launched the Report on the Competitiveness of European
Industry. A few years later, this publication became the annual Global
Competitiveness Report. Klaus Schwab’s seminal study was clearly innovative in
the sense that it did not define competitiveness exclusively in terms of productivity
and production costs. For him, many other factors had to be considered: “the inter-
nal dynamism of a country, its socio-political consensus, the quality of its human
resources, its commercial spirit, the manner in which it prepares for the future, etc.”
(The World Economic Forum 2009, p. 29). Ten key drivers of competitiveness were

The foundation’s original name was the European Management Forum, but it was changed to the
13

World Economic Forum in 1987 (The World Economic Forum 2009, p. 71).
5.1 Country Risk Rating Methodologies 207

identified: the economy’s “dynamism,” industrial efficacy and cost of production,

the dynamics of the market, financial dynamism, human resources, the role of the
state, the infrastructural dimension, outward orientation, forward orientation, and
sociopolitical consensus and stability.
During the 1980s and 1990s, the report expanded its coverage to include non-­
European economies and newly industrialized countries. The number of economies
under consideration increased from 32 in 1989 to 59 in 2000.
In 2001, the WEF ranked 75 countries and developed its Growth Competitiveness
Index (Growth CI). The methodology is based on a multi-step process.14 First, the 75
economies are classified into “core” and “noncore” groups according to their level of
technological sophistication. The 24 core countries are Australia, Austria, Belgium,
Canada, Denmark, Finland, France, Germany, Hong Kong, Iceland, Ireland, Israel,
Italy, Japan, the Netherlands, New Zealand, Norway, Singapore, South Korea,
Sweden, Switzerland, Taiwan, the United Kingdom, and the United States (World
Economic Forum 2001, p. 30). Second, three major indices are c­ onstructed: the tech-
nology index, the public institutions index, and the macroeconomic environment index.
For core economies, the technology index is a simple average of its innovation
subindex and the information and communication technology (ICT) subindex. For
noncore economies, the technology index is a weighted average of the innovation
subindex (accounting for 12.5%), the ICT subindex (50%), and the technology trans-
fer subindex (37.5%). The innovation subindex is based on hard data (e.g., gross ter-
tiary enrollment rate) and survey questions (e.g., “What is your country’s position in
technology relative to world leaders?”)15; the ICT subindex is also based on hard data
(e.g., number of mobile telephone and Internet users per capita) and survey questions
(e.g., “How extensive is Internet access in schools?”). The technology transfer subin-
dex is derived from of a “technology in trade” analysis and the following survey ques-
tion: “Is FDI in your country an important source of new technology?”
The Growth CI’s public institutions index relies on two series of survey data,
each accounting for 50%. The first series addresses contracts and law issues (e.g.,
“Is the judiciary independent from the government and/or parties to dispute?”); the
second addresses corruption issues (e.g., “How common are bribes paid in connec-
tion to export and import permits?”).
The macroeconomic environment index is a weighted average of the Institutional
Investor rating as of March 2001 (accounting for 25%), the ratio of general govern-
ment expenditure to GNP (25%), and a macroeconomic stability subindex (50%).
That subindex is based on hard data (the real exchange rate relative to the United
States, the interest rate spread between deposits and loans, the ratio of general gov-
ernment budget balance to GNP, the consumer price index, and the national savings
rate) and survey questions (e.g., “Is your country’s economy likely to be in reces-
sion next year?”).

This methodology was developed by economists Jeffrey Sachs and John McArthur.
14

The Executive Opinion Survey conducted annually by the WEF records the perspectives of busi-
15

ness leaders around the world by asking them to compare aspects of their local business environ-
ment with global standards.
208 5 Country Risk Indicators

Table 5.14 Thresholds Stage of development GDP per capita (in US$)
for establishing stages of
Stage 1: Factor-driven stage <2000
development for WEF’s
GCI Transition from stage 1 to stage 2 2000–3000
Stage 2: Efficiency-driven stage 3000–9000
Transition from stage 2 to stage 3 9000–17,000
Stage 3: Innovation-driven stage >17,000
Source: World Economic Forum (2006, p. 12)

The information derived from these two steps is then used to compute overall
Growth CI scores. For core countries, the Growth CI is weighted as follows: tech-
nology index (50%), public institutions index (25%), and macroeconomic environ-
ment index (25%). For noncore countries, the Growth CI is the simple average of
the three major indices (World Economic Forum 2001, pp. 28–51).
The maximum possible score on the Growth CI is 7, and the lowest is 1. Note
that all component variables—whether taken from the Executive Opinion Survey or
from hard data sources—are “rebased” so that the highest score is always equal to 7
and the lowest score is always equal to 1.
In 2006, the WEF amended its methodology (World Economic Forum 2006,
p. 5) and thus the Growth Competitiveness Index was replaced by the Global
Competitiveness Index (GCI).16 The GCI introduced the “stages of development”
concept into the index’s calculation. Stage 1 is the factor-driven stage, stage 2 is the
efficiency-driven stage, and stage 3 is the innovation-driven stage. The 125 coun-
tries covered are classified into these stages of development as a function of their
per capita GDP at market exchange rates (Table 5.14).
The GCI methodology establishes three subindices based on nine “pillars” and a
list of key component variables (Table 5.15). As before, all the component variables
are “rebased” so that the highest (resp. lowest) score is always 7 (resp. 1). The con-
version formula is:

 country value − sample min. 

Component variable = 6 ×   +1
 sample max. − sample min. 

where “sample min.” and “sample max.” are (respectively) the variable’s minimum
and maximum values observed in the sample.
Each pillar score is the simple average of its component variables, and each sub-
index score is the simple average of its pillar scores; finally, the subindex scores are
weighted to yield the GCI score. Those weightings differ depending on the focal
country’s developmental stage (Table 5.16). For countries “in transition,” the
weights change smoothly as the economy develops and thus reflect the transition
from one stage of development to the next.

16
The new competitiveness model was implemented by economist Xavier Sala-i-Martin.
5.1 Country Risk Rating Methodologies 209

Table 5.15 Composition of the Global Competitiveness Index for 2006

Subindices Pillars Component variables
Basic Institutions Public institutions: property rights; ethics and
requirements corruption; undue influence; government inefficiency;
and security
Private institutions: corporate ethics and accountability
Infrastructure Overall infrastructure quality; railroad infrastructure
development; quality of port and air transport
infrastructures; quality of electricity supply; and
telephone lines
Macroeconomy Government fiscal balance; national savings rate;
inflation; interest rate spread; government debt; and real
effective exchange rate
Health and Health: medium-term business impact of malaria,
primary education tuberculosis, and HIV/AIDS; infant mortality; life
expectancy; tuberculosis, malaria, and HIV prevalence
Primary education: primary enrolment
Efficiency Higher education Quantity of education: secondary and tertiary enrolment
enhancers and training ratios
Quality of education: quality of the educational system,
math and science education, and management schools
On-the-job-training: local availability of specialized
research and training services and extent of staff
training
Market efficiency Good markets: distortions, competition, and size
Labor markets: flexibility and efficiency
Financial markets: sophistication and openness
Technological Firm-level technology absorption; laws relating to ICT;
readiness FDI and technology transfer; cellular telephones;
Internet users; personal computers
Innovation and Business Networks and supporting industries: local supplier
sophistication sophistication quantity and quality
factors Sophistication of firms’ operations and strategy
Innovation Quality of scientific research institutions; company
spending on R&D; university/industry research
collaboration; government procurement of advanced
technology products; availability of scientists and
engineers; utility patents; intellectual property
protection; capacity of innovation
Source: World Economic Forum (2006, pp. 3–50)

Since 2006, there have been few changes in the GCI methodology. A brief
c­ omparison between the Global Competitiveness Reports published in 2006 and
2017 shows that the “efficiency enhancers” subindex is now composed of six pillars
(viz., higher education and training, goods market efficiency, labor market effi-
ciency, financial market development, technological readiness, and market size).
Also, some component variables are now weighted differently within the corre-
sponding pillar. Another change is that a country’s developmental stage depends not
210 5 Country Risk Indicators

Table 5.16 Weighting of GCI subindices by the country’s developmental stage

Basic requirements Efficiency Innovation and sophistication
(%) enhancers (%) factors (%)
Factor-driven stage 50 40 10
countries
Efficiency-driven stage 40 50 10
countries
Innovation-driven stage 30 40 30
countries
Source: World Economic Forum (2006, p. 12)

only on its GDP per capita but also on the share of raw materials among all exports
(World Economic Forum 2017).
Global Competitiveness Reports are published in September every year.
Prominent roles are played in this publication by Professor Klaus Schwab and by
Professor Xavier Sala-i-Martín, its Chief Advisor for more than a decade.

5.2 Country Risk Shocks

This section describes eight types of shocks that reflect the main components of
country risk analyzed in Chap. 3. In Sect. 5.2.1, I discuss the selection methodology.
Each of Sects. 5.2.2–5.2.9 is devoted to one of these eight selected shocks: major
episodes of international political violence, major episodes of domestic political
violence, expropriation acts, high-inflation peaks, deep economic depressions, sig-
nificant restrictions on capital flows, sovereign debt crises, and exceptional natural
disasters. Section 5.2.10 concludes with some additional comments.

5.2.1 Methodology

Recall from Chap. 3 that country risk consists of both shocks and latent hazards.
The rest of this chapter focuses on the shocks that may affect firms involved in busi-
ness relations abroad. There are three main reasons for studying shocks. First, they
are an observable embodiment of country risk. Second, they can be identified and
measured more easily than latent risks, whose effects may be difficult to perceive or
may become evident only in the long term. Third, shocks enable one to test the
accuracy of country risk indicators.
Selecting a country risk component as a potential shock is based on the analysis
conducted in Chap. 3. The selection is contingent on four factors: (i) the availability
of reliable information about the focal component; (ii) the extent to which such
information can be quantified; (iii) the possibility of observing a sharp decline in the
component’s measure within a short period of time (typically a year or less); and
5.2 Country Risk Shocks 211

(iv) the shock’s capacity to affect the business operations of a wide array of firms or
sectors in the short to medium term.17
I find that eight components—accounting for five of the seven broad components
of country risk analyzed in Chap. 3—satisfy these four criteria. For each compo-
nent, I shall determine a specific threshold beyond which its measure’s decline is
significant enough that one can reasonably deem the component to have been
affected by an actual shock. My efforts to set unbiased thresholds will be supported
by academic research, professional publications, and press articles.
The eight shocks materialized several times during the period under consider-
ation (1985–2014), resulting in a number of country risk crises.18 In the discussion
to follow, one such crisis corresponds to one specific shock experienced by one
country a given year. The crises identified will allow me to test, in Sect. 5.3, the
accuracy of country risk indicators.

5.2.2 Major Episodes of International Political Violence

For this type of shock, I use the data and analyses performed by the Center for
Systemic Peace (CSP). This Virginia-based nonprofit corporation has been studying
international and civil wars since 1997.19
The CSP defines major episodes of political violence as the “systematic and
sustained use of lethal violence by organized groups that result in at least 500
directly-related deaths over the course of the episode.” Episodes are coded for time
span and magnitude and are assigned to one of six categories of armed conflict:
international violence, international war, civil violence, civil war, ethnic violence,
and ethnic war. Each episode is designated as spanning a certain number of years
and is assessed as being of a certain “magnitude of societal-systemic impact.” The
CSP measures such magnitude on an 11-point scale (where 0 represents no major
episode of political violence and 10 the most violent episodes). Scores are consis-
tent and comparable across categories. Components of the two interstate categories
(i.e., international violence and international war) and of the four intrastate catego-
ries (i.e., civil violence, civil war, ethnic violence, and ethnic war) are combined to
yield, respectively, the CSP’s INTTOT and CIVTOT scores. These scores, which
are also measured on a 0–10 scale, reflect the magnitude of total international politi-
cal violence and of total domestic political violence.

17
Here I exclude not only latent risks but also threats that are likely to affect only a particular firm
or a limited set of firms: most microeconomic risks; protectionist measures; and industrial risks.
These “asymmetric shocks” can be more reliably anticipated by corporate-level risk analyses than
by the global country risk ratings presented in Sect. 5.1.
18
Determining the period to be examined is constrained by the availability of (i) country risk rat-
ings and (ii) data on the country risk components.
19
See [Link]
212 5 Country Risk Indicators

The analysis presented here employs only the INTTOT scores. However, it is
difficult to establish the threshold score beyond which an episode of international
political violence constitutes a shock. In order to perform this task, I analyze how
the New York Times and the Wall Street Journal covered the different international
conflicts listed by the CSP. I find that a country’s business environment is signifi-
cantly affected by an international political violence episode when its INTTOT
score exceeds 3, so I list all country-year observations that are assigned a score
higher than 3 during 1985–2014. When there are several consecutive country-year
observations with a score higher than 3, I retain only the first observation of the
series because my objective is to identify the year of the shock.20 When the first
observation is for an episode that occurred prior to 1985, it is removed along with
the following observations in that series.21 This procedure identifies five crises:
Eritrea:1998, Ethiopia:1998, Iraq:1990, Iraq:2003, and Kuwait:1990.

5.2.3 Major Episodes of Domestic Political Violence

To identify episodes of domestic political violence, I use the CIVTOT scores com-
puted by the CSP (cf. Sect. 5.2.2). As in the case of international episodes, I list all
country-year observations that scored higher than 3 during 1985–2014 (and retain
only the first in any series of such observations). As before, pre-1985 episodes (and
their sequelae) are omitted from the sample. I thus identify the 21 crises listed in
Table 5.17.

Table 5.17 Crises caused by a major episode of domestic political violence

Algeria:1991 Kenya:2008 Russia:1994
Bosnia and Herzegovina:1992 Liberia:1990 Russia:1999
Burundi:1993 Libya:2011 Rwanda:1994
Dem. Republic of Congo:1996 Mexico:2006 Somalia:1988
Indonesia:1999 Nigeria:2001 South Sudan:2013
Iraq:1996 Nigeria:2009 Syria:2011
Iraq:2011 Pakistan:2004 Yugoslavia (Fed. Rep.):1999
Sources: Author’s classification based on the major episodes of political violence listed by the
Center for Systemic Peace; available at [Link]

20
For example: because the INTTOT score of Iraq is 5 in 1990 and also in 1991, I retain only the
“Iraq:1990” observation.
21
In the case of Lebanon, for example, the INTTOT score is 4 during 1982–1990 and so none of
the nine observations for that country is retained.
5.2 Country Risk Shocks 213

5.2.4 Expropriation Acts

Any forced divestment constitutes a major shock because it indicates that the host
government does not respect property rights and has little interest in enforcing them.
The sources used to track nationalizations are Minor (1994) for the period
1985–1988 and Hajzler and Rosborough (2016) for 1989–2014. For each year, I
compile a list of expropriating countries. When a country expropriates foreign
investors during consecutive years, I retain only the first because (as mentioned
previously) it is the one most directly related to the notion of a shock. This selection
method results in 81 crises, which are listed in Table 5.18.

Table 5.18 Crises caused by expropriations

Antigua and Barbuda:2002 Georgia:2007 Mongolia:2009
Argentina:2001 Ghana:2011 Nigeria:2012
Argentina:2009 Guinea:2008 Pakistan:2011
Azerbaijan:2005 Guinea:2011 Pakistan:2013
Belarus:2011 Guinea:2013 Papua New Guinea:2011
Belize:2009 Hungary:2002 Peru:1985
Belize:2011 Hungary:2010 Peru:2011
Bolivia:2000 Hungary:2014 Romania:2009
Bolivia:2006 Indonesia:1998 Russia:2006
Bolivia:2012 Indonesia:2011 Sri Lanka:1990
Bulgaria:2014 Indonesia:2013 Togo:2014
China:2011 Ivory Coast:2003 Trinidad and Tobago:2010
Costa Rica:2007 Kazakhstan:1992 Turkey:2011
Costa Rica:2012 Kazakhstan:1999 Turkmenistan:1996
Dem. Republic of Congo:1993 Kazakhstan:2003 Turkmenistan:2007
Dem. Republic of Congo:1997 Kazakhstan:2007 Turkmenistan:2010
Dem. Republic of Congo:2010 Kenya:1998 Ukraine:2007
Dominican Republic:1994 Kyrgyzstan:2004 Ukraine:2009
Ecuador:2006 Kyrgyzstan:2010 Uzbekistan:2006
Ecuador:2008 Laos:2012 Uzbekistan:2011
Egypt:1989 Latvia:2008 Venezuela:2001
Egypt:1991 Lesotho:1992 Venezuela:2005
Egypt:1995 Libya:2009 Yemen:2005
Egypt:2014 Maldives:2012 Yugoslavia (Fed. Rep.):1999
El Salvador:2008 Mexico:1995 Zimbabwe:2004
Gambia:2008 Mexico:1998 Zimbabwe:2007
Georgia:1996 Mexico:2001 Zimbabwe:2010
Sources: Author’s classification based on Minor (1994) for 1985–1988 and on Hajzler and
Rosborough’s (2016) updated database for 1989–2014
214 5 Country Risk Indicators

5.2.5 High-Inflation Peaks

One might suppose that the threshold beyond which an inflation rate will likely
disrupt a country’s business environment is the “hyperinflation” level. The problem
is that Cagan’s (1956) traditional definition of hyperinflation (i.e., monthly rates
above 50%, corresponding to a 5-digit annual inflation rate) may not be appropriate
because foreign operations are undoubtedly disturbed by much lower inflation rates
(see Sect. [Link]). Furthermore, the 1985–2014 period was characterized by a
worldwide disinflation trend, from which it follows that what constitutes “high”
inflation has changed since the 1980s.
The threshold adopted here is an annual inflation rate of 100%. This boundary is
used by Dornbusch (1990) and Bruno (1991) to identify hazardous high-inflation
episodes in the 1980s. To obtain inflation rates, I use the consumer price index pro-
vided by the International Financial Statistics database maintained by the IMF. When
a country posts an annual inflation rate of 100% for several consecutive years, I
retain only the first year’s observation (unless it is before 1985, in which case I omit
both that observation and the series that it initiates).
The cases of the Soviet Union and the Socialist Federal Republic of Yugoslavia
require specific comments. The two federations were already experiencing high
inflation (as defined here) when they broke up in 1991. In the following months and
years, hyperinflation spread throughout most of the territories that had just gained
their independence (see Filatochev and Bradshaw 1992; Petrovic et al. 1999). Yet
because the initial shocks occurred during 1987 in Yugoslavia and during 1991 in
the Soviet Union, the high-inflation episodes observed in the newly independent
countries during 1992–1995 are not counted (based on the “series” criterion
described previously). Thus, I identify a total of 32 crises due to high inflation
(see Table 5.19).

Table 5.19 Crises caused by high-inflation episodes

Albania:1992 Laos:1999 Sudan:1996
Angola:1992 Mexico:1987 Suriname:1993
Argentina:1987 Mongolia:1993 Turkey:1994
Belarus:1999 Nicaragua:1985 Uganda:1985
Bulgaria:1991 Peru:1988 Uruguay:1990
Bulgaria:1996 Poland:1989 USSR:1991
Dem. Republic of Congo:1989 Romania:1991 Yugoslavia (Soc. Fed. Rep.):1987
Dem. Republic of Congo:1991 Romania:1997 Zambia:1989
Dem. Republic of Congo:1999 Sierra Leone:1987 Zambia:1992
Iraq:1991 Sierra Leone:1990 Zimbabwe:2002
Iraq:1993 Sudan:1991
Sources: Author’s classification based on the IMF’s International Financial Statistics database
5.2 Country Risk Shocks 215

5.2.6 Deep Economic Depressions

For the purposes of this analysis, a “deep” economic depression is defined as a

decline in real GDP of 10% or more within a calendar year. This definition has been
widely adopted and is consistent with other research that addresses major macro-
economic shocks (e.g., Barro and Jin 2011).
My main source for data on this factor is the World Bank’s World Development
Indicators. When a country’s GDP contracts by at least 10% for consecutive years,
I retain the first year’s observation only; if that is a pre-1985 observation, then (as
before) it is removed from the sample and the following observations are also
removed.
For the Soviet Union and the Socialist Federal Republic of Yugoslavia, I use
Angus Maddison’s historical statistics.22 In 1991, Yugoslavia was in depression, but
the Soviet Union was not. Hence, I do not count as shocks the depressions observed
in Bosnia and Herzegovina, Croatia, and the Federal Republic of Yugoslavia (includ-
ing Kosovo, Montenegro, and Serbia) in 1992. In contrast, the countries that became
independent of the Soviet Union and posted GDP growth rates worse than −10% in
1992 are viewed as being crisis countries; they are included in the total of 68 crises
listed by Table 5.20.

Table 5.20 Crises caused by deep economic depressions

Albania:1991 Jordan:1989 Romania:1991
Albania:1997 Kazakhstan:1994 Russia:1992
Angola:1993 Kuwait:1988 Russia:1994
Antigua and Barbuda:2009 Kyrgyzstan:1992 Rwanda:1994
Argentina:2002 Latvia:1992 Sierra Leone:1992
Armenia:1992 Latvia:2009 Solomon Islands:2000
Armenia:2009 Lebanon:1989 South Sudan:2012
Azerbaijan:1992 Liberia:1989 Suriname:1987
Belarus:1994 Liberia:2003 Tajikistan:1992
Central African Republic:2013 Libya:2011 Togo:1993
Chad:1993 Lithuania:1992 Turkmenistan:1992
Cuba:1991 Lithuania:2009 Turkmenistan:1994
Czechoslovakia:1991 Madagascar:2002 Turkmenistan:1997
Dem. Republic of Congo:1992 Malawi:1994 Ukraine:1993
Estonia:1992 Marshall Islands:1996 Ukraine:2009
Estonia:2009 Moldova:1992 United Arab Emirates:1986
Ethiopia:1985 Moldova:1994 Uzbekistan:1992
Gabon:1987 Myanmar:1988 Yemen:2011
Georgia:1992 Nicaragua:1988 Yugoslavia (Fed. Rep.):1999
(continued)

22
See [Link]/maddison/historical_statistics/horizontal-file_02-[Link]
216 5 Country Risk Indicators

Table 5.20 (continued)

Guinea-Bissau:1998 Nigeria:1987 Yugoslavia (Soc. Fed. Rep.):1991
Indonesia:1998 Palau:1993 Zimbabwe:2003
Iraq:1991 Panama:1988 Zimbabwe:2008
Iraq:2003 Peru:1989
Sources: Author’s classification based on the World Bank’s World Development Indicators and
Angus Maddison’s database; the latter is retrieved from [Link]/maddison/historical_statis-
tics/horizontal-file_02-[Link]

5.2.7 Significant Restrictions on Capital Flows

In order to identify significant restrictions in cross-border financial transactions, I

use Chinn and Ito’s (2006) updated index (see Sect. 3.4.2). This index captures the
extent of capital controls based on information culled from the IMF’s Annual Report
on Exchange Arrangements and Exchange Restrictions. Countries are scored each
year on a scale from 0 to 1; here 0 (resp. 1) corresponds to the lowest (resp. highest)
level of financial openness, which is reduced by such restrictions.
Because Chinn and Ito’s study does not specify any thresholds, its results cannot
be used to determine how much of a decline in the focal country’s score would con-
stitute a significant restriction on capital flows. I therefore compute and compare the
average world scores, for the years 1985 and 2014, toward the end of measuring the
average increase in financial openness among countries that were not fully liberal-
ized in 1985. Hence I define a shock in this context as any country-year’s decrease
in financial openness that is of at least the same magnitude as the average world
increase in financial openness observed during 1985–2014.
My sample excludes the 22 countries that were assigned a score of 1 in 1985, and
all missing country-year observations for 1985 and 2014 are assigned a score of 0.
The resulting sample includes 160 countries. I find that the average world score
increased by 0.30 points, rising from 0.17 points in 1985 to 0.47 points in 2014.
Therefore, a decline in financial openness is considered a shock if the reduction
amounts to at least 0.30 points within a year. When a country announces a major
restriction on capital flows in consecutive years (as Egypt did in 2012 and 2013),
only the first year’s observation is retained. Thus Table 5.21 lists a total of 16 crises.

Table 5.21 Crises caused by a significant restriction on capital flows

Argentina:2001 Dominican Republic:1996 Liberia:1986
Bosnia and Herzegovina:2012 Ecuador:2011 Seychelles:2004
Botswana:1996 Egypt:2012 Sierra Leone:2009
Cambodia:1996 Iceland:2008 Venezuela:2002
Chile:1996 Kyrgyzstan:2012
Cyprus:2012 Lebanon:2001
Sources: Author’s classification based on Chinn and Ito’s (2006) updated database
5.2 Country Risk Shocks 217

5.2.8 Sovereign Debt Crises

Using Beers and de Leon-Manlagnit’s (2019) database, I compile a list of countries

that lapsed into default on their FC bank loans, FC bonds, or LC debt—or that failed
to fulfill their financial obligations to private creditors—during 1985–2014. Defaults
affecting less than $100 million of debt are excluded for the purpose of this
classification.
This list also includes the countries already in default whose debt arrears soared
dramatically.23 After analyzing Beers and de Leon-Manlagnit’s database and brows-
ing the New York Times and the Wall Street Journal, I conclude that a tenfold increase
(within a single year) in the defaulted debt owed to foreign or private creditors
causes serious alarm among investors. Table 5.22 lists the 64 sovereign debt crises
so identified.24

Table 5.22 Crises caused by sovereign debt turmoil

Albania:1991 Grenada:2004 Saint Kitts and Nevis:2011
Algeria:1991 Indonesia:1999 Sierra Leone:2005
Angola:1989 Indonesia:2002 Slovenia:1992
Antigua and Barbuda:1996 Iraq:1988 South Africa:1985
Argentina:1987 Ivory Coast:2000 South Africa:1989
Argentina:2001 Jamaica:1987 South Africa:1993
Belarus:1994 Jamaica:2010 South Sudan:2013
Belize:2006 Jamaica:2013 Syria:1995
Belize:2012 Jordan:1989 Tajikistan:2010
Bosnia and Herzegovina:1992 Kazakhstan:1998 Trinidad and Tobago:1988
Bosnia and Herzegovina:1999 Kazakhstan:2014 Turkey:1999
Bulgaria:1990 Kuwait:1990 Ukraine:2012
Cameroon:1985 Macedonia:1992 Ukraine:2014
Chad:2014 Morocco:1989 Uruguay:1988
Colombia:1988 Mozambique:1985 Uruguay:1990
Croatia:1992 Mozambique:2007 Uruguay:2003
Cyprus:2013 Mozambique:2013 USSR:1991
Dominican Republic:2005 Myanmar:1985 Venezuela:1992
Ecuador:1999 Myanmar:1987 Yemen:2001
Ecuador:2008 Pakistan:1998 Yugoslavia (Fed. Rep.):1992
Egypt:1986 Paraguay:1986
Greece:2012 Romania:1986
Sources: Author’s classification based on Beers and de Leon-Manlagnit’s (2019) database

23
The objective here is to include all defaulting countries whose debt arrears may become
unsustainable.
24
Newly independent countries are included in the list if they satisfy the stipulated conditions.
218 5 Country Risk Indicators

5.2.9 Exceptional Natural Disasters

I use the Emergency Events Database (EM-DAT) to identify natural disasters that
had the most damaging economic effects. The EM-DAT, launched in 1988 by the
Centre for Research on the Epidemiology of Disasters, contains essential core data
on the occurrence and effects of more than 22,000 disasters worldwide since 1900.25
Natural disasters include geophysical, meteorological, hydrological, climatological,
biological, and extraterrestrial calamities. I focus on country-year observations and
examine two series of data: the cost of natural disasters and the percentage of a
country’s population affected.
The threshold beyond which I consider the annual cost of natural disasters to be
“exceptional” is 10% of a country’s GDP, which is the same threshold used in Sect.
5.2.6 to identify deep economic depressions. I analyze the EM-DAT and the news-
papers available through ProQuest to determine the proportion—of a country’s
inhabitants affected by a natural disaster—beyond which economic and social life
is devastated. I conclude that an appropriate threshold is one-third of the population.
Based on these two criteria, I identify the 11 crises listed in Table 5.23.

Table 5.23 Crises caused by El Salvador:2001 Honduras:1998 Samoa:1991

an exceptional natural Grenada:2004 Jamaica:1988 Tajikistan:2008
disaster
Guyana:2005 Liberia:1990 Vanuatu:1985
Haiti:2010 Samoa:1990
Sources: Author’s classification based on the EM-DAT
and [Link]

5.2.10 Comments on the Country Risk Crises Identified

The eight idiosyncratic shocks named at the start of this section resulted in 298
country risk crises. The next step is to aggregate the data so that no country-year
observation is counted more than once. For example, Albania was hit by two distinct
shocks in 1991—a deep economic depression and a sovereign debt crisis—but only
one crisis is counted: “Albania:1991.” Hence my final sample consists of 272 obser-
vations, which are listed (chronologically) in Appendix.
An examination of these 272 crises reveals that 117 nations were hit by at least
one of the eight shocks. There were 23 countries that experienced at least four crises
during 1985–2014: Argentina, Belize, Bulgaria, the Democratic Republic of Congo,
Ecuador, Egypt, Indonesia, Iraq, Jamaica, Kazakhstan, Kyrgyzstan, Liberia, Mexico,
Nigeria, Pakistan, Peru, Romania, Russia, Sierra Leone, Turkmenistan, Ukraine,
Venezuela, and Zimbabwe.

25
See [Link]
5.3 Performance of Country Risk Indicators 219

Observe that several low-income and lower-middle–income nations do not

appear in the sample. This does not mean that these countries posed no risks to for-
eign investors. Rather, it simply means that—despite their economic backwardness
and/or weak political system—these countries managed to avoid any major shocks
and to meet (at least roughly) the expectations of investors.

5.3 Performance of Country Risk Indicators

This section analyzes how well the ratings—issued during 1984–2013 by

Euromoney, ICRG, Credendo, the OECD, the Heritage Foundation, the Fraser
Institute, and the World Economic Forum—anticipated the country risk crises
observed during 1985–2014. After presenting the methodology in Sect. 5.3.1, I
examine the performance of each rater in Sects. 5.3.2–5.3.8.

5.3.1 Methodology

The tools used to measure the performance of country risk indicators are different
from those applied in Sect. 4.2.
Here, examining the stability of country risk ratings is not relevant for two rea-
sons. First, several rating data sets (e.g., those contained in the Heritage Foundation’s
Index of Economic Freedom and the Fraser Institute’s Economic Freedom of the
World) were not issued on a regular basis. Thus, the time that elapsed between the
two consecutive “annual” rating data sets could be anywhere between 10 and
16 months. Second, the very nature of some ratings differs: the ICRG metric is the
annual average of monthly ratings, whereas the metric used by other raters is a
“point in time” rating. These two factors would bias any analysis of ratings stability.
Neither are the accuracy ratios (ARs) used in Sect. 4.2 operative in this context.
The reason is that in this chap. I test the performance of country risk indicators in
terms of eight types of risks, whereas sovereign risk indicators were tested exclu-
sively in terms of sovereign default risk. In particular, the computation of ARs in
Sect. 4.2 required the ratings of countries already in default at the start of the time
interval t be removed from the cohort whose performance is measured over time t.
If the same procedure was applied to this chapter’s country risk crises, then a large
number of observations would have to be omitted. For example, the CIVTOT score
of the Democratic Republic of Congo exceeded 3 (i.e., the threshold beyond which
an episode of domestic political violence is viewed as major) in 1996 and remained
at that high level until 2014. Removing all country risk crises experienced by this
nation during 1997–2014 would oblige me also to drop three observations: the
expropriations of 1997 and 2010 and the high-inflation episode of 1999 (see
Appendix). Similar removals would affect other countries, which would substan-
tially reduce the total number of country risk crises.
220 5 Country Risk Indicators

As a result, I focus on six simple criteria to measure the performance of country

risk indicators:
• The average rating assigned to a country 1, 2, and 3 years before it was hit by a
shock.
• The average percentile ranking assigned to a country 1, 2, and 3 years before it
was hit by a shock.
• The percentage of countries in the “risk-free” rating category 1, 2, and 3 years
before they were hit by a shock.
• The percentage of countries in the top 25% of all ranked countries 1, 2, and
3 years before they were hit by a shock.26
• The percentage of countries in the “safe” and “relatively safe” rating categories
1, 2, and 3 years before they were hit by a shock.
• The percentage of countries in the top 50% of all ranked countries 1, 2, and
3 years before they were hit by a shock.27
The decision to focus on rankings as well as ratings is supported by the emphasis
that most raters—namely, Euromoney, the Heritage Foundation, the Fraser Institute,
and the World Economic Forum—place on both measurements. The country risk
crises used for testing are the ones listed in Appendix.
In what follows I measure the performance of each rater in terms of all six crite-
ria. I also identify the country risk crises that raters failed to anticipate and account
for those lapses in light of the methodologies analyzed in Sect. 5.1.

5.3.2 Performance of Euromoney’s Country Risk Ratings

I test how well Euromoney ratings issued during 1988–2013 anticipated the country
risk crises that occurred during 1989–2014. The ratings 1, 2, and 3 years prior to the
crisis observed in year y are those published in September of (respectively) year
y−1, y−2, and y−3.
For many years, Euromoney did not use broad rating categories as ICRG did
(e.g., “moderate risk,” “low risk,” and “very low risk”). Starting in the early 2010s,
however, Euromoney divided countries into five groups. Countries labeled Tier 1
are those rated in the 80–100 range. Its Tier 2, Tier 3, Tier 4, and Tier 5 countries are
those with ratings in the ranges of (respectively) 65–79.9, 50–64.9, 36–49.9, and
0–35.9. I therefore consider as “risk-free” the countries assigned a score of 80 or
higher. By the same token, I consider as “safe” and “relatively safe” the countries
assigned a score of at least 50.28

26
The selection of this threshold is supported by discussions I had with economists and analysts.
27
Idem.
28
My analysis is based on various internal briefs retrieved from [Link]
5.3 Performance of Country Risk Indicators 221

Table 5.24 Euromoney ratings performance 1, 2, and 3 years before a crisis

Performance criterion Year y–1 Year y–2 Year y–3
Average rating of the crisis countries 36.7 38.3 39.6
Average percentile ranking of the crisis countries 63rd 62nd 61st
Percentage of crisis countries rated in the “risk-free” category 0.5 0.5 1.1
Percentage of crisis countries ranked in the top 25% 4.3 5.7 7.1
Percentage of crisis countries rated in the “safe”/“relatively 19.0 23.7 23.6
safe” categories
Percentage of crisis countries ranked in the top 50% 34.1 36.6 37.4
Notes: Euromoney ratings are established on a 0–100 scale, where 0 (resp. 100) corresponds to
countries that are the most (resp. least) risky. The samples 1, 2, and 3 years prior to a crisis consist
of (respectively) 211, 194, and 182 observations. A crisis is a country-year pair in which a shock
occurred, and an observation is a crisis-rating pair. I view Russia and the Federal Republic of
Yugoslavia (FRY) as being the sole legal successors to the Soviet Union and the Socialist Federal
Republic of Yugoslavia (SFRY), respectively. As a result, the pre-1992 ratings of Russia and the
FRY are those of the Soviet Union and the SFRY, respectively
Source: Author’s computations based on Euromoney ratings

Table 5.24 displays the performance of Euromoney ratings as measured by the

six criteria detailed previously. One, two, and three years prior to a crisis, the aver-
age ratings and percentile rankings were especially accurate, as they were located in
the lower end of the Tier 4 category and in the 62nd percentile, respectively. The
overall good performance of Euromoney is confirmed by the very low percentages
of crisis countries rated in the “risk-free” category: 0.5%, 0.5%, and 1.1% (respec-
tively) 1, 2, and 3 years before a crisis. The percentages of crisis countries ranked in
the top 25% were higher (between 4.3% and 7.1%) but still relatively modest.
The percentages of crisis countries rated in the “safe” and “relatively safe” rating
categories are good, and the percentages of crisis countries ranked in the top 50%
are acceptable. As one might expect, all the metrics are increasingly accurate as the
country risk crises near.
Table 5.25 presents the few mistakes made by Euromoney. It shows that as many
as 2 (resp. 13) crisis countries were rated (resp. ranked) excessively high 3 years
before a crisis.
The capital controls implemented by Iceland in 2008 led to the most dramatic
instance of misrating. A deeper analysis reveals that Iceland enjoyed very high
scores on all the criteria emphasized in Euromoney’s methodology (see Sect. 4.1.3).
However, this failure should be put into perspective given that many top economists
were highly optimistic about the stability of Iceland’s financial system on the eve of
the 2007–2008 crisis (e.g., Mishkin and Herbertsson 2006).
The excessively high rating assigned to the Soviet Union until 1988 and its ele-
vated ranking until 1989 are more puzzling because that country had long rejected the
fundamental rules of capitalism. In September 1988, Euromoney supported its views
by referencing the positive effects expected from the perestroika reforms championed
by Gorbachev and by describing the Soviet Union as an “oil- and cash-­rich” nation.29

29
Euromoney, September 1988, p. 232.
222 5 Country Risk Indicators

Table 5.25 Euromoney’s misratings

Year y−1 Year y−2 Year y−3
Crisis Iceland:2008 Iceland:2008 (restriction Iceland:2008 (restriction
countries rated (restriction on capital on capital flows) on capital flows);
in the flows) USSR:1991 (high inflation,
“risk-free” sovereign debt crisis)
category
(types of
shocks in
parentheses)
Crisis Iceland:2008 Iceland:2008 (restriction Iceland:2008 (restriction
countries (restriction on capital on capital flows); on capital flows);
ranked in the flows); Cyprus:2012 Cyprus:2012 (restriction Cyprus:2013 (sovereign
top 25% (types (restriction on capital on capital flows); debt crisis); Cyprus:2012
of shocks in flows); Chile:1996 Cyprus:2013 (sovereign (restriction on capital
parentheses) (restriction on capital debt crisis); USSR:1991 flows); USSR:1991 (high
flows); Hungary:2002 (high inflation, sovereign inflation, sovereign debt
(expropriation); debt crisis); crisis); Greece:2012
China:2011 Hungary:2002 (sovereign debt crisis);
(expropriation); (expropriation); Russia:1992 (economic
Cyprus:2013 Turkey:1994 (high depression);
(sovereign debt crisis); inflation); Chile:1996 Indonesia:1998 (economic
Indonesia:1998 (restriction on capital depression, expropriation);
(economic depression, flows); Indonesia:1998 Estonia:2009 (economic
expropriation); (economic depression, depression); Hungary:2002
Peru:2011 expropriation); (expropriation);
(expropriation); Indonesia:1999 (major Indonesia:1999 (major
Mexico:2001 domestic political domestic political violence
(expropriation) violence episode, episode, sovereign debt
sovereign debt crisis); crisis); Hungary:2010
China:2011 (expropriation); Chile:1996
(expropriation); (restriction on capital
Estonia:2009 (economic flows); Lithuania:2009
depression) (economic depression)
Note: The higher the rating or ranking of a crisis country, the higher its position in the classification
Source: Author’s classifications based on Euromoney ratings

In fact, Euromoney seems to have greater difficulty in anticipating stringent

c­ apital controls and sovereign debt crises; these two types of shocks account for
more than half of its “mis-rankings” and for all of its misratings. I am therefore led
to draw two series of conclusions. On the one hand, Euromoney experts tend to
underestimate the riskiness of current account deficits and of inadequate prudential
regulations in countries exhibiting a high level of financial openness (cf. the crises
experienced by Iceland and Cyprus in 2008 and 2012, respectively). On the other
hand, Euromoney should pay more attention to the public debt’s sustainability and
public spending’s efficiency (see the sovereign debt crises in the Soviet Union in
1991, Greece in 2012, and Cyprus in 2013). Recall that the “debt indicators” criteria
for Greece and Cyprus were scored at the maximum (10 out of 10) 3 years prior to
their default.
5.3 Performance of Country Risk Indicators 223

5.3.3 Performance of ICRG’s Country Risk Ratings

Here I test how well ICRG ratings issued during 1984–2013 anticipated the country
risk crises that occurred during 1985–2014. The ratings 1, 2, and 3 years prior to a
crisis observed in year y are the average annual composite ratings for years y−1,
y−2, and y−3, respectively.
I consider as “risk-free” countries those that are assigned a score of 80 or higher,
and I consider as “safe” and “relatively safe” those countries that are assigned a
score of 60 or higher. This categorization is based on ICRG methodology (see
Sect. 5.1.1).
Table 5.26 displays the performance of ICRG ratings. One, two, and three years
prior to a crisis, the average ratings (at the upper end of its “high risk” category) and
percentile rankings (67th percentile) are especially good. The relative accuracy of
ICRG is confirmed by the low percentages of crisis countries rated in the “risk-free”
category: 0.6%, 1.9%, and 2.5% for 1, 2, and 3 years prior to a crisis. The percent-
ages of crisis countries ranked in the top 25% are slightly higher (between 3.6%
and 5.1%).
The percentages of crisis countries ranked in the top 50% are satisfactory. In
contrast, more than half of the crisis countries were rated in the “safe” and “rela-
tively safe” categories, which reflects poor performance. Note that the number of
crisis countries included in the “moderate risk,” “low risk,” and “very low risk”
­rating categories actually exceeds those in the “high risk” and “very high risk” cat-
egories. In fact, the “low-risk” and “moderate-risk” rating categories are insuffi-
ciently safe, which suggests that ICRG should do a better job of discriminating
among countries rated in those two categories and should probably downgrade
some of them to the “high-risk” category. These findings differ substantially from
what I observe for Euromoney ratings.

Table 5.26 ICRG ratings performance 1, 2, and 3 years before a crisis

Performance criterion Year y–1 Year y–2 Year y–3
Average rating of the crisis countries 57.8 58.6 58.6
Average percentile ranking of the crisis countries 68th 66th 66th
Percentage of crisis countries rated in the “risk-free” category 0.6 1.9 2.5
Percentage of crisis countries ranked in the top 25% 3.6 3.7 5.1
Percentage of crisis countries rated in the “safe”/“relatively 54.4 54.3 51.3
safe” categories
Percentage of crisis countries ranked in the top 50% 24.3 28.4 27.8
Notes: ICRG ratings are established on a 0–100 scale, where 0 (resp. 100) corresponds to countries
that are the most (resp. least) risky. The samples 1, 2, and 3 years prior to a crisis consist of (respec-
tively) 169, 162, and 158 observations. A crisis is a country-year pair in which a shock occurred,
and an observation is a crisis-rating pair
Source: Author’s computations based on ICRG ratings
224 5 Country Risk Indicators

Table 5.27 ICRG’s misratings

Year y−1 Year y−2 Year y−3
Crisis countries Libya:2009 Iceland:2008 Iceland:2008 (restriction
rated in the (expropriation) (restriction on capital on capital flows);
“risk-free” flows); Trinidad and Libya:2011 (major
category (types Tobago:2010 domestic political
of shocks in (expropriation); violence episode,
parentheses) Libya:2009 economic depression);
(expropriation) Trinidad and Tobago:2010
(expropriation);
Libya:2009
(expropriation)
Crisis countries Trinidad and Iceland:2008 Iceland:2008 (restriction
ranked in the Tobago:2010 (restriction on capital on capital flows);
top 25% (types (expropriation); flows); Trinidad and Cyprus:2012 (restriction
of shocks in Venezuela:1992 Tobago:2010 on capital flows);
parentheses) (sovereign debt crisis); (expropriation); Libya:2011 (major
Libya:2011 (major Libya:2009 domestic political
domestic political (expropriation); violence episode,
violence episode, China:2011 economic depression);
economic depression); (expropriation); El Trinidad and Tobago:2010
Libya:2009 Salvador:2001 (natural (expropriation);
(expropriation); disaster); Chile:1996 Chile:1996 (restriction on
Chile:1996 (restriction (restriction on capital capital flows); Libya:2009
on capital flows); flows) (expropriation);
China:2011 Hungary:2002
(expropriation) (expropriation);
China:2011
(expropriation)
Note: The higher the rating or ranking of a crisis country, the higher its position in the classification
Source: Author’s classifications based on ICRG ratings

Finally, the metrics are increasingly accurate as a country risk crisis nears—
except for the percentages of crisis countries rated in the “safe” and “relatively safe”
categories.
Table 5.27 presents ICRG’s misratings. There were a total of four and eight crisis
countries that were (respectively) rated and ranked excessively high 3 years prior to
a crisis. The four crises that ICRG failed to anticipate were the controls on capital
flows announced by Iceland in 2008, the expropriations that occurred in Libya dur-
ing 2009 and in Trinidad and Tobago during 2010, and the political and economic
turmoil that shook Libya in 2011.
The rating of Libya was an utter failure and merits closer examination. The gen-
erous rating granted during 2006–2008 was mainly driven by the country’s high
economic and financial scores: on average, 46.4 and 48.4 out of 50 (see Tables 5.2
and 5.6). These flaws suggest that even outstanding macroeconomic scores are
really no protection against a major economic shock. This ratings debacle also high-
lights the limits of scores that rely exclusively on quantitative data. If the composite
score of Libya had been set at the same level as its political score, no misrating
would have occurred.
5.3 Performance of Country Risk Indicators 225

In sum, ICRG failed to foresee capital controls and nationalizations (nearly 80%
of all misratings) but had no problem anticipating the major sovereign debt crises
that occurred since the 1980s.

5.3.4 Performance of Credendo’s Country Risk Ratings

Most of the metrics used by Credendo are not tested because they aim to measure a
specific type of shock that did not occur often enough to assess predictions (i.e.,
short-term and medium/long-term political risks, political violence risk, and the risk
of currency inconvertibility and transfer restrictions) or because the metric reflects
case-by-case microeconomic assessments (i.e., commercial risk).
However, I can test the predictive accuracy of Credendo’s expropriation risk
scores issued during 2002–2013 with regard to the nationalizations that occurred
during 2003–2014.30 The scores 1, 2, and 3 years prior to the expropriation observed
in year y are the scores as of 31 December in (respectively) years y−1, y−2, and y−3.
Countries that are assigned an expropriation risk score of 1 are considered to be
“risk free.” Because Credendo does not indicate the risk inherent to each score cat-
egory, I assume that “safe” and “relatively safe” countries are those with a score of
3 or lower.
Table 5.28 reports the performance of Credendo’s ratings. One, two, and three
years prior to a crisis, the average ratings and percentile rankings are adequate, fall-
ing in the middle rating category and around the 59th percentile.

Table 5.28 Credendo ratings performance 1, 2, and 3 years before an expropriation

Year y−1 Year y−2 Year y−3
Average rating of the expropriating countries 4.3 4.2 4.0
Average percentile ranking of the expropriating countries 60th 59th 57th
Percentage of expropriating countries rated in the “risk-free” 7.3 5.8 8.2
category
Percentage of expropriating countries ranked in the top 25% 7.3 5.8 8.2
Percentage of expropriating countries rated in the 30.9 40.4 36.7
“safe”/“relatively safe” categories
Percentage of expropriating countries ranked in the top 50% 30.9 42.3 36.7
Notes: Credendo expropriation risk scores are established on a 1–7 scale, where 7 (resp. 1) corre-
sponds to countries that are the most (resp. least) risky. The samples 1, 2, and 3 years prior to a
crisis consist of (respectively) 55, 52, and 49 observations. A crisis is a country-year pair in which
an expropriation occurred, and an observation is a crisis-rating pair
Source: Author’s computations based on Credendo scores

30
The list of expropriating countries is based on Table 5.18.
226 5 Country Risk Indicators

Table 5.29 Credendo’s misratings

Year y−1 Year y−2 Year y−3
Expropriating countries Latvia:2008; Latvia:2008; Latvia:2008;
rated in the “risk-free” Romania:2009; Hungary:2010; Hungary:2010;
category Hungary:2010; Bulgaria:2014 Bulgaria:2014;
Bulgaria:2014 Hungary:2014
Expropriating countries Latvia:2008; Latvia:2008; Latvia:2008;
ranked in the top 25% Romania:2009; Hungary:2010; Hungary:2010;
Hungary:2010; Bulgaria:2014 Bulgaria:2014;
Bulgaria:2014 Hungary:2014
Note: The higher the rating or ranking of a crisis country, the higher its position in the classification
Source: Author’s classifications based on Credendo scores

The percentages of expropriating countries rated in the “risk-free” category, on

the one hand, and ranked in the top 25%, on the other hand, are the same because the
countries that are assigned a score of 1 (the “risk-free” category) generally account
for a fourth of the total number of countries rated. That percentage is relatively high
(7.3%) 1 year prior to expropriation. However, I proceed cautiously in this analysis
because the three samples of expropriating countries are quite small (only 49–55
observations in total). The percentages of expropriating countries rated in the “safe”
and “relatively safe” rating categories and ranked in the top 50% are quite high.
The expropriating countries that were overrated and over-ranked by Credendo
are Bulgaria, Hungary (twice), Latvia, and Romania (see Table 5.29). The five
nationalizations in those countries were observed during 2008–2014. Credendo’s
excessive optimism about these nations could perhaps be explained by their mem-
bership in the European Union and/or their classification as upper–middle-income
or even high-income economies. It is also worth mentioning that all five of the
expropriation cases were brought to arbitration, which gave investors some hope of
eventually being compensated.31

5.3.5 Performance of OECD’s Country Risk Ratings

I test the capacity of OECD country risk ratings issued during 1999–2013 to antici-
pate the country risk crises that occurred during 2000–2014. The ratings 1, 2, and
3 years prior to a crisis observed in year y are the ratings as of 1 September in years
y−1, y−2, and y−3.
Countries that are assigned a score of 0 are considered “risk free.” Since the
OECD does not indicate the risk inherent to each score category, I assume that
“safe” and “relatively safe” countries are those with a score of 3 or lower.

See Hajzler and Rosborough’s (2016) updated database and [Link]

31

Pages/cases/[Link]?CaseNo=ARB/15/43
5.3 Performance of Country Risk Indicators 227

Table 5.30 OECD ratings performance 1, 2, and 3 years before a crisis

Year Year Year
y−1 y−2 y−3
Average rating of the crisis countries 5.6 5.6 5.6
Average percentile ranking of the crisis countries 52nd 51st 52nd
Percentage of crisis countries rated in the “risk-free” category 4.2 4.3 4.6
Percentage of crisis countries ranked in the top 25% 11.0 11.2 13.8
Percentage of crisis countries rated in the “safe”/“relatively 16.1 16.4 16.5
safe” categories
Percentage of crisis countries ranked in the top 50% 36.4 37.9 34.9
Notes: OECD country risk ratings are established on a 0–7 scale, where 7 (resp. 0) corresponds to
countries that are the most (resp. least) risky. The samples 1, 2, and 3 years prior to a crisis consist
of (respectively) 118, 116, and 109 observations. A crisis is a country-year pair in which a shock
occurred, and an observation is a crisis-rating pair
Source: Author’s computations based on OECD country risk ratings

Table 5.30 summarizes the performance of OECD ratings. One, two, and three
years prior to a crisis, the average ratings are very accurate (around 5.6); in contrast,
the average percentile rankings are too high (at about the 52nd percentile). This
schizophrenic performance reflects the conservative policy followed by the OECD:
on average, more than 57% of countries are assigned to its three riskiest rating cat-
egories (i.e., with scores of 5, 6, or 7). It follows that many countries with low
­ratings are not affected by a major shock, which inflates the average percentile rank-
ing of crisis countries.32
The reason that the percentages of crisis countries rated in the “risk-free” cate-
gory are significantly lower than those of crisis countries ranked in the top 25% is
that only a small proportion of countries is rated in the top category. The same com-
ments apply as regards the percentages of crisis countries rated in the “safe” and
“relatively safe” categories and of those ranked in the top 50%.
It turns out that OECD country risk ratings are relatively accurate metrics. The
poorer predictive power of rankings is of secondary concern given that this interna-
tional institution’s rating policy does not incorporate that tool.
The OECD country risk rating system failed to forecast six crises: the capital
controls announced in Iceland during 2008 and in Cyprus during 2012, the sover-
eign defaults suffered by Greece in 2012 and by Cyprus in 2013, and the national-
izations by Hungary’s government in 2010 and 2014 (Table 5.31). The OECD
membership (except for Cyprus) and the “high-income economy” status enjoyed by
these countries could have been key factors in the OECD’s decision to place them
in its top rating category.
The longer lists of “mis-ranked” crisis countries reflect that the percentage of
countries rated in the “risk-free” category is much lower than 25%. This fact
mechanically increases the rank of countries in the second, third, and fourth highest

32
On average, a country that was assigned a rating of 5 before being hit by a major shock was
ranked at about the 43rd percentile.
228 5 Country Risk Indicators

Table 5.31 OECD’s misratings

Year y−1 Year y−2 Year y−3
Crisis Iceland:2008 (restriction Iceland:2008 (restriction Iceland:2008 (restriction
countries on capital flows); on capital flows); on capital flows);
rated in the Hungary:2010 Cyprus:2012 (restriction Cyprus:2012 (restriction
“risk-free” (expropriation); on capital flows); on capital flows);
category Cyprus:2012 (restriction Greece:2012 (sovereign Greece:2012 (sovereign
(types of on capital flows); debt crisis); Cyprus:2013 debt crisis); Cyprus:2013
shocks in Greece:2012 (sovereign (sovereign debt crisis); (sovereign debt crisis);
parentheses) debt crisis); Cyprus:2013 Hungary:2014 Hungary:2014
(sovereign debt crisis) (expropriation) (expropriation)
Crisis Iceland:2008 (restriction Iceland:2008 (restriction Iceland:2008 (restriction
countries on capital flows); on capital flows); on capital flows);
ranked in the Hungary:2010 Cyprus:2012 (restriction Cyprus:2012 (restriction
top 25% (expropriation); on capital flows); on capital flows);
(types of Cyprus:2012 (restriction Greece:2012 (sovereign Greece:2012 (sovereign
shocks in on capital flows); debt crisis); Cyprus:2013 debt crisis); Cyprus:2013
parentheses) Greece:2012 (sovereign (sovereign debt crisis); (sovereign debt crisis);
debt crisis); Cyprus:2013 Hungary:2014 Hungary:2014
(sovereign debt crisis); (expropriation); (expropriation);
Hungary:2002 Hungary:2002 Latvia:2008
(expropriation); (expropriation); (expropriation);
Mexico:2006 (major Latvia:2008 Estonia:2009 (economic
domestic political (expropriation); depression); Latvia:2009
violence episode); Estonia:2009 (economic (economic depression);
Estonia:2009 (economic depression); Lithuania:2009 (economic
depression); Lithuania:2009 depression); Trinidad and
Lithuania:2009 (economic depression); Tobago:2010
(economic depression); Trinidad and (expropriation);
Trinidad and Tobago:2010 China:2011
Tobago:2010 (expropriation); (expropriation);
(expropriation); China:2011 Hungary:2002
China:2011 (expropriation); (expropriation);
(expropriation); Uruguay:2003 Uruguay:2003 (sovereign
Mexico:2001 (sovereign debt crisis); debt crisis); Mexico:2006
(expropriation); Mexico:2006 (major (major domestic political
Bulgaria:2014 domestic political violence episode); Costa
(expropriation) violence episode) Rica:2007 (expropriation)
Note: The higher the rating or ranking of a crisis country, the higher its position in the classification
Source: Author’s classifications based on OECD country risk ratings

rating categories and so enables them to join the top 25% for some years. In this
respect, there is substantial divergence between the methodology used by Credendo
to assess expropriation risk and the one used by OECD to assess country risk.

5.3.6 Performance of IEF’s Country Risk Ratings

The Heritage Foundation’s Index of Economic Freedom has been published at

­different times of the year since being launched in 1994. For 1995–1999, ratings
were reported in December of the previous year. The indices for 2000, 2001, 2002,
5.3 Performance of Country Risk Indicators 229

Table 5.32 IEF ratings performance 1, 2, and 3 years before a crisis

Year y−1 Year y−2 Year y−3
Average rating of the crisis countries (ratings issued during 3.4 3.4 3.3
1995–2006)
Average rating of the crisis countries (ratings issued during 56.2 56.9 56.8
2007–2014)
Average percentile ranking of the crisis countries 62nd 61st 61st
Percentage of crisis countries rated in the “risk-free” category 0.7 0.0 0.8
Percentage of crisis countries ranked in the top 25% 12.8 10.3 10.2
Percentage of crisis countries rated in the “safe”/“relatively 31.2 32.4 31.3
safe” categories
Percentage of crisis countries ranked in the top 50% 32.6 33.8 32.8
Notes: IEF ratings are established on a 1–5 scale during 1995–2006, where 5 (resp. 1) corresponds
to countries that are the most (resp. least) risky, and on a 0–100 scale during 2007–2014, where 0
(resp. 100) corresponds to countries that are the most (resp. least) risky. The samples 1, 2, and
3 years prior to a crisis consist of (respectively) 141, 136, and 128 observations. A crisis is a
country-year pair in which a shock occurred, and an observation is a crisis-rating pair
Source: Author’s classifications based on the IEF’s ratings

and 2003 were released in (respectively) January 2000, November 2000, November
2001, and December 2002. For 2004–2014, the IEF was reported in January of the
corresponding year.
I test how well the scores published in the 1995–2014 reports anticipated the
country risk crises that occurred during 1995–2014. The scores 1, 2, and 3 years
prior to the crisis observed in year y are those given in the IEF for years y, y−1, and
y−2, respectively.
Here, I view the IEF’s “free economies” as corresponding to “risk-free” coun-
tries. Recall that these are the economies observed in the countries rated from 1.00
to 1.99 during 1995–2006 and from 80 to 100 during 2007–2014 (see Sect. 5.1.4). I
consider as “safe” and “relatively safe” the countries that are assigned a score of less
than 3 during 1995–2006 and of at least 60 during 2007–2014.
Table 5.32 gives the performance of IEF ratings. One, two, and three years prior
to a crisis, the average ratings (near the top of its “mostly unfree economies” cate-
gory) and also the average percentile rankings (around the 61st percentile) are
quite good.
In particular, the percentages of crisis countries rated in the “risk-free” category
are remarkably low. These findings reflect the conservative policy followed by the
Heritage Foundation: on average, barely ten countries (accounting for just 6% of all
the nations rated) are classified as “free economies” in a given year. However, the
percentages of crisis countries ranked in the top 25% are higher, an outcome
­indicating that the category of “mostly free economies” (i.e., the second highest rat-
ing category) includes a significant number of risky nations.
The percentages of crisis countries rated in the “safe” and “relatively safe” rating
categories are similar to the percentages of those ranked in the top 50%, which
reflects that the proportion of nations classified as having “free,” “mostly free,” and
230 5 Country Risk Indicators

(since 2007) “moderately free” economies accounts for roughly half of the samples.
These percentages—around 32%—are satisfactory.
It is interesting that the IEF’s performances 1, 2, and 3 years prior to a crisis are
the same. This could mean that the Heritage Foundation’s index has some difficulty
perceiving the weakened political and/or economic position of countries that are
about to encounter a shock.
Two countries that were rated in the “risk-free” category before being hit by a shock
are El Salvador and Iceland (see Table 5.33). The nature of the shock suffered by El
Salvador (two earthquakes and subsequent landslides occurred in 2001) hardly allows
a test of whether that country’s “free economy” status was appropriately granted. A
less understandable misrating was the failure of Heritage Foundation experts to antici-
pate the capital controls implemented by the Icelandic government in 2008.
The crisis countries ranked in the top 25% have various profiles. Putting aside the
shocks resulting from the Great Recession of 2008–2009, I identify two facts that
deserve further comment. First, the IEF did not anticipate a number of nationaliza-
tions that occurred in Argentina, Costa Rica, El Salvador, Georgia, Hungary, Latvia,
Peru, and Trinidad and Tobago. This shortcoming casts doubt on an index that
claims to assess economic freedom. Second, Argentina was unquestionably over-­
rated during the few years preceding its economic turmoil of 2001–2002. For
instance, this country was rated at the very top of the “mostly free economies”
­category in 1999–2000. The Heritage Foundation was evidently way too optimistic
about the free-market reforms implemented under the Menem presidency. Yet in
December 2001, at the dawn of Argentina’s economic depression, the Heritage
Foundation admitted that this Latin American country still had many problems to
solve: a high cost of doing business, the insufficient protection of property rights,
and fragility of the rule of law.33

Table 5.33 IEF’s misratings

Year y−1 Year y−2 Year y−3
Crisis El Salvador:2001 No misrating Iceland:2008 (restriction
countries rated (natural disaster) on capital flows)
in the
“risk-free”
category
(types of
shocks in
parentheses)
(continued)

33
See [Link] It is not
surprising that the IEF rating of Argentina plummeted in the 2000s.
5.3 Performance of Country Risk Indicators 231

Table 5.33 (continued)

Year y−1 Year y−2 Year y−3
Crisis Estonia:2009 El Salvador:2001 Iceland:2008 (restriction
countries (economic depression); (natural disaster); on capital flows);
ranked in the El Salvador:2001 Estonia:2009 (economic Estonia:2009 (economic
top 25% (types (natural disaster); depression); depression);
of shocks in Iceland:2008 Iceland:2008 (restriction Argentina:2001
parentheses) (restriction on capital on capital flows); (expropriation, restriction
flows); Cyprus:2012 Cyprus:2012 (restriction on capital flows, sovereign
(restriction on capital on capital flows); debt crisis); Cyprus:2013
flows); Lithuania:2009 Argentina:2001 (sovereign debt crisis);
(economic depression); (expropriation, Argentina:2002 (economic
Armenia:2009 restriction on capital depression); El
(economic depression); flows, sovereign debt Salvador:2001 (natural
Argentina:2001 crisis); Cyprus:2013 disaster); Cyprus:2012
(expropriation, (sovereign debt crisis); (restriction on capital
restriction on capital Lithuania:2009 flows); Lithuania:2009
flows, sovereign debt (economic depression); (economic depression);
crisis); Hungary:2002 Armenia:2009 Trinidad and Tobago:2010
(expropriation); El (economic depression); (expropriation);
Salvador:2008 El Salvador:2008 Armenia:2009 (economic
(expropriation); (expropriation); depression); El
Georgia:2007 Argentina:2002 Salvador:2008
(expropriation); (economic depression); (expropriation);
Chile:1996 (restriction Chile:1996 (restriction Uruguay:2003 (sovereign
on capital flows); on capital flows); debt crisis); Latvia:2008
Uruguay:2003 Trinidad and (expropriation)
(sovereign debt crisis); Tobago:2010
Peru:2011 (expropriation);
(expropriation); Latvia:2009 (economic
Cyprus:2013 (sovereign depression);
debt crisis); Hungary:2010
Latvia:2008 (expropriation)
(expropriation);
Argentina:2002
(economic depression);
Costa Rica:2012
(expropriation);
Turkey:1999 (sovereign
debt crisis)
Note: The higher the rating or ranking of a crisis country, the higher its position in the classification
Source: Author’s classifications based on the IEF’s ratings

5.3.7 Performance of EFW’s Country Risk Ratings

Publication of the Fraser Institute’s Economic Freedom of the World report was
irregular for several years. I test the predictive accuracy of the EFW scores pub-
lished during 1995–2013 with respect to the country risk crises that occurred during
1996–2014. The sources of the scores 1, 2, and 3 years prior to a crisis-inducing
shock observed in year y are presented in Table 5.34.
Unlike the Heritage Foundation’s IEF, the Fraser Institute’s EFW does not use
broad rating categories to label “free economies.” Hence I assume that “risk-free”
232 5 Country Risk Indicators

Table 5.34 Shocks and sources of EFW ratings

Year of the Name of the EFW report used (date of publication)
crisis Year y−1 Year y−2 Year y−3
1996 EFW 1995 (Jan. 1996) Not Applicable Not Applicable
1997 EFW 1995 (Jan. 1996) EFW 1995 (Jan. 1996) Not Applicable
1998 EFW 1997 (May 1997) EFW 1995 (Jan. 1996) EFW 1995 (Jan. 1996)
1999 EFW 1998–1999 (Nov. EFW 1997 (May 1997) EFW 1995 (Jan. 1996)
1998)
2000 EFW 2000 (Jan. 2000) EFW 1998–1999 (Nov. EFW 1997 (May 1997)
1998)
2001 EFW 2000 (Jan. 2000) EFW 2000 (Jan. 2000) EFW 1998–1999 (Nov.
1998)
2002 EFW 2001 (April 2001) EFW 2000 (Jan. 2000) EFW 2000 (Jan. 2000)
2003 EFW 2002 (June 2002) EFW 2001 (April 2001) EFW 2000 (Jan. 2000)
2004 EFW 2003 (July 2003) EFW 2002 (June 2002) EFW 2001 (April 2001)
2005 EFW 2004 (July 2004) EFW 2003 (July 2003) EFW 2002 (June 2002)
2006 EFW 2005 (Sept. 2005) EFW 2004 (July 2004) EFW 2003 (July 2003)
2007 EFW 2006 (Sept. 2006) EFW 2005 (Sept. 2005) EFW 2004 (July 2004)
2008 EFW 2007 (Sept. 2007) EFW 2006 (Sept. 2006) EFW 2005 (Sept. 2005)
2009 EFW 2008 (Sept. 2008) EFW 2007 (Sept. 2007) EFW 2006 (Sept. 2006)
2010 EFW 2009 (Sept. 2009) EFW 2008 (Sept. 2008) EFW 2007 (Sept. 2007)
2011 EFW 2010 (Sept. 2010) EFW 2009 (Sept. 2009) EFW 2008 (Sept. 2008)
2012 EFW 2011 (Sept. 2011) EFW 2010 (Sept. 2010) EFW 2009 (Sept. 2009)
2013 EFW 2012 (Sept. 2012) EFW 2011 (Sept. 2011) EFW 2010 (Sept. 2010)
2014 EFW 2013 (Sept. 2013) EFW 2012 (Sept. 2012) EFW 2011 (Sept. 2011)
Source: Author’s classification based on the Fraser Institute’s EFW reports (various years)

countries are those that are given a rating higher than 7.5.34 Because setting a
threshold with respect to which countries can be reliably labeled as “safe” and
“relatively safe” is too uncertain an undertaking, I do not report data for this perfor-
mance criterion.
Because no EFW ratings clearly correspond to a “safe” and “relatively safe”
category, the average ratings of crisis countries convey less relevant information
than do the average percentile rankings; as reported in Table 5.35, those are ade-
quate (at about the 58th percentile).
Although the percentages of crisis countries rated in the “risk-free” category are
higher than those observed for the IEF, the percentages of such countries ranked in
the top 25% are much the same as those seen for the IEF. The EFW underperforms
against its neoliberal counterpart in terms of the proportion of crisis countries
ranked in the top 50%, which suggests that the EFW ranking’s second quartile is not
very accurate.

34
I set this threshold so that the rating assigned to the United States is always in the “risk-free”
category. For the period under consideration, the lowest US rating was 7.6 (see EFW 1995, p. xxi;
EFW 2011, p. 9).
5.3 Performance of Country Risk Indicators 233

Table 5.35 EFW ratings performance 1, 2, and 3 years before a crisis

Year Year Year
y−1 y−2 y−3
Average rating of the crisis countries 6.1 6.1 6.1
Average percentile ranking of the crisis countries 58th 58th 57th
Percentage of crisis countries rated in the “risk-free” category 10.4 8.9 8.3
Percentage of crisis countries ranked in the top 25% 13.2 13.9 12.5
Percentage of crisis countries rated in the “safe”/“relatively N.A. N.A. N.A.
safe” categories
Percentage of crisis countries ranked in the top 50% 41.5 42.6 42.7
Notes: EFW ratings are established on a 0–10 scale, where 0 (resp. 10) corresponds to countries
that are the most (resp. least) risky. The samples 1, 2, and 3 years prior to a crisis consist of (respec-
tively) 106, 101, and 96 observations. A crisis is a country-year pair in which a shock occurred, and
an observation is a crisis-rating pair. N.A. denotes Not Applicable
Source: Author’s computations based on EFW ratings

The EFW’s performance is much the same at 1, 2, and 3 years before a crisis. A
close examination of these ratings reveals that they are “sticky” and therefore do not
adjust as country risks approach a crisis point.
The misratings by the EFW are presented in Table 5.36. Most are primarily the
same as those observed for the IEF: the global crises in Argentina (2001–2002) and
Cyprus (2012–2013), and the restriction on capital flows in Iceland (2008). I exam-
ine these three cases in turn.
In its EFW 2000 report, the Fraser Institute lauded Argentina’s widespread priva-
tization of state-owned firms, decontrol of prices, and implementation of a currency
board that reduced 1990’s 4-digit inflation rate to only 1% by the end of that decade
(Fraser Institute 2000, p. 22). These key factors underpinned the rating of 8.4
granted to the country and its 12th place in the year 2000 ranking. The Fraser
Institute was even more enthusiastic than the Heritage Foundation about Argentina’s
“economic freedom,” so in that respect it failed completely.
The case of Cyprus is clearly different. The subcomponent rating this country
received on the “access to sound money” rating criterion in 2010 and 2011 (9.3–9.4
out of 10) is so high that it compensates for other categories (whose ratings range
from 6.7 to 7.5) and yields a final rating above 7.5. These findings question the rel-
evance of that criterion’s components—namely, money growth, the standard
­deviation of inflation, the most recent inflation rate, and the freedom to own foreign
currency bank accounts (Fraser Institute 2010, p. 56; 2011, p. 60).
The misrating of Iceland raises another important issue. Examination of the
EFW 2007 report reveals that its “international capital market controls” score—a
component of the “freedom to trade internationally” rating category—was espe-
cially low. However, it was offset by the high level of other sub-scores (Fraser
Institute 2007, p. 99). That failure illustrates how a rating system based on weight-
ings is likely to underestimate an economy’s true weaknesses. I shall return to this
issue in Sect. [Link].
234 5 Country Risk Indicators

Table 5.36 EFW’s misratings

Year y−1 Year y−2 Year y−3
Crisis Argentina:2001 Argentina:2001 Argentina:2001
countries (expropriation, restriction (expropriation, restriction (expropriation, restriction
rated in the on capital flows, on capital flows, on capital flows,
“risk-free” sovereign debt crisis); El sovereign debt crisis); sovereign debt crisis);
category Salvador:2001 (natural Argentina:2002 Argentina:2002
(types of disaster); Argentina:2002 (economic depression); El (economic depression);
shocks in (economic depression); Salvador:2001 (natural El Salvador:2001 (natural
parentheses) Bolivia:2000 disaster); Estonia:2009 disaster); Iceland:2008
(expropriation); (economic depression); (restriction on capital
Estonia:2009 (economic Iceland:2008 (restriction flows); Estonia:2009
depression); Iceland:2008 on capital flows); (economic depression);
(restriction on capital Bolivia:2000 Costa Rica:2012
flows); Mexico:2001 (expropriation); (expropriation);
(expropriation); Mexico:2001 Cyprus:2013 (sovereign
Cyprus:2013 (sovereign (expropriation); debt crisis);
debt crisis); El Cyprus:2012 (restriction Hungary:2014
Salvador:2008 on capital flows); (expropriation)
(expropriation); Cyprus:2013 (sovereign
Hungary:2014 debt crisis)
(expropriation);
Cyprus:2012 (restriction
on capital flows)
Crisis Iceland:2008 (restriction Estonia:2009 (economic Argentina:2001
countries on capital flows); depression); Iceland:2008 (expropriation, restriction
ranked in Estonia:2009 (economic (restriction on capital on capital flows,
the top 25% depression); flows); sovereign debt crisis);
(types of Argentina:2002 Argentina:2001 Estonia:2009 (economic
shocks in (economic depression); (expropriation, restriction depression);
parentheses) Argentina:2001 on capital flows, Argentina:2002
(expropriation, restriction sovereign debt crisis); (economic depression);
on capital flows, Argentina:2002 Iceland:2008 (restriction
sovereign debt crisis); El (economic depression); El on capital flows);
Salvador:2001 (natural Salvador:2001 (natural Hungary:2014
disaster); El disaster); Cyprus:2013 (expropriation); Costa
Salvador:2008 (sovereign debt crisis); Rica:2012
(expropriation); Cyprus:2012 (restriction (expropriation);
Cyprus:2012 (restriction on capital flows); Cyprus:2013 (sovereign
on capital flows); Latvia:2009 (economic debt crisis); El
Cyprus:2013 (sovereign depression); Salvador:2001 (natural
debt crisis); Latvia:2008 Lithuania:2009 disaster); Hungary:2010
(expropriation); (economic depression); (expropriation);
Hungary:2014 Costa Rica:2007 Bulgaria:2014
(expropriation); (expropriation); Costa (expropriation);
Bolivia:2000 Rica:2012 Bolivia:2000
(expropriation); (expropriation); (expropriation); El
Lithuania:2009 (economic Hungary:2010 Salvador:2008
depression); Peru:2011 (expropriation); (expropriation)
(expropriation); Costa Armenia:2009 (economic
Rica:2007 (expropriation) depression); El
Salvador:2008
(expropriation)
Note: The higher the rating or ranking of a crisis country, the higher its position in the classification
Source: Author’s classifications based on EFW ratings
5.3 Performance of Country Risk Indicators 235

5.3.8 Performance of the Growth CI and the GCI

Finally, I test how well the World Economic Forum’s Growth Competitiveness
Index and Global Competitiveness Index scores issued during 2001–2013 antici-
pated the country risk crises that occurred during 2002–2014. The scores 1, 2, and
3 years prior to the crisis observed in year y are those published in the Global
Competitiveness Reports of (respectively) years y−1, y−2, and y−3.
Global Competitiveness Reports do not use broad rating categories to label the
“most” or “very” competitive economies. Consequently, I assume that “risk-free”
countries are those that are assigned a rating higher than 5.00.35 Once again (cf. my
remarks concerning the EFW ratings), establishing a threshold for “safe” and “rela-
tively safe” countries is too uncertain to allow evaluation based on that performance
criterion.
As in Sect. 5.3.7, this absence of “safe” and “relatively safe” rating categories
lessens the relevance of the average ratings of the crisis countries referenced in
Table 5.37. In contrast, it is crucial to examine average percentile rankings because
the Global Competitiveness Reports place great emphasis on rankings. The table
shows that the average percentile rankings are especially satisfactory: around the
66th percentile.
The proportion of crisis countries rated in the “risk-free” category and ranked in
the top 25% is low, which means that those indices are very accurate. These findings
are confirmed by the low percentages (26.5%, on average) of crisis countries ranked
in the top 50%.

Table 5.37 Growth CI and GCI rating performance 1, 2, and 3 years before a crisis
Year Year Year
y−1 y−2 y−3
Average rating of the crisis countries 3.8 3.8 3.8
Average percentile ranking of the crisis countries 67th 65th 65th
Percentage of crisis countries rated in the “risk-free” category 1.3 1.5 3.1
Percentage of crisis countries ranked in the top 25% 3.9 4.4 4.7
Percentage of crisis countries rated in the “safe”/“relatively N.A. N.A. N.A.
safe” categories
Percentage of crisis countries ranked in the top 50% 26.3 26.5 26.6
Notes: Growth and Global Competitiveness Indices ratings are established on a 1–7 scale, where 1
(resp. 7) corresponds to countries that are the most (resp. least) risky. The samples 1, 2, and 3 years
prior to a crisis consist of (respectively) 76, 68, and 64 observations. A crisis is a country-year pair
in which a shock occurred, and an observation is a crisis-rating pair. N.A. denotes Not Applicable
Source: Author’s computations based on Growth CI and GCI scores

35
I set this threshold so that the rating assigned to the United States is always in the “risk-free”
category. For the period under consideration, the lowest US rating was 5.43 (World Economic
Forum 2010, p. 15; 2011, p. 15).
236 5 Country Risk Indicators

Table 5.38 Growth CI’s and GCI’s misratings

Year y−1 Year y−2 Year y−3
Crisis countries Iceland:2008 (restriction Iceland:2008 Iceland:2008 (restriction
rated in the on capital flows) (restriction on capital on capital flows);
“risk-free” flows) Estonia:2009 (economic
category (types of depression)
shocks in
parentheses)
Crisis countries Iceland:2008 (restriction Iceland:2008 Iceland:2008 (restriction
ranked in the top on capital flows); (restriction on capital on capital flows);
25% (types of China:2011 flows); Estonia:2009 Estonia:2009 (economic
shocks in (expropriation); (economic depression); depression); China:2011
parentheses) Estonia:2009 (economic China:2011 (expropriation)
depression) (expropriation)
Note: The higher the rating or ranking of a crisis country, the higher its position in the classification
Source: Author’s classifications based on Growth CI and GCI scores

The WEF ratings failed to anticipate three crises: the controls on capital flows in
Iceland (2008), the economic depression in Estonia (2009), and the expropriation
announced by China (2011); see Table 5.38.
The excessively high ranking of China is driven by the high scores granted to the
“macroeconomic environment” and “health and primary education” pillars.
However, this error is not entirely attributable to the GCI rating system. In fact,
China was ranked 38th and assigned a score of 5.1 (out of 7) in terms of property
rights protection in 2010—at the same level as the United States (World Economic
Forum, 2010, pp. 128–129, 366). This mis-ranking and misrating reflect the poor
judgment of business executives who participated in the WEF’s annual opinion sur-
vey and expressed positive views about the quality of property rights protection
in China.
The GCI rating of Estonia was inflated by the high scores given to the pillars of
“macroeconomic environment,” “health and primary education,” “higher education
and training,” and “technological readiness” (World Economic Forum 2006, p. 214).
This index echoed other raters in viewing Estonia favorably despite its vulnerability
to an international economic downturn.
The case of Iceland is perhaps less informative about GCI’s accuracy given that
no raters foresaw the sudden restriction on capital flows in 2008. Further remarks on
this matter are given in Sect. [Link].

5.4 General Comments

This section offers a series of comments that should help foreign investors grasp the
limits of country risk ratings, appreciate some historical background, and assess
country risk more accurately. Section 5.4.1 details the lessons drawn from Sect. 5.3
and makes some useful comparisons between Euromoney, ICRG, Credendo, the
5.4 General Comments 237

OECD, the Heritage Foundation’s IEF, the Fraser Institute’s EFW, and the World
Economic Forum’s GCI. Section 5.4.2 explains how a conservative rating system
can improve the capacity of country risk scores to anticipate crises; it also points to
some important yet overlooked factors that could enhance rating methodologies.
Section 5.4.3 studies the evolution of country risk ratings during the globalization
era and examines economies whose positions have improved (or weakened) the
most. Section 5.4.4 looks at the correlations across raters at the end of 2013.

5.4.1 Country Risk Indicators and Types of Risks

[Link] Do All Types of Shocks Really Matter for Country Risk Raters?

A first lesson from Sect. 5.3 is that certain types of shocks are much harder to antici-
pate than others. Table 5.39 shows which types of shocks most frequently led to a
misrating.
More than 60% of misratings were caused either by an expropriation or by a sud-
den control of capital flows. The latter is extremely difficult for country risk raters
to anticipate when one considers that it accounts for only 5.4% of the 298 shocks
observed during 1985–2014 (see Sect. 5.2.10).36 In Sects. [Link] and [Link], I
make some recommendations that can facilitate better anticipation of these
two shocks.

Table 5.39 Misratings and types of shocks

Misratings by causal type of Misratings by causal type of
shock (raw number) shock (as % of all misratings)
Major episode of international 0 0.0
political violence
Major episode of domestic 1 1.4
political violence
Expropriation 19 27.5
High inflation 1 1.4
Deep economic depression 8 11.6
Restriction on capital flows 23 33.3
Sovereign debt crisis 13 18.8
Exceptional natural disaster 4 5.8
Note: A misrating occurs when a crisis country is assigned a rating in the “risk-free” category
(Credendo’s ratings are excluded because they measure only expropriation risk). The six country
risk raters considered were responsible for a total of 69 misratings that occurred either 1, 2, or
3 years prior to a crisis. Several misratings were due to more than one shock. Values in the last
column do not total 100% because of rounding
Source: Author’s calculations

36
All the misratings caused by capital controls involved the same countries (i.e., Argentina in 2001,
Iceland in 2008, and Cyprus in 2012).
238 5 Country Risk Indicators

Deep economic depressions and sovereign debt crises, which caused 30% of
misratings, remain a source of concern. In contrast, the four other types of shocks
seem to be minor threats to the accuracy of country risk ratings. Of the raters exam-
ined in this chapter, ICRG is the only one to overrate an economy (Libya’s) that was
subsequently affected by a major episode of domestic political violence (see Sect.
5.3.3). Euromoney is the only rater that failed to forecast an episode of high infla-
tion (in the Soviet Union; see Sect. 5.3.2). Finally, on four occasions the two
­neoliberal think tanks rated a country (El Salvador) as “risk free” prior to it suffer-
ing an exceptional natural disaster.
In fact, it is fair to assume that Euromoney, ICRG, the OECD, the Heritage
Foundation, the Fraser Institute, and the World Economic Forum all managed to
anticipate political shocks, high-inflation episodes, and exceptional natural disasters
mainly because these crises affected low- and middle-income economies—which
are seldom assigned a “risk-free” rating in the first place. However, history has
taught us that developed nations are not immune to major political shocks (see
Gaillard 2014). In addition, global warming and the ensuing natural disasters could
pose a major threat to high-income countries in the years to come.

[Link] Comparisons Between Raters

Section 5.3 showed that the indicators designed to measure economic freedom and
competitiveness can serve as accurate metrics for assessing country risk. This state-
ment holds especially for the Heritage Foundation’s Index of Economic Freedom
and the World Economic Forum’s Global Competitiveness Index. That key find-
ing—which was far from evident when I started this research—is good news for
investors who are considering the use of alternative country risk indicators.
Although a strict comparison of the seven raters is impossible, their relative per-
formance (as described in Sect. 5.3) enables some judgments about the ratings’ rela-
tive accuracy.
Credendo requires a separate examination because its ratings measure only
expropriation risk.37 The performance of this Belgian export credit agency was quite
satisfactory. Only four countries were classified in the top rating category 1, 2, or
3 years before they announced an expropriation act. For two of these countries
(Bulgaria and Latvia), the nationalization was the only one observed within three
decades. Romania and Hungary seized foreign investors’ assets twice and four
times, respectively. The rating of Romania has remained unchanged since the first
nationalization, but Hungary’s rating was downgraded after its third expropriation.
It is also worth noting that Credendo managed to anticipate the wave of expropria-
tions in Bolivia, Ecuador, and Venezuela by downgrading these three “Bolivarian”
economies as early as 2005–2006.

37
Recall that Credendo also issues other ratings intended to measure other types of risks (see Sect.
5.1.2).
5.4 General Comments 239

Examining the accuracy of the ratings assigned by the six other raters reveals
some performance gaps. It appears that the Fraser Institute’s Economic Freedom of
the World index is less accurate than other indicators owing to the high proportion
of crisis countries in its top ratings and rankings. The OECD country risk ratings are
probably only the fifth best. The main weaknesses of the OECD metrics are the
same as those observed for the Fraser Institute. Discriminating between the four
remaining raters is more difficult. That said, the accuracy of ICRG ratings and of the
Heritage Foundation’s IEF ratings is compromised by their excessively high per-
centages of crisis countries in the “safe” and “relatively safe” categories. For these
reasons, Euromoney and the World Economic Forum’s Global Competitiveness
Index outperform (if only slightly) their counterparts. Euromoney’s “risk-free” rat-
ing category and the GCI’s top-ranked group (i.e., the top 25%) are especially
reliable.

[Link] Ratings Versus Rankings

Four of the raters examined in Sect. 5.3—Euromoney, the Heritage Foundation, the
Fraser Institute, and the World Economic Forum—put emphasis on both the ratings
and the rankings of the countries they study. A rating reflects the risk inherent to a
country and can be compared to the rating of another country; a ranking only makes
this comparison easier. So the natural question that arises is: Do rankings
really matter?
In fact, they do for a foreign investor who examines the Fraser Institute’s EFW
index or the World Economic Forum’s GCI. Because these two raters do not use
broad rating categories to label “risk-free,” “safe,” and “relatively safe” economies,
the rankings they assign are decidedly relevant. For the other raters, rankings are a
secondary consideration and, moreover, may be misleading. In the case of
Euromoney, which has rated and ranked no fewer than 180 countries for two
decades, a good ranking does not entail a “risk-free” status. For example, a country
to which Euromoney assigns a rating of 50 or higher is less likely to be affected by
a shock than is a country whose Euromoney’s percentile rank is 50 or lower (see
Sect. 5.3.2).

5.4.2 Improving Country Risk Methodologies

I investigate now how country risk methodologies could yield more accurate rat-
ings. Section [Link] addresses the rating systems; Sects. [Link] and [Link] advance
two series of proposals to amend rating criteria.
240 5 Country Risk Indicators

[Link] Why a Conservative Rating System Is an Option

Like sovereign rating methodologies, country risk rating methodologies are essen-
tially quantitative (see Sect. [Link]). The problem is that quantitative risk assess-
ments go hand in hand with weighting or averaging methods. When intermediate
ratings or subcomponent ratings are weighted (equally or not) to yield a final overall
rating, the impact of the riskiest broad categories (i.e., those that are assigned the
lowest intermediate ratings) is systematically diluted. In fact, the weighting and
averaging methods used by raters may well explain their inability to anticipate
country risk crises.
In order to test this assumption, I examine the 44 observations of crisis countries
rated in the “risk-free” category 1, 2, and 3 years before a crisis by every rater
(excepting Credendo and the OECD, which do not provide intermediate ratings).38
For every observation, I define a new final rating that is not a combination of the
intermediate ratings but rather the lowest intermediate rating.
Following this “weakest link” approach has the effect of removing 41 out of the
44 crisis-country observations from the misratings lists. The only three cases that
remain in the “risk-free” category are Iceland:2008 twice (still over-rated by
Euromoney and the WEF respectively 1 and 3 years before the crisis) and
Argentina:2001 (still overrated by the Fraser Institute 3 years prior to this crisis).
These striking results should convince country risk raters to apply their methodolo-
gies in a more conservative manner.
Next, for each of the 41 observations, I check for whether the broad category that
yielded the lowest intermediate rating—and thus my new final rating—includes the
area in which the shock actually materialized. I find that, in close to half (44%) of
the cases, the shock occurred in the “right” area.
It is noteworthy that the value is 100% for Euromoney’s, ICRG’s, and the
Heritage Foundation’s misratings. This outcome supports the view that these three
raters are able to identify which of a country’s weaknesses is most likely to trigger
a major shock. The corresponding proportion is only 25% for the EFW’s misrat-
ings, which indicates that the Fraser Institute has greater difficulty in identifying
potential crises. All these results are consistent with the conclusions drawn in Sect.
[Link]. The World Economic Forum’s GCI is in a peculiar position: none of the
lowest intermediate ratings assigned to the misrated countries falls in the “right”
area. This anomaly is driven mainly by the inclusion—in GCI’s pillars—of many
microeconomic criteria that are not closely connected to the shocks suffered by
those countries.39 These findings reflect the idiosyncratic methodology employed
by the WEF.

38
Two crisis countries are excluded from this grouping because no intermediate rating is available:
USSR:1991 (misrated by Euromoney) and El Salvador:2001 (misrated by the Heritage Foundation).
39
For example, the lowest intermediate ratings of Estonia and Iceland in 2006–2007 affected the
“innovation” and “market size” pillars.
5.4 General Comments 241

However, the soundness of a “weakest link” approach should not prevent country
risk raters from implementing other revisions that would improve the predictive
accuracy of their methodologies’ output. Two areas in particular merit examination.

[Link]  he Rule of Law: A Key Driver of Political and Economic

T
Confidence

The rule of law is a cornerstone of any legitimate, long-lasting regime. It is also

necessary for the enforcement of property rights.
The Glorious Revolution of 1688 and the subsequent passage of the Bill of
Rights in 1689 extended the powers of the English Parliament at the expense of the
monarch’s. This event was a watershed in the political and economic history of
Western societies. In the decades that followed, Parliament expanded the granting
of property rights to private individuals and companies and committed to secure
those rights (North and Weingast 1989; Bogart and Richardson 2011). This new
institutional order paved the way for the rise and domination of liberal capitalism.
My argument here is that the rule of law is certainly the most simple and reliable
indicator for an investor seeking to assess expropriation risk and/or political risk.
Following Kaufmann et al. (2010), I view the rule of law as reflecting “perceptions
of the extent to which agents have confidence in and abide by the rules of society,
and in particular the quality of contract enforcement, property rights, the police, and
the courts, as well as the likelihood of crime and violence.”
The rule of law in a country is explicitly considered by the two neoliberal raters
of country risk (see Fraser Institute 2017, pp. 3–5; Heritage Foundation 2017,
p. 455) but is considered in only an implicit way by Euromoney, ICRG, and the
World Economic Forum.40 Euromoney highlights “government stability,” “institu-
tional risk,” and “regulatory and policy environment”.41 Similarly, ICRG (The PRS
Group 2014, p. 3) focuses on the “government stability,” “law and order,” and “dem-
ocratic accountability” components and measures the involvement of military and
religious powers in politics. The WEF’s Global Competitiveness Report (2017,
p. 322) includes, as part of its “institutions” pillar, “judicial independence” as well
as “efficiency of [the] legal framework in settling disputes” and “challenging regu-
lations.” Yet, these approaches have several shortcomings.
First, a government’s stability does not convey reliable information about its
impartiality or about the executive’s relations with legislative and judicial branches
of government. For example, the Russian and Turkish authoritarian regimes have
proved especially stable (so far), but each is a far cry from exemplifying the rule of
law. The same statement applies to many “populist” regimes (e.g., Hungary under
Viktor Orban).

40
Neither the OECD nor Credendo discloses the methodologies it employs to assess country risk.
41
See [Link]
242 5 Country Risk Indicators

Second, democratic accountability and (more globally) the respect of democratic

values do not preclude political interference in judicial and regulatory processes.
Such interference is rife in Latin American democracies.
Third, even neoliberal methodologies exhibit some flaws on this account. The
Heritage Foundation and the Fraser Institute each have a fairly narrow view of the
rule of law; that is, both consider it almost exclusively through the lens of protecting
property rights. This errant perspective is a consequence of the two think tanks’
tendency to dissociate economic freedom from political freedom.
Country risk rating methodologies would yield better results if they incorporated
the “rule of law” score proposed by Kaufmann et al. (2010). For example, when I
test this indicator against all the countries that were affected by a jurisdictional or
political shock (i.e., an expropriation or a major episode of domestic or international
political violence),42 I find that the maximum score assigned to a crisis country is
0.91 on a scale that ranges from −2.5 to +2.5 (where +2.5 is the best score) and that
the maximum percentile ranking is 18%. The average score and percentile ranking
assigned to a crisis country are each highly appropriate: respectively −0.59 and the
75th percentile. Only 3 of the 83 observations (3.6%) have a percentile ranking in
the top 25%. For the three specific shocks considered here, the “rule of law” indica-
tor outperforms all country risk raters but one: the World Economic Forum’s GCI,
whose capacity to anticipate political and jurisdictional shocks is unparalleled.

[Link] Optimal Level of Financial Openness

Increasing financial openness has been a key factor of the financial globalization
that began in the 1980s. The problem is that country risk raters have not sufficiently
investigated the pace at which—or the extent to which—a country should liberalize
its financial sector.
A quick look at the average annual GDP growth and the evolution of financial
openness during 1985–2014 reveals no correlation between the two series of data.43
On the one hand, some countries that removed restrictions on capital and current
account transactions enjoyed high GDP growth (e.g., Botswana, Israel, and Uganda)
while others stagnated (e.g., Greece and Nicaragua). On the other hand, the few
countries that reduced their financial openness posted diverging performances: the
annual GDP growth of Malaysia was almost three times that of Gabon. Furthermore,
the economies that grew most rapidly during the past three decades (China and
India) did not change their respective levels of financial openness.

42
I use Kaufmann et al.’s updated database (released in 2016). For a crisis observed in year y, I
examine the “rule of law” score assigned to year y−2 (or the one assigned to y−3 if the y−2 score
is not available). Scores are available for all years since 1996 except for 1997, 1999, and 2001.
43
The adjusted R2 value is 0.01. I define the “evolution of financial openness” as the score on this
trait in 2014 minus the score in 1985. The sample includes 117 countries. Author’s computations
are based on World Development Indicators and Chinn and Ito’s (2006) updated index.
5.4 General Comments 243

The equivocal relationship between economic growth and the liberalization of

capital and current accounts should encourage country risk raters to implement anal-
yses of a more qualitative nature when assessing the likelihood that a government
will impose restrictions on capital flows.44 First of all, I believe that a high degree of
financial openness is a positive sign provided the country has a diversified economy,
a robust banking sector, and sophisticated domestic capital markets. These three fac-
tors mitigate the risk that a sudden stop in capital flows could trigger a major finan-
cial and economic crisis. In addition, raters should monitor the types of inflows
absorbed by a country with high financial openness. For instance, a high proportion
of short-term portfolio investments are cause for alarm, especially if they feed credit-
fueled asset bubbles (see Sect. [Link]). In the second place, a precipitate liberaliza-
tion of capital account transactions—as occurred in Argentina during the mid-1990s
and in Cyprus during the mid-2000s—may be counterproductive and could ulti-
mately oblige a government to impose significant restrictions on capital flows.
Finally, an extremely large current account deficit (i.e., exceeding 10% of GDP)
could spell serious trouble. Such a deficit is the other side of massive capital inflows,
and it renders the country vulnerable in the event of a sharp economic downturn.
The crises experienced by Iceland and the Baltic states in 2008–2009 are illustra-
tions of this vulnerability.
Combined with the “weakest link” approach and the recommendations advanced
in Sect. 4.3.1, an accurate assessment of the focal country’s rule of law and financial
stability is likely to enhance country risk methodologies and (in most cases) to
deflate country ratings.

5.4.3  volution of Country Risk Ratings During

E
the Globalization Era
[Link] Worst-Performing Countries

Table 5.40 lists the five economies whose country risk ratings fell the most dramati-
cally during 1988–2013 (as measured by Euromoney and ICRG ratings) and during
2001–2013 (as measured by the World Economic Forum’s GCI scores).
It is noteworthy that only 4 of the 16 worst-performing countries presented in
Table 5.40—Greece, Hungary, Iceland, and Venezuela—were hit by a major shock
(as defined in Sect. 5.2) during the globalization era. When one considers that the
countries most severely downgraded by Euromoney, ICRG, and the WEF are devel-
oped economies, it is clear that those countries experienced (and continue to experi-
ence) a slow decline in their economic and financial position.
That half of the worst performers are eurozone members is consistent with
Sect. [Link]. The three raters were more concerned about the weakening of these

44
See Prasad and Rajan (2008) for a more thorough analysis of how and when capital accounts
should be liberalized.
244 5 Country Risk Indicators

Table 5.40 Five worst-performing countries during the globalization era—according to Euromoney,
ICRG, and the GCI
Euromoney ICRG GCI
Downg. Downg. Downg.
Country (in points) Country (in points) Country (in points)
Greece −38.8 Spain −9.5 Iceland −0.74
Spain −33.6 Japan −9.1 Canada −0.67
Italy −30.9 United −8.0 Australia −0.65
Kingdom
Japan −29.8 Venezuela −6.5 Hungary −0.62
Portugal −27.7 France −5.1 Spain −0.60
Ireland −0.60
Notes: For Euromoney and the World Economic Forum’s GCI, the ratings published in September
2013 are compared with those published in September 1988 and September 2001, respectively. For
ICRG, the average ratings of 2013 are compared with those of 1988
Sources: Author’s calculations and classifications based on Euromoney (September 1988 and
September 2013), the ICRG database, and World Economic Forum (2001, 2013)

eurozone members’ credit position than about the significance of any deteriora-
tion in their respective business climates. Japan provides a good illustration of the
poorly performing countries more generally. This country was at the top of
Euromoney’s rankings in the late 1980s, but its credibility faded after more than
two decades of economic stagnation, deflation, and rising debt.
Table 5.41 lists the five economies whose associated country risk ratings declined
the most during 1994–2013 (as measured by Credendo’s expropriation risk ratings),
during 1995–2013 (as measured by IEF ratings), during 1996–2013 (as measured
by EFW ratings), and during 1999–2013 (as measured by OECD scores).
Three-fourths of worst-performing economies presented in Table 5.41 were hit
by a major shock during the globalization era. The profile of these countries differs
radically from those listed in Table 5.40. In fact, the most severe downgrades
announced by Credendo, the Heritage Foundation, the Fraser Institute, and the
OECD involved the ratings of developing and emerging economies only.
For example, the Latin American states that opted for Bolivarian-style policies
(Argentina, Bolivia, Ecuador, and Venezuela) as well as several African countries
(e.g., Gambia, Guinea, Zimbabwe) frightened international investors by national-
izing foreign assets. Other economies were shaken by wars, revolutions, or noxious
political atmospheres (e.g., Bahrain, the Central African Republic, Egypt, Sudan,
Syria, Yemen). One can conclude that Credendo, the Heritage Foundation, the
Fraser Institute, and the OECD lowered the ratings of countries in which the busi-
ness climate had deteriorated the most.
Tables 5.40 and 5.41 are instructive because they reveal two distinct paths in the
assessment of country risk. On the one hand, Euromoney, ICRG, and the World
Economic Forum tend to penalize countries that are unable to preserve their credit
position and competitiveness. On the other hand, Credendo, the Heritage Foundation,
the Fraser Institute, and the OECD tend to be ruthless when rating economies that
challenge the most fundamental capitalist rules (especially the enforcement of
­property rights).
5.4 General Comments 245

Table 5.41 Five worst-performing countries during the globalization era—according to Credendo,
the IEF, EFW, and OECD
Credendo IEF EFW OECD
Downg. Downg. Downg. Downg.
(in (in (in (in
Country notches) Country points) Country points) Country notches)
Bolivia −5 Argentina −22.7 Argentina −0.61 Argentina −2
Ecuador −4 Venezuela −21.6 Venezuela −0.57 Egypt −2
Argentina −3 Zimbabwe −12.3 Thailand −0.36 Jamaica −2
Namibia −3 Thailand −8.3 Hong Kong −0.23 Lebanon −2
Bahrain −2 Ecuador −6.9 Ecuador −0.05 Maldives −2
C. Afr. R. −2 Venezuela −2
Gabon −2
Gambia −2
Guinea −2
Yemen −2
Sudan −2
Syria −2
Thailand −2
Tunisia −2
Venezuela −2
Notes: For Credendo, the ratings as of 31 December 2013 are compared with those as of 31 December
1994. For the IEF, the ratings published in January 2014 are compared with those published in
December 1994. For the EFW, the ratings published in September 2013 are compared with those
published in January 1996. For the OECD, the ratings as of 1 September 2013 are compared with
those as of 1 September 1999. The IEF ratings published in December 1994 are converted to the 0–100
scale (see Heritage Foundation 2007, pp. 400–405). “C. Afr. R.” denotes Central African Republic
Sources: Author’s calculations and classifications based on the Credendo database, Heritage
Foundation (1994, 2014), Fraser Institute (1996, 2013), and the OECD database

[Link] Best-Performing Countries

Tables 5.42 and 5.43 list the five economies whose country risk ratings rose the
most dramatically during the globalization era. The respective raters and periods
considered are the same as in Tables 5.40 and 5.41.
Several comments are in order with respect to these two tables. First, the upgrades
by the Fraser Institute and ICRG are much greater in magnitude than their down-
grades (see Tables 5.40 and 5.41). These results mirror the inflation of the two rat-
ers’ country risk scores since the 1990s. The average rating assigned by the Fraser
Institute’s EFW and by ICRG soared by 1.7 and 11.4 points, amounts corresponding
to 17% and 11.4% of the span of their respective rating scales.45 This pattern explains
the excessively high percentage of crisis countries rated in the “safe” and “relatively
safe” rating categories by ICRG (see Sect. 5.3.3) and also the poor performance
posted by the Fraser Institute (see Sect. 5.3.7).

Author’s computations are based on the samples used for Tables 5.40, 5.41, 5.42, and 5.43. The
45

Fraser Institute and ICRG samples consist of 101 and 92 countries, respectively.
246 5 Country Risk Indicators

Table 5.42 Five best-performing countries during the globalization era—according to Euromoney,
ICRG, and the GCI
Euromoney ICRG GCI
Country Upg. (in points) Country Upg. (in points) Country Upg. (in points)
Peru +40.2 Nicaragua +36.9 Indonesia +0.84
Lebanon +26.7 Myanmar +36.3 Nicaragua +0.83
Panama +26.4 El Salvador +32.4 Ecuador +0.82
Chile +22.1 Peru +32.3 Ukraine +0.79
Uganda +22.0 Zambia +31.4 Bangladesh +0.67
Notes: For Euromoney and the World Economic Forum’s GCI, the ratings published in September
2013 are compared with those published in September 1988 and September 2001, respectively. For
ICRG, the average ratings of 2013 are compared with those of 1988
Sources: Author’s calculations and classifications based on Euromoney (September 1988 and
September 2013), the ICRG database, and World Economic Forum (2001, 2013)

Table 5.43 Five best-performing countries during the globalization era—according to Credendo,
the IEF, EFW, and OECD
Credendo IEF EFW OECD
Upg. (in Upg. (in Upg. (in Upg. (in
Country notches) Country points) Country points) Country notches)
Colombia +3 Moldova +24.3 Romania +4.42 Russia +4
Albania +2 Romania +22.6 Hungary +4.29 Algeria +3
Brunei +2 Albania +20.5 Iran +3.95 Brazil +3
Dom. Rep. +2 Angola +20.5 Nicaragua +3.93 Indonesia +3
El Nicaragua +18.9 Rwanda +3.76 Angola +2
Salvador +2
Croatia +2 Slovakia +3.76 Azerbaijan +2
Liberia +2 Bulgaria +2
Mauritius +2 Kazakhstan +2
Romania +2 Lithuania +2
Slovakia +2 Macedonia +2
Slovenia +2 Mongolia +2
Turkey +2 Nigeria +2
Uruguay +2 Oman +2
Peru +2
Romania +2
Zambia +2
Notes: For Credendo, the ratings as of 31 December 2013 are compared with those as of 31
December 1994. For the IEF, the ratings published in January 2014 are compared with those pub-
lished in December 1994. For the EFW, the ratings published in September 2013 are compared
with those published in January 1996. For the OECD, the ratings as of 1 September 2013 are
compared with those as of 1 September 1999. The IEF ratings published in December 1994 are
converted to the 0–100 scale (see Heritage Foundation 2007, pp. 400–405). “Dom. Rep.” denotes
Dominican Republic
Sources: Author’s calculations and classifications based on the Credendo database, Heritage
Foundation (1994, 2014), Fraser Institute (1996, 2013), and the OECD database
5.4 General Comments 247

Second, contrary to what is observed for the worst-performing countries, there is

no dichotomy between the upgrades by Euromoney, ICRG, and the WEF on the one
hand and, on the other hand, the upgrades by Credendo, the OECD, and the two
neoliberal raters. In fact, all the “best performers” are developing and emerging
economies. Several of these countries were slowly recovering from painful eco-
nomic and political crises (e.g., Angola, Indonesia, Nicaragua, Peru, Rwanda,
Uganda). Others (e.g., Bulgaria, Croatia, Hungary, Lithuania, Romania, Slovakia,
Slovenia) took advantage of the prospect of EU membership and, later, of that mem-
bership itself.
Finally, almost two-thirds of the countries that significantly improved their coun-
try risk position experienced no major shock during 2007–2014. This observation
suggests that, if a country can manage to avert a major shock, then it can reasonably
expect a substantial surge in its country risk rating in the long term.

5.4.4 Ratings Correlations

This section focuses on the correlations between country risk scorings. In contrast to
Sect. 4.3.3, I do not analyze the major disagreements between the six raters because
it is impossible to determine a standard rating interval across all the rating scales.
Table 5.44 reports the correlation coefficients between the country risk raters’
scores.46 The ratings examined are those contained in the last yearly cohort used in
Sect. 5.3 (i.e., those released between September 2013 and January 2014).
Although these correlations between the country risk ratings are strong, they are
weaker than those observed for sovereign risk indicators (see Sect. 4.3.3). This out-
come is not surprising. After all, the multidimensional nature of country risk obliges
raters to take many more risk components into account and, inevitably, to prioritize
different criteria.
The IEF and EFW ratings are highly correlated with each other but much less so
with the other four raters. This finding supports the view that assessing economic
freedom and assessing country risk are two distinct tasks. By the same token, one
might also view the Heritage Foundation and the Fraser Institute as exhibiting a
“neoliberal pattern.” These conclusions are confirmed when correlation coefficients
are calculated for the previous years.

46
I exclude Credendo’s expropriation risk ratings because they measure only a single aspect of
country risk.
248 5 Country Risk Indicators

Table 5.44 Correlation coefficients among country risk indicators, end 2013
Euromoney ICRG OECD IEF EFW GCI
ratings ratings ratings ratings ratings ratings
Euromoney 1 N.R. N.R. N.R. N.R. N.R.
ratings (186)
ICRG ratings 0.85 1 N.R. N.R. N.R. N.R.
(140) (140)
OECD ratings −0.89 −0.80 1 N.R. N.R. N.R.
(134) (104) (137)
IEF ratings 0.77 0.69 −0.62 1 N.R. N.R.
(175) (135) (128) (178)
EFW ratings 0.72 0.63 −0.57 0.88 1 N.R.
(151) (130) (113) (152) (152)
GCI ratings 0.89 0.83 −0.78 0.76 0.74 1
(146) (126) (110) (146) (141) (148)
Notes: The number of pairwise observations is reported in parentheses. N.R. = not relevant.
Euromoney, EFW, and GCI ratings are those published in September 2013. OECD ratings are as of
1 September 2013. ICRG scores are the average ratings of 2013. IEF ratings are those published in
January 2014. Contrary to the other country risk ratings, OECD high scores are associated with high
risk
Sources: Author’s calculations based on Euromoney (September 2013), the ICRG database, the
OECD database, Heritage Foundation (2014), Fraser Institute (2013), and World Economic Forum
(2013)

Appendix: List of the 272 “Country Risk Crises,” 1985–2014

Year Country Type of shock

1985 Cameroon Sovereign debt crisis
Ethiopia Deep economic depression
Mozambique Sovereign debt crisis
Myanmar Sovereign debt crisis
Nicaragua High inflation
Peru Expropriation
South Africa Sovereign debt crisis
Uganda High inflation
Vanuatu Exceptional natural disaster
1986 Egypt Sovereign debt crisis
Liberia Significant restriction on capital flows
Paraguay Sovereign debt crisis
Romania Sovereign debt crisis
United Arab Emirates Deep economic depression
Appendix: List of the 272 “Country Risk Crises,” 1985–2014 249

Year Country Type of shock

1987 Argentina High inflation and sovereign debt crisis
Gabon Deep economic depression
Jamaica Sovereign debt crisis
Mexico High inflation
Myanmar Sovereign debt crisis
Nigeria Deep economic depression
Sierra Leone High inflation
Suriname Deep economic depression
Yugoslavia (Soc. Fed. High inflation
Rep.)
1988 Colombia Sovereign debt crisis
Iraq Sovereign debt crisis
Jamaica Exceptional natural disaster
Kuwait Deep economic depression
Myanmar Deep economic depression
Nicaragua Deep economic depression
Panama Deep economic depression
Peru High inflation
Somalia Major episode of domestic political violence
Trinidad and Tobago Sovereign debt crisis
Uruguay Sovereign debt crisis
1989 Angola Sovereign debt crisis
Dem. Rep. of Congo High inflation
Egypt Expropriation
Jordan Deep economic depression and sovereign debt crisis
Lebanon Deep economic depression
Liberia Deep economic depression
Morocco Sovereign debt crisis
Peru Deep economic depression
Poland High inflation
South Africa Sovereign debt crisis
Zambia High inflation
1990 Bulgaria Sovereign debt crisis
Iraq Major episode of international political violence
Kuwait Major episode of international political violence and
sovereign debt crisis
Liberia Major episode of domestic political violence and exceptional
natural disaster
Samoa Exceptional natural disaster
Sierra Leone High inflation
Sri Lanka Expropriation
Uruguay High inflation and sovereign debt crisis
250 5 Country Risk Indicators

Year Country Type of shock

1991 Albania Deep economic depression and sovereign debt crisis
Algeria Major episode of domestic political violence and sovereign
debt crisis
Bulgaria High inflation
Cuba Deep economic depression
Czechoslovakia Deep economic depression
Dem. Rep. of Congo High inflation
Egypt Expropriation
Iraq Deep economic depression and high inflation
Romania Deep economic depression and high inflation
Samoa Exceptional natural disaster
Sudan High inflation
USSR High inflation and sovereign debt crisis
Yugoslavia (Soc. Fed. Deep economic depression
Rep.)
1992 Albania High inflation
Angola High inflation
Armenia Deep economic depression
Azerbaijan Deep economic depression
Bosnia and Herzegovina Major episode of domestic political violence and sovereign
debt crisis
Croatia Sovereign debt crisis
Dem. Rep. of Congo Deep economic depression
Estonia Deep economic depression
Georgia Deep economic depression
Kazakhstan Expropriation
Kyrgyzstan Deep economic depression
Latvia Deep economic depression
Lesotho Expropriation
Lithuania Deep economic depression
Macedonia Sovereign debt crisis
Moldova Deep economic depression
Russia Deep economic depression
Sierra Leone Deep economic depression
Slovenia Sovereign debt crisis
Tajikistan Deep economic depression
Turkmenistan Deep economic depression
Uzbekistan Deep economic depression
Venezuela Sovereign debt crisis
Yugoslavia (Fed. Rep.) Sovereign debt crisis
Zambia High inflation
Appendix: List of the 272 “Country Risk Crises,” 1985–2014 251

Year Country Type of shock

1993 Angola Deep economic depression
Burundi Major episode of domestic political violence
Chad Deep economic depression
Dem. Rep. of Congo Expropriation
Iraq High inflation
Mongolia High inflation
Palau Deep economic depression
South Africa Sovereign debt crisis
Suriname High inflation
Togo Deep economic depression
Ukraine Deep economic depression
1994 Belarus Deep economic depression and sovereign debt crisis
Dominican Rep. Expropriation
Kazakhstan Deep economic depression
Malawi Deep economic depression
Moldova Deep economic depression
Russia Major episode of domestic political violence and deep
economic depression
Rwanda Major episode of domestic political violence and deep
economic depression
Turkey High inflation
Turkmenistan Deep economic depression
1995 Egypt Expropriation
Mexico Expropriation
Syria Sovereign debt crisis
1996 Antigua and Barbuda Sovereign debt crisis
Botswana Significant restriction on capital flows
Bulgaria High inflation
Cambodia Significant restriction on capital flows
Chile Significant restriction on capital flows
Dem. Rep. of Congo Major episode of domestic political violence
Dominican Rep. Significant restriction on capital flows
Georgia Expropriation
Iraq Major episode of domestic political violence
Marshall Islands Deep economic depression
Sudan High inflation
Turkmenistan Expropriation
1997 Albania Deep economic depression
Dem. Rep. of Congo Expropriation
Romania High inflation
Turkmenistan Deep economic depression
252 5 Country Risk Indicators

Year Country Type of shock

1998 Eritrea Major episode of international political violence
Ethiopia Major episode of international political violence
Guinea-Bissau Deep economic depression
Honduras Exceptional natural disaster
Indonesia Deep economic depression and expropriation
Kazakhstan Sovereign debt crisis
Kenya Expropriation
Mexico Expropriation
Pakistan Sovereign debt crisis
1999 Belarus High inflation
Bosnia and Herzegovina Sovereign debt crisis
Dem. Rep. of Congo High inflation
Ecuador Sovereign debt crisis
Indonesia Major episode of domestic political violence and sovereign
debt crisis
Kazakhstan Expropriation
Laos High inflation
Russia Major episode of domestic political violence
Turkey Sovereign debt crisis
Yugoslavia (Fed. Rep.) Major episode of domestic political violence, expropriation,
and deep economic depression
2000 Bolivia Expropriation
Ivory Coast Sovereign debt crisis
Solomon Islands Deep economic depression
2001 Argentina Expropriation, significant restriction on capital flows, and
sovereign debt crisis
El Salvador Exceptional natural disaster
Lebanon Significant restriction on capital flows
Mexico Expropriation
Nigeria Major episode of domestic political violence
Venezuela Expropriation
Yemen Sovereign debt crisis
2002 Antigua and Barbuda Expropriation
Argentina Deep economic depression
Hungary Expropriation
Indonesia Sovereign debt crisis
Madagascar Deep economic depression
Venezuela Significant restriction on capital flows
Zimbabwe High inflation
Appendix: List of the 272 “Country Risk Crises,” 1985–2014 253

Year Country Type of shock

2003 Iraq Major episode of international political violence and deep
economic depression
Ivory Coast Expropriation
Kazakhstan Expropriation
Liberia Deep economic depression
Uruguay Sovereign debt crisis
Zimbabwe Deep economic depression
2004 Grenada Sovereign debt crisis and exceptional natural disaster
Kyrgyzstan Expropriation
Pakistan Major episode of domestic political violence
Seychelles Significant restriction on capital flows
Zimbabwe Expropriation
2005 Azerbaijan Expropriation
Dominican Rep. Sovereign debt crisis
Guyana Exceptional natural disaster
Sierra Leone Sovereign debt crisis
Venezuela Expropriation
Yemen Expropriation
2006 Belize Sovereign debt crisis
Bolivia Expropriation
Ecuador Expropriation
Mexico Major episode of domestic political violence
Russia Expropriation
Uzbekistan Expropriation
2007 Costa Rica Expropriation
Georgia Expropriation
Kazakhstan Expropriation
Mozambique Sovereign debt crisis
Turkmenistan Expropriation
Ukraine Expropriation
Zimbabwe Expropriation
2008 Ecuador Expropriation and sovereign debt crisis
El Salvador Expropriation
Gambia Expropriation
Guinea Expropriation
Iceland Significant restriction on capital flows
Kenya Major episode of domestic political violence
Latvia Expropriation
Tajikistan Exceptional natural disaster
Zimbabwe Deep economic depression
254 5 Country Risk Indicators

Year Country Type of shock

2009 Antigua and Barbuda Deep economic depression
Argentina Expropriation
Armenia Deep economic depression
Belize Expropriation
Estonia Deep economic depression
Latvia Deep economic depression
Libya Expropriation
Lithuania Deep economic depression
Mongolia Expropriation
Nigeria Major episode of domestic political violence
Romania Expropriation
Sierra Leone Significant restriction on capital flows
Ukraine Deep economic depression and expropriation
2010 Dem. Rep. of Congo Expropriation
Haiti Exceptional natural disaster
Hungary Expropriation
Jamaica Sovereign debt crisis
Kyrgyzstan Expropriation
Tajikistan Sovereign debt crisis
Trinidad and Tobago Expropriation
Turkmenistan Expropriation
Zimbabwe Expropriation
2011 Belarus Expropriation
Belize Expropriation
China Expropriation
Ecuador Significant restriction on capital flows
Ghana Expropriation
Guinea Expropriation
Indonesia Expropriation
Iraq Major episode of domestic political violence
Libya Major episode of domestic political violence and deep
economic depression
Pakistan Expropriation
Papua New Guinea Expropriation
Peru Expropriation
Saint Kitts and Nevis Sovereign debt crisis
Syria Major episode of domestic political violence
Turkey Expropriation
Uzbekistan Expropriation
Yemen Deep economic depression
References 255

Year Country Type of shock

2012 Belize Sovereign debt crisis
Bolivia Expropriation
Bosnia and Herzegovina Significant restriction on capital flows
Costa Rica Expropriation
Cyprus Significant restriction on capital flows
Egypt Significant restriction on capital flows
Greece Sovereign debt crisis
Kyrgyzstan Significant restriction on capital flows
Laos Expropriation
Maldives Expropriation
Nigeria Expropriation
South Sudan Deep economic depression
Ukraine Sovereign debt crisis
2013 Central African Rep. Deep economic depression
Cyprus Sovereign debt crisis
Guinea Expropriation
Indonesia Expropriation
Jamaica Sovereign debt crisis
Mozambique Sovereign debt crisis
Pakistan Expropriation
South Sudan Major episode of domestic political violence and sovereign
debt crisis
2014 Bulgaria Expropriation
Chad Sovereign debt crisis
Egypt Expropriation
Hungary Expropriation
Kazakhstan Sovereign debt crisis
Togo Expropriation
Ukraine Sovereign debt crisis
Sources: Author’s classification based on the analysis conducted in Sect. 5.2

References

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79(5).
Beers, D. & de Leon-Manlagnit, P. (2019). The BoC-BoE Sovereign Default Database: What’s
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Journal of Law & Economics, 54(2).
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International Finance No.183, Princeton University.
Cagan, P. (1956). The Monetary Dynamics of Hyperinflation. In M. Friedman (Ed.), Studies in the
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Chinn, M. D., & Ito, H. (2006). What Matters for Financial Development? Capital Controls,
Institutions, and Interactions. Journal of Development Economics, 81(1).
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Dornbusch, R. (1990). General Discussion on ‘Extreme Inflation: Dynamics and Stabilization’.
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Under the Threat of Expropriation. Bank of Canada Staff Working Paper 2016–13.
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NY: The PRS Group.
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Chapter 6
Concluding Remarks

The main obstacles to international business have evolved considerably over the two
centuries, mirroring the transformation of capitalism and its triumph over alterna-
tive economic systems.
During the Pax Britannica, protectionism was a major risk for importers, export-
ers, and multinational corporations. For example, Latin America, Russia, and newly
industrialized countries (especially Japan and the United States) imposed high tariff
rates on European manufactured products in this period (Bairoch 1999, pp. 59, 63).
The protectionist risk reached its peak in the 1930s but has waned substantially
since then. The main reasons are the progress of multilateralism (until the 2000s),
the adoption by emerging countries of export-promoting development strategies,
and the spread of “alliance capitalism,” which has increased interdependence among
nations.
The risk of expropriation risk was, for the most part, confined to years between
the 1930s and the 1970s. During this era, many Latin American and African leaders
were fascinated by communism and socialism. Once these ideologies lost ground
and eventually collapsed, the threat of expropriation declined markedly.
Since the advent of globalization, microeconomic risks have been pervasive
impediments to foreign direct and equity investments. Today’s MNCs are bound to
protect against fraud and copyright infringement as well as social and labor risks;
ensuring long-term profitability requires that they also avert boycotts and monitor
the reliability of their partners and contractors.
It is noteworthy that the persistence and seriousness of political and macroeco-
nomic risks led to the development of quantitative methods and of indicators
designed to measure business risks. The high level of political risk in the postwar
years motivated researchers and practitioners to establish political stability indices
(see Feierabend and Feierabend 1966) and political forecasting systems (Haner
1979). In the 1970s, the growing public debt of LDCs stirred concern among the
BIS, the IMF, and major private creditors; this concern engendered the concept of
country risk and paved the way for creation of country risk ratings (Gaillard 2015).

© Springer Nature Switzerland AG 2020 257

N. Gaillard, Country Risk, [Link]
258 6 Concluding Remarks

A plethora of political and country risk indicators were introduced during the last
two decades of the 20th century. Assessing the most prominent indicators’ accuracy
reveals that four-fifths of the misratings observed during the globalization era were
due to a sovereign debt crisis, a sudden control of capital flows, or an expropriation.
These findings suggest that country risk raters are prone to assign excessively high
ratings to countries with experience in attracting FDI and in accessing international
capital markets, but that are vulnerable to a capital flow reversal or a rapid deteriora-
tion of their credit position.
A crucial outcome of the globalization years was the new “geography of risks.”
The increasing number of high-income countries (e.g., Cyprus, Greece, Iceland)
that suffered a severe economic crisis since the late 2000s contrasts with the greater
resilience of major emerging economies during this period. Among the latter cate-
gory, the case of China deserves closer examination.
The Middle Kingdom enjoyed annual GDP growth averaging 10% for more than
three decades and transformed itself from a potential El Dorado for Western MNCs
into a major host country and the third most capital-exporting nation.1 This mutation
has led to four far-reaching yet essentially incommensurable consequences.
First, the rise of China has contributed to inflate the price of commodities and to
depress the price of manufactured goods. This dynamic has enhanced the purchas-
ing power of consumers all around the world and created business opportunities for
countries that export agricultural products and raw materials. The main losers have
been some industrial firms located in high-income countries.
Second, Chinese state capitalism has challenged liberal capitalism in a much
more insidious manner than did communism during the Cold War. As a response to
the deindustrialization process that has shaken the European and US economies,
neo-mercantilism and protectionism have been praised by many politicians. In this
respect, the election of Donald Trump reflects American fears of being superseded
by a global rival whose political and geopolitical goals are unclear (Cohen 2014).
One can argue that Washington’s drift toward weaponizing its trade and monetary
policies (and its criminal courts) to confront Beijing and its firms (e.g., Huawei)2 is
a legitimate way to retaliate against a competitor that has not hesitated to provide its
domestic companies with exorbitant state support for the purpose of attaining
greater market shares abroad.
Third, as a striking illustration of what Luttwak (1990) calls “geo-economics,”
the new normal of antagonistic trade policies could upset international business
relations. For instance, some countries may thus be led to limit investment and
financing from either superpower or to establish a “dual business environment” in
which US firms, or Chinese firms, are assigned junior status. The prospect of such
geo-economic bipolarization would oblige experts to revise thoroughly their ways
of assessing country risk.

1
Data for 2018; see [Link]
2
See [Link]
security-related-criminal-charges.
References 259

Finally, tensions between China and the United States may jeopardize the
international cooperation that is indispensable to addressing what is surely the
world’s greatest risk: global warming. Changes in climate have already affected
ecosystems on all continents—and absent concerted and major efforts, worse is still
to come. Climate risk should be viewed as a matrix of all other risks: it is likely to
destabilize entire economies, including developed ones (as illustrated by the fires
ravaging Australia), to trigger massive migration flows, and to undermine extant
societies.3 It is therefore time for world policy makers to coordinate their efforts at
reducing vulnerability and exposure to climate change. Country risk experts must
incorporate climate risk factors into their methodologies.4 Citizens and business
sectors (especially insurance and reinsurance companies) must likewise accept their
responsibility to force their respective governments to address, as vigorously as
possible, what has become humankind’s most imminent and potentially devastat-
ing threat.

References

Bairoch, P. (1999). Mythes et paradoxes de l’histoire économique. Paris: La Découverte/Poche.

Cohen, B. J. (2014). The China question—Can its rise be accommodated? In E. Helleiner &
J. Kirshner (Eds.), The Great wall of money—Power and politics in China’s international mon-
etary relations. Ithaca and London: Cornell University Press.
Feierabend, I. K., & Feierabend, R. L. (1966). Aggressive behaviors within polities, 1948–1962: A
cross-national study. Journal of Conflict Resolution, 10(3).
Gaillard, N. (2015). Le concept de risque pays. Politique Etrangère, 80(2).
Haner, F. T. (1979). Rating investment risks abroad. Business Horizons, 22(2).
Luttwak, E. N. (1990, Summer). From geopolitics to geo-economics: Logic of conflict, grammar
of commerce. The National Interest, 20.

3
The United Nations International Organization for Migration estimates that there could be
between 25 million and 1 billion environmental migrants by 2050; see [Link]
managing-climate-driven-migration.
4
See William J. Harrington, “Investors who want to fast-track sustainable fixed-income invest-
ments should inundate credit rating agencies with methodology critiques,” Responsible Investor,
28 January 2020; available at [Link]
to-fast-track-sustainable-fixed-income-investments-should-inundate-credit-rating-agencies-with-
methodology-critiques.