Multinational Finance

Chapter 6: Country Risk

Analysis

Alon Raviv
FIN-763, Spring 2008
Boston University, The Metropolitan College

FIn 763: Lecture 2 1

Today’s plan

PART 1: THE MEASUREMENT OF POLITICAL RISK

• The consequences of political risk
• Quantitative measures to evaluate Political Stability
• Economic Factors
• Subjective Factors
PART II. ECONOMIC AND POLITICAL FACTORS
• Economic and Political Factors Primary focus: How well is the
country doing economically?

PART III. COUNTRY RISK ANALYSIS IN INTERNATIONAL BANKING

FIn 763: Lecture 2 2

PART I. THE MEASUREMENT OF
POLITICAL RISK
I. MEASURING POLITICAL RISK
A. The consequences of political risk:

1. Expropriation
2. Currency or trade controls
3. Changes in tax
4. Changes in labor laws
5. Regulatory restrictions
6. Requirement for additional local production

Common denominator:
Government intervention into the working of the economy
that affect for good or ill the value of the firm

FIn 763: Lecture 2 3

THE MEASUREMENT OF POLITICAL RISK

B. Quantitative measures to
evaluate Political Stability
1. Measured by:
a. Frequency of government
changes
b. Level of violence
c. Number of armed
insurrections
d. Conflict with other states

FIn 763: Lecture 2 4

THE MEASUREMENT OF POLITICAL RISK

C. Economic Factors
1. Indicators of political unrest
a. Rampant inflation
b. Balance of payment deficits
c. Slowed growth of per capita GDP

• All this factors determine weather the economy is in

good shape or requires a quick fix, such as
expropriation to increase government revenues or
currency inconvertibility to improve the balance of
payments.

FIn 763: Lecture 2 5

THE MEASUREMENT OF POLITICAL RISK

A. Subjective Factors
 Profit Opportunity Recommendation: done by a panel of
experts
 Political Risk and Uncertain Property Rights: Determine the
general perception of the country’s attitude toward private
enterprise
 Capital Flight
Definition: the export of savings by a nation’s citizens because of
safety-of-capital fears. Measurement: use the balance-of-
payment account

FIn 763: Lecture 2 6

THE MEASUREMENT OF POLITICAL RISK

Causes of capital flight

 Inappropriate economic policies
 Expectation of devaluation
 High political risk (Hong Kong 1997)

The importance of capital flight as a measure: If the

local citizens do not trust the government, then
investment there is unsafe.

FIn 763: Lecture 2 7

THE MEASUREMENT OF POLITICAL RISK

What is needed to halt capital flight?

2. Cutting budget deficits
3. Cutting taxes
4. Removing barrier to investments by
foreigners
5. Selling state owned enterprises
6. Avoiding currency over valuation

FIn 763: Lecture 2 8

THE MEASUREMENT OF POLITICAL RISK

FIn 763: Lecture 2 9

PART II. ECONOMIC AND POLITICAL
FACTORS
II. Economic and Political Factors Primary focus: How
well is the country doing economically?
A. Fiscal Irresponsibility
The government deficit as a percentage of gross domestic
product: the higher this figure, the more the government is
promising to its citizens relative to its resources
high government deficits lowers the possibility that the
government can meet its promises without resorting to:
• Expropriation of property: Capital flight and dry up new
investments.
• Raising taxes: affect incentive to work, save and take
risks
• Printing money: monetary instability, high inflation,
high interest rates and currency depreciation

FIn 763: Lecture 2 10

PART II. ECONOMIC AND POLITICAL
FACTORS

B. Monetary instability
• Inflation is the logical outcome of
expansion of the money supply in excess of
real output growth.
• Expansion in the money supply is typical to
large government deficits that the central
bank monetizes (the example of Zimbabwe

FIn 763: Lecture 2 11

PART II. ECONOMIC AND POLITICAL
FACTORS

C. Controlled Exchange Rate System

• Currency control is used to fix the exchange rate.
• Goes hand with hand with an overvalued local currency
(equivalent of taxing exports and subsidizing imports)
• The risk of tighter currency controls and the treat of
devaluation encourage capital flight
• Leaves the economy with little flexibility to respond to
changing relative prices and wealth positions

FIn 763: Lecture 2 12

PART II. ECONOMIC AND POLITICAL
FACTORS

D. Wasteful Government Spending

• inability to service foreign debt
E. Resource base
Consists of: Natural, human and financial
resources
• lack of strong work ethic
• A highly skilled productive workers:
• Scientist
• Engineers
• Management talent

FIn 763: Lecture 2 13

ECONOMIC AND POLITICAL FACTORS

E. Country Risk and Adjustment to External

Shocks
1. What are the impacts of
external shocks:
- how well a nation responds varies

FIn 763: Lecture 2 14

ECONOMIC AND POLITICAL FACTORS

1. Key Indicators of Country Risk

• Relative size of government (debt as % of GDP)
• Money expansion
• Substantial government expenditures yielding low rate of return.
• Price controls, interest rate ceiling, trade restrictions rigid labor laws
and other imposed barriers to market forces that made by the
government
• Level of tax rats
• Amount of government-owned firms
• Amount and extend of corruption.
• Political and fiscal responsibility
•

FIn 763: Lecture 2 15

ECONOMIC AND POLITICAL FACTORS

3. Key indicators of economic health

a. Structural incentives
b. Legal structure
c. Clear incentives to save
d. Open economy
e. Stable macroeconomic policies

FIn 763: Lecture 2 16

 PART III. COUNTRY RISK ANALYSIS IN
INTERNATIONAL BANKING

I. Country Risk and the Terms of Trade

What ultimately determines a nation’s ability to repay
foreign loans?
- Its ability to generate U.S dollars and other
hard currencies which based on a nation’s “terms
of trade”. When the terms improved foreign
goods becomes relatively less expensive and the
standard of living rises and consumers and
business become more dependent on imports
- the speed of adjustment

FIn 763: Lecture 2 17

COUNTRY RISK ANALYSIS IN
INTERNATIONAL BANKING
II. The Government’s Cost/Benefit Calculus
- debt to wealth ratio
- cost of default: the likelihood of being cut off from
international credit
A bailout decision: depend on the :
- nation’s geopolitical importance to the US
- The probability that the necessary adjustment will
result in unacceptable political turmoil
-fluctuations in the terms of trade depends on
- degree of product diversification

FIn 763: Lecture 2 18

COUNTRY RISK ANALYSIS IN
INTERNATIONAL BANKING
I. Lessons from the International Debt Crisis of
1982
The crises began in Aug 1982, when Mexico announced that it was
not able to met its regulatory scheduled payments to international
creditors. The crises began in Aug 1982, when Mexico announced
that it was not able to met its regulatory scheduled payments to
international creditors.

Soon Argentina and Brazil found themselves in a similar situation

Economic reforms that work:
• Strong head of state
• Viable economic plan
• Competent economic team
• Support “at the top”
• Sell the program to all levels of society

FIn 763: Lecture 2 19

Quiz-1

1. One good indicator of political risk is

a. the seriousness of capital flight
b. the level of local interest rates
c. the level of local tax rates
d. a large middle class population

FIn 763: Lecture 2 20

Quiz-2: key indicators of country
risk
The state’s best strategy is to provide basic
_________ in order to promote
economic growth.
b) health care services
c) lifelong pensions for its workers
d) economic and political stability
e) natural resources

FIn 763: Lecture 2 21

Quiz-3: key indicators of country
risk
The economic experiences of Mexico, Chile, and
Argentina in the recent past show that they all
possessed a_________.
b) a political party system of many factions
c) a loosely drawn economic plan that is allowed to
evolve over time
d) a political lead who is more of a manager than a
leader
e) a head of state who demonstrates strong will and
leadership

FIn 763: Lecture 2 22

Quiz-4: capital flight
To halt capital flight, which one of the following would
NOT be a constructive measure governments may
take?
a. cutting budget deficits
b. impose comprehensive capital controls
c. sell off state‑owned enterprises
d. allowing for freer trade

FIn 763: Lecture 2 23

Quiz-5: Measuring political risk
Which one of the following is NOT a form of direct
political risk to the multinational corporation?
b) currency controls
c) privatization of public utilities
d) changes in tax or labor laws
e) regulatory restrictions

FIn 763: Lecture 2 24

Quiz-6: Measuring political
risk
During the 1980s many Latin American countries
believed in a policy that economic growth
was best promoted by extensive state
ownership which led to
b. capital flight
c. increased growth in GDP
d. rampant deflations
e. import subsidies

FIn 763: Lecture 2 25

Statistical Models

Commonly used economic ratios:

• Debt service ratio: (Interest + amortization on
debt)/Exports
• Import ratio: Total imports / Total FX reserves
• Investment ratio: Real investment / GNP
• Variance of export revenue
• Domestic money supply growth

FIn 763:02/11/08
Lecture 2
14:47
26 26
 The Supervisor of Banking
Attitude to Country Risk
• The Office of the Comptroller of the Currency

• Board of Governors of the Federal Reserve

System

• Federal Deposit Insurance Corporation

FIn 763: Lecture 2 27

 Definition of country risk
• "country risk" -- the risk that economic, social, and
political conditions and events in a foreign country
will adversely affect an institution's financial interests.
• The adverse effect that deteriorating economic
conditions and political and social unrest may have
on the rate of default by obligors in a country.
• Country risk includes the possibility of:
• nationalization or expropriation of assets
• government repudiation of external indebtedness
• exchange controls
• currency depreciation or devaluation.

FIn 763: Lecture 2 28

 El ement s of an Ef fecti ve Countr y Risk
Managem ent Process

A sound country risk management process includes:

 Effective oversight by the board of directors,
 Adequate risk management policies and procedures
 An accurate system for reporting country exposures
 An effective process for analyzing country risk
 A country risk rating system
 Established country exposure limits
 Regular monitoring of country conditions
 Periodic stress testing of foreign exposures
 Adequate internal controls and audit function.

FIn 763: Lecture 2 29

 Polic ie s a nd Pro ce dure s fo r
Managing C oun try R is k
Bank management is responsible for implementing
sound, well-defined policies and procedures for
managing country risk that:
 Establish risk tolerance limits;
 Delineate clear lines of responsibility and accountability
for country risk management decisions;
 Specify authorized activities, investments and
instruments; and
 Identify both desirable and undesirable types of business.
 Management should also ensure that country risk
management policies, standards and practices are clearly
communicated to the affected offices and staff

FIn 763: Lecture 2 30

 Coun try Exp osure R eportin g
Sy ste m
• To effectively manage country risk, the institution must
have a reliable system for capturing and categorizing the
volume and nature of foreign exposures
• The board of directors should regularly receive reports on
the level of foreign exposures. If the level of foreign
exposures in an institution is significant,
• If a country to which the institution is exposed is
considered to be high risk, exposures should be reported
to the board at least quarterly. More frequent reporting is
appropriate when a deterioration in foreign exposures
would threaten the soundness of the institution.

FIn 763: Lecture 2 31

 Coun try Ris k R at ings
• Country risk ratings summarize the
conclusions of the country risk analysis
process.
• The ratings provide a framework for
establishing country exposure limits that
reflect the institution's tolerance for risk.

FIn 763: Lecture 2 32

 Coun try Exp osure L im its
institutions should adopt a system of country exposure limits. Because
the limit-setting process often involves divergent interests within
the institution (such as the country managers, the institution's
overall country risk manager, and the country risk committee),
country risk limits will usually reflect a balancing of several
considerations, including:
 The overall strategy guiding the institution's international
activities;
 The country's risk rating and the institution's appetite for risk
 Perceived business opportunities in the country
 The desire to support the international business needs of
domestic customers.

FIn 763: Lecture 2 33

Stres s Te stin g
Institutions should periodically stress-test their foreign
exposures and report the results to the board of
directors and senior management.
Stress testing does not necessarily refer to the use of
sophisticated financial modeling tools, but rather to
the need for all institutions to evaluate in some way
the potential impact of different scenarios on their
country risk profiles.

FIn 763: Lecture 2 34

 Facto rs A ffe ctin g C ou ntry
Risk
Macroeconomic Factors
 The first of these factors is the size and structure of the
country's external debt in relation to its economy. More
specifically: The current level of short-term debt and the
potential effect that a liquidity crisis would have on the
ability of otherwise creditworthy borrowers in the country
to continue servicing their obligations.
 To the extent the external debt is owed by the public
sector, the ability of the government to generate sufficient
revenues, from taxes and other sources, to service its
obligations.

FIn 763: Lecture 2 35

 Soc ia l, Politic al a nd Le gal
Clima te
The analysis of country risk should also take into consideration the
country's social, political and legal climate, including:
 The country's natural and human resource potential.
 The willingness and ability of the government to recognize economic or
budgetary problems and implement appropriate remedial action.
 The degree to which political or regional factionalism or armed conflicts
are adversely affecting government of the country.
 Any trends toward government-imposed price, interest rate, or
exchange controls.
 The degree to which the country's legal system can be relied upon to
fairly protect the interests of foreign creditors and investors.
 The accounting standards in the country and the reliability and
transparency of financial information.
 The extent to which the country's laws and government policies protect
parties in electronic transactions and promote the development of
technology in a safe and sound manner.

FIn 763: Lecture 2 36

 What Factors do Ratings include?

 Standard & Poors and Moody‘s are the two largest rating
agencies.
Other agencies: Duff & Phelps, Fitch, Political Risk
Services, Beri …
 S&P concentrates on 8 categories to come up with their
ratings
 Each of this categories is related to the two major sources
of risk: economic and political risk

FIn 763: Lecture 2 37

 What Factors do Ratings include?

 Standard & Poors and Moody‘s are the two largest rating
agencies.
Other agencies: Duff & Phelps, Fitch, Political Risk
Services, Beri …
 S&P concentrates on 8 categories to come up with their
ratings
 Each of this categories is related to the two major sources
of risk: economic and political risk

FIn 763: Lecture 2 38

Sovereign Ratings Methodology
Profile

1. Political Risk
2. Income and Economic Structure
3. Economic Growth Prospects
4. Fiscal Flexibility
5. Public Debt Burden
6. Price Stability
7. Balance of Payments Flexibility
8. External Debt and Liquidity
FIn 763: Lecture 2 39
 Sovereign Credit Ratings
S&P Moody‘s
Invest- AAA Aaa Highest quality
ment- AA Aa High quality
grade A A Strong payment capacity
BBB Baa Adequate payment capacity

BB Ba Likely to fullfill obligations,uncertain

Specu-
lative- B B High-risk obligations
grade CCC Caa
CC Ca
„Junk
bonds“ C C
D D Default

FIn 763: Lecture 2 40

Major Impacts
 Signalling: refers to providing new
information to the market to lower cost of
capital
 Certification:

• refers to eligibility with regard to portfolio

standards issued by public regulators
• Importance of splitting ratings into
• investment grade
• speculative grade: junk bonds

FIn 763: Lecture 2 41

Sovereign Ratings: Impact on Capital
Flows and Other Rated Institutions

 International pool of investors: private

capital inflows - liquidity
 Usually, no corporation higher rated than
sovereign
• Agencies: all entities are influenced by same
macroeconomic situation
• Pressure on corporations‘ ability to raise
money

FIn 763: Lecture 2 42

Sovereign Ratings: Basic Considerations

 Two-way causuality
• Ratings influence spreads and vice versa
 Anticipation versus Reaction
• Are ratings able to anticipate financial crises
or do they just react on changed indicators?
 Reinforcement of business cycles
 Information processing into one figure:

• Are agencies able to process more

information than the market?

FIn 763: Lecture 2 43

Can Sovereign Ratings Anticipate
Financial Crises?

 Response mixed
 Asian Crises (97/98): no anticipation by
ratings: reluctant graduate downrating
but after begin of crisis drops to junk-
bond status

FIn 763: Lecture 2 44

Sovereign Ratings: Argentina

Local Currency Rating Foreign Currency Rating

Date Long Term/Outlook/Short- Long Term/Outlook/Short
Term Term
06.11.01 SD/Not Meaningful/C SD/Not Meaningful/C
30.10.01 CC/Negative/C CC/ Negative/C
09.10.01 CCC+/Negative/C CCC+/Negative/C
12.07.01 B-/Negative/C B-/Negative/C
06.06.01 B/Negative/C B/Negative/C
08.05.01 B/CW Neg./C B/CW Neg./C
26.03.01 B+/CW Neg./B B+/CW Neg./B
19.03.01 BB/CW Neg./B BB-/CW Neg./B
14.11.00 BB/Stable/B BB-/Stable/B
31.10.00 BBB-/CW-Neg./A-3 BB/CW-Neg./B
10.02.00 BBB-/Stable/A-3 BB/Stable/B
22.07.99 BBB-/Negative/A-3 BB/Negative/B
Source: Standard & Poors

FIn 763: Lecture 2 45

Differences Between Sovereign and
Corporate Ratings
 Information

• Publicly available versus private information

 Political risk
• Willingness to repay
• Absence of a supranational regulating body
• Importance of non-quantitative factors in
assessing country risk (Emerging markets!)
• Crises

FIn 763: Lecture 2 46

 Sovereign Rating
Africa Asia Europe Mid East Americas
A1 Australia Switzerland Canada
UK
A2 Botswana HK Japan Germany Kuwait USA
S. Korea Italy UAE
A3 Mauritius China Cyprus Israel Chile
Namibia Thailand Czech Rep Trinidad
A4 Egypt India Latvia Saudi Mexico
S. Africa Philippines Poland Arabia Panama
B Algeria Bangladesh Slovakia Egypt Brazil Peru
Uganda Sri Lanka Russia Jordan Venezuela
C Congo Indonesia Azerbaijan Iran Syria Haiti
Kenya Vietnam Romania Turkey Jamaica
D Nigeria Afghanistan Albania Iraq Argentina
Sudan N. Korea Ukraine Cuba
Zimbabwe Pakistan Yugoslavia Ecuador

FIn 763: Lecture 2 47

Credit Spread as a measure for
country risk

 One convenient measure of country

risk is provided by yields on sovereign
debt.
 The difference in the yields on the
public debt of two countries reflects a
country risk premium

FIn 763: Lecture 2 48

Country or Sovereign Risk

Sovereign Debt Spread over U.S. Treasury Securities

Country Spread Country Spread
(basis points) (basis points)
China 138 Mexico 441
Russia 188 Indonesia 539
Philippines 226 Brazil 1151
South Africa 254 Venezuela 1201
Poland 258 Argentina 1581
Uruguay 341 Nigeria 1973
Source : Bloomberg, August 30, 2001

FIn 763: Lecture 2 49

 Strategies for managing country risk
Negotiate the environment with the host country prior to investment

The investment environment:

• Taxes
• Labor issues
• Concessions
• Obligations and restrictions
• Provisions for planned investment divestiture
• Performance assurances and remedies
• International arbitration of disputes

FIn 763: Lecture 2 50

 Strategies for managing country
risk
•Negotiate the environment with the host country prior to investment

•The investment environment

•The financial environment

•Structure foreign operations to minimize country risk while maximizing

return

•Obtain political risk insurance

FIn 763: Lecture 2 51

 Political risk insurance

Insurable political risks include

Expropriation due to
• war
• revolution
• insurrection
• civil disturbance
• terrorism

Currency inconvertibility

FIn 763: Lecture 2 52

 Political risk insurers
Government export credit agencies
U.S. Overseas Private Investment Corporation
U.K. Export Credits Guarantee Department

International
World Bank
Multilateral Investment Guarantee Agency

Private
Lloyd’s of London
American International Group (AIG)

FIn 763: Lecture 2 53

Political risk insurance

 MNCs are self-insured if their risk

exposures are diversified across a
large number of countries

FIn 763: Lecture 2 54

*Debt-equity swaps

• Example:
• Citibank sells $100 million Chilean loan to Merrill Lynch
for $91 million.
• Merrill Lynch (market maker) sells to IBM at $93 million.
• Chilean government allows IBM to convert the $100
million face value loan into pesos at a discounted rate to
finance investments in Chile.

FIn 763: Lecture 2 55 55

The evidence on country risks and
investors’ required returns

• An increase (decrease) in country risk tends to be followed by a stock

market fall (rise)

• Countries with high country risk have

• more volatile returns
•lower betas (systematic risks)

Claude Erb, Campbell Harvey and Tadas Viskanta,

“Political Risk, Financial Risk and Economic Risk,”
Financial Analysts Journal, 1996.

FIn 763: Lecture 2 56

 Resources
• Human development report
•[Link]

FIn 763: Lecture 2 57

 Resources: S&P

• Defining Sovereign Defaults

• Sovereign Ratings Before The interest Equalization Tax
• Sovereigns' Path To Default
• Sovereign Ratings History Since 1975

FIn 763: Lecture 2 58

Resources: S&P

FIn 763: Lecture 2 59

S&P Criteria
for rating

FIn 763: Lecture 2 60

Moody’s Criteria for rating

Ten Year Average Cumulative Default Rates

Aaa 0.7%
Aa 0.8%
A 1.8%
Baa 4.7%
Ba 18.4%
B 36.7%
Investment Grade 2.4%
Speculative Grade 24.8%

FIn 763: Lecture 2 61

The BIS

•Report of the BIS: Bank for international settlements

[Link]

FIn 763: Lecture 2 62