BFIA/IV SEM/PAPER NO. XVII S.S.

College of Business Studies, University Of Delhi

PROJECT REPORT ON

SELECTION OF AN ECONOMY FOR INVESTMENTS
CRITICAL ISSUES & CHALLENGES

SUBMITTED BY RAMAN KUMAR (15715) ANMOL BHASIN (15820) VIRENDER NEHRA (15751)

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

MANISH SHAH(15706)

ACKNOWLEDGEMENT

We would like to express our gratitude to all those who have contributed directly or indirectly towards the completion of this project report Titled Selection of an Economy for Investment-Criteria, Issues & Challenges. We are deeply grateful to our mentor Mr. Kumar Bijoy for his assistance at every stage of this project. Without his valuable insight, moral and informative support the project would not have materialized. Finally we would like to thank Shaheed Sukhdev College of Business Studies for providing us the platform to do this project and increase our knowledge base.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

OBJECTIVES

• •

To study the investment climate in International Financial Market To analyze the economies with help of country risk analysis To ascertain the recent development in potential economies.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

SOURCES OF INFORMATION

This Report is based on first hand information from the discussion with

different personnel in internet forums • As well as the secondary data which included Various Journals, Reports,

Articles, Newspaper, and Websites etc.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

PREFACE
This report focuses on the selection of a country for investment purposes. The terms investment has many meaning in business but when it is at international level than it is broadly of two categories: • FOREIGN DIRECT INVESTMENTS: In its classic form is defined as a company from one country making a physical investment into building a factory in another country. Its definition can be extended to include investments made to acquire lasting interest in enterprises operating outside of the economy of the investor. 1 The FDI relationship consists of a parent enterprise and a foreign affiliate which together form a multinational corporation (MNC). In order to qualify as FDI the investment must afford the parent enterprise control over its foreign affiliate. The IMF defines control in this case as owning 10% or more of the ordinary shares or voting power of an incorporated firm or its equivalent for an unincorporated firm; lower ownership shares are known as portfolio investment.2 • FOREIGN INSTITUTIONAL INVESTMENTS : Foreign Institutional Investor (FII) is used to denote an investor - mostly of the form of an institution or entity, which invests money in the financial markets of a country different from the one where in the institution or entity was originally incorporated. When we think of investing in any economy, the investment can be done in only two ways i.e. as FDI or FII, FDI are generally long-term investments in real estate, manufacturing plants, MNE’s etc. and therefore investment decision is depends on various factors which are explained later in this report. FII are investments are in financial instruments such as foreign currency, future& options markets, shares, debentures, bonds etc. This reports analyses all factors which affects the decision of a investor while selecting an economy for its investment, we have mainly focused on Asian Economies which are so said
1 2

Foreign Direct Investment, United Nations Conference on Trade and Development, www.unctad.org International Monetary Fund (IMF), 1993. Balance of Payments Manual, fifth edition (Washington, DC).

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

next leader in global market(India & China), and other developing economies which are coming to the notice of investors. Data used in this reports is mainly secondary, compiled from various sources like World bank reports, Various country risk rating agencies (Fitch Ratings (U.S.), Moody’s (U.S.), Standard & Poor's (U.S), Business Monitor International etc.), articles & journals. However there is some primary data which is collected from the interaction with managers in online forums3.

3

Online forums like pagalguy.com, orkut.com,facebook.com

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

CRITERIA –VARIOUS FACTORS THAT AFFECTS INVESTMENT DECISION REGARDING AN ECONOMY. RISK CATEGORIES AND MEASUREMENTS Analysts have tended to separate country risk into the six main categories of risk shown below. Many of these categories overlap each other, given the interrelationship of the domestic economy with the political system and with the international community. Even though many risk analysts may not agree completely with this list, these six concepts tend to show up in risk ratings from most services. I. Economic Risk

Economic Risk is the significant change in the economic structure or growth rate that produces a major change in the expected return of an investment. Risk arises from the potential for detrimental changes in fundamental economic policy goals (fiscal, monetary, international, or wealth distribution or creation) or a significant change in a country's comparative advantage (e.g., resource depletion, industry decline, demographic shift, etc.). Economic risk often overlaps with political risk in some measurement systems since both deal with policy. Economic risk measures include traditional measures of fiscal and monetary policy, such as the size and composition of government expenditures, tax policy, the government's debt situation, and monetary policy and financial maturity. For longer-term investments, measures focus on long-run growth factors, the degree of openness of the economy, and institutional factors that might affect wealth creation. II. Transfer Risk

Transfer Risk is the risk arising from a decision by a foreign government to restrict capital movements. Restrictions could make it difficult to repatriate profits, dividends, or capital. Because a government can change capital-movement rules at any time, transfer risk applies to all types of investments. It usually is analyzed as a function of a country's ability to earn foreign currency, with the implication that difficulty earning foreign currency increases the probability that some form of capital controls can emerge. Quantifying the risk remains difficult because the decision to restrict capital may be a purely political response to another problem. For example, Malaysia's decision to impose capital controls and fix the exchange rate in the midst of the Asian

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

currency crisis was a political solution to an exchange-rate problem. Quantitative measures typically used to assess transfer risk provided little guidance to predict Malaysia's actions. Transfer risk measures typically include the ratio of debt service payments to exports or to exports plus net foreign direct investment, the amount and structure of foreign debt relative to income, foreign currency reserves divided by various import categories, and measures related to the current account status. Trends in these quantitative measures reveal potential imbalances that could lead a country to restrict certain types of capital flows. For example, a growing current account deficit as a percent of GDP implies an ever-greater need for foreign exchange to cover that deficit. The risk of a transfer problem increases if no offsetting changes develop in the capital account. III. Exchange Rate Risk

Exchange Risk is an unexpected adverse movement in the exchange rate. Exchange risk includes an unexpected change in currency regime such as a change from a fixed to a floating exchange rate. Economic theory guides exchange rate risk analysis over longer periods of time (more than one to two years). Short-term pressures, while influenced by economic fundamentals, tend to be driven by currency trading momentum best assessed by currency traders. In the short run, risk for many currencies can be eliminated at an acceptable cost through various hedging mechanisms and futures arrangements. Currency hedging becomes impractical over the life of the plant or similar direct investment, so exchange risk rises unless natural hedges (alignment of revenues and costs in the same currency) can be developed. Many of the quantitative measures used to identify transfer risk also identify exchange rate risk since a sharp depreciation of the currency can reduce some of the imbalances that lead to increased transfer risk. A country's exchange rate policy may help isolate exchange risk. Managed floats, where the government attempts to control the currency in a narrow trading range, tend to possess higher risk than fixed or currency board systems. Floating exchange rate systems generally sustain the lowest risk of producing an unexpected adverse exchange movement. The degree of over- or under-valuation of a currency also can help isolate exchange rate risk.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

IV.

Location or Neighborhood Risk

Location or Neighborhood Risk includes spillover effects caused by problems in a region, in a country's trading partner, or in countries with similar perceived characteristics. While similar country characteristics may suggest susceptibility to contagion (Latin countries in the 1980s, the Asian contagion in 1997-1998), this category provides analysts with one of the more difficult risk assessment problems. Geographic position provides the simplest measure of location risk. Trading partners, international trading alliances (such as Mercosur, NAFTA, and EU), size, borders, and distance from economically or politically important countries or regions can also help define location risk V. Sovereign Risk

Sovereign Risk concerns whether a government will be unwilling or unable to meet its loan obligations, or is likely to renege on loans it guarantees. Sovereign risk can relate to transfer risk in that a government may run out of foreign exchange due to unfavorable developments in its balance of payments. It also relates to political risk in that a government may decide not to honor its commitments for political reasons. The CRA literature designates sovereign risk as a separate category because a private lender faces a unique risk in dealing with a sovereign government. Should the government decide not to meet its obligations, the private lender realistically cannot sue the foreign government without its permission. Sovereign-risk measures of a government's ability to pay are similar to transfer-risk measures. Measures of willingness to pay require an assessment of the history of a government's repayment performance, an analysis of the potential costs to the borrowing government of debt repudiation, and a study of the potential for debt rescheduling by consortiums of private lenders or international institutions. The international setting may further complicate sovereign risk. In a recent example, IMF guarantees to Brazil in late 1998 were designed to stop the spread of an international financial crisis. Had Brazil's imbalances developed before the Asian and Russian financial crises, Brazil probably would not have received the same level of support, and sovereign risk would have been higher.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

VI.

Political Risk

Political Risk concerns risk of a change in political institutions stemming from a change in government control, social fabric, or other non-economic factor. This category covers the potential for internal and external conflicts, expropriation risk and traditional political analysis. Risk assessment requires analysis of many factors, including the relationships of various groups in a country, the decision-making process in the government, and the history of the country. Insurance exists for some political risks, obtainable from a number of government agencies (such as the Overseas Private Investment Corporation in the United States) and international organizations (such as the World Bank's Multilateral Investment Guarantee Agency). Few quantitative measures exist to help assess political risk. Measurement approaches range from various classification methods (such as type of political structure, range and diversity of ethnic structure, civil or external strife incidents), to surveys or analyses by political experts. Most services tend to use country experts who grade or rank multiple socio-political factors and produce a written analysis to accompany their grades or scales. Company analysts may also develop political risk estimates for their business through discussions with local country agents or visits to other companies operating similar businesses in the country. In many risk systems, analysts reduce political risk to some type of index or relative measure. Unfortunately, little theoretical guidance exists to help quantify political risk, so many "systems" prove difficult to replicate over time as various socio-political events ascend or decline in importance in the view of the individual analyst

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

COUNTRY RISK ANALYSIS
A Country Risk and Foreign Direct Investment Country risk analysis (CRA) attempts to identify imbalances that increase the risk of a shortfall in the expected return of a cross-border investment. This paper describes the general process used to create risk measures and discusses some of the weaknesses of this process. It then examines the degree of association of six measures and analyzes the ability of these measures to predict returns for a manufacturing investment. The paper concludes that company analysts may improve the performance of risk measures available from commercial services by adjusting risk measurement to fit the company's specific type of foreign direct investment INTRODUCTION All business transactions involve some degree of risk. When business transactions occur across international borders, they carry additional risks not present in domestic transactions. These additional risks, called country risks, typically include risks arising from a variety of national differences in economic structures, policies, socio-political institutions, geography, and currencies. Country risk analysis (CRA) attempts to identify the potential for these risks to decrease the expected return of a cross-border investment. "Risk" implies that an analyst can identify a well-defined event drawn from a large sample of observations. A large sample contains enough observations to develop a statistical function amenable to probability analysis. An event that lacks these requirements moves toward uncertainty on the continuum between pure risk and pure uncertainty. For example, the probability of death from an auto accident classifies as a risk; the probability of death from a nuclear meltdown falls into uncertainty, given a lack of nuclear meltdown observations. Many of the individual events investigated by country risk analysis fall closer to uncertainties than welldefined statistical risks. This forces analysts to construct risk measures from theoretical or judgmental, rather than probabilistic, foundations. Uncertainty makes CRA more similar to a soft art than a hard science. Analysts deal with the soft nature of CRA in different ways, which can result in widely varying views of the risk level of a country. For this reason, users of risk measures developed from commercial country-risk

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

services must understand analysts' construction methods if they wish to analyze a company investment risk appropriately. As demonstrated in the sections below, company analysts should be able to improve upon outside measures by adapting risk systems to their specific company investments. THEORY VS. PRACTICE Country risk analysis rests on the fundamental premise that growing imbalances in economic, social, or political factors increase the risk of a shortfall in the expected return on an investment. Imbalances in a specific risk factor map to one or more risk categories. Mapping all the factors at the appropriate level of influence creates an overall assessment of investment risk. The mapping structure differs for each type of investment, so an imbalance in a given factor produces different risks for different investments. This fundamental premise provides a simple theoretical underpinning to CRA. Unfortunately, no comprehensive country risk theory exists to guide the mapping process. In practice, most country-risk services create risk measures using an eclectic mix of economic or sociopolitical indicators based on selection criteria arising from their analysts' experiences and judgment. The services usually combine a variety of factors representing actual and potential imbalances into a comprehensive risk assessment that applies to a broad investment category. Most CRA literature emphasizes a number of common points, then slips into a detailed discussion of ways the respective authors enumerate risk for various investments. The best authors emphasize the necessity to adapt their analyses for a specific investment decision given the judgmental nature of their methods. OUTLINE OF THE MODEL At the heart of country risk is the Economist Intelligence Unit's Country Risk model which measures country specific risk associated with the political, economic policy, economic structure, and liquidity situation faced by 100 emerging markets. Risk scores can be used for making a general assessment of the risk of a crisis in the country's financial markets, where foreign investors may have exposure. It is also useful for investors wishing to get a snapshot of the generalised risk of investing in a particular country.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

CALCULATING THE RATINGS The model operates by asking our country expert to answer a series of quantitative and qualitative questions on recent and expected trends relating to the general categories of political risk, economic policy risk, economic structure risk and liquidity risk in the relevant country. Individual question responses are graded providing individual country risk assessments on individual indicators, the general categories and the country's overall credit risk. Scores are produced in single point increments from "0" to "100" or letter bands from "A" to "E", representing a movement from lower to higher risk.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

COUNTRY RISK RATINGS DEFINITION

Country risk model ratings are compiled in such a way that general country risk scenarios can be formulated which may help users of EIU Market Indicators & Forecasts interpret of our risk scores. The single point system ordered from "0" to "100" and corresponding letter band system ordered A to E, moves from less to higher risk. BAND A (0-20 POINTS)

Countries which have no foreign-exchange constraints on their debt-service ability and no problems financing their trade activities. Their economic policies are deemed to be effective and correct in relation to the conditions they face (whether in a boom or a recession) and they have a working government (not always a multiparty democracy in the European mould) capable of effective policy implementation. These countries have no significant constraints on any international financial transactions. BAND B (21-40 POINTS)

Countries which also have no significant foreign-exchange constraint, but whose economic policies or political structure may be a cause for concern. B-rated countries have access to commercial capital markets. There are no major risks with respect to international financial transactions, but political risk and economic policy risk often need to be watched carefully. BAND C (41-60 POINTS)

Countries which have a record of periodic foreign-exchange crises and political problems. Many of these countries will have negotiated external debt-rescheduling agreements and could be in the process of successfully carrying out an economic reform programme. These economies will usually be in a state of flux with persistent, but controllable, internal and external imbalances. However, some will have access to commercial capital markets. With caution, this set of countries will often offer exciting opportunities for foreign investors.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

BAND D (61-80 POINTS)

Countries which are currently suffering from serious economic and political problems. Arrears, debt rescheduling and restricted access to official lending are common characteristics. Many have a narrow, commodity-dependent export base, resulting in potentially large and frequent fluctuations in export earnings and lengthening remittance delays. Many of these economies will be heavily regulated in the initial phases of restructuring or will have failed to implement such reforms. Any investment or other international financial transactions should be very carefully considered and would best be postponed. BAND E (81-100 POINTS)

Countries which are likely to have a high and rising level of arrears. They will be characterised by severe fiscal imbalances and hyperinflation. Foreign exchange will be scarce, and their relations with multilateral lenders severely strained. Often they are in or on the verge of civil war or undergoing violent political change. Political risk is usually extremely high.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

RECENT TRENDS – VARIOUS ISSUES & CHALLENGES
The scenario calling for a marked economic slowdown this year seems to be holding true with annualized first-quarter growth of 2.2 per cent for the euro zone and 0.9 per cent for the United States. The statistics available for emerging countries notably bear out the continuing strength of the BRIC economies in 2008: China posted 10.6 per cent annualised growth in the first quarter, India 9.0 per cent, Russia 8.5, and Brazil 5.8. There has thus been little change in the scenario we presented for the full entire current year three months ago with a one-point loss of GDP growth suffered not only by industrialised countries, down from 2.5 to 1.5 per cent, but also by emerging countries down from 7.3°to°6.3 per cent. We still expect world economic growth of three per cent for the full year. Although there may be little change in the overall growth scenario, several risk-aggravating factors warrant particular attention: 1. More difficult access to bank credit has been the main driver of the credit crisis Central Bank surveys since mid-2007 reflect the much tougher attitude adopted by banks in extending credit to companies and households in both the United States and Europe. The results of these surveys are notably borne out by higher financing costs with the spreads on long-term rates between risk-free loans and those granted to companies growing wider. The ECB compared the trends on spreads in Europe and the United States, showing that at equivalent levels of risk interest rate spreads have widened substantially more in the United States, up 140 basis points for a BBB rated risk, than in Europe, up 115 points. According to available statistics on the supply of bank credit to companies, however, there was no observable slowdown in the first quarter this year in either the United States or Europe with bank credit continuing to expand at annual rates of 20 and 15 per cent respectively. This persistent dynamism may nonetheless be deceptive and cloak contrasting situations: Experiencing difficulties in obtaining financing on financial markets, companies have been turning to banks and thereby replacing the "poor risks" no longer enjoying access to loans due to the more selective screening criteria applied. With the tightening of credit conditions only taking place in recent months moreover, companies can continue to draw on credit lines granted at an

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

earlier date. And there is customarily a lag between decisions to tighten credit conditions and the moment when the resulting impact on lending shows up in available statistics. Statistics published on borrowing by non-financial companies in the euro zone in the first quarter this year reflect the shifting of corporate debt from the market to banks: While the borrowing continued to grow, bank loans were up 4.5 per cent but bond issues only 0.4 per cent. And total corporate debt now represents 78 per cent of GDP according to the European Central Bank. Like in Europe, the debt of non-financial companies grew further in the United States according to the Fed, up an annualised 9.5 per cent in the first quarter this year after a 10.8 per cent increase in the fourth quarter last year. And non-financial corporate debt now represents 74 per cent of GDP. Even household debt is still growing albeit at a slower pace — 3.5 per cent down from 6.1 per cent in the fourth quarter last year — with household debt representing nearly 100 per cent of GDP.

2. Rising energy prices have increased the pressure on companies with an easing of raw material prices appearing moreover unlikely this year or next. Raw material prices posted a spectacular increase early this year. From 1 January through midJune the average price of oil was 107 dollars against 72.5 dollars for 2007. The accelerating price rise complicates matters in developing a hypothesis on barrel prices. We foresee an average price of 118°dollars for 2008, up 63 per cent from last year. Unlike previous scenarios, we no longer envisage a price decline in 2009 with the average price reaching an estimated 123 dollars. Price trends for other raw materials will vary widely: While gold prices will continue to rise, up 27 per cent this year, price increases for commodity metals like aluminium and copper should be limited to about six per cent. Nickel and zinc prices, however, should fall respectively 27 per cent and 32 per cent. Prices for food raw materials will continue to soar, especially for grain and sugar as a result of reallocation of arable land to more profitable crops as well as an apparent increase in the livestock population in the United States

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

A decline in staple commodity prices seems very unlikely amid persistent problems with supply: prices levels have depended on both strong demand from emerging countries — expected to continue unabated — and a range of constraints affecting demand. The price rise is primarily attributable to a lack of investment in raw material production operations (farm as well as fuel products) in the 1990s. Until 2000, new technologies attracted a high proportion of new investment with staple commodities not considered to have good growth prospects. Since prices began to rise again — from their low-point early 1999 — the efforts made by producer countries have been insufficient: the more prices rise the less they feel a need to increase production capacity. In the case of oil, the 500.000 barrel increase in daily output announced by Saudi Arabia for June/July notwithstanding, barrel prices have continued to rise. Just before that announcement, Saudi Arabia had declared a freeze on production capacity beyond 12.5 million barrels per day for 2010. This new strategic orientation adopted by the world's leading oil producer constitutes a deliberate move that the country justifies by the objective of preserving the oil wealth for future generations. But government officials doubtless have another line of reasoning: if demand remains price inelastic there will be little need for costly investments to increase the short-term profitability of the oil export income. Beyond Saudi Arabia's strategic "about-turns", production declines or slowdowns have developed in many producer countries. The logic underlying that trend varies widely from country to country (besides a lack of investment, political tensions or maintenance problems can affect supply) and is rarely as deliberate as in the case of Saudi Arabia, which cut production by four per cent in 2007: In Russia, Venezuela, Mexico, Cameroon, Nigeria, Iran, and Algeria production stagnated, slowed, or even declined in 2007. The latest statistics published by BP show a production decline last year for eleven major oil producing countries representing 40 per cent of world production. Besides these supply issues, other factors argue in favour of high and volatile prices. The weakening of the dollar — the invoicing currency for oil transactions — has prompted producer countries to push up prices. The market considers available production reserves insufficient to cope with an interruption of production whatever the cause (maintenance, cyclones, sabotage, and so on), which tends to make price volatility sensitive to the slightest incident. Speculative investment also has a difficult to evaluate impact and constitutes demand that is insensitive to price trends.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

In short, the various constraints on supply at this juncture tend to reduce the likelihood of the scenario based on a significant price decline in the 2008 second half or next year.

3. Inflation constrains monetary policy in emerging countries and strengthens the strong euro scenario A troubling upsurge of Inflation — largely fuelled by rising staple commodity prices — has developed in the euro zone with prices up 3.7 per cent, substantially above the ECB's two per cent objective. In the United States prices rose 4.2 per cent in May and new rate cuts by the Fed seem less likely. In what shapes up as the most realistic scenario its key rates will remain at two per cent in the coming year. The ECB meanwhile will be likely to raise its key rates in July with European rates expected to reach 4.5 per cent by this September compared to 4.0 per cent midJune this year. As a result of the divergent policy stances across the Atlantic, the interest rate differential between the euro zone and the United States should increase in the near term. And this will not be conducive to easing the euro exchange rates with the dollar and other currencies. The European currency has appreciated 5.4 per cent against the dollar and 2.7 per cent against a basket of currencies thus far this year. Other factors with a crucial impact on the euro strengthen the appreciation scenario: the American and European current accounts have been relatively stable despite the pace of the euro/dollar appreciation. The euro zone current account balance should be 0.8 per cent (and 0.1 per cent of GDP) in 2007 and 2008 with the United States' balance expected to deteriorate slightly to a negative 5.4 per cent of GDP down a tenth of a point. As regards capital flows, the outstanding amount invested in euro-denominated securities continues to grow for all types of instruments: equity, debt, or monetary. The euro's international status as a reserve currency continues to grow with its share of world foreign exchange reserves increasing from 18 per cent in 2001 to 27 per cent early this year. The euro dollar scenario developed by Natixis supposes that the European currency appreciation will continue until September and ease toward year end with the euro expected to reach a still-high 1.50 dollar rate by mid-2009.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

Although emerging economies continue their strong expansion, emerging Asia, Latin America and emerging Europe should nonetheless lose a point of GDP growth while Africa and the Middle East continue to grow at a steady pace buoyed by firm raw material prices. The crisis has not, however, spared weak emerging countries, whose vulnerability it has exposed: In Turkey and South Africa, as a result of economic slowdowns and unsustainable external imbalances, the currencies have become very volatile and vulnerable to investor sentiment with the volatility heightened by political uncertainty. That deterioration of the economic environment will generate difficulties for companies in both countries. In Vietnam and the Baltic states, corporate debt has become excessively dollarized or "euro-ised". But a sharp adjustment of the economic overheating has developed in those countries, resulting in severe pressure on the exchange rate in Vietnam and a hard economic landing in Latvia and Estonia.

4. Inflation has given rise to risks of social instability in some emerging countries Inflation has become a priority issue this year in emerging countries. Rising food and energy prices have caused price indices to rise sharply in many of those countries with inflation exceeding seven per cent in the first quarter in, for example, China, India, Indonesia, Egypt, many sub-Saharan African countries, and the Gulf countries. There is a strong correlation between the poverty level and the weight of food prices in overall price indices. That correlation holds true not only by country but also by income category within a particular country.

In sub-Saharan Africa food price represent 60 per cent of the household shopping basket. And the prices for rice and wheat are up 50 per cent since December with the high cost of living sparking many violent demonstrations, particularly in Cameroon, Ethiopia, Côte d'Ivoire, and Senegal. The economic context of high growth associated with the upsurges of prices has not constituted an offsetting factor. In periods of improving economic conditions the public can be all

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

the more disgruntled by a price shock when the fruits of the growth are unevenly distributed. On that score, the riots against immigrant populations in South Africa attest to the vulnerability of the social situation even though the rise of the black middle class has been the source of the strong domestic demand observed since 2006. Tensions could lead to unrest in Egypt, for example, where prices were up 16 per cent in April while the economy grew seven per cent in 2007. Inflation has surged in a context combining frustration of the people, a failure to economic growth into tangible progress, and uncertainties over Hosni Mubarak's succession.

5. Tightening credit and investor skittishness will affect weak currencies and the growth of overheating emerging economies The external financial position of emerging countries has markedly improved as evidenced by the substantial aggregate current account surplus — nearly five per cent of GDP — they continue to enjoy in 2008. That enviable aggregate position nonetheless encompasses large disparities: Africa and emerging Europe continue to run current account deficits widened by strong domestic demand. The economies concerned are dependent on portfolio investment and/or debt financing. They particularly suffer when investor skittishness affects financial markets through greater selectivity or a possible widening of spreads. The increase in spreads has been relatively moderate in the recent past increasing from a low of 152 basis points end May 2007 to 330 bps mid-March this year before easing to 255 bps three months later (mid-June). The increase in risk premiums thus seems limited at this juncture especially in comparison to the high of 900 basis points reached end 2002. The weaknesses are of two very different and distinguishable types: Countries with their financing needs covered by concessional debt: loans from bilateral and/or bilateral creditors as in the case of low income African countries as well as Nicaragua and Kyrgyzstan. Although the current crisis of confidence does not really affect that financing, the political situations of those countries can affect their access to such aid.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

Countries with their financing needs covered by growing corporate and bank indebtedness as in the Baltic States, Romania, Bulgaria, Turkey, and Jordan. And these are precisely the countries that Coface has negative watchlisted or downgraded with the exception, however, of Serbia already rated at a high level of risk (C), Turkey already rated B, and Croatia (rated A4) whose prospective admission to the EU has strengthened investor confidence. The countries in this group seem vulnerable with their strong growth records often correlated with an upsurge of domestic bank credit — frequently denominated in foreign currencies — often financed itself by local banks through borrowing from their parent companies. The banking sector in other countries is often dominated by non-resident shareholders from Western Europe (Austrian banks in Central Europe, Scandinavian banks in the Baltic States). Western European banks weakened by the subprime crisis could thus pass on any credit tightening to their subsidiaries abroad. They could also decide to reduce their contributions to subsidiaries located in countries considered "risky" where the size of current account deficits augurs marked slowdowns in 2008 and 2009. Credit and economic slowdowns are thus likely this year in emerging Europe with a high proportion of negative watch listed and downgraded countries — Bulgaria, Romania, and three Baltic States — located in that region. The current credit crunch will, however, be likely to affect "only" economic growth and, to a lesser extent, exchange rates often protected by high foreign currency reserves, fixed exchange rate systems with their credibility enhanced by prospective membership — even in the distant future — in the euro zone as in the case of Bulgaria or the Baltic states. The Romanian leu governed by a floating exchange rate system will likely be among the most volatile currencies in the near term. The banking system in these vulnerable countries are solid, with the notable exception of Vietnam where bank credit underwent a vertiginous expansion from 35 per cent of GDP in 2000 to 70 per cent in 2006, without having benefitted from a thorough systemic overhaul.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

COUNTRY WISE ANALYSIS OF COUNTRY RISK RATING , THEIR RECENT MARKET & POLITICAL DEVELOPMENT 1. United States Rated A2 since March 2008 The subprime mortgage crisis and tighter credit conditions continue to spread to the real economy. The property downturn and the financial crisis have hit households and companies hard exacerbated by continuing and increasing inflation, up 4.2 per cent end May. Despite positive signs in the first months of the year economic growth will be weak in 2008, up 1.1 per cent with the deterioration limited by a fiscal package representing one point of GDP and an easing of monetary policy (with rates down 325 basis points between September and April) whose initial effects should become apparent this autumn. Households will continue to significantly reduce their consumption (70 per cent of GDP) by substantially cutting back on discretionary spending and adjusting their behaviour as consumers. With their confidence at a historic low they continue to cope with the decline in value of their real property and financial assets, a shrinking job market, growing unemployment (5.5 per cent in May, an increase of nearly one per cent more in a year), the decline of their disposable income affected by higher prices for petrol at the pump (up 28 per cent between January and May) and foodstuffs. With limited savings and high debt representing 13 per cent of their disposable income they have to deal with stiffer conditions for refinancing their mortgage loans. The continuing decline of residential construction, down 21 per cent for the year ending April 2008 will also affect economic growth with building permits and new housing starts down 30 per cent and sales down over 40 per cent. Home prices, meanwhile, fell over 15 per cent for the year ending this April. The default rate has moreover now begun to rise on borrower segments other than subprime with housing stocks (10.6 months) bloated by foreclosures, which have been accelerating. And the crisis has affected non-residential construction in turn with companies that lack good access to credit postponing investments in facilities. Buoyed by low debt (43 per cent of GDP) and high cash flow (80 per cent), companies will nonetheless likely continue — albeit cautiously — to buy equipment despite erosion of the profit rate (11.1 per cent

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

of GDP). In such conditions, the growth of corporate investment should be limited to 2.8 per cent. Exports (12 per cent of GDP) continue to grow at a satisfactory pace thanks to favourable exchange rates (effective real exchange rates down 9.6 per cent in the year) with Canada and the European Union and the ongoing economic dynamism of emerging regions, representing 50 per cent of sales abroad, especially China and the Middle East. Imports, meanwhile, have been at a standstill affected by the domestic consumption slowdown. Foreign trade should thus make a slightly positive contribution to GDP growth. The economic slowdown has affected corporate payment behaviour. According to the private AACER institute, corporate bankruptcies increased 46 per cent in May 2008 compared to May 2007. That reflects the deterioration of the Coface payment experience, centred particularly on companies in sectors associated with domestic consumption. Rising costs for energy, shipping, and some inputs have affected their margins and the current credit crunch has worsened their strained financial positions. The sectors particularly affected include not only residential construction (home developers and builders, manufacturers and distributors of furnishing materials for construction, intermediaries and financial institutions) but also car manufacturing, and distribution linked to housing. Services to private individuals and leisure (restaurants, hospitality, travel), as well as the textile-clothing and Hifi-TV-video sectors have also suffered from the greater selectivity exercised by households in their spending. WESTERN EUROPE Western Europe should lose a point of growth this year, down about a third from the expansion achieved in 2007 (1.8 per cent compared to 2.8 per cent). Contrary to expectations, economic growth was relatively satisfactory in winter and spring. The slowdown should thus mainly develop in the second half. Households faced with rising food and energy prices and tighter credit conditions have been holding back on spending. The residential property downturn has continued, affecting jobs and tax revenues.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

Companies have also been coping with rising costs and those operating in the euro zone with unfavorable exchange rates. Although their exports have slowed, companies have nonetheless maintained satisfactory growth thanks to continuing strong demand from emerging countries and raw material producing countries. Their margins have, however, tended to shrink. In such gloomy economic conditions, governments have elected to freeze efforts to improve public sector finances or, for those already endowed with surpluses, to use them as a growth stimulus. Beyond this broad overview, however, it is necessary to distinguish between the few countries where the economy will slow substantially and/or growth will be weak and the great majority where the differential will be limited and/or growth will remain at a reasonably good level. The first group of countries includes above all Spain where residential construction — the main growth engine — has been collapsing and payment behaviour has deteriorated sharply. The decline of Spain's domestic demand has had a recessive effect on Portugal, where growth was already weak and 30 per cent of exports flow to its Iberian neighbor. The slowdown has also been pronounced in Ireland and Iceland with the payment behaviour of Irish companies nonetheless only evidencing deterioration in construction and that of Icelandic companies showing no deterioration at all. In Italy, with payment behaviour traditionally below the European average, payments incidents have been perceptibly trending up. In Denmark, where growth has been weak, corporate bankruptcies have increased, especially in construction. In the United Kingdom, residential construction and consumption have lost their verve but payment behaviour continues to improve. The second group includes Germany and Austria where exports continue to drive the economy and France, Norway, Finland, the Netherlands, and Switzerland where consumption has held up well.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

Germany Rated A1 Although slowing in the second half, economic growth should still reach 2.2 per cent this year. Slower growth of exports to Europe and the United States notwithstanding, the foreign trade contribution to GDP growth will nonetheless remain largely positive amply offsetting the continued sluggishness of private consumption. Households will doubtless benefit from the continued easing of unemployment and concomitantly from reduction of the unemployment insurance contribution rate. But they will be prompted to exercise restraint by the rise of energy and food prices and by the weak growth of disposable income despite the significant wage increases won in certain sectors. Benefiting from low debt and high profit margins, companies should maintain good payment behaviour, a trend borne out in the first quarter this year by an excellent Coface payment incident index and a stable bankruptcy rate. The reduction of corporate income tax in 2008 in a context of balanced public sector finances will have a positive influence. Residential construction will, however, remain a difficult sector, particularly in the eastern part of the country. The kitchen furniture sector has also exhibited a high risk profile. Automotive subcontracting has suffered meanwhile from increasing delocalization eastward on the continent. France A1 rating Economic growth should slow to 1.6 per cent this year down from 2.1 per cent in 2007. According to the official statistics agency INSEE household confidence continued to deteriorate in May. That should prompt consumers — whose debt grew from 53 per cent of disposable income in 2000 to nearly 72 per cent in 2007 — to exercise caution on discretionary spending and to replenish precautionary savings (over 16 per cent of their gross disposable income). After a first quarter slowdown household consumption (57 per cent of GDP) should thus only increase slightly for the full year, up 1.3 per cent with purchasing power suffering from the rising cost of energy and food products and a higher tax burden compared to last year.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

Loans to households, particularly in relation to housing, have been gradually slowing since end 2006. Tightening conditions for granting bank credit will continue to affect residential investment. New housing starts fell nearly 10 per cent year-on-year in the first quarter 2008. Non-residential construction should stagnate meanwhile with companies postponing

infrastructure investments as a result of higher borrowing rates and greater difficulty in arranging financing. The steady erosion of their profits — down from 8.5 per cent of GDP in 2000 to 5.2 per cent in 2007 — and their cash flow ratio from 85 per cent in 2000 to 60 per cent in 2008 has made them particularly sensitive to the conditions of access to the credit on which they have relied more since 2004. The domestic demand slowdown will tend to slow import growth, which should limit any widening of the current account balance. Two main factors, meanwhile, will hamper exports: less dynamic demand from European trading partners and the euro appreciation in dollar zones undermining the competitiveness of French products. Those negative factors notwithstanding, exports will grow at essentially the same rate as they did in 2007 with foreign trade likely to make a positive contribution to GDP growth. The corporate mark-up rate should remain stable on average this year at 31.4 per cent. That rate nonetheless masks disparities with the margins of smaller companies eroded by price increases for intermediate products, which they will not always be able to pass on in sales prices, and with access to credit particularly tightened for this company segment. Industrial sectors burdened by high debt will thus bear close watching notably in automotive and aeronautical subcontracting, paper, and metals. Vigilance is also in order for the IT sector (assemblers and distributors), the hog industry (breeders, cooperatives, slaughter houses, distributors), and cattle feed and fertilizer wholesalers and cooperatives. In construction, the decline of orders from developers may affect some subcontracting companies. Corporate bankruptcies increased over nine per cent —12-month moving average through March 2008 (source Coface Services) — a trend consistent with the growth of payment incidents recorded by Co face thus far this year. DENMARK A1 RATING

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

ON NEGATIVE WATCHLISTING Reason for negative watchlisting the rating : Economic growth will be weaker in 2008, up 1 .4 per cent, affected by cutbacks in consumption by households whose confidence has begun to suffer from the inflationary pressures and the value lost by their financial wealth. Companies will put the brakes on investment (up 1.6 per cent after up 8.8 per cent in 2007) highly dependent on bank credit and thus particularly sensitive to current credit restrictions. Margins should shrink, squeezed by rising wage costs amid a very tight job market and by higher prices for inputs. Bankruptcies continue to rise, up 25 per cent for the first five months of the year. Growth slowed markedly in 2007. Households have reduced their spending affected by both a property market correction and higher interest rates. However, wage growth spurred by record employment had a mitigating effect on the slowdown. Companies suffered, meanwhile, from erosion of their productivity and a slowdown of their exports. The economy remained flat in the first months this year with only 1.4 per cent growth expected for the full year. Deeply in debt and not withstanding the steady rise of their incomes, households continue to exercise caution on spending and their consumption (49 per cent of GDP) should dwindle further. Several unfavourable trends have eroded their confidence: growing inflation expected to reach 3.1 per cent, the value lost by their financial assets (down USD 16 billion in the 2007 fourth quarter according to the Central Bank, and tighter credit conditions. Residential construction will decline about six per cent this year with commercial construction remaining at a standstill. With investment by manufacturing and service companies heavily dependent on bank credit, it will slow substantially, a trend consistent with the tightening loan conditions. Corporate competitiveness will suffer from a range of factors: a job market expected to remain tight, increasing difficulty in recruiting skilled personnel, wage growth, and saturation of production capacity. Oil and natural gas sales will continue to underpin exports whose growth will nonetheless be hampered by production capacity constraints, the economic slowdowns affecting traditional trading partners, and by the krone's strength in some markets. Weaker domestic demand will hold imports down meanwhile, which will contribute to limiting the reduction of the current account surplus.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

The government's' fiscal budget will show a surplus again this year buoyed by revenues associated with North Sea hydrocarbon prices. Spending could, however, increase more than expected due to commitments made during the autumn 2007 general elections. The government will in any event continue reducing public sector debt. In this context of weak growth, labourintensive sectors will likely be subject to cost pressure while sectors focusing mainly on the domestic market should suffer from the domestic demand slowdown. The pace of corporate bankruptcies continued to accelerate in the first five months this year, up 25 per cent after an increase of 21 per cent in 2007. The sectors affected most include industry, construction, distribution, and hospitality-catering.

Spain Rated A2 Reason for the rating change: Spain's A1 rating is downgraded to A2 due to deterioration of corporate payment behaviour amid weakening economic conditions with 1.6°per cent growth expected this year down from 3.8 per cent in 2007. The residential construction sector that had been the main growth driver has continued to decline with substantial negative repercussions on consumption and Investment. The marked growth slowdown under way since the year began has continued with the economy likely to be very dull by year end. That trend is mainly attributable to a very pronounced domestic demand slowdown affecting both consumption and investment. Investment in residential construction, which still represented nine per cent of GDP and jobs until recently, has collapsed. Households are contending at once with a significant increase in unemployment, price inflation for food and energy, price erosion affecting their property assets, rising interest rates while they carry variable rate debt, and the tightening of conditions for taking out loans. They have consequently sharply reduced their consumption spending.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

In this unfavourable context, payment behaviour has deteriorated overall. While remaining satisfactory for households due notably to social pressure, corporate payments have deteriorated sharply a trend consistent with the decline of their profits. Smaller companies associated with the housing market — joinery and fenestration, real estate agents, developers, manufacturers and distributors of equipment and material for the home — often debt-burdened and having increased in number while the market was strong, have been the most vulnerable. Road transport has suffered from rising petrol costs while the automotive industry has to contend increasingly with Eastern European competition and slumping local vehicle sales. Only tourism seems safe at this juncture but it could suffer in turn from the slowdown grinding away in Northern European countries. The foreseeable acceleration of the decline in housing prices, the continued rise of unemployment, the interest rate hikes announced by the ECB, and the expected slowdown of corporate investment in equipment and facilities do not augur well for an upturn any time soon. Tax breaks representing one point of GDP — rental support for youth and low-income families, increases in small pensions, an income tax reduction of EUR 400, cancellation of the wealth tax, —facilitated by the good health of public sector finances and the public infrastructure spending continuing under the PEIT multi-year modernisation programme will only have a limited positive impact. And with imports in a more pronounced slowdown than exports the negative foreigntrade contribution to GDP growth will be smaller but barely make a dent in the massive current account deficit.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

Portugal Rated A2 On negative watch listing Reason for negative watchlisting the rating: Economic growth will slow in 2008 in phase with the slowdown of household consumption and exports. Deeply in debt (129 per cent of disposable income), households have experienced difficulties in getting loans to finance their spending and will likely draw less on their savings. Corporate investment will remain moderate and the process of re-specialising in higher value-added sectors will still be too shaky to enable companies to cope with the weaker demand from the European Union — which provides a market for 70 per cent of its export sales — and particularly demand from Spain (30 per cent). The activity of some companies should, however, derive support from large infrastructure projects. The upsurge in bankruptcies in 2007, up 62 per cent, is partly attributable to a legislative change. Economic growth accelerated slightly in 2007, buoyed by domestic demand and exports. Limited wage growth prompted households to take on additional debt and draw on their savings to finance their spending. Corporate investment made a significant recovery facilitating a slight improvement in productivity and competitiveness. Exports thus developed at a solid pace without, however, winning new market share. Increased debt service notwithstanding, the government continued to pursue its public sector deficit reduction objectives. Growth should be weaker in 2008 amid slowdowns of both private consumption and exports. Households — with their heavy debt burden reaching 129 per cent of disposable income — will reduce spending in a context of weak job growth, higher interest rates, rising prices for energy and food products, and increasing tax pressure. Tighter credit conditions should undermine the timid property investment recovery fostered by tourism and the migration of the rural population to large cities. Companies will reduce their investment in machinery with production capacity utilisation down in the first months this year. Their business activity will benefit, however, from infrastructure projects like the new Lisbon airport facilitated by community funds supplemented by domestic resources. The results of the efforts made by companies in recent years to improve their competitiveness and adjust their specialisation in favour of higher value-added products are still too shaky to enable them to cope effectively with the slowdown of foreign demand,

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

particularly from the European Union, the outlet for 70 per cent of sales abroad. The domestic demand slowdown will slow and facilitate a slight reduction of the huge current account deficit. Despite the lagging pace of efforts to reorganise the civil service, the government will go forward with the process of growth convergence with the other euro zone countries by further reductions in its public sector deficit. Partial privatisation of Portugal's TAP airline, INAPA papermaker, and Energias electricity supplier will moreover facilitate reducing the public debt. Application of new legislation adopted in 2005 was partly responsible for the 62-per cent increase in bankruptcies last year. Reflecting the trend toward increasing difficulties for companies in the current economic context, the Coface payment incident index has deteriorated since April 2008. The economic fabric will remain weak this year as a result of the lagging pace of efforts in many sectors to integrate new technologies and improve labour skills. That has notably been the case in the textile-clothing and shoe industries, which have been contending with stiff competition not only from low-cost countries but also from emerging European and Euro-Med countries. The efforts to overhaul these sectors will thus continue in 2008. Emerging Europe The Emerging Europe region, encompassing Central Europe and Turkey, should lose a point of GDP growth in 2008, down from 5.6 to 4.6 per cent under the effect of sagging foreign demand, rising prices, and tighter monetary policy. Several factors have, however, had a mitigating effect on the slowdown: rising wages, the influx of foreign direct investment and European funds, and the growth of the region's share in Western European imports. Economic growth will moreover remain three points higher in the region than in the euro zone, its main trading partner. Except for the Baltic States, which have been contending with a marked credit slowdown, severe erosion of purchasing power, and a downturn in the property market, regional growth has mainly been trending up thus far this year. Although steady tax revenues have facilitated reducing the public sector deficit in several countries, fiscal reforms have lagged behind schedule, and wage and social spending are up sharply.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

Combating the inflation fuelled by rising foodstuff and energy prices and a tightening of the labour market has become the primary economic policy challenge. In this context regional central banks will likely continue tightening monetary policy. The high level of inflation has postponed adoption of the euro by the new member countries until at best 2012 with the exception of Slovakia, which already has approval to adopt the single currency on 1 January 2009. The widening of current account deficits and the rapid growth of private sector debt and loans denominated in foreign currencies in conjunction in some cases with the bursting of speculative property bubbles have made many regional countries vulnerable to a currency crisis or sudden adjustment of growth. Fears of a hard landing for the Estonian and Latvian economies in particular are largely borne out by the slowdowns observed early this year. Lithuania, Romania, Bulgaria, Hungary, and Turkey remain the other weak countries in the region. Turkey notably still has the highest external financing needs of any emerging country while the procedure underway to ban the party in power has substantially increased the political uncertainties. The risk premiums for sovereign default reached high levels for those weak economies in the wake of the subprime crisis before easing substantially since mid-March this year. The Romanian leu — even if it has steadied slightly since end January 2008 — remains the regional currency most affected by that crisis. Estonia Rated A3 Reason for the rating change: The severity of the growth slowdown observed in the first quarter this year (up 0.1 per cent year-on-year, after up 4.8 per cent in the 2007 fourth quarter and up 7.1 per cent for all of 2007) raises fears of a hard landing for economic growth. Household confidence is affected by falling property prices and resurgent inflation (up 11.4 per cent end April this year). Continued wage growth has, meanwhile, been squeezing the margins of companies moreover faced with increasingly tight credit conditions. That should affect investment. With domestic demand expected to decline, a slight recession is not out of the question this year even if exports remain dynamic (up 19 per cent in value terms in

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

the vulnerable.

first

quarter

this

year).

Construction and sectors linked to consumption or that are labour intensive are particularly

The marked first-quarter slowdown may foreshadow a hard landing for economic growth for all of 2008. Tighter credit conditions, deflation of the speculative property bubble, erosion of household purchasing power, and narrowing corporate margins could pave the way to a slight recession this year. Inflation continues to grow — up 11.4 per cent in a year through end April 2008 — due to increases in food and energy prices, excise taxes, and wages. The objective of joining the euro zone in 2011 seems out of reach in this context. The expected decline of tax revenues should not, however, jeopardise the solidity of public sector finances, which have been running surpluses until now. Government debt has moreover been low, representing 3.4 per cent of GDP. The weakening of domestic demand should, meanwhile, have the beneficial effect of reducing a current account deficit that reached a difficult to sustain level in 2007 (17.3 per cent of GDP) necessitating, in the absence of adequate foreign direct investment inflows extensive recourse to borrowing abroad. The resulting increase in debt reflects in particular the credit lines granted by Nordic banking groups to local subsidiaries. In the political arena the coalition government has been experiencing its first signs of tensions. Relations with Russia have moreover remained tense since the riots triggered in April 2007 by the officially-approved moving of a statue commemorating the glory of Soviet soldiers. But the economic impact of these diplomatic tensions should remain limited to oil transit trade .

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

Latvia Rated A4 Reason for the rating change: A hard landing for the Latvian economy has become a distinct possibility at this juncture. Growth fell to 3.3 per cent year-on-year in the 2008 first quarter, down from 8.1 per cent in the fourth quarter last year. Economic activity has suffered mainly from the deflation of the speculative property bubble and the tightening of credit conditions compounded by high inflation, up 17.5 per cent end April 2008. Exports have, however, been growing rapidly. GDP growth should fall to about 2.4 per cent in 2008, down from over 10 per cent these past three years. Sectors involved with construction or consumption and those that are labour intensive, which have to contend with rising payroll costs, are the most vulnerable.

The economic slowdown should be pronounced in 2008 with GDP growth down from 10.3°per°cent to 2.4 per cent under the effect of the property market downturn, tighter credit conditions, and the erosion of purchasing power. With domestic demand weakening slightly, only the positive contribution to growth made by foreign trade kept the country from falling into recession. The increases in regulated prices and in food and energy prices will keep inflation at high levels, up 17.5 per cent end April, the decline of domestic demand notwithstanding. In such conditions Latvia is not expected to adopt the euro before 2012/2013. The pronounced import slowdown should facilitate reducing the current account deficit from 22.8 per cent to 14 per cent of GDP this year. Foreign direct investment finances slightly under a third of that deficit while external debt, mostly owed by banks, has reached nettlesome levels. Although — after the virtual fiscal equilibrium of recent years — re-emergence of a slight public sector deficit appears likely, sovereign risk remains very moderate due to the low level of government debt (10 per cent of GDP). In the political arena meanwhile, corruption scandals could engender a degree of instability, but not of a nature, however, likely to jeopardise the main economic policy options.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

TURKEY RATED B After several years of strong growth in the wake of the 2001 crisis, Turkey suffered a slowdown (4.5 per cent in 2007) amid interest rates at their highest level since mid-2006 and a poor harvest. Rising inflation (slightly over 10 per cent in April 2008), tight credit conditions at the international level, and current new political uncertainties have prevented the easing of monetary policy crucial to reviving domestic demand. Middle Eastern dynamism, meanwhile, should only partly offset the European demand slowdown. Overall, growth should be relatively modest in 2008, around four per cent. A slight recovery will be possible in 2009 provided the political crisis is durably resolved and a more favourable international environment makes it possible to reduce interest rates. In the current volatile world financial environment, the demand filed by the public prosecutor attached to the highest court of appeal to ban the party in power (AKP) constitutes a major risk factor. The likelihood of the constitutional court approving the ban is significant. In that case new elections seem inevitable, which would prolong the uncertainties, probably until early 2009. These uncertainties in combination with a less favourable international credit environment heighten the main risk — a currency crisis — overhanging the country, especially with its external financing needs larger than those of any other emerging country. Although foreign direct investment inflows are now significant those needs are also covered by loans taken out by private companies whose debt has been growing strongly and by volatile capital. A loss of confidence by foreign creditors in this context could trigger a currency crisis that would particularly weaken companies with high foreign currency debt but with revenues denominated in local currency. Some of the firms with foreign currency debt are nonetheless exporters. Turkish companies moreover generally coped effectively with the previous — albeit relatively mild — shocks of May 2006 and summer 2007. Above all, and unlike 2001, public sector debt is now manageable and the banks enjoy solid foreign exchange positions. A crisis on the scale of that of 2001 is thus highly unlikely at this juncture.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

Russia Rated B GDP growth reached 8.5 per cent in the first quarter and should continue to trend up throughout the current year buoyed by the dynamism of household consumption and investment, especially currently-surging foreign direct investment, On the supply side, construction (up 28 per cent), wholesale and retail commerce, transport and telecommunications, property, and B2B services should continue to expand rapidly. In the current buoyant economic conditions, the Coface payment experience on Russian companies continues to reflect the major shortcomings of the business environment. The current surge of inflation (15.1 per cent in the first quarter this year) will moreover bear watching. Inflationary pressures should ease slightly for the full year as a result of the good grain harvest and tighter monetary policy with interest rates raised in June for the third time this year. Inflation will nonetheless remain high: 12.6 per cent expected for all of 2008). The financial position remains sound. Although external debt ratios have improved, massive recourse to borrowing abroad by companies and banks has kept credit risk at appreciable levels in a context marked by a lack of transparency. Liquidity crisis risk remains limited, however, thanks especially to the Russia's large foreign exchange reserves. The emergence this year and next of financing needs only partly covered by foreign direct investment contribute to increasing the country's dependence on financial markets and increasing its vulnerability to a loss of investor confidence. Although benefiting from the buoyant economic conditions, the banking sector still has significant weaknesses. Besides being too fragmented, it suffers from shortcomings on risk management and the transparency of financial information. With bank intermediation relatively limited, however, systemic risk is very small. In the political arena, relations with Georgia deteriorated early 2008 over the Abkhazia and South Ossetia issue. A risk of conflict remains a plausible scenario. Domestically, the coming into power of Dmitri Medvedev could mark a more liberal shift and facilitate progress on political liberty and the campaign against corruption.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

China Rated A3 After peaking at 11.9 per cent in 2007, China's economic growth is expected to ease slightly in 2008 to 9.5 per cent. In the first quarter this year it reached 10.6 per cent. With domestic demand the main growth driver, the impact of the American slowdown should thus remain limited. Inflation, meanwhile, accelerated to 6.5 per cent in 2007 and reached 8.0 per cent in the first quarter this year, fuelled mainly by rising food and energy prices. It is likely to remain high throughout the year with officials having decided in June this year to raise diesel and petrol fuel prices by 18 per cent as well as electricity prices. Underlying inflation nonetheless remains below two per cent. Concerned over the social repercussions, the government will likely continue to tighten monetary policy — with increases in interest rates and especially mandatory reserves (five increases since the year began) — even if the tightening has had little effect thus far. Targeted administrative measures, like price freezes, may moreover be taken in 2008. The yuan appreciation has been accelerating, meanwhile, up 9.3 per cent year-on-year in May 2008 compared to up 6.9 per cent for all of 2007. Even if the yuan appreciated 10 per cent a year, however, it would take twelve years to shed its undervalued status with the IMF evaluating the equilibrium exchange rate for the Chinese currency against the dollar at just 1.96 yuan compared to 7.39 yuan in 2007. Despite the expected export slowdown, meanwhile, China will continue to run large current account surpluses. The excess liquidity generated not only by those surpluses but also by the massive influx of capital ultimately ends up flooding the stock market evidenced by the 110 per cent increase in the Shanghai Stock Market index in 2007. Despite the price corrections that developed between January and May 2008 (down 35 per cent), the price earnings ratio remains a very high 60 showing that the attendant risks of speculative bubbles and volatility remain substantial. Organization of the Olympic Games will mark 2008 and the infrastructure investments made in consequence constitute an opportunity for the country. The results of a study by JP Morgan showed, however, that the Olympic Games only had a very marginal impact on the economy in Korea in 1988, Spain in 1992, the United States in 1996, Australia in 2000, and Greece in 2004.

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

The aftermath of the Games could moreover — by causing sharp cuts in investment and consumption spending, — be a contributing factor to the economic slowdown. Meanwhile, the social and political upheavals linked to growing inequality between urban and rural areas as regards the effects of rising prices will bear watching. VIETNAM RATED B ON NEGATIVE WATCHILISTING Reason for negative watchlisting the rating: Vietnam's strong growth — eight per cent on average since 2003 — has given rise to economic overheating with inflation reaching 12.6 per cent end 2007 and surging 25 per cent year-on-year this May. The current account deficit, meanwhile, widened significantly in 2007 and could reach 13.6 per cent this year. In the context of a Vietnamese currency — the dong — pegged to the dollar and a banking system highly dollarized, foreign exchange risk has increased. A major dong depreciation could thus be accompanied by a marked growth slowdown — with a 5.0 per cent expansion expected for 2008 down from 8.5 per cent in 2007— and an increase in corporate default risk. Vietnam has enjoyed growth of over eight per cent since 2003 thanks to development strategy (inspired by the Chinese model) based on trade liberalisation and marked by admission to the WTO in January 2007 and a high rate of investment. That economic dynamism has engendered signs of overheating, especially since 2007. And with the dong pegged to the dollar and the banking system highly dollarized the overheating has given rise to increased foreign exchange risk. A major dong depreciation could thus be accompanied by a marked growth slowdown — with a 5.0 per cent expansion expected for 2008 down from 8.5 per cent in 2007— and an increase in corporate default risk.

After accelerating to 12.6 per cent in 2007, inflation has surged thus far in 2008 reaching 25°per cent this May year-on-year. That acceleration is attributable to the rapid expansion of credit (up 54 per cent in 2007), rising prices for food and oil (with Vietnam a net oil importer since early

Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

2007), soaring housing and construction prices, and increases in wages have fuelled the inflationary spiral. Monetary policy has become tighter with mandatory reserves higher and interest rates increased from 8.0 per cent to 14 per cent. These measures notwithstanding inflation will likely remain high throughout the year, reaching 18.3 per cent. The current account deficit meanwhile has continued to widen. It represented 9.6 per cent of GDP in 2007 and could reach 13.6 per cent this year — compared to just 0.4 per cent in 2006 — amid strong growth of imports, especially capital goods needed for the many investment projects notably in construction. The widening current account deficit prompted the government to devalue the dong by two per cent in June. But foreign exchange risk has nonetheless remained substantial with the dong converted on the black market at rates below official parity with a 7.0 to 15 per cent discount. The forwards market has similarly discounted a 30 per cent-depreciation. And the banking system is very sensitive to exchange rate risk as a result of its extensive dollarization with 30 per cent of deposits and the appreciable proportion of bank intermediation resulting in dollar-denominated loans. Vietnam's banking system remains weak in general despite some recent reforms that resulted in a more straightforward opening of the market to foreign banks and privatization of three stateowned banks. Seven state-owned banks controlling 70 per cent of total bank assets nonetheless continue to dominate the sector. The high proportion of non-performing loans — one in four — associated with the rapid expansion of credit constitutes a major vulnerability. The lack of transparency and the failure to apply international risk management standards are additional sources of weakness. The growing risk of a liquidity crisis due to the country's limited foreign exchange reserves will also bear watching. The government's decision to stop publishing information on the banking system and the level of foreign exchange reserves has moreover resulted in a lowering of expectations on Vietnam's financial outlook.

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BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

Vietnamese risks have thus been sharply downgraded — with Standard and Poor's and Fitch notably reducing the outlook for Vietnam from "stable" to "negative" — and a hard landing may be looming for the economy. India Rated A3 Tighter monetary policy notwithstanding, economic growth was higher than expected in the first quarter this year (up 8.8 per cent) driven by industry (up 10.9 per cent) and services (up 13 per cent). Domestic demand nonetheless remains the main growth engine with consumption and especially investment still strong in the private sector. And GDP growth rests on sound fundamentals: high savings and investment rates and moderate external debt ratios. With a more self-contained economy than the other emerging major powers, India is less dependent on international economic conditions and should thus be largely spared the effects of the American slowdown. In these circumstances the Co-face payment incident index for Indian companies remains below the world average. The main source of concern at this juncture is an inflation rate that reached 11.05 per cent for the year ending 7 June 2008. That inflationary surge is partly attributable, however, to the 12°per°cent increase in fuel prices decided by the government and by rising prices for food, which represents high proportion of the household shopping basket. Further interest rates hikes by the central bank are nonetheless likely, which could affect growth in the second half this year. The deterioration of external accounts is less troublesome since it remains moderate and inflows of long-term capital largely cover India's external financing needs. The continuing presence of speculative property and stock market bubbles will continue to bear watching, however, in the currently more unstable world financial context.

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Latin America GDP growth is expected to slow to 4.3 per cent in Latin America this year down from 5.5 per cent in 2007 amid a less buoyant international environment and an economic slowdown in the United States, even with domestic demand still making a decisive contribution. Although still strong, world demand for staple commodities, especially in Asia, could decline in 2009, as could the high prices for raw materials, and deepen the economic slowdown. Most regional countries have, however, been able to reap the benefits of a previously favourable world context that facilitated cleaning up external accounts, building up substantial foreign exchange reserves, and continuing to reduce foreign debt. The resurgence of inflation — under relatively good control until now except in Argentina and Venezuela, — constitutes a challenge to continuing to pursue the generally appropriate monetary and fiscal policies that have contributed to the steadiness of local currencies and facilitated cleaning up public sector finances. With the region's stronger macroeconomic foundations and the greater credibility of the economic policies pursued, the international financial turbulence should have limited impact there with the region's large economies unlikely to experience major financing difficulties, tightening credit conditions at the world level notwithstanding. Although radical tendencies continue to mark the politics of some countries (Venezuela, Bolivia, Ecuador), the political options of most of the other countries are moderate. In general, however, the institutional and business environments leave room for improvement. In this context, corporate payment behaviour has deteriorated slightly but nonetheless remains relatively satisfactory although some sectors, like textiles, continue to be faced with competitiveness problems with others, like agriculture, remaining subject to weather conditions.

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Mexico Rated A3, negative watchlist status since mars 2008 The economy is likely to slow this year with 2.6 per cent growth in the first quarter and 2.3°per°cent for the full year down from 3.3 per cent in 2007 due especially to the economic slowdown in the United States on which Mexico remains dependent as a market for its exports. The fiscal stimulus through measures intended to buoy domestic demand, the main economic engine, should produce a slight upturn in 2009. Tight monetary policy meanwhile should ease inflationary pressures notably attributable to rising food and energy prices and limit the overall rise in prices to 4.5 per cent for the year. The economy's relatively solid foundations will likely mitigate the effects of international financial turbulence. The process of improving public sector finances, which depend on oil revenues, will stall, however, as result of the fiscal stimulus programme. With a decline in oil production, slumping exports to the United States, and a slowdown in emigrant worker remittances, the foreign trade deficit will begin to widen from 2009. Foreign direct investment is expected to cover half of external financing needs, however, with Mexico's already moderate external debt ratios likely to decline further. Efforts to modernise the economy, and particularly to reform the state-owned oil company Pemex, have come up against stiff resistance on political and social grounds with President Calderon lacking a parliamentary majority. In this context, the business environment still leaves room for improvement with the Coface payment experience on Mexican companies deteriorating somewhat although remaining acceptable. The difficulties experienced in the textile, clothing, and shoe industries reflect their problems in meeting foreign competition, especially Asian, while the problems in the food industry are more cyclical in nature.

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Brazil Rated A4 With domestic demand still the main growth engine, the economy is expected to remain relatively strong this year — after a 5.8 per cent expansion in the first quarter, 4.6 per cent is expected for all of 2008 and slightly less (4.1 per cent) in 2009 compared to 5.4 per cent in 2007 — but without reaching, however, the five per cent growth targeted in the government's priority Growth Acceleration Programme. The country has shown a noteworthy capacity to cope with the volatility of international financial markets. Inflationary pressures, with the rise of prices accelerating this year and likely to reach six per cent by year end, have prompted the central bank to begin another cycle of increases in its already high key rate. The underperformance of exports but especially the dynamism of imports and a widening services deficit should cause a current account deficit to emerge this year and increase in 2009. Foreign direct investment will likely cover, however, most of Brazil's external financing needs. The country's external vulnerability is expected to ease, moreover, thanks to the improvement in the external debt ratios. And the record level of foreign exchange reserves constitutes a very solid safety net even if a widening current account deficit in 2009 could contribute to a weakening of the currency. Public sector debt, meanwhile, is still too high (with the gross amount outstanding expected to represent 64 per cent of GDP this year and the net amount 41.5 per cent), which notably tends to impede investment and infrastructure modernisation. But the adoption of the structural reforms needed to sustain stronger growth is impeded, however, by the governing parliamentary coalition's lack of homogeneity and the government's lack of commitment in the run-up to municipal elections late this year and presidential elections in 2010 with the constitution denying President Lula da Silva the right to run for a third term.

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North Africa and Near & Middle East Oil prices, which virtually doubled in the space of a year, have provided the region's producer countries with the resources to ensure the perpetuity of major infrastructure projects whether in the Gulf Monarchies or Algeria. But the rising cost of rent, construction materials, and, subsidies notwithstanding, fuel and food products, have created inflationary pressures exacerbated by the depreciation of the dollar to which the currencies of most Gulf monarchies are pegged. The price surge could cause delays in some projects and severely reduce consumer purchasing power, limiting nonetheless strong growth outside the oil sector. That is especially the case in the United Arab Emirates and Saudi Arabia. After two years of reduced hydrocarbon production in the Arabian Kingdom, an upturn is expected this year with growth reaching about six per cent. Although foreign debt has been growing in the region — except in Algeria, which has pursued tight policy on that score — any over-indebtedness risk has to be put into the perspective of the extensive and growing asset holdings abroad. Fiscal expansionary policy in Iran has spurred growth but at the expense of stoking inflation that exceeds 20 per cent. The country's inflexible positions on the nuclear issue has prompted the United Nations and the United States to impose sanctions that make economic and financial transactions more complicated and costly. Petrodollars from the Gulf Monarchies have indirectly benefited the other countries in the region via investments, tourism, and emigrant worker remittances. Coping with the oil bill will be particularly painful for Jordan and Lebanon, which already run high external deficits, respectively 20 and 12 per cent. Soaring foodstuff prices have triggered riots, particularly in Egypt. Remedial measures taken to offset subsidy reductions and rising prices for food products have widened public sector deficits in Egypt, Jordan, Syria, Lebanon, and Yemen. Israel, meanwhile, has withstood the slowdown in the United States relatively well, achieving 5.4 per cent growth in the first quarter, driven by household consumption and investments. The international credit crunch has, in general, had little effect on the region. Geopolitical tensions continue to run high in that corner of the world, spurring Islamist movements in opposition to governments that in general enjoy good relations with the United States. The chaos reigning in Iraq remains a source of regional destabilisation and the Iranian

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nuclear issue continues to be a major factor of uncertainty. Perceptible signs of easing tensions have nonetheless emerged. Qatar's mediation in Lebanon notably led to the election of a president paving the way for restoring the normal functioning of institutions paralysed since autumn 2006. The resumption of talks between Hamas and Fatah and the truce between Israel and Hamas augurs a possible revival of the Middle East peace process that could include Syria. Saudi Arabia Rated A4 Adjusting oil production to foreign demand contributed last year to a new growth slowdown with the economic expansion limited to 3.5 per cent. The non-oil sector, meanwhile, continued to grow at a strong, steady pace of 6.5 per cent with the revenues generated by high barrel prices spurring domestic demand and both public and private investment in large industrial and infrastructure projects. The oil sector's contribution to growth is expected to rebound this year and next — an estimated six per cent in 2008 and four per cent in 2009 — in view of the programmed increases in oil and gas production and the buoyant demand from emerging countries. And high oil prices and large projects in progress will continue to underpin non-oil economic activity. The rising cost of commodity material and labour could, however, delay some projects and undermine economic growth. Increasing inflation has moreover affected purchasing power and could deter household consumption. The non-oil sector is thus expected to maintain about six per cent growth. The overall economy will grow an estimated six per cent in 2008 and five per cent in 2009. Petrochemicals, construction, and transports will be the sectors likely to outperform. Corporate earnings have been good and the Coface payment incident index for Saudi companies has remained below the world average. With the country's admission to the WTO end 2005, the business climate improved. The investment rate is, however, still below the country's potential amid continuing governance weaknesses and high geopolitical risk.

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Egypt Rated B With the liberal policy options adopted by the government since 2004, the business climate has improved. The boom conditions in oil producing countries have moreover benefited Egypt's economy through investments and emigrant worker remittances. The strength of domestic demand and the increases in staple commodity prices in conjunction with subsidy reductions have, however, caused a surge of inflation estimated at 14.5 per cent on average for the year ending June 2008. Although the marked increase in prices has undermined household purchasing power, investment and private consumption continue to drive the economy. Sharply higher demand for imported products has, however, made a negative contribution to GDP growth estimated at 6.5 per cent this year, or somewhat slower than the 7.1 per cent expansion achieved in 2006/07. The manufacturing, tourism and communications sectors performed particularly well. In construction, bottlenecks and higher material and wage costs have delayed some projects. Inflation targeting policy should facilitate keeping the rise of prices under control with an average increase of 9.3 per cent estimated for the 2008/09 financial year.

Underpinned by the good trend on foreign currency revenues and dynamic foreign direct investment spurred by privatisations, Egypt's external financial position is not a source of difficulty at this juncture. Debt service is low. The country continues to build up foreign exchange reserves. The fiscal deficit and public sector debt continue, however, to give cause for concern. With rising food prices having triggered riots, the government took compensatory measures — wage and subsidy increases — intended to keep a lid on the social climate. The planned cleanup of government finances was postponed in consequence and the public sector deficit could represent between 7.0 and 8.0 per cent of GDP for the current financial year, after easing to 5.7 per cent in 2006/07.

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Lebanon Rated C Reason for the removal from negative watchlist status: The Doha Accords that made the election of a President in May 2008 possible have paved the way to restoring the functioning of the country's institutions to normal. Despite the difficult economic conditions, corporate payment behaviour has held up well. After Raffik Harriri's assassination in 2005 and the war with Israel in 2006, insecurity and political instability exacerbated by the prospect of presidential elections supposed to be held late 2007 impeded an economic rebound. After pro-Syrian members of parliament and the government resigned, the ensuing blockage of normal institutional functioning stalled progress on reforms and implementation of the USD 7.6 billion promised in international aid at the Paris Conference in January 2007. That situation affected household consumption, investment, and tourism. Notwithstanding the difficulties, however, companies maintained good payment behaviour. In 2007, after two years of virtual stagnation, economic growth failed to rise above four per cent, underpinned by construction despite the slowdown of investment by Gulf countries in this sector and by a dynamic banking sector redeployed to other regional countries. Government finances remain marked by the cost of the reconstruction in the 1990s with public sector debt reaching 170 per cent of GDP. The government moreover ran a fiscal deficit of 12.4 per cent in 2007. With a large current account deficit that represented 12.5 per cent of GDP in 2007, the external financial position is also still shaky, remaining exposed to a crisis of investor confidence. The country's banks are its strong suit. Well capitalised, liquid, and profitable, they are nonetheless vulnerable due to their exposure to sovereign risk.

Mediation by Qatar made President Michel Suleiman's election in May 2008 possible, paving the way for institutions, paralysed since autumn 2006, to resume their normal functions even with the political situation remaining shaky in the run-up to general elections in 2009.

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Iran Rated D Buoyed by social policy based on redistribution of oil export revenues, the economy remained strong in the 2007/08 financial year with 5.8 per cent growth, which constitutes a slight slowdown compared to the 6.2 per cent achieved in 2006/07. The non-oil sector derived support from several sources: public spending, social incentives, and the easing of bank interest rates. Services and manufacturing performed well. For the second straight year construction was particularly dynamic, spurred by public infrastructure spending, and private savings, which have been turning away from stock market investments. Oil sector production rose just one per cent with the decline in capacity of old fields partly offsetting the production start-up of new facilities. Expansionary fiscal policy and accommodating monetary policy have kept inflation at high levels, between 25 and 30 per cent, undermining purchasing power in a country where incomes remain relatively low compared to the region's other oil producing countries. For 2008/09, economic growth is estimated at 5.3 per cent. The government will continue to support the economy through public spending in the run-up to presidential elections in 2009 and in view of the continuing strong growth of oil prices. The inflation rate is expected to remain above 20 per cent. The external financial position presents no particular difficulty. Iran will likely maintain large foreign exchange reserves, which will limit liquidity crisis risk. Public sector finances, however, give substantial cause for concern, however, with the sector's limited surplus despite the excellent oil market conditions reflecting the extensive redistribution of oil export revenues. The business climate has suffered from the government's populist policies and sanctions imposed on the country in the absence of a settlement of the nuclear issue. The World Bank's governance indicators moreover continue to place Iran at critical risk levels.

Sub-Saharan Africa

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The growth outlook for sub-Saharan Africa's remains bright with a 6.5 per cent expansion expected this year and 6 .3 per cent in 2009, underpinned by firm raw material prices, particularly hydrocarbons and ores. Risks have nonetheless been growing in a context of soaring foodstuff prices and persistent structural imbalances. Oil importing countries, with growth (five per cent) below the sub-Saharan average, have suffered from the widening of their twin deficits. In this context, improvement in their financial positions resulting from debt relief granted under the HIPC and MDRI programme could prove largely unsustainable. Soaring prices for foodstuffs, which represent 60 per cent of the household shopping basket in sub-Saharan Africa, exacerbate social and political risks. The 50 per cent increase in wheat and rice prices between December 2007 and April 2008 triggered violent protests over the cost of living in Cameroon, Burkina Faso, Ethiopia, and Senegal. The upsurge of inflation has moreover led the central bank of South Africa — which represents 40 per cent of sub-Saharan Africa's GDP — to adopt monetary policy options not very favourable to growth, affected meanwhile by an energy crisis likely to become chronic over the next five years. In a context where the markets have less confidence in emerging countries, South Africa (downgraded to A4) has also been contending with tightening conditions for financing its current account deficit. On a more general level, there continue to be many structural weaknesses: Producer countries still do not sufficiently re-invest the oil wealth. With diversification of the productive fabric still embryonic the region remains vulnerable to a downturn of raw material prices. The weight of the farm sector gives rise to a dependence on weather conditions. Poor transport and energy infrastructure impedes productivity improvement. The high poverty level limits development of human capital. The difficult business environment deters foreign direct investment inflows. And political and social risks remain high with the many domestic or sub-regional uncertainties susceptible of compromising otherwise brighter outlooks (Côte d'Ivoire, South Africa).

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South Africa [Rated A3] On negative watch listing Reasons for the rating change: Economic growth is likely to slow markedly and fall below three per cent in 2008 amid an increasingly severe energy crisis that has prompted realignment of major energy intensive investment projects. The central bank's tight monetary policy, meanwhile, has proven completely ineffective in stemming surging inflation that originates abroad and that reached 10.2 per cent this June. The monetary tightening has nonetheless affected the economy (household consumption and private investment). The risk of a currency crisis has moreover remained acute in a context of stiffening conditions for financing a large current account deficit. With social risk increasing sharply amid insufficient redistribution of wealth, the emergence of a new leader of the ANC stokes uncertainties over South Africa's future economic options The economy held up well in 2007 under the tightening of monetary policy with growth climbing to five per cent, underpinned by investment and dynamic household consumption. The growth rate is expected, however, to drop below three per cent in 2008 with South Africa contending with an energy crisis attributable to a shortage of production capacity in relation to growing demand. This critical energy situation, which could drag on for the next five years, has already prompted a reassessment of energy intensive investment projects crucial to expanding South Africa's capacity for economic growth. The tighter monetary policy, which resulted in a 450-basis point increase in the repo rate between June 2006 and June 2008 and in stiffer credit conditions (National Credit Act), has begun to have a significant impact on companies and households — with defaults on debt contracted by households noticeably increasing in consequence. And continuing inflationary tensions (10.2 per cent this June) could further undermine consumer purchasing power especially with South African Reserve Bank's tight monetary policy proving ineffective in combating inflationary pressures with exogenous causes. In this context, the country's external financial position remains shaky. A current account deficit that exceeded seven per cent in 2007 will likely remain large this year despite the growth slowdown. The oil bill is expected to continue to weigh on the deficit as will capital goods imports needed for

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infrastructure projects. External financing needs are covered by volatile portfolio investments very sensitive to swings in confidence with respect to emerging markets. Exchange rate risk has increased in consequence. The rand thus depreciated 20 per cent against the dollar between December 2007 and March 2008. Exchange rate variations observed since April 2008 attest to the greater volatility of the South African currency. Besides, the social context is tense amid an insufficient distribution of wealth. And the xenophobic violence that broke out this June in the Johannesburg and Cap townships, causing nearly one hundred deaths and displacing tens of thousands of people was also a reflection of deep currents of frustration. The naming of a Jacob Zuma backed by the Communist Party and the unions to lead the ANC South Africa's main political party increases the uncertainty over the country's future economic and social policies.

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FINDINGS
1. INTRODUCTION Many Asian countries have been able to maintain rates of growth well above 6 per cent in real terms over the course of two decades. The Asian Development Bank reports that with the exception of Pacific developing countries, nearly all countries in Asia grew at more than 5 per cent in 2004 (Asian Development Bank 2005). Therefore one of the primary challenges for Asian governments and international partners in the coming decade is to ensure that growth continues in states where performance has been strong, and to increase growth in lagging regions and states where growth has been weaker. The trend in high growth described above has been possible in part due to high investment levels by both domestic and international firms (see Table 1 for selected Asian economies gross investment rates). A key element to ensuring future levels of growth and improvements in growth rates in areas where it has been absent is to continue improving the conditions under which firms are able to invest and reap reward from their investments, or strengthening the investment climate.

The investment climate is the broad set of political, economic, legal and physical factors which make a given country an attractive destination for foreign investment, and a place in which domestic entrepreneurs of all sizes and across industries are willing to invest. Thus, while the investment climate has many components, it is possible to subdivide the components into two primary sets of variables: governance and infrastructure. Governance refers to characteristics

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such as corruption, transparent judicial systems, favorable competition policy, etc. Infrastructure includes both hard infrastructure (irrigation systems, ports, roads, bridges, airports) and soft infrastructure (telephony, other technologies, etc.). In a number of countries, the Asian growth experience challenges commonly accepted paradigmsabout the relationship between investment conditions and growth. For example, while the extensive literature on the investment climate places a strong emphasis on gover nance, many of the countries in Asia have experienced both high growth rates and high levels of investment in the past two decades despite levels of corruption and regulations which are inconsistent with ‘best practice’ as defined in the literature. Thus, parts of the Asian region demonstrate that achieving growth is certainly possible without implementing a comprehensive set of investment climate reforms. However, this observation fails to take into account that substantial rates of growth and productivity may have been lost by having such arrangements in place. Research detailed in this paper shows that incremental improvements in the investment climate have a strong impact on growth rates. It is also worth noting that when looking at the micro data on the investment climate in the Asian region as a whole, there are few trends which appear to be consistent across the region. The investment climate varies dramatically among Asian countries as well as between cities, regions and industries. One of the few general features of the data is that the investment climate in South Asia has more infrastructure and regulatory barriers than does the investment climate in Southeast and East Asia (Rahman 2005). There is also indication in the micro data that two ‘priority’ components are the time it takes to get business done in many parts of Asia and severe infrastructure based constraints in some countries, regions and cities. This report seeks to evaluate the current progress on creating a favorable climate for investment in Asia. The first section is a conceptualization: it offers a definition of the investment climate and discusses individual components, looks at the empirical links between growth and the investment climate and raises the question of whether investment climate policy should be centralised or decentralised. The second section looks at how challenges to doing business vary across types of firms (from small family farms and other small enterprises to large domestic and multinational firms). The third section analyses the micro data on the investment climate in Asia.

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The final section takes a pragmatic approach to the investment climate by analysing the constraints and political economy costs of implementing investment climate as well as outlining potential partnerships which can be built both within the Asian region and among Asian governments and international agencies to facilitate evaluation and reform of the investment climate.

3.3. The Investment Climate and Multinational Corporations in Asia
The final sector to which the investment climate is a central concern is multinational corporations investing in Asia; which continue to increase in number. The investment climate is central to determining the flows of foreign direct investment, for example, which is a major source of GDP growth and foreign exchange earnings. FDI also encourages an increase in exports in many cases, and can lead to technology transfer to host countries. Within Asia, there is some difference between the attractiveness of individual countries for inflows of foreign direct investment. While China was the largest receiver of FDI in the world in 2003 (overtaking the USA), East Asia and South-east Asia in general receive a high proportion of FDI relative to their economic size than is warranted – i.e. the ratio of East Asia’s global FDI inflows to its share of global GDP is greater than one, and is in fact 1.54. The same metric for South and West Asia, in contrast was far below one: 0.37 and 0.31, respectively (Rahman 2005). Asian governments have implemented an array of policies designed to attract FDI, with varying degrees of success on both economic and social indicators.7 One policy tool used by many governments in the Asian region is the signing of bilateral investment treaties (BITs) which provide protection to multinational investors. Bangladesh, Hong Kong, India, Indonesia, Korea, Laos, Malaysia, Nepal, Pakistan, Philippines, Singapore, Sri Lanka, Thailand and most recently Vietnam have signed BITs with the UK and numerous other governments (UNCTAD 2000). In theory, BITs should act as a commitment mechanism, by which developing countries commit themselves to ‘safe’ treatment of foreign investment, in turn increasing the amount of investment a country with otherwise weak institutions or weak credibility receives. However, there is a tradeoff between the stability provided for investors by BITs and their constraint on governments (especially during times of economic and financial crises) and empirical evidence on the impact of BITs on attracting investment has been mixed. Some researchers have found that the

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attraction of FDI is positively linked to signing BITs, but that BITs act as a complement rather than a substitute for strong political and legal institutions (Hallward-Driemeier, 2003; Tobin and Rose-Ackerman 2005). Others have found a strong relationship between signature of BITs from certain home countries (e.g. the USA) and FDI flows (Salacuse and Sullivan 2005).

4. Analyzing the Current Investment Climate in Asia A more systematic view of the Asian investment climate can be obtained by analyzing sources for detailed empirical information about cross-national differences in the investment climate. Two such studies have been gathered by the World Bank: the Investment Climate Surveys (ICS) and the Doing Business Surveys (DBS). The two differ in terms of the sources of data, types of issues covered and periodicity.4 The ICS covers fewer countries as well (10 as opposed to 18). Using these two data sources in addition to some private sector estimates of business climate (e.g. the Economist Intelligence Unit or EIU) provides a good initial picture of how far Asian economies have gone in creating a conducive investment climate, and helps to identify areas in which challenges remain. That said a serious failing of the surveys is that they often fail to accurately reflect challenges faced by rural and agricultural firms in particular. As noted in the body of the paper, the investment climate in Asia can generally be subdivided regionally – East Asia has implemented more ‘best practice’ measures than South Asia, increasing the overall strength of the investment climate, though there are substantial differences within these regions. As one author notes: ‘South Asia imposes some of the highest regulatory obstacles to running a company in the world, second only to sub-Saharan Africa in the overall difficulty of doing business (McLeish and Martin 2005: 1). Nonetheless, the authors note that it is relatively easy to start a business in South Asia given the lack of minimum capital requirements and procedural Hurdles. While these trends tend overall, there is significant
4

While ICS analyses an array of variables through firm based surveys and categorizes information in terms of size of enterprises, as well as looking for differences within countries (by cities or regions), the DBS is compiled by interviewing legal, tax and finance professionals based in large business centers (generally national capitals) about the time and monetary costs of setting up and conducting business. It has been conducted and revised with greater frequency, given the easier access to data involved.

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variation among countries even within Asian sub-regions, among elements of the investment climate within single countries, and even variation within regions of single countries, as the below graphic on the investment climate within Chinese cities demonstrates (Figure 2). As such, the remainder of this section attempts to categorize countries along investment climate issues (economic and political risk, rule of law, infrastructure, etc.) so as to get a better picture of the investment climate in Asia as a whole.

4.1. Governance
4.1.1. Economic and Political Stability
While the introductory section demonstrated that macroeconomic and political uncertainty were strong drivers of negative perceptions of the investment climate, in most of Asia, these two elements of the investment climate play a less central role. None of the firms thought that policy uncertainty was the

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largest problem in the countries surveyed, though macroeconomic instability was the top concern in Indonesia and the Philippines.9As is demonstrated in Figure 3, there is substantial variation in the perception of macroeconomic and political instability among Asian countries covered in the ICS. Both variables are of the largest concern in Indonesia, 10 and are notably lower in both India and China. One interesting note is that larger Chinese firms (250+ employees) more often said that economic and regulatory policy uncertainty were a major or very severe obstacle to business than other types of firms. There was little variation among sectors. The same was true to a lesser degree for India, though those in the garment and textile sectors were considerably more concerned about such risks.

Figure 1: Percentage of firms reporting political or economic risk as impediment to business

Interestingly, according to the Economist Intelligence Unit (EIU) which looks at such issues from perspective more oriented towards international investors, the risk in Indonesia is thought to be less than that in Pakistan and China, for example. Additionally, it is worth noting that political stability and government effectiveness is consistently thought to be a significantly larger problem across Asia than macroeconomic risk, with the exception of Japan.
Figure 2: Economic and Political Stability as measured by the EIU

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4.1.2. Rule of Law
Figure 3 attempts to compare Asian economies across corruption, crime theft and disorder, anticompetitive practices, and the strength of the judicial system (where a higher indicator shows confidence in the judicial system – in contrast to the rest of the indicators). Confidence in the judicial system is pronounced in China, India, Indonesia, the Philippines and Sri Lanka. In India confidence in the judiciary was markedly different between foreign and domestic investors, as the former had greater faith in the judicial system to enforce their claims (71 per cent as opposed to 56 per cent). In China both domestic and international firms had about 80 per cent confidence in the judicial system. There is little indication in the surveys whether perception of rule of law varies among small and rural investors, who may have heightened concerns about the arbitrariness of local systems of justice. Also notable from Figure 5 is that the perception of corruption is much higher in Bangladesh and Cambodia than in the other Asian countries surveyed. This is consistent with Transparency International’s (TI) Corruption Perception Index, which ranks these two countries last (Bangladesh and Chad tie for most corrupt) and 130 out of 158, respectively. Pakistan is perceived as significantly more corrupt under TI’s indicators: 144 out of 158.11 similarly, the perception of anticompetitive practices and crime, theft and disorder in Bangladesh and Cambodia are higher than in other countries by some margin.

Figure 3: Percentage of firms reporting rule of law as an impediment to business in Asia

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4.1.3. Tax and Regulations The metrics for analyzing regulations in Asia are best analyzed by looking at results from the Doing Business Survey, which covers a wide array of Asian countries. Tables 2, 3 and 4 present selected information from the DBS according to region. It is interesting to note that within South Asia, it is more difficult on some metrics to do business in India than in Bangladesh, in contrast with the statistics above.

Table 3 focusing on South-east Asia demonstrates that while it is easier to start and close a business in Malaysia and Thailand than elsewhere in the region, it can still take a significant amount of time to process a license, and few gains are made on import and export days. Singapore’s performance on such

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indices stands out – as do the tax statistics for Vietnam, where there are 44 types of payment and it takes more than 1,000 hours to pay taxes.
Table 3: Doing business in South-east Asia

The following group of East Asian countries and territories represent a mix of high income countries and developing countries, and generally doing business in this region seems easier than in most of South or South-east Asia (with the exception of Singapore). China’s metrics are comparable to Sri Lanka’s and still some ways from South-east Asian countries such as Malaysia or Thailand, as well as most other East Asian comparisons.
Table 4: Doing business in East Asia

The ICS also provides information about the role of tax rates and administration, as well as adding some information about business customs, licensing and permits. In Figure 6, Pakistan and Bangladesh appear in particular to have difficult investment climates; tax rates are considered to be a greater burden in China than in India, as are customs and business licensing requirements. This illustrates that the perceptions are slightly different from those obtained through interviewing tax, legal and business specialists in capital cities (the data source for the DBS). The information from the EIU has findings closer to that of the DBS in terms of the India /China comparison, suggesting that the different perceptions could come from foreign

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versus domestic perspectives on tax and regulation. The complete EIU risk rankings are shown in Figure 7.
Figure 6: Firms reporting tax or regulatory issues as an impediment to business in Asia

4.1.4. Labour Policies

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Labour policies impacting the investment climate can be broadly broken into two categories: indicators of skills and diversity of the workforce, and the extent to which the labour market is flexible in terms of regulations to hire and fire. As suggested in a previous section, the second set of labour market indicators are easier for the government to directly, and quickly, impact. In terms of market flexibility, a difference is again detectable between South Asia and East/Southeast Asia. According to the DBS, within South Asia, average hiring costs are 5.1 per cent of salary and firing costs are equivalent to 75 weeks of wages. In East/South-east Asia, hiring costs as slightly more (8.8 per cent of salary), but firing costs are significantly lower at 44 weeks of wages on average. That said the firing costs in China are as high as South Asia, at 90 weeks of wages, with an extraordinarily high 30 per cent salary cost to hire. The DBS ‘rigidity of employment index’ (the average of difficulty of hiring index, rigidity of hour’s index and difficulty of firing index) is compared for some key economies in Table 5.

The ICS survey gives a blended view of these two types of labour policies for surveyed countries: interestingly, more firms are concerned about skills and education of workers in China than in other countries surveyed by a significant margin. Even more interesting is that a higher percentage of domestically owned firms cite this as a major or severe obstacle to doing business than do international investors.

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Additional information on the social indicators of labour policies can be obtained through the ICS. Table 6 categorises skills and social indicators of labour across several economies. Notice that the level of training provided in China is much higher than in other economies, and that Pakistan is the only country to provide figures on the role of women in senior management.

Finally, the EIU provides a metric of labour market risk, showing that risk is highest in Vietnam and Indonesia; labour market risk in China and India is high and identical.

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4.2. Infrastructure
4.2.1. Infrastructure Constraints Infrastructure constraints in South Asia are perceived to be significantly more severe than in Southeast and East Asia. The data for Bangladesh in particular is striking: the ICS reports that the delay in obtaining an electrical connection in Bangladesh is 80 days and electrical outages are reported nearly 250 days a year. The time to obtain an electrical licence in India is even longer (82 days), though no data is available on the degree of power outages. These statistics are less severe, though still concerning, in other South Asian states.
Comparative statistics on South Asia are available in the Table 7.

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Figure 10 demonstrates that electricity is thought to be by far the largest constraint to business in Asia (note that the problem is perceived to be more acute in China than in India). Though no data is available for China on days of electrical outages, a significantly smaller percentage of sales are said to be lost through electrical outages (1.9 per cent).

4.2.2. Finance
Access to finance in Asia depends both on country and industries, and there is a large amount of information about such constraints in the Asian context. First, the ICS provides descriptive information about the availability and efficiency of finance in various countries (shown in Table 8).

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These statistics, however, obscure significant differences in access to credit across size of businesses and sectors. Table 9, shows the collateral needed and overdraft statistics for the same countries by size of firm 2

As Table 9 shows, small firms face obstacles in almost all countries to accessing an overdraft, and in many cases, collateral rates are higher for small firms than in medium and large firms. More broadly, the firm perception surveys from the ICS provide a sense of the overarching constraint of finance to the country: cost and access to financing are particularly problematic in Bangladesh and Pakistan.

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BFIA/IV SEM/PAPER NO. XVII S.S.College of Business Studies, University Of Delhi

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CONCLUSION
Investing in Asian markets is secure as there is huge market leading to huge potential to grow, and also concluded to be most safe place for investment as the recent developments in United states, Japan and most of Europe suggests. GDP growth should lose slightly over a point (7.6 per cent expected for 2008 down from 8.9 per cent in 2007) due to the slowdowns in the United States, Japan, and Europe in the wake of the subprime crisis. Emerging Asia will thus prove relatively resilient thanks to the growing influence of domestic demand on the growth dynamic and the financial solidity of most regional countries. The good regional performance moreover substantially reflects the excellent results achieved by China and India, which represent 55 per cent of emerging Asian GDP. The regional countries with the most open economies — Hong Kong, Singapore — should suffer most, however, and could lose two to three points of growth due to the slowdown of their exports. Taiwan also remains vulnerable with its dependence on the United States' economic cycle. China's economic development meanwhile is pregnant with risks as evidenced by the disquieting signs of overcapacity — especially in steel, the automotive industry, distribution, and property — and overheating. After reaching 6.5 per cent in 2007, inflation surged again in the first half this year (8%). With government officials concerned about the resulting social repercussions, they will likely step up the monetary tightening, the pace of the yuan appreciation, and measures that are administrative in nature (like price freezes, and so on). Surging inflation has also prompted India to tighten monetary policy, which should ultimately undermine growth. In the financial area, external over-indebtedness risk has remained limited throughout the region. Large current account surpluses have, however, tended to flood stock, property and credit markets with liquidity. After rising sharply in 2006 and 2007, Asian stock market indices have fallen thus far this year reaching levels comparable to those observed in summer 2007. Despite the downturns, price earnings ratios have remained high, which tends to suggest the continued presence of speculative bubbles. In China, the PER for section A on the stock

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exchange still exceeds 60. The ratios also remain high in India (20 times earnings) and Indonesia (21). In this context of overvalued stock exchanges the increased volatility observed in the first quarter this year is expected to continue throughout the year.

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ANNEXURE - 1
CALCULATING COUNTRY RISK OBSERVED BY BETAS

Market participants may observe that world markets have been moving in a synchronized fashion due to technical reasons such as capital flows as well as the increasingly interconnected nature of country-specific macro economic environments. Can we properly measure individual country risks? Or, has the country risk become less important given the global roller coaster nature of the financial markets? There are various ways and methodologies of measuring country risks. Yet as far as stock market movements are concerned, we should keep in mind that as markets are more integrated than ever, it is very likely that stocks of many of these countries will go up and down depending on the daily momentum observed in the world markets. When Asian markets have a good day, it may be an extension of the good mood in the U.S., which may or may not be followed by European markets. The trend may continue or change course depending on global economic developments of the day. For instance, Istanbul Stock Exchange opening depends on how Asian markets have done and on expectations of what Western markets are going to do later in the day. Turkish stock market is influenced by daily expectations related to the U.S. economy in terms of macroeconomic data to be announced later in the day. Also percentage moves up or down are generally sharper and more volatile than those observed in the world markets in general. If you have been following a foreign market closely, you may have noticed similar observations. Certain country performances have been more volatile than others. Also as the global markets have become more volatile, the correlations between countries have increased.

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THE INTERNATIONAL CAPITAL ASSET PRICING MODEL
In the Capital Asset Pricing Model, a stock’s beta signifies the risk of that stock with respect to the market. Beta is directly proportional to the correlation of the stock return to that of the market as well as its relative volatility with respect to the market. It’s a measure of the stock risk for one unit of market risk. The higher the risk of stock with respect to the market, the higher the expected compensation of the investor with respect to the particular stock. To keep the matters simple, a high beta signifies high risk, while a low beta signifies low risk. The beta of the market itself is one. The International Capital Asset Pricing Model is the extension of the Capital Asset Pricing Model where the risk of a specific country can be specified in a likewise fashion with respect to a chosen world index. I wanted to compare the daily moves of all markets and calculate the observed country risks in terms of betas to see how risky one country is with respect to another. That way I would have a valid methodology to rank countries because I could quantify market risks. The easiest way for me to come up with the betas was to regress the equity returns of individual countries to the world index of my choice. I wanted to keep the variables as simple as possible in order to include as many countries as possible in this study. I wished to come up with a riskranking system for the stock markets of all countries for which there is trading data available. Calculating country betas is not the only way to compare country risks and it is entirely dependent on past stock returns as well as the global market index returns one chooses to compare the performances to. There are many criticisms of the beta measurement as well as the CAPM theory in general, and I will state a few of them here. For instance, beta will vary depending on the time frame chosen, which may make it unreliable depending on the degree of change. Beta also captures “systematic” risk only, and thus it may give an incomplete picture of the total risk that includes unsystematic risk. While there is no guarantee that the future beta will look like the past data, it’s a reasonable indicator (as good as any) of the risks one can expect in a certain market. There are different ways of calculating country betas, and they may involve more sophisticated models than the good-old fashioned OLS regression that readers may have seen in an econometrics class. I wish to keep this article accessible by many, so I will keep such terminology to a minimum. But suffice it to say that such models may explicitly state a country’s degree of non-integration to the world market and involve various country-specific factors ranging from the level of interest rates, inflation and the like. They may also include other global information variables to further specify world risk. Yet the more sophisticated the model is, the stronger the false sense of security becomes and the more difficult it is to evaluate its shortcomings. Not to mention that such complexities in the

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model specification would have led me to decrease the number of countries in the study because of data issues, and the depth of the model would have necessitated concentrating on a region or a limited number of countries. I wanted breadth rather than depth. So what we have done was still data intensive, but more straightforward. DATA, METHODOLOGY AND RESULTS I used index data available at the Standard & Poors Index Services where they keep daily data for closing index prices of many countries for which trading data exists. For the series of regressions to be performed, I calculated daily returns of all countries in terms of U.S. dollars. The country “betas” are calculated by regressing each index return against the global equity portfolio. Beta is estimated as the slope of the fitted line from the linear least-squares calculation. I wanted to experiment with data that was available. Knowing that markets have become more volatile in the past year or more, I calculated each country beta in two ways: 2-year betas involved 522 observations (daily returns) covering the past two years from December 4, 2006 until December 2, 2008. 10-year betas, on the other hand, involved 2610 observations from December 2, 1998 until December 2, 2008. Given the lack of data for some of these periods, I had to exclude the following countries: Pakistan, Jordan, Nigeria, Slovenia, Columbia, Iceland, and Luxembourg. I did calculate betas for those countries for which there were adequate observations. However, either due to lack of significant t-values to validate the beta coefficients, or due to other extraordinary issues such as the collapse of the Icelandic market I decided to exclude these countries from the various data matrices I designed. Luxembourg was excluded due to the fact that the equity index houses 10 stocks with 3 firms making up more than 60% of the index and some 45% of the weighting belongs to bank stocks headquartered in Belgium, thus making the calculated beta meaningless. (Note: the weights may have shifted but the idea is that the beta of such an index is not representing the “risk” associated with the country of Luxembourg). In order to make sure that there were no errors within the Excel regression package, I checked the betas by multiplying the correlation coefficients of all countries (with respect to the world index) by the relative standard deviation of the each country. This was also a good way to see the composition of the beta of each country. An example of the display for the country of Brazil is given below:

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Note: This regression is done with daily beta, thus the standard deviations seen above represent daily numbers. Numbers are rounded to two decimal points, so if you do the math above you may find that the Brazilian beta is 1.79. This error is due to rounding. Brazilian markets indeed exhibited the highest daily beta for the last two years. Series of regressions covering the tenyear time frame also put Brazil at the top of the list in terms of beta. Another interesting but predictable observation is that two-year betas for almost all countries are considerably higher than their respective ten-year betas. This is due to the fact that both correlations as well as individual country standard deviations have increased recently. But note that the global standard deviation placed at the denominator has also increased. If you look at the composition of the betas, you may see the contribution of various parts of the equation to the betas themselves.

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Notable observations include high-beta countries, specifically Brazil, Hungary and Turkey. The emerging nature of these markets attract attention, however some developed markets have also registered riskier betas such as Norway, Austria, Sweden. On the other hand, Mexico, Russia and Argentina are also among the notable emerging markets with higher than average betas. All of these high-beta countries exhibit higher correlations as well as higher than average standard deviations. A lot of European markets have registered a beta closer to one, which indicates that these markets exhibit an average risk with respect to the rest of the world. The U.S. market with a beta of 1.06 seems to exhibit average risk with respect to the rest of the world as well. However, this is mainly due to the fact that American stock market is the largest constituent of the global market index. Indeed, when the U.S. stock returns are regressed against a global index that excludes the U.S., the resulting beta is 0.57 with an observed correlation of 0.49 as opposed to the high correlation of 0.84 of the original regression. This indicates that the U.S. market beta

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above is overstating the U.S. market risk. According to the beta of the second regression, the U.S. is actually towards the bottom of the list of these countries. Asian countries are the winners of this exercise in terms of lower risks associated with their markets. It is remarkable that some of the “emerging” markets of the Asian region have registered lower betas associated with a lower degree of risk, among them Thailand, Philippines, Taiwan, and Malaysia. Hong Kong showed a lower beta than I expected, and the presence of Japan towards the bottom of the list with a beta of 0.41 was another surprise for me. Among the lower beta countries were those of the Middle East and North Africa, namely Israel, Egypt, and Morocco. I must add that Jordan, Pakistan, and also Nigeria would have made it into the bottom of the list if I had included the results I was able get from the regressions I ran (notwithstanding some insignificant t-statistics associated with the regressions). I may include these countries in a following write-up if I am able to get hold of more complete data sets.

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Ten-year table country betas are strikingly lower than their respective two-year betas. There are a few exceptions: Finland occupies the second place in the ten-year list with a beta of 1.29 whereas during the last two years, its beta has decreased to 1.10 placing it towards the middle of the same list. Even more interesting is the fact that Israel registered a beta of 0.78 for the last ten years whereas its beta has fallen to 0.42 during the present time when the world has become a more volatile place. Japan seems to have resisted the trend somewhat but its tenyear beta of 0.46 is not strikingly different from its two-year beta of 0.41. Brazil occupies the first place in both tables as the riskiest of the bunch. Furthermore, a quick look at the former ranks at the ten-year table shows that Turkey, Hungary, Russia, and Norway have gained significant risk in terms of their respective betas during the last two-years. Turkey and Russia deserve extra attention in terms of their standard deviations for the last ten years. Despite the fact that Turkey registered the highest daily standard deviation of 3.33% during the

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last ten years, its relatively low correlation of 0.32 managed to keep the country from occupying a higher rank. This was also true for Russia who had the second highest standard deviation of 2.65% and a somewhat lower correlation of 0.41. However, during the last two years, the correlations of these two countries have increased to 0.69 and 0.62 respectively, thus placing their betas higher on the two-year list. The higher beta associated with the U.S. is misleading in this list as well. Indeed, when ten-year U.S. returns are regressed against global returns excluding the U.S., the resulting beta is 0.57 (same as the two-year beta) with a correlation coefficient of 0.46. Asian countries occupy lower ranks in the ten-year list as well. Among them are emerging (or so classified) markets of India, Indonesia, Thailand, Taiwan, Philippines, and Malaysia, besides the developed markets of Japan, Hong Kong, and New Zealand. Egypt and Morocco occupy the last two places in the ten-year list similar to the pattern observed in the two-year list. Conclusion An obvious conclusion of this exercise is that country risks have increased over the past two years when compared with ten years of data. It would be interesting to do the same study with weekly or monthly data as well, and perhaps by going back further in time. However, going back further in time risks capturing certain fundamentals or situations that no longer exist in today’s marketplace. Increased correlations due to the effects of globalization are examples of such fundamental or “regime” changes. Another notable observation of this exercise is that certain countries manifest higher risk than others on a consistent basis. The results of this exercise have captured what has been familiar to careful observers of world markets. As the Capital Asset Pricing Theory suggests, higher risk results in higher return expectations on the part of investors. Thus a higher risk should be evaluated according to return expectations of these countries. Conclusively, it may be a valid decision to invest in countries (or stocks) that exhibit higher levels of risk depending on long-term growth expectations, cheap valuations exhibited by fundamentals, or both. Yet another remarkable observation of this exercise is that there are emerging markets with higher expectations of return that also manifest lower risk. Certain emerging markets of Asia as well as North Africa and the Middle East have exhibited lower risks as measured by their betas. An inference of this study (or so I reckon) is that if all else is equal, it is more advisable to invest in nations with higher than average growth potential that also show a low degree of risk with respect to the world markets. The diversification effects are also valuable. Of course, all else is never equal and such quantitative studies should always be complemented by fundamental analysis as well as due diligence.

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A disclaimer related to this exercise should be announced in the sense that today’s high-risk countries may become tomorrow’s low-risk ones as well. Nevertheless, given what we can observe in the world markets today, investors should evaluate whether their return expectations are worth the risks. Source: http://www.euromoney.com/Article/2077030

Selection of an Economy for Investment - Critical Issues & Challenges