Multinational Finance Chapter 6: Country Risk Analysis

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

FIn 763: Lecture 2

1

Today’s plan
PART 1: THE MEASUREMENT OF POLITICAL RISK • The consequences of political risk • Quantitative measures to evaluate Political Stability • Economic Factors • Subjective Factors PART II. ECONOMIC AND POLITICAL FACTORS • Economic and Political Factors Primary focus: How well is the country doing economically? PART III. COUNTRY RISK ANALYSIS IN INTERNATIONAL BANKING

FIn 763: Lecture 2

2

PART I. THE MEASUREMENT OF POLITICAL RISK

I. MEASURING POLITICAL RISK
A. The consequences of political risk:
1. Expropriation 2. Currency or trade controls 3. Changes in tax 4. Changes in labor laws 5. Regulatory restrictions 6. Requirement for additional local production Common denominator: Government intervention into the working of the economy that affect for good or ill the value of the firm
FIn 763: Lecture 2 3

THE MEASUREMENT OF POLITICAL RISK

B. Quantitative measures to evaluate Political Stability
1. Measured by: a. Frequency of government changes b. Level of violence c. Number of armed insurrections d. Conflict with other states
FIn 763: Lecture 2 4

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

All this factors determine weather the economy is in good shape or requires a quick fix, such as expropriation to increase government revenues or currency inconvertibility to improve the balance of payments.
FIn 763: Lecture 2 5

THE MEASUREMENT OF POLITICAL RISK
A.

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

FIn 763: Lecture 2

6

THE MEASUREMENT OF POLITICAL RISK

Causes of capital flight
  

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

The importance of capital flight as a measure: If the local citizens do not trust the government, then investment there is unsafe.

FIn 763: Lecture 2

7

THE MEASUREMENT OF POLITICAL RISK

What is needed to halt capital flight?
2. 3. 4.

5. 6.

Cutting budget deficits Cutting taxes Removing barrier to investments foreigners Selling state owned enterprises Avoiding currency over valuation

by

FIn 763: Lecture 2

8

THE MEASUREMENT OF POLITICAL RISK

FIn 763: Lecture 2

9

PART II. ECONOMIC AND POLITICAL FACTORS
II. Economic and Political Factors Primary focus: How well is the country doing economically? A. Fiscal Irresponsibility
The government deficit as a percentage of gross domestic product: the higher this figure, the more the government is promising to its citizens relative to its resources high government deficits lowers the possibility that the government can meet its promises without resorting to: • Expropriation of property: Capital flight and dry up new investments. • Raising taxes: affect incentive to work, save and take risks • Printing money: monetary instability, high inflation, high interest rates and currency depreciation
FIn 763: Lecture 2 10

PART II. ECONOMIC AND POLITICAL FACTORS

B. Monetary instability

• •

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

FIn 763: Lecture 2

11

PART II. ECONOMIC AND POLITICAL FACTORS

C. Controlled Exchange Rate System • Currency control is used to fix the exchange rate. • Goes hand with hand with an overvalued local currency
• •

(equivalent of taxing exports and subsidizing imports) The risk of tighter currency controls and the treat of devaluation encourage capital flight Leaves the economy with little flexibility to respond to changing relative prices and wealth positions

FIn 763: Lecture 2

12

PART II. ECONOMIC AND POLITICAL FACTORS

D. Wasteful Government Spending

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

• • •

Scientist Engineers Management talent

FIn 763: Lecture 2

13

ECONOMIC AND POLITICAL FACTORS

E.

Country Risk and Adjustment to External Shocks 1. What are the impacts of external shocks: - how well a nation responds varies

FIn 763: Lecture 2

14

ECONOMIC AND POLITICAL FACTORS
1.
• • • •

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

• • • •

FIn 763: Lecture 2

15

ECONOMIC AND POLITICAL FACTORS

3. Key indicators of economic health a. Structural incentives b. Legal structure c. Clear incentives to save d. Open economy e. Stable macroeconomic policies

FIn 763: Lecture 2

16

PART III. COUNTRY RISK ANALYSIS IN INTERNATIONAL BANKING
I.

Country Risk and the Terms of Trade

What ultimately determines a nation’s ability to repay foreign loans? - Its ability to generate U.S dollars and other hard currencies which based on a nation’s “terms of trade”. When the terms improved foreign goods becomes relatively less expensive and the standard of living rises and consumers and business become more dependent on imports - the speed of adjustment
FIn 763: Lecture 2 17

COUNTRY RISK ANALYSIS IN INTERNATIONAL BANKING
II. The Government’s Cost/Benefit Calculus

- debt to wealth ratio - cost of default: the likelihood of being cut off from international credit A bailout decision: depend on the : - nation’s geopolitical importance to the US - The probability that the necessary adjustment will result in unacceptable political turmoil -fluctuations in the terms of trade depends on - degree of product diversification

FIn 763: Lecture 2

18

COUNTRY RISK ANALYSIS IN INTERNATIONAL BANKING
I.

Lessons from the International Debt Crisis of 1982
The crises began in Aug 1982, when Mexico announced that it was not able to met its regulatory scheduled payments to international creditors. The crises began in Aug 1982, when Mexico announced that it was not able to met its regulatory scheduled payments to international creditors. Soon Argentina and Brazil found themselves in a similar situation

Economic reforms that work:

• • • • •

Strong head of state Viable economic plan Competent economic team Support “at the top” Sell the program to all levels of society
FIn 763: Lecture 2 19

Quiz-1

1. One good indicator of political risk is a. the seriousness of capital flight b. the level of local interest rates c. the level of local tax rates d. a large middle class population

FIn 763: Lecture 2

20

Quiz-2:

risk

key indicators of country

The state’s best strategy is to provide basic _________ in order to promote economic growth. b) health care services c) lifelong pensions for its workers d) economic and political stability e) natural resources
FIn 763: Lecture 2 21

Quiz-3:

risk

key indicators of country

The economic experiences of Mexico, Chile, and Argentina in the recent past show that they all possessed a_________. b) a political party system of many factions c) a loosely drawn economic plan that is allowed to evolve over time d) a political lead who is more of a manager than a leader e) a head of state who demonstrates strong will and leadership
FIn 763: Lecture 2 22

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

FIn 763: Lecture 2

23

Quiz-5: Measuring political risk
Which one of the following is NOT a form of direct political risk to the multinational corporation?
b) c) d) e)

currency controls privatization of public utilities changes in tax or labor laws regulatory restrictions

FIn 763: Lecture 2

24

Quiz-6: Measuring political risk
During the 1980s many Latin American countries believed in a policy that economic growth was best promoted by extensive state ownership which led to b. capital flight c. increased growth in GDP d. rampant deflations e. import subsidies
FIn 763: Lecture 2 25

Statistical Models
Commonly

• Debt service ratio: (Interest + amortization on

used economic ratios:

debt)/Exports • Import ratio: Total imports / Total FX reserves • Investment ratio: Real investment / GNP • Variance of export revenue • Domestic money supply growth

FIn 763:02/11/08 14:47 Lecture 2

26

26

The Supervisor of Banking Attitude to Country Risk

The Office of the Comptroller of the Currency Board of Governors of the Federal Reserve System Federal Deposit Insurance Corporation

FIn 763: Lecture 2

27

Definition of country risk

• • • •

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

FIn 763: Lecture 2

28

El ement s of an Ef fecti ve Countr y Risk Managem ent Process
A sound country risk management process includes:  Effective oversight by the board of directors,  Adequate risk management policies and procedures  An accurate system for reporting country exposures  An effective process for analyzing country risk  A country risk rating system  Established country exposure limits  Regular monitoring of country conditions  Periodic stress testing of foreign exposures  Adequate internal controls and audit function.

FIn 763: Lecture 2

29

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

    

FIn 763: Lecture 2

30

Coun try Exp osure R eportin g Sy ste m

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

FIn 763: Lecture 2

31

Coun try Ris k R at ings

Country risk ratings summarize the conclusions of the country risk analysis process. The ratings provide a framework for establishing country exposure limits that reflect the institution's tolerance for risk.

FIn 763: Lecture 2

32

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

FIn 763: Lecture 2

33

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

FIn 763: Lecture 2

34

Facto rs A ffe ctin g C ou ntry Risk

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

FIn 763: Lecture 2

35

Soc ia l, Politic al a nd Le gal Clima te
      

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

FIn 763: Lecture 2

36

What Factors do Ratings include?

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

FIn 763: Lecture 2

37

What Factors do Ratings include?

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

FIn 763: Lecture 2

38

Sovereign Ratings Methodology Profile
1. 2. 3. 4. 5. 6. 7. 8.

Political Risk Income and Economic Structure Economic Growth Prospects Fiscal Flexibility Public Debt Burden Price Stability Balance of Payments Flexibility External Debt and Liquidity
FIn 763: Lecture 2 39

Sovereign Credit Ratings
S&P Investmentgrade AAA AA A BBB BB B CCC CC C D Moody‘s Aaa Aa A Baa Ba B Caa Ca C D Highest quality High quality Strong payment capacity Adequate payment capacity
Likely to fullfill obligations,uncertain

Speculativegrade „Junk bonds“

High-risk obligations

Default

FIn 763: Lecture 2

40

Major Impacts

Signalling: refers to providing new information to the market to lower cost of capital

 Certification:

• •

refers to eligibility with regard to portfolio standards issued by public regulators Importance of splitting ratings into

investment grade speculative grade: junk bonds
FIn 763: Lecture 2 41

Sovereign Ratings: Impact on Capital Flows and Other Rated Institutions
 International

pool of investors: private capital inflows - liquidity  Usually, no corporation higher rated than sovereign

• Agencies: all entities are influenced by same •
macroeconomic situation Pressure on corporations‘ ability to raise money
FIn 763: Lecture 2

42

Sovereign Ratings: Basic Considerations
 Two-way

• Ratings influence spreads and vice versa • Are ratings able to anticipate financial crises
or do they just react on changed indicators?

causuality

 Anticipation

versus Reaction

 Reinforcement

of business cycles  Information processing into one figure:

• Are agencies able to process more
information than the market?
FIn 763: Lecture 2

43

Can Sovereign Ratings Anticipate Financial Crises?
 Response

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

FIn 763: Lecture 2

44

Sovereign Ratings: Argentina
Local Currency Rating Date 06.11.01 30.10.01 09.10.01 12.07.01 06.06.01 08.05.01 26.03.01 19.03.01 14.11.00 31.10.00 10.02.00 22.07.99
Source: Standard & Poors

Foreign Currency Rating Long Term/Outlook/Short Term SD/Not Meaningful/C CC/ Negative/C CCC+/Negative/C B-/Negative/C B/Negative/C B/CW Neg./C B+/CW Neg./B BB-/CW Neg./B BB-/Stable/B BB/CW-Neg./B BB/Stable/B BB/Negative/B

Long Term/Outlook/ShortTerm SD/Not Meaningful/C CC/Negative/C CCC+/Negative/C B-/Negative/C B/Negative/C B/CW Neg./C B+/CW Neg./B BB/CW Neg./B BB/Stable/B BBB-/CW-Neg./A-3 BBB-/Stable/A-3 BBB-/Negative/A-3

FIn 763: Lecture 2

45

Differences Between Sovereign and Corporate Ratings
 Information  Political

• Publicly available versus private information • Willingness to repay • Absence of a supranational regulating body • Importance of non-quantitative factors in •
assessing country risk (Emerging markets!) Crises
FIn 763: Lecture 2 46

risk

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

FIn 763: Lecture 2

47

Credit Spread as a measure for country risk
 One

convenient measure of country risk is provided by yields on sovereign debt.  The difference in the yields on the public debt of two countries reflects a country risk premium
FIn 763: Lecture 2 48

Country or Sovereign Risk

Sovereign Debt Spread over U.S. Treasury Securities Country Spread Country (basis points) China 138 Mexico Russia 188 Indonesia Philippines 226 Brazil South Africa 254 Venezuela Poland 258 Argentina Uruguay 341 Nigeria Source : Bloomberg, August 30, 2001

Spread (basis points) 441 539 1151 1201 1581 1973

FIn 763: Lecture 2

49

Strategies for managing country risk
Negotiate the environment with the host country prior to investment The investment environment: • Taxes • Labor issues • Concessions • Obligations and restrictions • Provisions for planned investment divestiture • Performance assurances and remedies • International arbitration of disputes

FIn 763: Lecture 2

50

Strategies for managing country risk
•Negotiate the environment with the host country prior to investment •The investment environment •The financial environment •Structure foreign operations to minimize country risk while maximizing return •Obtain political risk insurance

FIn 763: Lecture 2

51

Political risk insurance
Insurable political risks include Expropriation due to • war • revolution • insurrection • civil disturbance • terrorism Currency inconvertibility

FIn 763: Lecture 2

52

Political risk insurers
Government export credit agencies U.S. Overseas Private Investment Corporation U.K. Export Credits Guarantee Department International World Bank Multilateral Investment Guarantee Agency Private Lloyd’s of London American International Group (AIG)

FIn 763: Lecture 2

53

Political risk insurance

MNCs are self-insured if their risk exposures are diversified across a large number of countries

FIn 763: Lecture 2

54

*Debt-equity

swaps

• Example:

• Citibank sells $100 million Chilean loan to Merrill Lynch

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

FIn 763: Lecture 2

55

55

The evidence on country risks and investors’ required returns

An increase (decrease) in country risk tends to be followed by a stock market fall (rise) • Countries with high country risk have • more volatile returns •lower betas (systematic risks) Claude Erb, Campbell Harvey and Tadas Viskanta, “Political Risk, Financial Risk and Economic Risk,” Financial Analysts Journal, 1996.

FIn 763: Lecture 2

56

Resources

• Human development report
•http://hdr.undp.org/en/statistics/

FIn 763: Lecture 2

57

Resources: S&P

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

FIn 763: Lecture 2

58

Resources: S&P

FIn 763: Lecture 2

59

S&P Criteria for rating

FIn 763: Lecture 2

60

Moody’s Criteria for rating
Ten Year Average Cumulative Default Rates Aaa 0.7% Aa 0.8% A 1.8% Baa 4.7% Ba 18.4% B 36.7% Investment Grade 2.4% Speculative Grade 24.8%

FIn 763: Lecture 2

61

The BIS

•Report of the BIS: Bank for international settlements http://www.bis.org/forum/research.htm

FIn 763: Lecture 2

62

Sign up to vote on this title
UsefulNot useful