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Country Risk Analysis March 26, 2010

Posted by Chetan Chitre in International Business Management, International Finance.
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Introduction

An International Business is exposed to various types of risks.

(i) Business risks – related to uncertainties and cycles within the sector that one is operating in eg. availability of raw material, supply chain snags, etc.

(ii) Counter-party risks – arising due to a default by the other party in honoring contractual commitments.

(iii) Environmental Risks – arising from general business environment such as global business cycles, climatic changes, changes in interest rate scenarios, general inflation, etc.

Country Risk may be classified as a specific type of environmental risk i.e. it’s source is the general business environment of a country that one is operating in.

In International Business one is often operating across different countries. Socio-political and economic environment in these different countries is therefore of concern to International Business. Change in these parameters may put an International Business to various kinds of risks.

Examples of situations where Country Risk could play an important role –

# Portfolio investment done in another country may suffer loss if the Share prices tumble because a certain party came to power in general elections

# A military dictator after coming to power announced that all foreign nationals should be deported within 24 hours. The management of MNC had to leave in haste and did not find time to sell FDI invested in the country take out the funds.

# A country suffered Balance of Payment Crisis as a result of which the currency depreciated sharply. Profits in that currency therefore lost value when converted to another currency.

Agencies that are internationally known for their Country Risk Analysis are – Standard and Poor and Moody’s. These agencies review countries regularly on various parameters and rate them from a business risk perspective.

In some ways the exercise is similar to a corporate rating exercise done by agencies like CRISIL, ICRA, Fitch, etc.

Country Risk Analysis – Defined –

“Study of business environment in different countries with an objective of predicting the likelihood of various kinds of risks that businesses operating in those countries may face. The term ‘business environment’ is defined by a certain set of predetermined and observable social, political and economic variables. ”

Time and Purpose

Country Risk Rating is (i) time and (ii) purpose specific.

The time dimension would mean that the concerned Country has been analyzed at a specific point of time and the rating is based on the situation prevailing at the particular point of time.

Further, different sets of users would look at different aspects of a country depending on their respective needs. Eg. –

(i) An investor in stock market portfolio of country A

(ii) A manufacturer exporting his products to country A

(iii) An MNC having its production facilities in country A

Each of the above users would be interested in knowing different aspects of a country’s social, political and economic performance.

Factors Affecting Country Risk –

Factors affecting Country Risk may be classified as –

(i) Economic

(ii) Political

(iii) Social

Economic Factors –

Certain specific economic parameters are analyzed while evaluating Country Risks. Here the basic issue is to examine the (i) ability of a country to honor its external obligations and (ii) the possible strain it would put on the exchange rate.

It is important to note here that both the above issues would directly depend on the external sector situation. However, external sector of any country cannot be examined in isolation. It is equally important to understand the domestic economy by means of various GDP, Fiscal Policy and Monetary policy related parameters.

Again depending upon the time horizon that one is looking at it is important to focus not only on the immediate values of these parameters but also on long term trends as also on the long term sustainability of these trends.

The internal economic situation as reflected by the GDP, Fiscal and Monetary variable becomes more important if one is considering a long term involvement by way of FDI in the country.

These can be grouped as –

(a)    GDP related parameters

(b)   Fiscal sector parameters

(c)    Monetary policy parameters

(d)   External sector parameters

(a)    GDP related Parameters –

(1) GDP in nominal and real terms

(2) GDP growth rate and its trend over long term

(3) Per Capita GDP

(4) Sectoral distribution of GDP – Contribution of Primary, Secondary and Tertiary sectors

(5) Saving / GDP ratio

(6) Investment / GDP ratio

(7) Investment / Saving ratio

(8) Investment/GDP growth ratio

(9) Unemployment

(b)   Fiscal sector parameters –

(1) Deficits – Fiscal, Revenue, Monetized

(2) Deficits as % of GDP

(3) Tax collection as % of GDP

(4) Tax buoyancy

(5) Internal Debt / GDP ratio

(6) Debt maturity profile

(c)  Monetary policy parameters –

(1) Inflation

(2) Interest rate

(3) All other monetary policy tools such as CRR, SLR, Bank rate – different countries would have different monetary policy tools.

(d) External sector parameters –

(1) Balance of Trade

(2) Balance of Payments

(3) Composition of Exports and Imports

(4) Trends in import and export growth

(5) Terms of Trade

(6) BOP Deficit /GDP ratio

(7) Forex reserves

(8) Forex Reserves / imports

(9) External Debt – quantum and maturity profile

(10) External Debt / GDP

(11) Debt Servicing / export earnings

(12) Capital flows

(13) Exchange rate stability

Political Factors –

A change in political situation of a country is likely to change the business environment. Some of the important political factors to be looked into would include –

(a)    System of government – democratic, authoritarian, etc.

(b)   Major political parties and their ideologies

(c)    Party in power, it vision, succession plan, etc.

(d)   Leading opposition parties and their ideologies and visions

(e)   Maturity of political institutions

Social Factors –

(a)    Culture and history

(b)   Values

(c)    Educational levels

(d)   Major fault-lines / dividing lines in the society

(e)   Attitudes towards foreigners, change, technology, profits, etc

Other factors –

Apart from the above factors one would also look at conjectural factors such as –

(a)    Economic and Financial Institutional Set-up

(b)   Law and order situation

(c)    Social stability

(d)   Performance on Human Development Index

(e)   World opinion about the country

(f)     Possibilities of war, external and internal aggression, etc.

(g)    Vulnerability to natural disasters such as floods, earthquakes, etc.

Other Available Indices –

Apart from the ratings provided by the rating agencies, some of the other indices can give important information about the business environment in a country. These include –

(a)    Corruption Perception Index – computed by Transparency International

(b)   Ease of Doing Business Index – computed by World Bank

(c)    Human Development Index – computed by UN

(d)   Global Competitiveness Index – computed by World Economic Forum

(e)   Gini Co-efficient – computed by CIA and UN

Application of Country Risk Analysis to International Business –

(a)    Understanding the likely source and nature of risk associated with doing business in a particular country.

(b)   Possibility of predicting the timing of the uncertain event – whether in short term or long term.

(c)    Planning for proper risk mitigation measures in the business plan.

(d)   Budgeting for costs involved in risk insurance and avoidance.

(e)   Adjusting the return expectations depending on the risk profile.

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