“International Finance and Payments” Lecture V “Risks of International Capital” Lect. Cristian PĂUN URL: Academy of Economic Studies Faculty of International Business and Economics

Course 5: Risks of International Financing2 Certainty, risk and uncertain situations Uncertain situations Risk Certain Managers know all the events that could affect their decisions and they can evaluate the impact on the results Managers have no any information about future events that can affect their decisions and they can’t appreciate the impact on the results

Course 5: Risks of International Financing3 Identified risks / Assumed risks Identified risks Not identified risks Risks involuntary not assumed Risks voluntary not assumed Risks voluntary assumed

Course 5: Risks of International Financing4 Risks in international business Environment risks (macro - risks) RM Project risks (micro-risks) Company risks (micro-risks) RF RP No control on further events Imperfect information Limited time for decisions Sources of risks in international business

Course 5: Risks of International Financing5 I. Country risk it is a new concept introduced by Milton Friedman in 1975 when Citibank grant a credit to a foreign government; it was initially connected with the capacity of a government to repay a loan today we use this concept in different decisions related to international business: international finance (private and public debt) FDI’s portfolio investments (bond valuation, stock valuation) cash flows projections – discounted rate we make now a distinction between country risk assessment in case of international financing and international investment

Course 5: Risks of International Financing6 Country risk – credit or investment risk ? International CreditInternational Investment IndicatorsDifferent MethodologySimilar Time horizon1 - 3 years1-5 years UtilityCost of debtExpected return Risk managementBeforeBefore / After

Course 5: Risks of International Financing7 Role of country risk assessment - To locate the credit / business (risk map); - To take the decision to be involved on international markets (“go / no go decision”); - To establish the level of your involvement; - To develop strategies for your company (ex. strategies to fight against your competitors); - To adapt your further decision related to an international credit or investment in accordance with the latest evolutions on a foreign market.

Course 5: Risks of International Financing8 Country risk determinants Country risk – international credit Current account balance, external debt, BP deficit, economic structure, economic development, the level of export concentration, the import dependency, the convertibility of national currency, GDP, international reserves, inflation, internal capital accumulation, political stability, corruption, credibility and independence of Central Bank, government orientation etc. Educational level of labor force, wages, internal market dimension, internal competition, infrastructure, country accessibility, market accessibility, interest rate, investment facilities, property and transfer regulations, taxation. Country risk – international investment

Course 5: Risks of International Financing9 Different types of country risk International creditsInternational business Late payments Debt service default; External debt repudiation Renegotiation of external debt Rescheduling external debt service External debt moratorium; Temporary default caused by chronic deficit in BP, budgetary deficit, shortfall in exportation incomes, major disturbances on foreign exchange markets, social and internal/external political disturbances ; Confiscation Nationalization; Expropriation ; Indigenization; Limitations/restrictions on capital repatriation Total/partial destruction of foreign investment caused by political and social events (strikes, social riots, military conflicts, elections) Profit losses caused by economic crises, shortfall of internal market, legislative instability, corruption etc.

Course 5: Risks of International Financing10 Country risk management - investments BBefore: · - gathering more host country specific information · - avoidance of higher country risk locations · - insurance policies (provided by insurance companies) ·- negotiating the environment · - adapting the investment project · - geographical or sectorial diversification of investment portfolioAAfter: · - permanent supervision of country risk level; · - adaptation of investments in order to reduce the exposure to risk; · - promoting good relations with local operators and institutions; · - disinvestments; profit maximization; sectorial diversification.

Course 5: Risks of International Financing11 Country risk management – credits Before: floating interest rate instead fixed rate; interest rate adjusted to country risk by using a risk premium in accordance with risk profile of the debtor; imposing a restrictive use of lend funds; financial consultancy for debtors; loan maturity adjusted to risk; credit condition; credit insurance (ex: export credit insurance); direct participation to the project financed (ex: E.B.R.D. or I.M.F. credits); require a set of measures that must be applied by the debtor as a condition to obtain the credit (ex: structural credits additional collaterals or guaranties. After: debt - by - debt swap; debt - by - equity swap; rescheduling debt or interest payments in the case of default; renegotiations of debt or interest.

Course 5: Risks of International Financing12 Country risk profiles - EEC

Course 5: Risks of International Financing13 Country risk assessment 1.Selecting group of countries; 2.Selecting the set of indicators (qualitative and quantitative) 3.Grouping indicators; 4.Weighting indicators 5.Selecting the source of information 6.Collecting data 7.Establishing the checking lists 8.According marks and points 9.Calculate the country risk indicator 10.Country risk maps 11.Using country risk in your decisions

Course 5: Risks of International Financing14 Different risk models Micro - models Macro - models Large number of countries Small number of countries Delphi models (BERI; PRS) Econometric models Financial models (Euromoney) Banking models In House Models (DOW CHEMICAL)

Course 5: Risks of International Financing15 “Institutional Investor” Country Risk Model Products: ratings for credit risk; Information: qualitative indicators; Source of information: information provided by international banks; Indicators: economic environment (10p), external debt service (10p), international reserves / current account balance (10p), fiscal policy (10p), political environment, capital market accessibility (10p), commercial balance (10p), international portfolio investment (10p), FDI’s (10p); Significance: credit risk measured on a scale between 0 and 90. Methodology: scalar indicator calculated as total amount of points mentioned above for each country

Course 5: Risks of International Financing16 “Standard & Poor’s” Country Risk Model Products: sovereign risk, international bond rating (public or private Information: qualitative and quantitative information; Source of information: published source, internal source; Indicators (sovereign risk): - political environment (stability, government changing, political system flexibility, political support, political parties orientation) - social environment (life standard, income distribution, labor conditions, relations with neighbor countries, social conflicts) - economic environment (international investment position, GDP, exports, economic structure, natural resources, currency regimes, taxation level; Significance: ordinal indicator by risk classes (using letters such as BB-) Methodology: weighted indicator.

Course 5: Risks of International Financing17 “Political Risk Services - PRS” Country Risk Model Products: country risk ; Information: qualitative and quantitative information; Information: qualitative and quantitative information; Indicators: economic evolution (6%), political parties (5%), external conflicts (5%), corruption (3%), invimplicarea of the religion in politic (3%), involvement of the army in politic (3%), racial or nationalist tensions (3%), terrorism (3%), civil wars (3%), historical evolution of the external debt (5%), transfer control (5%), expropriations (5%), inflation (5%), country’s financial leverage (5%), international liquidity (5%), current account (8%), FX market (5%). Significance: scale indicator expressed by a number Methodology: weighted average indicator using different weights for indicators groups: political (50%), financial (25%) and economical indicators (25%).

Course 5: Risks of International Financing18 “The Economist” Country Risk Model Products: country risk Information: qualitative and qualitative indicators; Source of information: experts (political indicators), internal sources published sources (economic indicators); Indicators: GDP growth, inflation, external debt, exports, neighbor countries, government, army’s involvement in politics, corruption, ethnical conflicts, internal conflicts. Significance: scale indicator Methodology: weighted indicator using different points: economic (33 p), social (17 p) and politic (50 p).

Course 5: Risks of International Financing19 II. Currency risk in international finance Currency risk Currency risk = possible losses caused by un unfavourable evolution of exchange rate in case of an international financing denominated in other currency Currency risk: A.Transaction exposure: possible losses in case of a specific transaction (such as export, import or credit); B.Translation exposure: possible losses in case of translation for a subsidiary’s balance sheet in mother company one; C.Economic exposure: possible losses of cash flow in case of a company involved on international business

Course 5: Risks of International Financing20 Transaction exposure Very easy to asses this type of particular risk; The exposure degree can be measured by the variation of current yield in case of a credit using different estimation for FX rate: Example: Credit for USD, interest rate of 10% p.y., paid at the end of the year, maturity 4 year, reimbursement yearly in equal payments.

Course 5: Risks of International Financing21 Translation exposure More difficult to asses (than transaction exposure); Specific for MNC’s with many subsidiaries that requires periodically a consolidation for the balance sheets of this subsidiaries into mother company one; The translation could be made using: Current rate method; Current / non - current method; Monetary method; Temporal method (for inventories we use a current exchange rate for translation).

Course 5: Risks of International Financing22 Translation exposure Example: Historical rate: 1 USD= 2 Euro= 3 Pounds= 4 Yen Current rate: 1 USD= 3 Euro= 6 Pounds= 8 Yen

Course 5: Risks of International Financing23 Economic exposure It is the most complex form of the currency risk; The assessment is based on the profit & loss account of a company involved on international business; The exposure degree is measured by the variance of the cash flow in case of the exchange rate variance; To asses this type of risk you should estimate cash flow using exchange rate in order to transform the inflows and outflows denominated in other currencies

Course 5: Risks of International Financing24 Economic exposure – example

Course 5: Risks of International Financing25 Exchange risk management A.Contractual measures: simple currency clause; simple currencies basket clause; weighted currencies basket clause; netting B. Non – contractual measures: Parallel loans; “Back to back” loans; Swaps; Forward; Futures; Options; Insurance Contracts.

Course 5: Risks of International Financing26 II. Interest rate risk Interest rate risk = possible loss caused by an unfavorable evolution of the interest rate in case of a international credit. This risk affects the debtor and the creditor too; Interest risk can affect a credit in which is used a fixed interest rate or a variable one too; The assessment is based on specific indicators: Loan maturity; Loan sensitivity; Loan duration.

Course 5: Risks of International Financing27 Interest rate risk - example

Course 5: Risks of International Financing28 Interest rate risk management A.Contractual measures: Non - financial clauses “Parri pass” clause (equal treatment for creditors); “Cross default” clause; “Material adverse change” clause Financial clauses Conditions on different indicators (net working capital, global financial leverage, long term financial leverage, liquidity, solvability); B.Non - contractual measures: Debt renegotiation; Floating rate notes; Swap, forward, futures, options; Collar, cap, floor (synthetic instruments).

Course 5: Risks of International Financing29 III. Default risk Default risk = possible loss caused by the payment incapacity of a debtor; It is a risk exclusive for creditors The assessment is based on a lot of indicators: Liquidity ratios Profitability ratios and activity ratios Financial leverage ratios Return ratios and the Du Pont system Shareholders ratios