Lecture V Country Risk Assessment Methodologies: the Qualitative, Structural Approach to Country Risk

Risk Analysis: Why?  The globalisation of the world’s trade, financial and technology markets and the emergence of new economies have created a new world environment, full of opportunities, but fraught with uncertainty and spill-over risks.

Country Risk: DEFINITION  It’s the possibility that a foreign country’s: borrower (financial investment); Importer/producer (trade and sub-contracting) Corporate partner (FDI) May be UNABLE or UNWILLING to fullfill its contractual obligations toward a: Foreign lender; Exporter; Investor.

Risk Analysis and Investment Decision  Two possible way to include Risk in our investment decision (NPV): Expected Value of Profit (EV)  probability of a negative event; Adjust the Discount Rate  risk premium.  Which are the sources of risk?  How can we measure it?

Sources of Risk (1)  Natural Disasters;  Tsunami;  Earthquake;  Socio-Political Risks:  Social Risk; Boycott; Terrorism; Strikes; Religion and racial problems;  Government Policy Risk: Trade restrictions; Legal enforcement; Loan repudiation; Foreign exchange controls; Expropriation.  Political Risk: War; Nationalisation.

Sources of Risk (2)  Country-Specific Economic risk  Macroeconomic Risks: Exchange rate; Hyperinflation; Terms of Trade; Debt Service.  Microeconomic Risks: Market Failure; Market Inefficiency.  Supranational Level  risk of contagion!

How can we measure Country Risk?  The Quantitative Approach  The Quantitative Approach (Lecture VI): Ratio, indices and ratings; Reduces a complex situation into a number/letter; Cross-country and cross-time comparison; Shortcomings:  Similar ratio and financial indicators BUT different socio-economic structure;  Quantitative data not available on time, incomplete, wrong or distorted;  Interpretation is difficult; SOL: integrate with qualitative data to account for volatility and regional contagion.

The Qualitative Approach (1)  Qualitative Approach (SWOP): Assessment of the economic, financial and socio-political fundamentals that can affect the investment return prospects in a foreign country; Describes/identifies the structure of a country’s development strategy/process by shedding light on:  Strengths and opportunities;  Weaknesses and threats.

The Qualitative Approach (2) A robust qualitative approach leads to comprehensive country risk report that tracke the following six elements:  Social and welfare dimension of the development strategy;  Macroeconomic fundamentals;  External indebtedness evolution, structure and burden;  Domestic financial system situation;  Assessments of the governance and transparency issues;  Evaluation of the political stability.

Welfare and Social Indicators (1)  Economic Growth VS Development  Not only GDP growth but also: Self-sustaining development; Enlarging people’s choice/rights;  Democracy;  Robust and stable institutions; Decent standard of living:  Access to education;  Nutrition and health;  Political and cultural freedom. close correlation  Basic components of country risk and close correlation between HDI and country risk (ex. Sierra Leone) but not the reverse (ex. Cuba!)

Welfare and Social Indicators (2)  “Development Diamond” from WB: Life-expectancy; Access to safe water; Per capita GNP; Primary school enrolment.  Compare these country’s feature with the average of a regional group of countries.

Welfare and Social Indicators (3)  Why is population growth crucial for assessing country risk? (-) Stable or declining population does not improve long term prospects; (-) Rapidly rising population exerts pressure on the government’s budget and on the country’s infrastructure; (+) Rising population generates demand for social services;

Welfare and Social Indicators (4)  Why is life expectancy crucial for assessing country risk? Good illustration of government’s commitment to the adoption of a basic human needs strategy; Good indicator of sustainable development.  Are there other useful indicators? Wealthiest 10% share of national income (inequality); Urban population % (urbanisation) Percentage under 15 years old (age structure); Number of computers per 1,000 inhabitants. Human capital (literacy); Health care; Poverty; Gender structure; Labour force and unemployment.

References  Bouchet, Clark and Groslambert (2003): “Country Risk Assessment”, Wiley finance (Chapter 4).