1. Lecture VII Country Risk Assessment Methodologies: the Qualitative, Structural Approach to Country Risk  The Macroeconomic Fundamentals  External indebtedness evolution, structure and burden;  Domestic financial system situation;  Assessments of the governance and transparency issues;  Evaluation of the political stability. Country Risk Assessment Methodologies: the Quantitative Approach to Country Risk

2. Nominal Exchange rates Determinants (3)  Uncovered Interest Parity: The investor takes a risk because he doesn’t cover his position by a forward transition F(0) = S e (1); Expected Appreciation of the dollar = interest rate gap; [S e (1) – S(0)]/S(0)=i JPN - i US What drives the Exhange rate?  Change in the overseas interest rate;  Change in the domestic interest rate;  Change in expectation of the dollar.

3. Nominal Exchange rates Determinants (3)  Risk Adverse investor: Premium at risk; US return = i US +expected dollar apprec = i jpn + risk premium Change in the risk premium would impact on the NER!

4. Exchange Rate Regimes  Floting Exchange Rate Systems: The value of the country’s currency can vary freely depending on the forces analyzed above; Different types:  Pure Float;  Managed Float: NER not target to any benchmark BUT the government interveen to moderate the ER fluctuation.

5. Exchange Rate Regimes (2)  Intermediate between floting and fixed ER: Target zone: fluctuate withing a given band; Basket peg; Crawling peg: fix a benchmark and a fluctuation profile; Intermediate peg: flexible periodic revaluazions.

6. Exchange Rate Regimes (3)  Rigid Fixed Echange Rate Systems: Truly fixed: the gov commits to a specific ER and NO tolerance of any bands or preannounced option to revalue; Dollarisation; Single Currency: merge their central banks.  ATT! Speculative Attacks!

7. Exchange Rate Regimes (4)  The impossible trilogy: Independent monetary policy  choose its own interest rates; Fixed Exhange rate; Capital Account Liberalissation.  Explain the impox trilogy with the UIP.

8. Exchange Rate Regimes (5)  Advantages of Fixed Exchange Rates: Providing a nominal anchor; Encouraging trade and investment; Avoiding speculative bubbles; Reducing Risk Premiums

9. Exchange Rate Regimes (6)  Advantages of Floating Exchange Rates: Indipendent monetaly policy; Automatic Adjustment to trade shocks; Lender of Last resort; Avoid speculative attacks!

10. Exchange Rate Regimes (7)  Which countries should adopt a fixed ER? Poor reputation for controlling inflation; High trade level with a particular country; Little involvment in the investment global capital market; Flexible labour market; High level of foreign exchange reserve.  IMP! Similar macro environment with the target country;

11. The Qualitative Approach A robust qualitative approach leads to comprehensive country risk report that tackles 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.

12. External Indebtedness, Liquidity and Solvency Analysis (1)  External debt is a temporary phenomenon that supplements savings (or negative trade balance), bridges the resource-investment gap and speeds up the growth process towards the ‘take-off’ stage of sustaining development.

13. Debt Service  Debt Service = principal + interest  If the size of debt ↑ or the interest rate ↑ Debt service increases Debt servicing difficulties

14. Debt Service (2)  Problem = Debt Repayment = Risk of Default!  If borrowing countries invest capital inflow in productive investments with higher return rates, without sizable adverse shocks, and compatible maturity  they would generate the right income for timely debt repayment.

15. Debt Service (3)  Risk of default increases for 3 reasons: Debt is not invested but is used:  to finance current consumption;  to finance the black hole of the government budget deficit;  Is recycled in international banks. Debt composition, in term of maturity, currency or interest rates, is such that the borrowing country becomes highly vulnerable to external shocks; ‘debt overhang’, i.e. the accumulated debt is larger than the country’s repayment capacity and expected debt servicing obligations will discourage domestic investors and exporters, as well as foreign creditors. Country becomes dependent from foreign loans.  Moreover, weak macroeconomic situation would increase the risk of default, ceteris paribus!

16. Debt Service (4) Weak fundamentals + large relative debt = debt overhang and deterioration of creditworthiness!

17. Debt Sustainability  Debt is sustainable when:  A country is able to meet its current and future external obligations in full without reschedule it in the future;  The annual debt service should not be more than 25% of export earnings.  How to improve debt sustainability? Sticking to sound policies:  Break the vicious cycle of poor policy and weak governance;  Create a better and more stable macroeconomic environment (fiscal, monetary and exchange rate policies);  Structural policies that create incentives for private investment and production (tax, trade, corruption, infrastructure, human capital, industry and agricultural policies).

18. Debt Sustainability (2) Improving the investment environment:  Lower debt burden  more favourable climate for private investment (domestic and foreign);  Attract Foreign capital and decrease the capital account deficit! Diversifying exports:  Protection against external shocks;  Export-driven growth;  Promote private initiatives. i.e. Increase the Current Account surplus!

19. Debt Sustainability (3) Prudent Policies on new borrowing:  Use funding for development strategies and debt repayment obligations instead of consumption.

20. HIPCs (Highly Indebted Poor Countries)  There are 42 eligible countries (34 in Africa) and they face common characteristics:  Over indebted over the last two decades;  They are poor countries: low economic growth and no improvement in poverty;  Major recipients of official development assistance (net transfer was about 10% of GDP in 1990 versus 2% in other developing countries);  Narrow export base  vulnerable to external shocks.

21. Debt Service and Balance of Payement internal  Debt external  Determinants:  Supply of domestic savings is low (S<I);  import > export: imports of capitals are needed to augment domestic resources.

22. Debt Service and Balance of Payement  Balance of Payments: Current account + capital account = 0

23. The Current Account  Current Account = Balance of trade (exports of goods – imports of goods) + balance of service (exports of service – imports of service) + investment income and dividends + net transfer

24. The Capital Account  It’s composed by: The Capital Account: capital transfers (such as debt forgiveness) and acquisition of nonproduced, nonfinancial assets (copyright and patents); Financial Account:  Direct Investment;  Porfolio Investment;  Other Investment (bank deposit and bank loans);  Reserve Assets. Errors and Omissions.

25. Current and Capital Account  Capital Account Deficit  savings – investment >0  country acquires foreign assets.;  GNI = GDP + NIFA (income) Where NIFa = net income earned on foreign assets.  GNI = GDP + NIFA = C + T + PS income utilisation  We get: PS = GDP + NIFA – C - T  Def GDP: GDP = C + I + G + (X-M)  We get: PS = C + I + G + (X-M) + NIFA – C - T  We get: PS + (T-G) – I = X – M +NIFA PS + (T-G) – I = Savings – investment  Capital Account! X – M = balance of trade on goods and service; NIFA = net income and dividends on overseas assets; Current Account!

26. Current and Capital Account  If S > I  net savings  capital account deficit;  X – M + NIFA  current account surplus.

27. Current, Capital Account and RER  What’s up if Decrease in Export or reduction in net income inflow?  Current Account Surplus decrease   Deficit in the Balance of Payment!  It requires Capital Account Deficit increase   i.e. acquire foreign assets using the foreign currency  foreign reserve decrease!  The balance of payment is now in equilibrium!  BUT if the foreign reserve are not suff  RER devaluation  X increase; M decrease and BP in eq! (Current Account Crisis)!  It’s important to consider: Trade Balance/GDP; Foreign Reserve/GDP.

28. Current, Capital Account and ER  What’s up if large fiscal deficit or investment boom? Net savings decrease  need foreign capital; Capital account deficit decreases (or surplus!); Deficit in the Balance of Payment! Need Current account surplus to decrease, i.e RER apreciation!  The gov has to sell foreign reserve: EXP decrease and IMP increasE!  What’s up if large Accumulation of foreign liabilities; If suddently the foreign capital inflow stops  sharp decrease of the domestic currency demand  risk of depreciation! The gov should intervene to sell foreign reserve and buy domestic currency!  In both bases if foreign reserve are not enoght: CAPITAL ACCOUNT CRISIS!  It’s important to consider: Debt/GDP Foreign liabilities/GDP; Foreign liabilities/Foreign Reserve.

29. Other type of Crisis  Currency Crisis: Linked to balance of payment disequilibria; More pronounced if:  Fixed exchange rate regime and;  Inconsistency between domestic and external policy;  No indipendence of the central bank.  Note! Currency Crisis and Debt Crisis are cause by weak macroeconomic foundamentals! They are usually defined First Generation Crisis (ex. Latin America 1970s).

30. Other type of Crisis (2)  Crisis caused by speculative attacks driven by decreased trust in the country’s credibility Second Generation Crisis:  EX. Europaan Exchange Rate Mechanism (ERM) in 1992;  Greece in 2010.

31. Other type of Crisis (3)  Banking crisis: decrease the value of assets and collateral that the banks hold owing to:  Domestic or international shocks/imbalances;  ER devaluation. ATT! Vicious circle! Example: USA 2008.  Twin Crisis (Third Generation Model?): Match a currency crisis due to balance of payment imbalances to a banking crisis. East Asia countries in 1997.

32. The Qualitative Approach A robust qualitative approach leads to comprehensive country risk report that trackle 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.

33. The Savings-Investment Gaps and Domestic Financial Intermediation (1)  Key role of a good and solid domestic financial system: Channel between savings (from different sources) and productive investment; Country’s sustainable economic growth.

34. The Savings-Investment Gaps and Domestic Financial Intermediation (2)  Efficiency factors in the Financial System: Banking system and efficiency; Level and structure of interest rates; Financial liberalisation; Stock market development and efficiency (capitalisation, value traded, listed companies, transparency); Non-bank credit and the role of securities markets in providing corporate funding; Interbank market; Development of financial instruments and financial innovation; institutional development and structural reforms; Legal restrictions on capital movements; Role of national authorities for effective prudential supervision; Legal, accounting, management and supervisory infrastructures.

35. The Qualitative Approach A robust qualitative approach leads to comprehensive country risk report that tackles 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.

36. Governance (1)  Governance is at the hearth of the development process;  Public sector institutional reform is the heart of good governance; “Second-generation reforms” that affect the relationship between the state, the market, and the civil society  avoid speculative attack based on weak credibility! Aim at strengthening the “social-capital”: group solidarity and trust in human capital;

37. Governance (2)  Today, to get market access and show robust creditworthiness to rating agencies, emerging market countries must demonstrate that they adhere to high transparency and governance standards;  One key aspect of the investment climate is the assessment of: Political stability; Transparency; And efficiency of the legal and judiciary system.

38. Governance (3)  What is Governance? All the values that drive the regulation and ultimate finality of the exercise of power in private and public institutions:  Transparency;  Sound and efficient administration;  Government accountability for the use of public funds;  Rule of law;  Social inclusion. The ‘bug in governance’ = corruption!

39. Governance (4)  What is corruption? Is the abuse of public power (discretionary public preferences) for private gains (speculation, insider information, cash payment…); It involves a patron-client relationship.  Where does corruption come from? High pace of social change combined with weak institutional development  EX. Planned economy which moves toward market-driven economic policy (Vietnam, Laos, Cambodia, Albania, Ukraine, Russia etc) Economic liberalisation and public sector reform reduce the opportunities for corruption.

40. Governance (5)  How does corruption relate to social and economic development? (-) sub-optimal allocation of resources; (-) Distortions in resource distributions and income inequalities; (-) Discourages savings and investment; (-) Discourages foreign investment; (-) Stimulates capital flight and brain drain; (-) Increase uncertainty and causes negative expectations; (+) useful flexibility in fast-changing social and economic structure.

41. The Qualitative Approach A robust qualitative approach leads to comprehensive country risk report that trackle 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.

42. Political Risk  Wide range of facts: Terrorist attacks; Regulatory change; Strikes; Social unrest; NGO action;

43. References  Bouchet, Clark and Groslambert (2003): “Country Risk Assessment”, Wiley finance (Chapter 4).  Colombo, E. and Lossani, M. (2009): “Economia dei Mercati Emergenti”, Carocci Editore.  Miles, D. and Schott, A. (2005): “Macroeconomics. Understanding the Wealth of Nations”, eds. Wiley (Chapter 19, 20, 21).  The Economist (2009): “Guide to Economic Indicators. Making Sense of Economics”.