MAJOR ASSIGNMENT

Country Risk Analysis (Edited from www2.gsu.edu/~wwwmms/8040fall06/Notes/countryrisk%20chp6.doc.)

Definition Key indicators Economic development Solvency

1. Definition

Multi-national Corporations (MNCs) constantly assess business environments of countries they operate in, as well as the ones they are considering investing in. Similarly, private and public investors are interested in determining which countries offer the best opportunities for sound investments. This is the area of country risk analysis --- assessing the potential risks and rewards associated with making investments and doing business in a country. MNCs are interested in the economic policies of these countries, because economic policies determine the business environment. However, country risk assessment cannot be only economic in nature. It is also important to consider the political factors that lead to economic policies. This interaction of politics and economics is the subject area of political economy.

2. Key Indicators

Expropriation (nationalization) is the most extreme form of political risk. However, there are other levels and forms of political risk, including currency and trade controls, changes in tax or labor laws, regulatory restrictions, and requirements for additional local production. Political risk can be assessed from a country-specific (macro or country risk analysis) and a firm-specific (micro or firm risk analysis) perspective. A useful indicator of the degree of political risk is the seriousness of capital flight. Capital flight refers to the export of savings by a state’s citizens because of fears about the safety of their capital. We now turn to some key indicators of the general level of risk in the country as a whole – termed country risk. Some of the common characteristics of country risk are:

i) a large government deficit relative to GDP ii) a high rate of money expansion, especially if it is combined with a

relatively fixed exchange rate iii) substantial government expenditures yielding low rates of return

iv) price controls, interest rate ceilings, trade restrictions, rigid labor laws, and other government-imposed barriers to the smooth adjustment of the economy to changing relative prices

v) high tax rates that destroy incentives to work, save, and invest vi) vast state-owned firms run for the benefit of their managers and

workers vii) Standard of Living - a citizenry that demands, and a political system

that accepts, government responsibility for maintaining and expanding the state’s standard of living through public-sector spending and regulations (the less stable the political system, the more important this factor will likely be.)

viii) Level of Corruption - pervasive corruption that acts as a large tax on legitimate business activity, holds back development, discourages foreign investment, breeds distrust of capitalism, and weakens the basic fabric of society

ix) Development of Political Institutions - the absence of basic institutions of government – a well-functioning legal system, reliable regulation of financial markets and institutions, and an honest civil service

Alternatively, indicators of a state’s long-run economic health include the following:

a) a structure of incentives that rewards risk taking in productive ventures

b) a legal structure that stimulates the development of free markets

c) minimal regulations and economic distortions d) clear incentives to save and invest e) an open economy f) stable macroeconomic policies

In summary, from the standpoint of an MNC, country risk analysis is the assessment of factors that influence the likelihood that a country will have a healthy investment climate. Several costly lessons have led to a new emphasis on country risk analysis in international banking as well. From the bank’s standpoint, country risk – the credit risk on loans to a state – is largely determined by the real cost of repaying the loan versus the real wealth that the country has to draw on. These parameters, in turn, depend on the variability of the state’s terms of trade and the government’s willingness to allow the state’s standard of living to adjust rapidly to changing economic fortunes. The experience of the countries that have made it through the international debt crisis suggests that others in a similar situation can get out only if they institute

broad systemic reforms. These countries need less government and fewer bureaucratic rules. Debt forgiveness or further capital inflows would only tempt these states to postpone economic adjustment further.