Transcript Diapositiva 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
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)
= Se(1);
Expected Appreciation of the dollar = interest
rate gap;
[Se(1) – S(0)]/S(0)=iJPN- iUS
What drives the Exhange rate?
 Change in the overseas interest rate;
 Change in the domestic interest rate;
 Change in expectation of the dollar.
Nominal Exchange rates Determinants
(3)

Risk Adverse investor:



Premium at risk;
US return = iUS+expected dollar apprec
= ijpn+ risk premium
Change in the risk premium would
impact on the NER!
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.

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.
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!
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.
Exchange Rate Regimes (5)

Advantages of Fixed Exchange
Rates:




Providing a nominal anchor;
Encouraging trade and investment;
Avoiding speculative bubbles;
Reducing Risk Premiums
Exchange Rate Regimes (6)

Advantages of Floating Exchange
Rates:




Indipendent monetaly policy;
Automatic Adjustment to trade shocks;
Lender of Last resort;
Avoid speculative attacks!
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;
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.
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.
Debt Service


Debt Service = principal + interest
If the size of debt ↑ or the interest
rate ↑
Debt service increases
Debt servicing difficulties
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.
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!
Debt Service (4)
Weak fundamentals + large relative debt
=
debt overhang and deterioration of creditworthiness!
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).
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!
Debt Sustainability (3)

Prudent Policies on new borrowing:

Use funding for development strategies
and debt repayment obligations instead of
consumption.
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.
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.
Debt Service and Balance of Payement

Balance of Payments:

Current account + capital account = 0
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
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.
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!
Current and Capital Account


If S > I  net savings  capital
account deficit;
X – M + NIFA  current account
surplus.
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.
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!


What’s up if large Accumulation of foreign liabilities;




The gov has to sell foreign reserve: EXP decrease and IMP increasE!
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.
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).
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.

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.
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.
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.
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.
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.
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;
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.
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!


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.
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.
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.
Political Risk

Wide range of facts:





Terrorist attacks;
Regulatory change;
Strikes;
Social unrest;
NGO action;
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”.