Transcript 11.C Economic and Political Factors Underlying Country Risk

Chapter 11 Outline
A. Country Risk
B. Measuring Political Risk
C. Economic and Political Factors Underlying Country Risk
D. Country Risk Analysis in International Banking
E. Appendix: Managing Political Risk
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11.A Country Risk

Country risk analysis – the assessment of the potential risks and
rewards associated with making investments and doing business in
a country.
– Because economic policies are often a function of political
considerations, country risk analysis focuses on both economic and
political considerations.

Nonbank MNCs analyze country risk to determine the investment
climate in various countries.Banks analyze country risk to determine
which countries to lend to, the currencies in which to denominate
their loans, and the interest rates to demand on those loans.

http://en.wikipedia.org/wiki/Country_risk
http://www.doingbusiness.org/ (World Bank)
http://www.oecd.org/tad/exportcredits/arrangementonexportcredits/c
ountryriskclassification.htm
http://www.euromoney.com/Article/2773235/Country-risk-March2011-Country-rankings-and-acknowledgements.html
http://www.eiu.com/site_info.asp?info_name=sovereign_ratings
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11.B Measuring Political Risk (1)

Political economy – the interaction of politics and economics that
creates risks relating to monetary and fiscal policy, currency or trade
controls, changes in labor laws, regulatory restrictions, and
requirements for additional local production.

Common political measures of political stability
– Frequency of changes of government
– Level of violence
– Number of armed insurrections
Extent of conflicts with other states
Common economic measures of political stability
– Inflation
– Balance of payments deficits/surpluses
– Per-capita GDP growth
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11.B Measuring Political Risk (3)

Subjective measures of political stability are based on a general
perception of the country’s attitude toward capitalism and MNCs.
– Profit Opportunity Recommendation (POR) is an index that rates
countries on an aggregation of subjective assessments of a panel of
experts.
– Property rights – from an economic standpoint, political risk refers to
uncertainty over property rights.
• Risk of expropriation – the degree to which a government can seize legal
title to property or the stream of income generated by the property
• Risk of constrained use of property
– Capital flight – the export of savings by a country’s citizens because of
fears about the safety of their capital.
• Capital flight can be inferred using balance of payments figures.
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11.C Economic and Political Factors Underlying
Country Risk (1)
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
Country risk is not confined to less developed countries (LDCs).
–
Western European countries have problems with economic stagnation,
overregulation, inflexible labor markets, and overly expansive and expensive
welfare states.
–
The U.S. business environment is subject to arbitrary changes in
employment and environmental laws, and the legal environment opens
MNCs to litigation risk.
–
Japan’s highly regulated business system places a preponderance of power
with the state, and its banking system has made approximately $1.23 trillion
in bad loans.
Determinants of a country’s economic performance and degree of risk
1.
2.
3.
4.
5.
6.
Fiscal irresponsibility
Monetary instability
Controlled exchange rate system
Wasteful government spending
Resource base
Adjustment to external shocks
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11.C Economic and Political Factors Underlying
Country Risk (2)
1.
Fiscal irresponsibility
– Indiscriminant government spending increases country risk.
– The higher the government deficit as a percentage of GDP, the lower
the probability a country can meet its obligations without resorting to
expropriations of property, raising taxes, or printing money.
2.
•
Expropriation causes capital flight and a shortage of new investment.
•
Raising taxes adversely affects incentives to work, save, and take risks.
•
Printing money to finance the government deficit (monetizing the deficit)
results in monetary instability, high inflation, high interest rates, and
currency depreciation.
Monetary instability – an expansion of the money supply in
excess of real output growth results in inflation.
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11.C Economic and Political Factors Underlying
Country Risk (3)
3.
4.
Controlled exchange rate system
–
Currency controls are used to fix the exchange rate and result in an
overvalued local currency.
–
An overvalued currency effectively taxes exports and subsidizes imports.
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The risk associated with currency controls encourages capital flight.
–
MNCs repatriate subsidiary profits rather than reinvest them.
–
A controlled exchange rate system exacerbates unfavorable trends in the
country’s terms of trade (the exchange rate between exports and imports).
Wasteful government spending
–
Unproductive spending results in a government having less money to repay
its foreign debts.
–
Funds used to purchase foreign assets will not add to an economy’s dollargenerating capacity unless investors feel safe in repatriating their foreign
earnings.
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11.C Economic and Political Factors Underlying
Country Risk (4)
5.
Resource base
– A country’s resources include natural, human, and financial resources.
– All things equal, a country with substantial natural resources is a better
economic risk than a country without natural resources.
– However, the quality of human resources and the degree to which those
resources are efficiently employed can offset disadvantages of having
sparse natural resources.
– Three factors are necessary to ensure the most efficient use of a
country’s human resource base:
•
A stable political system that encourages hard work and risk-taking by
entrepreneurs;
•
A flexible labor market that permits workers to be allocated to those jobs in
which they will be most productive; and
•
A free market system that ensures that prices people respond to correctly
signal the relative desirability of engaging in different activities.
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11.C Economic and Political Factors Underlying
Country Risk (5)
6.
Adjustment to external shocks
– Domestic policies are critical in determining how effectively a country
deals with external shocks.
•
In response to falling commodity prices, rising interest rates, and rising
exchange rates in the 1980s:
– Asian countries’ policies, characterized by imitation and innovation in
the international market, promoted timely internal and external
adjustment.
– Latin American countries, with extensive state ownership, controls,
and policies to encourage import substitution, exploited their internal
markets, fostering long-term inefficiency among Latin American
manufacturers and worsening their international competitive positions.
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11.C Economic and Political Factors Underlying
Country Risk (6)

Market-oriented versus statist policies
– Market (capitalist) economy
•
Individual decisions makers make economic decisions based on prices of
goods, services, capital, labor, land, and other resources.
•
Capitalism works because
– Economic decisions are made by those who have the information
necessary to determine the trade offs inherent in those decisions; and
– People have the incentive to efficiently act on that information.
– Command (socialist) economy
•
Top government decides what will be produced, how it is produced, and
where it is produced, and commands others to follow the central plan.
•
Command economies don’t work because
– All fragments of knowledge existing in different minds must be
transferred to the central planner, which is impossible; and
– Incentives that foster efficiency are lacking.
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11.C Economic and Political Factors Underlying
Country Risk (7)

Market-oriented versus statist policies, continued
– Most modern economies are a mix of market and command economies.
– Statist policies constrain growth through heavy government intervention,
regulations, tax-and-spend policies, and state ownership or control of
key industries.
•
Special interest groups lobby for state benefits and oppose reforms to
eliminate subsidies.
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11.C Economic and Political Factors Underlying
Country Risk (8)
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Review of common characteristics of high country risk
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A large government deficit relative to GDP
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High monetary expansion, especially if combined with a fixed exchange rate
–
High government spending yielding low rates of return
–
Price controls, interest rate ceilings, trade restrictions, rigid labor laws, and
other barriers that impede a smooth adjustment to changing relative prices
–
High tax rates that destroy incentives to work, save, and invest
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High level of state-owned firms
–
A citizenry that demands, and a political system that accepts, government
responsibility for maintaining and expanding the nation’s standard of living
through public-sector spending and regulations
–
Pervasive corruption that impedes development, discourages foreign
investment, and breeds distrust of capitalism
–
The absence of basic institutions
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11.C Economic and Political Factors Underlying
Country Risk (9)
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Review of common characteristics of low country risk
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A structure of incentives that rewards risk-taking in productive ventures
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A legal structure that stimulates the development of free markets
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Minimal regulations and economic distortions
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Incentives to save and invest
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An open economy
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Stable macroeconomic policies
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11.D Country Risk Analysis in International
Banking (1)

Country risk from a bank’s perspective stems from the
possibility that borrowers in a country will be unable to service
their debts to foreign lenders in a timely manner.

Underlying causes of default are internal and include
–
Massive corruption;
–
Bureaucracy;
–
Government intervention;
–
Poor macroeconomic policies; and
–
Large budget deficits that have been monetized.
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11.E Appendix: Managing Political Risk (1)
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Preinvestment planning – four options to manage political risk
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Avoidance
• An MNC may screen out investments in politically uncertain countries, but absolute
avoidance is impossible because the home country also carries political risk.
• However, avoiding investments with political risk ignores potentially high returns
and the extent to which the firm can control the risks.
–
Insurance
• Most developed countries sell political risk insurance covering foreign assets of
domestic companies.
• Problems with relying only on insurance
– If an investment is unprofitable, it is unlikely to be expropriated.
– If an investment is profitable and is expropriated, the firm is compensated only
for the value of its assets rather than the economic value of the investment (i.e.,
present value of future cash flows).
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11.E Appendix: Managing Political Risk (2)
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Preinvestment planning, continued
–
–
Negotiating the environment
•
Concession agreements – MNCs negotiate with the host government to define
rights and responsibilities of both parties before undertaking the investment.
•
Concession agreements may not be honored in many third-world countries.
Structuring the investment
•
Minimize exposure to political risk by increasing the host government’s cost of
nationalization (and ability to harm the MNC by seizing a single plant).
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Keep the subsidiary dependent on sister companies for markets and/or supplies.
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Concentrate R&D facilities and proprietary technology in the home country.
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Source production from multiple plants.
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Raise capital from the host and other governments, international financial
institutions, and customers instead of using funds supplied by the MNC.
–
Obtain unconditional host government guarantees for the amount of investment
to give creditors legal leverage against transactions between the host country
and third parties if a subsequent government repudiates the country’s
obligations.
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11.E Appendix: Managing Political Risk (3)

Operating policies
– Change the benefit/cost ratio of expropriation – an MNC can raise the
cost of expropriation by increasing the negative sanctions involved
through
•
Controlling export markets, transportation, technology, trademarks and
brand names, and components manufactured in other countries.
•
When expropriation is inevitable, the MNC should prepare for negotiations
to establish a future contract-based relationship.
– Develop local stakeholders – research indicates that having local
private investors as partners seems to provide protection against
expropriation.
– Adaptation – MNCs pursue a policy of adapting to the inevitability of
potential expropriation and try to earn profits on the firm’s resources
through licensing and management agreements.
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