Transcript Lecture VI

Lecture VI
Country Risk Assessment
Methodologies: the Qualitative,
Structural Approach to Country Risk
“Risk management is not a program but an
ongoing process that must be developed over
time. Our models are constantly reviewed and
improved. On the whole, they have proven their
worth. But good risk management isn't just
about mathematical models and systems – it
also requires an understanding of the market,
intuition and the ability to weigh up what
proportions of risk are healthy. In that respect,
the abbreviation CS in my opinion doesn't just
stand for Credit Suisse, but also for common
sense, which plays a key role in risk
management.”
Hans-Ulrich Doerig
Chairman of the
Board of Directors
of Credit Suisse
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.
Macroeconomic Structures of Growth
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Country’s main challenge = capacity
to preserve sustainable growth!
Excessive growth (of spending,
debt, money supply, GDP,
investment, domestic credit) is NOT
POSITIVE because it creates
bubbles and costly imbalances!
Macroeconomic Structures of Growth
(2)
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Growth is the product of:
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Capital accumulation:
Physical (land and infrastructure);
 Human (education, incentives);
 Institutional;
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Factor Productivity  technology!
( Growth Theory? The Solow Model!)
Globalisation (Trade and capital inflow);
Good governance;
Solid macroeconomic environment.
Macroeconomic Structures of Growth
(3)
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What is there behind the economic and financial
crisis?
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Macroeconomic disequilibria:
High internal and external debt;
To adjust them  expansionary monetary policy that
causes:
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Inflation;
Gov is unwilling to defend the fixed exchange rate!
High real interest rates to defend the exchange
rate parity in a context of speculative attack and
falling reserve (Mexico, 1995; Russia, 1998);
Underdevelopment of financial system; largescale financial capital inflows; financial panic (Asian
crisis, 1997-1998; Argentina, 2001-2002);
Market expectations and international contagion
(USA, 2008).
Macroeconomic Structures of Growth
(4)
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Domestic Economy Assessment:
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GDP evolution and composition; sector
analysis;
Informal economy, savings and
investment ratios;
Trade structure, terms of trade, trade
openness ratio, commodity prices.
Which variables?
Macroeconomic Structures of Growth
(5)
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Macroeconomic Policy Evaluation:
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Prices (inflation) and exchange rate;
Government finance: budget policy,
privatisation, public sector borrowing
requirement,
Money and credit policy: money supply growth,
reserve money, claims on government and on
private sector, real interest rate;
Legal and regulatory environment (customs,
taxation, company law, flexibility of the labour
market).
Which variables?
Macroeconomic Structures of Growth
(6)
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Balance of Payment Analysis:
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Trade balance, resource gap and current
account balance;
Capital accounts, international reserve assets;
Non-debt creating flows: FDI, foreign transfer,
remittances.
Liquidity ratio: current account/GDP;
Structure and composition of external capital
sources;
Exceptional financing and IMF credit.
Which variables?
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.
External Indebtedness, Liquidity and
Solvency Analysis (1)
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External debt is a temporary phenomenon
that supplements savings, bridges the
resource-investment gap and speeds up
the growth process towards the ‘take-off’
stage of sustaining development.
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.
External Indebtedness, Liquidity and
Solvency Analysis (2)
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Risk of default increases for 3 reasons:
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Debt is not invested but is used:
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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!
External Indebtedness, Liquidity and
Solvency Analysis (3)
Weak fundamentals + large relative debt
=
debt overhang and deterioration of creditworthiness!
External Indebtedness, Liquidity and
Solvency Analysis (4)
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Which indicators could be useful?
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Solvency VS Liquidity Indicators
Solvency Indicators:
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Illustrate the stock/stock relationship, linking the
country’s debt obligations with the overall assets and
its currency reserves.
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Debt/GDP
Net external debt/exports
Debt/exports
Debt/official reserve assets;
Real weight of the debt: NPV
Debt’s structure:
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Creditors, debtors, floating/fixed exchange rate,
currency, maturity etc.)
Short-term debt/liquidity reserve+contingent credit
lines;
Short term debt/outstanding debt.
External Indebtedness, Liquidity and
Solvency Analysis (5)
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Liquidity Indicators:
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Debt flows VS debt stock:
Debt servicing ratio (debt
payment/export);
 Interest payment/export;
 Current account/GDP;
 Reserves/imports;
 Average maturity of external liabilities.
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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)
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Key role of a good and solid
domestic financial system:
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Channel between savings (from
different sources) and productive
investment;
Country’s sustainable economic growth.
The Savings-Investment Gaps and
Domestic Financial Intermediation (2)
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Efficiency factors in the Financial System:
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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.
References
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Bouchet, Clark and Groslambert
(2003): “Country Risk Assessment”,
Wiley finance (Chapter 4).
Luo, Y. : “Political Risk and Country
Risk in International Business.
Concept and Measures”, in
Handbook of International Business,
chapter 26.