Country Risk Assessment Methodologies: the Qualitative, Structural Approach to Country Risk

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Lecture V

• Country Risk Assessment Methodologies the
  Qualitative, Structural Approach to Country Risk

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Risk Analysis Why?

• The globalisation of the worlds trade, financial
  and technology markets and the emergence of new
  economies have created a new world environment,
  full of opportunities, but fraught with
  uncertainty and spill-over risks.

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Country Risk DEFINITION

• Its the possibility that a foreign countrys
• borrower (financial investment)
• Importer/producer (trade and sub-contracting)
• Corporate partner (FDI)
• May be UNABLE or UNWILLING to fullfill its
  contractual obligations toward a
• Foreign lender
• Exporter
• Investor.

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Risk Analysis and Investment Decision

• Two possible way to include Risk in our
  investment decision (NPV)
• Expected Value of Profit (EV) ? probability of a
  negative event
• Adjust the Discount Rate ? risk premium.
• Which are the sources of risk?
• How can we measure it?

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Sources of Risk (1)

• Natural Disasters
• Tsunami
• Earthquake
• Socio-Political Risks
• Social Risk
• Boycott
• Terrorism
• Strikes
• Religion and racial problems
• Government Policy Risk
• Trade restrictions
• Legal enforcement
• Loan repudiation
• Foreign exchange controls
• Expropriation.
• Political Risk
• War
• Nationalisation.

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Sources of Risk (2)

• Country-Specific Economic risk
• Macroeconomic Risks
• Exchange rate
• Hyperinflation
• Terms of Trade
• Debt Service.
• Microeconomic Risks
• Market Failure
• Market Inefficiency.
• Supranational Level ? risk of contagion!

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How can we measure Country Risk?

• The Quantitative Approach (Lecture VI)
• Ratio, indices and ratings
• Reduces a complex situation into a number/letter
• Cross-country and cross-time comparison
• Shortcomings
• Similar ratio and financial indicators BUT
  different socio-economic structure
• Quantitative data not available on time,
  incomplete, wrong or distorted
• Interpretation is difficult
• SOL integrate with qualitative data to account
  for volatility and regional contagion.

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The Qualitative Approach (1)

• Qualitative Approach (SWOP)
• Assessment of the economic, financial and
  socio-political fundamentals that can affect the
  investment return prospects in a foreign country
• Describes/identifies the structure of a countrys
  development strategy/process by shedding light
  on
• Strengths and opportunities
• Weaknesses and threats.

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The Qualitative Approach (2)

• A robust qualitative approach leads to
  comprehensive country risk report that tracke 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.

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Welfare and Social Indicators (1)

• Economic Growth VS Development
• Not only GDP growth but also
• Self-sustaining development
• Enlarging peoples choice/rights
• Democracy
• Robust and stable institutions
• Decent standard of living
• Access to education
• Nutrition and health
• Political and cultural freedom.
• Basic components of country risk and close
  correlation between HDI and country risk (ex.
  Sierra Leone) but not the reverse (ex. Cuba!)

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Welfare and Social Indicators (2)

• Development Diamond from WB
• Life-expectancy
• Access to safe water
• Per capita GNP
• Primary school enrolment.
• ? Compare these countrys feature with the
  average of a regional group of countries.

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Welfare and Social Indicators (3)

• Why is population growth crucial for assessing
  country risk?
• (-) Stable or declining population does not
  improve long term prospects
• (-) Rapidly rising population exerts pressure on
  the governments budget and on the countrys
  infrastructure
• () Rising population generates demand for social
  services

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Welfare and Social Indicators (4)

• Why is life expectancy crucial for assessing
  country risk?
• Good illustration of governments commitment to
  the adoption of a basic human needs strategy
• Good indicator of sustainable development.
• Are there other useful indicators?
• Wealthiest 10 share of national income
  (inequality)
• Urban population (urbanisation)
• Percentage under 15 years old (age structure)
• Number of computers per 1,000 inhabitants.
• Human capital (literacy)
• Health care
• Poverty
• Gender structure
• Labour force and unemployment.

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References

• Bouchet, Clark and Groslambert (2003) Country
  Risk Assessment, Wiley finance (Chapter 4).