Political Risk or Country Risk
Lecture 9

 

Political, Country, and Global Risks

1. Political Risk - risk that originates from government

  • Government imposes control over an enterprise's operations within a border or even outside

    • Regulations

    • Taxes - transfer wealth from business to government

    • Predict whether to invest in a particular country

  • Firm specific risk - conflict between a business and the host government

    • Also called micro risk

    • Different firms have different risks

    • Example - restaurant chain versus electronics manufacturing

    • Electronics company requires large capital investment

    • Restaurant owner could lease space, etc.

    • Foreign exchange rate risk is a firm specific risk. However it does not result from government

  • Government and firms have conflicts over:

    • Foreign control over key industries

    • Infringe on national sovereignty

      • A Dubai company wanted to buy six U.S. ports in 2006

      • Caused an uproar in the United States because Dubai is a city in a Muslim country

      • A British company owned the ports and wanted to sell the ports

    • Local interests versus foreign company's interests

    • Government protects

      1. Defense industries - all countries impose restrictions on military equipment and supplies

      2. Agricultural industries - many countries protect agricultural markets

        • United States and Europe

        • Afraid a country could withhold exports as a means of control

      3. Infant industries - countries protect new industries

        • U.S. used it in 18th century to compete with Europe

        • Encourage domestic industry to thrive and grow

        • Gov. prevents international investment or foreign companies from entering country

      4. Tariffs - countries collect taxes on imports

        • Causes higher price and reduces imports

        • Government collects revenue

        • Foreign company may invest within country to circumvent trade barrier

        • Some third world countries have tax evasion problems and collect the revenue from tariffs because gov. controls the ports

      5. Trade Blocs - countries form free trade zones

        • Members have no or little trade protection; nonmembers have trade protection

        • Foreign company may invest within country to circumvent trade barrier

        • European Union and North American Free Trade Association (NAFTA)

    • Conditions imposed on foreign companies

      1. Government may force firm to use local companies, local resources, and local labor

        • Government restricts a foreign firm from using expatriates or limits the number

        • Firm employs expatriates for high level management and technical positions

      2. Transportation control - pipeline, highway, electric wires pass through a country

        • Government bargains for control by threatening to shut down

        • Example - Sudan split into two countries; petroleum is located in South Sudan while pipelines lead through North Sudan to the ports

        • North Sudan threatens to shut down pipelines and bargains with South Sudan

      3. Market control - firms and government strive for control over markets

        • Example - Organization of Petroleum Exporting Countries (OPEC)

        • Use quotas to reduce petroleum supplies to boost petroleum prices

        • OPEC members nationalized their petroleum industries

      4. Ownership - government requires foreign company a joint venture with government or local firms

        • Form joint ventures in former communistic countries, such as Kazakhstan

        • Common in national defense, agriculture, banking, or critical minerals industry

        • Western firms bring technology, efficient management practices, and investment

        • Was common in Japan, Mexico, China, India, and South Korea

2. A country could exhibit characteristics that endangers investment

  • Characteristic 1: A country experiences changes in government leadership often or a country has too many political parties.
    • Government policies and laws quickly change.
    • South American countries alternate between pro-business and socialist governments.
    • Government relaxes taxes and regulations during business phase and changes positions during its socialistic phase as it punishes businesses.
    • Strong nationalistic gov. may not view foreign investment favorably
  • Characteristic 2: International investors collect information about a foreign country's political leaders or a country's economic environment.
    • Leaders believe in free markets and limited government are likely to pass favorable government laws and regulations to foreign investment.
    • Heritage Foundation collect statistics on countries and measures economic freedom.
  • Characteristic 3: Some countries have contentious ethnic groups or religious fanaticism.
    • Poor investment choice
    • Bosnia and Herzegovina has three ethnic groups: Bosnians, Croats, and Serbs.
    • Bosnians are Muslims; the Croats are Catholics while the Serbs are Orthodox Christians
    • They fought the Bosnian War during the early 1990s after Yugoslavia had broken up.
  • Characteristic 4: Enterprises relocate to countries with uneven income gaps.
    • Businesses use the cheap labor force.
    • Foreign investors avoid a country with deteriorating economic conditions.
    • A country with high levels of poverty and massive unemployment breed protests, riots, and revolutions.
    • Protestors can damage the foreign investors' assets.
    • In extreme cases, the rioters and protestors could murder foreigners and tourists.

3. Country risk - risk originates by investing in a particular country. Political risk specifically entails problems with the government, while country risk is the risk for the entire country

  • Also called macro risk

  • Transfer risk - government restricts firms' ability to move funds into and outside of the country

    1. Blocked funds - if government has no foreign funds, cannot borrow, or attract investors to buy its debt, it may limit a firm's ability to transfer funds outside of country

      • Gov. prevents convertibility of currency

      • Blocked funds - reduces present value of investments

    2. Religion - could be a problem in Muslim countries, where religion and the state overlap

      • All Muslim countries use Sharia law, except Turkey

      • Women managers may not be acceptable in Middle Eastern countries

      • Sharia Law imposes restrictions on banking that differs from U.S. and Europe banks

      • Christian countries have secular governments

    3. Corruption - government has a severe corruption problem, such as kickbacks, extortion, and bribery

      • Extortion - gov. official threatens punish, fines, etc. to get business to pay money

      • Bribe - business pays money to get a gov. official to approve a license, permit, or overlook violations of the laws

      • Kickback - gov. official awards a gov. contract to a business friend. Then the friend pays a little money to the gov. official "under the table"

      • Nepotism may also be a problem; hiring of relatives and friends for high posts

      • Transparency International publishes the Corruption Perception Index

        • Tries to measure level of corruption

      • Advice

        • Avoid highly corrupt countries

        • Refuse bribes

          • Official could return with higher demands

          • Officials from other departments could show up and demand bribes

        • Court system tends to be weak in corrupt countries and just as corrupt

        • Publicity problems if news reporters find out

        • Some countries like the U.S. make it illegal to bribe leaders and governments in foreign countries

      • If you must pay

        • Use a local advisor or attorney to handle government officials

        • Form friends at high places

  • Strategies to reduce country and political risk

    1. Fronting loans - Parent company deposits U.S. dollars or euros into an international bank in a safe country

      • International bank lends to subsidiary in foreign country

      • Gov. usually allows a foreign business to pay international banks

      • If government prevents repayment, this could hurt government's image

    2. Leverage - firm borrows heavily from banks within the country

      • Leverage – a company borrows to finance operations without increasing equity

      • If firm and government have a conflict, then firm leaves and defaults on loans

      • Effective if government seizes assets or nationalizes an industry

    3. Create exports - firm exports a product to recoup its funds

      • Example - Burma has strong currency controls

      • Pepsi bought beans with its profits, then exported beans to get U.S. dollars

    4. Special dispensation - firm has bargaining power with government and may get government to repatriate funds

      • Effective in high tech industries, pharmaceuticals, electronics, etc.

      • Government believes these industries important for economic development

      • Spillover effects – creates a high tech workforce

      • Example - Google threatened to exit China over censorship rules

    5. Enterprises can buy investment insurance from home country or receive a government guarantee

      • Insurance covers

        • Investor does not recover profits or project investment from foreign country

        • Foreign government expropriates the business

        • Loss of business income from political violence, war, revolution, and riots

    6. Facility location - firm locates part of facility within a country

      • Further processing is done in other facilities in other countries

      • Increases transportation costs, but reduces risk

      • Example - petroleum is extracted in Middle East while refineries are in U.S. and Europe

    7. Intellectual Property Rights - firm retains control by owning rights to patents, trademarks, and brand names

      • Patents grant control over technology control

      • Foreign government cannot operate facility without permission

      • Effective when company continually upgrades technology

      • Some countries do not enforce intellectual property rights

      • World Trade Organization - help ensure countries enforce intellectual property rights

    8. Forced reinvestment - if all else fails, company reinvests its funds into country until it is able to transfer funds out

      • Goal of exchange controls is to keep money inside of country

      • Outside businesses may not enter a country with exchange controls

      • Hampers future investment

3. Global specific risk - risk originates at the global level

  • Most difficult to predict

  • Types

    1. Terrorism - September 11, 2001 - heightened awareness for terrorism

      • Multinational enterprises may have risk of attack because of association with home country

      • Enterprises cannot effectively fight terrorism; must depend on government

      • Riots and wars create problems for enterprises; may be attacked

    2. Just in time inventory system - enterprises hold low inventories

      • Expensive to store parts and products

      • Just in time - parts are produced as needed

      • Susceptible to a supply disruption, if parts come from many countries around the world

      • U.S. closed borders and grounded airplanes on September 11, 2001

      • Ford and other companies shut down and could not get parts

      • The 2011 earthquake in Japan shut down manufacturing

        • Supply disruption trickled around the world

    3. Anti-globalization Movement - people are angry about globalization

      • Loss of jobs

      • Competition with other cultures

      • Enterprises are at the core of globalization

    4. Environmental problems

      • Environmental regulations impose costs on enterprises

      • Enterprises relocated to countries with weak environmental laws, like China

      • Enterprises export pollution to other countries

    5. Poverty

      • Enterprises are located in countries with uneven income gaps

      • Enterprises may hire the better educated (i.e. higher income group)

    6. Cyber Attacks

      • Enterprises use network of computer systems

      • Hackers use coordinated attacks to shut down a corporation's or government's computer system or steal information

    7. Corporate Responsibility

      • Enterprises also benefit the communities where it operates

      • Enhance social, environmental, and economic conditions

      • Example - Starbuck's - pays more for coffee, which helps the small struggling coffee farmers

        • Note - used for slick marketing

 

Measuring Country Risk

 

  • Country risk is different from foreign exchange risk

    • Country risk can be zero and foreign exchange risk can be large for a specific country

    • The reverse can happen, but it is more rare

  • Why measure risk?

    • Multinational corporations

    • Global investors

    • Examples

      • 1998 Russian debt crisis

      • Argentina defaulted on December 2002

      • Value of Russian and Argentine assets fell significantly after both crises

  • How to measure risk?

    • Bonds are subject to two types of risk:

      • Interest rate risk- risk associated to changes in interest rates

        • As interest rate increase, bond prices decreases

      • Credit risk - the borrower does not repay the principal and/or interest of a loan

        • Credit rating agencies measure the risk with a credit rating

          • A letter grade

          • The higher the grade, the lower the yield of the bond

      • Risk Premium

        • U.S. government securities are considered risk free securities

        • U.S. government securities are backed by the U.S. government's ability to increase taxes and/or "print money"

      • A country's risk is measured the same way

    • Same credit rating rule applies:

    • The higher the grade for a country, the lower the discount rate used to evaluate projects in that country

    • A project's rate of return is the country risk plus the rate of return of comparable U.S. Treasury securities

    • A country's risk influences the interest on the debt issued by a government of a country

    • Example - Setting yields for Mexican government

      • Yields on Mexican government debt = US Treasuries + risk premium

      • Mexico’s grade: BBB - a spread of 140 bps (1.40%) over US Treasuries

      • U.S. Treasuries yield 4%

      • YieldMex = 4% + 1.40% = 5.40%

  • Two approaches to measure country risk:

    1. Qualitative – collect data, get an opinion from “experts,” form a “consensus”

      • Subjective

      • Experts are politicians, union members, economists

      • Monitor local radio, TV, newspapers, and publications from embassies

      • Historical stability

      • Political turmoil

    2. Quantitative – collect data, process the data with a computer, get a grade

      • More objective

      • Have data

      • Use data to compute a credit grade

  • Risk Rating Method - weighted average of grades for four aspects of a country

    • Each factor is a grade between 0 and 100

    • Economic Indicators (EI) - financial condition

      • GDP per capita

      • GDP growth rate

      • Inflation

      • Interest rates

    • Debt management (DM) - ability to repay debt

      • Money growth

      • Trade balance

      • Foreign and domestic debt

      • Fiscal balance

    • Political factors (PF) - political stability - could be subjective

      • A low grade indicates coups, violent protests, and even a revolution.

      • Election or revolution brings new leaders into power

        • Change the rules, regulations, and economy.

    • Structural factors (SF) - socioeconomic conditions

      • education level

      • healthcare

      • poverty rate

A country's score is

X = w1 Score(EI) + w2 Score(DM) + w3 Score(PF) + w4 Score(SF)

Note: The weights are positive and they sum: w1 + w2 + w3 + w4 = 1

Where are the weights and the formulae for the grades coming from?

  • This method seems more “objective,” because it is based on hard economic data, but weights and formula for grades might be “subjective.”

    • It’s more an art, than a science

    • The model can deliver different forecasts: Short-term, Medium-term, and Long-term

  • The weights and grades can change depending on your horizon

    • Example:

      • (a) Short-term: more weight to debt management and political factors

      • (b) Long-term: more weight to economic indicators and structural factor

    • Each model assigns a score between 0 and 100

  • Each grade is associated with a spread in basis points (bps) over base rate, usually the risk free rate

    • The following Table presents the standard conversion table for 1-year maturities

    • Conversion Table of a Country's Grade into a Rating and Spreads over U.S. Treasuries

Overall Grade Rating Spread
(bps)
Average
(bps)
Excellent
91 -100 AAA 10 -70 50
81 - 90 AA 50 - 100 70
71 - 80 A 80 - 130 100
Average Risk
61 - 70 BBB 110 - 220 160
51 - 60 BB 190 - 300 240
41 - 50 B 270 - 410 350
Excessive Risk
31 - 40 CCC 360 - 490 450
21 - 30 CC 450 - 700 570
10 - 20 C Above 700 800
0 - 10 In Default

Note 1 - As time to maturity increases, the spread (in bps) also increases

Note 2 - A rating of BBB or better is considered “investment grade”

Note 3 - A rating of BB or less is considered “junk.” In the U.S., the usual spread of junk debt is between 400 to 600 bps over 1-yr T-bills. Range is very wide: Spreads can go over 2600 bps

International Credit Rating Agencies

1. A.M. Best assigns country risk using a five-tier scale

  • The scale ranges from I to V with I being the lowest risk and V being the highest risk

  • A.M. Best uses country risk analysis to determine how the factors outside an insurer's control affect its ability to meet its obligations to its policyholders.

  • These analyses include:

    • Assessment of local accounting rules

    • Government policies and regulation

    • Economic growth and social stability

Rating Country
Tier 1 Australia, Austria, Canada, Denmark, Finland, France, Germany, Gibraltar, Guernsey, Isle Of Man, Jersey, Luxembourg, Netherlands, Norway, Singapore, Sweden, Switzerland, United Kingdom, and United States
Tier II Barbados, Belgium, Bermuda, British Virgin Islands, Cayman Islands, Chile, Hong Kong, Ireland, Italy, Japan, Liechtenstein, Macau, New Zealand, Slovenia, South Korea, Spain, and Taiwan
Tier III Anguilla, Bahamas, Bahrain, Brazil, China, Cyprus, Israel, Kuwait, Malaysia, Malta, Mexico, Netherlands Antilles, Oman, Poland, Qatar, Saint Kitts and Nevis, Saudi Arabia, South Africa, Thailand, Trinidad and Tobago, and United Arab Emirates
Tier IV Antigua and Barbuda, Argentina, Brunei, Colombia, Costa Rica, El Salvador, India, Indonesia, Jordan, Kazakhstan, Mauritius, Morocco, Panama, Peru, Philippines, Russia, Tunisia, and Turkey
Tier V Algeria, Belarus, Bolivia, Bosnia and Herzegovina, Dominican Republic, Ecuador, Egypt, Ghana, Guatemala, Honduras, Jamaica, Kenya, Lebanon, Libya, Nicaragua, Nigeria, Pakistan, Syria, Ukraine, Venezuela, and Vietnam

 

2. Coface is France's export credit underwriter

  • Coface offers insurance to companies that sell to a foreign company and the foreign company defaults

  • The default could result from a bankruptcy, violent protests, a revolution, or international war

  • Coface ranks a country's business climate that uses the same ranking scale

Country Rating Definition of Rating
Australia, Canada, Hong Kong, Japan, Luxembourg, New Zealand, Norway, Singapore, Sweden, Switzerland, and Taiwan A1 The steady political and economic environment has positive effects on an already good payment record of companies. Very weak default probability
Austria, Belgium, Chile, Denmark, Finland, France, Germany, Kuwait, Malaysia, Malta, Netherlands, Qatar, South Korea, and United States A2 Default probability is still weak even in the case when one country's political and economic environment or the payment record of companies are not as good as A1-rated countries
Brazil, China, Czech Republic, Estonia, India, Israel, Mauritius, Namibia, Oman, Poland, Slovakia, Slovenia, South Africa, Thailand, Trinidad and Tobago, United Arab Emirates, and United Kingdom A3 Adverse political or economic circumstances may lead to a worsening payment record that is already lower than the previous categories, although the probability of a payment default is still low
Algeria, Bahrain, Botswana, Colombia, Costa Rica, Iceland, Ireland, Italy, Lithuania, Mexico, Morocco, Panama, Peru, Saudi Arabia, Spain, Tunisia, Turkey, and Uruguay A4 An already patchy payment record could be further worsened by a deteriorating political and economic environment. Nevertheless, the probability of a default is still acceptable
Benin, Bulgaria, Cape Verde, Croatia, Dominican Republic, El Salvador, Gabon, Ghana, Hungary, Indonesia, Jordan, Kazakhstan, Latvia, Papua New Guinea, Philippines, Portugal, Romania, Russian Federation, Senegal, and Tanzania B An unsteady political and economic environment is likely to affect further an already poor payment record
Albania, Angola, Argentina, Armenia, Azerbaijan, Bangladesh, Bolivia, Burkina Faso, Cameroon, Congo, Cyprus, Djibouti, Ecuador, Egypt, Ethiopia, Georgia, Greece, Guatemala, Honduras, Jamaica, Kenya, Lebanon, Macedonia, Madagascar, Mauritania, Mongolia, Montenegro, Mozambique, Nicaragua, Niger, Paraguay, Sao Tome and Principe, Serbia, Sierra Leone, Sri Lanka, Timor-Leste, Togo, Uganda, Venezuela, Vietnam, and Zambia C A very unsteady political and economic environment could deteriorate an already bad payment record
Afghanistan, Belarus, Bosnia and Herzegovina, Burundi, Cambodia, Central African Republic, Chad, Congo, Cuba, Equatorial Guinea, Eritrea, Guinea, Haiti, Iran, Iraq, Ivory Coast, Kyrgyzstan, Lao, Liberia, Libya, Malawi, Mali, Moldova, Myanmar, Nepal, Nigeria, Pakistan, Rwanda, Sudan, Syria, Tajikistan, Turkmenistan, Ukraine, Uzbekistan, Yemen, and Zimbabwe D The high risk profile of a country's economic and political environment will further worsen further a generally very bad payment record

References

A.M. Best. 2012. Available from http://www3.ambest.com/ratings/cr/crisk.aspx (accessed on 10/16/2012)

Coface. 2012. Rating Table. Available from http://www.coface.com/CofacePortal/COM_en_EN/pages/home/risks_home/country_risks/rating_table?geoarea-country=&crating=&brating= (accessed on 10/16/2012)

 

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