School of Management Studies, Nagaland University

MFM 301 International Financial Management

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Country risk is exposure to a loss in a cross-border lending, caused by
events in a particular country. These events must be, at least to some
extent, under the control of the government of that country; they are
definitely not under the control of a private enterprise or individual.
COUNTRY RISK ANALYSIS


By
Rokov N. Zhasa
NU/MN-22/11
NU Reg. No. 111291 of 2011-2012

Keywords: Country Risk Analysis

Content
1.0 Introduction
1.2 What is at Risk?
1.3 Country Risk and Political, Social and Economic Risks
1.4 Time horizon
1.5 Need for Risk Evaluation
1.6 Geographical location of risks
1.7 Classification of Country Risk
1.8 Qualifications needed for proper assessment of country risk
1.9 Quantifying Country Risk
1.10 Use of Country Risk Assessment
1.11 Incorporating Country Risk in Capital Budgeting
1.12 Conclusion
Reference

1.0 INTRODUCTION
The Oxford English Dictionary defines risk as exposure to a perils. From an
investors point of view, risk is exposure to a loss.
Country risk applies to assets and not to liabilities, although there may exist
a cross country liability risk of branch banking abroad. Among foreign assets, the
definition of country risk includes only foreign loans.
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MFM 301 International Financial Management
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1.2 WHAT IS AT RISK?
All cross-border lending in a country-whether to the government, a bank, a private
enterprise or an individual-is exposed to a country risk. Country risk is thus a
broader concept than sovereign risk, which is the risk of lending to the
government of a sovereign nation. Further, only events that are, at least to some
extent, under the control of the government, can lead to the materialization of
country risk. A default caused by bankruptcy is country risk if the bankruptcy is the
result of mismanagement of the economy by the government; it is commercial risk
if it is the result of the mismanagement of the firm.
An interesting case is that of natural calamities. If they are unforeseeable,
they cannot be considered as country risks. But if the past experience shows that
they have a tendency to recur periodically-such as typhoons in Southeast Asia-
then the government can minimize their effects. Prudent analysts also make
allowance for them in their assessment of country risk.
Control by the government is understand in the broad sense. If the
government can to some extent control at least the impact of an adverse
development, even though it cannot control the event itself, the possibility of that
event is country risk.

1.3 COUNTRY RISK AND POLITICAL, SOCIAL AND ECONOMIC RISKS
The most frequent events that can lead to the materialization of country risk can
be classified as:
1.3.1 Political Components
War, occupation by foreign power, riots, disorders caused by territorial claims,
ideological differences, conflict of economic interests, regionalism, political
polarization, etc. are the many of the critical factors of country risk analysis of
political nature. Some of the Political factors are listed in Table-1. Depending on
the particular type of project for which the country risk analysis is being performed,
the analyst should consider more specific subcategories in some of these areas
and some other important categories.
1.3.2 Socio-Cultural Components
When a company operates in a foreign country, it must consider the possible
effects of many socio-cultural variables such as civil war, riots, disorders caused
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MFM 301 International Financial Management
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by tribal strife, unequal income distribution, union militancy, religious divisions,
antagonism between social classes, etc. Table-2 covers most of the major types
of the socio-cultural variables, but many more can be important, especially for
specific types of investments.
1.3.3 Economic Components
Economic factors e.g., a long-term slowdown in GNP growth, strikes, rapid rise in
production costs, fall in export earnings, sudden increase in food or energy
imports, etc. can obviously be of great importance in determining the degree of
country risk confronting a foreign company. Table-3 outlines many of the most
important of these variables.

Table-1 Political Factors Affecting Country Risk
I. DOMESTIC
A. The Political System
1. Its Basic Strength
2. Its resiliency-capacity for change without disruptive conflict
B. The Group in Power
1. Philosophy
2. Policies
3. Government officials
a. Ability and number of qualified officials
b. Willingness and capability for making tough decisions
4. Strength, capability of implementing plans
C. Opposition Groups
1. Strength
a. Likelihood of system disrupting conflicting from within the country
2. Philosophy of strong opposition groups
D. The Government System
1. Efficiency
2. Red Tape
3. Flexibility
4. Responsiveness
II. INTERNATIONAL
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A. Likelihood of system disrupting conflict arising from outside the country
1. Due to countrys own problems
2. Due to treaty or other obligations
B. Relations with major trading partners
C. Relations of the companys home country with other countries

Table-2 Socio-Cultural Factors Affecting County Risk
I. DOMESTIC
A. Social Groups
1. Homogeneity of population
a. Ethnic
b. Religious
c. Linguistic
d. Class.
2. Extent of cohesiveness or divisiveness
B. General psychology of population work ethic
C. Unemployment
D. Political activism of population
E. Extent of Social unrest
1. Strikes
2. Riots
3. Insurgency
II. INTERNATIONAL
A. Cross-border ties
a. Ethnic
b. Religious
c. Linguistic
d. Historical
B. Cross-border antagonism
a. Ethnic
b. Religious
c. Linguistic
d. Historical

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Table-3 Economic Factors Affecting Country Risk

I. DOMESTIC
A. Economic growth, investment trends
B. Cyclicality of economy, economic diversification
C. Inflation
a. Momentary policy
b. Fiscal policy, budget deficits
D. Strength of local financial markets, portion of total investment financed locally
II. INTERNATIONAL
A. Balance of payments
B. International trade
1. Importance of trade in GNP
2. Stability of trade earnings
a. Diversity of exports
b. Elasticity of export demand
c. Elasticity of import demand
i. capital equipment
ii. necessities
-Degree of self-reliance in food
-Reliance on imported energy
iii. luxuries
3. International trade ties, proximity to major markets
4. Extent if trade controls
C. International Capital
1. Currency
a. Strength
b. Stability
c. Quality of exchange markets
d. Depth of exchange markets
e. Extent of controls over exchange markets
2. Debt
a. Total
b. Short-term as share of total
c. Debt service ratio
d. Debt-service schedule
3. International Financial Resources
a. International reserves
b. International borrowings capacity
i. History of debt repayment
ii. Credit rating
c. Autonomous capital inflows
4. Share of total investment financed from abroad


1.4 TIME HORIZON
Loans are made from one day to maximum of 10-12 years, and country risk
evaluation encompasses these periods. It is extremely rare to contemplate a
direct investment for less than five years. This is thus the minimum time horizon
for risk assessment. The maximum is around 30 years, for example for oil
exploration, plantations, or mining.
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MFM 301 International Financial Management
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1.5 NEED FOR RISK EVALUATION
Events of the last decade have demonstrated that, just as the stock market, the
international financial market can in the short term be disastrously wrong in its
collective evaluation of country risk. Individual banks can be ahead of the market
in their evaluation of country risk if they have insight based on information and its
interpretation as well as analytical ability superior to the market average. The
purpose of country risk evaluation is to improve the individual banks performance
relative to the market average. If the bank can in the short term assess country
risk more accurately than the market and can anticipate changes in the risk
situation ahead of the market, it can move with countries where the risk is better
than the markets perception, or where the bank perceives an improvement before
its competitors, it can fund at the most favorable rates, and have smaller losses
and wider average spreads than its competitors.

1.6 GEOGRAPHICAL LOCATION OF RISKS
The risk of a loan is usually located in the country of domicile of the borrower. But
if the loan is guaranteed, should it be the country of the guarantor? What about
the brass plate domiciles, where the head office is legally domiciled in a tax
haven and the assets of the company are elsewhere?
As a general rule, the risk should belong to the country on which the
principal protection as the repayment of the loans depends. The risk of each loan
can only be located after careful scrutiny of the overall situations, covering
safeguards against loss and country jurisdiction.

1.7 CLASSIFICATION OF COUNTRY RISK
Much of the conceptual confusion that surrounds country risk arises from the
different criteria according to which risks can be classified. These include:
1. By the side of the balance sheet which is exposed to risk, whether assets
or liabilities
2. In case of assets, by type of asset which is at risk: loans (country risk) vs.
direct investment;
3. Geographically: Austrian, Brazilian, Chilean, etc. risk;
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MFM 301 International Financial Management
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4. Within each country, by the nature of events that may lead to its
materialization: political, social, economic, etc;
5. Regarding country risk, by type of borrower: government (or soverign) risk,
private sector risk, corporate risk, individual risk;
6. For each type of borrower, by the action taken by the borrower that causes
a loss: repudiation, default, renegotiation, rescheduling, etc.
7. For each of these, by degree, i.e. high, low, moderate risk.

1.7.1 Classification by action taken by borrower
Among the various classifications, the type of action taken by the borrower is
probably the most important.
Repudiation or default
In this case, the debtor notifies the creditor that he will definitely cease making any
further service payments because he cannot or does not want to pay (default), or
because he does not recognize the debt (repudiation). As the distinction between
repudiation and default has little relevance to the lender, and because repudiation
is extremely rare, we are concerned here only with default.

Renegotiation
Renegotiation here indicates that the lender will receive less than originally agreed
because the interest rates is lowered, the spread narrowed and/ or because part
of the principal will not be repaid. Refinancing not covered by a penalty clause has
similar consequences to the lender.

Rescheduling or moratorium
This implies that the terms of the loan are lengthened either because annual
repayments of principal are lowered and spread over a great number of years
than originally agreed (rescheduling) or because there will be a grace period for
the repayment of principal (moratorium). The interest (or spread) remains the
same as originally agreed.
There may be an opportunity loss if the lender could have relent the the
principla at a higher rate interest rate or wider spread had it been repaid as
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originally scheduled. There may alternatively be an opportunity gain, if the market
has become more liquid in the meantime.
There will also be a loss of convenience as the schedule of the actual cash
flow will be different from that of the expected cash flow. There are extra
administrative costs, such as the cost of negotiating the rescheduling or the
moratorium. This is usually the only measurable loss that the lender suffers as a
aresult of rescheduling or moratorium, but even that may be recovered through a
one percent penalty interest on re-scheduled amounts.

Technical default
Technical default arises when the borrower fails to meet one or several terms for
debt service payments because of, for example, temporary inability (or
unwillingness) to pay, administrative delays, or inefficiency. The accent is on the
word temporary usually there is little doubt that the debtor will eventually meet
his debt servicing obligations. Usually he also pays interest-sometimes at a
penalty rate-on service payments due, In that case the impact from the lenders
point of view is similar to that of a moratorium; there is a possibility of opportunity
loss and there will be a convenience loss as well as the extra costs incurred in
prompting the debtor to meet his debt servicing obligations.

Transfer risk
If prohibitive exchange restrictions have been imposed by the government, it may
become impossible to transfer payments. This type of country risk can only
materialize for private borrowers; if the government cannot service its own debt
because it does not have the required amount of foreign exchange, the risk would
come under default, renegotiation, rescheduling, moratorium, or technical default.
A so called improductive loan-a loan that is not serviced-may be a case of
technical default or transfer impossibility. Depending upon how the issue is
eventually resolved, it may also belong to any of the other categories.

1.8 QUALIFICATIONS NEEDED FOR PROPER ASSESSMENT OF COUNTRY
RISK
At least six qualifications are required for proper assessment of country risks:
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1. Conceptual awareness of factors that have a bearing on country risk
2. Analytical ability to assess how these factors interact in affecting debt
servicing ability.
3. In-depth knowledge of the country under scrutiny; its political and economic
structure, the institutional and regulatory framework, recent political and
economic developments, economic policies, strength and determination of
the government to implement policies, etc.
4. Specialized expertise to predict political variables
5. Familiarity with economic forecasting techniques to make short and lonf-
term projections of relevant variables; real GDP growth, inflation, balance
of payments, external debt, debt service payments.
6. Experience and skills to draw conclusions regarding debt servicing ability
from observed and predicted variables, and combine these into a risk
rating.

The acquisition of these qualifications requires considerable learning, training and
experience. Few individuals are likely to combine all the qualifications, so country
risk analysis should be the result of cooperation , drawing on all the available
expertise within, and accessible to, the bank, and should under no circumstances
be left to amateurs.

1.9 QUANTIFYING COUNTRY RISK
To develop an overall country risk rating, it is necessary to first construct separate
ratings for political and financial risk which depend on variety factors. First the
political factors can be assigned values within some arbitrarily chosen range,
which should add up to 100 percent. The assigned values of the factors times the
respective weights can then be summed up to derive a political risk rating.
The process described for deriving the political risk rating can then be
repeated to derives the financial risk rating. That is, values can be assigned (from
1 to 5, where 5 is the best value/ lowest risk) to all financial factors. The assigned
values of the factors times their respective weights can be summed up to derive a
financial risk rating.
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Once the political and financial ratings have been derived, a countrys
overall country risk rating as related to a specific project can be determined by
assigning weights to the political and financial ratings according to the perceived
importance. The political and financial ratings multiplied by their respective
weights would determine the overall country risk rating for a country as related to
a particular project.
In a realistic setting, many more factors might be included. Political risk
factor A might reflect the degree of political tension of the country with its
neighboring countries, and so on. Financial risk factors A might reflect potential
internal economic growth, and so on.
The number of relevant factors comprising both the poltitical risk and the
financial risk categories will vary with the country being assessed and the type of
corporate operations planned for the country. The assignments of values to the
factors, along with the degrees of importance (weights) assigned to the factors,
will also vary with the country being assessed and type of corporate opearations
planned for the country.
It should be emphasized that country risk assessors have their own
individual procedures for quantifying country risk. Most procedures are similar,
though, in that they somehow assign ratings and weights to all individual
characteristics relevant to country risk assessment.

1.10 USE OF COUNTRY RISK ASSESSMENT
The first step for a firm after it has developed a country risk rating is to determine
whether that rating suggests the risk is tolerable. If the country risk is too high,
then the firm does not need to analyse the feasibility of the proposed project any
further. Some firms may contend that no risk is too high when considering a
project. Their reasoning Is that if the potential return is high enough, the project is
worth undertaking. However, there are cases in which the degree of country risk
could be too high regardless of the projects expected return.
If the risk rating of a country is in the tolerable range any project related to
that country deserves further consideration. Capital budgeting analysis would be
appropriate to determine whether the project is feasible.

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1.11 INCORPORATING COUNTRY RISK IN CAPITAL BUDGETING
Country risk can be incorporated in the capital budgeting analysis of a proposed
project by adjustment of the discount rate, or by adjustment of the estimated cash
flows. Each method is discussed below:

Adjustment of the Discount Rate:
The discount rate of a proposed project is supposed to reflect the required rate of
return on that project. Thus, the discount rate could be adjusted to the amount for
the country risk. The lower the country risk rating, the higher is the perceived risk,
and the higher is the discount rate applied to the projects cash flows. This
approach is convenient in that one adjustment to the capital budgeting analysis
can capture country risk. However, there is no precise formula for adjusting the
discount rate to incorporate country risk. The adjustment is somewhat arbitrary,
and may therefore cause feasible projects to be rejected or unfeasible projects to
be accepted.

Adjustments of the estimated Cash Flows
If there is a chance that the host government takeover will occur, the foreign
projects NPV under these conditions should be estimated. Each possible form of
risk has an estimated impact on the foreign projects cash flows, and therefore on
the projects NPV. By analysiny each possible impact, the MNC can determine the
probability distribution of NPVs for the project will generate a positive NPV, as well
as the size of possible NPV outcomes. While this procedure may seem somewhat
tedious it directly incorporates forms of country risk into the cash flow estimates
and explicitly illustrates the possible results from implementing the project. The
more convenient methos of adjusting the discount rate in accordance with the
country risk rating does not indicate the probability distribution of possible
outcomes.

1.12 CONCLUSION
As sovereign lending increases with each passing year, the risk of operating
across ones national borders is increasingly given more attention. The need to
estimate the risks involved and thereafter putting in place appropriate measures
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has become of the key areas for planners and leaders of banks. Country Risk
Analysis with its comprehensive coverage of the political and economic
characteristics of a country is an attempt at the evaluation of a countrys debt
servicing ability.








REFERENCE
1. Bhalla V.K., International Financial Management (Text and Cases) 10
th

Revised and Enlarged Edition, Anmol Publications Pvt. Ltd. 2011