11. Country Risk

8/12/2019 11. Country Risk

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Country Risk


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Types of Risk Facing Businesses

Price risk Credit risk Pure risk

Output price risk Input price risk

Commodity price risk

Exchange rate risk

Interest rate risk

Damage to assets

Legal liability

Worker injury

Employee benefits


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Enterprise Risk Management

The holistic approach to assessing, measuring

and managing the different types of risk to

which an organisation is exposed.

Operational Risk

Credit Risk

Business Risk Market Risk

Country risk


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Risk Management

For any type of risk, the risk managementprocess involves a number of key steps

1. Identify all significant risks

2. Evaluate potential frequency and severity of losses3. Develop and select methods for managing risk

4. Implement risk management methods chosen

5. Monitor performance and suitability of risk management

methods and strategies on an ongoing basis


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Risk Management Methods

Three main methods of managing risk

Loss control

Loss financing

Internal risk reduction

Loss control and internal risk reduction usually

involve decisions to invest (or forego investing)

resources to reduce expected losses

Loss financing decisions relate to how to pay for

losses if they do occur


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Factors Affecting Country Risk

Macroeconomic Factors

The first of these factors is the size and structure of thecountrys external debt in relation to its economy.

More specifically: The current level of short-term debt and the potential

effect that a liquidity crisis would have on the ability ofotherwise creditworthy borrowers in the country tocontinue servicing their obligations.

To the extent the external debt is owed by the publicsector, the ability of the government to generate sufficientrevenues, from taxes and other sources, to service itsobligations.


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The condition and vulnerability of the countrys current

account is also an important consideration, including: The level of international reserves held by Central Bank

The importance of commodity exports as a source of

revenue, the existence of any price stabilization

mechanisms, and the countrys vulnerability to a downturnin either its export markets or the price of an exported

commodity.

The potential for sharp movements in exchange rates and

the effect on the relative price of the countrys imports andexports. (Iceland)


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The role of foreign sources of capital in meeting the

countrys financing needs is another important

consideration for country risk, including:

The countrys access to international financial markets and thepotential effects of a loss of market liquidity. (Greece)

The countrys relationships with private sector creditors, includingthe existence of loan commitments and the attitude among bankers

toward further lending to borrowers in the country. The countrys current standing with multilateral and official creditors,

including the ability of the country to qualify for and sustain anInternational Monetary Fund (IMF) or other suitable economicadjustment program.

The trend in foreign investments and the countrys ability to attractforeign investment in the future.

The opportunities for privatization of government-owned entities.

i h hi hli h d h i


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Past experience has highlighted the importance

of a number of other important

macroeconomic considerations, including:

The degree to which the economy of the country may beadversely affected through the contagion of problems inother countries.

The size and condition of the countrys banking system,

including the adequacy of the countrys system for banksupervision and any potential burden of contingentliabilities that a weak banking system might place on thegovernment.

The extent to which state-directed lending or othergovernment intervention may have adversely affected thesoundness of the countrys banking system, or the structureand competitiveness of the favoured industries orcompanies.


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Social, Political, and Legal Climate

The analysis of country risk should also take intoconsideration the countrys social, political, and legalclimate including:

The countrys natural and human resource potential.

The willingness and ability of the government torecognize economic or budgetary problems andimplement appropriate remedial action.

The degree to which political or regional factionalism

or armed conflicts are adversely affecting governmentof the country.

Any trends toward government-imposed price, interestrate, or exchange controls


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Social, Political, and Legal Climate

The degree to which the countrys legal system can be relied

upon to fairly protect the interests of foreign creditors and

investors.

The accounting standards in the country and the reliability and

transparency of financial information.

The extent to which the countrys laws and government policies

protect parties in electronic transactions and promote the

development of technology in a safe and sound manner.

The extent to which government policies promote the effective

management of the institutions exposures.

The level of adherence to international legal and business

practice standards


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Institution-Specific Factors

Finally, an institutions analysis of country risk should take intoconsideration factors relating to the nature of its actual (or approved)exposures in the country including, for example:

The institutions business strategy and its exposure management plans forthe country.

The mix of exposures and commitments, including the types ofinvestments and borrowers, the distribution of maturities, the types andquality of collateral, the existence of guarantees, whether exposures areheld for trading or investment, and any other distinguishing characteristicsof the portfolio.

The economic outlook for any specifically targeted industries within thecountry.

The degree to which political or economic developments in a country arelikely to affect the institutions chosen lines of business in the country.

For instance, the unemployment rate or changes in local bankruptcy lawsmay affect certain activities more than others.


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Institution-Specific Factors For an institution involved in capital markets, its susceptibility to

changes in value based on market movements. As the market value ofclaims against a foreign counterparty rise, the counterparty maybecome less financially sound, thus increasing the risk of nonpayment.This is especially true with regard to over-the-counter derivativeinstruments.

The degree to which political or economic developments are likely toaffect the credit risk of individual counterparties in the country. For example, foreign counterparties with healthy export markets or

whose business is tied closely to supplying manufacturing entities indeveloped countries may have significantly less exposure to the localcountrys economic disruptions than do other counterparties in thecountry.

The institutions ability to effectively manage its exposures in a countrythrough in-country or regional representation, or by some otherarrangement that ensures the timely reporting of, and response to,any problems.


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Foreign Direct Investment Theory

and Political Risk

Ch 18


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18-15

Sustaining and Transferring

Competitive Advantage In deciding whether to invest abroad, management must first determine

whether the firm has a sustainable competitive advantage that enables itto compete effectively in the home market.

The competitive advantage must be firm-specific, transferable, andpowerful enough to compensate the firm for the potential disadvantages

of operating abroad (foreign exchange risks, political risks, and increasedagency costs).

There are several competitive advantages enjoyed by MNEs.


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18-16


Competitive Advantage Economies of scale and scope:

Can be developed in production, marketing, finance, research anddevelopment, transportation, and purchasing

Large size is a major contributing factor (due to international and/or domesticoperations)

Managerial and marketing expertise:

Includes skill in managing large industrial organizations (human capital andtechnology)

Also encompasses knowledge of modern analytical techniques and theirapplication in functional areas of business


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Competitive Advantage

Advanced technology:

Includes both scientific and engineering skills

Financial strength: Demonstrated financial strength by achieving and

maintaining a global cost and availability of capital

This is a critical competitive cost variable thatenables them to fund FDI and other foreign

activities


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18-18


Competitive Advantage Differentiated products:

Firms create their own firm-specific advantages by producing andmarketing differentiated products

Such products originate from research-based innovations or heavy

marketing expenditures to gain brand identification Competitiveness of the home market:

A strongly competitive home market can sharpen a firms competitiveadvantage relative to firms located in less competitive ones

This phenomenon is known as the diamond of national advantage and

has four components


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Where to Invest?

The decision about where to invest abroad is influenced by behavioral factors.

The decision about where to invest abroad for the first time is not the sameas the decision about where to reinvest abroad.

In theory, a firm should identify its competitive advantages, and then search

worldwide for market imperfections and comparative advantage until it findsa country where it expects to enjoy a competitive advantage large enough togenerate a risk-adjusted return above the firms hurdle rate.

In practice, firms have been observed to follow a sequential search pattern asdescribed in the behavioral theory of the firm.


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Where to Invest?

The decision to invest abroad is influenced by behavioral factors.

The decision about where to invest abroad for the first time is not thesame as the decision about where to reinvest abroad.

In theory, a firm should identify its competitive advantages. Then it should

search worldwide for market imperfections and comparative advantageuntil it finds a country where it expects to enjoy a competitive advantagelarge enough to generate a risk-adjusted return above the firms hurdlerate.


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18-21

Exhibit 18.3 The FDI Sequence: Foreign Presence and

Foreign Investment


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How to Invest Abroad:

Modes of Foreign Investment

Exporting versus production abroad:

There are several advantages to limiting a firms activities to

exports as it has none of the unique risks facing FDI, Joint Ventures,

strategic alliances and licensing with minimal political risks

The amount of front-end investment is typically lower than other

modes of foreign involvement

Some disadvantages include the risks of losing markets to imitators

and global competitors


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18-23



Licensing and management contracts versus control of assets

abroad:

Licensingis a popular method for domestic firms to profit from foreign

markets without the need to commit sizeable funds

However, there are disadvantages which include:

License fees are lower than FDI profits

Possible loss of quality control

Establishment of a potential competitor in third-country markets

Risk that technology will be stolen


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18-24



Management contracts are similar to licensing,

insofar as they provide for some cash flow from a

foreign source without significant foreign

investment or exposure Management contracts probably lessen political

risk because the repatriation of managers is easy

International consulting and engineering firmstraditionally conduct their foreign business on the

basis of a management contract


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Joint venture versus wholly owned subsidiary:

Ajoint ventureis here defined as shared ownership in a foreignbusiness

Some advantages of a MNE working with a local joint venture partner

are: Better understanding of local customs, mores and

institutions of government

Providing for capable mid-level management

Some countries do not allow 100% foreign ownership

Local partners have their own contacts and reputationwhich aids in business


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18-26


Modes of Foreign Investment However, joint ventures are not as common as 100%-owned foreign

subsidiaries as a result of potential conflicts or difficulties including:

Increased political risk if the wrong partner is chosen

Divergent views about the need for cash dividends, or

the best source of funds for growth (new financingversus internally generated funds)

Transfer pricing issues

Difficulties in the ability to rationalize production on a

worldwide basis


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18-27



Greenfield investment versus acquisition:

A greenfield investmentis defined as establishing aproduction or service facility starting from the groundup

Compared to a greenfield investment, a cross-borderacquisition is clearly much quicker and can also be acost effective way to obtain technology and/or brandnames

Cross-border acquisitions are however, not withoutpitfalls, as firms often pay too high a price or utilizeexpensive financing to complete a transaction


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The term strategic allianceconveys different meanings to different

observers.

In one form of cross-border strategic alliance, two firms exchange a share

of ownership with one another.

A more comprehensive strategic alliance, partners exchange a share ofownership in addition to creating a separate joint venture to develop and

manufacture a product or service

Another level of cooperation might include joint marketing and servicing

agreements in which each partner represents the other in certain markets.


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Foreign Direct Investment Originating in

Developing Countries

In recent years, developing countries with

large home markets and some entrepreneurial

talent have spawned a large number of rapidly

growing and profitable MNEs

These MNEs have not only captured large

shares of their home markets, but also have

tapped global markets where they are

increasingly competitive


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Foreign Direct Investment Originating in

Developing Countries

The Boston Consulting Group has identified sixmajor corporate strategies employed by theseemerging market MNEs

Taking brands global

Engineering to innovation

Leverage natural resources

Export business model

Acquire offshore assets

Target a niche


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Defining Political Risk

In order for an MNE to identify, measure, and

manage its political risks, it needs to define

and classify these risks which include

Firm-specific risks

Country-specific risks

Global-specific risks


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Assessing Political Risk

At the macro level, prior to under-taking

foreign direct investment, firms attempt to

assess a host countrys political stability and

attitude toward foreign investors

At the micro level, firms analyze whether their

firm-specific activities are likely to conflict

with host-country goals as evidenced by

existing regulations


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Predicting Risks

Predicting firm-specific risk

Different foreign firms operating within the samecountry may have very different degrees of

vulnerability to changes in host-country policy orregulations

Predicting country-specific risk

Political risk analysis is still an emerging field,though firms need to attempt to conduct thisanalysis


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Firm-Specific Risks

Governance risks

Governance riskis the ability to exercise effective control over anMNEs operations within a host countrys legal and politicalenvironment

Historically, conflicts of interest between objectives of MNEs and host

governments have arisen over such issues as the firms impact oneconomic development, the environment, control over exportmarkets, balance of payments (to name a few)

The best approach to conflict management is to anticipate problemsand negotiate understanding ahead of time


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Firm-Specific Risks

Negotiating Investment Agreements

An investment agreement spells out specific rights

and responsibilities of both the foreign firm and

the host government

The presence of the MNE is as often sought by

development-seeking host governments

An investment agreement should define policies

on a wide range of financial and managerial issues


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Operating Strategies after the FDI Decision

Although an investment agreement creates obligations on thepart of both foreign investor and host government, conditionschange and agreements are often revised in the light of suchchanges

The firm that sticks rigidly to the legal interpretation of itsoriginal agreement may well find that the host governmentfirst applies pressure in areas not covered by the agreementand then possibly reinterprets the agreement to conform tothe political reality of that country


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Operating Strategies after the FDI Decision

Some key areas of consideration include:

Local sourcing

Facility location

Control of transportation

Control of technology

Control of markets

Brand name and trademark control

Thin equity base

Multiple-source borrowing


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Country-Specific Risk: Transfer Risk

Country-specific risks affect all firms, domestic

and foreign, that are resident in a host country

The main country-specific political risks aretransfer riskand cultural and institutional risks


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Country-Specific Risk: Transfer Risk

Transfer riskis defined as limitations on the MNEs ability to

transfer funds into and out of a host country without

restrictions

When a government runs short of foreign exchange and

cannot obtain additional funds through borrowing or

attracting new foreign investment, it usually limits transfers of

foreign exchange out of the country, a restriction known as

blocked funds


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18-40

Exhibit 18.6 Management Strategies for Country-

Specific Risks


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Country-Specific Risk: Cultural and Institutional

Risks

When investing in some of the emerging markets, MNEs thatare resident in the most industrialized countries face seriousrisks because of cultural and institutional differencesincluding:

Differences in allowable ownership structures

Differences in human resource norms

Differences in religious heritage

Nepotism and corruption in the host country

Protection of intellectual property rights

Protectionism


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Global-Specific Risks

Global specific risks faced by MNEs have come to theforefront in recent years

The most visible recent risk was, of course, the attack byterrorists on the twin towers of the World Trade Center inNew York on September 11, 2001.

In addition to terrorism, other global-specific risks include theantiglobalization movement, environmental concerns, povertyin emerging markets and cyber attacks on computerinformation systems

11. Country Risk

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