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CHAPTER 6: COUNTRY RISK ANALYSIS
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SUGGESTED SOLUTIONS TO CHAPTER 6 PROBLEMS
1.
Comment on the following statement discussing Mexico's recent privatization. "Mexican state companies are
owned in the name of the people, but are run and now privatized to benefit Mexico's ruling class."
ANSWER. Historically, Mexican state companies have been run to benefit politicians as well as their bureaucrats and
workers rather than consumers and taxpayers (who wound up subsidizing these firms). Whether privatization
benefits Mexico's ruling class depends on how prices are set and the terms of the sale. Even if privatization takes
places at unrealistically low prices, it will benefit all Mexicans, provided that (a) no laws restrict the ability of
domestic or foreign firms to compete with privatized firms and (b) the government ends its subsidies to them.
Competition will force privatized firms to be more efficient and lower their prices to consumers, while cutting
subsidies will end a major drain on the Mexican treasury.
2.
Between 1981 and 1987, direct foreign investment in the Third World plunged by more than 50%. The World
Bank is concerned about this decline and wants to correct it by improving the investment climate in Third
World countries. Its solution: Create a Multilateral Investment Guarantee Agency (MIGA) that will guarantee
foreign investments against expropriation at rates to be subsidized by Western governments.
a.
Assess the likely consequences of MIGA on both the volume of Western capital flows to Third World nations
and the efficiency of international capital allocation.
ANSWER. By lowering the risk-adjusted return required by investors, MIGA will increase the flow of Western
capital to Third World nations. At the same time, however, subsidizing investment insurance will tend to produce
less efficient capital allocation; more money will be channeled to those countries that have the greatest risk of
expropriation (since these are the countries that will receive the greater implicit subsidy from MIGA). Because
respect for property rights is critical for economic growth, these are also the nations with the poorest economic
prospects. Under MIGA, American taxpayers will wind up subsidizing the expropriation of American property.
Thus, MIGA becomes another welfare scheme, not a business venture.
b.
How will MIGA affect the probability of expropriation and respect for property rights in Third World
countries? Consider this question from an option pricing perspective.
ANSWER. Governments always have the option of expropriating foreign property in their nations. The decision of
whether to expropriate this property depends on the cost of exercising this option. By lowering the cost of
expropriation, MIGA would make expropriation more advantageous for Third World governments and, hence, more
likely. Instead of Third World governments compensating MIGA-insured investors, Western governments would
provide this compensation.
c.
Is MIGA likely to improve the investment climate in Third World nations?
ANSWER. Quite the contrary. MIGA would counter the decline in private investment not by making foreign
investment safer, but by having Western governments pay for the costs of Third World expropriations. If the World
Bank really wants to improve the investment climate in the Third World, it could simply stop giving money to Third
World governments that subvert their own development by expropriating foreign investors.
d.
According to a senior World Bank official (Wall Street Journal, December 22, 1987, p. 20), "There is vastly
more demand for political risk coverage than the sum total available." Is this a valid economic argument for
setting up MIGA?
ANSWER. In general, a shortage of a good or service reflects underpricing. This situation is no exception. The
problem is not that private insurance is not available--several private entities such as Lloyd's of London offer
insurance for foreign investments--but that its costs accurately reflect the true risk of placing one's money in
countries where property rights are routinely violated. In other words, the demand for low priced political risk
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insurance exceeds its supply. At the right price, enough insurance would be available to exactly satisfy the market's
demand. The purpose of MIGA is to boost FDI in Third World countries, most of which suffer from capital flight.
The fact that the countries' own citizens don't trust the government is a clue that investment there is unsafe.
e.
Assess the following argument made on behalf of MIGA by a State Department memo: "We should avoid
penalizing a good project [by not providing subsidized insurance] for bad government policies over which they
have limited influence... Restrictions on eligible countries [receiving insurance subsidies because of their
doubtful investment policies] will decrease MIGA's volume of business and spread of risk, making it harder to
be self-sustaining." (Quoted in the Wall Street Journal, December 22, 1987, p. 20.)
ANSWER. MIGA's approach to foreign investments seems to be based more on a protection of greedy governments
than on a respect for property rights. The World Bank seems to see expropriations as events that involve no human
responsibility or blame. The World Bank refuses to loudly condemn Third World governments for seizing Western
property. Countries throughout Africa that have nationalized foreign corporations have afterward received World
Bank loans at subsidized rates to help run the new state-owned industries. A question that the MIGA official failed
to ask is, "Why should taxpayers of developed countries subsidize the self-destructive behavior of Third World
countries?"
Some countries, like South Korea, Taiwan, and Hong Kong, have done very well at attracting foreign investment.
MIGA would play down the differences in how governments treat investors, thus penalizing nations that honor
property rights and rewarding nations that violate them. Given the crucial role that property rights play in economic
development, this is a perverse set of incentives.
3.
In the early 1990s, China decided that by 2000 it would boost its electricity-generating capacity by more than
half. To do that, it is planning on foreigners' investing at least $20 billion of the roughly $100 billion tab.
However, Beijing has informed investors that, contrary to their expectations, they will not be permitted to hold
majority stakes in large power-plant or equipment-manufacturing ventures. In addition, Beijing has insisted on
limiting the rate of return that foreign investors can earn on power projects. Moreover, this rate of return will be
in local currency without official guarantees that the local currency can be converted into dollars and it will not
be permitted to rise with the rate of inflation. Beijing says that if foreign investors fail to invest in these projects,
it will raise the necessary capital by issuing bonds overseas. However, these bonds will not carry the "full faith
and credit of the Chinese government."
a.
What problems do you foresee for foreign investors in China's power industry?
ANSWER. Since the return is set in nominal yuan terms, high inflation--a perennial Chinese problem--will reduce the
real value of this return. This high inflation, in turn, will put pressure on the yuan to devalue, lowering the dollar
value of the return. Finally, the local currency returns may be blocked. In other words, the dollar return is likely to
be lower than the yuan return and the dollar return may never be realized because of inconvertibility.
b. What options do potential foreign investors have to cope with these problems?
ANSWER. Don't invest under these terms. If they do invest, they can buy political risk insurance against currency
inconvertibility. They should also negotiate for higher yuan returns to compensate for the anticipated yuan
devaluation and the cost of political risk insurance.
c.
How credible is the Chinese government's fallback position of issuing bonds overseas to raise capital in lieu of
foreign direct investment?
ANSWER. Not very credible. If the bonds don't carry the "full faith and credit of the Chinese government," then
investors will either not buy them or, if they do, they will demand an interest rate that will compensate them for the
political risks associated with the absence of the guarantee. The bonds will have to be dollar denominated and the
interest rate will have to be as high as the dollar yield that investors would expect if they invested directly in the
power plants themselves. In other words, the Chinese government will realize no benefit by financing the power
projects through issuing bonds as opposed to enticing investors to provide equity financing for the projects.
CHAPTER 6: COUNTRY RISK ANALYSIS
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4.
You have been asked to head up a special presidential commission on the Russian economy. Your first
assignment is to assess the economic consequences of the following seven policies and suggest alternative
policies that may have more favorable consequences. Note: Since this set of questions was first written there
have been massive changes in Russia. Yet many of the policies discussed here still persist and the consequences
are as predicted.
a.
Under the current Russian system, any profits realized by a state enterprise are turned over to the state to be
used as the state sees fit. At the same time, shortfalls of money do not constrain enterprises from consuming
resources. Instead, the state bank automatically advances needy enterprises credit, at a zero interest rate, to buy
the inputs they need to fulfill the state plan and to make any necessary investments.
ANSWER. The system as described completely destroys all incentive to be efficient and profitable. In effect, it
penalizes success and rewards failure. At the same time, the ability to borrow unlimited amounts of money at a zero
interest rate encourages firms to squander capital without penalty and reduces the incentive to cut costs. Moreover,
the absence of any constraints on the ability of state banks to print money to cover shortfalls guarantees rapid
expansion of the money supply and inflation.
Short of an immediate and complete overhaul of the current system, the government should quit printing rubles and
allocate the available supply of capital by auctioning it off to firms. To ensure that firms are realistic in the price
they are willing to pay for capital, the state would have to allow enterprises that can't service their debts to go
bankrupt. Managers of profitable enterprises should be allowed to keep, say, 70% of their profits to reinvest or pay
bonuses (equivalent to a 30% corporate tax rate). Enterprises that show losses should be forced to borrow at the
auction-determined interest rate to cover their shortfalls or go out of business. At the same time, bankers should be
similarly incentivized to make money, thereby forcing them to assess the creditworthiness of potential borrowers.
b.
The Russian fiscal deficit had risen from 2.5% of GNP when Mikhail Gorbachev assumed power in 1985 to an
estimated 13.1% of GNP in 1989. This deficit has been financed almost exclusively by printing rubles. At the
same time, prices are controlled for most goods and services.
ANSWER. By printing money while controlling prices, the government guarantees that there will be massive
shortages of goods and services throughout the Soviet Union. At the same time, black markets will arise in
controlled products while prices of uncontrolled products will skyrocket. Shutting down the printing presses will end
suppressed inflation. Decontrolling prices will end shortages. Gorbachev can eliminate the deficit by raising taxes or
cutting spending. Alternatively, he can finance the deficit by borrowing from the public. This latter approach,
however, will require the government to pay an interest rate that yields a positive real return to savers.
c.
Russian enterprises are allocated foreign exchange to buy goods and services necessary to accomplish the state
plan. Any foreign exchange earned must be turned over to the state bank.
ANSWER. This system of foreign exchange allocation destroys any incentive to conserve on foreign exchange, and
allows bureaucrats to decide what amount of foreign exchange is needed to accomplish the state plan. It also
discourages Soviet exports since the government imposes what is, in effect, a 100% tax on foreign exchange
earnings.
A partial solution to this problem is to free up the market for foreign exchange. By allowing enterprises to buy or
sell foreign exchange as they see fit, they will have a stronger incentive to earn foreign exchange and to conserve on
its use.
d.
In an effort to introduce a more market-oriented system, some Russian enterprises have been allowed to set their
own prices on goods and services. However, other features of the system have not been changed: Each
enterprise is still held accountable for meeting a certain profit target; only one state enterprise can produce each
type of good or service; and individuals are not permitted to compete against state enterprises.
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ANSWER. The basic problem with this system is that without the possibility of competition, the state enterprises
become unregulated monopolies. Since their goods are already underpriced, deregulated enterprises can reach their
profit target by raising their prices rather than by cutting costs or producing higher quality goods. In fact, they
appear to have not only raised prices but also cut production, thereby simplifying their lives. In other words, freeing
prices for goods produced by monopoly factories just enables producers to reap monopoly profits.
The answer here is to permit competition, from individuals, other state enterprises, and foreign companies. At the
same time, producers must be able to keep most of their profits. Otherwise, they will have no incentive to produce
more and better goods.
e.
Given the disastrous state of Russian agriculture, the Russian government has permitted some private plots on
which anything grown can be sold at unregulated prices in open-air markets. Because of their success, the
government has recently expanded this program, giving Russian farmers access to much more acreage. At the
same time, a number of Western nations are organizing massive food shipments to the Russia to cope with the
current food shortages.
ANSWER. Although the Western nations are well-intentioned (we think; they may be using this as a means of
dumping the agricultural surpluses they have accumulated by subsidizing their domestic farmers), the effect of food
aid will be to drive down the price of food in the Russia, thereby reducing the incentive of Russian farmers to
produce food. If Western nations wish to aid the Russia, they can provide it with advice and money tied to the
implementation--not just the promise--of genuine economic and political reforms. After all, food shortages reflect a
combination of price controls and lack of incentive faced by farmers; it is not an act of nature.
f.
The United States and other Western nations are considering instituting a Marshall Plan for Eastern Europe that
would involve massive loans to Russia and other Eastern Bloc nations in order to prop up Gorbachev and the
reform governments.
ANSWER. The key here is to recognize that we are dealing with a political problem, not an economic problem, and
political problems cannot be solved with money alone. The basic problem with massive loans to these nations is that
by alleviating their economic crisis, it would reduce the governments' incentive to institute real economic and
political reform. It also boosts the power of the bureaucrats at the expense of the private sector. Thus, any loans
should be tied to the implementation of genuine reforms. Better still, money should be provided directly to private
companies on close-to-market terms, thereby building up the private--not the public--sector. As Mr. Gorbachev has
already proved to the world's satisfaction, no matter how many Harvard economists he puts to work, he will not be
able to restructure the Soviet economy and still preserve the power of the Communist Party. The two things are
antithetical. You can't have a free-market economy and an economy run by and for a Communist Party elite. The
contradictions inherent in this attempt ultimately led to the downfall of communism in the Soviet Union, as it also
will in China.
5.
The president of Mexico has asked you to advise him on the likely economic consequences of the following five
policies designed to improve Mexico's economic environment. Describe the consequences of each policy, and
evaluate the extent to which these proposed policies will achieve their intended objective.
a.
Expand the money supply to drive down interest rates and stimulate economic activity.
ANSWER. Rapid expansion of the money supply will lead to higher inflation and higher nominal interest rates. It will
also raise real interest rates to the extent that savers demand a bigger inflation risk premium for the higher inflation
risk that they must now bear. Higher inflation will make it more difficult for business to plan and lead to a reduction
in business investment. It will also reduce the reliability of price signals, thereby reducing the efficiency with which
the Mexican economy operates. The net effect will be higher interest rates and slower economic growth, exactly the
opposite of what is desired.
b.
Increase the minimum wage to raise the incomes of poor workers.
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ANSWER. Those workers covered by the higher minimum wage and who keep their jobs will see their incomes rise.
However, many workers will lose their jobs since the new wages will exceed the value of their work (low wages
typically signal low productivity and few salable worker skills, not exploitation). The most seriously affected
companies will be those facing foreign competition, since they will be unable to raise their prices much. Such
companies will attempt to lower their costs by substituting capital for labor, moving offshore, or just reducing their
workforce. Moreover, those workers who are not covered will find more competition for their jobs, leading to a fall
in wages in the uncovered sector of the economy. The net effect will be higher unemployment and a workforce that
is worse off overall. To the extent that companies can offset their higher labor costs by raising prices, their
customers will be worse off.
c.
Impose import restrictions on most products to preserve the domestic market for local manufacturers and,
thereby, increase national income.
ANSWER. Import restrictions will lead to higher domestic prices for lower quality products. It will also stifle
innovation and make domestic firms less competitive. The evidence is that countries that follow an export-oriented
growth strategy grow much more rapidly than those that seek to grow through import substitution. Thus, this policy
will reduce Mexico's national income, not increase it.
d.
Raise corporate and personal tax rates from 50% to 70% to boost tax revenues and reduce the Mexican
government deficit.
ANSWER. The odds are that the Mexican government will collect less tax revenue at a 70% tax rate than at a 50%
rate. People will have greater incentive to cheat on their taxes and less incentive to work if 70% of what they earn
goes to the government. Thus, both actual and reported income will probably be sufficiently lower at a 70% tax rate
than at a 50% rate that the rise in the tax rate will be more than offset by the decline in taxable income. At the same
time, economic growth will be reduced and there will be more demands on the government to "do something,"
which usually means spending more money. The net result will be a higher deficit.
e.
Fix the nominal exchange rate at its current level in order to hold down the cost to Mexican consumers of
imported necessities (assume that inflation is currently 100% annually in Mexico).
ANSWER. Mexico and many other Latin American countries already tried this during the 1970s and early 1980s. To
summarize the conclusions in the Mexican Peso case, the resulting jump in the real exchange rate boosted imports,
cut exports, and led to capital flight and huge and unsustainable trade and government budget deficits. Sorting out
the mess cost Latin America a decade of economic misery and lost economic growth. Fixing the exchange rate with
inflation running at 100% annually, as proposed here, will double the real value of the peso in a year. This will bring
on the troubles just described even faster than in the 1980s.