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Country Risk Analysis
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Definition
Key indicators
Economic development
Solvency
1. Definition
MNCs constantly assess business environments of countries they operate in, as
well as the ones they are considering investing in. Similarly, private and public
investors are interested in determining which countries offer the best opportunities
for sound investments.
This is the area of country risk analysis --- assessing the potential risks and
rewards associated with making investments and doing business in a country.
MNCs are interested in the economic policies of these countries, because
economic policies determine the business environment. However, country risk
assessment cannot be only economic in nature. It is also important to consider the
political factors that lead to economic policies. This interaction of politics and
economics is the subject area of political economy.
2. Key Indicators
Expropriation (nationalization) is the most extreme form of political risk.
However, there are other levels and forms of political risk, including currency and
trade controls, changes in tax or labor laws, regulatory restrictions, and
requirements for additional local production.
Political risk can be assessed from a country-specific (macro or country risk
analysis) and a firm-specific (micro or firm risk analysis) perspective. A useful
indicator of the degree of political risk is the seriousness of capital flight. Capital
flight refers to the export of savings by a nation’s citizens because of fears about
the safety of their capital.
We now turn to some key indicators of the general level of risk in the country as a
whole – termed country risk. Some of the common characteristics of country risk
are:
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a large government deficit relative to GDP
a high rate of money expansion, especially if it is combined with a
relatively fixed exchange rate
substantial government expenditures yielding low rates of return
price controls, interest rate ceilings, trade restrictions, rigid labor laws,
and other government-imposed barriers to the smooth adjustment of
the economy to changing relative prices
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high tax rates that destroy incentives to work, save, and invest
vast state-owned firms run for the benefit of their managers and
workers
a citizenry that demands, and a political system that accepts,
government responsibility for maintaining and expanding the nation’s
standard of living through public-sector spending and regulations (the
less stable the political system, the more important this factor will
likely be.)
pervasive corruption that acts as a large tax on legitimate business
activity, holds back development, discourages foreign investment,
breeds distrust of capitalism, and weakens the basic fabric of society
the absence of basic institutions of government – a well-functioning
legal system, reliable regulation of financial markets and institutions,
and an honest civil service
Alternatively, indicators of a nation’s long-run economic health include the
following:
a) a structure of incentives that rewards risk taking in productive
ventures
b) a legal structure that stimulates the development of free markets
c) minimal regulations and economic distortions
d) clear incentives to save and invest
e) an open economy
f) stable macroeconomic policies
In summary, from the standpoint of an MNC, country risk analysis is the
assessment of factors that influence the likelihood that a country will have a
healthy investment climate. Several costly lessons have led to a new emphasis on
country risk analysis in international banking as well. From the bank’s
standpoint, country risk – the credit risk on loans to a nation – is largely
determined by the real cost of repaying the loan versus the real wealth that the
country has to draw on. These parameters, in turn, depend on the variability of
the nation’s terms of trade and the government’s willingness to allow the nation’s
standard of living to adjust rapidly to changing economic fortunes.
The experience of the countries that have made it through the international debt
crisis suggests that others in a similar situation can get out only if they institute
broad systemic reforms. These countries need less government and fewer
bureaucratic rules. Debt forgiveness or further capital inflows would only tempt
these nations to postpone economic adjustment further.