Evaluating Country Risks for International Investments

Tools, Techniques and Applications

Ephraim Clark

• Publisher: WSPC
• Year: 2017
• eBook ISBN: 9789813224957
• Topic: Business
• Subtopic: Finance
• Index: Business

-->

This unique volume presents a trailblazing project of country risk analysis for international investments. It develops an innovative range of tools and techniques on the cutting edge of financial theories and practices for assessing and incorporating country/political risk in cross-border investment strategies. These tools and techniques address the nature of country risk as a broad concept that comprises an underlying combination of economics, finance, geopolitics, sociology, and history.

--> Contents:

• Terminology and Definitions of Country Risk
• History of Country Risk
• Current Methodologies for Country Risk Assessment
• Systematic Country Risk
• Cross Country Risk
• Country Financial Risk
• Political Risk as Stochastic Dominance
• Political Risk as a Hypothetical Insurance Policy
• Incremental Political Risk
• Multiple Dependent Sources of Political Risk
• Updating Political Risk
• Expropriation as an Option to Default
• Sovereign Risk as an Option to Default
• Sovereign Risk and Macroeconomic Fundamentals
• Asymmetric Information and Sovereign Eurobond Spreads
• Hedging Foreign Currency Risk
• Asymmetric Foreign Currency Exposure
• Foreign Currency Risk and Shareholder Value

-->
--> Readership: Graduate students and researchers interested in the topics of risk management and international investment. -->
Keywords:Portfolio Investment;Political Risk;Financial Risk;Equity Return;Market Efficiency;Stochastic Dominance;Risk Management;Derivatives;Foreign Currency DebtReview: Key Features:

• Explains the multi-faceted dimensions of cross-border risk with respect to portfolio investment, foreign direct investment, and cross border borrowing and lending
• Identifies the main sources of risks and opportunities arising from the growing integration of international financial and product markets
• Develops a range of tools and techniques on the cutting edge of financial theory and practice for assessing and incorporating country/political risk in cross-border investment strategies

Part 1

Introduction

Chapter 1

Terminology and History of Country Risk

Ephraim Clark

Middlesex University, Dubai, London, Malta, Mauritius

[email protected]

The last 60 years have seen the economic and financial environment evolve into a complex system of globalized markets whose effects are felt in all countries at all levels of society. Even small and medium sized companies have foreign clients and/or suppliers as well as foreign competitors either exporting or producing locally. Many, if not most, of the large multinational companies now do more business outside the frontiers of the countries where they are incorporated. They also have direct investments abroad as well as access to foreign financing. The resulting transactions involving foreign markets and currencies have to be negotiated, financed, and settled. As a result, banks have accompanied their clients abroad and now routinely borrow and lend on a worldwide basis. Portfolio investors have also followed them and look to markets around the globe as a means of enhancing their returns and exploiting diversification opportunities.

Although companies, banks and investors have learned to take advantage of the opportunities for the lower costs, increased returns and diversification benefits to be gained from the global economic and financial markets, experience has shown that these opportunities come at the expense of other risks that would not otherwise be present. There are cultural differences in institutions, legal and financial traditions, information sources and the like. There are also other serious constraints that include legal barriers, transactions costs, and discriminatory taxation that can affect the outcome of a cross-border financial operation. These risks are rooted in the fact that the world economy is organized around the concept of country and national sovereignty. Each country has its own economic, financial, political and legal organization, which determines how resources will be allocated and income distributed within the geographic area it controls. However, because of the interconnectedness of the world economy, events or anticipated events at the country level affect not only the performance of individual resident economic and financial agents and their relative performance vis à vis the rest of the world, they also affect non-resident economic agents doing business in the country or competing with local companies in foreign markets. Overall, the risk associated with international economic and financial transactions includes a wide-ranging set of complex factors encompassing political, social, geographic, and strategic considerations that could affect the outcome of an economic or financial transaction. As a concept, then, country risk or cross-border risk, as it is sometimes called, is vast and complex. It refers to the effects on economic and financial transactions caused by events associated with a particular country as opposed to events associated with a particular economic or financial agent or asset.

Keywords: Country risk; political risk; country-specific economic risk; country-specific financial risk; currency risk.

JEL Classification: D81, F21, F23, G31.

1.A Review of Country Risk

1.1.A Brief History

The economic and financial globalization of the last 60 years has nourished the field of country risk, which has been driven by a series of crises — the “political crises” in the 1960s and 1970s, the “debt crises” in the 1970s and 1980s, and the “financial crises” in the 1990s and 2000s. Each type of crisis induced an explosion of papers dealing with the causes and cures of the foregoing events.

The country risk literature over the period ranging from the 1960s to the end of the 1970s was dominated by studies on multinational corporations (MNCs). They focused on the political aspect of country risk, that is, the risk that a foreign government action will negatively affect the cash flows of a company conducting an international investment. At that time, many countries had just liberated themselves from their colonial occupiers and begun to question the benefits of having large, powerful foreign firms operating in their territory. Over this period, researchers were primarily concerned with the influence of governments on firms doing business abroad. They either looked specifically at government intervention, the “political risk” (e.g. Usher, 1965; Root, 1968), or the overall “investment climate” (e.g. Gabriel, 1966; Stobaugh, 1969a, 1969b). As many authors, such as Robock (1971), Kobrin (1979), Brewer (1981), Merrill (1982), Simon (1982), Fitzpatrick (1983), Desta (1985), Howell and Chaddick (1994), and Rivoli and Brewer (1997) pointed out, however, there was no clear consensus about what the terms “political risk” and “investment climate” actually meant and what exactly they were supposed to measure.

The second stage took place in the 1970s and 1980s with the advent of the international debt crises in many developing countries. A large part of the literature was dedicated to creditworthiness assessment. The concept of country risk in the banking sector evolved in the 1960s and 1970s in response to the banking sector’s efforts to define and measure its exposure to loss in cross-border lending. At one time before the advent of widespread international lending to sovereign nations, country risk was synonymous with transfer risk, the risk that a government might impose restrictions on debt service payments abroad. The term “sovereign risk” cropped up when governments themselves became major bank borrowers. Sovereign risk is broader than transfer risk insofar as it includes the idea that even if the government is willing to honor its external obligations, it might not be able to do so if the overall economy cannot generate the necessary foreign exchange. Just as in the corporate literature on country risk, “country risk” in the banking sector has also been shrouded in conceptual confusion from the beginning, often referring indiscriminately to transfer risk, sovereign risk, political risk, economic risk, financial risk, or any other type of risk that could conceivably affect the ability or willingness of a foreign agent or government to honor its financial obligations.

Finally, the 1990s and 2000s have been dominated by the currency and banking crises that started with the Mexican crisis in 1994 and the Asian meltdown in 1997. Financial crises such as these have occurred regularly over the last decades. For instance Kaminsky and Reinhart (1999) report 102 banking or currency crises from 1970 to 1995, among a sample of 20 industrialized and developing countries. Since 1995 we have seen financial crises in Asia 1997, Russia and Ecuador 1998, Argentina 1999–2002, Uruguay 2002 and the US sub-prime crisis of 2007 that spread around the world. The literature on “financial crises” is rooted in the crisis models of Krugman (1979), Flood and Garber (1984), Obstfeld (1994), Calvo and Mendoza (1996) and Krugman (1998). Another strand of the literature seeks to identify early warning crisis indicators. Frankel and Rose (1996) and Eichengreen et al. (1996) concentrate on currency crises, Hardy and Pazarbasioglu (1999) and Demirguc-Kunt and Detragiache (1998) tackle banking crises, while Kaminsky (1999) and Goldstein et al. (2000) include both types of crisis in a single approach.

1.2.Terminology

In spite of the large and growing literature on the subject, academics and practitioners are still far from a consensus about the scope of this field of research. This lack of consensus is reflected in the various terminologies used to deal with similar and/or overlapping issues. The various streams of the foregoing literature on country risk use several terminologies, depending on the source of the risk, the nature of the investment and the historical context. In the literature dealing with the risk of doing business abroad, the two terms most frequently encountered are “country risk” and “political risk”. Less frequently, references to “cross-border risk” or “sovereign risk” can be found. “Political risk” is the oldest terminology and appears mostly in the academic articles. “Country risk” began to be widely used in the 1970s. It was originally more professionally oriented in the sense that it aimed at addressing the concrete issue of a particular business in a particular country and was generally used by the banking industry. This stream of literature flourished in the aftermath of the international debt crisis of the 1980s.

In this book, we use the term “country risk” as the generic term to include any risk specific to a given country. We then break down country risk into its component parts. Political risk refers to events that are exclusively political in nature. Country-specific economic risk refers to the performance of the economy. Country-specific financial risk refers to the ability of the economy to generate sufficient foreign currency to meet its foreign obligations and maintain required levels of imports. Currency risk refers to the volatility of the value of the local currency.

1.3.Definitions of Country Risk

For some authors, country risk is defined as a performance variance, whether it impacts the firm positively or negatively. Robock (1971), Haendel et al. (1975), Kobrin (1979) and Feils and Sabac (2000) belong to this cluster. Another approach adopts a more practical stance and analyzes risk as a negative outcome. In this meaning, adopted by a wide range of authors, such as Root (1972), Simon (1982), Howell and Chaddick (1994), Roy and Roy (1994), Clark (1997) and Meldrum (2000), risk will exist if it implies a possible loss or a potential reduction of the expected return.

Thus, the notion of country risk can be understood either as the variance of expected performance or as the probability of a negative outcome that reduces the expected performance. The modeling technique for country risk analysis depends on how the risk is defined. Some like Miller (1992) retain the concept of risk as performance variance because it is widely used in mean/variance analysis (MV) in finance, economics, and strategic management. The problem with MV is that the conditions for MV to be analytically consistent with expected utility maximization, such as quadratic utility fu...

Table of contents

• Cover
• Halftitle
• Title
• Copyright
• Preface
• About the Author
• Acknowledgments
• Contents
• Part 1. Introduction
• Part 2. Portfolio Investment
• Part 3. Foreign Direct Investment
• Part 4. Sovereign Debt
• Part 5. Foreign Currency
• Index