Country Risk

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
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



Risk Management
For any type of risk, the risk management
process involves a number of key steps
1. Identify all significant risks
2. Evaluate potential frequency and severity of losses
3. 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
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
Factors Affecting Country Risk
Macroeconomic Factors
The first of these factors is the size and structure of the
countrys 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 of
otherwise creditworthy borrowers in the country to
continue servicing their obligations.
To the extent the external debt is owed by the public
sector, the ability of the government to generate sufficient
revenues, from taxes and other sources, to service its
obligations.

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 downturn
in 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 and
exports. (Iceland)
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 the
potential effects of a loss of market liquidity. (Greece)
The countrys relationships with private sector creditors, including
the 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 an
International Monetary Fund (IMF) or other suitable economic
adjustment program.
The trend in foreign investments and the countrys ability to attract
foreign investment in the future.
The opportunities for privatization of government-owned entities.

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 be
adversely affected through the contagion of problems in
other countries.
The size and condition of the countrys banking system,
including the adequacy of the countrys system for bank
supervision and any potential burden of contingent
liabilities that a weak banking system might place on the
government.
The extent to which state-directed lending or other
government intervention may have adversely affected the
soundness of the countrys banking system, or the structure
and competitiveness of the favoured industries or
companies.
Social, Political, and Legal Climate
The analysis of country risk should also take into
consideration the countrys social, political, and legal
climate including:
The countrys natural and human resource potential.
The willingness and ability of the government to
recognize economic or budgetary problems and
implement appropriate remedial action.
The degree to which political or regional factionalism
or armed conflicts are adversely affecting government
of the country.
Any trends toward government-imposed price, interest
rate, or exchange controls
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
Institution-Specific Factors
Finally, an institutions analysis of country risk should take into
consideration 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 for
the country.
The mix of exposures and commitments, including the types of
investments and borrowers, the distribution of maturities, the types and
quality of collateral, the existence of guarantees, whether exposures are
held for trading or investment, and any other distinguishing characteristics
of the portfolio.
The economic outlook for any specifically targeted industries within the
country.
The degree to which political or economic developments in a country are
likely to affect the institutions chosen lines of business in the country.
For instance, the unemployment rate or changes in local bankruptcy laws
may affect certain activities more than others.

Institution-Specific Factors
For an institution involved in capital markets, its susceptibility to
changes in value based on market movements. As the market value of
claims against a foreign counterparty rise, the counterparty may
become less financially sound, thus increasing the risk of nonpayment.
This is especially true with regard to over-the-counter derivative
instruments.
The degree to which political or economic developments are likely to
affect 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 in
developed countries may have significantly less exposure to the local
countrys economic disruptions than do other counterparties in the
country.
The institutions ability to effectively manage its exposures in a country
through in-country or regional representation, or by some other
arrangement that ensures the timely reporting of, and response to,
any problems.
Foreign Direct Investment Theory
and Political Risk

Ch 18
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 it
to compete effectively in the home market.
The competitive advantage must be firm-specific, transferable, and
powerful enough to compensate the firm for the potential disadvantages
of operating abroad (foreign exchange risks, political risks, and increased
agency costs).
There are several competitive advantages enjoyed by MNEs.
18-16
Sustaining and Transferring
Competitive Advantage
Economies of scale and scope:
Can be developed in production, marketing, finance, research and
development, transportation, and purchasing
Large size is a major contributing factor (due to international and/or domestic
operations)
Managerial and marketing expertise:
Includes skill in managing large industrial organizations (human capital and
technology)
Also encompasses knowledge of modern analytical techniques and their
application in functional areas of business
18-17
Sustaining and Transferring
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 that
enables them to fund FDI and other foreign
activities
18-18
Sustaining and Transferring
Competitive Advantage
Differentiated products:
Firms create their own firm-specific advantages by producing and
marketing 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 competitive
advantage relative to firms located in less competitive ones
This phenomenon is known as the diamond of national advantage and
has four components

18-19
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 same
as 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 finds
a country where it expects to enjoy a competitive advantage large enough to
generate a risk-adjusted return above the firms hurdle rate.
In practice, firms have been observed to follow a sequential search pattern as
described in the behavioral theory of the firm.
18-20
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 the
same 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 advantage
until it finds a country where it expects to enjoy a competitive advantage
large enough to generate a risk-adjusted return above the firms hurdle
rate.
18-21
Exhibit 18.3 The FDI Sequence: Foreign Presence and
Foreign Investment
18-22
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
18-23
How to Invest Abroad:
Modes of Foreign Investment
Licensing and management contracts versus control of assets
abroad:
Licensing is 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
18-24
How to Invest Abroad:
Modes of Foreign Investment
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 firms
traditionally conduct their foreign business on the
basis of a management contract
18-25
How to Invest Abroad:
Modes of Foreign Investment
Joint venture versus wholly owned subsidiary:
A joint venture is here defined as shared ownership in a foreign
business
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 reputation
which aids in business
18-26
How to Invest Abroad:
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 financing
versus internally generated funds)
Transfer pricing issues
Difficulties in the ability to rationalize production on a
worldwide basis
18-27
How to Invest Abroad:
Modes of Foreign Investment
Greenfield investment versus acquisition:
A greenfield investment is defined as establishing a
production or service facility starting from the ground
up
Compared to a greenfield investment, a cross-border
acquisition is clearly much quicker and can also be a
cost effective way to obtain technology and/or brand
names
Cross-border acquisitions are however, not without
pitfalls, as firms often pay too high a price or utilize
expensive financing to complete a transaction
18-28
How to Invest Abroad:
Modes of Foreign Investment
The term strategic alliance conveys 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 of
ownership 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.
18-29
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
18-30
Foreign Direct Investment Originating in
Developing Countries
The Boston Consulting Group has identified six
major corporate strategies employed by these
emerging market MNEs
Taking brands global
Engineering to innovation
Leverage natural resources
Export business model
Acquire offshore assets
Target a niche
18-31
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
18-32
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
18-33
Predicting Risks
Predicting firm-specific risk
Different foreign firms operating within the same
country may have very different degrees of
vulnerability to changes in host-country policy or
regulations
Predicting country-specific risk
Political risk analysis is still an emerging field,
though firms need to attempt to conduct this
analysis

18-34
Firm-Specific Risks
Governance risks
Governance risk is the ability to exercise effective control over an
MNEs operations within a host countrys legal and political
environment
Historically, conflicts of interest between objectives of MNEs and host
governments have arisen over such issues as the firms impact on
economic development, the environment, control over export
markets, balance of payments (to name a few)
The best approach to conflict management is to anticipate problems
and negotiate understanding ahead of time

18-35
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
18-36
Operating Strategies after the FDI Decision
Although an investment agreement creates obligations on the
part of both foreign investor and host government, conditions
change and agreements are often revised in the light of such
changes
The firm that sticks rigidly to the legal interpretation of its
original agreement may well find that the host government
first applies pressure in areas not covered by the agreement
and then possibly reinterprets the agreement to conform to
the political reality of that country

18-37
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
18-38
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 are
transfer risk and cultural and institutional risks

18-39
Country-Specific Risk: Transfer Risk
Transfer risk is 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

18-40
Exhibit 18.6 Management Strategies for Country-
Specific Risks
18-41
Country-Specific Risk: Cultural and Institutional
Risks
When investing in some of the emerging markets, MNEs that
are resident in the most industrialized countries face serious
risks because of cultural and institutional differences
including:
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

18-42
Global-Specific Risks
Global specific risks faced by MNEs have come to the
forefront in recent years
The most visible recent risk was, of course, the attack by
terrorists on the twin towers of the World Trade Center in
New York on September 11, 2001.
In addition to terrorism, other global-specific risks include the
antiglobalization movement, environmental concerns, poverty
in emerging markets and cyber attacks on computer
information systems