Country Risk in International Businesses

COUNTRY RISK IN INTERNATIONAL BUSINESSES

Mario G.R. Pagliacci[1]

Introduction

Historical documents give the lie to the common opinion that internationalisation is a modern phenomenon; in fact in any historical period people continuously moved to better their physical and spiritual welfare.

In comparison to past periods, it is possible to observe more intensity and diffusion of international activities nowadays, thanks to the increasing optimization of the space/time ratio (longer distances in minor time) and the development of transports and logistics.

Nevertheless, international economic activities are charged by: (i) generic business risks[2]; (ii) specific international risks[3].

The second category of risks represents the consequence of several differences among countries in the world[4]:geographic and climate differences;cultural differences;political and institutional differences.

Geographic and climate differences getdirect impact on the various range of natural catastrophic risks, and indirect impact on the human behaviour (with effects on operative risks and counterpart risks), as well as on the needs of people and enterprises (with effects on markets risks). All these phenomena take influence on competitive structure and distribution cannels.

Cultural differences have a strong influence on nature and characteristics of governmental and legalregimes, and on economic and financial systems; they originate the competitive behavior of enterprises as well as the decisions and actions of workers and consumers.

Political and institutional differences play a decisive role in consolidation of economic systems, in structuring demand and offer in the market, in putting more or minor barriers in free movement of people, goods and capitals.

All these differences generate the complexity of the systemic risks and the contamination among the other categories of risks.

Following table shows the main relationships linking phenomena and risks[5].

This paper has the target to put in evidence the difficult identification of nature and characteristics of systemic risks in international context. The uncertain and improbable assessment and evaluation of country risk is an additional barrier against the internationalization of enterprises and the activity of financial and insurance agencies, specialized in offering risk management tools.

1. Identification of systemic risks

Systemic risks are generated by a large range of different events; the only common factor can be found in the fact that they are not generated by decisions of single persons or enterprises, rather by the context where the economic activities develop.

Typical systemic risks are:

Catastrophic risks, caused by adverse events, which origin can be natural oneorunder thehuman responsibility;

Political and Social risks, determined bydecisions of institutional authorities, or social groups, or religious movements,etc.;

Technological risks, generated by strong or unexpected innovations in technologies models of life and/or work, with high impact on the whole community;

Economic risks, connected with significant critical conditions in the structure and/or conjuncture of inters sectors of economy and finance;

Legal risks, depending tolaws, rules and so on regulating a territorial or sectorial area.

Even ifdifferentterms and definitions are used in different countries and agents in identifying area of systemic risks (political risk, country risk, counterparty risk), nevertheless it is possible to put in evidence a common characteristic: this concept is generally used in case of countries with weak economic fundamentals and fragile institutional structures.

On the contrary, a lot of proves attest that systemic risks are not a prerogative of emerging countries. The events of international terrorism (i.e. in New York, London, Madrid) as well as the ecologic disaster (i.e. hiding of radioactive waste in Italy and other european countries), as well as the financial crises in Greece and Hungary, demonstrate that industrialized countries are also exposed to systemic risks.

In addition it is important to underline that the origin of systemic risks can beexternal - caused by host countries -or domestic, when the causes are found in relevant diversities or conflicts existing among the territories of the same country.

In all cases, systemic risks havealways an international impact and became global risks, because world is more and more integrated.

1. Focus on country risk

Rather than some difference exists among systemic risk, political risk and country risk, these expressions are frequently used in promiscuous manner.

Indeed these concepts can be treated like a particular type of fractal, because any component of risk is comprehensive of the whole risk [6].In this direction is the opinion of Raoul Ascari, who writes: “political risk is an omnibus term and as such cannot be precisely framed and analyzed”[7].According to this vision, I will maintainin this paper the original terms adopted by different Authors; nevertheless I wish to underline thatin my opinion the expression “country risk” is more complete and suitable in international context.

An important definition of “Political risks” is offered by MIGA-Multilateral Investment Guarantee Agency:“Probability of disruption of operations of MNEs (Multi-National Enterprises) by political forces or events when they occur in host countries, home countries, or as a result from changes in the international environment. In host countries, political risk is largely determined by uncertainty over the actions of governments and political institutions, but also minority groups, such as separatist movements. In home countries, political risk may stem from political actions directly aimed at investments destinations, such as sanctions, or from policies that restrict outward investment” [8].

This definition is clearly partial, because it considers Multi-National Enterprisesonly and their investments; it neglects other enterprises (i.e. small and medium enterprises, banks, etc.) that can be engaged in different businesses (i.e. manufacturing or financial activities).In addition, MIGA considersevents caused byhost countries only:currency convertibility and transfer;expropriation;political violence;breach of contract by host government;non-honoring of sovereign financial obligations.

Anotherdefinition is given byMeldrum:“When business transactions occur across international borders, they carry additional risks not present in domestic transactions. These additional risks, called country risks, typically include risks arising from a variety of national differences in economic structures, policies, socio-political institutions, geography, and currencies”[9].

In my opinion, this definition - utilizing the concept of “country risk” -is more complete in comparison to MIGA’s definition, because it take in account “a variety of national differences”, that are able to generate a variety of risks.

Meldrum attests it is possible to classify risks in six categories, taking in account that “many of these categories overlap each other, given the interrelationship of the domestic economy with the political system and with the international community”:

I. Economic Risk;

II. Transfer Risk;

III. Exchange Rate Risk;

IV. Location or Neighborhood Risk;

V. Sovereign Risk;

VI. Political Risk.

I)Economic risk : this risk can be the consequence of internal measures (i.e. size and composition of government expenditures, tax policy, government's debt situation, monetary policy and financial maturity) or external events (i.e. bad relationships towards other countries). Economic risk becomes systemic in case of crisis, when several negative events, generate a strong ruin, evidenced by unbalancing of fundamentals.Owing to globalization, internal causes of crisishave international impact also (becoming external causes).

II)Transfer risk :it regards any institutional foreign decision restricting capital flows (i.e difficulty to repatriate profits, dividends, capital),owing to potential imbalances that could lead a country. Generally these measures concern strong limits to currency convertibility, with the purpose to put any barriers to free movement of capitals.

III)Exchange Risk : this risk is rightly classified in the area of systemic risks when it concerns unexpected change in currency regime(i.e. a change from a fixed to a floating exchange rate), because it takes origin by institutional decision. On the contrary, I do not agree to Meldrum, when he considersin this category an unexpected adverse movement in the exchange rate; thiscase is not in the area of systemic risks, rather in market risks area, because floating of exchanging rate is a effects of demand and offer of currencies.

IV)Location or Neighborhood Risk: it includes spillover effects caused by problems in a region and/or in border countries with similar characteristics, where it is really high the probability of contagion. In addition, this risk concerns all countries taking part of over national institutions (i.e. European Union, NATO, etc.); in fact these countries areinvolved and influenced by the events happening in alliance area.

V)Sovereign Risk : it is a particular kind of credit risk, when the government of a country refuses or is enable to respect its financial obligations towards public or private lenders. This risk is usually examined in international context; nevertheless is not unusual to observe some grave cases of credit risk in domestic relationships with public entities.

VI)Political Risk: it concerns the risk of a change in political institutions, in government control, social fabric, or other noneconomic factors. This category can be considered an omnibus category, concerninga lot internal and external events (see the fractal vision): legal, social, religious, ethnic events and so on.

It is possible to observe that MIGA’s and Meldrum’s definitions utilize different terms (Political risks and Country risks), but they showseveralsimilarities. Neverthelessthey neglect the risks caused by catastrophic events. Someone might observe that they arenot in political/institutional frame; on the contrary,some recent events demonstrate that a lot of catastrophes are caused directly (i.e. leak of oil in Gulf of Mexico) or indirectly (i.e. pandemic phenomena) by insufficient controls or wrong decisions of institutional authorities.

1. Is it possible to measure these risks?

Ascari writes: “Ideally we can think of risks as being positioned along a straight line: at one extreme we can have pure actuarial risks; in the middle financial risks distributed on large portfolios; and the other extremely lumpy, political risks. The first group of risks meets the criteria of the ‘Law of large numbers’…The second one can approximate a normal distribution but with unknown (fat) tails.The third one cannot be expressed statistically at all”[10].

Actually, multiple causes influence political risks (institutional, legal, financial ones, and so on), and they are linked each other, so creating complicate phenomena of contamination.

As consequence, political risks change dramatically their nature over time and/or in different contexts and geographic areas, as Ascari demonstrates in following table[11].

1970s / 1980s / 1990s / 2000s
Confiscation, expropriation, nationalization / XXX / XXX / X / X
Creeping expropriation / X / X / XX / XX
Break
of
contract / n.r. / n.r. / XX / X
Political
violence / XXX / XXX / X / XX
Transfer
and
convertibility / XXX / XXX / X / X
Non-honoring
of financial
obligations / XXX / XXX / X / XX
Trade-related
Financing / n.r. / n.r. / X / XX

Legenda: X = the lowest intensity of the event; XXX = the highest intensity; n.r. = not relevant

Owing to political risks change continuously, estimating historical performance is difficult while predicting future evolution is almost impossible. Nevertheless enterprises have to decide if and where make businesses and specialized organizations have to decide if and how to insure political risks.

This is the reason that scholars and experts are engaged in assessing and measuring systemic risks in international context. It is a complicate job, because no comprehensive country risk theory exists.

1. Methodologies for analysing and measuring country risk[12]

Authors and country-risk services engaged in this job generally use an eclectic mix of economic andsocio-political indicators based on their experience and judgment.Anyway, it is possible to evidencesomehistoricaltrends:

1960-70’s literatureadopted prevailing qualitative methods, having the purpose to analyse political risks;

starting to’80quantitative approach prevailed, for investigating on possible country default or financial crisis;

nowadays econometric models are preferred, considered more available for anticipatory analysis.

Following Authors marked the stages of this itinerary.

Dragoslav Avramovic

The origin of country risk analysisis signed by the Chief of the Central Bank of Yugoslavia, Avramovic. He studied the problems of emerging countries after the war and concluded that they were caused by the highfrequency of the due dates in international loans. The unique solution was in utilizing monetary reserve of Central Bank and accessing to drawing measures at International Monetary Fund.

Avramovic analysis founded ontwo financial indicators:

Monetaryreserve adequacy:monetary reserve in comparison to current import flow;

Debt-service ratio : annual debt service in comparison to current export flow.

Avramovic concluded that in long period of time, the capacity of a country in serving foreign debts is related to: saving rate, output rate of internal investments, cost of foreign debt.

Nicholas Sargen

At the beginning of ’80 the sort of international credits was a big problem for lender banks.

Sargen gave two different conceptual approaches to the problem of rescheduling:the first one connected to the influence of exogenous causes (i.e. floating of international prices); the secondlinked to the monetary dynamics. Hestudiedseveralindicators and thanks to the discriminant analysis he selected the most significant ones in order to classify different countries according to the major or minor probability of insolvency.

Robert Aliber

Aliber’s paper was published in the same period of Sargen one.

Robert Aliber takes in account two fundamentalmatters about the foreign debt of emerging countries:

First one - similarly to Avramovic e Sargen - consists in financial indicator about debts;

Second matter is new one, and concerns some output and growth indicators, able to compare the performances of emerging and industrialized countries.

According Aliber’sconclusion, if the growth rate of a country is higher than the prevalent rate of industrialized countries, it is convenient for financial entities to allocate capitalsin that country, under the conditionthat interest rate is able to cover additional risks.

Completely different is the approachpreferred by financial operators, always looking for easy and synthetic indicators in their job.They frequently measure country risk on using the level ofspreadquoted in interest rate in comparison to an official referring rate. For instance, in spring 2010 public bonds of Greece recognize 12% of interest, in comparison to other european countries, quoting less than 2-3%: this spread is a clear sign of the high risk in Greece.

Nevertheless the critical question is that spread is not influenced by the country risk’s perception only, because some other financial entities play (i.e. level and volatility of interest rate, liquidity of financial system, and so on).

Scholars and operators are searching the optimal methodology yet, but this target is really far.

At the moment it is possible to classify at least four categories of methodologies:

Qualitative systems;

Structured qualitative systems;

Quantitative systems based on check list;

Other quantitative systems.

Any system offers some opportunities and isuseful for specificanalysis. Generally speaking, qualitative systems are better for political and environmental investigations, in order to understand how to move in the context of a foreign country; quantitative systems are frequently adopted in order to compare theopportunities offered by different countries.

Qualitative Systems

These systems do not utilize any model and format, so that the personal experiences of analystdeterminate high level of subjectivity. In addition, the evaluations are influenced by the nature and quality of information.

The absence of quantitative measures makes impossible to compare different countries and to generate the ranking of risks. As consequence, these systems are useful in order tohave an intensive knowledge about a country, without any purpose of comparison to others.

Structured qualitative systems

Subjectivity of analyst is influent, but it is balanced by standardized models, formats and sources of information.

The level of partial standardization and the use of some quantitative information make possible a kind of comparison among different countries.

The analysis is generally conducted on three areas:

Domestic policy and economy;

Foreign relationships;

Situation of foreign debts.

Quantitative systems based on check list

Usingcheck-list is really useful in order to identify specific factors that are considered able to influence the country risk.

Each political, social, economic factor is expressed by one or several quantitative indicators. After having measured each indicator according a common scale, it is possible to make atotal sum in order to have a final score, able togive a measure of country risk.

Check-list systems make possible to produce: systematic, comparable, intensive, objective analysis.

Other quantitative systems

This category concerns a lot of econometric models, all characterized by high standardization with the purpose tominimize the subjectivity of analyst.

These models are generally focused on the attempt of forecasting future financial crisis of countries and their default in honoring their international debts.

The strong formality in these systems is not a guarantee of good evaluation, because the algorithms and mathematics relationships never represent the reality of a country.

***

Whatever methodology may be chosen, strategic and competitive intelligence are fundamental in order to collect and select the necessary information about countries under evaluation.

Authors that are specialist in the discipline of intelligence[13]recommendto operate according to six fundamental conditions:

1)Orientation towards future;

2)Accuracy on information and data;

3)Efficiency of cost in comparison to the objective;

4)Objectivity of analysis;

5)Functionality of decisional process;

6)Actuality of conclusions.

1. Industry of country risk insurance

International competition of States is founded onthe capacity of national enterprises to penetrate foreign markets. Considering that this activity is particularly risky, modern States promoted specialinsurance agencies (Export Credit Agencies)uncharged to guaranty national enterprises against political risks and commercial risks.

In past periods these Agencies cumulated high losses and negative cash flow, and the Governments preferred to adopt a confidential approach, so by-passing the scientific investigation of scholars and academic literature.Nevertheless, in last decade most of themwere engaged in changing their strategy, their policy, their juridical status, according to criteria of efficiency and profitability.

There are four important events that contributed in this direction:

1)the growing importance of emerging markets;

2)the changing nature of emerging economies;

3)the increasing sophistication of capital markets;