Country Risk Analysis

Doing business or investing in foreign markets, especially emerging countries, carry a certain element of risk. The risks could be from the government that may decide to make changes to the country’s foreign investment rules, or it could be a small buyer deciding to cancel a contract due to some economic concerns.

Country risk refers to the various risks (political, economic and others) associated with investing or doing business in a foreign country. The goal of these risk measures is to determine how the political/ economic events in a country will affect the business climate in that country, and will it cause the investors to lose money or make less money (Howell, 1998). A sovereign risk, on the other hand, is the credit risk of a sovereign government (the govt is a borrower) and is about a country’s ability and willingness to service (pay interest and repay principal) on its external debt; it basically refers to the credit risk of borrowers from a specific country perspective (Timurlenk and Kaptan, 2012).

Country Risk is a wider collection of risks and includes political risk, economic risk, exchange rate risk, as well as sovereign risk.

Country risk analysis involves assessing the political, and economic factors prevalent in a country that could impact the timely payment of interest and principal. These factors hinder the ability of the non-sovereign sector to generate enough foreign currency to honour their obligations to foreign creditors/investors. The country risk analysis results (measured risk) are often used as decision tools during pre-lending as well as post-lending. Before the lending, these results help understand if it is safe to lend, how much to lend, etc. Post-lending, these results serve as a monitoring tool for borrowers, serving as a pre-warning system.

Foreign investments (FDI) in any country are usually for a significant amount of time – three- to five-years at least, which means the investors not only have to be worried about the present scenario but also need to know how the economic and political scenario of a country could possible unfold in the coming years. This is where country risk measures can provide guidance to such investors.

There are several professional agencies around the world, such as IMF, WORLD BANK, Standard & Poor’s, Moody’s, Euromoney, international banks, Business Environmental Risk Intelligence, that work as rating agencies by providing country risk analysis, in addition to providing analysis of the various economic sectors (Oetzel and Zenner, 2001). In order to do country risk analysis, analysts in these agencies need data from varied sources such as IMF, WORLD BANK, IIF, etc. besides getting it from the public offices of the country, as the need for transparency is very high (Timurlenk and Kaptan, 2012).

There are several factors that drive country risk, some of which include the country’s position in the economic growth cycle, levels of corruption, political risk, legal system, history of economic mismanagement, per capita GDP, etc. So, country risk mostly depends on political and economic factors (Oetzel, Bettis & Zenner, 2001).

Countries that are in early growth (such as India) offer risks that are much larger than mature countries (such as Germany). The economy of a mature country like Germany will witness some dip in the economy (GDP) during a slowdown/recession; however, the fall in the economy (GDP) for a country like India during such times will be proportionately much higher. For example, Germany’s economy shrank by 2.2% in the first three months of 2020 due to the Covid-19 pandemic. However, India’s economic growth dipped by 23.8% in the first quarter of 2020-21 due to the Covid-19 pandemic (Reuters Staff, 2020).

Also, dependence of a country’s economy on few products and services can be concerning factors. For example, the dependence of a country only on oil, or only on Tourism can be a risky thing for investments. Germany is one of the world’s largest economies and supports a variety of industries, with the top industries being the automotive, mechanical engineering/machinery, chemical, electrical and services industries (GTAI, 2020). While agriculture used to be the major industry in India at one point of time, the country has since done well and diversified in other industries as well, such as auto components, cements, pharma and services sectors (IBEF, 2020), although it still remains a developing country.

When it comes to political risk, depending on the type of government, the country might offer Continuous or discontinuous risk (Analystprep, 2019). Democracies offer continuous risk because rules and regulations always go through scrutiny and amendments. Authoritarian states on the other hand offer discontinuous risk as the rules and regulations do not change often. Then there are other factors that contribute to political risk, and an unstable government usually leads to economic instability, which can pose serious risks to foreign investors (Ginsburg, 2019).

Internal conflicts or civil war often leads to higher operational costs and insurance costs; risks related to exports that exporters face due to market conditions or import barriers; companies that are planning to invest in industries such as mining run the risk of Expropriation; depending on the nature of the business devaluation of the currency could reduce the values of generated revenues; the government might put restrictions on movement of funds to banks in other countries preventing a foreign company from sending back profits to its home country; host government may raise taxes to generate finds for public services and they might ask foreign companies to cough out more.

While developed countries offers a safe and attractive business environment throughout the country for foreign businesses to invest in, in developing countries, certain locations may not be suitable for foreign businesses to invest in, due to locale strife and security concerns. These are some pollical risks that businesses/investors need to be worried about before they decide to put money in foreign shores.

Legal Risk refers to the robustness of the legal framework in a country, how efficiently the system operates, and how easy/difficult it is to enforce contractual rights. Things like governance and corruption are also factors that contribute towards political risk; higher levels of corruption mean it’s easier to circumvent the regulations and systems that have been set in place. Compared to Germany, corruption in India is much higher with several scams particularly targeting foreigners, which can be unnerving to foreign investors; and while India has well established legal system, the judiciary is inefficient and cases can drag for a long time (asialinkbusiness, n.d.).

A sovereign default, especially Foreign currency default, is particularly challenging for countries because it doesn’t give the government the option to print money (it cannot print foreign currency) and pay the debt, assuming the country is unable to service the debt for some reason; same applies to countries with shared currency (such as Euro). Sovereign defaults cause reputation loss, political instability, and cause chaos among investors (Tomz and Wright, 2013).

While information on country risk can be useful, there are certain limitations of the Risk Services providing agencies as well. Firstly, there is no standardization of the risk score and these agencies use their own methods and protocols to come up with the overall risk scores; these scores/indices use combinations of factors such as political, social, economic, environmental and other factors, however, there is no universally standard methodology to assess risk (Rao, 2012).

Comparison between the various methodologies is different, because of the opacity of those methodologies; because most of these risk indices are sold as commercial products, most agencies do not easily reveal the methodologies and sources that are used to come up with the various risk scores. Also, the final score that some of these models throw up may be more appropriate for policy making and less relevant for businesses/investments. Besides, the scores can even be misleading at times, so assuming if India had double the risk score compared to Germany, India may not necessarily be twice riskier than Germany.

Also, most agencies are reactive, and not proactive with their ratings; they are likely to update their ratings and/or downgrade countries after a problem or crisis has become clearly evident and its too late to protect one’s investments.

It’s important for investors and businesses to take into country risk and have plans in place to mitigate those in order to protect their investments and also to sustain the investment returns. Here are a few things that they can do. Investors/businesses should regularly monitor the situation, as events many not unfold with adequate warnings; they should keep an eye on sovereign ratings so that they can enough time to take remedial actions if the need arises.

Companies should diversify wherever possible – not just its investments put also when working with suppliers, trading partners and banks; big companies can diversify their portfolio by investing in multiple countries/regions to diversify the risks; companies it should also ask for guarantees, collaterals and consider financial hedging transactions (Kuepper, 2019). Investors can also assess the risk by comparing the situation in the country with other countries having similar risk exposure and get an idea of what other investors might be doing. Businesses are likely to face challenges due to political instability in future too. So, it is important to evaluate investments in a foreign country by analyzing the country risks and considering it in the decision-making process.

Governments, on the other hand, should also play their part to reduce risk which will encourage more investors/businesses to trade/invest with their country. Governments should work towards reducing the size of the debt, the larger the debt of a government, the more likely it is to default on the debt. Countries should also work towards increasing their GDP, because more the revenue for country, less is the chance of defaulting on its debt. A country should also work towards building more stable revenue streams. Being part of a regional economic block also helps as other member states are likely to rush in to help if a particular member faces the risk of defaulting on a sovereign debt economic crisis.

Prince Chart for Country Risk

The Prince model is a model used to assess Political Risk.

Back in the year 1972, William Coplin and Michael Leary (from Syracuse University), developed a framework, called the Prince Model, which made it easier to compare the political situation across countries. “Prince” is basically an acronym for the 4 steps required to carry out this assessment: Probe, Interact, Calculate, Execute.

Essentially a power analysis, the Prince model tries to figure out who holds more mover and probably needs to be moved, and where there is leverage to move them. The steps:

• Probe: Identify the key players and issues.
• Interact: Interact with these people/groups to understand their influence on the issue. In this model, Influence is measured using the combination of position, salience, and power.
• Calculate: Put all the information gathered in the form of table, and summarize the findings
• Execute: Formulate and execute a strategy.

The Prince Model is commonly used by forecast models to assess political risks associated with international business. The Prince Model is used to generate probability scores for various political situations such as which party is likely to form government, chances of turmoil, restrictions on international trade, government policies, etc.

This information on position, salience, power and affiliation is collected from the various actors (there are various ways in which one can collect this information) and depicted on Prince Charts.

1. Orientation (Position): What does the actor feel in general about the action – Support (S), Neutrality (N); or Opposition (O). This captures the general attitude of the actor.
2. Certainty: This parameter indicates the firmness of the actor’s orientation. This is measured on a scale of 1 (less certainty) to 5 (high certainty)
3. Power: This indicates the degree to which an actor can exert influence on a matter, relative to other actors. This is measured on a scale of 1 (less power) to 5 (high power). Power could mean group size, wealth, authority, political skill, etc.
4. Salience – This indicates the importance or strength of the support or opposition by the actor. This is measured on a scale of 1 (little importance) to 5 (high importance).

While the variables related to economic conditions are generally easier to quantify, variables used to measure political risk are often subjective and even complicated to measure.

To begin using the Prince model to assess a country, a team of analysts first need to survey the country and identify actors (individuals, groups, and institution), and then note down their positions about particular actions that could affect international business in the country. These actors could be individuals, groups – ministries within the government, opponents of the government, or groups in the society – business, unions, etc.

The analysts then indicate on the Prince chart the position (numbers) of all the actors surveyed, as per the four categories.

The “Prince Score” is obtained by multiplying certainty, power, and salience. Orientation makes the score positive or negative depending on the support or opposition of that actor.

The information collected in the Prince Charts is then used to create a Decision Structure Chart for each risk factor, clearly showing the forces supporting and opposing the factor.

Closing Thoughts

To sum it up, country risk is the risk that a foreign government will default on its financial commitments and is dependent on various political and economic factors. Because the consequences of bad overseas investments can be costly, investors/businesses refer to rating-agency reports, produced by different agencies, to understand the risk associated with a particular country, before deciding to invest. While it important for investors, managers, and exporters to have access to resources that make them aware of country risks, the challenge with most country risk ratings is that there are limitations to it and most of them fail to notify investors of impending crises well in advance; these data also do not provide guidance on what decision makers should do. Once invested, it is important for investors/companies to continue to monitor the situation closely, stay diversified as much as possible, and hedge their bets.

Developed countries have a favorable political, economic and business environment, and offer lower country risk. Developing countries, on the other hand, are fast-growing economies, and while they have the right systems in place, there are inefficiencies which will need to be improved over time. Irrespective, Investors need to do the right due diligence before making their investments.

 

References

Country Risk: Determinants, Measures, and Implications [online]. Available at:

Coronavirus pushes German economy into recession [online]. Available at:

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Howell, L. D. (Ed.) (1998). The handbook of country risk analysis. New York: The PRS Group.

How to Evaluate Country Risk for International Investing [online]. Available at:

Michael Tomz and Mark L.J. Wright, 2013. Empirical Research on Sovereign Debt and Default. Annual Review of Economics 5(1), pp.247-272

Oetzel, J., Bettis, R. and Zenner, M., 2001. Country risk measures: how risky are they?. Journal of World Business, 36(2), pp.128-145.

Rao, S. (2012) Country Risk Indices (GSDRC Helpdesk Research Report). Birmingham, UK: Governance and Social Development Resource Centre, University of Birmingham.

A Reasonable Way To Manage Country Risk. Available at:

Timurlenk, O. and Kaptan, K., 2012. Country Risk. Procedia – Social and Behavioral Sciences, 62, pp.1089-1094.

Everyman’s Prince: A guide to understanding your political problems
Book by William D Coplin and Michael K. O’Leary

COUNTRY ANALYSIS International Investing
https://www.bauer.uh.edu/rsusmel/7386/ln9.pdf

PRINCE Analysis (Urban Policy & Strategic Analysis)
http://kr.mnsu.edu/~jp5985fj/courses/411/PRINCE.html