Valuations and Risk Models

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 Assessing Country Risk

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Country risk management

 Risk can be based on either on randomness of events or a lack of knowledge:

• Aleoteric risk – from contingent event, based on the intrinsic randomness of nature (managed
through insurance)
• Epistemic risk – from lack of information about risk (managed through knowledge of risk)

 Guidelines for approach to country risk management:

• Politics can defy logic
• Know your data sources – question the validity and accuracy about information from the sources
• Question official statistics – governments can manipulate statistics for political purposes
• Benefit from the power of observation – visiting country and project site are best means to analyze
• Qualitative risk assessment can ultimately undo all quantitative approaches – too much quantitative
measures can be dangerous

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Information sources

 Central bank websites

 General publications – newspapers, magazines and newsletters
 Government sources – embassies, commerce, and EXIM banks
 International financial organizations – BIS , IMF
 Internet search engines
 MDBs – ex: African Development Bank, Asian Development Bank, IFC etc
 Newswires – Bloomberg, Dow Jones and Thomson Reuters
 Consulting firms
 Ratings agencies – Fitch, Moody’s and Standard & Poors
 Specialist publications – Business Monitor International (BMI), The Econimist Intelligence
Unit (EIU) etc

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Rating Agencies
Reliability of Rating Agencies
 Rating agencies failed in the recent past by awarding higher ratings to financial institutions and
corporation that did not deserve it (during Global recession)
 Although lower ratings were awarded to organizations that should have received them, but the process
were reactive rather than being proactive. Example: the rating downgrade of USA from AAA to AA+ by
S&P happened after the slowdown in USA.
 Rating agencies often end up with the same views, albeit some take a little longer than others. Despite
using range of quantitative and qualitative inputs to arrive at their ratings.

Indicators used by rating agencies for Country ratings

 Macroeconomic performance
 Public/external debt
 External financing needs
 Structural features (openness to trade and investment)
 Social pressures
 Regime legitimacy
 International security

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S&P sovereign rating methodology

 Political risk
 Economic structure
 Economic growth prospects
 Fiscal flexibility
 General government debt burden
 Offshore and contingent liabilities
 Monetary flexibility
 External liquidity
 External debt burden

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Measuring Political Stability

Factors affecting political instability

 Popular discontent, resulting in political demands, heightened degree of protest and
overthrow of existing leadership
 Social change such as frustration about urbanization and its effects on gender or labor
inequality. Cultures take time to adapt to economic, social and technological changes that
occur in dynamic societies.
 Perception of economic failure, relative to other countries. When countries experience
growth pattern of “inverted J – curve”, and the level of economic growth declines; it leads to
frustration among the population
 Inverted J – curve is also denoted as stability (y-axis) vs openness (x axis) curve. It holds for
countries having closed, or undemocratic government (ex: Cuba, North Korea etc.)

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 Country Risk Assessment in Practice

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Creating a risk management framework
Basic set of steps for deciding whether to proceed with a trade or investment transaction in a
Country
 A general risk management framework, to analyze if the risk associated with a proposed
transaction can be managed efficiently. (doing cost/benefit analysis). Steps involved are:
• Develop a strategic plan;
• identify targets for trade or investment
• Identify the nature of the risks
• Create a risk management process
• Evaluate costs and benefits
• Determine whether to proceed
 A country risk management framework. Steps involved are
• Identify exposures
• Analyze exposures
• Analyze risk management techniques
• Select appropriate risk management technique
• Implement chosen technique
• Monitor results/ revise program

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Case study: Assessing the attractiveness of China vs India
(for trade and Investment)
 Comparing primary issues of the investment climate of China and India

CHINA INDIA
•Human Rights •Terrorism
•Environmental •Periphery tension •Regional insecurity
concerns •Bureaucracy •Poverty
•Legal frameworks •Urbanization •Naxalites
•Excessive growth •Regulatory issues •Clash of religion
•One party state •Weak corporate
•Intellectual property governance

 History in attracting FDI: China has been consistently more successful than India in attracting FDI in the
past
 Analyzing working age population of China and India:
• China’s workforce has peaked (albeit china’s workforce is larger than India). Labor costs have risen
• India’s workforce is not expected to peak till 30 years, but faces increased regulation in labor market
 On the basis of per capita Income, India lags China by a huge margin (10 years lag).
 Using the rating provided by country risk information providers and rating agencies. (the various
Country risk information providers and rating agencies have different biases, and usually have a narrow
range vs a broader range respectively for rating countries)

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Selecting country risk management tools
Devise simple tools for country risk management, that meets your organization’s specific
needs, while utilizing the information available
 Categorize the countries by number and colors based on various information. Example:
• Green – Australia, Canada, UK
Green 100 – 88
• Blue – Chile, malaysia, South Africa
Blue 84 – 74
• Yellow – Costa Risk, Jordan, Mauritius
Yellow 70 – 60
• Red – Iran, North Korea, Venezuela
 A simple grade based rating scheme Red 57 – 50

• Ratings from high to low: AAA, AA, A, BBB, BB, B, CCC, CC, C
 Listing risks and mitigants for a specific transaction, and considering costs and benefits
 Measuring event probability (grades vs probabilities of events)
• E – certain
• D – likely
• C – Possible
• B – Unlikely
• A – Rare

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Selecting country risk management tools

 The range of quantitative measures and qualitative tools available to assess country risk are
endless. Analyst should identify the issues to be address and the tools best suited to enable
him.
 Various economic measures
• Economic growth: GDP growth vs oil demand growth; Growth in industrial production; Foreign
capital as a % of total investment; household and corporate liquidity; urban vs rural population
growth etc
• Economic health: Gross domestic savings as % of GDP; expenditure on health and education as a % of
GDP; military expenditures as a % of GDP; Labor force as a % of total population; government fiscal
deficit; government expenditure etc
• Power sector: Sources of demand of power; amounts of energy used to generate GDP growth; power
generation capacity growth and utilization hours; power demand forecast etc

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Mapping out a country risk analysis methodology
Determine the risk attributes/ indicators that should be included (broad and sub-topics)
1. Economic development – Degree of economic openness, monetary stability, fiscal imbalance
2. Trade and investment climate – Import/export restrictions, capital controls, protectionism,
3. Financial considerations – availability fo consumer credit, excessive growth in national debt
4. Local environment – prone to natural disasters, endemic corruption, labor unrest, existence of civil society
5. Developmental issues – adequacy of infrastructure, degree of poverty, sufficiency of income levels,
6. Cultural issues – orientation towards western values, work ethic, history of ethnic conflict,
7. Geostrategic consideration – perceived military value, relationship to existing regional conflict
8. Social environment – international orientation, friendliness toward people from other coubntries
9. Political stability – degree of political competition, regularity of elections
10. Personnel risks – mobility of labor force, employment regulations
11. Currency risks – nature of conversion regime, existence of wide fluctuation in currency value
12. Legal/ regulatory risks – rule of law, sanctity of contracts
13. Asset risks – local ownership requirements, control issues
14. Supply/ delivery risks – vulnerability of critical raw materials, history of supply interruption
15. Operational risks, security risks – production quotas, denial of permits and licenses
16. Security risks – existence of civil war, history of cross border conflict

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Alternative ways

 Corruption perceptions index

 Democracy index
 Freedom in the world
 Gini coefficient
 Global peace index
 Human development index
 Youth unemployment

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