Country Risk Analysis Balance of Payments

The dictionary defines risk as exposure to peril From an investor point of view risk is exposure to a loss Country risk is exposure to a loss in crossborder lending/ investment, caused by events in a particular country Generally these events are, to a great extent, under the control of the Govt. of that country

All cross border lending/ investment in a country whether to the Govt., a bank, a private enterprise or an individual is exposed to country risk Country risk is thus a broader concept as compared to Sovereign risk- which is the risk of lending to the Govt. of a sovereign nation Only events that are, to some extent, under the control of the Govt. can lead to the materialisation of country risk Natural calamities, in unforeseeable, cannot be considered as country risk But if past experience shows the recurrence of such events then these must be considered for the analysis of country risk There are three components of country risk they are: Political component Socio-cultural component Economic component Each of these has a domestic aspect and an international aspect

A Domestic 1 The political system Its basic strength Its resiliency-capacity for change without disruptive conflict 2 The group in power Philosophy Policies Govt. officials Ability and number of qualified officials Willingness and capacity to make tough decisions Strength & capability to implement plans

3 Opposition groups Strength Likelihood of system-disrupting conflict arising from within the country Philosophy of strong opposition groups 4 The Govt. system Efficiency Red tape Flexibility Responsiveness

B International Likelihood of system-disrupting conflict arising from outside the country Due to countrys own problems Due to treaty or other obligations 1. Relations with major trading partners 2. Relations of companys home country with other countries

We must consider possible effects socio-cultural variables such as:

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A. B. C. D. E.

Domestic Social groups Homogeneity of population Ethnic Religious Linguistic Class Extent of cohesiveness or divisiveness General psychology of the people Work ethic Unemployment Political activism of population Extent of social unrest strikes, riots, insurgency
International Cross border ties Cross border antagonism Historical issues in the region

Domestic Economic growth, investment trends Cyclicality of economy, economic diversification Inflation monetary policy, fiscal policy, budget deficit Strength of local financial markets, proportion of local investment International Balance of payments International trade- importance of trade to economy, diversity of exports, elasticity of export demand, elasticity of import demand: capital equipment, necessities, degree of self reliance on food, luxuries, international trade ties, proximity to major markets, extent of trade controls

International capital Currency- strength, stability, quality of exchange markets, depth of exchange markets, extent of control over exchange markets Debt. total, short-term as share of total, debt. Service International financial resources- international reserves, international borrowing capacity, history of debt. Repayment, credit rating, autonomous capital inflows

Generally country risks are quite difficult to analyse Most organisations will look for various types of historical data To approach through govt. commercial arrangements is also a safer route Also it is common for companies to take the premium for risk approach This is a form of self insurance that the firm implements by requiring a higher rate of return in countries considered exceptionally risky

Before investing: One way to hedge risks is to minimise the firms equity investment in the country Local borrowing not only limits the company investment that is subject to risks, it has the important benefit of creating allies, local lenders who have a vested interest in the success of the firm This also helps reduce the firms exposure to forex risks, since local profits will go to service the borrowing Minimising equity stake can also be achieved through local equity participation-forming a joint venture with local share holders Participation of local share holders will also help build links with the local markets and also provide the benefits of local management advice and knowledge In some countries this is a pre-requisite to doing business Equity risk can be eliminated altogether through a management contract that compensates the firm for management services provided

International integration: if the company established in a foreign country is dependent on raw-materials, technical skills, machinery, management or other inputs from abroad then local pressures will think before jeopardising these inflows This can also be achieved through control of external markets Also the use of international trade marks and brand names which can be registered in a wide numbed of countries External hedging: insurance is available for covering certain types of risks associated with loss of assets Does not cover opportunity costs/ losses Host govt. guarantees cover things like tax concessions, provisions for compensation, and some other contingencies These serve as an additional protective measure but change in govts. Can repudiate such agreements

Some other ways mitigate risks after investing are: Prompt response to host govt. requests Contribution to national goals Contribution to national welfare Developing a national image Increased technical contribution

Investment codes: An increasing number of international organisations are attempting to promulgate international codes providing guarantees between multinational companies and host govts. United nations and IMF are involved in enabling such agreements which will ensure compensation if there is a default Multilateral investment guarantee agency, a member of the world bank group is trying to put together processes in place for Guaranteeing investment made by foreign investors against political risks And producing promotional and advisory services to assist member countries to creating an alternative climate for private foreign direct investment

The balance of payments can be defined as the statistical record of a countrys international transactions, over a certain period of time presented in the form of double entry book keeping It is worth looking at because: It provides detailed information concerning the demand and supply of a countrys currency A countrys BOP data may signal its potential as a business partner for the rest of the world The BOP data can be used to evaluate the performance of the country in terms of its international competitiveness

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A countrys international transaction can be grouped into the following three types: The current account The capital account The official reserve account

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The current account includes the export and imports of goods and services The structure of the account Merchandise Invisibles (a+b+c) Service travel, transportation, insurance, govt. not classified elsewhere and miscellaneous Transfers- official, private Investment incomes

Merchandise trade covers all transactions relating movable goods, where the ownership changes from resident to nonresident(export)and from non-resident to resident(import) Exports valued at FOB (international freight and insurance are treated distinctly from the value of goods) Imports valued at CIF

Invisibles account include services like transportation and insurance, income payments and receipts for factor services and unilateral transfers Credits include services rendered by residents to non-residents, income earned by residents from their ownership of foreign financial assets(interest, dividends), income earned from the use by non-residents, of non-financial assets such as patents and copyrights owned by residents and the offsets entries to the cash and in-kind gifts recd. By residents and non-residents. Debits consists of the same items with the roles reversed of residents and non-residents Transfers include foreign aid, repatriations, official and private grants and gifts- these are usually uni-directional

The current account balance, especially the trade balance, tends to be sensitive to exchange rate changes

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Capital account includes all purchases and sale of assets such as stocks, bonds, bank accounts, real estate and business The structure of capital account: Foreign investments In India direct & portfolio Abroad Loans External assistance - By India and To India Commercial borrowings - By India and To India Short term - To India Banking capital Commercial banks assets, liabilities and non-resident deposits Others Rupee debt services Other capital

The first sub-group relates to foreign equity investments in India either in the form of direct investments or portfolio investments by institutional investors The next group of loans include concessional loans recd. By the Govt. or public sector bodies, long and medium term borrowings from commercial capital markets in the form of loans, bond issues and short term credits such as trade related credits The third group separates out the changes in foreign assets and liabilities of the banking sector Non-resident deposits with Indian banks are shown separately The reserve assets consists of RBI holdings of gold and foreign exchange ( in the form of balance with foreign central banks and investments in foreign Govt. securities and Govt. holdings of SDRs

1 Trade balance Refers to merchandise trade account 2 Balance on goods and services This is the balance exports and imports of goods and services 3 Current account balance This is the net balance on the entire current account 4 Balance on current account and long-term capital This is also called basic balance This indicates long-term trends in BOP Essentially short-term flows can be volatile but longterm capital flows indicate the strength of the economy

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Classification BOP on current account BOP on capital account BOP current account includes Trade relating to imports and exports Invisible items such as shipping, banking, insurance, travel etc. Unilateral transfers such as donations The current account shows whether India has a favourable balance or deficit balance of payments in any given year The BOP in capital account shows the implications of current transactions for the countrys international financial position For instance, the surplus and the deficit of the current account is reflected in the capital account, through change, in the foreign exchange reserves of India, which is an index of the current strength or weakness of Indias payment position

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Capital account is divided into three parts Private capital further divided into long-term and short-term capital Anything more than one year is long-term and less than one year is short-term Private capital includes foreign investment(direct and portfolio) and long-term loans, foreign currency loans and estimated portion of the unclassified receipts allocated to the capital account Banking capital covers movements in the external financial assets and liabilities of commercial and co-operative banks authorised to deal in forex Official capital, The RBIs holdings in terms of forex and Special drawing rights held by the Govt. categorised into loans, amortisations and miscellaneous receipts and payments