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Money and international finance countries at risk

“Analysing country risk is an art, not a science”. Discuss, and comment on whether increased globalisation will reduce or increase the country risk problem for firms.

More and more firms are seeking investment potentials in foreign countries. This trend has been encouraged by the occurrence of globalisation which makes business activities overseas more possible (Parker, 2005). However, a firm that has undertaken or is contemplating an investment in a foreign country is exposed to country risk (Meldrum, 2000). The term country risk is used to refer to the potential for a country’s environment to unfavourably impact on the business activities of a firm (Madura, 2008). These risks are broadly categorised as political, economic and financial and the assessment of these risks is the process of country risk analysis. Analysing country risk has become an important part in the decision making process of firms.

The measures that are used in the assessment of these risks are both quantitative (for example inflation rates and Gross Domestic Product) and qualitative (for example the probability of war and policy developments) but their interpretation is largely subjective. Coupled with the unpredictable nature of a country’s environment likens the analysis of country risk to an art as opposed to a science (Meldrum, 2000).

1.0 Introduction

The purpose of this assignment is to critically discuss the statement “analysing country risk is an art, not a science”. The analysis of country risk is usually undertaken by companies and individuals alike who want to embark on an investment in a foreign country and usually entails consideration of a country’s political, economic and financial situation. This report has chosen to draw the conclusion that the process of analysing country risk is an art rather than a science. In order to ascertain this the report will start by giving a detailed description of what country risk analysis entails along with consideration of its significance in the decision making process of foreign investments. This will be followed by identifying the techniques and measures used in analysing the risk of a country. Globalisation has provided the opportunity for an international approach to business and as firms become increasingly aware of the benefits to be gained from cross-border business activities this trend is showing signs of not dwindling. Therefore, the issue of increased globalisation will also be considered in this report and whether it contributes to lessen or intensify the country risk problems firms’ encounter. Ending with a reference to CAPM as a tool….

2.0 Country Risk Analysis: An Overview

According to Hertz and Thomas (1983) the term risk is used to refer to uncertainty. They suggest that risk arises in situations where there is a degree of unpredictability about outcomes or consequences of a decision; there are varying definitions of risk. In the financial context, Madura and Fox (2007) defined risk as the probability that the projected return on an investment will be different. There have been many observed changes in the world economy over the years, including the reduction in trade barriers facilitating the free movement of goods, services and capital across borders. Technological development has resulted not only in advances in transportation and communication but contributed to their significantly lowered costs (Parker, 2005). This process, according to Parker (2005), is commonly referred to as globalisation and is characterised by a greater interdependence and connection of countries creating an integrated market on a global scale. These changes have opened the door to a greater number of business activities, such as trade and foreign direct investment (FDI) occurring overseas in emerging markets. Investors seek therefore to take advantage of new opportunities i.e. to find new markets and to diversify their markets (Rugman and Collinson, 2006). It is agreed that to some extent all business transactions carry with it some degree of risk (Meldrum, 2000). However, Meldrum (2000) adds that those firms which make foreign investments face a greater risk, because several new variables like exchange rates and taxes are introduced. These risks are grouped under the umbrella term ‘country risk’ which Madura (2008, p446) defines as “the potentially adverse impact of a country’s environment on a multinational corporation’s (MNC’s) cash flows” as well as the value of its assets. Country risk can be separated into three broad categories of risks: political, economic and financial (Buckley, 2004); yet it is not limited to these alone.

Analysing country risk is an on-going process that is often vast and complex (Madura, 2008). It is the process of assessing the possibility for the risks mentioned above to have a negative impact on the investment yield potential of a country (Lumby and Jones, 2001). Certain historical events served to increase the awareness of country risk and thus the importance of country risk analysis (CRA). Events such as the 1991 Gulf War which increased the threat of terrorism activities and additionally saw the cash flow of MNC’s significantly affected (Madura and Fox, 2007). Also, the 1997 Asian financial crisis where the level of inflation rose to greater than 180% in four of the leading Asian economies and, the 1989 Chinese inflation crisis.

2.1 Political Risk

POLITICAL FACTORS

Terrorism

The operations of MNCs and its employees can be impacted directly or indirectly by the activities of terrorists.

As an example, the September 11 2001 terrorist attack directly impacted over 50 MNCs that had offices located in the World Trade Center as well as indirectly compromising the safety of US subsidiaries abroad where there potentially existed anti-US feelings.

War

Can influence the cash flows of MNCs in several ways such as threatening the safety of employees of MNCs within the country as well as creating volatile business cycles.

Level and type

of legal standards

MNCs can be either positively or negatively affected by the different standards and regulations of a country, for example low standards for environmental protection and no copyright and patent laws.

For example, South Africa introduced a law that permitted patented drugs to be legally copied and as a result of this 41 pharmaceutical companies saw major financial losses.

Regulation of competition

The implementation of policies which maintain a state monopoly cause high entry barriers into an industry also fixing prices are examples of regulations on competition that countries may impose these can have huge negative consequences.

Bureaucracy

Has the potential to complicate the activities of a MNC’s business.

Corruption

Corruption can have unfavorable outcomes for a MNC’s activity overseas, either in reducing its revenue or through raising the cost of doing business. An example of this is if a government favorably gives a contract to a local firm as opposed to a MNC causing it to lose revenue.A political risk refers to “an exposure to a change in value of an investment or cash position resultant from government actions” (Buckley, 2004: p489). Clark (2002) highlighted that political risks incorporates a range of factors some of which are considered in Table 1.

Table 1: identifies and explains a handful of political risk factors for consideration in a CRA (source:

Furthermore, there are various methods and techniques in the analysis of political risk and include the comparative techniques of rating systems (Clark, 2002). The few indices that exist which attempt to quantify political risk include the Business Environment Risk Intelligence (BERI) and Political Risk Services (PRS). Nonetheless, Shapiro and Sarin (2009) stipulated that these are often based on the subjective views of a panel of experts. According to Meldrum (2000) very few of the factors to be considered in political risks involve quantitative measures, Buckley (2004) substantially agrees and added that most comprise of qualitative analysis and are largely subjective in nature.

2.2 Economic Risk

The macro-economic policies of a country, fiscal, monetary, international, or wealth distribution and creation, constitutes the economic risk of a country (Oetzel, Bettis and Zenner, 2000). The variables and ratios for consideration in the economic risk analysis of a country, refer to Table 2, are largely quantifiable and include ratios such as great domestic product (GDP) and inflation rates, but there are some aspects of qualitative analysis.

ECONOMIC RISKS

GDP per Capita

Gross Domestic Product is a standard used to estimate the economic progress of a country. When conveyed as per capita it indicates the country’s standard of living. A high GDP per capita means high productivity and demand for goods and services. However, this will also mean wages are higher deterring low labour seeking MNCs

Growth Rate of

GDP per Capita

This measures the growth potential of a country. A high GDP per capita growth rate is beneficial for those MNCs seeking new markets because this is a sign of high investment returns.

Interest rates

A high interest rate may negatively impact on a country because it slows down the growth of the economy and will ineffective decrease the demand for MNC’s products. In contrast a Lower interest rate has the opposite effect.

Inflation

A high inflation rate of a country impacts on the spending potential reducing the demand for a MNC’s products.

Exchange rates

The volatility of a country’s exchange rate increases uncertainty.

The exchange rate of a country influences the demand placed on its exports.

For example, a country with a devalued currency will mean that an investment made there will see a reduction in the cash flow and earnings value in the home currency of an investor.Table 2: identifies and explains the a few economic risk factors for consideration in a CRA (Source: ).

2.3 Financial Risk

The Financial risk of a country specifically refers to the ability of its government to finance its official, commercial and trade obligations. An assessment needs to be made of the foreign obligation of that country and a comparison made of its current and future economic situation (Buckley, 2004). Stipulated in Table 3 are variables used in the measurement of the financial risk of a country. The typical measures used are ratios and although these allow a quantifiable analysis to be made of the economic strength of a country, the interpretation of these ratios is an art that is potentially of value (Buckley, 2004); this also applies in the case of economic risk factors. The partiality of these interpretations is heightened by the cautious nature by which these country ratios need to be treated, as the accuracy of their measurements is not always 100% particularly for emerging countries (Buckley, 2004).

FINANCIAL RISKS

Exchange control and limitations

A restriction placed by a government that stops the conversion of its currency into another currency will mean the MNC may need to exchange it for goods in order to benefit from doing business in that country.

Total external debt-to-GDP

A comparison is made between a country’s federal debt and its economic position, which will indicate its ability to repay its debts owed.Table 3: identifies and explains a few financial risk factors for consideration when a conducting a CRA (sources: ).

3.0 Techniques of Assessing Country Risk

Madura and Fox (2007) have identified five main techniques that are used in the assessment of country risk. The first of these is the checklist approach, where all identified political, economic, financial and social risk factors are allocated a rating. These ratings will then be consolidated to arrive at an overall assessment of the country. What is important to note is that although there will be factors such as GDP which can be measured from data that is available, other factors such as the probability of war will involve a high level of subjectivity. The next approach suggested by Madura and Fox (2007) is the Delphi technique, where a number of subjective opinions are obtained from experts and then correlated in order to identify a consensus. Quantitative analysis is another technique which relies on historical data about various risk factors. These are then used in an attempt to “identify the characteristics that influence the level of country risk” (Madura, 2008: p454). The fourth technique is inspection visits; this entails travelling to the relevant country and meeting up with key government officials, business executives and customers to clear uncertainties (Neale and Pike, 2006). Lastly, a combination of these methods could be used in making a country risk analysis. Research has shown that most corporations involved in foreign investments have no set method of country risk analysis (Madura, 2008) making it more of an art rather than a science.

4.0 Art or Science

The level of exposure to country risk will vary from business-to-business (Parker, 2005). Furthermore, what is evident from the academic literature is that there is clearly a degree of subjectivity involved in the analysis of country risk. Country risk analysis has both quantitative and qualitative aspects of the analysis. The quantitative aspect involves a variety of economic and financial measurements; however, making a judgement on the reliability of the data is more qualitative. The qualitative aspect of the analysis is done in relation to factors such as political and policy developments (Shapiro and Sarin, 2009). For the reasons mentioned above it can be argued therefore that the analysis of country risk is not an exact science, but rather an art whereby a substantial level of unpredictability must be acknowledged. Meldrum (2000: p1) agrees and states “uncertainty makes CRA more similar to a soft art than a hard science.” Furthermore it is the level of uncertainty involved that allows for a wide variety of interpretations of the riskiness of a country.

5.0 Increased Globalisation and the Country Risk Problem

Hood and Young (2000) have suggested that globalisation began during the 1970 World Economic Crisis due to a combination of factors, these include the Asian crisis.., Oil crisis…, post-Vietnam war… Furthermore, during that time Western industrialised countries experienced a slow down in their economies, reduction in profits as well as strong competition. As a result, the following strategies were utilised in order to tackle these problems: cheap labor usage in manufacturing process, new market exploration as well as strategic alliances formation. These led MNCs to explore developing countries such as Mexico, Tunisia and Taiwan enabled by the deregulation of international trade. (Hood and Young, 2000). The decision by a firm to invest overseas is usually motivated by two essential elements, these are the return expectations and the possible risks (Click, 2005).

Globalization has changed the international financial flows and has resulted in foreign direct investment (FDI) becoming the dominant source of private capital flows. ( Graph…). FDI is perceived as a more stable investment option and is believed to bring many of the indirect benefits of the globalization, such as sharing managerial and technological expertise (Kose, Prasad, Rogoff & Wei, 2007). Large companies invest abroad when they see an opportunity to become more competitive, expanding their international operations, satisfying global demand and reducing production costs. This is also beneficial for emerging markets as investments help the country to accelerate their growth. For example, in Israel, global giants such as Microsoft (MSFT), General Electric (GE) and IBM (IBM) have made large investments achieving high profits and fostering the country economy (Sifma). Furthermore, giant corporations, like Coca-Cola, Nestlè, Gillette have also built much of their success through manufacturing products in various countries, moving their operations across national borders, sharing resources and serving customers worldwide (Yan, 2010). Globalization has strengthened the competitive position of MNCs against their local rivals because international expansion has enhanced growth opportunities. However, operating overseas can be more expensive than operating at home for the reason that the exposure of country risk can offset its benefits (Pitelis & Sugden, 2000).

One remarkable feature of FDI flows is they are concentrated in countries that are considered as being riskier and deemed to have higher sovereign and debt credit rating (see Chart..). One explanation to this paradoxical finding is that FDIs are likely to take place in countries where the quality of institutions is lower and markets are inefficient (Loungani, Razin, 2001).

Furthermore, it is possible to exploit the largest diversification benefits where political risks are greater, such as in less-developed countries (LDCs) because their economies are less closely tied to the economy of the developed countries (Shapiro jana). The key to achieving a successful diversification in terms of risk reduction is selecting a portfolio project whose performance is not correlated over the time. In other words, the low correlation between projects and market returns offsets the effects of a high project risk (Shapiro). Consequently, they should not experience poor performance simultaneously (Mandura, 2006). A firm can benefit from less volatile cash flows by diversifying sales and possibly even production internationally. Furthermore, MNCs can take advantage of a lower cost of capital as creditors and shareholders perceive company’s risk lower, as a result of a more stable cash flow ( Mandura, 2006).

According to Capital Asset Pricing Model (CAPM), the MNCs’ cost of capital should be considerably lower than domestic firms. This is because MNCs have the opportunity to diversify across the markets the non systematic risks, such as economic and political (Mandura & Fox, 2007). Although, non systematic risks can be substantial it should not affect the discount rate to be used in valuing foreign projects. The element of risk that cannot be diversified away from the CAPM is market risk, in other words the risk common to all investments in the economy. (Mandura & Fox, 2007). Thus, the cost of equity for a firm that operates abroad will have an additional country risk premium;

Cost of equity= Risk free Rate+ Beta (Mature Market Premium + Country Risk Premium).

According to Shapiro ( ) even though beta is widely available, this method is limited due to the subjectivity of the risk premium estimation and therefore not the best measure of country risk. The risk premium applied to foreign projects might be less than the required return on comparable domestic projects. Consequently, the net benefit enable MNCs to undertake overseas projects that would otherwise be unattractive. (Shapiro).

Giants have managed to succeed abroad due to their experience and considerable size, therefore they have exploited the benefits of globalisation, reducing their exposure to country risk. However, globalisation has also proved to increase country risk; this has been demonstrated by the numerous firms that have closed their activity down in emerging markets. This failure, according to Johnson, Scholes and Whittington (2009), can be accounted to overconfidence of duplicating their domestic success abroad as well as their substantially smaller size. Furthermore, they ignore the fact that international strategies have to create a sustainable competitive advantage in order to overcome home competitors. The latter have strong market knowledge, established supply chains and well-built relationships with local customers; international firms will find it difficult to compete under these circumstances. In addition, it is often the case that discrimination by the host countries occur. For example, inconsistent government policies and ambiguous property rights were found to be the major barriers for MNCs' entry and establishment in China (Ni & Wan, 2008).

Learning from the failure of Best Buy’s company, there is a requirement for every product or service to be adapted to the specific need of the target segments. Therefore a company has to decide whether to be different or to compete on price ( Hill, 2011).

Some studies argue that the impact of MNCs competition on local firms depends on industry contexts. Thus, in order to enjoy significant advantages, MNCs should base their activities where large investments are required, customer needs are homogeneous and few distribution networks are necessary. In contrast there are some industries that have limited economies of scale, specific customer needs and high importance of downstream assets such as distribution, where local firms might be stronger than MNCs therefore the risk of failure is higher (Pitelis & Sugden, 2006). Damodaran (2003) advocates that not all companies in a market are similarly exposed to country risk. Furthermore, he states that assessing country risk is important even for companies that get a considerable portion of revenues from emerging markets, since the revenue source is considered as one of the most evident determinants of company exposure.

Conclusion

Country risk analysis has become an important part of foreign investment decision making process and includes such factors as currency fluctuations, macroeconomic performance, political, legal, profit repatriation issues. Regardless of how country risk analysis is conducted, MNCs are often unable to predict crises in various countries. The unpredictability of country risk along with the subjectivity involved in its interpretation makes it more of an art rather than a science. Since country risk can change dramatically over time, periodic reassessment is required, especially for less stable countries.

MNCs should recognise their limitations when assessing the risk and consider the ways they might limit their exposure to a possible increase in that risk.

Globalisation has strengthened MNC’s competitive position for large firms but also complicated country risk assessment for investors.

International investments signify additional risk that would not happen to investments in a solely domestic context. However, two projects may signify the same rate of return as well as equal commercial risks, a project that is placed in a certain national context may return to be riskier than an investment in other country.

Those large firms that are well established in the market have exploited the benefits of globalisation and managed to lessen country risk. In contrast, globalization has increased country risk problems for certain firms resulting in failure. This is due to the fact that they failed to understand the market and adapt their strategy accordingly.

It is often the case where MNCs invest abroad to reduce their exposure to exchange rate risk, taking advantage of the “natural hedging” (Mandura & Fox, 2007).

6.0 Conclusion

Hayakawa, K., Kimura, F., Lee, H., 2011, "How does country risk matter for foreign direct investment?" Institute of Developing Economies Discussion Paper;

Ronald, S., 1992, "Country Risk Analysis. A handbook", London, Taylor & Francis Group

Madura, J., Fox, R., 2007, "International Financial Management", Cengage Learning EMEA

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