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country risk analysis mscif 2008 introduction what is risk about what is country risk all about

MH Bouchet/CERAM (c). 5 Objectives. Defining country risk

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country risk analysis mscif 2008 introduction what is risk about what is country risk all about

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    1. MH Bouchet/CERAM (c) Michel Henry Bouchet

    2. MH Bouchet/CERAM (c)

    3. MH Bouchet/CERAM (c) Why is Country Risk Analysis so important? To assess risk versus opportunity prospects To screen out excessively risky countries To monitor countries where an investor should do, or should NOT do, business may engage in divestiture if risk increases To use in a proposed capital budgeting project and to assess gain & loss probability outcomes of cross-border investment or export strategy

    4. MH Bouchet/CERAM (c) Country Risk

    5. MH Bouchet/CERAM (c) What is Risk about? Risk stems from a situation of uncertainty regarding the near or long term, where information about the situation’s outcome is insufficient, lacking or simply wrong Information availablility is, in itself, a measure of risk (BOP, debt data, transparency…) Information scarcity then requires taking action that might produce negative and costly consequences (investigation time, transaction cost, delays, wrong decisions…)

    6. MH Bouchet/CERAM (c) What is Risk about?

    7. MH Bouchet/CERAM (c) The « discovery » of risk

    8. MH Bouchet/CERAM (c) Risk has to do with uncertainty regarding the future, hence the need of predicting the future

    9. MH Bouchet/CERAM (c) Historical roots of Risk assessment 1 Until the Middle-Age, decision-making is based on tradition, “Lady Luck”, and superstition: order is to be found only in the Sky(ies) As Christianity spread across the western world, the will of God emerged as the orienting guide to the future 1000: Crusades: Westerners collide with the Arab empire which had become familiar with the Hindu numbering system through the invasion of India: without numbering, risk is wholly a matter of gut (Le Goff, Braudel) Rational process of risk-taking requires a numbering system that traces back to the Hindu-Arabic system. It reached the West in the VIII° century and expanded during the Renaissance in the XVI° century: Colombus, Copernicus, Paccioli, Cardano, Galileo…

    10. MH Bouchet/CERAM (c) Historical roots of risk assessment 2 In 1654, Chevalier de Méré, Blaise Pascal and Fermat work on puzzle-solving, mathematics and gambling: replacing randomness with systematic probability 1703: von Leibniz and Jacob Bernoulli: “Law of Large numbers” and methods of statistical sampling 1730: de Moivre suggested the structure of the normal distribution, “the bell curve”, and the concept of standard deviation, opening way to the Law of averages.

    11. MH Bouchet/CERAM (c) Gaussian Law and « normal » distribution

    12. MH Bouchet/CERAM (c) Historical roots of risk assessment 3 1900: L. Bachelier, Gaussian law and market efficiency 1952: Nobel Prize Markowitz works on risk diversification Frank Knight (Chicago Ph.d-1916-Milton Friedman’s economics profesor): theory of uncertainty: there is an underlying social trend to consider the future as a mere projection of past; no strict rational behavior of consumers, savers and investors; economic policy is unable to correct imbalances over the long run! 1962-2008: Benoît Mandelbrot and fractal theory

    13. MH Bouchet/CERAM (c) What is « modern » risk about? Ulrick Beck argues that we live in a ‘global risk society’ where the unwanted consequences of technological development cut across the spatial and temporal boundaries University of Munich- Beck: Risk Society (1986), Counterpoison (1991), Ecological Politics in an Age of Risk (1994). The concept of risk is a modern concept. It requires attemps and decisions to render the unpredictable consequences of civil decisions predictable and controllable. The novelty of the world risk society lies is the fact that current decisions trigger long-term global consequences. The latter require global alliances and multilateralism. Transnational cooperation leads to a loss of autonomy but to a gain in sovereignty.

    14. MH Bouchet/CERAM (c) Benoît Mandelbrot Sterling Professor of Mathematical Sciences, EmeritusMathematics Department - Yale University IBM Fellow Emeritus T.J. Watson Research CenterInternational Business Machines Corporation Emergence of fractal geometry: 1963-1965 and 1990s Thesis: risk is much larger and more frequent in a free, global-market economy and standard financial theories are not adequate to capture riskiness Standard arithmetic is wrong to capture the reward and risk ratio as risk is much bigger than generally acknowledged!

    15. MH Bouchet/CERAM (c) Mandelbrot was the first to take seriously and study the so-called power-law distributions. His 1962 argument that prices vary far more than the standard model allows -that their distributions have "fat tails"-is now widely accepted by econometricians. By their very essence, prices can vary by leaps and bounds rather than in a continuous blur, and there changes today are dependent on changes in the long past. In 1966 Mandelbrot developed a mathematical model explaining how rational market mechanisms can generate price "bubbles."

    16. MH Bouchet/CERAM (c)

    17. MH Bouchet/CERAM (c) Traditional financial analysis tools Fundamental analysis: economic statistics, corporate profits… but causes are often obscure, information is lacking Technical analysis: patterns and chartism: the future movement of asset prices can be divined from past data (predetermined waves and Fibonacci’s golden ratio of 61,8%). If the efficient market theory is correct, financial should not work at all as the prevailing market price should reflect all the information, including past price movements: deterministic view of history and pre-ordained pattern! Behavioural finance: investors may not be completely rational and their psychological biases could cause prices to deviate from their « correct » level (and many market participants are not profit-maximizing : central banks) www.cass.city.ac.uk/magicnumbers

    18. MH Bouchet/CERAM (c) The 4 key (and wrong) assumptions of modern financial theory

    19. MH Bouchet/CERAM (c) The 4 key (and wrong) assumptions of modern financial theory

    20. MH Bouchet/CERAM (c) Mandelbrot’s Conclusions

    21. MH Bouchet/CERAM (c) Mandelbrot’s Conclusions 4) Time in markets is relative. The best way to model prices is to put into the math what traders know instinctively: "Trading time" speeds up and slows down as the action mounts or subsides. 5) Contrary to economic dogma, markets in all times and places work much the same way. Prices jump or fall abruptly, rather than glide up and down continuously. Price changes tend to cluster together - big changes beget more big changes

    22. MH Bouchet/CERAM (c) A fractal, a term he coined from the Latin for "broken," is a geometric shape that can be broken into smaller parts, each a small-scale echo of the whole. The branches of a tree, the florets of a cauliflower, the bifurcations of a river-all are examples of natural fractals.

    23. MH Bouchet/CERAM (c) What is Risk about?

    24. MH Bouchet/CERAM (c) Tackling country risk COUNTRY + RISK Country= sovereign debtor, culture, geographical distance, specific values, legal and regulatory constraints, socio-political parameters Risk= uncertainty, lack of perfect information in real time, transfer risk from the private sector, spill-over effect

    25. MH Bouchet/CERAM (c) Country risk Country risk results from a set of complex and interdependent socio-economic, financial and political factors, that are specific for a particular country, but that can quickly evolve given the country’s global integration.

    26. MH Bouchet/CERAM (c) What country risk is NOT Country risk is NOT a monopoly of foreign creditors, exporters, importers, or investors Domestic residents (households, investors, corporate sector) also face country risk from their own country’s socio-economic situation: The country’s goverment can take arbitrary decisions that will affect the residents’ situation The country can be contaminated by negative regional or global forces A deterioration in the risk perception by capital markets and rating agencies will feedback on domestic residents’ socio-economic environment and well-being.

    27. MH Bouchet/CERAM (c) Country risk analysis Country risk analysis involves the assessment of a private or public foreign entity’s ability and willingness to service its external obligations in full and in time (contractual, debt servicing, import payments, legal commitment…). It incorporates a forward-looking estimate of default probability

    28. MH Bouchet/CERAM (c) How does country risk materialize? 1. CREDITOR = Payment arrears, default, rescheduling, write down and/or write off 2. INVESTOR = Capital control ?Limits on dividends and capital repatriation Contractual obligations and legal commitment : contract repudiation, corruption Public guarantees: unilateral suspension 3. TRADE PARTNER = Supplies and purchases (imports of goods & services) ? delays, defective merchandise Sales (exports of goods & services) ? payment arrears

    29. MH Bouchet/CERAM (c) Sovereign Foreign Currency Bond defaults 

    30. MH Bouchet/CERAM (c)

    31. MH Bouchet/CERAM (c) Paris Club official bilateral debt restructuring ($ billion)

    32. MH Bouchet/CERAM (c) Tsunami & natural risk disasters Hurricane Katrina 08/2005= $59 billion Thailand 12/2004= $5 billion Hurricane Ivan 2004= $7,4 billion Hurricane Wilma 2005= $10,3 billion Hurricane Andrew (1992)= $21,6 billion Hurricane Charley : $7,7 billion Japan’s Earthquake= $1 billion

    33. MH Bouchet/CERAM (c) Risk Analysis and Project EvaluationDiscount Rate Example: Assume an investment project with expected $100 in perpetual cash flows If located in the OECD zone, the discount rate would be, say, 10% and NP Value= $100/0.10= $1,000

    34. MH Bouchet/CERAM (c) Risk Analysis and Project EvaluationDiscount Rate Simple example: However, project is not located in the OECD zone, but in a risky country If we reflect the country risk (rating, spread, secondary market debt price, volatility) in the discount rate, the rate might rise then to, say, 20% in China Value = $100/0.20 = $500 Discount rate for Ivory Coast risk? 60%? Value = $100/0.60 = $166 The discount rate is one accounting way for reflecting country risk but the point remains to anticipate and assess country risk! How to determine the appropriate discount rate?

    35. MH Bouchet/CERAM (c) Risk Analysis and Project Evaluation: “does a risky investment create value?” Evaluating alternative or simultaneous investment decisions in an efficient market environment can be done with several criteria: Payback period (cash inflows/cash outflows) Net present value (discounting future cash flows) Internal rate of return Profitability index

    36. Dr Barbara S. Pécherot Petitt - Slide 2 36 Calculating an investment return with the Net Present Value (NPV)

    37. MH Bouchet/CERAM (c) Risk Analysis and Project Evaluation: “does a risky investment create value?” PROBLEM: in emerging markets, the cost of capital is not the adequate discount factor! And markets might no be « efficient »!

    38. MH Bouchet/CERAM (c) Sovereign and Transfer Risks Sovereign risk = risk stemming from the country government's policy Transfer risk = risk that a foreign country’s private sector might be unable to meet its payment obligations due to restrictions on remittances of capital, dividends, interest, fees, debt payments… Why? exchange restrictions, discretionary balance of payments policy, moratorium or breach of contract

    39. MH Bouchet/CERAM (c) Main components of country risk Economic risk Financial risk Foreign exchange risk Political risk Cultural environment risk Legal and contractual risk (repudiation, confiscation, bribes...) Regional contamination risk (spill-over effect) Systemic risk (global crisis)

    40. MH Bouchet/CERAM (c) Country Risk Assessment Economic risk: low growth, inflation, low and declining investment and savings ratios, interest rate rise, banking system structural weaknesses, budget deficit, economic overheating… Financial risk: credit crunch, banking crisis, current account deficit, Foreign Exchange risk: drop in official international reserves, Ex Rate overvaluation, devaluation, liquidity and solvency risk, capital controls

    41. MH Bouchet/CERAM (c) Rise and drop in inflation in Emerging Countries

    42. MH Bouchet/CERAM (c) Risk Assessment Political risk = risk incurred by lenders, exporters or investors that a payment or the repatriation of an investment be restricted by the arbitrary decision of the state (confiscation, repudiation, nationalization, war, default…) , by a situation of political upheaval, or by deteriorating governance (lack of transparency, corruption, bureaucracy…) *** Ex. Resignation of PM Prodi in January 2008 due to no vote of confidence at the Italian Senate 62nd government since 1945!

    43. MH Bouchet/CERAM (c) Risk Assessment Components Legal & Regulatory risk = abrupt and arbitrary change in rules and regulations’ framework of economic, trade and financial activities in the host country, including FDI laws Lack of transparency in regulatory framework

    44. MH Bouchet/CERAM (c) Thailand in 2007: tightening of foreign ownership rules! Draft law requiring that Thai citizens hold >51% of the voting rights for a company to be deemed Thai, discouraging inward FDI: MNCs have one year to sell down any equity holdings >49% Exceptions: service industries (accounting, legal services, hotels, advertising and construction)

    45. MH Bouchet/CERAM (c) Risk Assessment Is the risk high and is it acceptable?

    46. MH Bouchet/CERAM (c) Country risk assessment Economic intelligence + Reliable and updated information sources = robust risk analysis

    47. MH Bouchet/CERAM (c) How Mitigating Country Risk?

    48. MH Bouchet/CERAM (c) Specialized country risk analysis institutions EIU International Financial Risk Institute BERI (Business Environment Risk Index) Rating agencies: Dun and Bradstreet, Moody ’s, S & P, FITCH IBCA Institutional Investor & Euromoney Frost & Sullivan Credit Risk International The Institute for International Finance AT Kearney COFACE

    49. MH Bouchet/CERAM (c) Main Public Sources of Country Risk Intelligence IMF/World Bank BIS OECD Regional Development Banks (AfDB, IDB, EBRD, AsDB) UNDP, UNCTAD Export Credit Agencies (Coface, Hermes, ECGD, SACE, CESCE, Eximbank…) CIA US State dept.

    50. MH Bouchet/CERAM (c)

    51. MH Bouchet/CERAM (c)

    52. MH Bouchet/CERAM (c) Country Risk Analysis Further readings: Bouchet, Clark & Groslambert, Country Risk Assessment: A guide to global investment strategy, Wiley, 2003. Risk Magazines (Euromoney, Institutional Investor, RISK…) Managing Risk: Alan Waring and Ian Glendon (International Thomson Business Press) 1998 Assessing Financial Vulnerability: Early Warning System for EMCs, Goldstein, Kaminsky & Reinhart, IIE, June 2000 Multinational Finance, Adrian Buckley, Prentice Hall, 1996-2000 Bouchet: The political Economy of International Debt, Greenwood/Praeger Against the Gods, Peter L. Bernstein, John Wiley & Sons, 1998 Bouchet & alii: The Market-Based Menu Approach (World Bank-DMFAS) International Debt and the Developing Countries, WB Symposium, edited by Smith and Cuddington

    53. MH Bouchet/CERAM (c)

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