Lecture V Country Risk Assessment Methodologies: the Qualitative, Structural Approach to Country Risk –The Welfare and Social Dimension and the Macroeconomic Fundamentals -

“Risk management is not a program but an ongoing process that must be developed over time. Our models are constantly reviewed and improved. On the whole, they have proven their worth. But good risk management isn't just about mathematical models and systems – it also requires an understanding of the market, intuition and the ability to weigh up what proportions of risk are healthy. In that respect, the abbreviation CS in my opinion doesn't just stand for Credit Suisse, but also for common sense, which plays a key role in risk management.” Hans-Ulrich Doerig Chairman of the Board of Directors of Credit Suisse

The Qualitative Approach A robust qualitative approach leads to comprehensive country risk report that tackle the following six elements:  Social and welfare dimension of the development strategy;  Macroeconomic fundamentals;  External indebtedness evolution, structure and burden;  Domestic financial system situation;  Assessments of the governance and transparency issues;  Evaluation of the political stability.

Inequality

 The richest 10% of the population in a European nation may receive 20.1% of national income, as they do in Sweden, or 27.3%, as they do in the UK and Ireland.  USA (2005):The top 10 percent of the population carried away some 48.5 percent of all reported income in the US in 2005— also the highest percentage since 1928, on the eve of the Depression—an increase of 2 percent from 2004, and up from 33 percent of the reported total in the late 1970s.

Poverty VS Inequality  Multi-dimensional concepts: income, wealth, assets, opportunities;  Poverty  people below the poverty line;  Inequality  whole population. We will focus on INCOME as an indicator for inequality.

Inequality: definition  DEF: “Distribution of income and wealth among different groups in the society and it concern variation in living standards and in wealth itself across a whole population.”  Why inequality matters?  Philosophical and ethical reasons;  Functional level

Three Concepts of Inequality  Concept 1: Unweighted inter-national inequality  Unit of observation: country;  Measure: income per capita;  within country distribution is equal;  country size doesn’t matter;  converging issues.  Concept 2: Weighted inter-national inequality  The same features as the previous one but COUNTRY SIZE matters;  Concept 3: True world inequality  Unit of observation: individual (no matter the country of origin);  Our benchmark!

Measurement Issues  Which currency unit?  Convert local currency into dollar;  International purchasing power  Purchasing Power Parity exchange rate  This purchasing power rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods.currenciesbasket of goods

Measurement Issues  Survey based mean income from survey or GDP per capita?  Mean income from survey ≠ GDP per capita:  Key factors: taxes and consumption;  Gap is bigger in developed countries.  Concept 1 and 2  GDP per capita  Concept 3  distribution of income across individuals

Measurement Issues  Income or Expenditure?  Expenditure  actual living standards;  Income  potential living standards  Per Capita or Equivalent Adult?  World income distribution  per-capita basis  Equivalent adult: more complex, more precise but difficult comparison across countries.

Measurement Indicator (1)  Variation of income distribution (among nations or among individuals):  Concept 1 & 2:  refers to the average world income (weighted or non weighted);  N refers to the number of countries.  Concept 3:  refers to the average income from the survey;  N refers to the number of people in the world.  Within a country:  refers to the average income from the survey, based in the population of ONE country;

 Problem with V: If I double everyone’s income  V would quadruple If country i is richer than country j  inequality is higher in j  Solution  standardize V: Measurement Indicator (2)

Measurement Indicator (3)  Lorenz Curve:  The greater the inequality, the further the Lorenz curve will be from the 45° line.  Gini Coefficient:  It’s the area between the Lorenz curve and the 45°line;  Range [0,1];  the greater the inequality, the bigger the area, the greater the Gini coefficient.  Wealthiest 10% share of national income (%).

Trend in Inequality: Concept 1 VS Concept 2

Trend in Inequality: Concept 1  Why 1952? First Year China’s data are available;  Sharp increase in C1 after 1980s (i.e.  divergence): Lost decade in Latin America; Decline in income in Eastern Europe and former Soviet Union; Disastrous economic performance of many African Countries; Good economic performance of rich countries.  Since 2001: ↓ divergence! High economic growth rate!  African Countries > 4%;  Post-Communist countries > 6%;  Latin America ≈ 3%  BUT level of Inequality is much higher today than in 1960s!

Trend in Inequality: Concept 2  Higher level of Inequality if we account for country’s size!  Decreasing trend mainly driven by China’s economic growth (late 1980s);  BUT after 2000 the decline take place even without China! Mainly due to India great performance!

Trend in Inequality: Concept 3

 Inequality has increased between 1988 and 2002;  Why?  Increasing GAP between rich countries and large rural countries in Asia (Bangladesh, rural India, rural China)  Rural china VS Urban china  Decline in income in Eastern Europe

Inequality and Poverty  Small change in income distribution can have a large effect on poverty: If the income of the poorest 20% of population increases from 6 to 6.25%  it represents an increase of 4% in their total income  it has the same effect on poverty as doubling the annual growth of GDP from 4% to 8%

Inequality, Poverty and Growth  High Inequality may have a dampening effect on growth:  Political Reasons:  lobbies  inefficiency;  Demand Mechanism:  low demand for domestic products and high imports  Human capital:  lower investment in HC and less positive externalities;  Conflict Mechanism ✔ Social Discontent and Uncertainty Lower Investment Higher Social rRisk = higher country risk!

CRA and Social/Welfare Indicators  To decrease the Country Risk Level a country should: Boost Development; Favour Gender Equality and Empowerment; Control Demographic Trend; Reduce Poverty; Reduce Inequality.

The Qualitative Approach A robust qualitative approach leads to comprehensive country risk report that tackle the following six elements:  Social and welfare dimension of the development strategy;  Macroeconomic fundamentals;  External and internal indebtedness evolution, structure and burden;  Domestic financial system situation;  Assessments of the governance and transparency issues;  Evaluation of the political stability.

Macroeconomic Structures of Growth  Country’s main challenge = capacity to preserve sustainable growth!  Excessive growth (of spending, debt, money supply, GDP, investment, domestic credit) is NOT POSITIVE because it creates bubbles and costly imbalances!

Macroeconomic Structures of Growth: GDP def  GDP combines in a single figure, and with no double counting, all the output (or production) carried out by all the firms, non-profit institutions, government bodies and households in a given country during a given period, regardless of the type of goods and services produced, provided that the production takes place within the country’s economic territory.  It’s calculated quarterly or annualy or monthly.

Macroeconomic Structures of Growth (2)

Macroeconomic Structures of Growth (3)

Macroeconomic Structures of Growth (4)

Macroeconomic Structures of Growth (5)  Growth is the product of: Capital accumulation:  Physical (land and infrastructure);  Human (education, incentives);  Institutional; Factor Productivity  technology! (  Growth Theory? The Solow Model!) Globalisation (Trade and capital inflow); Good governance; Solid macroeconomic environment.

References  Bouchet, Clark and Groslambert (2003): “Country Risk Assessment”, Wiley finance (Chapter 4).  Human Development Report –UNDP web site-  Milanovic, B. (2009): “Global Inequality Recalculated: the effect of new 2005 PPP estimates on global inequality”, World Bank.  Grusky, D.B and Kanbur, R. (2000): “Poverty and Inequality”, Stanford University Press, Stanford, California.  Miles, D. and Scott, A. (2005): “Macroeconomics : understanding the wealth of nations” Chichester; Wiley.  The Economist (2007): “Guide to Economic Indicators: Making sense of economics”. - 6th ed. - New York : Bloomberg.