Lecture VI Country Risk Assessment Methodologies: the Qualitative, Structural Approach to Country Risk - The Macroeconomic Fundamentals -

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.

Global GDP Contraction

 Country-Specific Economic risk  Macroeconomic Risks: Inflation and Hyperinflation; Exchange rate; Terms of Trade; Debt Service.

GDP in value and in volume

The Inflation Rate  Inflation = increase in the general level of prices;  How to measure inflation? Consumer Price Index; Producer’s input and output prices Index; GDP deflator.  Causes of Inflation: Demand Pull  the Economic Cycle! Supply Shocks;  OPEC I (1970s)  oil prices from 3$ a barrel to 11.65$;  OPEC II (1980s)  over 36$ a barrel;  Nowdays.

The Inflation Rate (2)

The Inflation Rate (3)

The Cost of Inflation  Real Interest Rate;  Inflation tax;  Menu costs;  Relative Price VS General Price Level  ↓ Economic Efficiency;  Volatitlity of Inflation: Reduces investment; Income Redistribution.  Nominal Illusion.

Deflation  DEF: Decrease in the general level of prices  Japan since 1999  The Cost of Deflation: Effect on Real Interest Rate, Savings and Investment; Effect on the real burden of debt.

Hyperinflation  Inflation is running at more than 50% at month;  CAUSE: large fiscal deficit that, without tax or bond issues, led govs to finance their activities through the inflation tax and by printing money.  Unless the gov reforms its fiscal position it has to print money and create inflation.  It has origin in fiscal policy (government’s decision about spending and taxation) and not monetary policy (gov’s decision for investing and loaning money);

Hyperinflation (2)  WHERE: Latin America and Central East Europe (1920s and );  Government issues to finance the debt: Hungary = 48%; Poland = 62%; Germany = 88%.  End of Hyperfinflation when: New currency issue; Fiscal reform; Return to fiscal surplus; Establishment of an indipendent central bank  ignore the demand of the fiscal authority!

The Qualitative Approach  Country-Specific Economic risk  Macroeconomic Risks: Inflation and Hyperinflation; Exchange rate; Terms of Trade; Debt Service.

Exchange Rate  Types of Exch rates: Bilateral and effective Exch rate Nominal VS real Exch rate.  Nominal Exchange rate determinats: CIP UIP Risk Adverse Investor  Currency Crisis and the Exchange Rate System

Exchange Rate: different Types  BILATERAL: rate at which you can swap the money of one country for that of another: Indirect Approach: how many yen (amount foreign currency) to get 1$ (unit of local currency);  Example: yen*/dollar = yen  Devaluation if we need less yen to buy 1$  the value of the ER decreases;  Appreciation if we need more yen to buy 1$  the value of the ER increases;

Exchange Rate: different Types (2) Direct Approach: how many dollar (amount local currency) to get 1 yen (unit of foreign currency)!  Example: dollar/yen*= $;  Devaluation if we need more dollar to buy 1yen  the value of the ER increase;  Appreciation if we need less dollar to buy 1yen  the value of the ER decreases. We would follow the INDIRECT APPROACH!

Exchange Rate: different Types (3)  EFFECTIVE: measure the average appreciation/depreciation of a currency in comparison to different countries! Trade weighted basis (see charts pag 498); EX: Jap yen appreciate by 1% against the $ and 1% againt the Thai Baht and remain unchanged versus other currency = increase in the yen EER; Usually expressed using an index = 100.

Exchange Rate: different Types (4)  NOMINAL ER: rate at which you can swap two currencies (as above);  REAL ER: how expensive commodities are in different countries and reflect the competitiveness of a country’s export.

Exchange Rate: different Types (5)  Example: Cup of coffee = 200 yen in JPN and 1$ in USA; Nominal Exchange rate = 100 yen per $ (Yen/$); BUT real exchange rate = 0.5  you can only buy half as much with your money in Japan as you can in the US; Yen-US dollar RER is low! Goods in the US are cheaper than in Japan!

Exchange Rate: different Types (6)  RER is based on a basket of commodities and not just 1!!! RER=NER * domestic price level overseas price level; Example: -1$ in US buy the same amount of goods as 3 pesos in Argentina; -NER: 3 pesos/$  RER = 3 * 1US$/3pesos = 1 If price increases in Argentina (1$ in US buy the same amount of goods as 5 pesos in Argentina):  RER = 3 * 1US$/5pesos = 0.6  i.e with 1$ in Argentina you can buy only the 60% of goods that you could buy in US.

Nominal Exchange rates Determinants  Converted Interest Parity: Value of foreign investment (yen) in local currency (dollar) at the end of the period: Yen(1+r*)(F(0)/S(0))  S(0) = spot exchange rate (current exchange rate);  F(0) = forward exchange rate (exchange rate in the future)  forward exchange rate is prefectly forecast in the CIP;

Nominal Exchange rates Determinants (2) Equilibrium (i.e the investor is indifferent between yen and dollar investment):  Yen(1+r*)(F(0)/S(0)) = $(1+r)  If we put F(0)/S(0) = 1+ fp  Where fp is the forward premium (proportion by which a country’s gorward exchange rate exceeds its spot rate) we get: (1+i JPN )(1+fp) = (1 + i USA ) = i JPN - i USA = fp OR i JPN +fp = i US i.e. as a result of arbritage, the return on the dollar investment will equal the return on the yen investment when evaluated using the forward rate!

Nominal Exchange rates Determinants (3)  Uncovered Interest Parity: The investor takes a risk because he doesn’t cover his position by a forward transition F(0) = S e (1); Expected Appreciation of the dollar = interest rate gap; [S e (1) – S(0)]/S(0)=i JPN - i US What drives the Exhange rate?  Change in the overseas interest rate;  Change in the domestic interest rate;  Change in expectation of the dollar.

Nominal Exchange rates Determinants (4)  Risk Adverse investor: Premium at risk; US return = i US +expected dollar apprec = i jpn + risk premium Change in the risk premium would impact on the NER!

Reference  Bouchet, Clark and Groslambert (2003): “Country Risk Assessment”, Wiley finance (Chapter 4).  Colombo, E. and Lossani, M. (2009): “Economia dei Mercati Emergenti”, Carocci Editore.  Miles, D. and Schott, A. (2005): “Macroeconomics. Understanding the Wealth of Nations”, eds. Wiley (Chapter 11,19, 20).  The Economist (2009): “Guide to Economic Indicators. Making Sense of Economics”, eds. The Economist.