Lecture VI Country Risk Assessment Methodologies: the Qualitative, Structural Approach to Country Risk

“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 trackle 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.

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 (2)  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.

Macroeconomic Structures of Growth (3)  What is there behind the economic and financial crisis? Macroeconomic disequilibria:  High internal and external debt; To adjust them  expansionary monetary policy that causes: Inflation; Gov is unwilling to defend the fixed exchange rate!  High real interest rates to defend the exchange rate parity in a context of speculative attack and falling reserve (Mexico, 1995; Russia, 1998); Underdevelopment of financial system; large- scale financial capital inflows; financial panic (Asian crisis, ; Argentina, ); Market expectations and international contagion (USA, 2008).

Macroeconomic Structures of Growth (4)  Domestic Economy Assessment: GDP evolution and composition; sector analysis; Informal economy, savings and investment ratios; Trade structure, terms of trade, trade openness ratio, commodity prices.  Which variables?

Macroeconomic Structures of Growth (5)  Macroeconomic Policy Evaluation: Prices (inflation) and exchange rate; Government finance: budget policy, privatisation, public sector borrowing requirement, Money and credit policy: money supply growth, reserve money, claims on government and on private sector, real interest rate; Legal and regulatory environment (customs, taxation, company law, flexibility of the labour market).  Which variables?

Macroeconomic Structures of Growth (6)  Balance of Payment Analysis: Trade balance, resource gap and current account balance; Capital accounts, international reserve assets; Non-debt creating flows: FDI, foreign transfer, remittances. Liquidity ratio: current account/GDP; Structure and composition of external capital sources; Exceptional financing and IMF credit.  Which variables?

The Qualitative Approach A robust qualitative approach leads to comprehensive country risk report that trackle 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.

External Indebtedness, Liquidity and Solvency Analysis (1)  External debt is a temporary phenomenon that supplements savings, bridges the resource-investment gap and speeds up the growth process towards the ‘take-off’ stage of sustaining development.  Problem = Debt Repayment = Risk of Default!  If borrowing countries invest capital inflow in productive investments with higher return rates, without sizable adverse shocks, and compatible maturity  they would generate the right income for timely debt repayment.

External Indebtedness, Liquidity and Solvency Analysis (2)  Risk of default increases for 3 reasons: Debt is not invested but is used:  to finance current consumption;  to finance the black hole of the government budget deficit;  Is recycled in international banks. Debt composition, in term of maturity, currency or interest rates, is such that the borrowing country becomes highly vulnerable to external shocks; ‘debt overhang’, i.e. the accumulated debt is larger than the country’s repayment capacity and expected debt servicing obligations will discourage domestic investors and exporters, as well as foreign creditors. Country becomes dependent from foreign loans.  Moreover, weak macroeconomic situation would increase the risk of default, ceteris paribus!

External Indebtedness, Liquidity and Solvency Analysis (3) Weak fundamentals + large relative debt = debt overhang and deterioration of creditworthiness!

External Indebtedness, Liquidity and Solvency Analysis (4)  Which indicators could be useful? Solvency VS Liquidity Indicators  Solvency Indicators: Illustrate the stock/stock relationship, linking the country’s debt obligations with the overall assets and its currency reserves.  Debt/GDP  Net external debt/exports  Debt/exports  Debt/official reserve assets; Real weight of the debt: NPV Debt’s structure:  Creditors, debtors, floating/fixed exchange rate, currency, maturity etc.)  Short-term debt/liquidity reserve+contingent credit lines;  Short term debt/outstanding debt.

External Indebtedness, Liquidity and Solvency Analysis (5)  Liquidity Indicators: Debt flows VS debt stock:  Debt servicing ratio (debt payment/export);  Interest payment/export;  Current account/GDP;  Reserves/imports;  Average maturity of external liabilities.

The Qualitative Approach A robust qualitative approach leads to comprehensive country risk report that trackle 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.

The Savings-Investment Gaps and Domestic Financial Intermediation (1)  Key role of a good and solid domestic financial system: Channel between savings (from different sources) and productive investment; Country’s sustainable economic growth.

The Savings-Investment Gaps and Domestic Financial Intermediation (2)  Efficiency factors in the Financial System: Banking system and efficiency; Level and structure of interest rates; Financial liberalisation; Stock market development and efficiency (capitalisation, value traded, listed companies, transparency); Non-bank credit and the role of securities markets in providing corporate funding; Interbank market; Development of financial instruments and financial innovation; institutional development and structural reforms; Legal restrictions on capital movements; Role of national authorities for effective prudential supervision; Legal, accounting, management and supervisory infrastructures.

References  Bouchet, Clark and Groslambert (2003): “Country Risk Assessment”, Wiley finance (Chapter 4).  Luo, Y. : “Political Risk and Country Risk in International Business. Concept and Measures”, in Handbook of International Business, chapter 26.