CHAPTER THREE COUNTRY RISK ASSESSMENT

International banking is dealing with customers in another country. In addition to the customer credit risk, there are other risks which are related to the foreign country (political, economical, social risks as in Turkey). This is referred as the country risk. There are 2 types of risk: Direct and Indirect Country Risks.

DIRECT RISK: The banker directly lends to a borrower who actually lives in the country at risk. INDIRECT RISK: The banker finances a local borrower who is dealing with a customer in a country at risk (i.e. An American bank lends money to an American businessman who exports computers to Turkey). Country risk assessment begins with analysis of a country’s economic information such as inflation, government deficits, interest rates, balance of payments deficits etc.. Social, cultural, historical, political factors are important as well. The likelihood of change should be taken into account (i.e. Turkey- IMF- EU) Past - Present factor should be examined for projecting future events. The major component of this analysis is (1) economic and (2) political

1.ANALYZING THE ECONOMIC COMPONENT Balance of Payment It measures flow of goods, services and capital taking place over a period of time (usually one year). It is divided into 3 categories: - Current Account: The value of visible and invisible trade accounts - Capital Account: Short-term or long-term investment transactions, such as stocks and investments. - Reserves : Is part of capital account that are assets, available for use by an economy’s central authorities in meeting balance of payments needs (gold, special drawing rights, government funds in other countries, reserves positions in the IMF etc. ). When all information from individual categories do not balance and shows differences, to obtain the balance of debits and credits, an entry is made that is called “net errors and omissions”. It is a problem if it exceeds 5% of the gross credit and debit entries for merchandising combined.

Achieving a Balance: For example, a developing country tends to export less than it imports (net importer). To pay for this net import gap, it needs to be a net borrower of money, that is to attract investment or receive gifts. If you can not achieve this, then the balance is achieved by changes in the country’s reserve. If there is a current account deficit the reserve will be drawn down, if there is a surplus the reserve will go up (discuss US case). Types of Balances -The trade balance (goods exports and imports) -The current account balance (goods and services transfers) -The basic balance (goods + services+ transfers+ long tern capital “ exclude short term capital movement”) -The official settlement balance (all standard components except reserves) The long run effect of a deficit is that; if not corrected, the country will eventually have no means to pay for imports and international debts.

The deficit can be financed by borrowing from the IMF, postponing payments, encouraging exports, discouraging imports (quotas, tariffs) devaluation, liberalizing investment rules, tax reductions, encouraging foreigners to invest in the country, etc. The USA covers its deficit by encouraging foreigners to hold dollars and invest in the USA. Domestic Policies: Sometimes a country’s balance of payments problems develop from domestic activities, such a budget deficit. When the government spends more than it earns, it creates inflation. If such country tries to maintain fixed exchange rate or devaluing its currency less than inflation (hot money policy in Turkey), the imports become cheaper and exports become expensive. Gradually the decline in exports and growth in imports cause payment crises for that country (Turkey). Hot Money Policy + Capital Flight.

2. ANALYZING THE POLITICAL COMPONENT Political changes in any country change the countries economic outlook. The banker must consider the country’s political tradition (the power of army in Turkey, 59 governments in 53 years etc). Major divisions in the country (religions, language, ethnic nationality lines) should be taken into account as well. Corruption  Undermines the government effectiveness. History  The place of the state and the army in Turkey. Colonial Relationship (England with common wealth countries). Banks in two countries may tend to view risk in another country differently (Turkey and Germany view differently the risks in TRNC). To coordinate the assessment of country risk between the various regulatory agencies, the Interagency Country Exposure Review Committees (ICERC) was established. ICERC categorizes countries on the basis of economic, social and political conditions (strong, weak, etc.)

3. ASSESSING COUNTRY RISK Country risk assessment begins with a study of the most recent balance of payment elements. See Table 3.1 Balance of Payment (Australia) We should look at the Following Factors; Whether the country in exports is depending on a single commodity. Whether the country is exporting raw materials. Long- term global commodity price trends. Sudden changes in prices (oil in 1974 and 2004). Income from remittances (Turkish guest workers in Germany ). Workers remittances for Bangladesh (Gulf war in 1990 ).

Ratios can be meaningful guides for assessing country risk Current account deficit to exports. Cumulative current account to exports. Net external interest payments to exports. Net external payments to international reserves. Total current debt service requirements to receipts from exports of goods and services. Number of months a nation’s reserves would finance the country’s imports, Each bank does its own analysis and come to its own assessment.

Examine economic trends Assess political and social trends and likelihood’s of changes (Turkey) before making a decision. Develop a business plan for that country. Business development A nation’s competitive industries (M. Porter) Clusters (Italy in shoe making, tiles, fashion etc. and Turkey in white & brown goods, textile, car spare parts etc) In short, for country risk assessment the banker must look into: - The balance of payment - Political Factors and trends - Economic Factors and trends - Social Factors and trends