Analyzing Country Risk 19 Chapter South-Western/Thomson Learning © 2006 Slides by Yee-Tien (Ted) Fu

Chapter Objectives To identify the common factors used by MNCs to measure a country’s political risk and financial risk; To explain the techniques used to measure country risk; and To explain how MNCs use the assessment of country risk when making financial decisions.

Importance of Country Risk Analysis Country risk represents the potentially adverse impact of a country’s environment on an MNC’s cash flows.

Country risk analysis can be used: ¤ to monitor countries where the MNC is currently doing business; ¤ as a screening device to avoid conducting business in countries with excessive risk; and ¤ to revise its investment or financing decisions in light of recent events. Importance of Country Risk Analysis

Political Risk Factors Consumers attitude in the host country ¤ Some consumers are very loyal to locally manufactured products. Host government actions ¤ The host government may impose special requirements or taxes, restrict fund transfers, and subsidize local firms. MNCs can also be hurt by a lack of restrictions, such as failure to enforce copyright laws.

Political Risk Factors Fund transfers blockage ¤ If fund transfers are blocked, subsidiaries will have to undertake projects that may not be optimal for the MNC. Currency inconvertibility ¤ The MNC parent may need to exchange earnings for goods if the foreign currency cannot be changed into other currencies.

War ¤ Internal and external battles, or even the threat of war, can have devastating effects. Bureaucracy ¤ Bureaucracy can complicate businesses. Corruption ¤ Corruption can increase the cost of conducting business or reduce revenue. Political Risk Factors

Corruption Index Ratings for Selected Countries Maximum rating = 10. High ratings indicate low corruption.

Financial Risk Factors Economic growth indicators ¤ The current and potential state of a country’s economy is important since a recession can severely reduce demand. ¤ A country’s economic growth is dependent on several financial factors - interest rates, exchange rates, inflation, etc.

Types of Country Risk Assessment A macroassessment of country risk is an overall risk assessment of a country without considering the MNC’s business. A microassessment of country risk is the risk assessment of a country with respect to the MNC’s type of business. The overall assessment thus consists of macropolitical risk, macrofinancial risk, micropolitical risk, and microfinancial risk.

Note that there is clearly a degree of subjectivity in: ¤ identifying the relevant political and financial factors, ¤ determining the relative importance of each factor, and ¤ predicting the values of factors that cannot be measured objectively. Types of Country Risk Assessment

Techniques to Assess Country Risk The checklist approach involves rating and weighting all the macro and micro political and financial factors to derive an overall assessment of country risk. The Delphi technique involves collecting various independent opinions and then averaging and measuring the dispersion of those opinions.

Techniques to Assess Country Risk Quantitative analysis techniques like regression analysis can be applied to historical data to assess the sensitivity of the business to various risk factors. Inspection visits involve traveling to a country and meeting with government officials, firm executives, and consumers to clarify uncertainties.

Often, firms use a variety of techniques for making country risk assessments. For example, they may use the checklist approach to develop an overall country risk rating, and some of the other techniques to assign ratings to the factors. Techniques to Assess Country Risk

Measuring Country Risk The checklist approach involves:  Assigning values and weights to political and financial risk factors,  Multiplying the factor values with their weights, and summing up to give the political and financial risk ratings,  Assigning weights to the risk ratings, and  Multiplying the ratings with their weights, and summing up to give the country risk rating.

Cougar Co.: Determining the Overall Country Risk Rating

Cougar Co.: Derivation of the Overall Country Risk Rating

The procedures for quantifying country risk will vary with the assessor, the country being assessed, as well as the type of operations being planned. Firms use country risk ratings when screening potential projects, and when monitoring existing projects. Measuring Country Risk

Comparing Risk Ratings Among Countries One approach to comparing political and financial ratings among countries is the foreign investment risk matrix (FIRM ). The matrix displays financial (or economic) and political risk by intervals ranging from “poor” to “good.” Each country can be positioned on the matrix based on its political and financial ratings.

Actual Country Risk Ratings Across Countries

Incorporating Country Risk in Capital Budgeting If the risk rating of a country is acceptable, the projects related to that country deserve further consideration. Country risk can be incorporated into the capital budgeting analysis of a proposed project either by adjusting the discount rate or by adjusting the estimated cash flows.

Adjustment of the discount rate ¤ The higher the perceived risk, the higher the discount rate that should be applied to the project’s cash flows. Adjustment of the estimated cash flows ¤ By estimating how the cash flows could be affected by each form of risk, the MNC can determine the probability distribution of the net present value of the project. Incorporating Country Risk in Capital Budgeting

Spartan, Inc.: Summary of Estimated NPVs Across Possible Scenarios

Applications of Country Risk Analysis As a result of the crisis that culminated in the Gulf War in 1991, many MNCs reassessed their exposure to country risk and revised their operations accordingly. The 1997–98 Asian crisis caused MNCs to realize that they had underestimated the potential financial problems that could occur in the high-growth Asian countries.

Following the September 11, 2001 attack on the United States, some MNCs reduced their exposure to country risk by downsizing or discontinuing their business in countries where U.S. firms may be subject to more terrorist attacks. Applications of Country Risk Analysis

Reducing Exposure to Host Government Takeovers The potential benefits of DFI can be offset by country risk, the most severe of which is a host government takeover. To reduce the chance of a takeover by the host government, firms often:  Use a short-term horizon ¤ This technique concentrates on recovering cash flow quickly.

Reducing Exposure to Host Government Takeovers  Relying on unique supplies or technology ¤ In this way, the host government will not be able to take over and operate the subsidiary successfully.  Hiring local labor ¤ The local employees can apply pressure on their government if they are affected by the takeover.

 Borrowing local funds ¤ The local banks can apply pressure on their government if they are affected by the takeover.  Purchasing insurance ¤ Investment guarantee programs offered by the home country, host country, or an international agency insure to some extent various forms of country risk. Reducing Exposure to Host Government Takeovers

 Using project finance ¤ Project finance deals are heavily financed with credit, thus limiting the MNC’s exposure. The loans are secured by the project’s future revenues and are “nonrecourse.” A bank may guarantee the payments to the MNC. Reducing Exposure to Host Government Takeovers