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Lecture V Country Risk Assessment Methodologies: the Qualitative, Structural Approach to Country Risk
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Risk Analysis: Why? The globalisation of the world’s trade, financial and technology markets and the emergence of new economies have created a new world environment, full of opportunities, but fraught with uncertainty and spill-over risks.
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Country Risk: DEFINITION It’s the possibility that a foreign country’s: borrower (financial investment); Importer/producer (trade and sub-contracting) Corporate partner (FDI) May be UNABLE or UNWILLING to fullfill its contractual obligations toward a: Foreign lender; Exporter; Investor.
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Risk Analysis and Investment Decision Two possible way to include Risk in our investment decision (NPV): Expected Value of Profit (EV) probability of a negative event; Adjust the Discount Rate risk premium. Which are the sources of risk? How can we measure it?
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Sources of Risk (1) Natural Disasters; Tsunami; Earthquake; Socio-Political Risks: Social Risk; Boycott; Terrorism; Strikes; Religion and racial problems; Government Policy Risk: Trade restrictions; Legal enforcement; Loan repudiation; Foreign exchange controls; Expropriation. Political Risk: War; Nationalisation.
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Sources of Risk (2) Country-Specific Economic risk Macroeconomic Risks: Exchange rate; Hyperinflation; Terms of Trade; Debt Service. Microeconomic Risks: Market Failure; Market Inefficiency. Supranational Level risk of contagion!
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How can we measure Country Risk? The Quantitative Approach The Quantitative Approach (Lecture VI): Ratio, indices and ratings; Reduces a complex situation into a number/letter; Cross-country and cross-time comparison; Shortcomings: Similar ratio and financial indicators BUT different socio-economic structure; Quantitative data not available on time, incomplete, wrong or distorted; Interpretation is difficult; SOL: integrate with qualitative data to account for volatility and regional contagion.
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The Qualitative Approach (1) Qualitative Approach (SWOP): Assessment of the economic, financial and socio-political fundamentals that can affect the investment return prospects in a foreign country; Describes/identifies the structure of a country’s development strategy/process by shedding light on: Strengths and opportunities; Weaknesses and threats.
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The Qualitative Approach (2) A robust qualitative approach leads to comprehensive country risk report that tracke 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.
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Welfare and Social Indicators (1) Economic Growth VS Development Not only GDP growth but also: Self-sustaining development; Enlarging people’s choice/rights; Democracy; Robust and stable institutions; Decent standard of living: Access to education; Nutrition and health; Political and cultural freedom. close correlation Basic components of country risk and close correlation between HDI and country risk (ex. Sierra Leone) but not the reverse (ex. Cuba!)
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Welfare and Social Indicators (2) “Development Diamond” from WB: Life-expectancy; Access to safe water; Per capita GNP; Primary school enrolment. Compare these country’s feature with the average of a regional group of countries.
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Welfare and Social Indicators (3) Why is population growth crucial for assessing country risk? (-) Stable or declining population does not improve long term prospects; (-) Rapidly rising population exerts pressure on the government’s budget and on the country’s infrastructure; (+) Rising population generates demand for social services;
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Welfare and Social Indicators (4) Why is life expectancy crucial for assessing country risk? Good illustration of government’s commitment to the adoption of a basic human needs strategy; Good indicator of sustainable development. Are there other useful indicators? Wealthiest 10% share of national income (inequality); Urban population % (urbanisation) Percentage under 15 years old (age structure); Number of computers per 1,000 inhabitants. Human capital (literacy); Health care; Poverty; Gender structure; Labour force and unemployment.
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References Bouchet, Clark and Groslambert (2003): “Country Risk Assessment”, Wiley finance (Chapter 4).
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