© 2018 Cambridge University Press 14-1 Michala Moravcová Department of Finance, Masaryk University International Finance COUNTRY RISK International Finance © 2018 Cambridge University Press 14-2 • Country risk • Political and economic risks of operating in a country • Political: government action will negatively affect a company’s cash flows (expropriation, nationalization) • Economic: Country recession, labor strikes, clashes • Sovereign risk • Risk associated with government defaulting on bond payments • What factors enter a country risk analysis? • Financial and economic risk factors • Ratio of a country’s external debt to its GDP • Ratio of a country’s debt service payments to its exports • Ratio of a country’s imports to its official international reserves • A country’s terms of trade (export / import prices) • A country’s current account deficit 1. Country Risk Versus Political Risk International Finance © 2018 Cambridge University Press 14-3 • Political risk factors • Expropriation / nationalization – worst-case scenario • Contract repudiation • Taxes and regulation (i.e., hiring / firing, environmental standards, repatriation of funds) • Exchange controls (e.g., Argentina in 2002) • Corruption and legal inefficiency • Transparency International Corruption Perceptions Index for more than 170 countries • Ethnic violence, political unrest, and terrorism • Home-country restriction 1. Country Risk Versus Political Risk International Finance © 2018 Cambridge University Press 14-4 • The Debt Crisis (1980s) • Origins of the debt crisis • Mexico announced in 1982 they could not repay their foreign debt; by the end of the year 24 other countries followed suit • Managing the debt crisis: The Baker plan (1985) • Loans by banks/World Bank in exchange for agreeing to follow economic advice • Debt overhang issue • Debt and debt service-reducing operations • Debt buyback (at a discount) • Debt-equity swap • MNC buys discounted debt to invest – helps country and is cheaper way for companies to invest in developing nations 1. Country Risk Versus Political Risk International Finance © 2018 Cambridge University Press 14-5 • Adjusting expected cash flows for political risk (infinite constant cash flows, constant probability of expropriation) • Compute discount rate normally (i.e., without expropriation risk) • Compute a probability distribution of expropriation risks for each future period • Compute an expected NPV based on those • Adjusting the discount rate instead of cash flows • Discount rates for emerging markets and political risk: • 𝑟 ∗ = (𝑟 + 𝑝)/(1 − 𝑝), p = probability of worse case scenario 2. Incorporating Political Risk in Capital Budgeting International Finance © 2018 Cambridge University Press 14-6 Adjusting the MNC’s Cash Flows for Political Risk • Oconoc, an American oil company invests 75 million USD, predicts that the project will yield it $50 million per year for 2 years. • The probability that the government will expropriate the project is 12% each year • Discount rate = 10% • 𝑉 = !.##×%! &(!.()×!) (.( + !.##!×%! & !.##×!.()×! &(!.()+!) (.(! = 72 mil. USD • Manager can also find the expropriation • Probability p that would cause the project to have a net present value (NPV) of 0. • 𝑟 ∗ = 0.25 International Finance © 2018 Cambridge University Press 14-7 Example of Political Risk Analysis Risk Attributes: • Political risk analysis uses measurable “risk attributes” (at top) to predict risk events for MNCs (bottom). • Political stability (for example, the number of different governments in power over time) • Ethnic and religious unrest; the strength and organization of radical groups • The level of violence and armed insurrections; the number of demonstrations • Enforcement of property rights • The extent of xenophobia (fear of foreigners); the presence of extreme nationalism • The different political variables are then weighted and added to provide one country score. International Finance © 2018 Cambridge University Press 14-8 Examples of Rating Systems • The PRS Group’s ICRG Rating System Political Risk Services Group (PRS Group), focuses on future risks, some ratings services focus on current conditions only (more info) • The political risk measure is based on 12 different subcomponents, and the financial and economic risk measures are based on five subcomponents each International Finance © 2018 Cambridge University Press 14-9 Country and Political Risk Ratings for Selected Countries International Finance © 2018 Cambridge University Press 14-10 • https://info.worldbank.org/governance/wgi/Home/Reports • https://www.marsh.com/us/services/political-risk/insights/political-risk-report.html • Credit rating: https://tradingeconomics.com/country-list/rating • Ease of doing business index: https://data.worldbank.org/indicator/IC.BUS.EASE.XQ • The composite risk indicator of the Economist Intelligence Unit (EIU), a sister company to the magazine The Economist Examples of Rating Systems International Finance © 2018 Cambridge University Press 14-11 • Country Credit Spreads • Difference between yields of government bonds. If the yield on a 5-year Italy bond is 6%, and the yield on a 5-year bond issued by the German government is 3%, the Italian country credit spread is 3%. • Sovereign credit ratings – Moody’s, S&P, Fitch • Why is sovereign credit risk different? • Cannot take a country to bankruptcy court, no formal bankruptcy proceedings. • Still, there are consequences • Country will not be able to borrow so easily going forward • International trade could be impacted • Default could make economic crises worse 3. Country and Political Risk Analysis International Finance © 2018 Cambridge University Press 14-12 Sovereign Credit Ratings by Standard & Poor’s International Finance © 2018 Cambridge University Press 14-13 • Brady Bonds • Valued like other fixed-income securities but have special features • Principal collateral: all par and discount bonds are collateralized by US Treasury zero-coupon securities • Interest collateral: the government issuing Brady bonds deposits money w/ NY Federal Reserve Bank in amounts covering 12 – 18 months of interest payments • Sovereign portion: The remaining cash flows are subject to sovereign risk 3. Country and Political Risk Analysis International Finance © 2018 Cambridge University Press 14-14 • Country spreads and political risk probabilities • An indication of default risk of a sovereign bond • Not the risk of expropriation • Moody’s reported in 2011 an historical recovery rate of 30-35% • Default probabilities with positive recovery values • Stripped Price is the dollar price of the bond after subtracting the value of the collateral • Stripped price: • 𝑆𝑡𝑟𝑖𝑝𝑝𝑒𝑑 𝑃𝑟𝑖𝑐𝑒 = ∑!"# #$ %&(!)(#)*)! [#,-(!)]! , CF(j) is the promised dollar cash flow at time j; i( j) is the USD spot interest rate for period j ; and p is the default probability. The assumptions are that the default probability is constant over time and the recovery value upon default is 0. 3. Country and Political Risk Analysis International Finance © 2018 Cambridge University Press 14-15 • Adjusting capital flows • Preferred to adjusting discount rate • Must compute the political risk probabilities • Computing political risk probabilities • Country credit spreads • Examine securities of different maturities • Local macroeconomic conditions and, importantly, global risk factors (such as U.S. credit spreads) play an important role • About 40% of the variation in spreads is due to political risk factors Bekaert et al. (2011) • Political risk ratings • No evidence of predictive ability • Could be lagging (and not leading) • Political risk insurance premiums 3. Country and Political Risk Analysis International Finance © 2018 Cambridge University Press 14-16 Country and Currency Premiums Around the Mexican Currency Crisis International Finance © 2018 Cambridge University Press 14-17 • The credit default swap (CDS) is a type of credit derivative product. Credit derivatives provide transferring credit risk, which is the possibility that one of the contract parties will not able to fulfill his obligations, from one contractor to another • http://www.worldgovernmentbonds.com/sovereign-cds/ Credit Default Swap