Country Risk Assessment

\ Country Risk Assessment\ \ \ A guide to Global Investment Strategy\ \ \ \ By Michel Henry Bouchet Ephraim Clark Bertrand Groslambert\ \ \ John Wiley & Sons\ \ \ \ Copyright © 2003\ \ Michel Henry Bouchet, Ephraim Clark, Bertrand Groslambert\ All right reserved.\ \ \ ISBN: 0-470-84500-7\ \ \ \ \ Chapter One\ \ \ Introduction\ \ 1.1 AN HISTORICAL PERSPECTIVE\ Following the numerous successes it had met with during the flotation of shares and bonds\ in the capital markets, Baring Brothers was eager to underwrite a loan to be issued by the\ Buenos Aires Water Supply and Drainage Company. However, the demand was not there and\ this operation proved to be a failure, leaving the investment bank holding the bulk of the debt.\ In the meantime, after an extended period of investment boom, the major central banks had\ decided to substantially increase their discount rates. This tightening of the global liquidity\ prevented Barings from refinancing at affordable cost and rapidly made its situation untenable.\ The deterioration of the economic conditions in Argentina hastened an international financial\ crisis and drove Barings to the verge of bankruptcy. Then, because of contagion effects, Brazil\ was next on the list. Its currency as well as its stock market collapsed, causing a sharpeconomic\ recession.\ Does this story sound familiar? Well, any resemblance to an existing situation is probably\ not coincidental. However, the aforementioned events do not relate one of the recent crises\ experienced by many emerging markets over the last decade, but actually refer to what is\ known as the 1890 Baring crisis, more than a century ago. This example illustrates one of the\ many similarities that can be found when comparing the current period with the prevailing\ conditions in the nineteenth century.\ With the end of Bretton Woods in 1971, and more particularly since the beginning of the\ 1990s, the world economy has been characterized by its globalization. The fall of communism\ has permitted the rise of the single American superpower, replacing the Pax Britannica of\ pre-World War I with Pax Americana. The economic liberalism that started to be implemented\ in the industrialized nations by Margaret Thatcher in 1979, and later on was extended to the\ developing countries by the IMF's adjustment programs, looks like the "laissez faire" policy of\ the Victorian epoch. Most financial markets are now fully deregulated and capital flows freely\ circulate all around the world. As a consequence, in the 1990s and for the first time since 1913,\ the structure of the international capital flows was marked by the return of portfolio investments,\ especially in the form of bonds and equities. Therefore, exactly like a century ago, "we enjoy\ at present an undisputed right to place our money where we will, for Government makes no\ attempt to twist the system into a given channel, and every borrower - native, colonial and\ foreign - has an equal opportunity for satisfying his needs in London" (The Economist, 20\ February 1909, in Baring Securities, 1994).\ Regrettably and similarly, this also corresponds to a strong increase in the frequency of\ economic crises. As stated by Krugman (2000) when comparing the current events with the\ period 1945-1971: "The good old days probably weren't better, but they were certainly calmer."\ The debt crisis of the 1980s, the Chilean collapse of 1982, the bursting of the European\ Exchange Rate Mechanism (ERM) in 1992, the debacle of the Mexican peso in 1994, the\ Asian disaster of 1997, the Russian default and the American bailout of LTCM in 1998,\ the Argentine chaos in 2001/2002, all demonstrate an accrued volatility of the international\ economic system. In the same vein, the nineteenth century was regularly shaken by financial\ crashes. In the years 1836-1839, seven states of the then emerging United States defaulted. A\ short time later, the railroad boom turned into a speculative bubble and eventually led to the\ panic of 1857. Turkey, Egypt and Greece defaulted on their debt in 1875-1876. Australia and\ Canada did the same in 1893, and were followed by Brazil and Mexico in 1914. All through\ the nineteenth century, speculative mania, financial euphoria, and sharp crises accompanied\ the economic take-off of the industrial revolution.\ Does this mean we are left in exactly the same situation as the one prevalent in the age of\ the gold standard? Probably not. However, many observers agree on the growing instability\ of the economic system and believe that "the likelihood of escaping economic and financial\ crises in the years ahead seems small" (Kindleberger, 2000).\ Parallel to this increasing volatility, feeding on and fuelled by globalization, more and more\ firms invest, trade and compete outside of their home market. Hitherto reserved for the biggest\ companies, even the smallest firms have started to reason on a global basis. Thus, between 1950\ and 2000, the ratio of merchandise exports to world GDP rose from less than 10% to almost\ 20%. This means that firms are more and more internationally exposed, and national economies\ are increasingly interlinked. This economic integration translates into a higher sensitivity to\ foreign events. Consequently, international trade is more and more crucial for companies and\ countries alike. Furthermore, as the world political leadership is increasingly wielded by the\ industrialized countries in general and by the United States in particular, there is evidence of\ a backlash against these countries. In this context, their firms' interests abroad have shown\ themselves to be especially vulnerable. As the former US Ambassador Paul Bremer outlined:\ "In the past 30 years, 80% of terrorist attacks against the United States have been aimed at\ American businesses" (Harvard Business Review, 2002). All this demonstrates the growing\ importance of a reliable risk management system based on accurate country risk assessment\ methods.\ Forecasting is at the core of all decision-making in the management field. Businessmen must\ plan and anticipate what the future will bring. They must then make their choices based on their\ analyses, taking into consideration how today's choices are likely to affect their companies in\ the future. This implies a certain amount of risk. The ability to look ahead and to take on risk is a\ major determinant in the frontier between Modern and Ancient times. As Bernstein (1996) put\ it, "the transformation in attitudes toward risk management has channeled the human passion\ for games and wagering into economic growth, improved quality of life, and technological\ progress".\ Until the Renaissance, men did not generally try to forecast the future. This was reserved\ for the Gods. At best, the Gods could possibly deliver their views through an oracle such\ as the Pythia at Delphi. Starting in the sixteenth century, though, a series of mathematical\ discoveries enabled mankind to reconsider its position on this issue. Indeed, from this date,\ Pascal, Fermat, Bernouilli, de Moivre, Laplace and Gauss, to name just a few, progressively\ built what became the theory of probability. This branch of mathematics created the toolbox\ to deal with the future in a rational and orderly manner. At the end of the nineteenth century,\ it led to the conclusion that everything could be measured, either with a deterministic or with\ a probabilistic approach. Risk was thought to be under control.\ However, the twentieth century was to challenge this optimistic vision. Two world wars\ and the Great Depression showed that even the unthinkable could happen. This altered the\ perception of risk and caused researchers to redefine it. In the 1920s, Knight introduced the\ notion of uncertainty as opposed to the notion of risk. Whereas risk can be appraised with\ probability, uncertainty is not measurable. This distinction was well retranscribed by Keynes\ (1937) in his famous statement: "By 'uncertain' knowledge ... I do not merely distinguish\ what is known for certain from what is only probable. The game of roulette is not subject, in\ this sense, to uncertainty; nor the prospect of a Victory bond being drawn ... Even the weather\ is only moderately uncertain. The sense in which I am using the term is that in which the\ prospect of a European war is uncertain, or the price of copper and the rate of interest twenty\ years hence ... About these matters there is no scientific basis on which to form any calculable\ probability whatever. We simply do not know."\ There may be several reasons why "we simply do not know". First, the system may be too\ complex to be measured. In this case, the theory of chaos explains the situation by saying\ that it contains too many degrees of freedom, and is therefore unpredictable in the long run.\ Alternatively, it may be because we don't have a long enough time series to extrapolate the\ underlying probability law. For instance, many economic variables follow certain probability\ laws of "rare events", such as Pareto's law. In order to be accurately estimated, these types\ of distributions require extremely large empirical databases, which are hardly ever found\ in real life. Lastly, another argument could lie in the permanently changing and inherently\ unstable nature of the environment. To draw on the past in order to infer the probability of\ future occurrences would be completely misleading, if a structural change took place in the\ meantime.\ If the size of the population under scrutiny is sufficiently large (in the billions) to be valid for\ statistical appraisal and provided it is unaware of the existence of the science of Psychohistory,\ then Hari Seldom demonstrated that Psychohistory could predict the behavior of human soci-eties\ over at least 30 000 years. Psychohistory is "a branch of mathematics which deals with\ the reactions of human conglomerates to fixed social and economic stimuli" (Asimov, 1967).\ Unfortunately, or rather maybe fortunately, this science has not been invented yet, except in the\ imagination of the famous science fiction novelist, Isaac Asimov. Today, organization science,\ political science, economics, or country risk are still light years away from Psychohistory.\ Nevertheless, we can reasonably expect from them a certain ability to anticipate social changes.\ The objective of this book is to explore the question for country risk. What is the state of the art\ in this field? What are the various country risk assessment methods? Do they rely on modern\ science or are they merely based on intuition and subjective perceptions? Can we reasonably\ measure country risk with a probabilistic view? Or do we rather face the type of uncertainty as\ defined by Knight, the one which cannot be addressed with probability laws? In April 1982,\ Institutional Investor ranked South Korea below Mexico. In August of the same year, Mexico\ defaulted and triggered the international debt crisis of the 1980s. Meanwhile, Korea initiated\ a period of unparalleled economic growth that would increase its per capita GDP in US dollars\ fivefold over the next 20 years. In December 1986, The Economist tried to detect which\ countries were at the greatest risk of becoming unstable in the following years. They found\ that Chile was in the very high-risk category alongside Nigeria and Zaire, while Venezuela\ and Brazil were in the very low-risk category, like Taiwan and Singapore. As these selected\ examples clearly illustrate, risk management, and country risk in particular, has proved to be\ a very difficult task. No one method is able to perfectly assess country risk. However, taken as\ a whole, the methods of country risk assessment provide a framework for analysis and some\ necessary guidelines to tackle the issues at hand.\ When considering an investment abroad, it is essential that managers do not blindly follow\ the general consensus. Based on the methods presented in this book, they must take into\ account their own features, so as to derive their own evaluations. In addition, they should\ regularly question the validity of their models. They should wonder what could make them\ defective in the future, whatever their degree of success in the past. As Bernstein (1996)\ explains: "The science of risk management sometimes creates new risks even as it brings old\ risks under control. Our faith in risk management encourages us to take risks we would not\ otherwise take ... Research reveals that seatbelts encourage drivers to drive more aggressively.\ Consequently, the number of accidents rises even though the seriousness of injury in any one\ accident declines." Furthermore, the Minsky Paradox of Tranquility is never far away, just\ waiting to lull investors' awareness. This paradox postulates that after a long enough period\ of relative tranquility, entrepreneurs and banks tend to become complacent about economic\ prospects. Little by little, they start to take more risk, going for more debt, and hence making\ the system more vulnerable. This may be what happened in South East Asia in 1997, when\ so many investors were trapped, unprepared to bear such a high risk. "Only the pathological\ weakness of the financial memory,... or perhaps our indifference to financial history itself,\ allows us to believe that the modern experience of Third World debt ... is in any way a new\ phenomenon" (Galbraith, 1994).\ Finally, we should keep in mind that it is precisely the difficulty of estimating the risk\ that can make the investment opportunities attractive. An anecdote by Jean-Louis Terrier, the\ founder of the French rating firm Nord Sud Export, illustrates this point. A few years ago he\ had a discussion with one of his clients, a wealthy and quite secretive Belgian entrepreneur,\ who, every year, was very impatient to read the annual country risk ratings. To Terrier's utmost\ surprise, the man confessed to him that he wanted to be sure his investments were made\ effectively in the riskiest countries, those able to generate the highest returns.\ \ 1.2 OUTLINE OF THE BOOK\ Various definitions and several terminologies exist to deal with the risk related to a foreign\ investment. In this book, we define country risk as all the additional risks induced by doing\ business abroad, as opposed to domestic transactions. When a firm starts to expand internationally,\ it is faced with a new environment, composed of different risks and uncertainties,\ which it is not used to dealing with. Country risk encompasses all these specific sources of\ potential difficulties encountered when investing overseas, ranging from political and social\ risks to macro- and microeconomic risks.\ This book should allow the reader to get an insight into the nature of risk when investing in\ a foreign country. Based on the three authors' experience, it combines a rigorous, theoretical\ treatment of country risk with some very concrete and practical illustrations. It aims to present\ and analyze most of the existing country risk assessment methods. It also provides a broad\ overview of the country risk field with an emphasis on the specific nature of the emerging\ countries. It should allow professionals to explore the origins of country risk, to understand\ the assessment process of each method, and to grasp their limits.\ \ Continues...\ \ \ \ \ \ \ Excerpted from Country Risk Assessment\ by Michel Henry Bouchet Ephraim Clark Bertrand Groslambert\ Copyright © 2003 by Michel Henry Bouchet, Ephraim Clark, Bertrand Groslambert.\ Excerpted by permission.\ All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.\ Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.\ \ \

PrefaceAcknowledgmentsForeword1Introduction12An Overview of Country Risk93The Economic and Financial Foundations of Country Risk Assessment314Country Risk Assessment Methodologies: The Qualitative, Structural Approach to Country Risk495Assessment Methodologies: Ratings796Econometric and Mathematical Methods1157Risk Models1338International Portfolio Investment Analysis1499Financial Crises in Emerging Market Countries: An Historical Perspective17110Country Risk and Risk Mitigation Instruments19711Country Risk Assessment: A Matter of Information and Intelligence Gathering221Glossary247Index265