Chapter

16
Country Risk Analysis

South-Western/Thomson Learning 2006

Slides by Yee-Tien (Ted) Fu

Chapter Objectives

To identify the common factors used by MNCs to measure a countrys 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.

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Why Country Risk Analysis Is Important

Country risk represents the potentially
adverse impact of a countrys environment on an MNCs cash flows.

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Why Country Risk Analysis Is Important

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.

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Political Risk Factors

Attitude of consumers in the host country

Some consumers are very loyal to locally manufactured products. 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.

Actions of host government

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Political Risk Factors

Blockage of fund transfers

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

Currency inconvertibility

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Political Risk Factors

War

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

Bureaucracy

Corruption

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Corruption Index Ratings for Selected Countries

Maximum rating = 10. High ratings indicate low corruption.

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Financial Risk Factors

Indicators of economic growth

The current and potential state of a countrys economy is important since a recession can severely reduce demand. A countrys economic growth is dependent on several financial factors - interest rates, exchange rates, inflation, etc.

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Types of Country Risk Assessment

A macroassessment of country risk is an
overall risk assessment of a country without considering the MNCs business.

A microassessment of country risk is the

risk assessment of a country with respect to the MNCs type of business.

The overall assessment thus consists of

macropolitical risk, macrofinancial risk, micropolitical risk, and microfinancial risk.
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Types of Country Risk Assessment

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.

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Techniques of Assessing 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.

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Techniques of Assessing 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.

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Techniques of Assessing Country Risk

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.

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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.
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Cougar Co.:
Determining the Overall Country Risk Rating

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Cougar Co.:
Derivation of the Overall Country Risk Rating

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Measuring Country Risk

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.

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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.
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Actual Country Risk Ratings Across Countries

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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.

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Incorporating Country Risk in Capital Budgeting

Adjustment of the discount rate

The higher the perceived risk, the higher the discount rate that should be applied to the projects 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.
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Adjustment of the estimated cash flows

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

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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 199798 Asian crisis caused MNCs to

realize that they had underestimated the potential financial problems that could occur in the high-growth Asian countries.

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Applications of Country Risk Analysis

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.

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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.

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Reducing Exposure to Host Government Takeovers

Rely on unique supplies or technology

In this way, the host government will not be able to take over and operate the subsidiary successfully. The local employees can apply pressure on their government if they are affected by the takeover.

Hire local labor

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Reducing Exposure to Host Government Takeovers

Borrow local funds

The local banks can apply pressure on their government if they are affected by the takeover. Investment guarantee programs offered by the home country, host country, or an international agency insure to some extent various forms of country risk.
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Purchase insurance

Reducing Exposure to Host Government Takeovers

Use project finance

Project finance deals are heavily financed with credit, thus limiting the MNCs exposure. The loans are secured by the projects future revenues and are nonrecourse. A bank may guarantee the payments to the MNC.

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