Country Risk
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COUNTRY RISK MANAGEMENT

A PRACTICAL GUIDE

 

RON WELLS  CCE

 

"Country risk" may be defined as the risk that something may happen in a foreign country which will negatively influence the willingness or ability of state owned and/or privately owned customers in that country to pay their debts on time.


In terms of this definition it is usual to think of payment defaults as a result of a State decreed moratorium on foreign payments or a situation where assets are nationalised and foreign debts are not recognised (repudiated). However it is also probable that a severe decline in the external value of a country’s currency would cause all importers with payments due in foreign currency to face bankruptcy and to default. Similarly a harsh tax introduced with retrospective application could convert many previously solvent companies into bankrupt companies.


"Repudiation" is the act of a borrower or debtor which ceases to acknowledge its debt obligations.


"Default" is the act of a borrower or debtor which ceases to pay its debts because it cannot or will not.


A "receivable" may be characterised as an "investment" since it represents the cash value of goods given to a buyer to use for a period of time before payment is due. The time which elapses before payment is due is usually less than one year and therefore the investment is considered to be "short-term". In the case where the party obliged to pay the receivable on due date (be that the buyer or the buyer’s guarantor e.g. a bank or parent company) is resident in a foreign country, the receivable is a "short-term foreign investment". That is to say the receivable is a "foreign asset".


Recovery of a foreign investment and the repatriation of the cash equivalent of the investment or receipt of payment of a foreign receivable requires:

- firstly that the foreign currency exchange regulations of the foreign country must allow the transfer of funds to be accomplished and

- secondly that the foreign country must have available in its national treasury or through international credit lines sufficient foreign currency to enable the necessary currency conversion.


The risk that one or other or both of these conditions will not be met and a transaction will therefore fail is a branch of Country Risk which is called "Transfer Risk" (if the buyer is privately owned) or "Sovereign Risk" (if the buyer is state owned).


This is the branch of Country Risk which banks and country risk consultancies (such as the Economist Intelligence Unit, Rundt’s and Euromoney) have traditionally utilised their resources to analyse and forecast. This type of evaluation requires the employment of a specialised team of Economists and Political Scientists to analyse and report on social trends, economic data, political information and demographic statistics.


The second branch of Country Risk may be called "Local Factors Risk". This includes all elements which could have a negative effect on the financial well-being of many of the businesses operating in a particular country.


These elements would include, among other things, (1) the imposition of a new tax effective retrospectively, (2) the sudden drastic reduction in the external value of the domestic currency, (3) a natural disaster affecting the country’s financial centre, such as a strong earthquake striking the Tokyo area, (4) the outbreak of rebellion or civil war and (5) a sharp rise in domestic interest rates.


There are several alternative and/or complementary ways to assess country risk due to the fact that "Country risk assessment is an art and not a science". (A quotation from ‘International Finance and Investment’ [1987] edited by Brian Terry - page 429.)


It is submitted however that what any company needs is a systematic, cost effective and practical internal process designed to produce a relevant quantitative monetary limit for the company’s exposure to risk in each pertinent country.

 

A PRACTICAL PROCESS FOR COUNTRY LIMIT DECISION MAKING

The process described in this section is the author’s preferred approach. If this process is applied in practice it should be adapted to the particular needs and circumstances of the company.


This is not the only process available. Therefore it should be noted that another equally effective process may be more appropriate for the circumstances of a particular company.

The process described has been developed by Y A Jarmain and R K Wells.

The process consists of eleven sequential steps, viz:

(1) Establish the amount of the company’s shareholders’ own funds (equity).

(2) Decide how much of the company’s equity should be allocated to each category of risk from ‘A’ (least risky) through ‘B’, ‘C1’, ‘C2’, ‘D1’, ‘D2’ to ‘E’ (most risky).

(3) Choose a country risk rating agency from which to regularly obtain basic country risk ratings. Alternatively the ratings of several agencies could be obtained and ‘averaged’.

(4) Assign categories of risk to agency country risk ratings.

(5) Decide on the list of countries pertinent to the company’s business plans and obtain the Gross Domestic Product (GDP) figure for each country.

(6) Calculate an initial limit for each country, using the formula shown below.

(7) Systematically consider special elements which apply to the company’s industry or sector and those which apply to the company itself in respect of each country. Assign a limit adjustment amount to each such element using subjective judgment.

(8) Add (and/or subtract) the limit adjustment elements to (and/or from) the initial country limit to establish a specific country limit appropriate for the company.

(9) Consider whether the limits created in this way are sensible and practical. If necessary review and adjust some of the assumptions made or formulae applied in the model and rework the limits.

(10) Regularly gather information as to the company’s risk exposure in each country and compare this with the country limits. Take action to eliminate any exposure in excess of a particular country limit.

(11) Regularly review and update country limits to take account of changed circumstances.

 


THE COUNTRY RISK LIMIT DECISION PROCESS EXPLAINED

(1) SHAREHOLDERS’ EQUITY:


"Establish the amount of the company’s shareholders’ own funds (equity)."


The central idea behind country risk exposure management is that the company should be protected from destruction should any one country fail. A country would be said to have ‘failed’ if the company’s customers in that country were unable or unwilling to pay their debts due to the company.

If a particular class of receivables were to be lost in this way, the loss would have to be covered by the shareholders’ equity or the company would face bankruptcy.

Therefore the first step in deciding on country limits is to discern how much money is available to cover any loss; that is what is the amount of the shareholders’ equity.


(2) RISK CATEGORIES AND EQUITY ALLOCATION:


"Decide how much of the company’s equity should be allocated to each category of risk from ‘A’ (least risky) through ‘B’, ‘C1’, ‘C2’, ‘D1’, ‘D2’ to ‘E’ (most risky)."


The low risk rated countries are less likely to fail and therefore the company can afford to put at risk a large proportion of its equity by exposure to such countries. In fact the company may be able to justify putting at risk a multiple of its capital in respect of low risk rated countries.

Conversely the company should risk progressively smaller proportions of its equity against each category as the risk of failure increases.


This may be illustrated as follows:

Say a company has an equity of $100 million.

Accept risk exposures as to;

Risk Category... Proportion.... Amount.*

A........................ 75%............... $75 million.

B........................ 50%............... $50 million.

C1...................... 20%............... $20 million.

C2...................... 10%............... $10 million.

D1........................ 3%................. $3 million.

D2........................ 1%................. $1 million.

E........................... 0%................ $0.

 

* The total amount allocated across all risk categories will be greater than the total amount of the equity.

 

(3) COUNTRY RISK RATING AGENCY:


"Choose a country risk rating agency from which to regularly obtain basic country risk ratings. Alternatively the ratings of several agencies could be obtained and ‘averaged’."


There are several internationally renowned agencies which produce regular country risk analysis reports and risk ratings for subscribers. They generally employ teams of Economists and Political Scientists to analyse countries on the following criteria:

Economic Indicators;

- Balance of Payments,

- Size of external debt,

- Growth in GNP (Gross National Product),

- Inflation,

- Debt servicing burden and

- Structure of exports.


Political Factors;

- Internal stability,

- External stability and

- The ‘unknown factor’.


Each agency coalesces its analysis down to a rating for each country and each agency has its own way of expressing such rating. Some agencies assign a score out of say 10, others assign a letter or series of letters or a word, for example ‘substandard’, others assign a combination of letters and numbers.

It is submitted that if the various agencies’ ratings were used to rank a list of countries the ranking would be similar for each agency regardless of the variety of scoring methods used. This is so since all the agencies utilise similar data (data available publicly from sources such as the International Monetary Fund, World Bank and Bank for International Settlements).

Differences will arise where judgment has been applied particularly in assessing the economic management skills of a country’s officials and the political factors. Nevertheless it should be sufficient to choose one agency’s risk ratings to serve as a base for the company’s country risk analysis.

It is conceivable that several ratings could be used to produce a combined or average rating for each country. However it is unlikely that such an exercise would make sufficient difference to the overall outcome of this process to justify the additional costs and effort involved.

 


(4) LINK RISK RATINGS WITH RISK CATEGORIES:


"Assign categories of risk to agency country risk ratings."


The risk ratings of "Euromoney" have been chosen here for the purposes of illustration.

"Euromoney" publishes ratings out of 100 for each country analysed. The higher the rating the lower the risk of failure and vice versa. These ratings may be translated into risk categories as follows, for example:


Euromoney

Rating......... Risk Category... Proportion.... Amount.

76-100........ A........................ 75%............... $75 million.

60-75.......... B........................ 50%............... $50 million.

50-59.......... C1...................... 20%............... $20 million.

40-49.......... C2...................... 10%............... $10 million.

30-39.......... D1........................ 3%................. $3 million.

20-29.......... D2........................ 1%................. $1 million.

0-19............ E........................... 0%................ $0.

 

 

(5) CHOOSE LIST OF COUNTRIES:


"Decide on the list of countries pertinent to the company’s business plans and obtain the Gross Domestic Product (GDP) figure for each country."


This list should include all the foreign countries with which the company will transact business.

 

(6) CALCULATE THE INITIAL COUNTRY LIMIT:


"Calculate an initial limit for each country, using the formula shown below."

 

ONE;

Calculate the share of equity available for each country in each risk category. This is done by dividing the equity amount allocated for ‘A’ rated countries by the number of ‘A’ rated countries, dividing the equity amount allocated for ‘B’ rated countries by the number of ‘B’ rated countries and so on.


Thus creating a table such as that which follows for illustration purposes;


Euromoney

Rating......... Risk Category... Proportion.... Amount... Countries ^... Equity Allocated.

76-100........ A........................ 75%............... $75 mio... 5.................. $15 mio each.

60-75.......... B........................ 50%............... $50 mio.... 10................ $5 mio each.

50-59.......... C1...................... 20%............... $20 mio.... 4.................. $5 mio each.

40-49.......... C2...................... 10%............... $10 mio.... 2.................. $5 mio each.

30-39.......... D1........................ 3%................. $3 mio.... 3.................. $1 mio each.

20-29.......... D2........................ 1%................. $1 mio.... 4.................. $0,25 mio each.

0-19............ E........................... 0%................ $0........... 2................... $0.

 

^ This is the number of countries in each risk category.

 

TWO;

Decide on a ‘factor per risk category’ to apply to each country’s GDP figure to obtain a limit indication.


This could be done as follows;


Euromoney

Rating......... Risk Category... Proportion.... Amount... Countries.... Equity...... Factor. #

76-100........ A........................ 75%............... $75 mio... 5.................. $15 mio.... 0,002

60-75.......... B........................ 50%............... $50 mio.... 10................ $5 mio..... 0,0018

50-59.......... C1...................... 20%............... $20 mio.... 4.................. $5 mio..... 0,0015

40-49.......... C2...................... 10%............... $10 mio.... 2.................. $5 mio..... 0,001

30-39.......... D1........................ 3%................. $3 mio.... 3.................. $1 mio..... 0,0008

20-29.......... D2........................ 1%................. $1 mio.... 4.................. $0,25 mio. 0,0005

0-19............ E........................... 0%................ $0........... 2................... $0............ 0.

 

# The ‘factors’ utilised are decided upon by the user in an arbitrary manner. However they are designed to reduce the limit resulting from their application as the risk of failure increases in accord with the risk category scale.

 

GDP has been chosen here since (a) it is a figure which is generally available and comparable for all countries and (b) it is an indication of the relative size of a country’s economy. It may be argued that some other indicator should be used such as ‘foreign currency reserves’ for example but this is a matter for each user of the system to decide.

 

THREE;

Multiply the GDP of each relevant country by the applicable factor and compare the result with the applicable per country equity allocation. The ‘initial country limit’ is the lesser of these two amounts.


Consider the following illustrations;

 

Abu Dhabi

Euromoney rating.... 77,47

Risk category........... A

0,002 x GDP............. $69,95 million

Equity allocation...... $15 million

Initial limit................ $15 million.

 

Slovakia

Euromoney rating.... 57,92

Risk category........... C1

0,0015 x GDP........... $18 million

Equity allocation...... $5 million

Initial limit................ $5 million.

 

Estonia

Euromoney rating.... 49,4

Risk category........... C2

0,001 x GDP............. $2,5 million

Equity allocation...... $5 million

Initial limit................ $2,5 million.

 


(7) EVALUATE COMPANY SPECIFIC ELEMENTS:


"Systematically consider special elements which apply to the company’s industry or sector and those which apply to the company itself in respect of each country. Assign a limit adjustment amount to each such element using subjective judgment."


The initial country limit which is derived by using the process thus far is a generally applicable limit. Clearly it is based on information available to all parties and is not tailored specifically to the circumstances of the company. It is therefore important to consider the company’s unique position vis a vis each country and adjust the initial limit accordingly.

The following elements could be considered and each could be assigned a monetary limit value. These monetary limit values could be positive or negative depending on whether the element assessed is thought to reduce the country risk or increase it, respectively.


Examples of elements to be considered;


The strategic position of the goods supplied within the country being analysed.

- Are the goods vital for the maintenance of good order in the country or for the maintenance of exports? Examples of such goods are pharmaceuticals, fuel, fertiliser and food. A government may be relied upon to insure that debts due for essential goods are paid. However non-essential goods will carry a higher risk of non-payment in a crisis, in the latter case therefore consideration must be given to reducing the initial limit by an amount.


The company’s influence with decision makers in the country.

- If the company is in regular contact with decision makers in a country it will (a) have early warning of impending problems and (b) have a means to insure that its interests and those of other foreign creditors are properly considered; in the long term best interests of the host country.


The company’s strategy in the geographic area in question.

- The company may, for example, have a branch office operating in a neighbouring country but need to increase sales in order to cover office costs. This may require an easing of limits to assist the building of a regional market share.


The strategy of the company’s competitors.

- In order to compete effectively with other suppliers the company may have to increase the amount of credit made available in a particular country.


The availability of payment risk cover from the banks and the credit insurance market.

- If cover is available it may be possible to adopt a more conservative approach and limit exposure to the country in question below that indicated by the initial limit.


Note that initial limits should not be increased to amounts in excess of a certain predetermined multiple of the equity allocation for each country. That is to say that the user of this process should decide at the outset that after an initial limit has been adjusted it should not exceed say, for example, twice the equity allocation for the country in question.

 


(8) ADJUST THE INITIAL LIMIT:


"Add (and/or subtract) the limit adjustment elements to (and/or from) the initial country limit to establish a specific country limit appropriate for the company."


Refer to the illustration below:

If the company were a crude oil supplier to Slovak refineries the following adjustments may be considered to be justified;

+ $10 million, because the country imports 100% of its crude requirements,

- $7 million, because the company has no contacts or influence in the country,

+ $3 million, because the company has surplus production and few alternative markets.

This yields a net adjustment amount of $6 million positive.

 

Slovakia

Euromoney rating.... 57,92

Risk category........... C1

0,0015 x GDP........... $18 million

Equity allocation...... $5 million

Initial limit................ $5 million.

Adjustment............. +$6 million

Country limit.............. $10 million

(the Country limit indicated by the addition of the adjustment is $11 million [$5 plus $6 million] but this must be restricted here to a maximum of twice the Equity allocation i.e. 2 x $5 million).

 


(9) OVERALL REVIEW:


"Consider whether the limits created in this way are sensible and practical. If necessary review and adjust some of the assumptions made or formulae applied in the model and rework the limits."


In view of the subjectivity and assumptions involved in this process it is advisable to review the list of country limits created and consider whether these are practical in terms of the needs of the company.


The objective of the process is ultimately to protect the company from bankruptcy due to the failure of one country and consequently the failure to collect the receivables due by all the customers in that country. Nonetheless it must be flexible enough to cope with changed circumstances and not to hamper the conduct of good quality business. Hence the need for an overall review of the results of the process from time to time.


All country limits recommended as a result of the process should be confirmed by a senior company executive authorised by the Board of Directors.

 


(10) MONITOR AND MANAGE EXPOSURE:


"Regularly gather information as to the company’s risk exposure in each country and compare this with the country limits. Take action to eliminate any exposure in excess of a particular country limit."


This is the most important part of the process since it is through this step that the company’s country exposures are actively managed.

The company’s accounting system must be designed to produce a regular report (perhaps weekly) which shows an analysis of receivables outstanding by country. If a particular receivable is secured by a party resident in another country (a bank or parent company) the country designation of that receivable should be changed to that of the guarantor.

Other company exposures within the listed countries could be added to such a report.

Consignment inventory (stock) in a foreign country is an example of a type of exposure which could be added.

Comparing such a report to the country limits will highlight excess exposures so that action can be taken to transfer risks to other countries (by obtaining credit insurance or bank guarantees) or to limit (redirect) business activities.

 


(11) REVIEW AND UPDATE LIMITS:


"Regularly review and update country limits to take account of changed circumstances."


The situation in each country is dynamic and subject to rapid change
. In addition countries are interdependent so a change which affects one will affect many, often in different ways. Nevertheless changes are often subtle so it is necessary to be constantly alert.

Positive changes are as important to note as negative changes. Positive changes bring with them opportunities to do more business and to beat the competition.

Individual country limits should be reviewed formally at least twice every year and on an ad hoc basis if important developments come to the notice of the company. It is therefore imperative that a person or persons within the company must be given the responsibility to undertake regular reviews and to monitor developments in all relevant countries on a daily basis. The latter task should be accomplished through giving attention to the news media, conversations with agents, banks and colleagues and through personal visits.

 

© R K WELLS (APRIL 1996)

 

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