"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.

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 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.

"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.

"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.

"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:

- Balance of Payments,

- Size of external debt,

- Growth in GNP (Gross National Product),

- Inflation,

- Debt servicing burden and

- Structure of exports.

- 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.

"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.

"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.

"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.