Country Risk Analysis in International Business

Country Risk Analysis

Country Risk

•

Country risk involves the potentially adverse

impact of a country’s environment on an

MNC’s cash flows.

•

Country risk includes the adverse political and

economic risks of operating in a country.

sovereign risk

•

The narrower risk associated with a

government defaulting on its bond payments

is called 

sovereign risk .

Example

•

A recession in a country that reduces the

revenues of exporters to that nation is a

realization of country risk.

•

Labor strikes by a country’s dockworkers,

truckers, and transit workers that disrupt

production and distribution of products, thus

lowering profits, also qualify as country risks.

•

 Clashes between religious groups that prevent

people in a country from shopping can also be

considered country risks.

Example

•

We have significant international operations and plan

to continue expanding our operations abroad where

we have limited operating experience, and this may

subject us to increased business and economic risks

that could affect our financial results.

Facebook

•

We could be subject to economic, political, regulatory

and other risks arising from our international

operations.

Netflix

Country Risk

•

MNCs periodically conduct a country risk analysis

to determine the exposure of their existing

foreign business operations to country risk.

•

They also conduct a country risk analysis when

considering new direct foreign investment.

•

 Financial managers must understand how to

measure country risk and incorporate country

risk within their capital budgeting analysis so that

they can make investment decisions that

maximize their MNC’s value.

Country Risk Characteristics

Political Risk Characteristics/Factors

•

Political risk can impede the performance of a local subsidiary.

An extreme form of political risk is the possibility that the host

country will take over a subsidiary.

•

In some cases of expropriation, compensation (in an amount

determined by the host country government) is awarded.

•

 In other cases, the assets are confiscated and no

compensation is provided.

•

Expropriation can take place peacefully or by force.

•

The following are some of the more common characteristics

of political risk:

Political Risk Characteristics/Factors

•

Expropriation or Nationalization

•

Attitude of consumers in the host country

•

Actions of host government

•

Blockage of fund transfers

•

Currency inconvertibility

•

War

•

Inefficient bureaucracy and

•

Corruption

•

Contract Repudiation

•

Taxes and Regulation

•

Exchange Controls

•

Corruption and Legal Inefficiency

Expropriation or Nationalization

•

The most extreme form of political risk is the possibility that

the host country takes over an MNC’s subsidiary, with or

without compensation. This is the worst-case scenario for

firms.

Attitude of Consumers in the Host Country

•

A mild form of political risk (to an exporter) is the

tendency of residents to purchase only locally

produced products. Even if the exporter decides to set

up a subsidiary in the foreign country, that tendency

could prevent its success. Country governments

commonly encourage local consumers to purchase

from locally owned manufacturers. An MNC that

considers entering a foreign market (or has already

entered that market) must monitor the general

attitude of consumers toward locally produced

products. If consumers are very loyal to local products,

then a joint venture with a local company may be more

feasible than an exporting strategy.

Actions of Host Government

•

Various actions of the host government can affect an MNC’s

cash flow. A host government might impose pollution control

standards (which affect costs) and additional corporate taxes

(which affect after-tax earnings) as well as withholding taxes

and fund transfer restrictions (which affect after-tax cash

flows sent to the parent).

Example

•

When Facebook went public in 2012, its registration

statement disclosed its exposure to political risk as follows: “It

is possible that governments of one of more countries may

seek to censor content available on Facebook in their country,

restrict access to Facebook from their country entirely, or

impose other restrictions that may affect the accessibility in

their country…. In the event that access to Facebook is

restricted, …we may not be able to maintain or grow our

revenue as anticipated and our financial results could be

adversely affected.”

Actions of Host Government

•

In 2014, Russia announced that it had temporarily closed four

McDonald’s restaurants due to health and safety violations.

The closures may have been prompted by the U.S. sanctions

that were imposed on Russia as a result of Russia’s conflict

with Ukraine. Surveys of executives of U.S.-based MNCs doing

business in Russia at the time found that they were concerned

that their Russian subsidiaries might be subjected to

restrictions by the Russian government as a form of retaliation

against the U.S. government.

Blockage of Fund Transfers

•

Subsidiaries of MNCs often send funds back to headquarters

to repay loans, purchase supplies, pay administrative fees,

remit earnings, or other purposes. In some cases, a host

government may block fund transfers, which could force

subsidiaries to undertake projects in the host country that are

not optimal (just to make use of the funds). Alternatively, the

MNC may invest the funds in local securities that provide

some return while the funds are blocked. But this return may

be inferior to what could have been earned on funds remitted

to the parent.

Currency Inconvertibility

•

Some governments do not allow the home currency

to be exchanged into other currencies. Thus the

earnings generated by a subsidiary in these countries

cannot be remitted to the parent through currency

conversion. When the currency is inconvertible, an

MNC’s parent may need to spend it in the host

country.

War

•

Some countries tend to engage in conflicts with neighboring

countries or to experience internal turmoil. This can affect the

safety of employees hired by an MNC’s subsidiary or by

salespeople who attempt to establish export markets for the

MNC. In addition, countries plagued by the threat of war

typically have volatile business cycles, which make cash flows

generated from such countries more uncertain. Multinational

corporations in all countries have some exposure to terrorist

attacks, but this exposure is much higher in certain countries

than in others. Even if an MNC is not directly damaged due to

a war, it may incur costs from ensuring the safety of its

employees. If a country’s risk of war is high, MNCs do not

need to analyze the feasibility of the proposed project any

further.

War

•

Significant MNC losses can occur due to

internal civil strife or wars. In war-torn regions

•

across the world, companies often hire their

own private armies in order to try to function

•

normally. For example, piracy near the Somali

coast has prompted some companies to hire

•

private security firms to protect their ships.

This, of course, is expensive and raises thorny

•

legal and humanitarian issues.

Inefficient Government Bureaucracy

•

An inefficient government bureaucracy can delay an MNC’s

efforts to establish a new subsidiary or expand business in a

country. In general, bureaucracy is a bigger problem in some

emerging countries. The problem is commonly caused by a

lack of government organization, so the development of a

new business is delayed until various applications are

approved by different sections of the bureaucracy. Delays can

also be caused by government employees who expect “gifts”

before they will approve an MNC’s applications.

Corruption

•

Highly inefficient governments with large bureaucracies can

increase a company’s costs of doing business. Governments

may also be corrupt and demand bribes.

•

Corruption can adversely affect an MNC’s international

business because it can increase the cost of conducting

business or reduce revenue. Various forms of corruption can

occur at the firm level or as a result of relationships between

firms and government agencies. For example, an MNC may

lose revenue because a government contract is awarded to a

local firm that paid off a government official. Laws defining

corruption and their enforcement vary among countries.

Contract Repudiation

•

Governments sometimes revoke, or repudiate, contracts

without compensating companies for their existing

investments in projects or services.

•

Governments default on the payments associated with the

contracts, cancel licenses, or otherwise introduce laws and

regulations that interfere with the contracts to which the

government and the MNC agreed.

•

 In 2010, Pakistani authorities halted all operations of the $3

billion Reko Diq copper and gold project, led by Canada’s

Barrick Gold and Chile’s Antofagasta, citing that the contract

substantially undervalued the value of the project.

Taxes and Regulation

•

Governments can dramatically change the “rules of the game”

that were in place when an MNC first made its investment in

the host country.

•

Examples include unexpected increases in taxes, restrictions

on hiring and firing local workers, and sudden stricter

environmental standards.

•

Some industries may be more susceptible than others,

especially if the foreign corporation is dominating its local

competition.

•

MNCs are also sometimes forced by governments to sell their

equity stakes in local subsidiaries because of foreign

ownership restrictions.

Taxes and Regulation

•

Regulations that MNCs find particularly problematic are

regulations restricting the transfer of their profits earned

abroad back to their home countries. Governments not only

have the power to change the tax rates on these earnings, but

they can also completely block their transfer.

•

This essentially forces the MNC to invest its funds locally, even

if doing so is less profitable. Finally, governments often make

decisions that can indirectly affect the cash flows of MNCs.

Example

•

In 2010, Chile, the world’s main copper

producer, increased royalty rates on copper

producers changing to a progressive tax from

5% to 14% rather than a flat 5% tax.

Exchange Controls

•

Another political risk factor relates to exchange controls.

Governments have been known to prevent the conversion

of their local currencies to foreign currencies. In general,

doing business in countries with inconvertible currencies

puts an MNC at considerable risk.

•

An interesting case is the 2002 collapse of the Argentine

currency board, which effectively ended the one-for-one

convertibility of pesos into dollars. The Argentine

government also curtailed bank deposit withdrawals and

prohibited the unauthorized export of foreign currency

from the country.

Financial Risk Characteristics

Financial Risk Characteristics

•

Along with political characteristics, financial

characteristics should be considered when assessing

country risk. Financial characteristics can have a

strong impact on international projects that MNCs

have proposed or implemented.

Economic Growth

•

The most obvious financial characteristic is the current and

potential state of the country’s economy. An MNC that

exports to a country or develops a subsidiary there is naturally

concerned about that country’s demand for its products,

which is influenced by the country’s economy. A recession

could severely reduce demand for the MNC’s exports or for

products sold by the MNC’s local subsidiary. A country’s

economic growth is influenced by interest rates, exchange

rates, and inflation.

Economic Growth

•

Interest rates. Higher interest rates tend to slow the growth

of an economy and reduce demand for the MNC’s

products. Governments commonly attempt to maintain low

interest rates when they want to stimulate the economy.

Low interest rates can encourage more borrowing by firms

and consumers and thus can result in more spending.

•

■

 Exchange rates. Exchange rates can influence the demand

for the country’s exports, which affects the country’s

production and income level. A strong currency may reduce

demand for the country’s exports, increase the volume of

products imported by the country, and therefore reduce

the country’s production and national income.

Economic Growth

•

Inflation. Inflation can affect consumers’ purchasing

power and their demand for an MNC’s products. In

addition, it affects the expenses associated with

operations in the country. Inflation may also

influence a country’s financial condition by affecting

the country’s interest rates and currency value.

Economic Growth

•

A country’s financial risk characteristics are strongly

influenced by the government’s fiscal policy. Some

countries use expansionary fiscal policies that involve

massive spending and low taxes in order to stimulate

their economy. However, this type of policy results in a

large national budget deficit and therefore increases

the amount of funds borrowed by the government. An

expansionary fiscal policy can have long-term adverse

effects if the level of government borrowing is so high

that it causes concerns about the government’s ability

to repay its loans.

Example

•

During the 2008–2015 period, the government of

Greece continued to pay generous salaries and

pensions to government employees, and it spent much

more money than it received in taxes. The government

finally had to take actions to correct its debt problems

so that it could obtain new loans from creditors. To

reduce its budget deficit, the government was forced

to reduce its spending and to raise taxes, which

adversely affected the economy. Many MNCs did not

pursue new business in Greece because they

recognized that economic conditions might be weak

and that corporate tax rates might be increased to pay

for the huge budget deficit

Measuring Country Risk

Macro-assessment of country risk

•

A macro-assessment of country risk is an overall risk

assessment of a country and involves consideration of

all variables that affect country risk except those that

are unique to a particular firm or industry. This type of

assessment is convenient because it remains the same

for a given country regardless of the firm or industry of

concern; however, it excludes relevant information that

could improve the assessment’s accuracy. A macro

assessment of country risk serves as a foundation that

can be modified to reflect the particular business of

the MNC, as explained next.

Macro-assessment of country risk

•

A micro-assessment of country risk involves the

assessment of a country as it relates to the MNC’s

type of business. It is used to determine how the

country risk relates to the specific MNC. The specific

impact of a particular form of country risk can affect

MNCs in different ways, which is why a micro-

assessment of country risk is needed.

Techniques for Assessing Country Risk

•

Once a firm identifies all the macro- and micro-factors

that deserve consideration in the country risk

assessment, it may wish to implement a system for

evaluating these factors and determining a country risk

rating. Various techniques are available to achieve this

objective. Among the most popular techniques are the

following:

Checklist approach,

Delphi technique,

Quantitative analysis,

Inspection visits, and

A combination of techniques

Checklist Approach

•

A checklist approach involves making a judgment on all the

political and financial factors (both macro and micro) that

contribute to a firm’s assessment of country risk. Ratings are

assigned to a list of various financial and political factors, and

these ratings are then consolidated to derive an overall

assessment of country risk. Some factors (such as real GDP

growth) can be measured from available data, whereas others

(such as probability of entering a war) must be subjectively

measured.

Checklist Approach

•

A substantial amount of information about countries

is available on the Internet. This information can be

used to develop ratings of various factors used to

assess country risk. The factors are then converted to

a numerical rating in order to assess a particular

country. Those factors thought to have a greater

influence on country risk should be assigned greater

weights. Both the measurement of some factors and

the weighting scheme implemented are subjective.

Delphi Technique

•

The Delphi technique involves the collection of independent opinions

without group discussion. As applied to country risk analysis, the MNC

could survey specific employees or outside consultants who have some

expertise in assessing a given country’s risk characteristics. After the MNC

receives responses from its survey, it

•

attempts to determine some consensus opinions (without attaching

names to any of the opinions) about the country’s perceived risk. The firm

then sends this summary of the survey back to the survey respondents

and asks for additional feedback regarding its summary of the country’s

risk.

Inspection Visits

•

Inspection visits involve traveling to a country

and meeting with

•

government officials, business executives,

and/or consumers. Such meetings can help

•

clarify any uncertain opinions the firm has

about a country. Indeed, some variables

•

(such as intercountry relationships) may be

difficult to assess without a trip to the host

•

country.

Combination of Techniques

•

Many MNCs do not have a formal method to

assess

•

country risk, because there is no proven

method that is always most appropriate.

Consequently,

•

many MNCs use a combination of techniques

to assess country risk.

Incorporating Risk in Capital Budgeting

•

When MNCs assess the feasibility of a

proposed project, country risk can be

incorporated

•

in the capital budgeting analysis by adjusting

the discount rate or by adjusting the

•

estimated cash flows. Each method is

discussed here.

Adjustment of the Discount Rate

•

The discount rate of a proposed project is supposed to reflect the required

rate of return

•

on that project. Thus the discount rate can be adjusted to account for the

country risk.

•

The lower the country risk rating, the higher the perceived risk and the

higher the discount

•

rate applied to the project’s cash flows. This approach is convenient in that

one

•

adjustment to the capital budgeting analysis can capture country risk.

However, there is

•

no precise formula for adjusting the discount rate to incorporate country

risk. The

•

adjustment is somewhat arbitrary and may therefore cause feasible

projects to be rejected

•

or infeasible projects to be accepted.

Adjustment of the Estimated Cash

Flows

•

Perhaps the most appropriate method for

incorporating forms of country risk in a capital

•

budgeting analysis is to estimate how the cash flows

would be affected by each form

•

of country risk. For example, if there is a 20 percent

probability that the host government

•

will temporarily block funds from the subsidiary to the

parent, the MNC should

•

estimate the project’s net present value (NPV) under

these circumstances, realizing that

•

there is a 20 percent chance that this NPV will occur.

•

If there is a chance that a host government will impose

higher taxes on the subsidiary,

•

then the foreign project’s NPV to the MNC should be

estimated under these conditions.

•

Each possible form of risk has an estimated effect on the

foreign project’s cash flows and

•

therefore on the project’s NPV. By analyzing each possible

effect, the MNC can determine

•

the probability distribution of NPVs for the project. Its

accept/reject decision on

•

the project will be based on its assessment of the

probability that the project will generate

•

a positive NPV and of the size of possible NPV outcomes.

Accounting for Uncertainty

•

Although MNCs cannot anticipate all changes in

•

country risk conditions that may happen, they should at least

consider various scenarios

•

that might occur, especially when considering a long-term project in

a foreign country.

•

In the previous example, the initial assumptions for most input

variables were used as if

•

they were known with certainty. However, Spartan, Inc., could

account for the uncertainty

•

of country risk characteristics while also allowing for uncertainty in

the other variables

•

as well. This process is facilitated by performing the analysis with

the aid of a

•

computer spreadsheet.

MANAGING POLITICAL RISK

MANAGING POLITICAL RISK

•

Political risk management means more than

computing the probability of political risk events

•

occurring. Even after a project is accepted and

implemented, political risk must continue to be

•

monitored. An MNC should develop a strategy

that minimizes the chances that political risk

•

events will materialize. They should also

determine what actions they will take if political

risk

•

events do materialize. We discuss these strategies

and others in the following sections.

Structuring an Investment

•

When political risk is a factor, an MNC should

structure its investment so as to minimize the

•

chance that political risk events will adversely

affect its cash flows. Here is a short list of

actions

•

that could be taken:

Rely on unique supplies or

technology:

•

The MNC can make a government takeover

difficult without its cooperation by relying on

unique supplies coming in from its

headquarters or unique technology that is

difficult to operate without the collaboration

of the MNC.

Use local resources:

•

When the MNC hires local labor or borrows

funds locally, it

•

reduces the government’s incentive to close

down the plant.

Bargain with the government

•

Prior to making a major investment in a particular

•

country, the MNC can improve its position by negotiating

an agreement with the

•

host country regarding how profits the MNC earns will be

taxed and converted to

•

foreign currency. Developing relationships with government

officials can come in

•

handy if a political risk event occurs and a settlement must

be negotiated. Nevertheless,

•

bargaining with the current government can also backfire

when the government

•

turns over.

Hire protection:

•

In the case of kidnapping possibilities or violence—for

example,

•

because of local warfare—MNCs can hire bodyguards

or, at the extreme, employ private

•

military companies for protection. With conflicts raging

all around the globe, private

•

military companies have become an important global

business in their own right.

•

Many private military companies are no longer small

companies built by a few veteran

•

soldiers but are sophisticated companies that offer a

wide range of services.

Focus on the short term:

•

Anshuman et al. (forthcoming) formally motivate front-

loading

•

cash flows in cases where expropriation risk is high. If

possible, the MNC can try to

•

repatriate cash flow early. It can also sell assets to local

investors or the government in

•

stages rather than reinvesting funds for the long haul.

Insurance

•

Perhaps the clearest indication that political risk is a

cash flow risk is that it is an insurable risk. If MNCs can

fully insure against all possible risk events and are fully

compensated for their losses, subtracting the insurance

premium from the expected cash flows suffices to

account for political risk. The reality is much different,

however. Full insurance is impossible to purchase.

Because cash flows are uncertain, it is typically difficult

to insure an amount more than the current investment.

Nevertheless, political risk insurance is available from

an increasingly wide variety of sources.

•

There are three potential sources of political risk insurance:

international organizations

•

aimed at promoting foreign direct investment (FDI) in developing

countries, government

•

agencies, and the private market. Among international

organizations providing insurance, the

•

World Bank’s Multilateral Investment Guarantee Agency (MIGA),

the Inter-American

•

Development Bank (IDB), and the Asian Development Bank (ADB)

are the best known.

•

Most Organization for Economic Cooperation and Development

(OECD) countries have

•

national agencies that provide domestic companies with political

risk insurance.

Questions

•

What are three political risk factors?

•

What economic variables would give some

indication of the country risk present in a

particular country?

•

Describe the differences between country risk

and political risk.