Country risk analysis

by Zhing Siang Boon

Country risk is the risk of investing or doing international trade in other country such as foreign exchange risk, political risk and default risk (Oetzel 2001). The bank will consider political and economic situations of a country in place of country risk analysis (Mazzotta 2008). Such analysis was invented to help the bank make decision on the acceptability of risk and adequacy condition for the loan.

Early twentieth-century, bankers mainly used experiential approach to country risk analysis, namely traditional country risk in the individual situation (Mehta 2004). This article explores, discuss and analyse the traditional country risk analysis and the development of new approaches to query on their effectiveness.

There are two scopes in traditional country risk analysis which are political and economic. The political analysis scrutinises the law and political perspective of country risk, while the economic analysis emphasis on the financial aspect of the country (Gonzalez 2005). A focus on the major shortcomings of the current account is the absence of capital account of hypothesis of inactive flows of capital (Mehta 2004).

Financial investigation must take into account the balance of international payments instead of only current account. Autonomous capital flows require more attention as they can conceal a looming debt crisis, though the assets show a glowing level (Eichler 2012). Other than that, long-term directly in the low priority industry investment flows may increase in the power of inflation which will then decrease the competitiveness of traditional exports adversely (Saini 1984).

Default probability is the rating score from periodicals such as Euro money or institutional investor. Such score range is from 0 to 100 and 100 represented the most anticipated country risk score.

However, problem arises with the use of this default probability as it only links the index with a set of assumed features and unable to forecast the probability of non-payment by a country accurately. Those institutional investors score was the survey responses of individual bankers, and it can show their personal analysis of national credit (Mehta 2004).

Traditional country risk analysis involved many economic indicators which are based on the financial performance including liquidity, debt structure, profitability and willingness to pay (Mehta 2004). Different ratios used to measure a country’s liquidity have been used by banks on behalf of debt service. This measure was proportion of export revenue of debt service obligations.

In addition, foreign exchanges reserves of the country are the proportion of imports. A lower ratio in these cases showed a weaker gauge of liquidity suitability. Therefore, it was negatively correlated with country risk (Alquist 2010).

Debt structure between a country and a firm is same and it is used to reflect the financial risk of the entity. A ratio concerning debt to gross national product (GNP) also can be used to measure country’s debt structure. A greater number shows larger country risk (Fuest 2011).

By measuring probability, prospective for making profits in a particular country can be reflected by measuring growth of income, growth of exports, and growth in GDP of such country. High profitability is beneficial for both generation of larger liquidity and the enhancement of future capital inflows.

A country willingness to repay its debts can be reflected by the measurement of a ratio of imports to GDP. This is due to the fact that default in payments may adversely affect the economic condition of that particular country (Mehta 2004).

The political factors in country risk analysis are essential as the political reality may be more volatile than in the near future. For instance, revolution in Iran, war in Lebanon and the Russia attacked Afghanistan in the year 1970 will influence the solvency of countries (Goodwin 2008).

There are some factors such as malpractice of economy and prevalent corruption will cause the government fail to meet its responsibilities (Garitt 2012). The impact of political risk divided into three variables namely armed conflict, governmental regime shift and political legitimacy. Among these three factors, government regime shift had the greatest influence on solvency of a country.

The allocation of international asset is aim to receive higher returns with lower risk. However, the following issues will arise when bank offered loan for sovereign governments by using the portfolio approach. Firstly, estimation of expected return and its instability are difficult to calculate because it only depends on the probability of appropriate settlement of principal and interest which is excluded on the loan documentation and thus it is not easy to calculate.

As a measure of country risk, agency credit ratings are the most reliable recently. This is because they can contribute a good scale with which to assess its cross-sectional distribution. The main purpose of sovereign credit ratings is that banks can access the borrowers from 0 to 100 based on the institutional investor ratings.

Macroeconomics factors such as inflation and growth, the external debt burden, deputations for liquidity and the fiscal situation will be reflected by using the measures of sovereign credit ratings. Average rating of Moody’s, Standard and Poor’s are more reliable than a single rating. Thus, banks can estimate the default rate of the country from the credit ratings report (Borio 2012). Explicitly, various deputations for hedging possibilities relevant to the exchange and derivatives statistics have been added.

On the other hand, the size of the country is also important in the measures of country risk. International banks able to determine the creditworthiness of a particular country who want to apply for loans by analysing the off-balance sheet. This analysis can make an assumption by banks to consider whether losses on assets that deplete bank capital partially or fully. All losses will appear in the off-balance sheet. If losses are large, banks can restore their capital adequacy (Marhavilas 2011).

Boon Zhing Siang is a third-year Bachelor of Commerce Banking and Finance student of Curtin Sarawak. His interest is in foreign exchange traded market as well as the solutions to mitigate various types of risk faced by organisations. 

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