Lecture IV

Country Risk Assessment Methodologies: the Qualitative, Structural Approach to Country Risk

–The Welfare and Social Dimension-

Risk Analysis: Why?

The globalisation of the world’s trade, financial and technology markets and the emergence of new economies have created a new world environment, full of opportunities, but fraught with uncertainty and spill-over risks.

Country Risk: DEFINITION

It’s the possibility that a foreign country’s: borrower (financial investment); Importer/producer (trade and sub-contracting) Corporate partner (FDI)May be UNABLE or UNWILLING to fullfill its

contractual obligations toward a: Foreign lender; Exporter; Investor.

Risk Analysis and Investment Decision

Two possible way to include Risk in our investment decision (NPV): Expected Value of Profit (EV)

probability of a negative event; Adjust the Discount Rate risk

premium. Which are the sources of risk? How can we measure it?

Sources of Risk (1)

Natural Disasters; Tsunami; Earthquake;

Socio-Political Risks: Social Risk;

• Boycott;• Terrorism;• Strikes;• Religion and racial problems;

Government Policy Risk:• Trade restrictions;• Legal enforcement;• Loan repudiation;• Foreign exchange controls;• Expropriation.

Political Risk:• War;• Nationalisation.

Sources of Risk (2)

Country-Specific Economic risk Macroeconomic Risks:

• Exchange rate;• Hyperinflation;• Terms of Trade;• Debt Service.

Microeconomic Risks:• Market Failure;• Market Inefficiency.

Supranational Level risk of contagion!

How can we measure Country Risk?

The Quantitative ApproachThe Quantitative Approach (Lecture VII): Ratio, indices and ratings; Reduces a complex situation into a number/letter; Cross-country and cross-time comparison; Shortcomings:

Similar ratio and financial indicators BUT different socio-economic structure;

Quantitative data not available on time, incomplete, wrong or distorted;

Interpretation is difficult;

SOL: integrate with qualitative data to account for volatility and regional contagion.

The Qualitative Approach (1)

Qualitative Approach (SWOP):Qualitative Approach (SWOP): Assessment of the economic, financial

and socio-political fundamentals that can affect the investment return prospects in a foreign country;

Describes/identifies the structure of a country’s development strategy/process by shedding light on:

Strengths and opportunities; Weaknesses and threats.

The Qualitative Approach (2)

A robust qualitative approach leads to comprehensive country risk report that includes the following six elements:

Social and welfare dimension of the development strategy;

Macroeconomic fundamentals; External indebtedness evolution, structure

and burden; Domestic financial system situation; Assessments of the governance and

transparency issues; Evaluation of the political stability.

Social and Welfare Dimension

Development: Definition; Measurement;

Poverty: Definition; Measurement;

Inequality: Definition; Measurement;

✔ ✔ Impact on Country Risk AssessmentImpact on Country Risk Assessment

What is Development?

Adam Smith (1774) “Wealth of Nations”;

Recent years distinctive analytic and methodological identity:

NARROW INCOME Def BROADER BASIC NEED

A Narrow Definition of Development

“The capacity of a national economy, whose initial economic condition has been more or less static for a long time, to generate and sustaingenerate and sustain an annual increase in its gross national product (GNP) at rates of perhaps 5% to 7%”;

OR “ rates of growth of income per capita or per capita GDP”.

ADVANTAGES: easily to measure and understand DISADVANTAGES: experience 1950s 1960s:

“growth without human development”

The Broader Basic Needs Approach

Three basic components: Ability to meet basic needs;

(food, shelter, health and protection) Self-esteem;(self respect and cultural identity) Human Freedom(emancipation from material conditions,

ignorance, misery)

Three objectives of Development

Increase the availability and distribution of basic goods;

Raise the living standards: higher income; better jobs; better education; cultural and humanistic values.

More economic and social choices.

Development: Income measurement

GDP = Gross Domestic Product; final output

GNP = Gross National Product; total income

GDP and GNP per capita; Purchasing Power Parity (PPP):

DEF: This purchasing power rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods.

Different purchasing power of US$1 in different countries;

better than Exchange Rate (underestimate real value of income in LDC).

Countries Classification (per capita GNP in 2000)

Low-Income: < 755 US$ Lower Middle Income:

[$756 - $2995] Upper Middle Income

[$2996 - $755]

High Income OECD and other Countries

> $ 9265

Developing Countries

Development: Non-Income Measurement (1)

A long and Healthy Life Life expectancy at birth (age);

Knowledge: Adult Literacy Rate (% aged 15 and above); Gross enrollment ratio in education (%)

A decent Standard of Living: GDP per capita (PPP US$)

Composite Indicator UNDP Human Development Index: Low Human Development [0.00 – 0.49]; Medium [0.5 – 0.799]; High [0.8 – 1].

Development: Non-Income Measurement (2)

Are there other useful development indicators? Urban population % (urbanisation) Percentage under 15 years old (age

structure); Gender structure;

Gender-Related Development Index (GDI); Gender Empowerment Measure (GEM)

Number of computers per 1,000 inhabitants; Health care.

Social and Welfare Dimension: Development

Economic Growth VS Development Not only GDP growth but also:

Self-sustaining development; Enlarging people’s choice/rights;

Democracy; Robust and stable institutions;

Decent standard of living: Access to education; Nutrition and health; Political and cultural freedom.

Basic components of country risk and close close correlationcorrelation between HDI and country risk (ex. Sierra Leone) but not the reverse (ex. Cuba!)

What is Poverty?

Poverty is a complex and multi-dimensional concept: Material aspects; Non material aspects; Personal features (age, gender, race); Location

cannot be fully captured by the income level!

Three Perspectives on Poverty

Income Need Perspectives: Being below a defined poverty line;

Basic Need Perspective: no minimal acceptable fulfilment of

human needs; Capability Perspective

physical; non-physical needs and functionings.

Measuring Poverty

1st STEP: IDENTIFICATION 2nd STEP: AGGREGATION

i.e. how identify the poor people in society and once identified how summarise (aggregate) the information on them into an useable and meaningful measure of poverty

(Amartya Sen)

Identification

A) Objective indicators of poverty: Income or Expenditure? Unit of analysis: Household, Families or

Individuals? Adjusting for differences in household

size and composition: equivalence of scale

B) Subjective Indicators of Poverty

Basic needs: adequate clothing, food and shelter, health and education;

Measure: Human Poverty Index (HPI):Human Poverty Index (HPI): Decent Standard of Living:

% of pop not using an improved water source; % of chinldren under weight for age;

Knowledge/Adult Illiteracy Rate: % of illiterate people aged > 15;

A long and healthy life: Prob at birth of not surviving to age 40 (60 in OECD

countries); HDI Achievements Weak relationship between objective indicator of

poverty and HPI.

Aggregation:The Poverty Line

1° step: choose and indicator of well-being;

2° step: define a threshold or poverty line; 3° step: population below the PL are poor. Absolute (Sen) Poverty as an concept Relative (Atkinson)

Growth & Poverty

Growth reduces poverty;

BUT it depends on two factors:

The type of growth; The initial level of inequality (share of population just below the poverty line

VS extreme poverty).

Poverty and Growth

Poverty may be a barrier to growth: Vicious circle and poverty traps: high

poverty leads to low growth and low growth leads to high poverty!

Which channels? Poverty deters investment and growth

especially where the degree of financial development is limited;

But also through a negative impact on education, health and innovation!

 

     

                    

                    

                    

                    

                    

                  

                

                   

Millenium Development Goals

References

Bouchet, Clark and Groslambert (2003): “Country Risk Assessment”, Wiley finance (Chapter 4).

Human Development Report –UNDP web site-

McCulloch, N.; Winters, A. and Cirera, X. (2002): “Trade Liberaliation and Poverty: an Handbook”, Chapter3 “Poverty and the poor”, eds. CEPR

Perry, G. et all (2006): ”Poverty Reduction and Growth: Virtuous and Vicious Circles”, World Bank Report