Economic Risk

Like political risk, we first encountered the concept of economic risk in Chapter 2. There we defined it as the likelihood that economic mismanagement will cause drastic changes in a country's business environment that hurt the profit and other goals of a business enterprise. In practice, the biggest problem arising from economic mismanagement seems to be inflation. Historically, many governments have expanded their domestic money supply in misguided attempts to stimulate economic activity. The result has often been too much money chasing too few goods, resulting in price inflation. As we saw in Chapter 9, price inflation is reflected in a drop in the value of a country's currency on the foreign exchange market. This can be a serious problem for a foreign firm with assets in that country because the value of the cash flows it receives from those assets will fall as the country's currency depreciates on the foreign exchange market. The likelihood of this occurring decreases the attractiveness of foreign investment in that country.

There have been many attempts to quantify countries' economic risk and long-term movements in their exchange rates. Euromoney's annual country risk rating (Table 20.1) incorporates an assessment of economic risk in its calculation of each country's overall level of risk. As we saw in Chapter 9, there have been extensive empirical studies of the relationship between countries' inflation rates and their currencies' exchange rates. These studies show that there is a long-run relationship between a country's relative inflation rates and changes in exchange rates. However, the relationship is not as close as theory would predict; it is not reliable in the short-run and is not totally reliable in the long run. So, as with political risk, any attempts to quantify economic risk must be tempered with some healthy skepticism.

Risk and Capital Budgeting

In analyzing a foreign investment opportunity, the additional risk that stems from its location can be handled in at least two ways. The first method is to treat all risk as a single problem by increasing the discount rate applicable to foreign projects in countries where political and economic risks are perceived as high. Thus, for example, a

Rank

			Change									Debt in				Access to	Access to	Access to	Discount
Sep		Dec	Sept-				Total	Political	Economic	Debt		default or		Credit		bank	short-term	capital	on
98		97	Dec				score	risk	performance	indicators		rescheduled		ratings		finance	finance	markets	forfeiting
					Weighting:	100		25	25	10		10		10		5	5	5	5
	1	2		1	Luxembourg	98.90		24.76	25.00		10.00		10.00		10.00	5.00	5.00	5.00	4.14
	2	1		-1	United States	97.85		24.97	22.88		10.00		10.00		10.00	5.00	5.00	5.00	5.00
	3	6		3	Germany	97.06		24.89	22.21		10.00		10.00		10.00	5.00	5.00	5.00	4.96
	4	3		-1	Netherlands	96.92		24.84	22.57		10.00		10.00		10.00	5.00	5.00	5.00	4.50
	5	10		5	Austria		96.79	24.19	22.65		10.00		10.00		10.00	5.00	5.00	5.00	4.95
	6	7		1	Switzerland	96.43		25.00	21.45		10.00		10.00		10.00	5.00	5.00	5.00	4.99
	7	11		4	France		95.87	24.22	21.69		10.00		10.00		10.00	5.00	5.00	5.00	4.96
	8	4		-4	Norway		95.83	22.91	23.03		10.00		10.00		10.00	5.00	5.00	5.00	4.89
	9	5		-4	United Kingdom	95.01		25.00	20.04		10.00		10.00		10.00	5.00	5.00	5.00	4.97
	10	12		2	Ireland		94.87	23.02	22.61		10.00		10.00		9.57	5.00	5.00	5.00	4.66
	11	9		-2	Denmark	94.67		23.74	21.91		10.00		10.00		9.36	5.00	5.00	5.00	4.66
	12	13		1	Finland		94.52	22.54	22.47		10.00		10.00		9.57	5.00	5.00	5.00	4.93
	13	14		1	Belgium		94.25	23.72	21.01		10.00		10.00		9.57	5.00	5.00	5.00	4.95
	14	15		1	Sweden		93.39	23.25	21.49		10.00		10.00		8.72	5.00	5.00	5.00	4.93
	15	8		-7	Canada		93.02	22.98	21.21		10.00		10.00		8.94	5.00	5.00	5.00	4.89
	16	19		3	Spain		92.01	22.24	21.33		10.00		10.00		9.15	5.00	4.64	5.00	4.64
	17	20		3	New Zealand	91.34		22.23	19.86		10.00		10.00		9.36	5.00	5.00	5.00	4.89
	18	22		4	Italy		91.10	21.66	20.57		10.00		10.00		8.94	5.00	5.00	5.00	4.93
	19	17		-2	Australia		90.91	22.60	20.51		10.00		10.00		8.72	5.00	5.00	5.00	4.07
	20	21		1	Portugal		90.73	21.76	21.34		10.00		10.00		8.94	5.00	4.64	5.00	4.04
	21	16		-5	Singapore	89.17		23.29	19.24		10.00		10.00		9.68	5.00	4.64	4.30	3.02
	22	24		2	Iceland		89.03	21.38	21.17		10.00		10.00		7.77	5.00	4.64	5.00	4.07
	23	18		-5	Japan		88.02	23.39	15.85		10.00		10.00		10.00	5.00	5.00	5.00	3.79
	24	23		-1	Taiwan		86.49	22.28	19.52		10.00		10.00		8.72	5.00	4.64	3.30	3.02
	25	26		1	Cyprus		81.92	18.69	18.22		10.00		10.00		7.45	5.00	4.64	5.00	2.92
	26	47		21	Malta		81.75	19.84	21.94		10.00		10.00		6.81	5.00	4.64	0.00	3.52
	27	32		5	Greece		79.61	18.03	18.01		10.00		10.00		4.89	5.00	4.64	5.00	4.04
	28	27		-1	United Arab	79.38		19.20	17.51		10.00		10.00		6.81	5.00	4.02	3.30	3.54
					Emirates
	29	28		-1	Kuwait		77.70	18.34	17.50		10.00		10.00		6.38	5.00	4.40	2.72	3.36
	30	31		1	Chile		76.60	18.56	17.29		8.63		10.00		5.96	5.00	3.75	3.40	4.02
	31	33		2	Israel		76.06	17.22	15.96		10.00		10.00		6.17	5.00	4.35	3.77	3.59
	32	25		-7	Hong Kong	75.75		19.32	16.20		10.00		10.00		7.02	5.00	5.00	3.21	0.00
	33	37		4	Slovenia		74.49	17.56	17.34		9.57		10.00		6.38	3.04	3.45	3.58	3.56
	34	34		0	Saudi Arabia	73.68		17.43	15.20		10.00		10.00		4.26	5.00	4.64	3.68	3.47
	35	41		6	Qatar		72.68	16.77	14.53		10.00		10.00		4.89	5.00	4.64	3.30	3.54
	36	42		6	Bahrain		71.97	15.77	16.52		10.00		10.00		3.62	5.00	4.64	3.06	3.36
	37	43		6	Oman		71.47	16.74	14.23		10.00		10.00		4.57	5.00	4.64	3.11	3.18
	38	48		10	Poland		71.11	17.60	18.45		9.50		10.00		4.47	0.22	3.21	3.87	3.79
	39	45		6	Hungary		71.06	17.16	17.84		8.02		10.00		4.68	3.58	2.44	4.06	3.29
	40	44		4	Czech Republic	71.01		17.58	16.99		9.34		10.00		5.96	1.14	3.15	3.96	2.88
	41	39		-2	China		67.26	17.08	16.32		9.65		10.00		5.96	0.01	2.68	2.83	2.74
	42	30		-12	South Korea	64.47		15.11	14.06		10.00		10.00		3.62	5.00	3.87	2.26	0.55
	43	52		9	Tunisia		63.43	15.43	15.16		8.86		10.00		4.26	0.10	3.45	3.02	3.15
	44	58		14	Uraguay		62.88	13.06	17.42		9.19		10.00		4.26	0.05	3.33	2.74	2.83
	45	56		11	Colombia	62.85		13.31	13.68		8.59		10.00		4.26	3.09	3.51	3.11	3.29
	46	99		53	Trinidad & Tobago	61.99		17.74	16.52		9.02		10.00		3.62	0.00	3.21	1.89	0.00
	47	50		3	Mexico		61.75	14.25	15.16		8.38		10.00		2.98	1.69	3.48	3.30	2.51
	48	54		6	Argentina	61.33		13.73	15.58		8.36		10.00		2.77	1.05	4.17	3.40	2.29
	49	62		13	Egypt		61.22	14.83	15.01		9.12		9.93		4.04	0.00	2.50	2.64	3.15
	50	46		-4	South Africa	61.09		14.96	13.26		9.53		10.00		3.62	0.07	3.51	3.40	2.74
	51	60		9	Estonia		61.08	13.52	15.88		9.95		10.00		5.32	0.00	2.01	2.49	1.92
	52	63		11	Botswana	59.85		15.90	19.05		9.81		10.00		0.00	0.00	3.51	1.58	0.00
	53	35		-18	Malaysia	59.70		15.25	12.47		9.28		10.00		4.47	3.22	3.51	1.51	0.00
	54	51		-3	Thailand		59.24	14.00	12.26		9.05		10.00		3.83	4.23	2.98	2.26	0.64

			Change									Debt in				Access to	Access to	Access to	Discount
	Sep	Dec	Sept-				Total	Political	Economic	Debt		default or		Credit		bank	short-term	capital	on
	98	97	Dec				score	risk	performance	indicators		rescheduled		ratings		finance	finance	markets	forfeiting
					Weighting:	100		25	25	10		10		10		5	5	5	5
55		57		2	Philippines	58.42		13.69	14.54		9.04		10.00		3.62	1.30	3.33	2.17	0.73
56		69		13	Morocco	57.90		13.10	14.04		8.42		10.00		3.30	0.12	3.10	2.94	2.88
57		64		7	Latvia		57.65	12.65	13.99		9.92		10.00		4.89	0.00	2.01	2.26	1.92
58		61		3	Slovak Republic	57.35		13.11	13.08		9.17		10.00		4.04	1.66	2.22	2.60	1.46
59		53		-6	India		57.11	14.46	13.86		9.05		10.00		3.30	0.14	1.67	2.17	2.47
60		68		8	Costa Rica	56.28		13.48	16.94		9.16		10.00		2.98	0.00	3.15	0.57	0.00
61		59		-2	Turkey		56.22	13.48	13.72		8.86		10.00		1.49	1.35	3.21	2.64	1.46
62		70		8	Lithuania	56.20		11.60	14.21		9.79		10.00		3.83	0.30	2.01	2.55	1.92
63		66		3	Jordan		55.15	12.89	15.21		8.09		9.33		2.34	0.00	1.79	2.45	3.04
64		114		50	Dominican Republic	54.80		16.82	14.34		9.30		9.93		1.70	0.00	2.32	0.38	0.00
65		86		21	Jamaica		54.38	16.36	12.56		8.22		10.00		2.34	0.00	2.92	1.98	0.00
66		72		6	Croatia		54.29	11.97	13.65		9.61		5.59		4.26	1.87	1.64	2.83	2.88
67		65		-2	El Salvador	53.03		10.95	14.53		9.45		10.00		3.62	0.00	3.21	1.27	0.00
68		73		5	Lebanon		53.01	11.13	10.65		9.47		10.00		2.13	1.73	1.96	2.92	3.02
69		36		-33	Brunei		52.79	20.55	0.00		10.00		10.00		0.00	5.00	4.40	2.83	0.00
70		67		-3	Brazil		52.56	11.69	12.92		8.57		9.98		1.91	1.70	1.55	2.83	1.42
71		55		-16	Panama		51.40	12.56	16.44		8.55		3.35		4.26	0.59	3.48	2.17	0.00
72		75		3	Peru		50.43	10.89	14.51		8.37		7.25		2.66	0.16	2.62	2.04	1.92
73		76		3	Guatemala	49.37		9.31	13.97		9.45		10.00		2.98	0.00	3.10	0.57	0.00
74		131		57	St Lucia		48.04	18.78	6.59		9.67		10.00		0.00	0.00	2.62	0.38	0.00
75		81		6	Paraguay	47.83		10.10	13.03		9.64		10.00		1.70	0.07	2.92	0.38	0.00
76		71		-5	Venezuela	47.33		9.83	11.66		8.87		10.00		1.91	0.39	2.86	1.81	0.00
77		38		-39	Mauritius	47.32		15.44	0.00		9.30		10.00		4.89	0.27	3.51	1.98	1.92
78		84		6	Bolivia		47.16	11.26	12.88		8.03		8.83		2.02	0.91	2.08	1.13	0.00
79		87		8	Papua New Guinea	47.15		10.48	12.22		9.05		10.00		0.00	2.16	2.86	0.38	0.00
80		80		0	Fiji		46.91	11.32	13.10		9.87		10.00		0.00	0.00	2.62	0.00	0.00
81		82		1	Kazakhstan	46.73		7.50	12.02		9.64		10.00		2.55	1.66	1.56	1.79	0.00
82		74		-8	Romania	46.25		10.27	9.60		9.41		10.00		2.13	0.05	1.98	1.36	1.46
83		83		0	Sri Lanka	45.65		10.53	12.64		9.06		10.00		0.00	0.00	2.38	1.04	0.00
84		40		-44	Bahamas	44.89		19.02	12.79		0.00		0.00		6.17	0.00	4.64	2.26	0.00
85		79		-6	Ghana		44.87	10.61	11.18		7.89		9.86		0.00	2.57	2.38	0.38	0.00
86		100		14	Ecuador		44.84	8.13	12.35		8.27		9.97		1.70	0.00	2.92	1.51	0.00
87		77		-10	Vietnam		43.97	10.11	11.04		8.33		9.91		1.70	0.00	1.96	0.91	0.00
88		49		-39	Indonesia	43.56		8.89	8.49		8.18		10.00		0.21	3.97	2.50	1.32	0.00
89		110		21	Iran		43.26	10.74	9.66		9.92		10.00		0.00	0.00	1.16	0.23	1.55
90		95		5	Zimbabwe	43.22		9.40	9.81		8.50		10.00		0.00	1.25	3.21	1.04	0.00
91		90		-1	Uganda		43.00	7.85	14.09		8.65		10.00		0.00	0.00	2.02	0.38	0.00
92		97		5	Côte d'Ivoire	42.71		8.73	11.37		6.41		9.78		0.00	2.61	2.68	1.13	0.00
93		101		8	Bulgaria		42.30	9.40	10.30		7.95		9.98		1.38	0.43	1.55	1.32	0.00
94		98		4	Gabon		42.26	8.66	13.72		8.53		8.47		0.00	0.00	2.50	0.38	0.00
95		106		11	Senegal		42.24	7.74	13.31		8.60		9.78		0.00	0.00	2.44	0.38	0.00
96		93		3	Bangladesh	41.45		8.24	11.55		9.04		10.00		0.00	0.00	2.38	0.23	0.00
97		89		-8	Barbados	41.43		16.21	6.90		0.00		10.00		3.62	0.00	3.57	1.13	0.00
98		96		-2	Kenya		40.97	8.96	10.47		8.20		10.00		0.00	0.00	2.32	1.02	0.00
99		103		4	Syria		40.58	9.43	9.23		8.11		10.00		0.00	0.00	1.25	0.28	2.29
100		108		8	Mali		40.47	7.96	11.94		7.91		9.91		0.00	0.00	2.38	0.38	0.00
101		158		57	Guyana		40.44	13.24	11.24		6.53		7.62		0.00	0.00	1.43	0.38	0.00
102		136		34	Honduras	40.32		8.37	10.86		7.66		9.79		0.00	1.06	2.20	0.38	0.00
103		111		8	Algeria		39.64	9.38	10.25		8.20		8.47		0.00	0.00	1.96	1.02	0.37
104		143		39	St. Vincent	39.41		17.47	0.00		8.71		10.00		0.00	0.00	2.86	0.38	0.00
					& Grenadines
105		92		-13	Uzbekistan	39.03		5.55	10.62		9.75		10.00		0.00	0.00	1.55	1.56	0.00
106		91		-15	Nepal		38.80	9.61	6.90		9.11		10.00		0.00	0.00	2.80	0.38	0.00
107		102		-5	Yemen		38.73	8.30	10.19		8.30		10.00		0.00	0.00	1.56	0.38	0.00

			Change										Debt in				Access to	Access to	Access to	Discount
	Sep	Dec	Sept-					Total	Political	Economic	Debt		default or		Credit		bank	short-term	capital	on
	98	97	Dec					score	risk	performance	indicators		rescheduled		ratings		finance	finance	markets	forfeiting
					Weighting:		100		25	25	10		10		10		5	5	5	5
108		161		53	Haiti		38.16		7.39	10.16		9.22		9.97		0.00	0.00	1.43	0.00	0.00
109		162		53	Grenada		37.76		15.25	0.00		9.52		10.00		0.00	0.00	2.62	0.38	0.00
110		146		36	Dominica			37.75	15.51	0.00		9.24		10.00		0.00	0.00	2.62	0.38	0.00
111		148		37	Mongolia		37.71		7.09	10.31		9.04		10.00		0.00	0.00	0.89	0.38	0.00
112		105		-7	Burkina Faso			37.71	5.99	10.70		9.07		9.52		0.00	0.00	2.14	0.28	0.00
113		137		24	Ethiopia		37.51		5.42	13.88		6.40		10.00		0.00	0.00	1.43	0.38	0.00
114		29		-85	Bermuda			37.38	21.53	0.00		0.00		0.00		8.94	0.00	4.64	2.26	0.00
115		112		-3	Benin		37.33		3.77	13.41		8.86		8.88		0.00	0.00	2.02	0.38	0.00
116		142		26	Azerbaijan			37.28	5.00	10.43		9.89		10.00		0.00	0.00	0.89	1.06	0.00
117		128		11	Madagascar		36.83		8.04	9.02		8.32		10.00		0.00	0.00	1.07	0.38	0.00

Euromoney Risk Assesment						Euromoney's assessment of country risk uses three categories. These are analytical indicators, 40%; credit indicators, 20%; and market indicators, 40%. These offer a broad but sensitive evaluation of the relative risks faced by exposure in these countries.
Analytical Indicators						This 40% is made up of political risk, 20%; economic risk, 10%; and economic indicators, 10%. Political risk is a measure of stability and the potential fallout from any instability. The economic indicators consist of three key ratios: the debt-service-to-export ratio as a measure of liquidity, and balance-of-payments-to-GNP and external-debt-to-GNP as measures of solvency. As these are historical, the prospective view of economic performance to 1993 is used to gauge economic risk.
Credit Indicators						This 20% is made up of payment record, 15% and ease of rescheduling, 5%. Ease of rescheduling indicates a country's general creditworthiness in the face of temporary liquidity problems.
Market Indicators						These consist of access to bond markets (FRN, straight, and Yankee), 15%; availability of short-term finance, 10%; and access to and discount available on forfeiting, 15%. Bond market access is fine-tuned by considering access to syndicated loans, credit ratings, and secondary market spreads. The attitudes of the market to countries will incorporate analytical and credit indicators, but its favor can be crucial to sustaining a country's economy as well as maintaining liquidity for its sovereign debt in the secondary markets.

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