International Financial Management Country Risk Analysis PDF

International Financial Management International Financial Management Country Risk Analysis & Credit Ratings Chief Asst. Prof. T. Tzanov, Ph.D. © Tzvetomir Tzanov, Ph.D., © T.Tzanov,...

International Financial Management International Financial Management Country Risk Analysis & Credit Ratings Chief Asst. Prof. T. Tzanov, Ph.D. © Tzvetomir Tzanov, Ph.D., © T.Tzanov, Ph.D, UNWE  International Financial Management Outline Concept background & definitions Factors influencing country risk Examples, empirical data Assessing risks – methodologies Country risk ratings and agencies Credit ratings and credit rating agencies (CRA) Country default spreads and risk premiums Insurance against country risk Structural decisions Funding from external sources © T.Tzanov, Ph.D, UNWE  International Financial Management Background Since long ago cross-border business risks – important issue for those with transactions/assets in foreign countries. Turn of XXth century, 1960s, 1970s. Late 70s – high liquidity, plenty of dollars coming mostly from OPEC countries, reinvested by banking financial institutions mainly in developing countries (enhanced foreign exposure). As of 1980s – problems (country level) with repayment of those credits: Poland, Mexico, Brazil, etc. New analytical data, strong credit procedures – financial institutions. Relevance as of today. The same for MNCs – when implementing foreign financing and investment decisions. © T.Tzanov, Ph.D, UNWE  International Financial Management Definitions Country risk – potentially adverse impacts associated with the macro environment that are inflicting the investments and other business operations in a particular country. Combination of risks associated with doing business in a foreign country. These include political risk, economic risk, sovereign risk, ER risk and transfer risk (locking or freezing MNC’s capital by a host government action). Thus, implications over the financial performance (profits, cash flows, value of assets). Risks can reduce the expected returns on an investment. Impact on MNC’s foreign operations, in particular. © T.Tzanov, Ph.D, UNWE  International Financial Management Country risk analysis Scope and components: Country risk analysis took off in the 1970s in response to banking sector’s attempts to measure its exposure to cross- border lending. Later on – stressing on transfer risk – the risk that a government may impose restrictions on payments abroad. Provided that governments became major bank borrowers – sovereign risk (inability to honour external obligations). Political risk – came to be used rather on industrial (firm level) – to describe adverse foreign events of political, but also macroeconomic, social nature, that might affect businesses. Nowadays ‘country risk’ synonymous with cross-border risk or international business risk. © T.Tzanov, Ph.D, UNWE  International Financial Management Assessment Assessment of country risk – analysis of appropriate factors and national governments’ policies. Factors, such as financial & macroeconomic indicators, e.g.: currency controls, currency devaluation. Policies such as regulatory changes, stability factors – strikes, civil war, etc. Non-financial MNCs tend to focus on investment climate factors (political & economic risks). Financial MNCs – mainly interested in a entity’s/ country’s ability to service its foreign debts. © T.Tzanov, Ph.D, UNWE  International Financial Management Country risk assessment & IFM Financing decisions /Investment decisions © T.Tzanov, Ph.D, UNWE  International Financial Management Assessing country risk Quantitative approach (econometrics, modeling) and qualitative analysis (analytical, experts’ opinions). Institutes, institutions, credit rating agencies - different methodologies to assess and rate countries' comparative risk exposure. Credit rating agencies - quantitative econometric models, focus on macroeconomic and financial data. Political risk providers - qualitative methods, focus also on political, legal, regulatory parameters. Rating and scoring. There is NO consensus on a single methodology in assessing country risk. © T.Tzanov, Ph.D, UNWE  International Financial Management Analytical instrument and purposes Analytical instrument: (1) Country risk analysis can be used to monitor countries where the MNC is currently doing business; (2) Or, as a screening device to assess and select potential destinations for locating of operations/subsidiaries. Scope: Macro level, affecting all companies entering specific country. Micro – selected industries, firm level. Data processed and provided: (1) analysts – own MNC structure; (2) credit departments (financial institutions); (3) rating agencies; (4) research institutions. © T.Tzanov, Ph.D, UNWE  International Financial Management Political risk – scope & methodology Political refers to risks affecting companies in relation mainly to particular political decisions and political environment factors. Country = Political risk? Country risk – more general term. Political risk services (PRS) methodology – developed by Koplin and O’Leary – identification of the three most likely future regime scenarios for respective country over two time periods and assignment of a probability to each scenario over each period, 18 months and 5 years. Letter grades (A+ to D-) for three investment areas: financial transfers (banking and lending), FDI and exports. © T.Tzanov, Ph.D, UNWE  International Financial Management Political risk assessment & empirics Scenarios when assessing political risk: Positive – no restrictions. Repatriation risk (foreign currency – assets, converted back to home currency); Expropriation risk (the State seizes private property without the owners’ consent); Probabilities – impact on MNC’s CF and profits. Empirical data: Expropriations – mining industry (12-18%), insurance and banking (4%), manufacturing (less than 1%). © T.Tzanov, Ph.D, UNWE  International Financial Management Political risk & IFM decisions Consider a particular investment project abroad: Return on investment (ROI) = 15% How to deal with political risk? Scenarios – probability distribution: ROIp = 15% (positive scenario, no restrictions – no risk) – probability 0.99; ROIn = -100% (negative scenario, expropriation) – probability 0.01. ROIadj = (0.99)(15%)+(0.01)(-100%)=13.85% © T.Tzanov, Ph.D, UNWE  International Financial Management Political risk examples Host countries policies to FDI in particular. FDI restrictions 70s – obligations for establishing of a JV with local company (India), China, liberalization – 90s. Subsidies – France (‘national champions’), Japan… E.g., decisions of country host governments – pollution control standards (higher costs), additional taxes, withholding taxes, etc. China (2004) enacted a law requiring computer chips to include security technology licensed by Chinese firms. In addition imposed 17% tax on computer chips sold there, but rebate of up to 14 per cent for chips Made in China. Blockage of fund transfers – loan repayments, purchase of supplies, remitted earnings. In case of blockage by local governments difficulties in operating the MNC. © T.Tzanov, Ph.D, UNWE  International Financial Management Economic risk & Sovereign risk Economic risk – potentially adverse impact on MNC’s foreign operations (investments) following an economic downturn/change (e.g. recession, inflation, etc.). Macroeconomic indicators – GDP, interest rates, exchange rates (demand for country’s exports), inflation, unemployment. Most of financial indicators – influenced by political risk factors/ decisions. Sovereign risk – probability that a government (agency backed by the government) will not comply with the terms of a loan agreement during volatile periods. © T.Tzanov, Ph.D, UNWE  International Financial Management BERI Business Environment Risk Intelligence S.A. Swiss-based private source for risk rating on over 130 countries. Created in the late 1960s, the oldest country risk assessment service. Delphi Method with a panel of 105 international experts rating 15 criteria for current and medium-term business horizon. 3 components of country risk: business climate, political stability, currency and repayment risk. FORELEND reports (Forecast of Country Risk for International Lenders). Two risk indexes three times a year: ORI Operations Risk Index and PRI Political Risk Index. © T.Tzanov, Ph.D, UNWE  International Financial Management Euromoney’s country risk ratings Bi-annual Country risk survey monitoring political and economic stability of 186 countries (up to 2022). Combination of data sources on various debt figures and ratings as well as economic experts’ opinion on economic projections and political situation within a country; Factors included in the ranking of countries by risk: - Political factors (30% weighting) - Economic performance (30%) - Structural assessment – qualitative: prod. factors (10%) - Debt indicators (10%) - Credit ratings (10%) - Access to bank finance (10%) Bulgaria’s ECR ranking – 52,18 (Sep. 2022) vs. 55,22 (Sep. 2020), vs. 48,99 (Sep. 2015). © T.Tzanov, Ph.D, UNWE  International Financial Management Credit ratings & CRA The Big 3 CRA: Moody’s Investors Service Fitch Ratings Standard & Poor’s Credit rating of Bulgaria’s Government debt and up-to-date credit ratings, published by the Ministry of Finance: Ministry of Finance :: Credit Rating (minfin.bg) Regulation of the CRA within the EU by ESMA - European Securities and Markets Authority): https://www.esma.europa.eu/ © T.Tzanov, Ph.D, UNWE  International Financial Management Moody’s risk ratings Moody’s Investors Service Sovereign risk assessment since 1909; Provider of credit ratings, research, and risk analysis; The firm's ratings and analysis track debt covering more than 110 countries, 12,000 corporate issuers, 25,000 public finance issuers, and 106,000 structured finance obligations; Rating Symbols Gradations of creditworthiness are indicated by rating symbols, with each symbol representing a group in which the credit characteristics are broadly the same. There are nine symbols as shown below, from that used to designate least credit risk to that denoting greatest credit risk: Aaa Aa A Baa Ba B Caa Ca C Bulgaria (BG): Baa1/Baa2 © T.Tzanov, Ph.D, UNWE  International Financial Management Fitch’s risk ratings Fitch Ratings – global rating agency; Fitch Ratings' credit ratings provide an opinion on the relative ability of an entity to meet financial commitments, such as interest, preferred dividends, repayment of principal, insurance claims or counterparty obligations. Credit ratings are used by investors as indications of the likelihood of receiving the money owed to them. The agency's credit ratings cover the global spectrum of corporate, sovereign (including supranational and sub-national), financial, bank, insurance, municipal and other public finance entities and the securities or other obligations they issue, as well as structured finance securities. Categories from AAA – BBB (investment grades); BB to D (speculative grade). BG: BBB. © T.Tzanov, Ph.D, UNWE  International Financial Management Standard & Poor’s ratings Independent provider of credit ratings, different industries – financial institutions, insurance, corporate; Governments ratings - rating the creditworthiness of public sector entities around the world such as state and local governments; municipal enterprises; bond insurers; sovereign nations; supranational issuers; healthcare systems, etc. Credit Ratings - based on analysis performed by professionals who evaluate and interpret information from a multitude of sources. Rating Symbols AAA AA+/- A+/- BBB+/- BB+/- B+/- CCC+/- CC+/- D NR BG: BBB positive/stable © T.Tzanov, Ph.D, UNWE  International Financial Management JCR Japan Credit Rating Agency Sovereign risk rating & public entities – assessing the debt- servicing capacity of a sovereign government. Risk factors evaluated – management of foreign exchange reserves, foreign exchange-rate policy, external debt structure, financial system, industrial structure. Stages of evaluation – quantitative evaluation synthetic analysis, qualitative and overall evaluation, predictive evaluation (one-year horizon). Rating Symbols AAA AA+/- A+/- BBB+/- BB+/- B+/- CCC+/- CC+/- © T.Tzanov, Ph.D, UNWE  International Financial Management Credit rating agencies – shortcomings By definition, RA are to be independent third parties, consulted in the course of a market transaction. The goal – to overcome asymmetric information between both market sides by using standardized quality assessement methods. Major Criticism: Power without accountability; Conformity & Sociocultural bias; Punishment of disobedient firms/countries that do not request a rating; Sometimes procyclical bias, hence followjng the majority opinion of market participants without early warning signals. Bad examples: Rep. of Korea before the crisis (1998) – investment grade AA- (Fitch, S&P), Lehman Brothers (A, A2 – Moody’s and S&P, 2 weeks before it filed for bankruptcy. © T.Tzanov, Ph.D, UNWE  International Financial Management COFACE Coface mainly trade credit insurance (intercompany credit) against the risk of customer’s default. Coface country risk assessment – evaluating the average credit risk of companies in a given country. Assessment based on economic, financial and political data, as well as Coface experience in the country. 3 levels of assessment: macroeconomic assessment, expert opinion on business environment, microeconomic expert assessment. Risk assessment of 165 countries. Rating symbols: А1, А2, А3, А4, В1, В2, В3, В4. Speculative: B, C, D. © T.Tzanov, Ph.D, UNWE  International Financial Management OECD credit rating Country Risk Classification Based on Knaepen Package (1999). Country Risk Assessment Method (CRAM) measures the country credit risk – ability for servicing its external debt. CRAM - econometric model based on quantitative indicators (e.g. the financial and the economic situation and the payment experience), taking into account possible qualitative factors (e.g. political and other economic and financial factors not included in the quantitative Econometric Model). The details of the CRAM - confidential and not published. Final classification, based on a consensus decision of the sub- Group of Country Risk Experts, involving country risk experts of the Participating Export Credit Agencies. © T.Tzanov, Ph.D, UNWE  International Financial Management OECD credit rating (2) The sub-Group of Country Risk Experts: every country is reviewed each time a fundamental change is noticed and at least once a year. 8 country risk categories: 0 (no risk) to 7 (high risk). Current developments – differentiation high-income countries Bulgaria’s rating: 3 (as of June 2018, relevant as of today). https://www.youtube.com/watch?v=W6k_s_onqDE (Accessed, 14 Oct. 2024). © T.Tzanov, Ph.D, UNWE  International Financial Management Other ratings & agencies - Economist Intelligence Unit (EIU) ratings; - Institutional Investor; - A.M. Best – historically the first in the U.S. – rating of insurance companies, 1906. Recognized for NRSRO (stat.rating org.). - Index of Economic Freedom (Heritage Foundation & Fraser Institute); - Corruption perceptions index (Transparency International). - Different aspects of country advantages and risks: - Assessment of national competitiveness – Global competitiveness report (WEF), World competitiveness yearbook (IMD); - Doing business of the WB – rankings on investment climate including business regulations (2004 – 2020). - Quantitative and qualitative data. © T.Tzanov, Ph.D, UNWE  International Financial Management Comparing risk ratings by MNC Companies may evaluate country risk for several countries, comparison – Foreign investment risk matrix (FIRM). Outside evaluators or own resources. Delphi technique (collection of independent opinions), checklist approach, quantitative analysis, combination. Incorporating country risk in capital budgeting – adjustment of the discount rate. No precise formula for that type of adjustment! Adjustment of estimated cash flows – probabilities. © T.Tzanov, Ph.D, UNWE  International Financial Management Country default spreads Spreads and risk premiums. National bond ratings (Moody’s) and appropriate default spread for those ratings (based upon traded bonds) over a default free government bond rate specific country. Thus, measure of the added country risk premium. The default spread added to a historical risk premium for a mature equity market – U.S. historical data. Thus, total risk premium for the appropriate market. A. Damodaran, Stern, NYU: Damodaran Online: Home Page for Aswath Damodaran (nyu.edu) http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ct ryprem.html Risk premium while calculating cost of equity and NPV over a foreign investment project. © T.Tzanov, Ph.D, UNWE  International Financial Management Insurance through Credit default swap Definition: A credit default swap (CDS) – a swap contract in which the protection buyer of the CDS makes a series of payments (often referred to as the CDS "fee" or "spread“ – quarterly) to the protection seller and, in exchange receives a payoff if a credit instrument (typically a bond or loan) defaults, thus experiences a credit event (bankruptcy, failure to pay, moratorium, etc.). The CDS may refer to a specified loan or bond obligation of a “reference entity”, usually a corporation or government. Thus, these premiums can be derived in such as the probability (PD) is that the country is truly (in)solvent and enters a state bankruptcy. Credit default swap (CDS premium). The annual insurance premium payable for insurance against the risk that the country will default in basic points (hundredths of a percent equal to 1 basis point = 0.01%). © T.Tzanov, Ph.D, UNWE  International Financial Management Credit default swap – technology As an example – an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor (the buyer of protection) will make regular payments to AAA-Bank (the seller of protection). If Risky Corp defaults on its debt, the investor will receive a one-time payment from AAA-Bank, and the CDS contract is terminated. If the investor owns Risky Corp debt, the CDS can be thought of as hedging. But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in order to make money if it fails, or to hedge investments. Most CDS’s are in the $10–20 million range with maturities between one and 10 years (5 years most typical). © T.Tzanov, Ph.D, UNWE  International Financial Management Country risk – CDS File:Basic Credit Default Swap (CDS) diagram.svg In case the reference entity (Risky Corp) defaults – 2 types of settlement: (1) the investor delivers a defaulted asset to AAA-Bank for payment of the par value (=notional/face amount =nominal), which is known as physical settlement; (2) AAA-Bank pays the investor the difference between the par value and the market price of a specified debt obligation (even if Risky Corp defaults there is usually some recovery, i.e. not all your money will be lost), which is known as cash settlement. © T.Tzanov, Ph.D, UNWE  International Financial Management Country risk – CDS (2) Example: Greece 10-year bond maturity. CDS premium (spread) of 250 b.p. € 10 million on an insurance against the insolvency of Greece is 10 million * 250 / 10,000 = 250,000 per year. Thus, over the ten years of bond maturity € 2.5 million to be paid in insurance premium to get in claim 10 million. Ratings sources: Thomson Reuters, Bloomberg. Country risk rating based on b.p. premium. © T.Tzanov, Ph.D, UNWE  International Financial Management Strategies to protect against country risk Insurance against country risk components: Export transactions insurance – BAEZ, BG. Purchase insurance (expropriation), such as from Overseas Private Investment Corporation (OPIC) – U.S. Multilateral Investment Guarantee Agency (MIGA) of the WB – insurance against political risk in FDI projects in developing countries. Structural decisions: Establish a joint venture with a local/third country partner; Relocation of subsidiaries/operations. Constraints: LT decisions. © T.Tzanov, Ph.D, UNWE  International Financial Management Country risk and international policies Multilateral: UN Center on Transnational Corporations (UNCTNC)/UNCTAD – The UN Code of Conduct on TNCs (ethical issues, respect the sovereignty of host countries, non- interference, reciprocal minimizing potential adverse impacts related to political risk). OECD: Guidelines for Multinational Enterprises – adopted by the governments of all 30 member states, incl. 12 non-members. ILO – Declaration of Principles Concerning Multinational Enterprises and Social Policy – employment and industrial relations. Resolution of the European Parliament, March 2007 – CSR. Checks and balances, mutual responsibility and obligations, non-interference, minimized country risk impacts on MNCs. © T.Tzanov, Ph.D, UNWE  International Financial Management THANK YOU FOR YOUR ATTENTION! © T.Tzanov, Ph.D, UNWE