International Finance 1 Country and Political Risks Oleg Deev Department of Finance 2 Country Risk ̶the risk of investing or lending in a country, arising from possible changes in the business environment that may adversely affect operating profits or the value of assets in the country ̶the risk of economic agents (including government) in a particular country will not fulfill their international financial obligations ̶the risk that a foreign government will default on its bonds or other financial commitments ̶the uncertainty associated with investing in a particular country, and more specifically the degree to which that uncertainty could lead to losses for investors 3 Financial and Economic Risk Factors ̶Ratio of a country’s external debt to its GDP ̶Ratio of a country’s debt service payments to its exports ̶Ratio of a country’s imports to its official international reserves ̶A country’s terms of trade (export/import prices) ̶A country’s current account deficit ̶ 4 Political Risk Factors ̶Expropriation/nationalization – worst-case scenario ̶Contract repudiation (revoking) without compensation ̶Default on payments, cancelation of licenses ̶Taxes and regulation (i.e., hiring/firing, environmental standards, repatriation of funds) ̶Exchange controls (e.g., Argentina in 2002) ̶Corruption and legal inefficiency ̶Transparency International Corruption Perceptions Index (for more than 150 countries) ̶Ethnic violence, political unrest, and terrorism ̶Home-country restriction ̶ 5 Legal System Quality ex14_01 6 The Debt Crisis Origins (late 70s, early 80s) ̶Origins of the debt crisis – oil prices went from $2.50 to $60.00 per barrel (in 2000 dollars)! ̶OPEC extra income was deposited with international banks, which in turn loaned “petrodollars” to non-OPEC developing countries at floating interest rates ̶Oil shock of late 1970s led to the change of macroeconomic situation in developed countries: high real interest rates, dollar appreciation ̶Mexico announced in 1982 they could not repay their foreign debt; by the end of the year 24 other countries followed suit ̶ ̶ 7 ex14_02 The Debt Crisis Origins (late 70s, early 80s) 8 The Debt Crisis Resolution (late 70s, early 80s) ̶First treated as a liquidity problem (IMF recommendations) ̶Managing the debt crisis - The Baker plan (1985) ̶Implemented when IMF debt restructurings didn’t work ̶Included new loans by banks/World Bank in exchange for agreeing to follow economic advice ̶“Debt overhang” – the country with a huge debt burden has little incentive to implement economic reforms or stimulate investment because the resulting increase in income will simply be appropriated by the country’s creditors ̶Debt and debt service-reducing operations ̶Debt buyback (at a discount) ̶Debt-equity swap – MNC buys discounted debt to invest in country. This helps country and is a cheaper way for companies to invest in developing nations ̶ 9 The Debt Crisis Resolution (late 70s, early 80s) ̶The Brady Plan (1989), Options available to the banks: ̶Buybacks: the debtor country was allowed to repurchase part of its debt at an agreed discount ̶Discount bond exchange: the loans could be exchanged for bonds at an agreed discount, with the bonds yielding a market rate of interest ̶Par bond exchange: the loans could be exchanged at their face value for bonds yielding a lower interest rate than the one on the original loans ̶Conversion bonds combined with new money: loans could be exchanged for bonds at par that yield a market rate; banks had to provide new money in a fixed proportion of the amount converted ̶Official credit enhancements in the form of collateral provisions 10 Brady Bonds Valued like other fixed-income securities but have special features ̶Principal collateral: all par and discount bonds are collateralized by U.S. Treasury zero-coupon securities ̶Interest collateral: the government issuing Brady bonds deposits money w/ NY Federal Reserve Bank in amounts covering 12 – 18 months of interest payments ̶Sovereign portion: The remaining cash flows are subject to sovereign risk ̶ 11 Analyzing a Brady Bond ̶ ex14_08 12 Country Risk Analysis ̶The PRS Group’s ICRG Rating System ̶Financial and economic risk factors – assessing a country’s ability to repay foreign debt; objective inputs ̶The political risk components – stability based on government; subjective inputs ̶Overall ratings 1-49: Very risky 50-59.9 High risk 60-69.9 Moderate risk 70-79.9 Low Risk 80-100 Very low Risk ̶ 13 Political Risk Analysis ex14_04 14 ICRG Risk Components ex14_05 15 Political Risk Ratings ex14_06 16 Country Credit Spreads ̶Institutional Investor’s Annual Rating ̶Sovereign credit ratings – Moody’s, S&P, Fitch ̶ Why is sovereign credit risk different? ̶Can’t take a country to bankruptcy court ̶Still, there are consequences ̶Assets may be seized ̶Country won’t be able to borrow so easily going forward ̶International trade could be impacted ̶Default could make economic crises worse ̶ 17 Country and Political Risk Analysis (1) ̶Country spreads and political risk probabilities ̶An indication of default risk of a sovereign bond ̶Moody’s reported in 2008 an historical recovery rate of 35% ̶Default probabilities with positive recovery values ̶ ̶ ̶ where Stripped Price is the dollar price of the bond after subtracting the value of the collateral, CF(j) is the promised dollar cash flow, i(j) is the USD interest rate for period j and p is the default probability ̶ 18 Country and Political Risk Analysis (2) ̶In order to adjust capital flows (preferred to adjusting discount rate) one must compute the political risk probabilities ̶Information ̶Country spreads Don’t just add to discount rate Uncover default probabilities ̶Political risk ratings No evidence of predictive ability Could be lagging (and not leading) ̶Political risk insurance premiums (if available) ̶ 19 Country and Currency Premiums Around the Mexican Currency Crisis ex14_09 20 Managing Political Risk (1) ̶What MNCs need to keep in mind when structuring an investment ̶Focus on the short term ̶Rely on unique supplies or technology (making government takeover more difficult) ̶Use local resources ̶Bargain with the government ̶Hire protection (i.e., bodyguards, or even military companies) ̶ 21 Managing Political Risk (2) Insurance ̶Coverage ̶Currency inconvertibility and non-transferability ̶Expropriation ̶War and political violence Political risk insurance for U.S. Companies ̶Overseas private investment corporation (OPIC) ̶Political risk insurance in emerging and transitioning economy ̶Multilateral investment guarantee agency (MIGA) ̶Public versus private insurance ̶Private - more important as time goes on ̶Public – may deter rogue nations ̶ 22 Country Risk Analysis in Bloomberg SRSK DDIS