Country Risk Definition

Country Risk Definition

By: John Ries Full Article at: Click Here

Country risk relates to the likelihood that changes in the business environment will occur that reduce the profitability of doing business in a country. These changes can adversely affect operating profits as well as the value of assets.

A. Types of country risk

1. Political changes: governments may change economic policies. Changes in the ruling party (brought about by elections or even wars) may results in major policy changes. What are the specific events that may occur due to political changes and how do they affect the MNE?

- expropriation (loss of assets, termination of operations)

- currency inconvertaibility (inability to repatriate profits, import)

- higher taxes (less after tax revenues)

- higher tariffs (higher import costs)

- elimination of FDI incentives (higher costs)

- domestic ownership requirements (loss of revenue, loss of proprietary info, more difficult management)

- local content requirements (higher costs)

2. Macroeconomic mismanagement: Governments may pursue unsound monetary and fiscal policies.

What economic events occur when a country rapidly increases the money supply?

- inflation (higher costs, difficult planning, currency depreciation)

- what economic events occur when a country runs a fiscal deficit?

- higher interest rates (higher borrowing costs in host country)

- recession (lower demand in host country)

- hard currency shortage (must use hard currency earnings to pay debts to foreigners)

3. Other

- war (general disruptions)

- labour unrest (higher costs, work stoppages)

TYPE	EVENT	EFFECT ON MNE
Political change (due to elections, revolution, secession, etc.)	expropriation	loss of assets, termination of operations
	higher taxes	less after-tax revenues
	higher tariffs	higher import costs
	elimination of FDI incentives	higher costs, other
	domestic ownership requirements	loss of revenue, loss of proprietary info, more difficult management
	local content requirements	higher costs
	currency inconvertility	inability to repatriate profits, import
Macroeconomic mismanagement	inflation	higher costs, difficult planning, currency depreciation
Macroeconomic mismanagement	high interest rates	higher borrowing costs, recession
Other	wars	general disruption
Other	labour unrest (strikes)	higher costs, production stoppage

B. Measuring country risk

1. Country risk ratings: Euromony Magazine's Country Risk ratings and the Business Environmental Risk Index (BERI) rank countries according to the weighted average of a large number of factors. How can an MNE use this information? A single measure may be of limited use when a MNE's exposure depends on its particular business.

2. Credit ratings (Moody, Standard and Poor): These rate the creditworthiness of the government. Why is this information useful to business?

C. Responses to country risk

1. Project evaluation: when deciding on new projects, require higher returns on investments in risky countries (or discount future profits at a higher rate).

2. Insure: a MNE might buy insurance for specific events. The Overseas Private Insurance Corporation (OPIC) (U.S.) and the Economic Development Corporation (EDC) (Canada) are government agencies providing insurance. Why will the private market be willing to provide the insurance? What events will be difficult to insure against?

a. Three criteria for the provision of insurance

(1) large number of customers with less than perfectly correlated outcomes

(2) Ability to predict future payouts (define loss and loss amount, calculate probability of loss occurring)

(3) Loss must be accidental from point of view of insured.

b. Private country risk insurance market is small (limited coverage in terms of countries/"events" covered) and costly for customers.

3. Reduce the likelihood that host country governments may act in a way that harms MNE. Potential strategies that an MNE may adopt include:

- An MNE can maintain alternatives to producing in a foreign country. This allows the firm an escape and lowers the incentive for the foreign government to impose controls, since the MNE is likely to move to alternative locations.

- Maintaining control over intangible assets--management know-how, technical skills, product development, etc.--will create an economic loss to the host government if the MNE leaves.

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