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Country risk: it's unfeasible for any company with an international presence to eliminate this factor, but Anthony Boczko explains some of the ways to minimise it.

Everyone's talking about globalisation its ethical pros and cons and the potential of vast emerging markets in, say, China. But overseas investment is not only a huge opportunity; it's also an enormous risk. To assess and manage this, you first have to understand the volatility of the global marketplace. This puts pressure on local cultures and identities; on established political boundaries and social constituencies; and on traditional market arrangements.

It is also important to consider what globalisation really means. Some people see it as a predominantly social trend--a westernisation of the world involving the extension of western rationalism to create a standardised culture. This depend', on the global media and consumer demand for a western identity. Other people see globalisation as predominantly political--a shift in state sovereignty and an attempt to reshape the geography of international power relations between core nation states and peripheral economies. And others see it as an economic trend, fuelled by the deregulation of international commodity markets, the increased mobility of investment capital and the expansion of multinational businesses.

The connections between the economics of international trade and the social and political pressures of cultural expansion and geographical sovereignty combine to create country risk.

Understanding the risk

Given its complexity, it's not surprising that country risk is defined using a wide range of political, economic and socio-cultural criteria. Broadly, it is the exposure that a company faces as a consequence of a change in a national government's policy and the effect this change could have on the value of an investment, a project or cash receipts.

Country risk often arises when a government seeks to expropriate assets and/or profits, impose discriminatory pricing intervention policies, enforce restrictive foreign exchange currency controls or impose discriminatory tax laws. It can also occur if a government attempts to impose social or work-related regulations that favour domestic companies, limit the movement of assets or restrict access to local resources. Any one of these actions can damage a company's short-term ability to generate profits. In the long term, they can dramatically limit its ability to repatriate or reinvest profits.

Unfortunately, recognising and assessing your firm's exposure to this risk is complicated. It is relatively easy to spot increasing social unrest, economic volatility and an unstable political infrastructure, but much harder to quantify the resulting risks.

Assessing the risk

There are a number of sophisticated rating models that attempt to provide a structured framework to assess potential country risk. The models vary widely, but most rely on two distinct, but interrelated, levels of analysis: a macro assessment of overall country risk and a micro assessment of industry-segment or company-specific risk.

Macro risk assessment generally involves evaluating a range of social, economic and political characteristics. Although the quantification of these is subjective, the assessment framework tends to equate country risk with economic volatility, social unrest and political instability.

The results of most rating methods, while interesting, are too often inconsistent and inconclusive. This reinforces the belief of many social scientists that measuring qualitative social, economic and political characteristics using a rigid formula is of limited use.

Micro risk assessment involves evaluating a range of country characteristics as they relate to the company or its industry. The aim is to determine the sensitivity of the company or industry to particular macroenvironmental factors. Although such models vary from a simple Pest or Swot analysis to a sophisticated qualitative rating model, the underlying assumption remains the same: the greater the company or sector profile, and the greater the socio-economic volatility, the higher the possibility of government intervention.

But, as with the macro assessment models, the reliability of such analyses remains contentious.

Managing the risk

Once a company has identified the potential country risk it is facing, it needs to consider how this could affect its current and future activities. The aim should be to evaluate possible courses of action that could eliminate or minimise the consequences without doing the same to the firm's potential profits.

Some academics categorise these management strategies as defensive or offensive. In Pact, most companies adopt a range of different risk-minimising strategies. These could include:

* Taking out insurance against the expropriation of the firm's assets.

* Negotiating concessions or guarantees with the government.

* Structuring financial and operating policies to ensure that they conform with the regulatory requirements.

* Maintaining high levels of local borrowing to cover the possibility that exchange rates will be adversely affected by government action.

* Encouraging the movement of surplus assets from host-country firms to home-country firms.

* Developing close relationships with institutions in the host country.

* Internationally integrating production to include host-country and home-country firms in such a way as to ensure that the former depend on the latter.

* Locating research and development activities and any proprietary technology in the home country to reduce the possibility of expropriation.

* Establishing global trademarks for company products and services to ensure that rights are protected domestically and internationally.

* Encouraging local participation in company activities and inviting local shareholders to invest in these.

Evaluating the impact of country risk on international investment strategies

The success of any of these strategies will depend on a range of unique and related social, political and economic factors. It can be extremely difficult to quantify their financial consequences. Despite this. the broad impact of any chosen risk-minimising strategy must be considered in a company's investment appraisal procedures.

Adrian Buckley (1) and Alan Shapiro (2) discuss how to evaluate investment projects that might, for example, involve:

* The imposition of regulations controlling the movement of funds.

* The expropriation of assets.

* An increase in taxation.

Clearly, calculating the probability of government action can be useful in providing a comparative index of the relative risk in different countries --for example, for comparing Iraq with Indonesia or Ukraine with Belarus. But, although such comparative indices may provide insights into potential country risk, they, must be used cautiously. They provide merely a superficial quantification of the risk and do not take into account the complex relationships between national and international socio-political events.

The task of recognising, assessing and managing country risk remains difficult and controversial. Sophisticated macro and micro rating models exist to measure potential country risk, but the desire of practitioners to quantify complex qualitative variables in financial terms ensures that such models are of limited use.

Companies can adopt a whole range of social, economic or political risk-minimising strategies to deal with the impact of country risk, but, given the increasingly competitive international business environment, most have to settle for strategies that limit, rather than eliminate, the risk.

References

(1) A Buckley, Multinational Finance, Prentice Hall, 2000.

(2) A Shapiro, Multinational Financial Management, John Wiley and Sons, 2002.

PROJECT EVALUATION

Adrian BuckLey (1) argues that, if the present value of a project can be determined by:

NPV = - I + [n.summation over t = 1] ([a/[(1 + k).sup.t])

where:

NPV = present value of the investment;

a = net cash flows;

I = present value of the capital investment;

k = cost of capital/expected rate of return;

t = time period, then the NPV of an investment or project that is susceptible to possible government action can be adjusted by the probability of such action multiplied by the present values of the foregone cash flows. That is, p(c), where:

p = probability of government action;

c = present value of cash flows foregone as a result of government action.

Incorporating this into the formula gives:

NPV = - I + [n.summation over t = 1] [([a/[(1 + k).sup.t])- p (c)]

where:

NPV = present value of the investment;

a = net cash flows;

I = present value of the capital investment;

k = cost of capital/expected rate of return;

t = time period;

p = probability of government action;

c = present value of cash flows foregone as a result of government action.

Buckley suggests that the probability of government action can be determined by rearranging the equation as follows:

NPV = - I + [n.summation over t = 1] [(a/[(1 + k).sup.t]/c)]

where:

a = net cash flows;

I = present value of the capital investment;

k = cost of capital/expected rate of return;

t = time period;

p = probability of government action;

c = present value of cash flows foregone as a result of government action.

Anthony Boczko (a.boczko@hull.ac.uk) is a lecturer in finance at the University of Hull.
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Title Annotation:Technical Matters
Author:Boczko, Anthony
Publication:Financial Management (UK)
Geographic Code:9CHIN
Date:Feb 1, 2005
Words:1376
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