Hand out # 12

International IT University Faculty of Information Technologies

Subject: Financial Risk Management Department of Economics & Business
Lecture theme: Country Risk Analysis Fall Semester
Associate Professor: M.A. Sohrabian, Ph.D. Academic Year: 2018-2019

Country Risk Analysis

Country risk is the potentially adverse impact of a country’s environment on a MNC’s

cash flows. Investments with all the normal business guarantees attached against non-
payment, including government guarantees, can become worthless overnight. Loan
repayments can be delayed or reduced without warning. Such financial crises are a
regular phenomenon in international finance. If the credit risk level of a particular
country begins to increase, the multinational corporation (MNC) may consider divesting
its subsidiaries located there. On the other hand, the MNC can also use country risk
analysis as a screening device to avoid conducting business in countries with excessive
risk.
Country risk analysis can be used to monitor countries where the MNC is currently
doing business.
Please note that country risk is an ongoing process. Most MNCs will not be affected by
every event, but they will pay close attention to any events that may have an impact on
the industries or countries in which they do business. They also recognize that they
cannot eliminate their exposures to all events but may at least attempt to limit their
exposures to any single country-specific event.

Country risk can be partitioned into the country’s political and financial/economic risks.

Political Risk Factors

If you want to review an assessment of various political risk characteristics by outside
evaluators, it can obtain this information through different websites but common forms
of political risk are as follows:
1. Attitude of consumers in the host country
2. Actions of host government
3. Blockage of fund transfers
4. Currency inconvertibility
5. War
6. Bureaucracy
7. Corruption, etc.

Corruption can be adversely affected on MNC’s international business because it can

increase the cost of conducting business or it can reduce revenue. Various forms of
corruption can occur between firms or between a firm and the government.
For example, a MNC may lose revenue because a government contract is awarded to a
local firm that paid off a government official. Laws and their enforcement vary among
countries, however. For example, in the United States, it is illegal to make a payment to
a high-ranking government official in return for political favors, but it is legal in most
countries for companies to make contributions to political parties.
A corruption index is derived for most countries by transparency international (you can
simply refer to http://www.transparency.org for the country of your choice). Please note
that, not one single country, anywhere in the world, is corruption-free.

Note 1: previously maximum rating was equal to 10, and high rating indicates low
corruption (0 highly corrupt to 10 very clean) although nowadays 0 (highly corrupt) to
100 (very clean) is used. A country or territory’s score indicates the perceived level of
public sector corruption on these scales. A country's rank indicates its position relative
to the other countries in the index.

Exhibit 1: Corruption index ratings for selected countries in 2005

Country Rank Country 2005 CPI Confidence Surveys
Score* Range** Used***
1 Iceland 9.7 9.5-9.7 8
2 Finland 9.6 9.5-9.7 9
3 New Zealand 9.6 9.5-9.7 9
… … … … …
109 Honduras 2.6 2.2-3.0 7
110 Kazakhstan 2.6 2.2-3.2 6
111 Nicaragua 2.6 2.4-2.8 7
… … … … …
157 Turkmenistan 1.8 1.7-2.0 4
158 Bangladesh 1.7 1.4-2.0 7
159 Chad 1.7 1.3-2.1 6
www.transparency.org

Exhibit 2: Corruption index ratings for selected countries in 2009

Country Rank Country 2009 CPI Confidence Surveys
Score* Range** Used***
1 New Zealand 9.4 9.1-9.5 6
2 Denmark 9.3 9.1-9.5 6
3 Singapore 9.2 9.0-9.4 9
… … … … …
120 Ethiopia 2.7 2.4-2.9 7
120 Kazakhstan 2.7 2.1-3.3 7
120 Mongolia 2.7 2.4-3.0 7
… … … … …
178 Myanmar 1.4 0.9-1.8 3
179 Afghanistan 1.3 1.0-1.5 4
180 Somalia 1.1 0.9-1.4 3
www.transparency.org
 Exhibit 3: Corruption index ratings for selected countries in 2015
Country Rank Country 2015 CPI
Score*
1 Denmark 91
2 Finland 90
3 Sweden 89
… … …
123 Guatemala 28
123 Kazakhstan 28
123 Kyrgyzstan 28
… … …
166 Afghanistan 11
167 Korea (North) 8
167 Somalia 8
www.transparency.org

Exhibit 4: Corruption index ratings for selected countries in 2016

Country Rank Country 2015 CPI

Score*
1 Denmark 90
2 New Zealand 90
3 Finland 89
… … …
131 Iran 29
131 Kazakhstan 29
131 Nepal 29
131 Russia 29
131 Ukraine 29
… … …
174 Korea (North) 12
175 South Sudan 11
176 Somalia 10
www.transparency.org

2015 year's Corruption Perceptions Index includes 165 countries and territories,
however, 2016 year’s CPI includes 176 ones while 2017 year’s CPI was based on 180
countries.

Note 2: The Republic of Kazakhstan had the rank of 131 out of 176 countries on 2016
with the score of 29 and the rank of 122 out of 180 countries in 2017. Other KZ ranks
and scores from 2012 – 2015 are:
Ø "2015 rank of 123_score" 28,
Ø "2014 rank of 126_score" 29,
Ø "2013 rank of 140_score" 26,
Ø "2012 rank of 133_score" 28,
Note 3: No country is perfect to get 100 score. According to the CPI’s report, the
average score of Eastern Europe and Central Asia is 34 in 2016. Moreover, over two
third of the countries all over the world have got the score below the 50 from the 100
points in 2017. The best is New Zealand (rank 1) and the worst is Somalia (rank 180) in
CPI of 2017.

Explanatory notes:

*CPI Score – relates to perceptions of the degree of corruption as seen by business

people and country analysts and ranges nowadays between 100 (highly clean) and 0
(highly corrupt).
**Confidence Range – provides a range of possible values of the CPI score. This
reflects how a country’s score may vary, depending on measurement precision.
Nominally, with 5% probability the score is above this range and with another 5% it is
below. However, particularly when only few sources (n) are available an unbiased
estimate of the mean coverage probability is lower than the nominal value of 90%.
***Surveys used – refers to the number of surveys that assessed a country’s
performance. 16 surveys and expert assessments were used and at least three were
required for a country to be included in the CPI.

Financial Risk Factors

Along with political factors, financial factors should be considered when assessing
country risk. One of the most obvious financial factors is the current and potential state
of the country’s economy. A multinational corporation that exports to a country or
develops a subsidiary in a country is highly concerned about the country’s economy. A
recession in the country could severely reduce demand for the MNC’s exports or
products sold by the MNC’s local subsidiary.

In the early 1990s and again in the 2000-2002 period, the European business
performance of Ford Motor Co, Nike, Walt Disney Co, and many other US-based
MNCs was adversely affected by a weak European economy.

A country’s economic growth is dependent on several financial factors:

1. Interest rates: Higher interest rates tend to slow the growth of an economy and
reduce demand for the MNCs products. Lower interest rates often stimulate the
economy and increase demand for the MNCs products.
2. Exchange rates: Exchange rates can influence the demand for the country’s exports,
which in turn affects the country’s production and income level. A strong currency may
reduce demand for the country’s exports, increase the volume of products imported by
the country, and therefore reduce the country’s production and national income. A very
weak currency can cause speculative outflows and reduce the amount of funds available
to finance growth by businesses. From the point of view of a guest MNC, in order to
have a high level of export for obtaining huge revenue the host country should have a
stable strong local currency so that they can afford to import high volume of the
products of the guest MNCs.
3. Inflation: Inflation can affect consumers’ purchasing power and therefore their
demand for a MNC’s goods. It also directly affects a country’s financial condition by
influencing the country’s interest rates and currency value. A high level of inflation
may also lead to a decline in economic growth.

Measuring Country Risk

Deriving an overall country risk rating using a checklist approach requires separate
ratings for political and financial risks.
Firstly, the political factors are assigned values within some arbitrarily chosen range
(such as values from 1 to 5, where 5 is the best value, lower risk)
Next, these political factors are assigned weights (representing degree of importance),
which should add up to 100%. The assigned values of the factors times their respective
weights can then be summed to derive a political risk rating.
The process is then repeated to derive the financial risk rating. All financial factors are
assigned values (from 1 to 5, where 5 is the best value, lowest risk). Then the assigned
values of the factors times their respective weights can be summed to derive a financial
risk rating.
Once the political and financial risk ratings have been derived, a country’s overall
country risk rating as it relates to a specific project can be determined by assigning
weights to the political and financial ratings according to their perceived importance.

The political and financial ratings multiplied by their respective weights will determine
the overall country risk rating for a country as it relates to a particular project.

Exhibit 5: Determining the overall country risk rating

 Derivation of the overall country risk rating based on assumed information

Exhibit 6: Political Risk Rating

1 2 3 4=2x3
Political Risk Rating assigned by Weight assigned by Weighted value to
Factors company to factor company to factor factor
(within a range of 1-5) according to
importance
Blockage of fund 4 30% 1.2
transfer
Bureaucracy 3 70% 2.1
100% 3.3 Political Risk
Rating

Exhibit 7: Financial Risk Rating

1 2 3 4=2x3
Financial Risk Rating assigned by Weight assigned by Weighted value to
Factors company to factor company to factor factor
(within a range of 1-5) according to
importance
Interest Rate 5 20% 1.0
Inflation Rate 4 10% 0.4
Exchange Rate 4 20% 0.8
Industry 5 10% 0.5
Competition
Industry Growth 3 40% 1.2
100% 3.9 Financial Risk
Rating

Exhibit 8: Overall Country Risk Rating

The Rating of each risk factor as determined above must be multiply to the weights
assigned by company to each risk factor in order to get the weighted rating of Political
Risk or Financial Risk and finally we have to sum them up to get an overall country risk
rating which is 3.42

(1) (2) (3) (4) = (2) x (3)

Political Risk 3.3 80% 2.64
Financial Risk 3.9 20% 0.78
100% 3.42
Exhibit 9: Top Ten Countries based on Country Risk Ranking the 4th Quarter of 2017

Rank Rank Change* Country Score

1 0 Singapore 88.60
2 0 Norway 87.66
3 0 Switzerland 87.64
4 0 Denmark 85.67
5 +2 Sweden 85.59
6 -1 Luxembourg 83.85
7 -1 Netherland 83.76
8 +4 Finland 83.10
9 0 Canada 82.98
10 +1 Australia 82.18
Source: ECR data base.
*Rank changes are relative to the last quarter.

Note 4: In order to provide the MNCs and foreign investors with country risk service
report, some outside risk evaluators use 10- point scale for scoring and some such as
Euromoney Country Risk (ECR) and Economist Intelligent Unit (EIU) rate the country
risk on a 100-point scale.

Using the Country Risk Rating for Decision Making

If the country risk is too high, then the firm does not need to analyze the feasibility of
the proposed project any further. Some firms may contend that no risk is too high when
considering project. Their reasoning is that if the potential return is high enough, the
project is worth undertaking. When employee safety is a concern, however, the project
may be rejected regardless of its potential return.
Even after a project is accepted and implemented, the MNC must continue to monitor
country risk. Since country risk can change dramatically over time, periodic
reassessment is required, especially for less stable countries.