Selection of An Economy For Investment (Country Risk Analysis)

BFIA/IV SEM/PAPER NO.
XVII
S.S.College of Business Studies, University Of Delhi
PROJECT REPORT ON
SELECTION OF AN
ECONOMY FOR
INVESTMENTS
CRITICAL ISSUES & CHALLENGES
SUBMITTED BY
RAMAN KUMAR (15715)

ANMOL BHASIN (15820)
VIRENDER NEHRA (15751)
Selection of an Economy for Investment - Critical Issues & Challenges

BFIA/IV SEM/PAPER NO. XVII
MANISH SHAH(15706)
ACKNOWLEDGEMENT
We would like to express our gratitude to all those who have contributed directly or
indirectly towards the completion of this project report Titled Selection of an
Economy for Investment-Criteria, Issues & Challenges.
We are deeply grateful to our mentor Mr. Kumar Bijoy for his assistance at every
stage of this project. Without his valuable insight, moral and informative support the
project would not have materialized.
Finally we would like to thank Shaheed Sukhdev College of Business Studies for
providing us the platform to do this project and increase our knowledge base.

OBJECTIVES
• To study the investment climate in International Financial Market
• To analyze the economies with help of country risk analysis
• To ascertain the recent development in potential economies.

SOURCES OF INFORMATION
• This Report is based on first hand information from the discussion with
different personnel in internet forums
• As well as the secondary data which included Various Journals, Reports,
Articles, Newspaper, and Websites etc.

PREFACE
This report focuses on the selection of a country for investment purposes. The terms investment
has many meaning in business but when it is at international level than it is broadly of two
categories:
• FOREIGN DIRECT INVESTMENTS: In its classic form is defined as a company from one
country making a physical investment into building a factory in another country. Its
definition can be extended to include investments made to acquire lasting interest in
enterprises operating outside of the economy of the investor. 1 The FDI relationship
consists of a parent enterprise and a foreign affiliate which together form a multinational
corporation (MNC). In order to qualify as FDI the investment must afford the parent
enterprise control over its foreign affiliate. The IMF defines control in this case as owning
10% or more of the ordinary shares or voting power of an incorporated firm or its
equivalent for an unincorporated firm; lower ownership shares are known as portfolio
investment.2
• FOREIGN INSTITUTIONAL INVESTMENTS : Foreign Institutional Investor (FII) is used

to denote an investor - mostly of the form of an institution or entity, which invests
money in the financial markets of a country different from the one where in the institution
or entity was originally incorporated.
When we think of investing in any economy, the investment can be done in only two ways i.e. as
FDI or FII, FDI are generally long-term investments in real estate, manufacturing plants, MNE’s
etc. and therefore investment decision is depends on various factors which are explained later in
this report. FII are investments are in financial instruments such as foreign currency, future&
options markets, shares, debentures, bonds etc.
This reports analyses all factors which affects the decision of a investor while selecting an
economy for its investment, we have mainly focused on Asian Economies which are so said
1
Foreign Direct Investment, United Nations Conference on Trade and Development, www.unctad.org
2
International Monetary Fund (IMF), 1993. Balance of Payments Manual, fifth edition (Washington, DC).

next leader in global market(India & China), and other developing economies which are coming
to the notice of investors.
Data used in this reports is mainly secondary, compiled from various sources like World bank
reports, Various country risk rating agencies (Fitch Ratings (U.S.), Moody’s (U.S.), Standard &
Poor's (U.S), Business Monitor International etc.), articles & journals. However there is some
primary data which is collected from the interaction with managers in online forums3.
3
Online forums like pagalguy.com, orkut.com,facebook.com

CRITERIA –VARIOUS FACTORS THAT AFFECTS INVESTMENT DECISION REGARDING

AN ECONOMY.
RISK CATEGORIES AND MEASUREMENTS
Analysts have tended to separate country risk into the six main categories of risk shown below.
Many of these categories overlap each other, given the interrelationship of the domestic
economy with the political system and with the international community. Even though many risk
analysts may not agree completely with this list, these six concepts tend to show up in risk
ratings from most services.
I. Economic Risk
Economic Risk is the significant change in the economic structure or growth rate that produces a
major change in the expected return of an investment. Risk arises from the potential for
detrimental changes in fundamental economic policy goals (fiscal, monetary, international, or
wealth distribution or creation) or a significant change in a country's comparative advantage
(e.g., resource depletion, industry decline, demographic shift, etc.). Economic risk often overlaps
with political risk in some measurement systems since both deal with policy.
Economic risk measures include traditional measures of fiscal and monetary policy, such as the
size and composition of government expenditures, tax policy, the government's debt situation,
and monetary policy and financial maturity. For longer-term investments, measures focus on
long-run growth factors, the degree of openness of the economy, and institutional factors that
might affect wealth creation.
II. Transfer Risk
Transfer Risk is the risk arising from a decision by a foreign government to restrict capital
movements. Restrictions could make it difficult to repatriate profits, dividends, or capital.
Because a government can change capital-movement rules at any time, transfer risk applies to
all types of investments. It usually is analyzed as a function of a country's ability to earn foreign
currency, with the implication that difficulty earning foreign currency increases the probability that
some form of capital controls can emerge. Quantifying the risk remains difficult because the
decision to restrict capital may be a purely political response to another problem. For example,
Malaysia's decision to impose capital controls and fix the exchange rate in the midst of the Asian

currency crisis was a political solution to an exchange-rate problem. Quantitative measures

typically used to assess transfer risk provided little guidance to predict Malaysia's actions.
Transfer risk measures typically include the ratio of debt service payments to exports or to
exports plus net foreign direct investment, the amount and structure of foreign debt relative to
income, foreign currency reserves divided by various import categories, and measures related to
the current account status. Trends in these quantitative measures reveal potential imbalances
that could lead a country to restrict certain types of capital flows. For example, a growing current
account deficit as a percent of GDP implies an ever-greater need for foreign exchange to cover
that deficit. The risk of a transfer problem increases if no offsetting changes develop in the
capital account.
III. Exchange Rate Risk
Exchange Risk is an unexpected adverse movement in the exchange rate. Exchange risk
includes an unexpected change in currency regime such as a change from a fixed to a floating
exchange rate. Economic theory guides exchange rate risk analysis over longer periods of time
(more than one to two years). Short-term pressures, while influenced by economic
fundamentals, tend to be driven by currency trading momentum best assessed by currency
traders. In the short run, risk for many currencies can be eliminated at an acceptable cost
through various hedging mechanisms and futures arrangements. Currency hedging becomes
impractical over the life of the plant or similar direct investment, so exchange risk rises unless
natural hedges (alignment of revenues and costs in the same currency) can be developed.
Many of the quantitative measures used to identify transfer risk also identify exchange rate risk
since a sharp depreciation of the currency can reduce some of the imbalances that lead to
increased transfer risk. A country's exchange rate policy may help isolate exchange risk.
Managed floats, where the government attempts to control the currency in a narrow trading
range, tend to possess higher risk than fixed or currency board systems. Floating exchange rate
systems generally sustain the lowest risk of producing an unexpected adverse exchange
movement. The degree of over- or under-valuation of a currency also can help isolate exchange
rate risk.

IV. Location or Neighborhood Risk
Location or Neighborhood Risk includes spillover effects caused by problems in a region, in a

country's trading partner, or in countries with similar perceived characteristics. While similar
country characteristics may suggest susceptibility to contagion (Latin countries in the 1980s, the
Asian contagion in 1997-1998), this category provides analysts with one of the more difficult risk
assessment problems.
Geographic position provides the simplest measure of location risk. Trading partners,
international trading alliances (such as Mercosur, NAFTA, and EU), size, borders, and distance
from economically or politically important countries or regions can also help define location risk
V. Sovereign Risk
Sovereign Risk concerns whether a government will be unwilling or unable to meet its loan
obligations, or is likely to renege on loans it guarantees. Sovereign risk can relate to transfer risk
in that a government may run out of foreign exchange due to unfavorable developments in its
balance of payments. It also relates to political risk in that a government may decide not to honor
its commitments for political reasons. The CRA literature designates sovereign risk as a
separate category because a private lender faces a unique risk in dealing with a sovereign
government. Should the government decide not to meet its obligations, the private lender
realistically cannot sue the foreign government without its permission.
Sovereign-risk measures of a government's ability to pay are similar to transfer-risk measures.

Measures of willingness to pay require an assessment of the history of a government's
repayment performance, an analysis of the potential costs to the borrowing government of debt
repudiation, and a study of the potential for debt rescheduling by consortiums of private lenders
or international institutions. The international setting may further complicate sovereign risk. In a
recent example, IMF guarantees to Brazil in late 1998 were designed to stop the spread of an
international financial crisis. Had Brazil's imbalances developed before the Asian and Russian
financial crises, Brazil probably would not have received the same level of support, and
sovereign risk would have been higher.

VI. Political Risk
Political Risk concerns risk of a change in political institutions stemming from a change in
government control, social fabric, or other non-economic factor. This category covers the
potential for internal and external conflicts, expropriation risk and traditional political analysis.
Risk assessment requires analysis of many factors, including the relationships of various groups
in a country, the decision-making process in the government, and the history of the country.
Insurance exists for some political risks, obtainable from a number of government agencies
(such as the Overseas Private Investment Corporation in the United States) and international
organizations (such as the World Bank's Multilateral Investment Guarantee Agency).
Few quantitative measures exist to help assess political risk. Measurement approaches range
from various classification methods (such as type of political structure, range and diversity of
ethnic structure, civil or external strife incidents), to surveys or analyses by political experts.
Most services tend to use country experts who grade or rank multiple socio-political factors and
produce a written analysis to accompany their grades or scales. Company analysts may also
develop political risk estimates for their business through discussions with local country agents
or visits to other companies operating similar businesses in the country. In many risk systems,
analysts reduce political risk to some type of index or relative measure. Unfortunately, little
theoretical guidance exists to help quantify political risk, so many "systems" prove difficult to
replicate over time as various socio-political events ascend or decline in importance in the view
of the individual analyst

COUNTRY RISK ANALYSIS
A Country Risk and Foreign Direct Investment
Country risk analysis (CRA) attempts to identify imbalances that increase the risk of a shortfall in
the expected return of a cross-border investment. This paper describes the general process
used to create risk measures and discusses some of the weaknesses of this process. It then
examines the degree of association of six measures and analyzes the ability of these measures
to predict returns for a manufacturing investment. The paper concludes that company analysts
may improve the performance of risk measures available from commercial services by adjusting
risk measurement to fit the company's specific type of foreign direct investment
INTRODUCTION
All business transactions involve some degree of risk. When business transactions occur across
international borders, they carry additional risks not present in domestic transactions. These
additional risks, called country risks, typically include risks arising from a variety of national
differences in economic structures, policies, socio-political institutions, geography, and
currencies. Country risk analysis (CRA) attempts to identify the potential for these risks to
decrease the expected return of a cross-border investment.
"Risk" implies that an analyst can identify a well-defined event drawn from a large sample of
observations. A large sample contains enough observations to develop a statistical function
amenable to probability analysis. An event that lacks these requirements moves toward
uncertainty on the continuum between pure risk and pure uncertainty. For example, the
probability of death from an auto accident classifies as a risk; the probability of death from a
nuclear meltdown falls into uncertainty, given a lack of nuclear meltdown observations. Many of
the individual events investigated by country risk analysis fall closer to uncertainties than well-
defined statistical risks. This forces analysts to construct risk measures from theoretical or
judgmental, rather than probabilistic, foundations.
Uncertainty makes CRA more similar to a soft art than a hard science. Analysts deal with the
soft nature of CRA in different ways, which can result in widely varying views of the risk level of a
country. For this reason, users of risk measures developed from commercial country-risk

services must understand analysts' construction methods if they wish to analyze a company
investment risk appropriately. As demonstrated in the sections below, company analysts should
be able to improve upon outside measures by adapting risk systems to their specific company
investments.
THEORY VS. PRACTICE
Country risk analysis rests on the fundamental premise that growing imbalances in economic,
social, or political factors increase the risk of a shortfall in the expected return on an investment.
Imbalances in a specific risk factor map to one or more risk categories. Mapping all the factors at
the appropriate level of influence creates an overall assessment of investment risk. The mapping
structure differs for each type of investment, so an imbalance in a given factor produces different
risks for different investments.
This fundamental premise provides a simple theoretical underpinning to CRA. Unfortunately, no

comprehensive country risk theory exists to guide the mapping process. In practice, most
country-risk services create risk measures using an eclectic mix of economic or sociopolitical
indicators based on selection criteria arising from their analysts' experiences and judgment. The
services usually combine a variety of factors representing actual and potential imbalances into a
comprehensive risk assessment that applies to a broad investment category. Most CRA
literature emphasizes a number of common points, then slips into a detailed discussion of ways
the respective authors enumerate risk for various investments. The best authors emphasize the
necessity to adapt their analyses for a specific investment decision given the judgmental nature
of their methods.
OUTLINE OF THE MODEL
At the heart of country risk is the Economist Intelligence Unit's Country Risk model which
measures country specific risk associated with the political, economic policy, economic structure,
and liquidity situation faced by 100 emerging markets. Risk scores can be used for making a
general assessment of the risk of a crisis in the country's financial markets, where foreign
investors may have exposure. It is also useful for investors wishing to get a snapshot of the
generalised risk of investing in a particular country.

CALCULATING THE RATINGS
The model operates by asking our country expert to answer a series of quantitative and
qualitative questions on recent and expected trends relating to the general categories of political
risk, economic policy risk, economic structure risk and liquidity risk in the relevant country.
Individual question responses are graded providing individual country risk assessments on
individual indicators, the general categories and the country's overall credit risk. Scores are
produced in single point increments from "0" to "100" or letter bands from "A" to "E",
representing a movement from lower to higher risk.

COUNTRY RISK RATINGS DEFINITION
Country risk model ratings are compiled in such a way that general country risk scenarios can be
formulated which may help users of EIU Market Indicators & Forecasts interpret of our risk
scores. The single point system ordered from "0" to "100" and corresponding letter band system
ordered A to E, moves from less to higher risk.
BAND A (0-20 POINTS)
Countries which have no foreign-exchange constraints on their debt-service ability and no

problems financing their trade activities. Their economic policies are deemed to be effective and
correct in relation to the conditions they face (whether in a boom or a recession) and they have a
working government (not always a multiparty democracy in the European mould) capable of
effective policy implementation. These countries have no significant constraints on any
international financial transactions.
BAND B (21-40 POINTS)
Countries which also have no significant foreign-exchange constraint, but whose economic
policies or political structure may be a cause for concern. B-rated countries have access to
commercial capital markets. There are no major risks with respect to international financial
transactions, but political risk and economic policy risk often need to be watched carefully.
BAND C (41-60 POINTS)
Countries which have a record of periodic foreign-exchange crises and political problems. Many
of these countries will have negotiated external debt-rescheduling agreements and could be in
the process of successfully carrying out an economic reform programme. These economies will
usually be in a state of flux with persistent, but controllable, internal and external imbalances.
However, some will have access to commercial capital markets. With caution, this set of
countries will often offer exciting opportunities for foreign investors.

BAND D (61-80 POINTS)
Countries which are currently suffering from serious economic and political problems. Arrears,
debt rescheduling and restricted access to official lending are common characteristics. Many
have a narrow, commodity-dependent export base, resulting in potentially large and frequent
fluctuations in export earnings and lengthening remittance delays. Many of these economies will
be heavily regulated in the initial phases of restructuring or will have failed to implement such
reforms. Any investment or other international financial transactions should be very carefully
considered and would best be postponed.
BAND E (81-100 POINTS)
Countries which are likely to have a high and rising level of arrears. They will be characterised
by severe fiscal imbalances and hyperinflation. Foreign exchange will be scarce, and their
relations with multilateral lenders severely strained. Often they are in or on the verge of civil war
or undergoing violent political change. Political risk is usually extremely high.

RECENT TRENDS – VARIOUS ISSUES & CHALLENGES

The scenario calling for a marked economic slowdown this year seems to be holding true with
annualized first-quarter growth of 2.2 per cent for the euro zone and 0.9 per cent for the United
States. The statistics available for emerging countries notably bear out the continuing strength of
the BRIC economies in 2008: China posted 10.6 per cent annualised growth in the first quarter,
India 9.0 per cent, Russia 8.5, and Brazil 5.8. There has thus been little change in the scenario
we presented for the full entire current year three months ago with a one-point loss of GDP
growth suffered not only by industrialised countries, down from 2.5 to 1.5 per cent, but also by
emerging countries down from 7.3°to°6.3 per cent. We still expect world economic growth of
three per cent for the full year.
Although there may be little change in the overall growth scenario, several risk-aggravating
factors warrant particular attention:
1. More difficult access to bank credit has been the main driver of the credit crisis
Central Bank surveys since mid-2007 reflect the much tougher attitude adopted by banks in
extending credit to companies and households in both the United States and Europe. The
results of these surveys are notably borne out by higher financing costs with the spreads on
long-term rates between risk-free loans and those granted to companies growing wider. The
ECB compared the trends on spreads in Europe and the United States, showing that at
equivalent levels of risk interest rate spreads have widened substantially more in the United
States, up 140 basis points for a BBB rated risk, than in Europe, up 115 points.
According to available statistics on the supply of bank credit to companies, however, there was
no observable slowdown in the first quarter this year in either the United States or Europe with
bank credit continuing to expand at annual rates of 20 and 15 per cent respectively. This
persistent dynamism may nonetheless be deceptive and cloak contrasting situations:
Experiencing difficulties in obtaining financing on financial markets, companies have been
turning to banks and thereby replacing the "poor risks" no longer enjoying access to loans due to
the more selective screening criteria applied. With the tightening of credit conditions only taking
place in recent months moreover, companies can continue to draw on credit lines granted at an

earlier date. And there is customarily a lag between decisions to tighten credit conditions and the
moment when the resulting impact on lending shows up in available statistics.
Statistics published on borrowing by non-financial companies in the euro zone in the first quarter
this year reflect the shifting of corporate debt from the market to banks: While the borrowing
continued to grow, bank loans were up 4.5 per cent but bond issues only 0.4 per cent. And total
corporate debt now represents 78 per cent of GDP according to the European Central Bank.
Like in Europe, the debt of non-financial companies grew further in the United States according
to the Fed, up an annualised 9.5 per cent in the first quarter this year after a 10.8 per cent
increase in the fourth quarter last year. And non-financial corporate debt now represents 74 per
cent of GDP. Even household debt is still growing albeit at a slower pace — 3.5 per cent down
from 6.1 per cent in the fourth quarter last year — with household debt representing nearly 100
per cent of GDP.
2. Rising energy prices have increased the pressure on companies with an easing of
raw material prices appearing moreover unlikely this year or next.
Raw material prices posted a spectacular increase early this year. From 1 January through mid-
June the average price of oil was 107 dollars against 72.5 dollars for 2007. The accelerating
price rise complicates matters in developing a hypothesis on barrel prices. We foresee an
average price of 118°dollars for 2008, up 63 per cent from last year. Unlike previous scenarios,
we no longer envisage a price decline in 2009 with the average price reaching an estimated 123
dollars.
Price trends for other raw materials will vary widely: While gold prices will continue to rise, up 27
per cent this year, price increases for commodity metals like aluminium and copper should be
limited to about six per cent. Nickel and zinc prices, however, should fall respectively 27 per cent
and 32 per cent. Prices for food raw materials will continue to soar, especially for grain and
sugar as a result of reallocation of arable land to more profitable crops as well as an apparent
increase in the livestock population in the United States

A decline in staple commodity prices seems very unlikely amid persistent problems with supply:
prices levels have depended on both strong demand from emerging countries — expected to
continue unabated — and a range of constraints affecting demand. The price rise is primarily
attributable to a lack of investment in raw material production operations (farm as well as fuel
products) in the 1990s. Until 2000, new technologies attracted a high proportion of new
investment with staple commodities not considered to have good growth prospects. Since prices
began to rise again — from their low-point early 1999 — the efforts made by producer countries
have been insufficient: the more prices rise the less they feel a need to increase production
capacity. In the case of oil, the 500.000 barrel increase in daily output announced by Saudi
Arabia for June/July notwithstanding, barrel prices have continued to rise. Just before that
announcement, Saudi Arabia had declared a freeze on production capacity beyond 12.5 million
barrels per day for 2010. This new strategic orientation adopted by the world's leading oil
producer constitutes a deliberate move that the country justifies by the objective of preserving
the oil wealth for future generations. But government officials doubtless have another line of
reasoning: if demand remains price inelastic there will be little need for costly investments to
increase the short-term profitability of the oil export income.
Beyond Saudi Arabia's strategic "about-turns", production declines or slowdowns have
developed in many producer countries. The logic underlying that trend varies widely from
country to country (besides a lack of investment, political tensions or maintenance problems can
affect supply) and is rarely as deliberate as in the case of Saudi Arabia, which cut production by
four per cent in 2007: In Russia, Venezuela, Mexico, Cameroon, Nigeria, Iran, and Algeria
production stagnated, slowed, or even declined in 2007. The latest statistics published by BP
show a production decline last year for eleven major oil producing countries representing 40 per
cent of world production. Besides these supply issues, other factors argue in favour of high and
volatile prices. The weakening of the dollar — the invoicing currency for oil transactions — has
prompted producer countries to push up prices. The market considers available production
reserves insufficient to cope with an interruption of production whatever the cause
(maintenance, cyclones, sabotage, and so on), which tends to make price volatility sensitive to
the slightest incident. Speculative investment also has a difficult to evaluate impact and
constitutes demand that is insensitive to price trends.

In short, the various constraints on supply at this juncture tend to reduce the likelihood of the
scenario based on a significant price decline in the 2008 second half or next year.
3. Inflation constrains monetary policy in emerging countries and strengthens the

strong euro scenario
A troubling upsurge of Inflation — largely fuelled by rising staple commodity prices — has
developed in the euro zone with prices up 3.7 per cent, substantially above the ECB's two per
cent objective. In the United States prices rose 4.2 per cent in May and new rate cuts by the Fed
seem less likely. In what shapes up as the most realistic scenario its key rates will remain at two
per cent in the coming year. The ECB meanwhile will be likely to raise its key rates in July with
European rates expected to reach 4.5 per cent by this September compared to 4.0 per cent mid-
June this year. As a result of the divergent policy stances across the Atlantic, the interest rate
differential between the euro zone and the United States should increase in the near term. And
this will not be conducive to easing the euro exchange rates with the dollar and other currencies.
The European currency has appreciated 5.4 per cent against the dollar and 2.7 per cent against
a basket of currencies thus far this year. Other factors with a crucial impact on the euro
strengthen the appreciation scenario: the American and European current accounts have been
relatively stable despite the pace of the euro/dollar appreciation. The euro zone current account
balance should be 0.8 per cent (and 0.1 per cent of GDP) in 2007 and 2008 with the United
States' balance expected to deteriorate slightly to a negative 5.4 per cent of GDP down a tenth
of a point.
As regards capital flows, the outstanding amount invested in euro-denominated securities

continues to grow for all types of instruments: equity, debt, or monetary. The euro's international
status as a reserve currency continues to grow with its share of world foreign exchange reserves
increasing from 18 per cent in 2001 to 27 per cent early this year. The euro dollar scenario
developed by Natixis supposes that the European currency appreciation will continue until
September and ease toward year end with the euro expected to reach a still-high 1.50 dollar rate
by mid-2009.

Although emerging economies continue their strong expansion, emerging Asia, Latin America
and emerging Europe should nonetheless lose a point of GDP growth while Africa and the
Middle East continue to grow at a steady pace buoyed by firm raw material prices.
The crisis has not, however, spared weak emerging countries, whose vulnerability it has
exposed: In Turkey and South Africa, as a result of economic slowdowns and unsustainable
external imbalances, the currencies have become very volatile and vulnerable to investor
sentiment with the volatility heightened by political uncertainty.
That deterioration of the economic environment will generate difficulties for companies in both
countries. In Vietnam and the Baltic states, corporate debt has become excessively dollarized or
"euro-ised". But a sharp adjustment of the economic overheating has developed in those
countries, resulting in severe pressure on the exchange rate in Vietnam and a hard economic
landing in Latvia and Estonia.
4. Inflation has given rise to risks of social instability in some emerging countries
Inflation has become a priority issue this year in emerging countries. Rising food and energy
prices have caused price indices to rise sharply in many of those countries with inflation
exceeding seven per cent in the first quarter in, for example, China, India, Indonesia, Egypt,
many sub-Saharan African countries, and the Gulf countries. There is a strong correlation
between the poverty level and the weight of food prices in overall price indices. That correlation
holds true not only by country but also by income category within a particular country.
In sub-Saharan Africa food price represent 60 per cent of the household shopping basket. And
the prices for rice and wheat are up 50 per cent since December with the high cost of living
sparking many violent demonstrations, particularly in Cameroon, Ethiopia, Côte d'Ivoire, and
Senegal. The economic context of high growth associated with the upsurges of prices has not
constituted an offsetting factor. In periods of improving economic conditions the public can be all

the more disgruntled by a price shock when the fruits of the growth are unevenly distributed. On
that score, the riots against immigrant populations in South Africa attest to the vulnerability of the
social situation even though the rise of the black middle class has been the source of the strong
domestic demand observed since 2006. Tensions could lead to unrest in Egypt, for example,
where prices were up 16 per cent in April while the economy grew seven per cent in 2007.
Inflation has surged in a context combining frustration of the people, a failure to economic
growth into tangible progress, and uncertainties over Hosni Mubarak's succession.
5. Tightening credit and investor skittishness will affect weak currencies and the
growth of overheating emerging economies
The external financial position of emerging countries has markedly improved as evidenced by
the substantial aggregate current account surplus — nearly five per cent of GDP — they
continue to enjoy in 2008. That enviable aggregate position nonetheless encompasses large
disparities: Africa and emerging Europe continue to run current account deficits widened by
strong domestic demand.
The economies concerned are dependent on portfolio investment and/or debt financing. They
particularly suffer when investor skittishness affects financial markets through greater selectivity
or a possible widening of spreads. The increase in spreads has been relatively moderate in the
recent past increasing from a low of 152 basis points end May 2007 to 330 bps mid-March this
year before easing to 255 bps three months later (mid-June). The increase in risk premiums thus
seems limited at this juncture especially in comparison to the high of 900 basis points reached
end 2002.
The weaknesses are of two very different and distinguishable types:

Countries with their financing needs covered by concessional debt: loans from bilateral and/or
bilateral creditors as in the case of low income African countries as well as Nicaragua and
Kyrgyzstan. Although the current crisis of confidence does not really affect that financing, the
political situations of those countries can affect their access to such aid.

Countries with their financing needs covered by growing corporate and bank indebtedness as in
the Baltic States, Romania, Bulgaria, Turkey, and Jordan. And these are precisely the countries
that Coface has negative watchlisted or downgraded with the exception, however, of Serbia
already rated at a high level of risk (C), Turkey already rated B, and Croatia (rated A4) whose
prospective admission to the EU has strengthened investor confidence. The countries in this
group seem vulnerable with their strong growth records often correlated with an upsurge of
domestic bank credit — frequently denominated in foreign currencies — often financed itself by
local banks through borrowing from their parent companies.
The banking sector in other countries is often dominated by non-resident shareholders from
Western Europe (Austrian banks in Central Europe, Scandinavian banks in the Baltic States).
Western European banks weakened by the subprime crisis could thus pass on any credit
tightening to their subsidiaries abroad. They could also decide to reduce their contributions to
subsidiaries located in countries considered "risky" where the size of current account deficits
augurs marked slowdowns in 2008 and 2009.
Credit and economic slowdowns are thus likely this year in emerging Europe with a high
proportion of negative watch listed and downgraded countries — Bulgaria, Romania, and three
Baltic States — located in that region.
The current credit crunch will, however, be likely to affect "only" economic growth and, to a
lesser extent, exchange rates often protected by high foreign currency reserves, fixed exchange
rate systems with their credibility enhanced by prospective membership — even in the distant
future — in the euro zone as in the case of Bulgaria or the Baltic states. The Romanian leu
governed by a floating exchange rate system will likely be among the most volatile currencies in
the near term. The banking system in these vulnerable countries are solid, with the notable
exception of Vietnam where bank credit underwent a vertiginous expansion from 35 per cent of
GDP in 2000 to 70 per cent in 2006, without having benefitted from a thorough systemic
overhaul.

COUNTRY WISE ANALYSIS OF COUNTRY RISK RATING , THEIR RECENT MARKET &
POLITICAL DEVELOPMENT
1. United States
Rated A2 since March 2008
The subprime mortgage crisis and tighter credit conditions continue to spread to the real
economy. The property downturn and the financial crisis have hit households and companies
hard exacerbated by continuing and increasing inflation, up 4.2 per cent end May. Despite
positive signs in the first months of the year economic growth will be weak in 2008, up 1.1 per
cent with the deterioration limited by a fiscal package representing one point of GDP and an
easing of monetary policy (with rates down 325 basis points between September and April)
whose initial effects should become apparent this autumn.
Households will continue to significantly reduce their consumption (70 per cent of GDP) by
substantially cutting back on discretionary spending and adjusting their behaviour as consumers.
With their confidence at a historic low they continue to cope with the decline in value of their real
property and financial assets, a shrinking job market, growing unemployment (5.5 per cent in
May, an increase of nearly one per cent more in a year), the decline of their disposable income
affected by higher prices for petrol at the pump (up 28 per cent between January and May) and
foodstuffs. With limited savings and high debt representing 13 per cent of their disposable
income they have to deal with stiffer conditions for refinancing their mortgage loans.
The continuing decline of residential construction, down 21 per cent for the year ending April
2008 will also affect economic growth with building permits and new housing starts down 30 per
cent and sales down over 40 per cent. Home prices, meanwhile, fell over 15 per cent for the
year ending this April. The default rate has moreover now begun to rise on borrower segments
other than subprime with housing stocks (10.6 months) bloated by foreclosures, which have
been accelerating. And the crisis has affected non-residential construction in turn with
companies that lack good access to credit postponing investments in facilities. Buoyed by low
debt (43 per cent of GDP) and high cash flow (80 per cent), companies will nonetheless likely
continue — albeit cautiously — to buy equipment despite erosion of the profit rate (11.1 per cent

of GDP). In such conditions, the growth of corporate investment should be limited to 2.8 per
cent.
Exports (12 per cent of GDP) continue to grow at a satisfactory pace thanks to favourable
exchange rates (effective real exchange rates down 9.6 per cent in the year) with Canada and
the European Union and the ongoing economic dynamism of emerging regions, representing 50
per cent of sales abroad, especially China and the Middle East. Imports, meanwhile, have been
at a standstill affected by the domestic consumption slowdown. Foreign trade should thus make
a slightly positive contribution to GDP growth.
The economic slowdown has affected corporate payment behaviour. According to the private
AACER institute, corporate bankruptcies increased 46 per cent in May 2008 compared to May
2007. That reflects the deterioration of the Coface payment experience, centred particularly on
companies in sectors associated with domestic consumption. Rising costs for energy, shipping,
and some inputs have affected their margins and the current credit crunch has worsened their
strained financial positions. The sectors particularly affected include not only residential
construction (home developers and builders, manufacturers and distributors of furnishing
materials for construction, intermediaries and financial institutions) but also car manufacturing,
and distribution linked to housing. Services to private individuals and leisure (restaurants,
hospitality, travel), as well as the textile-clothing and Hifi-TV-video sectors have also suffered
from the greater selectivity exercised by households in their spending.
WESTERN EUROPE
Western Europe should lose a point of growth this year, down about a third from the expansion
achieved in 2007 (1.8 per cent compared to 2.8 per cent). Contrary to expectations, economic
growth was relatively satisfactory in winter and spring. The slowdown should thus mainly
develop in the second half.
Households faced with rising food and energy prices and tighter credit conditions have been
holding back on spending. The residential property downturn has continued, affecting jobs and
tax revenues.

Companies have also been coping with rising costs and those operating in the euro zone with
unfavorable exchange rates. Although their exports have slowed, companies have nonetheless
maintained satisfactory growth thanks to continuing strong demand from emerging countries and
raw material producing countries. Their margins have, however, tended to shrink.
In such gloomy economic conditions, governments have elected to freeze efforts to improve
public sector finances or, for those already endowed with surpluses, to use them as a growth
stimulus.
Beyond this broad overview, however, it is necessary to distinguish between the few countries
where the economy will slow substantially and/or growth will be weak and the great majority
where the differential will be limited and/or growth will remain at a reasonably good level.
The first group of countries includes above all Spain where residential construction — the main
growth engine — has been collapsing and payment behaviour has deteriorated sharply. The
decline of Spain's domestic demand has had a recessive effect on Portugal, where growth was
already weak and 30 per cent of exports flow to its Iberian neighbor. The slowdown has also
been pronounced in Ireland and Iceland with the payment behaviour of Irish companies
nonetheless only evidencing deterioration in construction and that of Icelandic companies
showing no deterioration at all. In Italy, with payment behaviour traditionally below the European
average, payments incidents have been perceptibly trending up. In Denmark, where growth has
been weak, corporate bankruptcies have increased, especially in construction. In the United
Kingdom, residential construction and consumption have lost their verve but payment behaviour
continues to improve.
The second group includes Germany and Austria where exports continue to drive the economy
and France, Norway, Finland, the Netherlands, and Switzerland where consumption has held up
well.

Germany
Rated A1
Although slowing in the second half, economic growth should still reach 2.2 per cent this year.
Slower growth of exports to Europe and the United States notwithstanding, the foreign trade
contribution to GDP growth will nonetheless remain largely positive amply offsetting the
continued sluggishness of private consumption. Households will doubtless benefit from the
continued easing of unemployment and concomitantly from reduction of the unemployment
insurance contribution rate. But they will be prompted to exercise restraint by the rise of energy
and food prices and by the weak growth of disposable income despite the significant wage
increases won in certain sectors.
Benefiting from low debt and high profit margins, companies should maintain good payment
behaviour, a trend borne out in the first quarter this year by an excellent Coface payment
incident index and a stable bankruptcy rate. The reduction of corporate income tax in 2008 in a
context of balanced public sector finances will have a positive influence. Residential construction
will, however, remain a difficult sector, particularly in the eastern part of the country. The kitchen
furniture sector has also exhibited a high risk profile. Automotive subcontracting has suffered
meanwhile from increasing delocalization eastward on the continent.
France
A1 rating
Economic growth should slow to 1.6 per cent this year down from 2.1 per cent in 2007.
According to the official statistics agency INSEE household confidence continued to deteriorate
in May. That should prompt consumers — whose debt grew from 53 per cent of disposable
income in 2000 to nearly 72 per cent in 2007 — to exercise caution on discretionary spending
and to replenish precautionary savings (over 16 per cent of their gross disposable income). After
a first quarter slowdown household consumption (57 per cent of GDP) should thus only increase
slightly for the full year, up 1.3 per cent with purchasing power suffering from the rising cost of
energy and food products and a higher tax burden compared to last year.

Loans to households, particularly in relation to housing, have been gradually slowing since end
2006. Tightening conditions for granting bank credit will continue to affect residential investment.
New housing starts fell nearly 10 per cent year-on-year in the first quarter 2008.
Non-residential construction should stagnate meanwhile with companies postponing

infrastructure investments as a result of higher borrowing rates and greater difficulty in arranging
financing. The steady erosion of their profits — down from 8.5 per cent of GDP in 2000 to 5.2
per cent in 2007 — and their cash flow ratio from 85 per cent in 2000 to 60 per cent in 2008 has
made them particularly sensitive to the conditions of access to the credit on which they have
relied more since 2004. The domestic demand slowdown will tend to slow import growth, which
should limit any widening of the current account balance. Two main factors, meanwhile, will
hamper exports: less dynamic demand from European trading partners and the euro
appreciation in dollar zones undermining the competitiveness of French products. Those
negative factors notwithstanding, exports will grow at essentially the same rate as they did in
2007 with foreign trade likely to make a positive contribution to GDP growth.
The corporate mark-up rate should remain stable on average this year at 31.4 per cent. That
rate nonetheless masks disparities with the margins of smaller companies eroded by price
increases for intermediate products, which they will not always be able to pass on in sales
prices, and with access to credit particularly tightened for this company segment. Industrial
sectors burdened by high debt will thus bear close watching notably in automotive and
aeronautical subcontracting, paper, and metals. Vigilance is also in order for the IT sector
(assemblers and distributors), the hog industry (breeders, cooperatives, slaughter houses,
distributors), and cattle feed and fertilizer wholesalers and cooperatives. In construction, the
decline of orders from developers may affect some subcontracting companies. Corporate
bankruptcies increased over nine per cent —12-month moving average through March 2008
(source Coface Services) — a trend consistent with the growth of payment incidents recorded by
Co face thus far this year.
DENMARK
A1 RATING

ON NEGATIVE WATCHLISTING
Reason for negative watchlisting the rating : Economic growth will be weaker in 2008, up 1 .4
per cent, affected by cutbacks in consumption by households whose confidence has begun to
suffer from the inflationary pressures and the value lost by their financial wealth. Companies will
put the brakes on investment (up 1.6 per cent after up 8.8 per cent in 2007) highly dependent on
bank credit and thus particularly sensitive to current credit restrictions. Margins should shrink,
squeezed by rising wage costs amid a very tight job market and by higher prices for inputs.
Bankruptcies continue to rise, up 25 per cent for the first five months of the year.
Growth slowed markedly in 2007. Households have reduced their spending affected by both a
property market correction and higher interest rates. However, wage growth spurred by record
employment had a mitigating effect on the slowdown. Companies suffered, meanwhile, from
erosion of their productivity and a slowdown of their exports.
The economy remained flat in the first months this year with only 1.4 per cent growth expected
for the full year. Deeply in debt and not withstanding the steady rise of their incomes,
households continue to exercise caution on spending and their consumption (49 per cent of
GDP) should dwindle further. Several unfavourable trends have eroded their confidence:
growing inflation expected to reach 3.1 per cent, the value lost by their financial assets (down
USD 16 billion in the 2007 fourth quarter according to the Central Bank, and tighter credit
conditions. Residential construction will decline about six per cent this year with commercial
construction remaining at a standstill. With investment by manufacturing and service companies
heavily dependent on bank credit, it will slow substantially, a trend consistent with the tightening
loan conditions. Corporate competitiveness will suffer from a range of factors: a job market
expected to remain tight, increasing difficulty in recruiting skilled personnel, wage growth, and
saturation of production capacity. Oil and natural gas sales will continue to underpin exports
whose growth will nonetheless be hampered by production capacity constraints, the economic
slowdowns affecting traditional trading partners, and by the krone's strength in some markets.
Weaker domestic demand will hold imports down meanwhile, which will contribute to limiting the
reduction of the current account surplus.

The government's' fiscal budget will show a surplus again this year buoyed by revenues
associated with North Sea hydrocarbon prices. Spending could, however, increase more than
expected due to commitments made during the autumn 2007 general elections. The government
will in any event continue reducing public sector debt. In this context of weak growth, labour-
intensive sectors will likely be subject to cost pressure while sectors focusing mainly on the
domestic market should suffer from the domestic demand slowdown. The pace of corporate
bankruptcies continued to accelerate in the first five months this year, up 25 per cent after an
increase of 21 per cent in 2007. The sectors affected most include industry, construction,
distribution, and hospitality-catering.
Spain
Rated A2
Reason for the rating change: Spain's A1 rating is downgraded to A2 due to deterioration of
corporate payment behaviour amid weakening economic conditions with 1.6°per cent growth
expected this year down from 3.8 per cent in 2007. The residential construction sector that had
been the main growth driver has continued to decline with substantial negative repercussions on
consumption and Investment.
The marked growth slowdown under way since the year began has continued with the economy
likely to be very dull by year end. That trend is mainly attributable to a very pronounced domestic
demand slowdown affecting both consumption and investment. Investment in residential
construction, which still represented nine per cent of GDP and jobs until recently, has collapsed.
Households are contending at once with a significant increase in unemployment, price inflation
for food and energy, price erosion affecting their property assets, rising interest rates while they
carry variable rate debt, and the tightening of conditions for taking out loans. They have
consequently sharply reduced their consumption spending.

In this unfavourable context, payment behaviour has deteriorated overall. While remaining
satisfactory for households due notably to social pressure, corporate payments have
deteriorated sharply a trend consistent with the decline of their profits. Smaller companies
associated with the housing market — joinery and fenestration, real estate agents, developers,
manufacturers and distributors of equipment and material for the home — often debt-burdened
and having increased in number while the market was strong, have been the most vulnerable.
Road transport has suffered from rising petrol costs while the automotive industry has to
contend increasingly with Eastern European competition and slumping local vehicle sales. Only
tourism seems safe at this juncture but it could suffer in turn from the slowdown grinding away in
Northern European countries.
The foreseeable acceleration of the decline in housing prices, the continued rise of
unemployment, the interest rate hikes announced by the ECB, and the expected slowdown of
corporate investment in equipment and facilities do not augur well for an upturn any time soon.
Tax breaks representing one point of GDP — rental support for youth and low-income families,
increases in small pensions, an income tax reduction of EUR 400, cancellation of the wealth tax,
—facilitated by the good health of public sector finances and the public infrastructure spending
continuing under the PEIT multi-year modernisation programme will only have a limited positive
impact. And with imports in a more pronounced slowdown than exports the negative foreign-
trade contribution to GDP growth will be smaller but barely make a dent in the massive current
account deficit.

Portugal
Rated A2
On negative watch listing
Reason for negative watchlisting the rating: Economic growth will slow in 2008 in phase with the
slowdown of household consumption and exports. Deeply in debt (129 per cent of disposable
income), households have experienced difficulties in getting loans to finance their spending and
will likely draw less on their savings. Corporate investment will remain moderate and the process
of re-specialising in higher value-added sectors will still be too shaky to enable companies to
cope with the weaker demand from the European Union — which provides a market for 70 per
cent of its export sales — and particularly demand from Spain (30 per cent). The activity of some
companies should, however, derive support from large infrastructure projects. The upsurge in
bankruptcies in 2007, up 62 per cent, is partly attributable to a legislative change.
Economic growth accelerated slightly in 2007, buoyed by domestic demand and exports. Limited
wage growth prompted households to take on additional debt and draw on their savings to
finance their spending. Corporate investment made a significant recovery facilitating a slight
improvement in productivity and competitiveness. Exports thus developed at a solid pace
without, however, winning new market share. Increased debt service notwithstanding, the
government continued to pursue its public sector deficit reduction objectives.
Growth should be weaker in 2008 amid slowdowns of both private consumption and exports.
Households — with their heavy debt burden reaching 129 per cent of disposable income — will
reduce spending in a context of weak job growth, higher interest rates, rising prices for energy
and food products, and increasing tax pressure. Tighter credit conditions should undermine the
timid property investment recovery fostered by tourism and the migration of the rural population
to large cities. Companies will reduce their investment in machinery with production capacity
utilisation down in the first months this year. Their business activity will benefit, however, from
infrastructure projects like the new Lisbon airport facilitated by community funds supplemented
by domestic resources. The results of the efforts made by companies in recent years to improve
their competitiveness and adjust their specialisation in favour of higher value-added products are
still too shaky to enable them to cope effectively with the slowdown of foreign demand,

particularly from the European Union, the outlet for 70 per cent of sales abroad. The domestic
demand slowdown will slow and facilitate a slight reduction of the huge current account deficit.
Despite the lagging pace of efforts to reorganise the civil service, the government will go forward
with the process of growth convergence with the other euro zone countries by further reductions
in its public sector deficit. Partial privatisation of Portugal's TAP airline, INAPA papermaker, and
Energias electricity supplier will moreover facilitate reducing the public debt.
Application of new legislation adopted in 2005 was partly responsible for the 62-per cent
increase in bankruptcies last year. Reflecting the trend toward increasing difficulties for
companies in the current economic context, the Coface payment incident index has deteriorated
since April 2008. The economic fabric will remain weak this year as a result of the lagging pace
of efforts in many sectors to integrate new technologies and improve labour skills.
That has notably been the case in the textile-clothing and shoe industries, which have been
contending with stiff competition not only from low-cost countries but also from emerging
European and Euro-Med countries. The efforts to overhaul these sectors will thus continue in
2008.
Emerging Europe
The Emerging Europe region, encompassing Central Europe and Turkey, should lose a point of
GDP growth in 2008, down from 5.6 to 4.6 per cent under the effect of sagging foreign demand,
rising prices, and tighter monetary policy. Several factors have, however, had a mitigating effect
on the slowdown: rising wages, the influx of foreign direct investment and European funds, and
the growth of the region's share in Western European imports. Economic growth will moreover
remain three points higher in the region than in the euro zone, its main trading partner. Except
for the Baltic States, which have been contending with a marked credit slowdown, severe
erosion of purchasing power, and a downturn in the property market, regional growth has mainly
been trending up thus far this year.
Although steady tax revenues have facilitated reducing the public sector deficit in several
countries, fiscal reforms have lagged behind schedule, and wage and social spending are up
sharply.

Combating the inflation fuelled by rising foodstuff and energy prices and a tightening of the
labour market has become the primary economic policy challenge. In this context regional
central banks will likely continue tightening monetary policy. The high level of inflation has
postponed adoption of the euro by the new member countries until at best 2012 with the
exception of Slovakia, which already has approval to adopt the single currency on 1 January
2009.
The widening of current account deficits and the rapid growth of private sector debt and loans
denominated in foreign currencies in conjunction in some cases with the bursting of speculative
property bubbles have made many regional countries vulnerable to a currency crisis or sudden
adjustment of growth. Fears of a hard landing for the Estonian and Latvian economies in
particular are largely borne out by the slowdowns observed early this year. Lithuania, Romania,
Bulgaria, Hungary, and Turkey remain the other weak countries in the region. Turkey notably still
has the highest external financing needs of any emerging country while the procedure underway
to ban the party in power has substantially increased the political uncertainties. The risk
premiums for sovereign default reached high levels for those weak economies in the wake of the
subprime crisis before easing substantially since mid-March this year. The Romanian leu —
even if it has steadied slightly since end January 2008 — remains the regional currency most
affected by that crisis.
Estonia
Rated A3
Reason for the rating change: The severity of the growth slowdown observed in the first quarter
this year (up 0.1 per cent year-on-year, after up 4.8 per cent in the 2007 fourth quarter and up
7.1 per cent for all of 2007) raises fears of a hard landing for economic growth. Household
confidence is affected by falling property prices and resurgent inflation (up 11.4 per cent end
April this year). Continued wage growth has, meanwhile, been squeezing the margins of
companies moreover faced with increasingly tight credit conditions.
That should affect investment. With domestic demand expected to decline, a slight recession is
not out of the question this year even if exports remain dynamic (up 19 per cent in value terms in

the first quarter this year).

Construction and sectors linked to consumption or that are labour intensive are particularly
vulnerable.
The marked first-quarter slowdown may foreshadow a hard landing for economic growth for all
of 2008. Tighter credit conditions, deflation of the speculative property bubble, erosion of
household purchasing power, and narrowing corporate margins could pave the way to a slight
recession this year. Inflation continues to grow — up 11.4 per cent in a year through end April
2008 — due to increases in food and energy prices, excise taxes, and wages. The objective of
joining the euro zone in 2011 seems out of reach in this context. The expected decline of tax
revenues should not, however, jeopardise the solidity of public sector finances, which have been
running surpluses until now. Government debt has moreover been low, representing 3.4 per
cent of GDP. The weakening of domestic demand should, meanwhile, have the beneficial effect
of reducing a current account deficit that reached a difficult to sustain level in 2007 (17.3 per
cent of GDP) necessitating, in the absence of adequate foreign direct investment inflows
extensive recourse to borrowing abroad. The resulting increase in debt reflects in particular the
credit lines granted by Nordic banking groups to local subsidiaries. In the political arena the
coalition government has been experiencing its first signs of tensions. Relations with Russia
have moreover remained tense since the riots triggered in April 2007 by the officially-approved
moving of a statue commemorating the glory of Soviet soldiers. But the economic impact of
these diplomatic tensions should remain limited to oil transit trade
.

Latvia
Rated A4
Reason for the rating change: A hard landing for the Latvian economy has become a distinct
possibility at this juncture. Growth fell to 3.3 per cent year-on-year in the 2008 first quarter, down
from 8.1 per cent in the fourth quarter last year. Economic activity has suffered mainly from the
deflation of the speculative property bubble and the tightening of credit conditions compounded
by high inflation, up 17.5 per cent end April 2008. Exports have, however, been growing rapidly.
GDP growth should fall to about 2.4 per cent in 2008, down from over 10 per cent these past
three years. Sectors involved with construction or consumption and those that are labour
intensive, which have to contend with rising payroll costs, are the most vulnerable.
The economic slowdown should be pronounced in 2008 with GDP growth down from
10.3°per°cent to 2.4 per cent under the effect of the property market downturn, tighter credit
conditions, and the erosion of purchasing power. With domestic demand weakening slightly,
only the positive contribution to growth made by foreign trade kept the country from falling into
recession. The increases in regulated prices and in food and energy prices will keep inflation at
high levels, up 17.5 per cent end April, the decline of domestic demand notwithstanding. In such
conditions Latvia is not expected to adopt the euro before 2012/2013. The pronounced import
slowdown should facilitate reducing the current account deficit from 22.8 per cent to 14 per cent
of GDP this year. Foreign direct investment finances slightly under a third of that deficit while
external debt, mostly owed by banks, has reached nettlesome levels. Although — after the
virtual fiscal equilibrium of recent years — re-emergence of a slight public sector deficit appears
likely, sovereign risk remains very moderate due to the low level of government debt (10 per
cent of GDP). In the political arena meanwhile, corruption scandals could engender a degree of
instability, but not of a nature, however, likely to jeopardise the main economic policy options.

TURKEY
RATED B
After several years of strong growth in the wake of the 2001 crisis, Turkey suffered a slowdown
(4.5 per cent in 2007) amid interest rates at their highest level since mid-2006 and a poor
harvest. Rising inflation (slightly over 10 per cent in April 2008), tight credit conditions at the
international level, and current new political uncertainties have prevented the easing of monetary
policy crucial to reviving domestic demand. Middle Eastern dynamism, meanwhile, should only
partly offset the European demand slowdown. Overall, growth should be relatively modest in
2008, around four per cent. A slight recovery will be possible in 2009 provided the political crisis
is durably resolved and a more favourable international environment makes it possible to reduce
interest rates.
In the current volatile world financial environment, the demand filed by the public prosecutor
attached to the highest court of appeal to ban the party in power (AKP) constitutes a major risk
factor. The likelihood of the constitutional court approving the ban is significant. In that case new
elections seem inevitable, which would prolong the uncertainties, probably until early 2009.
These uncertainties in combination with a less favourable international credit environment
heighten the main risk — a currency crisis — overhanging the country, especially with its
external financing needs larger than those of any other emerging country. Although foreign
direct investment inflows are now significant those needs are also covered by loans taken out by
private companies whose debt has been growing strongly and by volatile capital. A loss of
confidence by foreign creditors in this context could trigger a currency crisis that would
particularly weaken companies with high foreign currency debt but with revenues denominated
in local currency. Some of the firms with foreign currency debt are nonetheless exporters.
Turkish companies moreover generally coped effectively with the previous — albeit relatively
mild — shocks of May 2006 and summer 2007. Above all, and unlike 2001, public sector debt is
now manageable and the banks enjoy solid foreign exchange positions. A crisis on the scale of
that of 2001 is thus highly unlikely at this juncture.

Russia
Rated B
GDP growth reached 8.5 per cent in the first quarter and should continue to trend up throughout
the current year buoyed by the dynamism of household consumption and investment, especially
currently-surging foreign direct investment, On the supply side, construction (up 28 per cent),
wholesale and retail commerce, transport and telecommunications, property, and B2B services
should continue to expand rapidly. In the current buoyant economic conditions, the Coface
payment experience on Russian companies continues to reflect the major shortcomings of the
business environment.
The current surge of inflation (15.1 per cent in the first quarter this year) will moreover bear
watching. Inflationary pressures should ease slightly for the full year as a result of the good grain
harvest and tighter monetary policy with interest rates raised in June for the third time this year.
Inflation will nonetheless remain high: 12.6 per cent expected for all of 2008).
The financial position remains sound. Although external debt ratios have improved, massive
recourse to borrowing abroad by companies and banks has kept credit risk at appreciable levels
in a context marked by a lack of transparency. Liquidity crisis risk remains limited, however,
thanks especially to the Russia's large foreign exchange reserves. The emergence this year and
next of financing needs only partly covered by foreign direct investment contribute to increasing
the country's dependence on financial markets and increasing its vulnerability to a loss of
investor confidence.
Although benefiting from the buoyant economic conditions, the banking sector still has
significant weaknesses. Besides being too fragmented, it suffers from shortcomings on risk
management and the transparency of financial information. With bank intermediation relatively
limited, however, systemic risk is very small.
In the political arena, relations with Georgia deteriorated early 2008 over the Abkhazia and
South Ossetia issue. A risk of conflict remains a plausible scenario. Domestically, the coming
into power of Dmitri Medvedev could mark a more liberal shift and facilitate progress on political
liberty and the campaign against corruption.

China
Rated A3
After peaking at 11.9 per cent in 2007, China's economic growth is expected to ease slightly in
2008 to 9.5 per cent. In the first quarter this year it reached 10.6 per cent. With domestic
demand the main growth driver, the impact of the American slowdown should thus remain
limited. Inflation, meanwhile, accelerated to 6.5 per cent in 2007 and reached 8.0 per cent in the
first quarter this year, fuelled mainly by rising food and energy prices. It is likely to remain high
throughout the year with officials having decided in June this year to raise diesel and petrol fuel
prices by 18 per cent as well as electricity prices. Underlying inflation nonetheless remains
below two per cent. Concerned over the social repercussions, the government will likely
continue to tighten monetary policy — with increases in interest rates and especially mandatory
reserves (five increases since the year began) — even if the tightening has had little effect thus
far. Targeted administrative measures, like price freezes, may moreover be taken in 2008. The
yuan appreciation has been accelerating, meanwhile, up 9.3 per cent year-on-year in May 2008
compared to up 6.9 per cent for all of 2007. Even if the yuan appreciated 10 per cent a year,
however, it would take twelve years to shed its undervalued status with the IMF evaluating the
equilibrium exchange rate for the Chinese currency against the dollar at just 1.96 yuan
compared to 7.39 yuan in 2007.
Despite the expected export slowdown, meanwhile, China will continue to run large current
account surpluses. The excess liquidity generated not only by those surpluses but also by the
massive influx of capital ultimately ends up flooding the stock market evidenced by the 110 per
cent increase in the Shanghai Stock Market index in 2007. Despite the price corrections that
developed between January and May 2008 (down 35 per cent), the price earnings ratio remains
a very high 60 showing that the attendant risks of speculative bubbles and volatility remain
substantial.
Organization of the Olympic Games will mark 2008 and the infrastructure investments made in
consequence constitute an opportunity for the country. The results of a study by JP Morgan
showed, however, that the Olympic Games only had a very marginal impact on the economy in
Korea in 1988, Spain in 1992, the United States in 1996, Australia in 2000, and Greece in 2004.

The aftermath of the Games could moreover — by causing sharp cuts in investment and
consumption spending, — be a contributing factor to the economic slowdown.
Meanwhile, the social and political upheavals linked to growing inequality between urban and
rural areas as regards the effects of rising prices will bear watching.
VIETNAM
RATED B
ON NEGATIVE WATCHILISTING
Reason for negative watchlisting the rating: Vietnam's strong growth — eight per cent on
average since 2003 — has given rise to economic overheating with inflation reaching 12.6 per
cent end 2007 and surging 25 per cent year-on-year this May. The current account deficit,
meanwhile, widened significantly in 2007 and could reach 13.6 per cent this year. In the context
of a Vietnamese currency — the dong — pegged to the dollar and a banking system highly
dollarized, foreign exchange risk has increased. A major dong depreciation could thus be
accompanied by a marked growth slowdown — with a 5.0 per cent expansion expected for 2008
down from 8.5 per cent in 2007— and an increase in corporate default risk.
Vietnam has enjoyed growth of over eight per cent since 2003 thanks to development strategy
(inspired by the Chinese model) based on trade liberalisation and marked by admission to the
WTO in January 2007 and a high rate of investment. That economic dynamism has engendered
signs of overheating, especially since 2007. And with the dong pegged to the dollar and the
banking system highly dollarized the overheating has given rise to increased foreign exchange
risk. A major dong depreciation could thus be accompanied by a marked growth slowdown —
with a 5.0 per cent expansion expected for 2008 down from 8.5 per cent in 2007— and an
increase in corporate default risk.
After accelerating to 12.6 per cent in 2007, inflation has surged thus far in 2008 reaching 25°per
cent this May year-on-year. That acceleration is attributable to the rapid expansion of credit (up
54 per cent in 2007), rising prices for food and oil (with Vietnam a net oil importer since early

2007), soaring housing and construction prices, and increases in wages have fuelled the
inflationary spiral.
Monetary policy has become tighter with mandatory reserves higher and interest rates increased
from 8.0 per cent to 14 per cent. These measures notwithstanding inflation will likely remain high
throughout the year, reaching 18.3 per cent.
The current account deficit meanwhile has continued to widen. It represented 9.6 per cent of
GDP in 2007 and could reach 13.6 per cent this year — compared to just 0.4 per cent in 2006 —
amid strong growth of imports, especially capital goods needed for the many investment projects
notably in construction. The widening current account deficit prompted the government to
devalue the dong by two per cent in June. But foreign exchange risk has nonetheless remained
substantial with the dong converted on the black market at rates below official parity with a 7.0 to
15 per cent discount. The forwards market has similarly discounted a 30 per cent-depreciation.
And the banking system is very sensitive to exchange rate risk as a result of its extensive
dollarization with 30 per cent of deposits and the appreciable proportion of bank intermediation
resulting in dollar-denominated loans.
Vietnam's banking system remains weak in general despite some recent reforms that resulted in
a more straightforward opening of the market to foreign banks and privatization of three state-
owned banks. Seven state-owned banks controlling 70 per cent of total bank assets nonetheless
continue to dominate the sector. The high proportion of non-performing loans — one in four —
associated with the rapid expansion of credit constitutes a major vulnerability. The lack of
transparency and the failure to apply international risk management standards are additional
sources of weakness.
The growing risk of a liquidity crisis due to the country's limited foreign exchange reserves will
also bear watching. The government's decision to stop publishing information on the banking
system and the level of foreign exchange reserves has moreover resulted in a lowering of
expectations on Vietnam's financial outlook.

Vietnamese risks have thus been sharply downgraded — with Standard and Poor's and Fitch
notably reducing the outlook for Vietnam from "stable" to "negative" — and a hard landing may
be looming for the economy.
India
Rated A3
Tighter monetary policy notwithstanding, economic growth was higher than expected in the first
quarter this year (up 8.8 per cent) driven by industry (up 10.9 per cent) and services (up 13 per
cent). Domestic demand nonetheless remains the main growth engine with consumption and
especially investment still strong in the private sector. And GDP growth rests on sound
fundamentals: high savings and investment rates and moderate external debt ratios. With a
more self-contained economy than the other emerging major powers, India is less dependent on
international economic conditions and should thus be largely spared the effects of the American
slowdown. In these circumstances the Co-face payment incident index for Indian companies
remains below the world average.
The main source of concern at this juncture is an inflation rate that reached 11.05 per cent for
the year ending 7 June 2008. That inflationary surge is partly attributable, however, to the
12°per°cent increase in fuel prices decided by the government and by rising prices for food,
which represents high proportion of the household shopping basket. Further interest rates hikes
by the central bank are nonetheless likely, which could affect growth in the second half this year.
The deterioration of external accounts is less troublesome since it remains moderate and inflows
of long-term capital largely cover India's external financing needs. The continuing presence of
speculative property and stock market bubbles will continue to bear watching, however, in the
currently more unstable world financial context.

Latin America
GDP growth is expected to slow to 4.3 per cent in Latin America this year down from 5.5 per
cent in 2007 amid a less buoyant international environment and an economic slowdown in the
United States, even with domestic demand still making a decisive contribution. Although still
strong, world demand for staple commodities, especially in Asia, could decline in 2009, as could
the high prices for raw materials, and deepen the economic slowdown. Most regional countries
have, however, been able to reap the benefits of a previously favourable world context that
facilitated cleaning up external accounts, building up substantial foreign exchange reserves, and
continuing to reduce foreign debt.
The resurgence of inflation — under relatively good control until now except in Argentina and
Venezuela, — constitutes a challenge to continuing to pursue the generally appropriate
monetary and fiscal policies that have contributed to the steadiness of local currencies and
facilitated cleaning up public sector finances. With the region's stronger macroeconomic
foundations and the greater credibility of the economic policies pursued, the international
financial turbulence should have limited impact there with the region's large economies unlikely
to experience major financing difficulties, tightening credit conditions at the world level
notwithstanding. Although radical tendencies continue to mark the politics of some countries
(Venezuela, Bolivia, Ecuador), the political options of most of the other countries are moderate.
In general, however, the institutional and business environments leave room for improvement. In
this context, corporate payment behaviour has deteriorated slightly but nonetheless remains
relatively satisfactory although some sectors, like textiles, continue to be faced with
competitiveness problems with others, like agriculture, remaining subject to weather conditions.

Mexico
Rated A3, negative watchlist status since mars 2008
The economy is likely to slow this year with 2.6 per cent growth in the first quarter and
2.3°per°cent for the full year down from 3.3 per cent in 2007 due especially to the economic
slowdown in the United States on which Mexico remains dependent as a market for its exports.
The fiscal stimulus through measures intended to buoy domestic demand, the main economic
engine, should produce a slight upturn in 2009. Tight monetary policy meanwhile should ease
inflationary pressures notably attributable to rising food and energy prices and limit the overall
rise in prices to 4.5 per cent for the year. The economy's relatively solid foundations will likely
mitigate the effects of international financial turbulence.
The process of improving public sector finances, which depend on oil revenues, will stall,
however, as result of the fiscal stimulus programme. With a decline in oil production, slumping
exports to the United States, and a slowdown in emigrant worker remittances, the foreign trade
deficit will begin to widen from 2009. Foreign direct investment is expected to cover half of
external financing needs, however, with Mexico's already moderate external debt ratios likely to
decline further.
Efforts to modernise the economy, and particularly to reform the state-owned oil company
Pemex, have come up against stiff resistance on political and social grounds with President
Calderon lacking a parliamentary majority.
In this context, the business environment still leaves room for improvement with the Coface
payment experience on Mexican companies deteriorating somewhat although remaining
acceptable. The difficulties experienced in the textile, clothing, and shoe industries reflect their
problems in meeting foreign competition, especially Asian, while the problems in the food
industry are more cyclical in nature.

Brazil
Rated A4
With domestic demand still the main growth engine, the economy is expected to remain
relatively strong this year — after a 5.8 per cent expansion in the first quarter, 4.6 per cent is
expected for all of 2008 and slightly less (4.1 per cent) in 2009 compared to 5.4 per cent in 2007
— but without reaching, however, the five per cent growth targeted in the government's priority
Growth Acceleration Programme. The country has shown a noteworthy capacity to cope with the
volatility of international financial markets. Inflationary pressures, with the rise of prices
accelerating this year and likely to reach six per cent by year end, have prompted the central
bank to begin another cycle of increases in its already high key rate.
The underperformance of exports but especially the dynamism of imports and a widening
services deficit should cause a current account deficit to emerge this year and increase in 2009.
Foreign direct investment will likely cover, however, most of Brazil's external financing needs.
The country's external vulnerability is expected to ease, moreover, thanks to the improvement in
the external debt ratios. And the record level of foreign exchange reserves constitutes a very
solid safety net even if a widening current account deficit in 2009 could contribute to a
weakening of the currency.
Public sector debt, meanwhile, is still too high (with the gross amount outstanding expected to
represent 64 per cent of GDP this year and the net amount 41.5 per cent), which notably tends
to impede investment and infrastructure modernisation. But the adoption of the structural
reforms needed to sustain stronger growth is impeded, however, by the governing parliamentary
coalition's lack of homogeneity and the government's lack of commitment in the run-up to
municipal elections late this year and presidential elections in 2010 with the constitution denying
President Lula da Silva the right to run for a third term.

North Africa and Near & Middle East
Oil prices, which virtually doubled in the space of a year, have provided the region's producer
countries with the resources to ensure the perpetuity of major infrastructure projects whether in
the Gulf Monarchies or Algeria. But the rising cost of rent, construction materials, and, subsidies
notwithstanding, fuel and food products, have created inflationary pressures exacerbated by the
depreciation of the dollar to which the currencies of most Gulf monarchies are pegged. The price
surge could cause delays in some projects and severely reduce consumer purchasing power,
limiting nonetheless strong growth outside the oil sector. That is especially the case in the
United Arab Emirates and Saudi Arabia. After two years of reduced hydrocarbon production in
the Arabian Kingdom, an upturn is expected this year with growth reaching about six per cent.
Although foreign debt has been growing in the region — except in Algeria, which has pursued
tight policy on that score — any over-indebtedness risk has to be put into the perspective of the
extensive and growing asset holdings abroad. Fiscal expansionary policy in Iran has spurred
growth but at the expense of stoking inflation that exceeds 20 per cent. The country's inflexible
positions on the nuclear issue has prompted the United Nations and the United States to impose
sanctions that make economic and financial transactions more complicated and costly.
Petrodollars from the Gulf Monarchies have indirectly benefited the other countries in the region
via investments, tourism, and emigrant worker remittances. Coping with the oil bill will be
particularly painful for Jordan and Lebanon, which already run high external deficits, respectively
20 and 12 per cent. Soaring foodstuff prices have triggered riots, particularly in Egypt. Remedial
measures taken to offset subsidy reductions and rising prices for food products have widened
public sector deficits in Egypt, Jordan, Syria, Lebanon, and Yemen. Israel, meanwhile, has
withstood the slowdown in the United States relatively well, achieving 5.4 per cent growth in the
first quarter, driven by household consumption and investments. The international credit crunch
has, in general, had little effect on the region.
Geopolitical tensions continue to run high in that corner of the world, spurring Islamist
movements in opposition to governments that in general enjoy good relations with the United
States. The chaos reigning in Iraq remains a source of regional destabilisation and the Iranian

nuclear issue continues to be a major factor of uncertainty. Perceptible signs of easing tensions
have nonetheless emerged. Qatar's mediation in Lebanon notably led to the election of a
president paving the way for restoring the normal functioning of institutions paralysed since
autumn 2006. The resumption of talks between Hamas and Fatah and the truce between Israel
and Hamas augurs a possible revival of the Middle East peace process that could include Syria.
Saudi Arabia
Rated A4
Adjusting oil production to foreign demand contributed last year to a new growth slowdown with
the economic expansion limited to 3.5 per cent. The non-oil sector, meanwhile, continued to
grow at a strong, steady pace of 6.5 per cent with the revenues generated by high barrel prices
spurring domestic demand and both public and private investment in large industrial and
infrastructure projects. The oil sector's contribution to growth is expected to rebound this year
and next — an estimated six per cent in 2008 and four per cent in 2009 — in view of the
programmed increases in oil and gas production and the buoyant demand from emerging
countries. And high oil prices and large projects in progress will continue to underpin non-oil
economic activity. The rising cost of commodity material and labour could, however, delay some
projects and undermine economic growth. Increasing inflation has moreover affected purchasing
power and could deter household consumption.
The non-oil sector is thus expected to maintain about six per cent growth. The overall economy
will grow an estimated six per cent in 2008 and five per cent in 2009. Petrochemicals,
construction, and transports will be the sectors likely to outperform. Corporate earnings have
been good and the Coface payment incident index for Saudi companies has remained below the
world average. With the country's admission to the WTO end 2005, the business climate
improved. The investment rate is, however, still below the country's potential amid continuing
governance weaknesses and high geopolitical risk.

Egypt
Rated B
With the liberal policy options adopted by the government since 2004, the business climate has
improved. The boom conditions in oil producing countries have moreover benefited Egypt's
economy through investments and emigrant worker remittances. The strength of domestic
demand and the increases in staple commodity prices in conjunction with subsidy reductions
have, however, caused a surge of inflation estimated at 14.5 per cent on average for the year
ending June 2008. Although the marked increase in prices has undermined household
purchasing power, investment and private consumption continue to drive the economy. Sharply
higher demand for imported products has, however, made a negative contribution to GDP
growth estimated at 6.5 per cent this year, or somewhat slower than the 7.1 per cent expansion
achieved in 2006/07. The manufacturing, tourism and communications sectors performed
particularly well. In construction, bottlenecks and higher material and wage costs have delayed
some projects. Inflation targeting policy should facilitate keeping the rise of prices under control
with an average increase of 9.3 per cent estimated for the 2008/09 financial year.
Underpinned by the good trend on foreign currency revenues and dynamic foreign direct
investment spurred by privatisations, Egypt's external financial position is not a source of
difficulty at this juncture. Debt service is low. The country continues to build up foreign exchange
reserves. The fiscal deficit and public sector debt continue, however, to give cause for concern.
With rising food prices having triggered riots, the government took compensatory measures —
wage and subsidy increases — intended to keep a lid on the social climate. The planned clean-
up of government finances was postponed in consequence and the public sector deficit could
represent between 7.0 and 8.0 per cent of GDP for the current financial year, after easing to 5.7
per cent in 2006/07.

Lebanon
Rated C
Reason for the removal from negative watchlist status: The Doha Accords that made the election
of a President in May 2008 possible have paved the way to restoring the functioning of the
country's institutions to normal. Despite the difficult economic conditions, corporate payment
behaviour has held up well.
After Raffik Harriri's assassination in 2005 and the war with Israel in 2006, insecurity and political
instability exacerbated by the prospect of presidential elections supposed to be held late 2007
impeded an economic rebound. After pro-Syrian members of parliament and the government
resigned, the ensuing blockage of normal institutional functioning stalled progress on reforms
and implementation of the USD 7.6 billion promised in international aid at the Paris Conference
in January 2007. That situation affected household consumption, investment, and tourism.
Notwithstanding the difficulties, however, companies maintained good payment behaviour.
In 2007, after two years of virtual stagnation, economic growth failed to rise above four per cent,
underpinned by construction despite the slowdown of investment by Gulf countries in this sector
and by a dynamic banking sector redeployed to other regional countries. Government finances
remain marked by the cost of the reconstruction in the 1990s with public sector debt reaching
170 per cent of GDP. The government moreover ran a fiscal deficit of 12.4 per cent in 2007.
With a large current account deficit that represented 12.5 per cent of GDP in 2007, the external
financial position is also still shaky, remaining exposed to a crisis of investor confidence. The
country's banks are its strong suit. Well capitalised, liquid, and profitable, they are nonetheless
vulnerable due to their exposure to sovereign risk.
Mediation by Qatar made President Michel Suleiman's election in May 2008 possible, paving the
way for institutions, paralysed since autumn 2006, to resume their normal functions even with
the political situation remaining shaky in the run-up to general elections in 2009.

Iran
Rated D
Buoyed by social policy based on redistribution of oil export revenues, the economy remained
strong in the 2007/08 financial year with 5.8 per cent growth, which constitutes a slight
slowdown compared to the 6.2 per cent achieved in 2006/07. The non-oil sector derived support
from several sources: public spending, social incentives, and the easing of bank interest rates.
Services and manufacturing performed well. For the second straight year construction was
particularly dynamic, spurred by public infrastructure spending, and private savings, which have
been turning away from stock market investments. Oil sector production rose just one per cent
with the decline in capacity of old fields partly offsetting the production start-up of new facilities.
Expansionary fiscal policy and accommodating monetary policy have kept inflation at high
levels, between 25 and 30 per cent, undermining purchasing power in a country where incomes
remain relatively low compared to the region's other oil producing countries.
For 2008/09, economic growth is estimated at 5.3 per cent. The government will continue to
support the economy through public spending in the run-up to presidential elections in 2009 and
in view of the continuing strong growth of oil prices. The inflation rate is expected to remain
above 20 per cent.
The external financial position presents no particular difficulty. Iran will likely maintain large
foreign exchange reserves, which will limit liquidity crisis risk. Public sector finances, however,
give substantial cause for concern, however, with the sector's limited surplus despite the
excellent oil market conditions reflecting the extensive redistribution of oil export revenues.
The business climate has suffered from the government's populist policies and sanctions
imposed on the country in the absence of a settlement of the nuclear issue. The World Bank's
governance indicators moreover continue to place Iran at critical risk levels.
Sub-Saharan Africa

The growth outlook for sub-Saharan Africa's remains bright with a 6.5 per cent expansion
expected this year and 6 .3 per cent in 2009, underpinned by firm raw material prices,
particularly hydrocarbons and ores. Risks have nonetheless been growing in a context of
soaring foodstuff prices and persistent structural imbalances.
Oil importing countries, with growth (five per cent) below the sub-Saharan average, have
suffered from the widening of their twin deficits. In this context, improvement in their financial
positions resulting from debt relief granted under the HIPC and MDRI programme could prove
largely unsustainable. Soaring prices for foodstuffs, which represent 60 per cent of the
household shopping basket in sub-Saharan Africa, exacerbate social and political risks. The 50
per cent increase in wheat and rice prices between December 2007 and April 2008 triggered
violent protests over the cost of living in Cameroon, Burkina Faso, Ethiopia, and Senegal. The
upsurge of inflation has moreover led the central bank of South Africa — which represents 40
per cent of sub-Saharan Africa's GDP — to adopt monetary policy options not very favourable to
growth, affected meanwhile by an energy crisis likely to become chronic over the next five years.
In a context where the markets have less confidence in emerging countries, South Africa
(downgraded to A4) has also been contending with tightening conditions for financing its current
account deficit.
On a more general level, there continue to be many structural weaknesses: Producer countries
still do not sufficiently re-invest the oil wealth. With diversification of the productive fabric still
embryonic the region remains vulnerable to a downturn of raw material prices. The weight of the
farm sector gives rise to a dependence on weather conditions. Poor transport and energy
infrastructure impedes productivity improvement. The high poverty level limits development of
human capital. The difficult business environment deters foreign direct investment inflows. And
political and social risks remain high with the many domestic or sub-regional uncertainties
susceptible of compromising otherwise brighter outlooks (Côte d'Ivoire, South Africa).

South Africa [Rated A3]
On negative watch listing
Reasons for the rating change: Economic growth is likely to slow markedly and fall below three
per cent in 2008 amid an increasingly severe energy crisis that has prompted realignment of
major energy intensive investment projects. The central bank's tight monetary policy, meanwhile,
has proven completely ineffective in stemming surging inflation that originates abroad and that
reached 10.2 per cent this June. The monetary tightening has nonetheless affected the
economy (household consumption and private investment). The risk of a currency crisis has
moreover remained acute in a context of stiffening conditions for financing a large current
account deficit. With social risk increasing sharply amid insufficient redistribution of wealth, the
emergence of a new leader of the ANC stokes uncertainties over South Africa's future economic
options
The economy held up well in 2007 under the tightening of monetary policy with growth climbing
to five per cent, underpinned by investment and dynamic household consumption. The growth
rate is expected, however, to drop below three per cent in 2008 with South Africa contending
with an energy crisis attributable to a shortage of production capacity in relation to growing
demand. This critical energy situation, which could drag on for the next five years, has already
prompted a reassessment of energy intensive investment projects crucial to expanding South
Africa's capacity for economic growth. The tighter monetary policy, which resulted in a 450-basis
point increase in the repo rate between June 2006 and June 2008 and in stiffer credit conditions
(National Credit Act), has begun to have a significant impact on companies and households —
with defaults on debt contracted by households noticeably increasing in consequence. And
continuing inflationary tensions (10.2 per cent this June) could further undermine consumer
purchasing power especially with South African Reserve Bank's tight monetary policy proving
ineffective in combating inflationary pressures with exogenous causes. In this context, the
country's external financial position remains shaky. A current account deficit that exceeded
seven per cent in 2007 will likely remain large this year despite the growth slowdown. The oil bill
is expected to continue to weigh on the deficit as will capital goods imports needed for

infrastructure projects. External financing needs are covered by volatile portfolio investments
very sensitive to swings in confidence with respect to emerging markets. Exchange rate risk has
increased in consequence. The rand thus depreciated 20 per cent against the dollar between
December 2007 and March 2008. Exchange rate variations observed since April 2008 attest to
the greater volatility of the South African currency.
Besides, the social context is tense amid an insufficient distribution of wealth. And the
xenophobic violence that broke out this June in the Johannesburg and Cap townships, causing
nearly one hundred deaths and displacing tens of thousands of people was also a reflection of
deep currents of frustration. The naming of a Jacob Zuma backed by the Communist Party and
the unions to lead the ANC South Africa's main political party increases the uncertainty over the
country's future economic and social policies.

FINDINGS
1. INTRODUCTION
Many Asian countries have been able to maintain rates of growth well above 6 per cent in real
terms over the course of two decades. The Asian Development Bank reports that with the
exception of Pacific developing countries, nearly all countries in Asia grew at more than 5 per
cent in 2004 (Asian Development Bank 2005). Therefore one of the primary challenges for Asian
governments and international partners in the coming decade is to ensure that growth continues
in states where performance has been strong, and to increase growth in lagging regions and
states where growth has been weaker.
The trend in high growth described above has been possible in part due to high investment
levels by both domestic and international firms (see Table 1 for selected Asian economies gross
investment rates). A key element to ensuring future levels of growth and improvements in growth
rates in areas where it has been absent is to continue improving the conditions under which
firms are able to invest and reap reward from their investments, or strengthening the investment
climate.
The investment climate is the broad set of political, economic, legal and physical factors which
make a given country an attractive destination for foreign investment, and a place in which
domestic entrepreneurs of all sizes and across industries are willing to invest. Thus, while the
investment climate has many components, it is possible to subdivide the components into two
primary sets of variables: governance and infrastructure. Governance refers to characteristics

such as corruption, transparent judicial systems, favorable competition policy, etc. Infrastructure
includes both hard infrastructure (irrigation systems, ports, roads, bridges, airports) and soft
infrastructure (telephony, other technologies, etc.).
In a number of countries, the Asian growth experience challenges commonly accepted

paradigmsabout the relationship between investment conditions and growth. For example, while
the extensive literature on the investment climate places a strong emphasis on gover nance,
many of the countries in Asia have experienced both high growth rates and high levels of
investment in the past two decades despite levels of corruption and regulations which are
inconsistent with ‘best practice’ as defined in the literature. Thus, parts of the Asian region
demonstrate that achieving growth is certainly possible without implementing a comprehensive
set of investment climate reforms. However, this observation fails to take into account that
substantial rates of growth and productivity may have been lost by having such arrangements in
place. Research detailed in this paper shows that incremental improvements in the investment
climate have a strong impact on growth rates.
It is also worth noting that when looking at the micro data on the investment climate in the Asian
region as a whole, there are few trends which appear to be consistent across the region. The
investment climate varies dramatically among Asian countries as well as between cities, regions
and industries. One of the few general features of the data is that the investment climate in
South Asia has more infrastructure and regulatory barriers than does the investment climate in
Southeast and East Asia (Rahman 2005). There is also indication in the micro data that two
‘priority’ components are the time it takes to get business done in many parts of Asia and severe
infrastructure based constraints in some countries, regions and cities.
This report seeks to evaluate the current progress on creating a favorable climate for investment
in Asia. The first section is a conceptualization: it offers a definition of the investment climate and
discusses individual components, looks at the empirical links between growth and the
investment climate and raises the question of whether investment climate policy should be
centralised or decentralised. The second section looks at how challenges to doing business vary
across types of firms (from small family farms and other small enterprises to large domestic and
multinational firms). The third section analyses the micro data on the investment climate in Asia.

The final section takes a pragmatic approach to the investment climate by analysing the
constraints and political economy costs of implementing investment climate as well as outlining
potential partnerships which can be built both within the Asian region and among Asian
governments and international agencies to facilitate evaluation and reform of the investment
climate.
3.3. The Investment Climate and Multinational Corporations in Asia
The final sector to which the investment climate is a central concern is multinational corporations
investing in Asia; which continue to increase in number. The investment climate is central to
determining the flows of foreign direct investment, for example, which is a major source of GDP
growth and foreign exchange earnings. FDI also encourages an increase in exports in many
cases, and can lead to technology transfer to host countries. Within Asia, there is some
difference between the attractiveness of individual countries for inflows of foreign direct
investment. While China was the largest receiver of FDI in the world in 2003 (overtaking the
USA), East Asia and South-east Asia in general receive a high proportion of FDI relative to their
economic size than is warranted – i.e. the ratio of East Asia’s global FDI inflows to its share of
global GDP is greater than one, and is in fact 1.54. The same metric for South and West Asia, in
contrast was far below one: 0.37 and 0.31, respectively (Rahman 2005).
Asian governments have implemented an array of policies designed to attract FDI, with varying
degrees of success on both economic and social indicators.7 One policy tool used by many
governments in the Asian region is the signing of bilateral investment treaties (BITs) which
provide protection to multinational investors. Bangladesh, Hong Kong, India, Indonesia, Korea,
Laos, Malaysia, Nepal, Pakistan, Philippines, Singapore, Sri Lanka, Thailand and most recently
Vietnam have signed BITs with the UK and numerous other governments (UNCTAD 2000). In
theory, BITs should act as a commitment mechanism, by which developing countries commit
themselves to ‘safe’ treatment of foreign investment, in turn increasing the amount of investment
a country with otherwise weak institutions or weak credibility receives. However, there is a trade-
off between the stability provided for investors by BITs and their constraint on governments
(especially during times of economic and financial crises) and empirical evidence on the impact
of BITs on attracting investment has been mixed. Some researchers have found that the

attraction of FDI is positively linked to signing BITs, but that BITs act as a complement rather
than a substitute for strong political and legal institutions (Hallward-Driemeier, 2003; Tobin and
Rose-Ackerman 2005). Others have found a strong relationship between signature of BITs from
certain home countries (e.g. the USA) and FDI flows (Salacuse and Sullivan 2005).
4. Analyzing the Current Investment Climate in Asia
A more systematic view of the Asian investment climate can be obtained by analyzing sources
for detailed empirical information about cross-national differences in the investment climate. Two
such studies have been gathered by the World Bank: the Investment Climate Surveys (ICS) and
the Doing Business Surveys (DBS). The two differ in terms of the sources of data, types of
issues covered and periodicity.4 The ICS covers fewer countries as well (10 as opposed to 18).
Using these two data sources in addition to some private sector estimates of business climate
(e.g. the Economist Intelligence Unit or EIU) provides a good initial picture of how far Asian
economies have gone in creating a conducive investment climate, and helps to identify areas in
which challenges remain. That said a serious failing of the surveys is that they often fail to
accurately reflect challenges faced by rural and agricultural firms in particular.
As noted in the body of the paper, the investment climate in Asia can generally be subdivided
regionally – East Asia has implemented more ‘best practice’ measures than South Asia,
increasing the overall strength of the investment climate, though there are substantial
differences within these regions. As one author notes: ‘South Asia imposes some of the highest
regulatory obstacles to running a company in the world, second only to sub-Saharan Africa in
the overall difficulty of doing business (McLeish and Martin 2005: 1). Nonetheless, the authors
note that it is relatively easy to start a business in South Asia given the lack of minimum capital
requirements and procedural Hurdles. While these trends tend overall, there is significant
4
While ICS analyses an array of variables through firm based surveys and categorizes information in terms of size of enterprises,
as well as looking for differences within countries (by cities or regions), the DBS is compiled by interviewing legal, tax and
finance professionals based in large business centers (generally national capitals) about the time and monetary costs of setting
up and conducting business. It has been conducted and revised with greater frequency, given the easier access to data
involved.

variation among countries even within Asian sub-regions, among elements of the investment
climate within single countries, and even variation within regions of single countries, as the
below graphic on the investment climate within Chinese cities demonstrates (Figure 2). As such,
the remainder of this section attempts to categorize countries along investment climate issues
(economic and political risk, rule of law, infrastructure, etc.) so as to get a better picture of the
investment climate in Asia as a whole.
4.1. Governance
4.1.1. Economic and Political Stability
While the introductory section demonstrated that macroeconomic and political uncertainty were strong
drivers of negative perceptions of the investment climate, in most of Asia, these two elements of the
investment climate play a less central role. None of the firms thought that policy uncertainty was the

largest problem in the countries surveyed, though macroeconomic instability was the top concern in
Indonesia and the Philippines.9As is demonstrated in Figure 3, there is substantial variation in the
perception of macroeconomic and political instability among Asian countries covered in the ICS. Both
variables are of the largest concern in Indonesia, 10 and are notably lower in both India and China. One
interesting note is that larger Chinese firms (250+ employees) more often said that economic and
regulatory policy uncertainty were a major or very severe obstacle to business than other types of firms.
There was little variation among sectors. The same was true to a lesser degree for India, though those in
the garment and textile sectors were considerably more concerned about such risks.
Figure 1: Percentage of firms reporting political or economic risk as impediment to business
Interestingly, according to the Economist Intelligence Unit (EIU) which looks at such issues from
perspective more oriented towards international investors, the risk in Indonesia is thought to be less than
that in Pakistan and China, for example. Additionally, it is worth noting that political stability and
government effectiveness is consistently thought to be a significantly larger problem across Asia than
macroeconomic risk, with the exception of Japan.
Figure 2: Economic and Political Stability as measured by the EIU

4.1.2. Rule of Law
Figure 3 attempts to compare Asian economies across corruption, crime theft and disorder,
anticompetitive practices, and the strength of the judicial system (where a higher indicator shows
confidence in the judicial system – in contrast to the rest of the indicators). Confidence in the judicial
system is pronounced in China, India, Indonesia, the Philippines and Sri Lanka. In India confidence in the
judiciary was markedly different between foreign and domestic investors, as the former had greater faith
in the judicial system to enforce their claims (71 per cent as opposed to 56 per cent). In China both
domestic and international firms had about 80 per cent confidence in the judicial system. There is little
indication in the surveys whether perception of rule of law varies among small and rural investors, who
may have heightened concerns about the arbitrariness of local systems of justice.
Also notable from Figure 5 is that the perception of corruption is much higher in Bangladesh and
Cambodia than in the other Asian countries surveyed. This is consistent with Transparency
International’s (TI) Corruption Perception Index, which ranks these two countries last (Bangladesh and
Chad tie for most corrupt) and 130 out of 158, respectively. Pakistan is perceived as significantly more
corrupt under TI’s indicators: 144 out of 158.11 similarly, the perception of anticompetitive practices and
crime, theft and disorder in Bangladesh and Cambodia are higher than in other countries by some
margin.
Figure 3: Percentage of firms reporting rule of law as an impediment to business in Asia

4.1.3. Tax and Regulations
The metrics for analyzing regulations in Asia are best analyzed by looking at results from the
Doing Business Survey, which covers a wide array of Asian countries. Tables 2, 3 and 4 present
selected information from the DBS according to region. It is interesting to note that within South
Asia, it is more difficult on some metrics to do business in India than in Bangladesh, in contrast
with the statistics above.
Table 3 focusing on South-east Asia demonstrates that while it is easier to start and close a business in
Malaysia and Thailand than elsewhere in the region, it can still take a significant amount of time to
process a license, and few gains are made on import and export days. Singapore’s performance on such

indices stands out – as do the tax statistics for Vietnam, where there are 44 types of payment and it takes
more than 1,000 hours to pay taxes.
Table 3: Doing business in South-east Asia
The following group of East Asian countries and territories represent a mix of high income
countries and developing countries, and generally doing business in this region seems easier
than in most of South or South-east Asia (with the exception of Singapore). China’s metrics are
comparable to Sri Lanka’s and still some ways from South-east Asian countries such as
Malaysia or Thailand, as well as most other East Asian comparisons.
Table 4: Doing business in East Asia
The ICS also provides information about the role of tax rates and administration, as well as
adding some information about business customs, licensing and permits. In Figure 6, Pakistan
and Bangladesh appear in particular to have difficult investment climates; tax rates are
considered to be a greater burden in China than in India, as are customs and business licensing
requirements. This illustrates that the perceptions are slightly different from those obtained
through interviewing tax, legal and business specialists in capital cities (the data source for the
DBS). The information from the EIU has findings closer to that of the DBS in terms of the
India /China comparison, suggesting that the different perceptions could come from foreign

versus domestic perspectives on tax and regulation. The complete EIU risk rankings are shown
in Figure 7.
Figure 6: Firms reporting tax or regulatory issues as an impediment to business in Asia
4.1.4. Labour Policies

Labour policies impacting the investment climate can be broadly broken into two categories:
indicators of skills and diversity of the workforce, and the extent to which the labour market is
flexible in terms of regulations to hire and fire. As suggested in a previous section, the second
set of labour market indicators are easier for the government to directly, and quickly, impact. In
terms of market flexibility, a difference is again detectable between South Asia and
East/Southeast Asia. According to the DBS, within South Asia, average hiring costs are 5.1 per
cent of salary and firing costs are equivalent to 75 weeks of wages. In East/South-east Asia,
hiring costs as slightly more (8.8 per cent of salary), but firing costs are significantly lower at 44
weeks of wages on average. That said the firing costs in China are as high as South Asia, at 90
weeks of wages, with an extraordinarily high 30 per cent salary cost to hire. The DBS ‘rigidity of
employment index’ (the average of difficulty of hiring index, rigidity of hour’s index and difficulty
of firing index) is compared for some key economies in Table 5.
The ICS survey gives a blended view of these two types of labour policies for surveyed
countries: interestingly, more firms are concerned about skills and education of workers in China
than in other countries surveyed by a significant margin. Even more interesting is that a higher
percentage of domestically owned firms cite this as a major or severe obstacle to doing business
than do international investors.

Additional information on the social indicators of labour policies can be obtained through the
ICS.
Table 6 categorises skills and social indicators of labour across several economies. Notice that
the level of training provided in China is much higher than in other economies, and that Pakistan
is the only country to provide figures on the role of women in senior management.
Finally, the EIU provides a metric of labour market risk, showing that risk is highest in Vietnam
and Indonesia; labour market risk in China and India is high and identical.

4.2. Infrastructure
4.2.1. Infrastructure Constraints
Infrastructure constraints in South Asia are perceived to be significantly more severe than in
Southeast and East Asia. The data for Bangladesh in particular is striking: the ICS reports that
the delay in obtaining an electrical connection in Bangladesh is 80 days and electrical outages
are reported nearly 250 days a year. The time to obtain an electrical licence in India is even
longer (82 days), though no data is available on the degree of power outages. These statistics
are less severe, though still concerning, in other South Asian states.
Comparative statistics on South Asia are available in the Table 7.

Figure 10 demonstrates that electricity is thought to be by far the largest constraint to business
in Asia (note that the problem is perceived to be more acute in China than in India). Though no
data is available for China on days of electrical outages, a significantly smaller percentage of
sales are said to be lost through electrical outages (1.9 per cent).
4.2.2. Finance
Access to finance in Asia depends both on country and industries, and there is a large amount
of information about such constraints in the Asian context. First, the ICS provides descriptive
information about the availability and efficiency of finance in various countries (shown in Table
8).

These statistics, however, obscure significant differences in access to credit across size of
businesses and sectors. Table 9, shows the collateral needed and overdraft statistics for the
same countries by size of firm 2
As Table 9 shows, small firms face obstacles in almost all countries to accessing an overdraft,
and in many cases, collateral rates are higher for small firms than in medium and large firms.
More broadly, the firm perception surveys from the ICS provide a sense of the overarching
constraint of finance to the country: cost and access to financing are particularly problematic in
Bangladesh and Pakistan.


CONCLUSION
Investing in Asian markets is secure as there is huge market leading to huge potential to
grow, and also concluded to be most safe place for investment as the recent developments in
United states, Japan and most of Europe suggests. GDP growth should lose slightly over a point
(7.6 per cent expected for 2008 down from 8.9 per cent in 2007) due to the slowdowns in the
United States, Japan, and Europe in the wake of the subprime crisis. Emerging Asia will thus
prove relatively resilient thanks to the growing influence of domestic demand on the growth
dynamic and the financial solidity of most regional countries. The good regional performance
moreover substantially reflects the excellent results achieved by China and India, which
represent 55 per cent of emerging Asian GDP. The regional countries with the most open
economies — Hong Kong, Singapore — should suffer most, however, and could lose two to
three points of growth due to the slowdown of their exports. Taiwan also remains vulnerable with
its dependence on the United States' economic cycle.
China's economic development meanwhile is pregnant with risks as evidenced by the

disquieting signs of overcapacity — especially in steel, the automotive industry, distribution, and
property — and overheating. After reaching 6.5 per cent in 2007, inflation surged again in the
first half this year (8%). With government officials concerned about the resulting social
repercussions, they will likely step up the monetary tightening, the pace of the yuan
appreciation, and measures that are administrative in nature (like price freezes, and so on).
Surging inflation has also prompted India to tighten monetary policy, which should ultimately
undermine growth.
In the financial area, external over-indebtedness risk has remained limited throughout the
region. Large current account surpluses have, however, tended to flood stock, property and
credit markets with liquidity. After rising sharply in 2006 and 2007, Asian stock market indices
have fallen thus far this year reaching levels comparable to those observed in summer 2007.
Despite the downturns, price earnings ratios have remained high, which tends to suggest the
continued presence of speculative bubbles. In China, the PER for section A on the stock

exchange still exceeds 60. The ratios also remain high in India (20 times earnings) and
Indonesia (21). In this context of overvalued stock exchanges the increased volatility observed in
the first quarter this year is expected to continue throughout the year.

ANNEXURE - 1
CALCULATING COUNTRY RISK OBSERVED BY BETAS
Market participants may observe that world markets have been moving in a synchronized
fashion due to technical reasons such as capital flows as well as the increasingly interconnected
nature of country-specific macro economic environments.
Can we properly measure individual country risks? Or, has the country risk become less
important given the global roller coaster nature of the financial markets?
There are various ways and methodologies of measuring country risks. Yet as far as stock
market movements are concerned, we should keep in mind that as markets are more integrated
than ever, it is very likely that stocks of many of these countries will go up and down depending
on the daily momentum observed in the world markets. When Asian markets have a good day, it
may be an extension of the good mood in the U.S., which may or may not be followed by
European markets. The trend may continue or change course depending on global economic
developments of the day.
For instance, Istanbul Stock Exchange opening depends on how Asian markets have done and
on expectations of what Western markets are going to do later in the day. Turkish stock market
is influenced by daily expectations related to the U.S. economy in terms of macroeconomic data
to be announced later in the day. Also percentage moves up or down are generally sharper and
more volatile than those observed in the world markets in general.
If you have been following a foreign market closely, you may have noticed similar observations.
Certain country performances have been more volatile than others.
Also as the global markets have become more volatile, the correlations between countries have
increased.

THE INTERNATIONAL CAPITAL ASSET PRICING MODEL
In the Capital Asset Pricing Model, a stock’s beta signifies the risk of that stock with respect to
the market. Beta is directly proportional to the correlation of the stock return to that of the market
as well as its relative volatility with respect to the market. It’s a measure of the stock risk for one
unit of market risk. The higher the risk of stock with respect to the market, the higher the
expected compensation of the investor with respect to the particular stock.
To keep the matters simple, a high beta signifies high risk, while a low beta signifies low risk.
The beta of the market itself is one.
The International Capital Asset Pricing Model is the extension of the Capital Asset Pricing Model
where the risk of a specific country can be specified in a likewise fashion with respect to a
chosen world index.
I wanted to compare the daily moves of all markets and calculate the observed country risks in
terms of betas to see how risky one country is with respect to another. That way I would have a
valid methodology to rank countries because I could quantify market risks.
The easiest way for me to come up with the betas was to regress the equity returns of individual
countries to the world index of my choice. I wanted to keep the variables as simple as possible in
order to include as many countries as possible in this study. I wished to come up with a risk-
ranking system for the stock markets of all countries for which there is trading data available.
Calculating country betas is not the only way to compare country risks and it is entirely
dependent on past stock returns as well as the global market index returns one chooses to
compare the performances to. There are many criticisms of the beta measurement as well as
the CAPM theory in general, and I will state a few of them here. For instance, beta will vary
depending on the time frame chosen, which may make it unreliable depending on the degree of
change. Beta also captures “systematic” risk only, and thus it may give an incomplete picture of
the total risk that includes unsystematic risk.
While there is no guarantee that the future beta will look like the past data, it’s a reasonable
indicator (as good as any) of the risks one can expect in a certain market.
There are different ways of calculating country betas, and they may involve more sophisticated
models than the good-old fashioned OLS regression that readers may have seen in an
econometrics class. I wish to keep this article accessible by many, so I will keep such
terminology to a minimum. But suffice it to say that such models may explicitly state a country’s
degree of non-integration to the world market and involve various country-specific factors
ranging from the level of interest rates, inflation and the like. They may also include other global
information variables to further specify world risk.
Yet the more sophisticated the model is, the stronger the false sense of security becomes and
the more difficult it is to evaluate its shortcomings. Not to mention that such complexities in the

model specification would have led me to decrease the number of countries in the study
because of data issues, and the depth of the model would have necessitated concentrating on a
region or a limited number of countries. I wanted breadth rather than depth.
So what we have done was still data intensive, but more straightforward.
DATA, METHODOLOGY AND RESULTS
I used index data available at the Standard & Poors Index Services where they keep daily data
for closing index prices of many countries for which trading data exists. For the series of
regressions to be performed, I calculated daily returns of all countries in terms of U.S. dollars.
The country “betas” are calculated by regressing each index return against the global equity
portfolio. Beta is estimated as the slope of the fitted line from the linear least-squares
calculation.
I wanted to experiment with data that was available. Knowing that markets have become more
volatile in the past year or more, I calculated each country beta in two ways: 2-year betas
involved 522 observations (daily returns) covering the past two years from December 4, 2006
until December 2, 2008. 10-year betas, on the other hand, involved 2610 observations from
December 2, 1998 until December 2, 2008.
Given the lack of data for some of these periods, I had to exclude the following countries:
Pakistan, Jordan, Nigeria, Slovenia, Columbia, Iceland, and Luxembourg. I did calculate betas
for those countries for which there were adequate observations. However, either due to lack of
significant t-values to validate the beta coefficients, or due to other extraordinary issues such as
the collapse of the Icelandic market I decided to exclude these countries from the various data
matrices I designed. Luxembourg was excluded due to the fact that the equity index houses 10
stocks with 3 firms making up more than 60% of the index and some 45% of the weighting
belongs to bank stocks headquartered in Belgium, thus making the calculated beta meaningless.
(Note: the weights may have shifted but the idea is that the beta of such an index is not
representing the “risk” associated with the country of Luxembourg).
In order to make sure that there were no errors within the Excel regression package, I checked
the betas by multiplying the correlation coefficients of all countries (with respect to the world
index) by the relative standard deviation of the each country. This was also a good way to see
the composition of the beta of each country.
An example of the display for the country of Brazil is given below:

Note: This regression is done with daily beta, thus the standard deviations seen above represent
daily numbers. Numbers are rounded to two decimal points, so if you do the math above you
may find that the Brazilian beta is 1.79. This error is due to rounding. Brazilian markets indeed
exhibited the highest daily beta for the last two years. Series of regressions covering the ten-
year time frame also put Brazil at the top of the list in terms of beta.
Another interesting but predictable observation is that two-year betas for almost all countries are
considerably higher than their respective ten-year betas. This is due to the fact that both
correlations as well as individual country standard deviations have increased recently. But note
that the global standard deviation placed at the denominator has also increased. If you look at
the composition of the betas, you may see the contribution of various parts of the equation to the
betas themselves.

Notable observations include high-beta countries, specifically Brazil, Hungary and Turkey. The
emerging nature of these markets attract attention, however some developed markets have also
registered riskier betas such as Norway, Austria, Sweden. On the other hand, Mexico, Russia
and Argentina are also among the notable emerging markets with higher than average betas. All
of these high-beta countries exhibit higher correlations as well as higher than average standard
deviations.
A lot of European markets have registered a beta closer to one, which indicates that these
markets exhibit an average risk with respect to the rest of the world. The U.S. market with a beta
of 1.06 seems to exhibit average risk with respect to the rest of the world as well. However, this
is mainly due to the fact that American stock market is the largest constituent of the global
market index. Indeed, when the U.S. stock returns are regressed against a global index that
excludes the U.S., the resulting beta is 0.57 with an observed correlation of 0.49 as opposed to
the high correlation of 0.84 of the original regression. This indicates that the U.S. market beta

above is overstating the U.S. market risk. According to the beta of the second regression, the
U.S. is actually towards the bottom of the list of these countries.
Asian countries are the winners of this exercise in terms of lower risks associated with their
markets. It is remarkable that some of the “emerging” markets of the Asian region have
registered lower betas associated with a lower degree of risk, among them Thailand, Philippines,
Taiwan, and Malaysia. Hong Kong showed a lower beta than I expected, and the presence of
Japan towards the bottom of the list with a beta of 0.41 was another surprise for me.
Among the lower beta countries were those of the Middle East and North Africa, namely Israel,
Egypt, and Morocco. I must add that Jordan, Pakistan, and also Nigeria would have made it into
the bottom of the list if I had included the results I was able get from the regressions I ran
(notwithstanding some insignificant t-statistics associated with the regressions). I may include
these countries in a following write-up if I am able to get hold of more complete data sets.

Ten-year table country betas are strikingly lower than their respective two-year betas. There are
a few exceptions: Finland occupies the second place in the ten-year list with a beta of 1.29
whereas during the last two years, its beta has decreased to 1.10 placing it towards the middle
of the same list. Even more interesting is the fact that Israel registered a beta of 0.78 for the last
ten years whereas its beta has fallen to 0.42 during the present time when the world has
become a more volatile place. Japan seems to have resisted the trend somewhat but its ten-
year beta of 0.46 is not strikingly different from its two-year beta of 0.41.
Brazil occupies the first place in both tables as the riskiest of the bunch. Furthermore, a quick
look at the former ranks at the ten-year table shows that Turkey, Hungary, Russia, and Norway
have gained significant risk in terms of their respective betas during the last two-years. Turkey
and Russia deserve extra attention in terms of their standard deviations for the last ten years.
Despite the fact that Turkey registered the highest daily standard deviation of 3.33% during the

last ten years, its relatively low correlation of 0.32 managed to keep the country from occupying
a higher rank. This was also true for Russia who had the second highest standard deviation of
2.65% and a somewhat lower correlation of 0.41. However, during the last two years, the
correlations of these two countries have increased to 0.69 and 0.62 respectively, thus placing
their betas higher on the two-year list.
The higher beta associated with the U.S. is misleading in this list as well. Indeed, when ten-year
U.S. returns are regressed against global returns excluding the U.S., the resulting beta is 0.57
(same as the two-year beta) with a correlation coefficient of 0.46.
Asian countries occupy lower ranks in the ten-year list as well. Among them are emerging (or so
classified) markets of India, Indonesia, Thailand, Taiwan, Philippines, and Malaysia, besides the
developed markets of Japan, Hong Kong, and New Zealand.
Egypt and Morocco occupy the last two places in the ten-year list similar to the pattern observed
in the two-year list.
Conclusion
An obvious conclusion of this exercise is that country risks have increased over the past two
years when compared with ten years of data.
It would be interesting to do the same study with weekly or monthly data as well, and perhaps by
going back further in time. However, going back further in time risks capturing certain
fundamentals or situations that no longer exist in today’s marketplace. Increased correlations
due to the effects of globalization are examples of such fundamental or “regime” changes.
Another notable observation of this exercise is that certain countries manifest higher risk than
others on a consistent basis. The results of this exercise have captured what has been familiar
to careful observers of world markets.
As the Capital Asset Pricing Theory suggests, higher risk results in higher return expectations on
the part of investors. Thus a higher risk should be evaluated according to return expectations of
these countries. Conclusively, it may be a valid decision to invest in countries (or stocks) that
exhibit higher levels of risk depending on long-term growth expectations, cheap valuations
exhibited by fundamentals, or both.
Yet another remarkable observation of this exercise is that there are emerging markets with
higher expectations of return that also manifest lower risk. Certain emerging markets of Asia as
well as North Africa and the Middle East have exhibited lower risks as measured by their betas.
An inference of this study (or so I reckon) is that if all else is equal, it is more advisable to invest
in nations with higher than average growth potential that also show a low degree of risk with
respect to the world markets. The diversification effects are also valuable. Of course, all else is
never equal and such quantitative studies should always be complemented by fundamental
analysis as well as due diligence.

A disclaimer related to this exercise should be announced in the sense that today’s high-risk
countries may become tomorrow’s low-risk ones as well. Nevertheless, given what we can
observe in the world markets today, investors should evaluate whether their return expectations
are worth the risks.
Source: http://www.euromoney.com/Article/2077030

Selection of An Economy For Investment (Country Risk Analysis)

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BFIA/IV SEM/PAPER NO.

CRITICAL ISSUES & CHALLENGES

RAMAN KUMAR (15715)

Selection of an Economy for Investment - Critical Issues & Challenges

Selection of an Economy for Investment - Critical Issues & Challenges

• To study the investment climate in International Financial Market

• To analyze the economies with help of country risk analysis

• To ascertain the recent development in potential economies.

Selection of an Economy for Investment - Critical Issues & Challenges

different personnel in internet forums

• As well as the secondary data which included Various Journals, Reports,

Articles, Newspaper, and Websites etc.

Selection of an Economy for Investment - Critical Issues & Challenges

• FOREIGN INSTITUTIONAL INVESTMENTS : Foreign Institutional Investor (FII) is used

Selection of an Economy for Investment - Critical Issues & Challenges

Selection of an Economy for Investment - Critical Issues & Challenges

CRITERIA –VARIOUS FACTORS THAT AFFECTS INVESTMENT DECISION REGARDING

RISK CATEGORIES AND MEASUREMENTS

II. Transfer Risk

Selection of an Economy for Investment - Critical Issues & Challenges

currency crisis was a political solution to an exchange-rate problem. Quantitative measures

III. Exchange Rate Risk

Selection of an Economy for Investment - Critical Issues & Challenges

IV. Location or Neighborhood Risk

Location or Neighborhood Risk includes spillover effects caused by problems in a region, in a

Sovereign-risk measures of a government's ability to pay are similar to transfer-risk measures.

Selection of an Economy for Investment - Critical Issues & Challenges

VI. Political Risk

Selection of an Economy for Investment - Critical Issues & Challenges

COUNTRY RISK ANALYSIS

A Country Risk and Foreign Direct Investment

Selection of an Economy for Investment - Critical Issues & Challenges

THEORY VS. PRACTICE

This fundamental premise provides a simple theoretical underpinning to CRA. Unfortunately, no

OUTLINE OF THE MODEL

Selection of an Economy for Investment - Critical Issues & Challenges

CALCULATING THE RATINGS

Selection of an Economy for Investment - Critical Issues & Challenges

COUNTRY RISK RATINGS DEFINITION

BAND A (0-20 POINTS)

Countries which have no foreign-exchange constraints on their debt-service ability and no

BAND B (21-40 POINTS)

BAND C (41-60 POINTS)

Selection of an Economy for Investment - Critical Issues & Challenges

BAND D (61-80 POINTS)

BAND E (81-100 POINTS)

Selection of an Economy for Investment - Critical Issues & Challenges

RECENT TRENDS – VARIOUS ISSUES & CHALLENGES

Selection of an Economy for Investment - Critical Issues & Challenges

Selection of an Economy for Investment - Critical Issues & Challenges

Selection of an Economy for Investment - Critical Issues & Challenges

3. Inflation constrains monetary policy in emerging countries and strengthens the

As regards capital flows, the outstanding amount invested in euro-denominated securities

Selection of an Economy for Investment - Critical Issues & Challenges

Selection of an Economy for Investment - Critical Issues & Challenges

The weaknesses are of two very different and distinguishable types:

Selection of an Economy for Investment - Critical Issues & Challenges

Selection of an Economy for Investment - Critical Issues & Challenges

Rated A2 since March 2008

Selection of an Economy for Investment - Critical Issues & Challenges

Selection of an Economy for Investment - Critical Issues & Challenges

Selection of an Economy for Investment - Critical Issues & Challenges