Overview on Risk in

International Business

Gargi Sanati
 Foreign Exchange Risk
 Great Depression of ‘30s
 Hypothesis of Fama
 Why did Fama fail?
 Country Risk
 Contagion Effect
Efficient Market Hypothesis
• The efficient market hypothesis was pioneered by Eugene
Fama’s (1970)
– article “Efficient Capital Markets.”
– The premise is that investors react instantaneously to any
informational advantages they have, thereby eliminating
profit opportunities. Thus, prices always fully reflect the
information available and no profit can be made from
information based trading.
• It was generally believed that securities markets were
extremely efficient in reflecting information about individual
stocks and about the stock market as a whole.
• So no arbitrage opportunity prevails when market is efficient.
Fundamental and Technical Analysis
 Fundamental Analysis: analysis of financial information such
as company earnings, asset values, money supplies, trade
balance etc.
 Fundamental Approach to exchange rate forecasting uses various
models. For example, monetary approach to exchange rate model the
spot exchange rate to test the sensitivity to relative money supplies,
relative national outputs
 Technical Analysis: study of past stock prices in an attempt to
predict future prices.
 In exchange market, this method analyzes past behaviour of exchange
rates to identify patters and then projects them into the future to
generate forecasts. It sometimes consider various transactions data like
trading volume, interests and bid-ask spreads.
Efficient Market Hypothesis
• Fama (1970) stated that there are three versions of efficient
markets:
 Weak-form: comprises of historical prices only (such as stock prices,
trading volume, and short interest), meaning that it is not possible to
earn superior risk adjusted profits which are based on past prices. This
leads to the random walk hypothesis. Hence, even the weak form of
the EMH implies that technical analysis can’t work, since technical
analysis relies exclusively on past trading data to forecast future price
movements.

 Semi-strong form: includes historical prices and all publicly available

information as well. The semi-strong form extends the information to
public information other than market data, such as news, accounting
reports, company management, patents, products of the company, and
analysts’ recommendations.
  Strong form: is broadened still further to include even
insider information. The strong form extends the
information further to include not only public information,
but also private information, typically held by corporate
insiders, such as officers and executives of the corporation.

 Efficient Market Hypothesis is associated with the Random

walk model.
 the flow of information is unimpeded and
 as the news by definition is unpredictable and random resulting price
changes must be unpredictable and random.
Co-integrated Series
16

14

12

10

0
90 92 94 96 98 00 02 04 06

JAPAN UK
Country Risk_Gargi Sanati_NIBM US
Why did Fama Fail?
 Conflict with Keynesian Theory?

 Contagion Effect – Is it more difficult?

 The most adverse feature of a globally integrated financial
system.
 The spillover effect of the crises like Mexican crisis of
1994-95, the Asian crisis of 1997-98, the Russian crisis of
1998.
 The frequency and intensity of these crises in emerging
market countries had been a growing concern for the
policy makers.
 The spill over effect of the recent US crisis is evident in
many developed and developing countries.
 India is not an exception
 What is Country Risk and why it has become so important?
 Country risk relates to the likelihood that changes the foreign
business environment, which will reduce the profitability or
increase the riskiness of an overseas transaction.

 Country risk is the risk specified to a particular country although we

are living in a globalized era.

 Country risk may be a threat to the global economy because of the

contagion effect.

Country Risk_Gargi Sanati_NIBM

 World-wide recession – Is it country risk?

• Among economic event recession is an interesting

case. If it is worldwide, and the government applies
the appropriate countercyclical policies, it is not
country risk. But if it occurs in one country in
isolation, or if it is aggravated by inept government
policies, it is country risk.
 Natural Disasters
• A natural calamities when it is unforeseeable they would not be
considered as the country risk. But if the past experience shows that
they have the tendency to reoccur periodically – such as monsoons in
South East Asia, then it can be considered as the country risk

• Turkish Earthquake in 1999 – Anika Therapeutics Inc. (a

biotechnology firm based in Massachusetts, USA)
17th August 1999 (7.6 on Richter Scale)
Izmit – an industrial centre near Istanbul, Turkey

6.67 lakh people either killed/injured/homeless.

150 industrial plants, among them 50 MNCs with production facilities were
badly affected

Total Economic loss : $2 billion, estimated by insurance company.

$5 to $10 billion according to Gaci Ercel, head of the Turkish Central Bank
Why the Turkish earthquake is considered a case of country risk?

• Insufficient preventive measures by the government, in spite of

knowing for a long time the high exposure of the region to
earthquake.
 Effect on ATI
• ATI used to derive a substantial share of its revenues from
Orthovisc, serving for the treatment of osteoarthrities (is not
approved for the use in the US), which was distributed in
Israel, Spain and Turkey.
• Biomeks, the Turkish distributor was obliged to postpone the
delivery of the product which caused a significant disruption in
sales
 CRISES

1998 - Russia
2001 - Kosovo 2001/2002- 2001/2002 - Afghanistan
Middle East War on Terrorism
USA 1990 - ME war
2000/2001 - Turkey 2003 – N. Korea
1999 - Earthquake 2003 – Iraq war
1980s Iran/Iraq 1998 - India/Pakistan
Nuclear Test/Explosions

1995/96 - Mexico
1997 – Asia
2003 - SARS

2002 Brazil, 1990s-

2002 - Argentina 2003 - Venezuela AIDS

Political Crisis /Natural Disaster

Country Risk_Gargi Sanati_NIBM

Financial Crisis
 Financial Integration – Are Developing Countries
prepared for?

 The integration of the emerging market economies with the

world economy has raised the issue of country risk
management since 80’s as
 These economies have neither the depth (many commodity
driven, dependent upon high commodity prices or non-
diversified) nor the resiliency (lack of large/varied
manufacturing base, etc.) of more advanced countries

 Financial sectors and markets in emerging market

economies are the least developed areas of the economy
and typically are fragile, under-developed and poorly
regulated

Country Risk_Gargi Sanati_NIBM

Increasing Relevance of monitoring country exposure

 Globalisation of Indian economy

 Growth in Foreign Trade
 Growth in Capital inflows and outflows
 Overseas Banking expansion

 Guidelines for CRM, 2004 indicates that banks should replace ratings
of Credit rating agencies and put in place internal assessment system
by 31 March 2005

 Till banks move over to internal rating systems, they may use the 7
category classification followed by ECGC for the purpose of
classification and making provisions for country risk exposures.

Country Risk_Gargi Sanati_NIBM

Factors affecting country risk

 Political - Butler and Joaquin (1998) defined political risk ‘as

the risk that a sovereign host government will unexpectedly
change the ‘rules of the game’ under which businesses
operate.’ It influences the cost of capital of the investment.
 May include war, occupation, invasion, riots, disordered caused by
territorial claims. Political climate, and foreign investment climate,
relationship with major trading partner.
 Financial – delayed payment, default, repudiation of
government, Exchange control mechanism, interest rate.
 Economic – Overall growth of the economy, international
liquidity position, export and import growth, debt service ratio,
tax rate, demand for a firm’s products, the availability of local
labor, local wage rates, and employment laws.
Country Risk_Gargi Sanati_NIBM
Parameter Factors Exporter Direct
Investors
Sovereign  Public debt in the economy 30% 10%
Financial Risk  Sovereign default risk
 Non-convertibility risk
Financial Market  Fundamental macroeconomic 40% 30%
Risk (more equilibrium
focused after the  Risk of unexpected and sharp
Mexican and devaluation
Asian Crises)  Systematic risk and economic volatility

Political Risk  Homogeneity of the society 10% 30%

 Regime and government stability
 External conflicts

Business  Attitude towards foreign investments 20% 30%

Environment  Labor conditions
Risk  Quality of the governance

Country Risk_Gargi Sanati_NIBM

Quantification of Country Risk

 Check list approach – It is based on the probability of occurrence

of certain events, like war, slow down in economic growth. It is
mostly judgmental and sometimes subjective, though depend on the
past data
 It involves all political, financial and economic factors (both
macro and micro) that contributes to a firm’s assessment of
country risk
 It gives priorities to different types of action taken by borrower;
eg. Default, renegotiation, reschedule, technical default,
impossibility of transferring payments.

Country Risk_Gargi Sanati_NIBM

Some Terminology

 Repudiation or Default – the debtor notifies the creditor that he will

cease making any further payments because he cannot (ability to
pay) or does not willing to pay (willingness to pay) means default.
Repudiation basically means that debtor denies to recognize the debt
and thereby defaults, a very rare incidence in international banking.
 Renegotiation – lender will receive less than the originally agreed
because the interest rate is lowered or the part of the principal will
not be repaid in the absence of penalty clause.
 Rescheduling – the terms of the loan are lengthened because annual
repayments of principal are lowered and spread over a greater
number of years than originally agreed (rescheduling).
Some Terminology

 Technical default: borrower fails to meet one or several terms

for debt service payments because of temporary inability (or
unwillingness) to pay or administrative delay or inefficiency.
There is little doubt that the debtor will eventually meet his
debt-servicing obligations. Usually, borrower also pays interest
sometimes at a penalty rate – on service payments due.

 Impossibility of transferring payments – because prohibitive

exchange restrictions have been imposed by the government
(transfer risk). Only private borrowers are exposed to this kind
of country risk
Quantification of Country Risk

 Delphi Technique - It involves the collection of independent

opinions on country risk without group discussion by assessors,
mostly the experts in that area.
 Euro Money Scoring

Country Risk_Gargi Sanati_NIBM

Important Ratios in Country Risk Management
1. Long-term growth Prospects
– Gross Domestic Fixed Investment/gross national (or domestic)
product
– Gross Domestic saving/GNP (or GDP) or
– Gross domestic saving/gross domestic fixed investment
2. External debt
– Service payments on the external debt/GNP
– Services payments on the external debt/exports of goods and services
(the debt service ratio)
3. Balance of Payment
– Percentage increase in imports/percentage increase in GNP (or GDP)
– Exports to main customer country (ies)/total merchandise exports
– Value of main commodity exports/total merchandise exports
 Important Ratios
Ratio Ratio Definition Interpretation
Import Ratio Total Imports/Total Lower the ratio, lesser the likelihood
Foreign Exchange that the country will have to
Reserves reschedule the debt
Investment Ratio Real Investment/GNP Higher the likelihood of the country
being able to service its debt in the
future due to a higher income
generating capacity in the future.
Variance of Statistical variance in Higher the variance, higher the
Export Revenue export earnings from year instability and therefore, weaker the
(Variance) to year capacity to service debt.
Domestic Money Change in Money Higher the growth rate, higher the
Supply Growth Supply/Money Supply at likelihood of inflation, while that
the beginning of the year country’s currency and its ability to
service foreign debt becomes weaker.
 10
15
20
25
30
35
40
45

0
5

10
15
20
25
30
35
40
45

0
5
1975 1975
1976 1976
1977 1977
1978 1978
1979 1979
1980 1980
1981 1981
1982 1982
1983 1983
1984 1984
1985 1985
1986 1986
1987 1987
1988 1988
1989 1989
1990 1990
1991 1991
1992 1992
1993 1993
1994 1994
1995 1995
1996 1996
1997 1997
1998 1998
1999 1999
2000 2000
2001 2001
2002 2002

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2003 2003
2004 2004
2005 2005
(Exports of Goods and Services/GDP)%

2006 2006
2007 2007
2008 2008
2009 2009
2010 2010
2011 2011
India-E
China-E

India-E

Brazil-E
China-E
 Foreign trade as a percentage of GDP
35

30

25

20
%

Export/gdp
15 import /GDP

10

Country Risk_Gargi Sanati_NIBM

 Export growth in different countries and region

1990-2000 2000-2009
China 14.90858089 19.10211672
India 8.958908829 16.29810605
Brazil 5.783518161 12.01187765
UK 4.290123891 2.640459294
US 7.105431407 3.403338483
central and
Eastern Europe 5.384657878 15.39414011
Middle East &
North Africa 5.853969566 11.81324287
Emerging & Dev.
Economies 8.901047424 12.23108701
Developing Asia 12.6884828 13.83684587
advncd econ 5.580398037 7.657005718
 Share of different countries and region in the world
export

1990 2000 2009

China 1.800465 3.917227 9.724636
India 0.521053 0.666161 1.334604
Brazil 0.910912 0.866415 1.238004
UK 5.367583 4.428739 2.882483
US 11.41306 12.29098 8.551003
Central and Eastern Europe 2.444463 2.23886 4.181191
Middle East & North Africa 4.688266 4.489038 6.312651
Emerging & Dev. Economies 20.00284 25.43793 36.99301
Developing Asia 5.341862 9.562194 15.80238
 India's Foreign trade
16000

14000

12000

10000
US $ Million

8000 Export
Import
6000

4000

2000

0
 Foreign trade as a percentage of GDP
35

30

25

20
%

Export/gdp
15 import /GDP

10

0
 Destination wise India’s Export to top 10 Countries
Partner 2006Partner 2007Partner 2008
USA 15.43346USA 13.79959USA 11.77115
United United United
Arab Arab Arab
Emirates 9.448428Emirates 9.902125Emirates 10.50063
China 6.459677China 6.505898China 5.550356
Singapore 5.055461Singapore 4.379817Singapore 4.868501
China,
United United Hong Kong
Kingdom 4.442081Kingdom 4.309114SAR 3.722925
China, China,
Hong Kong Hong Kong United
SAR 3.694922SAR 4.006218Kingdom 3.627784
Germany 3.177949Germany 3.239446Netherlands 3.589887
Italy 2.793851Netherlands 2.976736Germany 3.252574
Saudi
Belgium 2.744723Belgium 2.767394Arabia 2.955751
Japan 2.313701Italy 2.590678Belgium 2.59426
 India’s Import: countries with top 10 share
Partner 2006Partner 2007Partner 2008
China 8.775517China 11.24002China 10.00469
USA 6.352799Saudi Arabia 7.578555USA 7.756158
Saudi Arabia 6.050688USA 6.497449Saudi Arabia 7.279683
United Arab United Arab
Switzerland 4.438654Emirates 5.352431Emirates 6.150948
United Arab
Emirates 4.212602Switzerland 4.865464Iran 4.368377
Germany 4.033093Iran 4.191985Switzerland 4.092405
Australia 3.648544Germany 4.017445Germany 3.616766
Iran 3.320787Australia 3.512968Kuwait 3.405368
Nigeria 3.188462Nigeria 3.209488Nigeria 3.206931
Singapore 2.909203Singapore 3.156531Australia 3.030908
 Specialized Ranking Firms

The Economic 100 point Index - the 5 bands (A - lowest Political risk, Economic
Intelligence Unit (EIU): higher the score, riskier to E - highest) risk, Economic structure
London Based; 100 in the country risk, Liquidity risk
developing countries,
Quarterly basis
International Country Below 50 - very high risk Political risk, Economic
Risk Guide (ICRG) 50 - 59.9 - high risk risk, Financial risk
140 countries, Monthly 60 - 69.9 - moderate risk
Forecast on 1 year and 5 70-79.9 - low risk
years 80 - 100 - low risk
Nord Sud Export - 100 Sovereign financial risk,
developing countries, bi- financial market risk,
monthly political risk, business
environment risk
Business Environment Political Risk Index
Risk Intelligence (PRI), Operational Risk
(BERI) Index (ORI), Remittance
and repatriation factor
(R-factor), Composite
Score

Country Risk_Gargi Sanati_NIBM

 Credit Rating Agency

Fitch Short-term and long-term factors

80 sovereign and country ratings
Macro economic policy
BOP

Moody's 100 countries Economic fundamentals

Socio economic debt

Standard and Poor’s Political Risk,

Income and
Economic Structure

Euromoney Political risk,

Economic Performance
Debt Indication
Country Risk_Gargi Sanati_NIBM