Country Risk Analysis: 50 Ways…

A company is likely to perish if it ignores its markets. Shutting down its accounts payable is one way to survive a storm. Using creative accounting to justify ignoring its payables could be another. Neither of these strategies is tolerated or permitted where laws are established and observed. But with the rise of Country Risk Analysis (CRA), it can be argued that such practices have been conceptually legitimized.

How? Well, Simon and Garfunkel might conclude there may be 50 ways, but here only two aspects of CRA — econometrics and “history as mystery” — shall be reviewed. First, a little backtracking to establish context.

BACKGROUND

Historically, CRA emerged as a discipline based on the confluence of two major 1970s financial events:Western banks extended defaulted sovereign loans to “emerging market” countries without IMF backing, and OPEC hiked its oil rates in 1973.To address solvency concerns arising out of these events, many financial institutions, credit rating agencies and business publications close to the financial industry evolved methodologies to establish any given country’s credit worthiness.

Wikipedia notes providers of country/political risk analysis use different methodologies to assess and rate countries’ comparative risk exposure. Say Wikipedia’s online contributors: “Credit rating agencies tend to use quantitative econometric models and focus on financial analysis, whereas political risk providers tend to use qualitative methods, focusing on political analysis. However, there is no consensus on methodology in assessing credit and political risks.” ¹

Country/political risk analysis has always tended to be the preserve of governments’ foreign affairs departments, working in tandem with their intelligence and military departments. But access to such sources was at best unreliable and, in many cases, not permissible. So, the private sector evolved its own methodologies to assess [future] credit-worthiness risk of both sovereign governments and business entities within their jurisdictions.

ASSESSING A COUNTRY’S CREDIT RISK

For simplicity’s sake, a CRA 100-point score sheet system — familiar to individual consumers and corporate borrowers — will be discussed.

Credit decisions are typically based on complex weighted elements, including political, economic and social factors. For example, chances of a military coup could rate a 1 (if a peaceful, bloodless coup) or significantly higher if the civilian government is removed with considerable resistance and bloodshed (resulting in, say, a 10). Economic stability based on a weak or strong economic infrastructure, volatile commodity-based foreign sales (extracted minerals, wheat) affects the rating yet again. As for social factors (civil society), these can influence ratings on the basis of tolerance of corruption and nepotism in society, with its inevitable crossover effect into business. The more corrupt the society, the higher the cost of doing business, the lower the efficiency of output, and the lower the return on investment (ROI) for the foreign direct investor (FDI) or foreign trader.

ENTER SIMON AND GARFUNKEL

Applying predictive econometric criteria to such non-economic dynamics of national history and culture is [potentially] flawed. On this basis, future “results are in” before events have even unfolded, let alone assessed. Tim Weiner notes in ‘How to Make a Spy’ (Foreign Policy magazine): “Billion dollar spy satellites…do not tell us what we need to know… Language, history, and culture [are] where Americans need to begin.”²

Econometrics

Calibration techniques related to econometric models may benefit from a similar need. According to noted economist and CR analyst Armen Kouyoumdjian, CRA sins include:

Looking at a country intrinsically in terms of risk

“This…weakness … was much affected by the Asian and Argentine crises, both of which [credit rating agencies] failed to predict,” Kouyoumdjian writes. ³

Indeed, Argentine economist Carlos Escud maintains the 2001 IMF crisis was deliberately conceived and executed by corrupt Argentine officials who profited handsomely from this fraudulent scheme. ⁴ Leaving aside whether Escud is right or wrong, the point is: if such crimes were conceived secretly, what CRA practitioner could have known of it?

Concentrating too heavily on a country’s ability to service and reimburse external debt

This has the effect of downplaying other cross-border activities — such as trade and investment — that have their own risk patterns and are not always linked to currency cash flows. ⁵

Incorrect diagnosis and treatment

The Mexican financial crisis of 1991-92 is an example, Kouyoumdjian observes. This was “an old-fashioned, currency cash-flow shortage,” he writes. “In order to treat it, in a country that had a balanced budget and single-digit inflation, the foreign juju doctors obliged the country to raise domestic interest rates to three digits.”The result? Recession, inflation, a bankrupt banking sector and a gaping budget deficit. All of these bad consequences could have been avoided with a US$50-billion currency facility, which came partially and much later, anyways, after all the damage was done. ⁶

Obsession with “phantom” GDPs

These are “nebulous and capricious” figures, Kouyoumdjian notes. The first estimate of a GDP is not even available until well into the following year, after which it is often corrected (up or down) in subsequent years — to which one has to factor in base-date and composition changes, and the impact of erratic exchange rates. Kouyoumdjian notes that what matters [in] debt and payments, are the actual quantities. “Irrespective of how large the debt or its servicing… the important thing is how much money it is, and whether the fiscal, currency and borrowing resources for such an amount are available from different potential sources.”⁷

Putting ‘balance of payments analysis’ at the centre of country risk assessment

Kouyoumdjian writes that “high commodity prices and other changes in terms of trade and investment have meant that few countries today…have severe external problems. In fact, many have record levels of reserves.” However, he further observes, the situation may go into reverse one day. In 2007, for example, Mexico had a non-oil trade balance deficit of some US$55 billion with a falling oil output, which, barring reforms, may mean an end to its oil-exporting capacity in the medium term. ⁸

Considering debt service as a percentage of exports

“This…presupposes that export revenue could and should primarily be destined to debt service,” Kouyoumdjian notes. “It also presupposes that export revenue… accrues to the government treasury.”

It forgets the fact that the country also needs to import, he adds. “If it only imports Champagne and Cognac, these could be done away with, but is a country supposed to stop importing the energy…and food [for]…its population…and the intermediate and capital goods with which its various sectors develop, in order to service debt?”⁹

Changing the definition of fiscal deficit

This practice evolved in the late 1980s to save the increasingly shaky reputation of the crisis managers. Having invented a statistic called ‘the Primary Balance,’ CRA analysts then targeted the category for elimination. “Basically, the authors of this aberration decided that by taking away from the figures the worst reflection of the problem, they would make it more presentable,” Kouyoumdjian writes. “To the extent…that the interest bill had become the main expenditure element in the budget, ignoring it was akin to a clinical director [instructing] all doctors and radiologists to omit from their written diagnosis any threatening illness which may turn up in the examinations.” ¹⁰

HISTORY AS MYSTERY

An open question is whether and to what extent CRA practitioners take into account the history and culture of jurisdictions being assessed for a probability outcome scenario. A separate, but very important question is whether this makes any difference to the outcome anyway.

Business understandably works on a need for predictability over a “deal/ investment-related” time frame — a given framework being five to 10 years. Countries produce “five-year plans,” as do large corporations. Individuals looking to the future in their own lives ask themselves where they will be in that time? Companies hiring them ask the same thing.

But what are five or 10 years to the long (or even short) tail of history? Take two examples: Iran and the former Soviet Union. In the Iranian example, using a five-year accuracy forecast projection when the Shah was still in power (and following the Yom Kippur war in 1973), countries buying Iranian oil were anxious to sell into Iran to earn back the petrodollars that OPEC was charging. This worked out fine until 1978. By 1979, one year after the five-year forecast expired, the Shah was out and the Iranian Revolution was in. Similarly, Mikhail Gorbachev’s glasnost/perestroika reforms in 1985 led to the complete collapse of the European Communist system within six years. The new opportunity to advance private enterprise market dynamics was completely unforeseen in 1984.

CRA makes predictive assumptions about jurisdictions and societies in much the same way a biologist determines a tree’s age by counting its annual trunk rings. Says Nassim Taleb in The Black Swan: “History and societies do not crawl. They make jumps. They go from fracture to fracture with a few vibrations in between. Yet we (and historians) like to believe in the predictable, small, incremental progression.” ¹¹

In other words, the past is not necessarily a guide to the future.

Let the record show CRA still has a way to go as a discipline. If Taleb is right, if a guess is as good as a prediction, then if the outcome is as predicted, is it luck? Or is this something upon which a risk manager can stake his or her professional reputation?

If so, what of NASA’s 1986 Challenger Shuttle disaster. Was it a one-time event? Yes, until 2003’s Columbia re-entry. In both scenarios, heat shield foam padding resulted in disaster. This is no less a case of “apples-to-apples” comparison as pre-or post-revolutionary Iran in 1979 or (counter-) revolutionary Russia in 1989.

1 http://en.wikipedia.org/wiki/Country_risk

2 Tim Weiner, ‘How to Make a Spy,’ Foreign Policy, September, 2007,Pg. 48.

3 Armen Kouyoumdjian, Country Risk Analysis: Time for a New Approach, February 14, 2008

http://www.rgemonitor.com/latammonitor/608/country_risk_analysis_time_for_ a_new_approach

4 Carlos Escud, From Captive to Failed State: Argentina under systemic populism, 1975 – 2006, The Fletcher Forum of World Affairs, Vol 30, No 2, Summer 2006, Pg 125 – 147.; fletcher.

tufts.edu/forum/archives/pdfs/30 -2pdfs/escude.pdf

5 Armen Kouyoumdjian, Country Risk Analysis: Time for a New Approach, February 14, 2008;

http://www.rgemonitor.com/latammonitor/608/country_risk_analysis_ time_for_a_new_approach

6 Ibid

7 Op. cit.

8 Op. cit.

9 Op. cit.

10 Op. cit.

11 Nassim Nicholas Taleb, The Black Swan, Random House, NYC, 2007, Pp 11 – 12.