Investment portfolios are generally determined by two general factors: country risk and political risk. Country risk refers to the likelihood that changes in the macro environment adversely affecting the operating profits or the value of assets (domestic and foreign) in a specific country. There are three key phrases in the definition that are of importance to any risk analysis. First, only changes in the macro environment (economic environment) are perceived as significant variables in assessing country risk. Second, it is assume that country risk is probabilistic in nature. One can assume that the methods used in evaluating country risk are statistical in orientation.
And third, it is assumed that the higher is the country risk, the higher is the chance for the operating profits or the value of assets to be adversely affected.There are several indicators of country risk. Here are as follows: 1) monetary controls used by central banks, 2) fiscal policies implemented by governments, 3) exchange rate conditions (whether a currency is protective, floating, or semi-floating), 4) level of tariffs or subsidies, 5) marginal domestic propensity to invest, 6) credit ratings, and 6) political risk.
For simplicity purposes, the last indicator of country risk will be discussed in the next paragraphs. It is assumed that the higher the monetary controls of central banks, the lower is the probability that assets (foreign and domestic) will lose significant value. Monetary controls stabilize the value of assets in a given period of time. Because liquid assets are susceptible to changes in international money markets, central banks can issue ‘assurance’ bills that will guarantee the face value of such assets. However, monetary controls must not be overtly protective.
Higher monetary controls mean lower returns for liquid assets. Fiscal policies pursued by governments also determine the level of country risk. High government spending drives aggregate demand upwards, increasing incentives to invest. However, the optimal level of spending must be carefully assessed. Excessive spending leads to high inflation and unemployment rates. Exchange rate conditions are also an important factor in evaluating country risk.
A general depreciation of a currency is a signal for firms to shift their supply schedules to exportable goods. For foreign firms, it is also a signal to shift their production schedules to domestic goods (theoretical). In secondary markets, a depreciation of a currency relative to another currency leads to lower returns for foreign assets.An appreciation results to an increased demand for foreign currency. Depreciation, appreciation, and devaluation have significant bearing on the value (returns) of assets. The level of tariffs and subsidies are also important in evaluating country risk.
A higher marginal domestic propensity to invest is an indication that a particular country has a rising economic growth (translated into real terms). A lower marginal domestic propensity to invest is an indication of low aggregate output. Translated into risk, a country with low aggregate economic output is relatively risky for foreign investment. Credit rating is another important indicator of country risk. A country with good credit ratings is a good avenue for increased foreign investment.
A country with ‘bad’ credit ratings is relatively a risky avenue for investment (domestic and foreign). However, it is noteworthy that the level of risk associated with credit ratings is never a sufficient determinant in assessing the value of assets. For example, it is possible for an asset to increase steadily even if the reference country has ‘bad’ credit ratings. Value of assets is generally determined by the level of clearing in the secondary market, type of monetary controls used in an economy, and guarantees used by the issuing firm/individual.Health risk is a general indicator used by the United Nations (and its agencies) in assessing the health status of a particular country. Some of the factors assessed are as follows: 1) susceptibility to common ailments and diseases, 2) diet, 3) nutritional deficiencies, 4) consumption patterns, and 5) work-related illness.
A country where a significant portion of its population exposed to common diseases has high health risk. The same goes with nutritional deficiencies. Third World countries have the highest levels of nutritional deficiencies, covering about 40% of its total population. Consumption patterns are difficult to assess because of subjectivity.
However, it is a generally accepted rule that countries which approximate the consumption patterns of Western countries have low health risk. A country with high incidence of work-related illness has high health risk. However, such proposition should be structurally viewed. High income countries have different health risk patterns (with regard to work-related illness) than developing countries.
It is possible for high income countries to have high incidence of work-related illness.Political risk is one of the most popular indicators used in assessing country risk. This type of risk refers to the complications businesses, individual investors, and governments face as a result of political decisions (public decisions). In technical terms, it is a type of risk related to political instability and government inefficiency in implementing economic reforms. Here, delineation between political risk and country risk must be established. Some books assume that the two concepts are synonymous.
However, when viewed from the point of view of individual firms, there is a contrasting significance. Firms usually distinguish risks into two forms: economic risks and political risks. Political risk therefore would be limited to actions undertaken by governments, associated ideology of public governance, and the level of political instability.
Country risk is measured by macro and global economic variables.Like country risk, political risk is probabilistic in nature. It is measured by variables (although some variables may be qualitative in orientation).
The degree of prediction depends mainly on the depth of the analysis used in evaluating political risk and its relation to accepted theoretical propositions. For example, it is assume that a low level of political risk is not necessarily correlated to a high degree of political freedom. There are some states that are authoritarian but are stable (less political risk). Countries in Western Europe which have high degrees of political freedom are also politically stable. To further illustrate this case, there is a need to analyze the experiences of North and South Korea, Taiwan, and China.With the end of the Second World War, China erupted into a civil war. Nationalist were driven from the mainland.
They established their seat of government in Taiwan. China became a Communist country. Mao directed the so-called ‘great leap forward’, an economic revolution designed to transform China into an industrial power.
His policy, however, failed (as was the Cultural Revolution). With his death in 1976, Deng Xiaoping assumed the position as secretary-general of the CCP. He declared, “To get rich is glorious.” He initiated economic reforms that increased foreign investments in the country.
Industries were also streamlined to meet world market demands.Finance analysts from World Bank and IMF classified China as a less politically risky country; that is, it was desirable for foreigners to invest in the country (Xiaoping even initiated a supra restructuring of the legal system to suit his economic policies. The same can be said about China. To prevent Communism from spreading in Taiwan, Chiang Kai-shek (former Chinese president and leader of the Nationalists) initiated a powerful land reform program.
He destroyed the power of the landlords and introduced economic measures to increase foreign investments into the country. For the next 30 years, the country did not experience any major political turmoil. No political group could overthrow or at least effectively oppose the policies of the Nationalist Party (Kuomintang). Taiwan was then classified as a less politically risky country by international finance agencies. After the Korean War, the government of South Korea implemented economic reforms that increase national aggregate output. Since that time, economic growth of South Korea increased steadily. Politically, it was stable. International finance agencies put South Korea in the list of less politically risky countries.
There are several things that one can learn from the experiences of the above-mentioned countries. First, political stability is related to economic growth. Once a country attains political stability, economic growth soon follows. Second, economic growth leads to increased foreign investment (because of low political risks). Improvement in the market infrastructure of a country coupled with a stable and efficient government is one of the determinants of low political risk.
And lastly, political instability is an antithesis of economic development (economic development encompasses economic growth because it assumes the totality of the economic efficiency of the domestic market). Revolution, riots, and civil wars (which characterized the above-mentioned countries in the past) lead to poor economic performance.The World Bank and its agencies may succeed in their efforts to improve the investment climate in Third World countries.
First, because Third World countries not very susceptible to the effects of the global financial crisis, loans provided by the International Monetary Fund are usually invested in long-term economic projects. Even if FDI from developed countries decline, the ratio improvement per capital may actually increase. And, second, Third World countries today are beginning to become less and less dependent on developed countries for FDI. This can be illustrated by the so-called ‘regional areas.’ Members of ASEAN which mostly are Third World countries are heavily involved in capital exchanges. These capital exchanges are designed to foster capital mobility among member countries in order to lessen dependence on FDI from developed countries. The significant growth of the capital infrastructure of Indonesia was the result of capital inflows from Malaysia, the Philippines, and India.
Note here that the creation of ‘regional areas’ was a move initiated by the United Nations as a move to improve the investment climate in Third World countries.