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What types of country risks might be applicable when operating internatioally? What are tools to evaluate...

What types of country risks might be applicable when operating internatioally? What are tools to evaluate such risks? What are some tools to mitigate risks?

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Answer #1

Types of country risks might be applicable when operating internatioally are as follows :

  1. Political risk : Political risk is the risk of a country’s external relations has undergone significant changes. For example, the war is occurred with other countries or the occupation of territory. Sometimes the political risk is an internal instability environment of the country, such as the coup caused by the ideological differences, the unrest caused by terrorist, the conflict of economic institutions, and the local separatist struggle. All of these phenomenons will likely lead to loss and cause the country risk.
  2. Sovereign risk : The sovereign risk is the risk that the acts of sovereign government or government agencies affect to the lenders. Sometimes, the sovereign government or government agencies may refuse to carry out the debt refunding or refuse to bear the surety responsibility. Consequently, that will lead losses to the lending banks.
  3. Economic risk : Economic risk is the risk caused by a country refuse to pay the external debt. The reasons of the payment refusing may be variety such as the slow national economic growth, the low investment willingness, the decreasing of the exporting revenues, the balance of payment deteriorated, and the shortage of foreign exchange.
  4. Transfer risk : Transfer risk is due to the host government policies or regulations prohibiting or restricting the transfer of funds, thus composes the threat to the lenders. In the international business, as the foreign exchange control and regulation of capital movements of the host country, banks’ deposits and income cannot be exported in the host country, and the principle of loans cannot be recovered. For instance, in the Asian currency crisis, the capital control of Malaysia was a political solution to solve the exchange rate problem in their country. That led the deposits and income of foreign countries in Malaysia against high risks and may not be recovered.
  5. Exchange risk : Exchange risk means that the potential loss from any negative unexpected changes of exchange rate. The exchange risk generally caused by different factors such as the international receipts and payments and currency reserves, interest rate, inflation, and the political situation.
  6. Location or neighborhood risk : Meldrum (1999) states this type of risk as “spillover effects caused by problems in a region, in a country’s trading partner, or in countries with similar perceived characteristics”. Several more sectors can also cause the location or neighborhood risk such as geographic position, international business partner and trading institution and organizations.

Tools to evaluate such risks are as follows :

  1. Euromoney Country Risk Survey: This survey covers 186 countries and gives a comprehensive picture of a country's investment risk. The rating is given on a 100-point scale, with a score of 100 representing virtually zero risk.
  2. Economist Intelligence Unit's Country Risk Service Report:  The EIU is the research arm of The Economist and one of its best offerings is its Country Risk Service Report. These ratings cover over 130 countries, with an emphasis on "emerging and highly indebted" markets. The rating analyzes factors similar to the ECR rating, such as economic and political risk, and provides a rating on a 100-point scale; however, unlike the ECR rating, higher scores mean higher sovereign risk.
  3. Institutional Investor's Country Credit Survey: This rating service is based on a survey of senior economists and analysts at large international banks. The uniqueness of this approach is appealing because it surveys people from companies that are at the ground level, lending and providing capital directly to these countries. In a sense, this adds a degree of credibility to the ratings because major international banks typically do a significant amount of due diligence before exposing themselves to certain countries. Similar to the other approaches, this rating is based on a scale of 0 to 100, with 100 being virtually risk-free and zero being equivalent to certain default.

Tools to mitigate risks are as follows :

  1. Consider the timing of your investments : Investors should restrict capital transfers to a country to those times when the foreign exchange rate is in equilibrium. The theory of “Purchasing Power Parity” provides a guide to likely exchange rate changes. Compare a country’s cumulative inflation over a number of years with the cumulative inflation rate of its major trade partners. If the difference in cumulative inflation rates exceeds the percentage change in the foreign exchange rate, then devaluation is a real possibility. For example, this calculation would suggest that the Mexican peso is currently substantially overvalued.
  2. Borrow domestically to do business domestically and avoid foreign exchange rate exposure :Keep in mind that this approach does expose the business to the possibility of interest rate increases as a result of a central bank’s response to foreign exchange rate devaluation. For a foreign-owned financial institution, this approach also involves the possibility of a “run” on deposits, as the depositors seek to withdraw funds in order to transfer them abroad.
  3. Focus on the devaluation risk when choosing among countries as investment sites : From this perspective, Chile is currently a less risky region for investment than Argentina or Mexico.
  4. Spread the purchase price over as long a time period as possible : This allows domestic currency to be purchased at a lower cost if devaluation occurs. Alternatively, gear the purchase price to a weighted average of the exchange rate over future years, with projected future payments adjusted in accordance with the exchange rate.
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