19
Country Risk Analysis

Short Description

Country risk assessment (CRA) deals with how a firm addresses the risks involved in making investments in a foreign country. Country risk is the risk that economic, political, or social conditions and events in a foreign country will adversely affect a firm's financial and strategic interests. Decision makers need to weigh any potential loss of invested capital that could result from troublesome circumstances in a foreign country. CRA as a discipline seeks to identify these risks and determine the degree to which they will negatively impact their return on investment (ROI). Country risk can be segmented into the following six distinct, yet interrelated, categories:

• Economic risk
• Transfer risk
• Exchange rate risk
• Location or neighborhood risk
• Sovereign risk
• Political risk

Background

Risks are generically viewed as the potential damage or harm that may arise in the present or future. Risks are often mapped to the probability of some future event or current process, which may result in an undesirable outcome. CRA is primarily used for business analysis, although it can also be used to assess the vulnerability associated with rivals' foreign investments and market entry.

CRA became popular in the 1970s and was refined in subsequent decades. Its first manifestations were designed to help private investor banks make educated decisions about lending money to entities in foreign countries. Following the oil crisis in the 1970s, CRA took a more quantitative approach. Risk assessment forecasting services from agencies such as the International Monetary Fund, the Economist's Economic Intelligence Unit, and the Wharton Economic Forecasting Associates (WEFA) grew and became more sophisticated, often with the assistance of analytical models that had benefited from years of empirical testing and experience.

Indices that rated country risk began to be developed, often with data collected from vast and knowledgeable sources. These services typically used a combination of qualitative and quantitative measures to regularly rank over 200 different countries. A range of experts from universities, government, and organizations would be surveyed by the respective indices developers to produce an individual score and or ranking.

Unfortunately, there were often differences in ratings/rankings between indices because experts' definition and conversion of the data into measurable actions and behaviors could differ. Thus, there was an element of subjectivity in the models. Additionally, they were often too general for most business people and decision makers to use in their planning considerations because they were primarily prepared for banks and institutional lenders for a fee. They also commonly lacked the specificity of which risks were more prevalent in different types of investments or market entry activities. With such international events as the change of governments in Iran and Nicaragua in the late 1970s, the models became more refined in the 1980s and 1990s and began to make use of more types of quantitative measures and the inclusion of investment limits and statistical significance for commercial CRA services and indices.

Strategic Rationale

Today's reality is that firms interested in becoming industry leaders must seek global, not local, market dominance. Global expansion is becoming increasingly attractive for firms whose home markets have reached maturity or are simply too small to allow exploitation of economies of scale or learning curve advantages.¹ Multinationals are locating manufacturing facilities in foreign countries, outsourcing, joint venturing, and exploring licensing opportunities to gain access to developing markets.² All of these situations will present risks that the firm may not have experienced in its home country.

The term "investment" covers a range of actions that a firm can take to extend its operations into a foreign country. A strategy as simple as selling products in another country can represent a risk in the short term. These risks include not getting paid for the full cash value of the goods, or getting paid in a valueless currency.³ Many expansion strategies require longer-term investments and a correspondingly longer period over which a risk may be experienced, such as the construction of manufacturing facilities or development of strategic alliances.

Although international expansion or investments can provide many positive opportunities to generate profitability and wealth, the risks associated with investing in a foreign country are numerous. Some of these risks include a foreign entity defaulting on its debt; renegotiating or rescheduling obligations in order to alleviate problems associated with the financing instruments or processes; and the transfer of risk, which includes losses to the home country firm that emanate from foreign exchange rates and controls.⁴ Firms will want to assess the potential that their ROI may fall short of what might be reasonably projected.⁵ Firms' or governments' financial positions in the foreign market are affected by changes in taxation, exchange rates, and exchange controls.

In the twentieth century, there were numerous situations where domestic debtors were relieved of obligations to foreign investors, leaving foreign investors few options for recourse to compensation. One reason for this was because the laws of independent countries were outside the bounds foreign courts. Even with a ruling by the International Court of Justice (the World Court or ICJ) in The Hague, if the situation would even qualify, firms receive little more than moral vindication if the guilty country refuses to act on the ruling.

Strengths and Advantages

Foreign markets enable firms to gain access to less-developed markets, capitalize on economies of scale, and develop more cost-effective value chains. For firms looking to expand abroad, it is important to be educated about the potential risks and create contingency plans where possible. CRA is important to enhance the firm's understanding of the kind and degree of risks that are associated with a potential foreign investment. Firms that have a realistic grasp of risks stand a much better chance of achieving success with their investments over the long term.

CRA also helps you to identify not only the nature of the risks inherent in making investments abroad, but may also allow you to identify remedies to minimize or even eliminate taking on all of the risk. In addition, certain risks can be insured against or hedged—for example, exchange rate risk, which can help firms weather the tough times that they would not experience in their home market.

When a firm has an investment choice among several countries, CRA can help it make relative determinations and prioritize those places, which are likely to generate the most favorable return/risk trade-offs. Analysts can help their decision makers gain confidence in their investment decisions by choosing countries that have lower risk levels.

CRA may also help you identify other firmsc, particularly those in non-competing markets, which have previously invested in risky countries. This can help you to identify the actions those firms took to lessen country risk. As such, this becomes a form of benchmarking that can help the firm adapt practices that have been successful elsewhere (see Chapter 11, "Benchmarking," for more about benchmarking).

Finally, CRA is part of the cultural awareness a firm must develop for long-term success when investing and operating in a foreign country. A comprehensive CRA helps to educate analysts, managers, and decision makers about a country's political system, history, economic, judicial, and commercial factors in advance of making a major investment. Hence, it accelerates the firm up the "learning curve" and can potentially also facilitate an adjustment into a foreign country after a decision to invest has been made.

Weaknesses and Limitations

Concerns arising from data collection, lack of objectivity, looking to past events to predict the future, and lack of specificity are problems that plague the CRA discipline. Many attempts by CRA experts and advisory agencies to standardize and quantify dynamic, simultaneous events and isolate them are conducted upon a shaky foundation of causal and affective relationships. Ultimately, CRA tries to assign quantitative measures to human events, actions, and concepts that are themselves constantly developing and unfolding.⁶ As such, analysts need not only to understand how to interpret the various country risk ratings or rankings they encounter, but also to have a reasonable conceptual understanding (meaning that they can explain it in common sense terms to their decision makers) of the modeling that underlies and provides the computational foundations of these results. To increase confidence in their findings, analysts will need to focus on the root causes of the problems, not just on the more visible symptoms of these problems. However, even with the elaborate techniques and models used by many firms, research has shown the results are often subsequently wrong.⁷

A CRA model based on substantial volumes of historical data may also be flawed. This occurs because past actions may be unreliable indications of future behavior. A country with a high level of risk in the past may have taken actions to reduce these factors, while countries with lower levels may have become riskier in recent years. This is one reason why data gathering for CRA purposes must be kept active and regularly updated.

The data collection efforts that provide the raw data to calculate country risk scores are often flawed. Political risk assessment models are often comparative, and it is difficult to procure the same data for different countries when it is subjective. Much of the data is based on opinion, which is highly subjective, and can be biased. An interviewee that is an "insider" (that is, a resident or citizen of the country in question) may be biased toward the country or biased against the home country of the interviewer. As such, different studies of the same country will often deliver dramatically different results. Apart from potential respondent biases, expert interviewees and interviewers may simply attach different meanings to a variable or interpret questions or answers differently, thereby introducing an additional bias.⁸

In underdeveloped or slowly developing countries, much of the economic data needed to accurately calculate risk scores using today's sophisticated quantitative models may not be published. If this data is published, it may not reflect the actual state or an accurate picture of the market in the global economy. Many countries have well-developed black markets where the exchange of cash, bribes, and goods, both legal and illicit, go unrecorded, and the data captured about economic activity is corrupt, or suspect at best.

Finally, CRA is helpful in illuminating the risks of investing or establishing operations in a foreign country, but it is not so helpful in providing an understanding of the other side of the risk and reward/return equation—that being the benefits to be generated for the firm from making these investments. You will need to employ different techniques, particularly those associated with modeling financial returns over time, and even more economic models like Porter's Diamond of National Advantage, in order to have a strong sense of the entire risk/reward equation.

Process for Applying the Technique

The investment decision-making process for a firm looking to enter a foreign market often follows a common pattern, and it can be adapted to a large or smaller scale project. Country risk ratings are commonly used to summarize the conclusions of the CRA process. The ratings provide a framework for establishing country exposure limits that reflect the firm's risk tolerance and willingness to balance potential rewards against these risks.

Business and competitive analysts can play a prominent role on a CRA effort. This will become more evident once we describe the organizational process for performing CRA. The following fairly standard methodology is adapted from one recommended by D.H. Meldrum:

1. Create a foreign country market risk assessment team. The team will be responsible for assessing risk in terms of the specific kind of investment being contemplated. For example, if the firm is considering locating a plant in a foreign country, longer-term risk factors, like economic risk, will be viewed as more important. If it is to be financed by the home firm, sovereign risk will not require consideration. If a firm is looking at a shorter-term investment, for example, selling goods in the private sector, economic outlook and exchange rate risk may reflect more pressing issues.
2. Analysts should help executives decide how important or potentially influential each of the different risk categories will be to the decision under consideration. The most influential receive the highest relative weight, and the least influential receive the lowest relative weight. These weights must be established for a particular time period because they will not likely be fixed at the same weights over long periods of time.
3. The team should select appropriate measures or metrics for each of type of risk. At this point, focus on a small number of quantifiable indicators (say between five and 10, which appear to be particularly relevant), such as GDP and debt service ratios, and determine if those indices are falling within a desirable range. Each index is given a score between 1 and 5, according to how closely the measure reflects low risk. Some samples of indicators for each type of risk are outlined in the risk descriptors described in subsequent paragraphs of this section.
4. For qualitative indicators, analysts should canvas risk experts (or the consensus of several experts) for their opinion on conditions in the country in question, and those outcomes are given a score from 1 to 5.
5. The resulting values can all be combined for each risk factor.
6. Each risk factor's score can then be multiplied by its weight, and all weighted scores can then be aggregated to create a total country risk score. If different countries are being compared, it is important to use the same weighting scheme consistently for all countries in order to get a relative assessment of country risk. Although this step results in a quantitative score, it is important not to attribute any spurious accuracy or confidence intervals to the results.

Assessing country risk ordinarily requires the use of a variety of sophisticated quantitative techniques. In many typical country analysis or planning situations, the analyst will begin with an index acquired through subscription or fee payment from a country risk consultancy or reporting body. Country risk reports can be purchased from the Business Environment Risk Intelligence (BERI) S.A., Control Risks Information Services (CRIS), Economist Intelligence Unit (EIU), Euromoney, Institutional Investor, Moody's Investor Services, Standard and Poor's Rating Group, and Political Risk Services: International Country Risk Guide (ICRG), among others. These reports are generated by groups that continually monitor and assess country risk and publish them on a regular and systematic basis.

The advantage of commercial reports is the vast resources and knowledge they have at their fingertips. Most, like the WEFA, IMF, and EIU reports, provide timely and regularly updated information on over 200 countries as well as periodic global reports. It is almost impossible for any other than the most resourceful firms to attempt to match the reach and capabilities that these commercial services provide. That said, the commercial reports are general overviews, not tailored to any particular type of investment or situation and not necessarily designed to answer the kind of investment oriented questions that a firm might be called upon to address. That is why a combination of commercially available material, adapted to and complemented with other analysis that apply to a firm's specific investment situation, is a preferable country risk assessment method for most firms looking to expand and invest abroad.

Acquiring these reports is a helpful but not a sufficient step in doing CRA for competitive or strategic decision-making purposes. None of the indices is sufficient to predict the array of social, political, and economic factors that can align to create a good or bad environment on any given day or at the time your firm is planning to make its investment. Very generally, the more stable a country is, the easier it is to make predictions about the nature and level of risk that will be experienced.

As assessing country risk for the strategic analyst is as much "art" as it is "science," the technique can vary according to the practitioner. Most CRA researchers will use their best judgment and knowledge to select a mix of social, economic, and political measures that will allow them to develop confident insights into the relative risk of a potential investment. In any case, it is pretty much impossible, if not impractical, to include every risk factor in any analysis; the range of economic, political, social, infrastructure, and other variables that can potentially be combined is too extensive for any single model.

A more desirable approach will involve a model being tailored to the strategy or competitive analysis needs of the firm, focusing on the factors that pose the greatest risk for the specific situation under analytical consideration. Although intertwined, country risks will fall into one or more of the following six categories described in Table 19.1.

Table 19.1
Common Types, Sources, and Indicators of Country Risk

Economic Risk

Economic risk is the risk associated with less than expected rates of return or performance to an investment stemming from changes in economic policies or growth rate. Economic risk can occur most commonly when:

• Economic policies change.
• The goals underlying economic policies change.
• The market growth rate changes.
• An economy's strengths or advantages are somehow compromised.

Material changes in a country's natural or human resources, demographics, or industry performance can all result in economic risk. Political risk and economic risk may be closely intertwined. Some models for assessing political risk will put economic risk under the political risk umbrella, as government economic policies affect both the political and economic climates.

Economic Risk Indicators

There are numerous ratios that can be used to determine the relative level of health of a country's economy. A simple and accessible indicator is the gross domestic product (GDP) growth rate. A high growth rate can frequently indicate a developing country whose economy is experiencing rapid change, whereas a slow growth rate can indicate a mature market. In order to determine the amount and burden of external debt, one can look at the ratio of Net External Debt (NED) to GDP or the ratio of Net External Debt to exports of goods and services. These ratios give an indication of the country's ability to service its debt. As a rule of thumb, a debt service ratio under 10 percent is a positive sign, while anything over 20 percent is a negative sign. The amount and growth of GDP and the current tax system are also factors you should consider examining.

Transfer Risk

Transfer risk is the potential for a government, public agencies, or its officials to confine or hinder capital movement from their country to another. This can make it difficult or impossible for a firm to shift (or transfer) profit or capital assets back to their home country or elsewhere. Countries can hinder capital movement at any time through a variety of measures. Generally, countries that are having a hard time attracting foreign currency are more likely to enact capital restrictions. Like economic risk, some models for assessing political risk put transfer risk under the political risk umbrella, as political policies can also affect the flow of goods.

Transfer Risk Indicators

Imbalances in quantitative figures can expose the risk of transfer restrictions. It is more important to look at the trend of consistency or inconsistency in these figures than the absolute figures themselves. Some ratios to examine to determine transfer risk are: debt service payments to exports, foreign debt to income ratios, foreign currency reserves to imports (in categories), and relative current account status. Adverse imbalances in accounts could create a situation where governments will restrict capital in order to cover up deficits.

Exchange Risk

Exchange risk generally entails a quick or unexpected movement in the exchange rate between countries that causes detrimental investment results. This can include a country switching from fixed to floating exchange rate systems or vice versa. Currency traders and analysts are trained in making longer term predictions and can be a valuable source of information in assessing exchange rate activity. Short-term exchange risk can be mitigated by the use of hedging tactics. For the longer term, the firm will want to look at whether costs and revenues in the same currency match up or build in safety nets to cushion against currency fluctuations. The structure of the exchange rate policy is also an indicator. Floating rates, particularly when the country is an active participant in global trading regimes and its currency is regularly traded and exchanged, often produce less-unexpected movements. Managed floats, the situation in which governments are trying to keep their currency's rate of exchange pegged within a certain range, often increase this risk.

Exchange Risk Indicators

Transfer risk indicators can also be useful in determining exchange rate movement because over valuation of a currency can lead to increased imbalances that increase transfer risk. Alternatively, a currency devaluation can decrease these kinds of imbalances.

Location/Neighborhood Risk

These risks exist by virtue of being physically close to an unstable environment. They can occur wherever there are problems in a particular region: problems with a geographically near trading partner, with a neighboring country, or a country with similar traits or characteristics. For example, religious or racial persecution can lead to a flood of refugees to neighboring countries and cause disruption in commerce and trade.

Location/Neighborhood Risk Indicators

The best indicator for neighborhood risk is geographic proximity. Proximity to superpowers, troubled nations, unstable, warring, or impoverished countries can increase the levels of this risk. The number of borders (particularly pertinent for land-locked nations within larger continents), border disputes, and membership (or lack thereof) of alliances or trade agreements can also have an effect on this form of risk.

Sovereign Risk

The unique characteristic with sovereign risk is not so much the risk of loss, but the lack of repercussions in the event of loss, due to the sovereignty of nations. Any form of investment or partnership by a private investor with a government or one of its designated agencies runs the risk of default due to an inability or refusal by a country's government to honor its commitments. An inability to pay is related to economic and transfer risk, and a refusal to cooperate may be politically motivated. International law states that a private investor cannot sue a sovereign government without the government's permission.

Transfer risk indices are helpful in determining if a country will be able to honor financial commitments. Willingness to pay is a little trickier. It can be helpful to look at the historical record of payment by a particular nation and its respective governments. Although past actions are no guarantee of future behavior, an historical trend of not paying is a track record to be mindful of. The analyst must also consider the consequences to the nation/its government and the firm if the government does not pay. Could the nation experience potentially damaging consumer boycotts or receive strong pressure from other nations?

Political Risk

Generally speaking, assessing political risk is another elusive and varied task. Briefly, these are risks that result from political changes. Macro- and micro-risk can be further divided into two categories: societal and governmental.

Societal macro-risk refers to instability caused by civil wars, terrorism, coups, dramatic shifts in societal values, pressures by powerful unions, religious disagreements, revolutions, national work stoppages, or any other politically charged civil event that is detrimental to the activities of a foreign firm.

Governmental macro-risk encompasses all actions by the host government that can have negative effects on foreign businesses. These include nationalization and expropriation, limits on the repatriation of assets and profits, a dramatic change in leadership, and/or general bureaucracy. A less extreme, though far more common, example is the incongruence that results from high tariffs in countries that are trying to attract foreign business.

Societal micro-risks include boycotts, activism, some acts of terrorism, and competition from other multinationals.

Governmental micro-risks are those that are directed toward a specific foreign country or industry. They include selective nationalization, prejudicial tax systems, equity, content and hiring regulations, supporting indigenous competition, disregarding contracts, and putting controls on pricing.

In most cases of political risk analysis, either a business or political risk assessment service will interview experts (academics, business people, politicians, and consultants) and quantify the results into a numerical score or index in order to evaluate the country in relation to other countries. These political risk scores have been criticized as being inconsistent, subjective, and lacking future orientation.

Other techniques for gauging political risk include the "grand tours" technique, whereby a firm representative investigates the investment site and interviews local officials and businesses. Another method is the "old hands" technique, where the firm seeks out country experts and veterans in order to gather their views and insights.

This six-step process is best demonstrated via an example. The case study in this chapter is for a fairly standard application of the CRA process and will provide you with a better understanding of the process just outlined.

Although the nature of the CRA process and the level of analytical resources devoted to it will vary from firm to firm depending on the size and sophistication of its international operations, a number of considerations are relevant to evaluating the process:

• Is there a quantitative and qualitative assessment of the risk associated with each country in which the firm is operating or planning to conduct business?
• Is a formal analysis of country risk conducted at least annually, and does the firm have an effective system for monitoring prominent developments in the interim?
• Does the analysis take into account all aspects of the broadly defined concept of country risk, as well as any special risks associated with specific groups of counterparties the firm may have targeted in its business or market strategy?
• Is the analysis adequately documented, and are conclusions concerning the level of risk communicated in a way that provides decision makers with a reasonable basis for determining the nature and level of the firm's exposures or potential exposures in a country?
• Given the size and sophistication of the firm's international activities, are the resources (that is, data gathering, analysts, processes, systems, and time) devoted to the CRA process adequate?
• Have analysts checked with their decision makers to assess their satisfaction with previous country risk analyses? Did decision makers make use of the provided CRAs? Were the results provided credible? Have decision makers been surprised by an adverse event occurring in a country where an analysis was performed?
• As a final check of the process, are the analyst's conclusions concerning a country reasonable in light of information available from other sources, including external research and rating services?

CRA is important in an increasingly global marketplace, particularly for small- to medium-sized firms that are planning to make investments abroad for the first time. Conclusions about the level of country risk provide an evaluation of prevailing (and possible future) economic, political, and social conditions, which reflect on a country's ability to meet its obligations, as well as the credit risk on individual counterparties located in the country. CRA should be combined with other tools to improve the firm's ability to make better decisions about its international business activities.

Case Study: Zyboldt Metals (ZMC) Expansion into Eastern Europe

Zyboldt Metals Corporation (ZMC), headquartered in the mid-western part of the U.S., is a spin-off of a large American conglomerate that had gone through a massive restructuring and divesture initiative in order to focus on its core businesses of metal and plastics. ZMC, a firm with close to $130 million in sales in 2004 (nearly all of which were in Canada and the U.S.), viewed home canning products as a key part of the firm's product offering. The firm hoped to achieve at least a 50 percent growth in its home canning sales within the next three years, and an expansion into Eastern Europe, the first investment the firm would make outside of North America, would potentially be part of the strategy.

An observant CEO, Arthur Rieden, noticed some interesting things while on a six-week pleasure trip to several nations in Eastern Europe during July and August 2005. He observed that many people in the bed and breakfast facilities, as well as small hotels he stayed in, had their own vegetable gardens, with the Hungarians, Poles, Romanians, and Ukrainians having sizable vegetable gardens. When he asked his hosts about the produce from their gardens, he discovered that most of the people repetitively used the same jars to store their vegetables, and many of these jars lacked the proper seals; hence, they had to use a large volume of various preservatives in the canning process to avoid the contents being spoiled when bacteria, enzyme, mold, and yeast grew out of control.

Rieden knew that his canning products, properly applied, would control the spoilage, allowing the canned food to be kept for a substantially longer time. Market research the firm had authorized some years ago also showed that families in this part of the world generally preferred the ZMC canning process and its preservative-free taste.

With this information and forecasted market potential of around 60 million jars per year, expansion into Eastern European markets looked promising. While lids would be imported from Canada, upwards of eight million dollars for the glass jars molds and production, carton design and production, and an extensive multi-media advertising campaign would be invested directly in the country of entry. Based on his visits, the views of some of his well-traveled employees, and some sparse country data he was able to acquire, Rieden considered Hungary and Ukraine good entry points to establish an Eastern European market.

Before making the investment, Rieden asked his firm's analysts to perform a CRA, along with a number of other complementary market, competitor, and partner analyses of the two countries. For the CRA, he wanted to know if the potential benefits of investing in these countries would outweigh the associated risks. He asked the analyst to compare Hungary and Ukraine and their relative country risk. This study was carried out in late 2005.

Step One: What kind of investment is ZMC making? Which types of country risk will ZMC potentially be exposed to?

As the firm is outsourcing suppliers for jars, packaging, distribution, and advertising, the expansion into Eastern Europe can be classified as "Direct Investment—Private Sector." Therefore, the risk impact would be as follows:

Source: Adapted from Meldrum, 2000.

Step Two: Choose weighting for each risk type, as follows:

Step Three: Select indicators:

Grading Guide: A = 0 points, B = 1 point, C = 2 points, D = 3 points, F = 4 points, +/– = add/subtract .25 points.

Hungary

Hungary is a landlocked country in Central Europe bordered by Austria, Slovakia, Ukraine, Romania, Serbia and Montenegro, Croatia, and Slovenia. Hungary fell under Communist rule following World War II. In 1956, a revolt and announced withdrawal from the Warsaw Pact were met with a massive military intervention by the USSR. Under the leadership of Janos Kadar in 1968, Hungary began liberalizing its economy, introducing so-called "Goulash Communism." Hungary held its first multiparty elections in 1990 and initiated a free market economy. It joined NATO in 1999 and the EU in 2004. In mid-2005, the population was just above 10 million.⁹

Basic Economic Facts

• GDP (purchasing power parity, or ppp): USD$149.3 billion (2004)
• GDP (ppp) per capita: USD$14,900
• GDP (ppp) real growth rate: 3.9 percent (2004 est.)
• Inflation rate: 7 percent (2004 consumer est.)
• Debt (external): USD$57 billion

Economic Risk Indicators

This points to a very high debt service ratio (23.5 for 2004) and total debt increasing over the next two years. Hungary maintains large fiscal and external deficits. However, domestic spending is getting stronger, and a cut in the VAT will help keep inflation down.
Score = B = (1).

Transfer Risk Indicators

Current account balance was –8.8 percent of GDP in 2004 and is projected to remain around 8 percent in 2005 and 2006. The country's debt-service ratio paid is over 20 percent, averaging around 22 percent between 2004 and 2006. Foreign investment has been a key to Hungary's economic success. With about $55.44 billion in foreign direct investment (FDI) since 1989, Hungary has been a leading destination for FDI in this part of Europe. Slightly over 25 percent has come from U.S.-based firms. Foreign firms have helped modernize Hungary's industrial sector and created thousands of new, high-skilled, high-paying jobs. Foreign firms account for over 70 percent of Hungary's exports, 33 percent of GDP, and about 25 percent of new jobs.
Score = B = (1).

Exchange Rate Indicators

In 1995, Hungary's currency, the forint (HUF), became convertible for all current account transactions and subsequent to it gaining OECD membership in 1996 for almost all capital account transactions. In 2001, the Government lifted the remaining currency controls and broadened the band around the exchange rate, allowing the forint to appreciate by more than 12 percent in a year. Conflicting fiscal and monetary policy in the summer of 2002 caused confusion in the market, with the forint surging against the Euro for several months. In attempts to reassure the market, the Medgyessy Government repeatedly said the country would join the ERM II as soon as possible, with hopes of adopting the Euro by 2008. This issue remains on hold until the next elections (in mid-2006), which may settle direction and timing.
Score = B– = (1.25).

Location Risk Indicators

There are no significant location risks in the near future, although the surrounding area has been tumultuous within the last decade.
Score = A– = (.25).

Sovereign Risk Indicators

Hungary has not had any problems in this area since becoming a liberalized economy and shows no obvious signs of sovereign risks in the near to mid-term.
Score = A = (0).

Political Risk Indicators

There will be another election in mid-2006, after several rounds of governments have been unable to hold power for long periods. The current ruling party was trailing badly in the polls at the end of 2005. Both the government and opposition have populist platforms, so there is unlikely to be much in the way of structural reform until the election concludes.
Score = B– = (1.25).

Hungary Country Risk Summary

The analyst concluded that Hungary did not have high levels of country risk for the firm's Eastern European expansion. Nevertheless, the charge by CEO Rieden was to compare the relative risk levels of Hungary to Ukraine. The next section performs the same CRA process on Ukraine.

Ukraine

Situated in East-Central Europe, Ukraine is bordered by Poland, Slovakia, Hungary, Romania, and Moldova to the West, by Belarus to the North, and by the Russian Federation to the North-East and East. To the south of the country lies the Black Sea. The capital is Kiev.

Ukraine became independent in 1991 with the dissolution of the USSR. Since that time, democracy has remained elusive as the legacy of state control and endemic corruption stalled efforts to improve civil liberties, achieve economic reform, and accelerate privatization. A peaceful mass protest (the "Orange Revolution") toward the end of 2004 compelled the authorities to overturn a rigged presidential election and to allow a new internationally monitored vote. This election swept into power a reformist slate under Viktor Yushchenko. The population was around 47.4 million in the middle of 2005.¹⁰

Basic Economic Facts

• GDP (ppp): USD$299.1 billion
• GDP (ppp) per capita: USD$6300
• GDP (ppp) growth: 12 percent (2004)
• Inflation rate: 12 percent (2004 est.)
• Debt external: USD$16.4 billion (est. 2004)

Economic Risk Indicators

Ukraine has many of the components of a major European economy—rich farmlands, a well-developed industrial base, highly trained labor, and a good education system. The country experienced a sharp period of economic decline in the 1990s, and the standard of living for most citizens declined steadily, leading to widespread poverty. Beginning in 2000, economic growth has averaged almost 9 percent per year, reaching 9.4 percent in 2003 and 12.5 percent in 2004. The GDP in 2000 showed strong export-based growth of 6 percent (the first growth since independence), and industrial production grew 12.9 percent. The economy continued to expand in 2001 as real GDP rose 9 percent and industrial output grew by over 14 percent. Growth was driven by strong domestic demand and growing consumer and investor confidence. The rapid economic growth in 2002–4 was largely attributed to a surge in steel exports to China, and personal income levels have been rising. The macro-economy is stable, and high inflation level is gradually coming under control. While economic growth continues, Ukraine's long-term economic prospects depend on the acceleration of market reforms. The economy remains burdened by excessive government regulation, corruption, and lack of law enforcement, and while the Yushchenko Government took steps against corruption and small and medium firms have been largely privatized, much remains to be done to restructure and privatize key sectors such as energy and telecommunications.
Score = B = (1).

Transfer Risk Indicators

Ukraine has been encouraging foreign trade and investment. The foreign investment law allows non-citizens to purchase businesses and property, to repatriate revenue and profits, and to receive compensation in the event that their property is nationalized by a future government. On paper, there is no legal distinction between domestic and foreign capital; in practice, large local firms—mostly state-owned firms in the industrial sector—have considerable political and legal influence. However, complex laws and regulations, poor corporate governance, weak judicial enforcement of contract law, and corruption inhibit large-scale foreign direct investment in Ukraine. Contracts are difficult to enforce, and regulation is neither impartial nor clear. Although it is possible for foreign firms to win court cases, particularly at the higher levels, the judicial process remains slow and inefficient. Ukraine is dominated by powerful local players who have successfully prevented foreign investment. The risk that foreign investors' assets will be de facto expropriated is low, but recent examples exist. While there is a functioning stock market, the lack of protection for minority shareholders' rights severely restricts portfolio investment activities. Total FDI in Ukraine was approximately $7.72 billion as of October 1, 2004, which, at $162 per capita, was still one of the lowest figures in the region.
Score = C = (2).

Exchange Rate Indicators

Ukraine's currency, the hryvnia, was introduced in September 1996 and has remained stable until quite recently. There has been increasing volatility in the rate since 2000, and successive governments have stated their aim was to enact policies that increased outsiders' confidence towards the economy as well as its credit rating. These actions remain in flux.
Score = C = (2).

Location Risk Indicators

The region surrounding Ukraine is mostly stable and appears to be entering a period of stable adjustment to the global economy. The only remaining location risk issue is inside the country, as crime is a serious problem in Ukraine, and a higher than European average number of racially motivated assaults and incidents of harassment to individuals of African or Asian descent have been reported in recent years.
Score = C = (2).

Sovereign Risk Indicators

Ukraine has a recent history of defaults and therefore may have higher than average levels of sovereign risk. There are still some trends on the horizon to suggest the retention of higher than average levels of risk in this indicator.
Score = D+ = (2.75).

Political Risk Indicators

A new democratic constitution was adopted on June 28, 1996, which mandates a pluralistic political system with protection of basic human rights and liberties. Recent elections have been challenged, and there remains some skepticism over the long term stability of the government.
Score = C– (2.25).

Ukraine Country Risk Summary

Recommendation

Based on the calculations performed, it was clear to the analyst that at the end of 2005, Ukraine held a far higher degree of country risk in the short and medium term than Hungary. This raised a number of "yellow flags" that the analyst knew would require further analysis. When the results of the CRA were combined with the firm's examination of customers, market, and financial projections, the analyst was confident to make an insightful recommendation to CEO Rieden about the firm's preferred choice for locating its new Eastern European operations.

FAROUT Summary

Figure 19.1 Country risk assessment FAROUT summary

Future orientation—Medium. The technique can be somewhat future oriented if projections and the assumptions upon which they are based are prudently constructed and clearly communicated, but analysts who rely too heavily on data that is historical or stale in nature will compromise the future orientation.

Accuracy—Low to medium. The nature of any form of risk (including country risk) is that there is always an element of unpredictability, and no method will ever consistently and accurately predict outcomes.

Resource efficiency—Medium. Depending on the extent to which one is undertaking the analysis, the process of gathering extensive data from experts, weighting, and aggregating outcomes, can be time-consuming and expensive, whereas buying reports from country risk forecasting advisors or services can be more efficient.

Objectivity—Medium. CRA will always rely at least partly on subjective data, despite the common efforts by consultancies and advice vendors to quantify the method.

Usefulness—Medium. Country risk and the concepts discussed to forecast it can be applied in many areas of business strategy and decision making.

Timeliness—Medium. If the process is ongoing and a part of a firm's ongoing operations, the information should be developed and delivered on a more timely basis. If the data needs to be gathered, the process will be slower to complete.

Related Tools and Techniques

• Investment valuation analysis
• Outsourcing analysis
• Political risk analysis
• Porter's Diamond of National Advantage
• Scenario analysis
• STEEP/PEST and related macro-environmental analysis
• Strategic relationships analysis
• SWOT analysis
• Value chain analysis

References

Alon, I., and M. Martin (1998). "A normative model of macroeconomic political risk assessment," Multinational Business Review, Fall.

Bartlett, C.A., and S. Ghoshal (1998). Managing Across Borders: The Transnational Solution, 2^nd edition. Boston, MA: Harvard Business School Press.

Bremmer, I. (2005). "Managing risk in an unstable world," Harvard Business Review, 83(6), June, pp. 51–62.

CIA World Factbook (2005). U.S. Dept. of State Country Background Notes (Source Date: 08/05). Retrieved Oct. 10, 2005 from http://www.odci.gov/cia/publications/factbook.

Coplin, W.D., and M.K. O'Leary (1994). The Handbook of Country and Political Risk Analysis. East Syracuse, NY: Political Risk Services, International Business Communications.

Desta, A. (1993). International Political Risk Assessment for Foreign Direct Investment and Investment Lending Decisions. Needham Heights, Massachusetts: Ginn Press.

Ghose, T.K. (1988). "How to analyze country risk." Asian Finance, October 15, pp. 61–63.

GlobalEDGE (2006). Country insights section, retrieved from the web on March 18, 2006, from http://globaledge.msu.edu/ibrd/countryindex.asp.

Meldrum, D.H. (2000). "Country risk and foreign direct investment." Business Economics, 35, January, pp. 33–40.

Merill, J. (1982). "CRA." Columbia Journal of World Business, 17, pp. 88–91.

OCC (Office of the Controller of the Currency) (2001). Country Risk Management. Administrator of National Banks. Washington, DC: U.S. Department of the Treasury.

Perlitz, M. (1985). "Country-portfolio analysis-assessing country risk and opportunity," Long Range Planning, 18, pp. 11–26.

Porter, M.E. (1990). The Competitive Advantage of Nations. New York, NY: The Free Press.

Robock, S.H. (1971). "Political risk: Identification and assessment," Columbia Journal of World Business, 6, pp. 6–20.

Sethi, P.S., and K.A. Luther (1986). "Political risk analysis and direct foreign investment: Some problems of definition and measurement," California Management Review, 28, pp. 57–68.

Simon, J.D. (1982). "Political risk assessment: Past trends and future prospects," Columbia Journal of World Business, pp. 62–71.

Thompson, A.A., Gamble, J., and A.J. Strickland (2006). Strategy: Winning in the Marketplace, 2nd edition. New York, NY: McGraw-Hill.

Ting, W. (1988). Multinational Risk Assessment and Management. New York, NY: Quorum Books.

Wells, R.K. (1997). "Country risk management: A practical guide," Business Credit, 99, Nov/Dec, pp. 20–24.

Endnotes

¹ Thompson, Gamble, and Strickland, 2006.

² Ting, 1988.

³ Wells, 1997.

⁴ Ghose, 1988.

⁵ Meldrum, 2000.

⁶ Bremmer, 2005.

⁷ Alon and Martin, 1998; Sethi and Luther, 1986.

⁸ Desta, 1993.

⁹ Sources: GlobalEDGE, 2006; CIA World Factbook, 2005.

¹⁰ Sources: GlobalEDGE, 2006; CIA World Factbook, 2005.