Country Risk Analysis (international finance).pptx

International Finance

1. Country Risk Analysis ECONOMICS AND ADMINISTRATIVE SCIENCES

2. Key Points C ommon factors used by MNCs to measure country risk H ow to measure country risk H ow MNCs use the assessment of country risk when making financial decisions H ow MNCs can prevent host government takeovers

3. Introduction Country risk refers to the potential negative impact of a country's environment on an MNC's cash flows. MNCs , like Facebook and Netflix, regularly conduct country risk analyses to assess their foreign business operations and potential risks. Financial managers must understand how to measure and incorporate country risk into their capital budgeting analysis to maximize their MNC's value.

4. Country Risk Characteristics Country risk characteristics can be partitioned into political risks and financial risks.

5. Political Risk Characteristics Political risk, especially the chance of the host country taking control, can impact how well a local branch performs. Expropriation , where the government takes over a business, might involve giving some compensation or taking assets without any compensation. This can happen in a peaceful way or a forceful one.

6. Political Risk Characteristics The following are some of the more common characteristics of political risk: A ttitude of consumers in the host country A ctions of host government B lockage of fund transfers Currency inconvertibility War I nefficient bureaucracy Corruption

7. Attitude of Consumers in the Host Country Political risk for exporters is local product preference, which could hinder success in foreign markets. Governments often encourage local consumers to buy from local manufacturers. MNCs should monitor consumer attitudes towards locally produced products and consider joint ventures with local companies.

8. Actions of Host Government MNCs' cash flow can be influenced by various actions of the host government, such as pollution control standards, additional corporate taxes, withholding taxes, and fund transfer restrictions. Changes in government members or philosophy can also affect MNCs' future cash flows. A subsidiary can be affected by new policies or attitudes towards the home country. A host government can also require local employees for managerial positions, impose extra taxes or restrictions, or take actions that protect competitors.

9. Actions of Host Government However, a lack of restrictions can lead to illegitimate businesses capturing market share. A significant issue for MNCs is the failure to enforce copyright laws against local firms illegally copying MNCs' products, causing an estimated $3 billion in sales annually in Asia.

10. Blockage of Fund Transfers Multinational company branches often send money back to their main office for different reasons. However , governments in the host country might stop these money transfers. This situation can compel the subsidiaries to take on less-than-ideal projects or invest in local financial assets, which may not be as profitable as sending earnings back to the parent company.

11. Currency Inconvertibility Certain governments prohibit currency conversion, preventing subsidiary earnings from being remitted to parent countries. Inconvertible currencies may require spending in host countries.

12. War Conflicts or unrest in specific countries can affect the safety of employees and subsidiaries of multinational companies (MNCs). Business cycles becoming unpredictable and an elevated risk of terrorist attacks can make it uncertain how money will flow . When there's a high risk of war, multinational companies might decide not to investigate whether a project is feasible.

13. Inefficient Government Bureaucracy Inefficient government bureaucracy can delay MNCs in establishing subsidiaries or expanding businesses, particularly in emerging countries. This is often due to a lack of government organization and government employees expecting gifts before approval.

14. Corruption Corruption can negatively impact MNCs' international business by increasing costs or reducing revenue. It can occur at the firm level or through relationships with government agencies. Laws defining corruption vary across countries. Transparency International's Corruption Perceptions Index ranks countries based on perceived public-sector corruption, with emerging countries having lower ratings. MNCs should periodically update their assessments of each country they operate in to stay informed.

15. Corruption Corruption Perceptions Index Ratings for Selected Countries

16. Financial Risk Characteristics Along with political characteristics, financial characteristics should be considered when assessing country risk. Financial characteristics can have a strong impact on international projects that MNCs have proposed or implemented.

17. Economic Growth The current and potential state of a country's economy significantly impacts the financial stability of multinational corporations (MNCs) exporting or developing subsidiaries. A recession could significantly reduce demand for MNC products. GDP levels can measure and predict economic growth . A country’s economic growth is influenced by interest rates, exchange rates, and inflation.

18. Economic Growth Higher interest rates slow economic growth and reduce demand for MNC products. Governments maintain low rates to stimulate the economy. Exchange rates affect export demand, production, and income levels. Inflation affects consumers' purchasing power, expenses, and financial condition by affecting interest rates and currency value. Maintaining low rates encourages borrowing and spending . Inflation impacts consumers' purchasing power, demand for MNCs, operational expenses, and financial condition by affecting interest rates and currency value.

19. Economic Growth A country's financial risk is significantly influenced by its fiscal policy, with some countries using expansionary policies that stimulate the economy but can lead to a large budget deficit and increased borrowing, causing long-term financial risks.

20. Measuring Country Risk A macro-assessment of country risk is an overall risk assessment considering all variables affecting a country, except those unique to a firm or industry. It remains consistent across countries but may not include relevant information for accuracy . A micro-assessment of country risk assesses a country's impact on a MNC's business, determining how it relates to the specific MNC's type of business.

21. Techniques for Assessing Country Risk A firm can identify macro- and micro-factors for a country risk assessment and implement a system to evaluate these factors and determine a country risk rating using various techniques. Among the most popular techniques are the following: C hecklist approach Delphi technique Q uantitative analysis I nspection visits A combination of techniques

22. Checklist Approach A checklist approach evaluates political and financial factors contributing to a firm's assessment of country risk. Ratings are assigned to these factors, combining them to determine a country's risk. Factors like GDP growth can be measured from data, while others require subjective measurement. Information on countries is available online, converting factors into numerical ratings.

23. Delphi Technique The Delphi technique is used for country risk analysis by MNCs to gather independent opinions without group discussion. They survey employees or consultants, determine consensus opinions, and send a summary back to respondents for further feedback.

24. Quantitative Analysis Quantitative models can identify country risk characteristics affecting MNCs' sales or earnings in a specific country, indicating business susceptibility to the economy. However , they cannot predict problems before they occur, cannot evaluate subjective data, and historical trends of country characteristics are not always useful for anticipating crises.

25. Inspection Visits & Combination of Techniques Inspection visits involve visiting a country to meet with government officials, business executives, and consumers to clarify opinions and assess intercountry relationships, ensuring accurate evaluations . Many multinational corporations (MNCs) lack a formal method for assessing country risk, leading to a combination of techniques used for this purpose.

26. Deriving a Country Risk Rating An overall country risk rating can be created using a checklist approach, assigning political and financial factors within a range of 1 to 5. These factors are then weighted to determine their relative importance. The overall country risk rating for a specific project is determined by assigning weights to these ratings based on their perceived importance. The importance of political risk versus financial risk varies depending on the intent of the multinational corporation (MNC). If political risk is considered more relevant than financial risk, the political risk rating receives a higher weight.

27. Determining the Overall Country Risk Rating Diagram

28. Derivation of the Overall Country Risk Rating Based on Assumed Information

29. Governance of the Country Risk Assessment MNCs often pursue international projects for 20 years or more, overlooking potential country risk over time. To ensure accountability, they need a proper governance system to consider country risk. One solution is requiring major long-term projects to use external input for country risk assessment, allowing for better long-term assessment.

30. Comparing Risk Ratings among Countries MNCs use a foreign investment risk matrix (FIRM) to assess country risk across multiple countries, determining where to establish a subsidiary based on political and financial ratings, ranging from "poor" to "good".

31. Incorporating Risk in Capital Budgeting When MNCs assess the feasibility of a proposed project, country risk can be incorporated in the capital budgeting analysis by adjusting the discount rate or by adjusting the estimated cash flows.

32. Adjustment of the Discount Rate The discount rate of a project can be adjusted to account for country risk, with lower ratings indicating higher perceived risk. This approach is convenient but arbitrary, potentially leading to the rejection of feasible or infeasible projects.

33. Adjustment of the Estimated Cash Flows Incorporating country risk in capital budgeting analysis involves estimating the impact of each form of risk on cash flows. For example, if a host government temporarily blocks funds from a subsidiary, the MNC should estimate the project's net present value (NPV) under these conditions. This helps determine the probability distribution of NPVs, allowing the MNC to make an informed decision on the project.

34. Accounting for Uncertainty MNCs should consider various scenarios for long-term projects in foreign countries, considering uncertainty in country risk characteristics and other variables. Spartan , Inc. can account for these uncertainties using a computer spreadsheet, facilitating the analysis process.

35. Analysis of Existing Projects MNCs should regularly review country risk, including subsidiary feasibility, after implementing projects, especially in adverse political conditions, to ensure the success of their subsidiaries.

36. Preventing Host Government Takeovers The most severe country risk is that the host government will take over the MNC’s subsidiary. This type of takeover may result in major losses, especially when the MNC does not have any power to negotiate with the host government. The following are the most common strategies used to reduce exposure to a host government takeover: Use a short-term horizon. Rely on unique supplies or technology. Hire local labor. Borrow local funds. Purchase insurance. Use project finance.

37. Use a Short-Term Horizon MNCs may focus on recovering cash flow quickly to minimize losses in expropriation, replace equipment, and phase out overseas investment by selling assets to local investors or the government, reducing host government incentive.

38. Rely on Unique Supplies or Technology The host government cannot take over a subsidiary without its unique supplies, and the MNC can cut off supplies if the subsidiary is treated unfairly. A successful takeover requires the MNC providing necessary technology and adequate compensation.

39. Hire Local Labor Local employees can pressure the host government to avoid a subsidiary takeover, but this strategy has limited effectiveness as the government could retain employees post-takeover.

40. Borrow Local Funds Local banks may try to prevent a government takeover of a subsidiary borrowing funds locally to ensure timely loan repayments, but this strategy has limited effectiveness and may not be preferable to losing the subsidiary and owing home country creditors.

41. Purchase Insurance Insurance can help cover the risk of expropriation, but it typically only covers a portion of a company's total exposure to country risk. Investment guarantee programs in home countries provide insurance against risks like expropriation, wars, and currency blockage. However , insurance policies may not cover all forms of expropriation and may have a waiting period before compensation is paid. The cost of insurance is high, and subsidiaries must weigh the benefits against the premiums and potential losses. The World Bank offers political insurance for MNCs in less developed countries.

42. Use Project Finance Project finance deals are used to finance large infrastructure projects, limiting MNCs' exposure due to heavy financing, bank guarantees, and the project's future revenues. These deals are nonrecourse, allowing creditors to only receive the project's assets and cash flows. This transparency allows funding for projects that may not receive conventional financing. Host governments are unlikely to take over these projects due to existing liabilities.

43. Thank you!