Country Risk Analysis: Time for a New Approach

Though perceptive people have been analyzing country risk since times immemorial (observations of many famous travelers since Antiquity who have left us their memoirs often include useful information in that sphere), the formalization of the exercise is only a few decades old. The re-emergence of sovereign lending in a big way from the late 1960’s, meant increasing bond issues, and then large syndicated bank loans following the oil shocks of the 1970’s. Directly concerned financial institutions, helped with the growing importance of rating agencies, decided that it was time to look “scientifically” at countries’ ability to pay.

There was probably one of the original sins of the game, with the whole effort concentrating on the ability to service and reimburse external debt. It left aside all the other cross-border activities such as trade and investment which had their own risk patterns, not always linked to currency cash flows. For most analysts, it all became a mere accounting exercise. It left aside the human, political and social aspects, often ignoring geopolitics altogether. It sought a one-size-fits-all methodology, and comparative tables as to which country was “better” or “worse” than another. It introduced totally false premises such as the famous statement by Citibank’s Walter Wriston to the effect that “Countries do not go broke, and they do not disappear”. The serious gap in teaching economic and financial history, or mere geography, in the educational establishments of some countries is reflected here. Countries have appeared and disappeared throughout history, a process still going on, and both old and new countries can go broke, both de facto and de jure (obviously the chairman of Citibank had never read about the “faillite des deuxtiers” formally declared by a Republican French government of old.

This paper only aims to be a sampler of some current mistakes in looking at country risk. It is not a full methodology handbook, though I am ready and available to expand on the subject conceptually, as I have done on many occasions during my nearly 38-year analytical career, 32 of which devoted to Latin America but also encompassing Europe, the Middle East and the Caucasus. I have advised the Inter American Development Bank on its analytical methodology in the 1990’s, lectured on the subject on four continents, and trained many corporate and financial sector analysts as well as academics in modern techniques.

A Personalized Approach

The first sin of most country risk analysts is to look at a country intrinsically in terms of risk, whereas they should start by asking: “what am I or my client planning to do there”. This is the weakness of the rating agencies (whose reliability was much affected by the Asian and Argentine crises, both of which they failed to predict). They have to come up with a single “judgment”.

Let me illustrate this with the striking example of the Lebanon at the height of its civil conflict on the 1970’s and 80’s. Prima facie, it would have been the epitome of worst possible country risk. But look again at the particular case of three business risks from abroad into the Lebanon.

The owners of the Beirut Holiday Inn hotel, on the dividing line of the conflict, obviously had the short end of the stick (and were in legal disputes with their insurers for years as to how the conflict could be legally defined for the purpose of cover). Definitely a bad risk. However, if you had a sovereign loan to Lebanon, which at the time had a very low public debt, more than covered by external reserves mainly in gold safely kept outside the country, your risk was neutral. In fact, despite the sharp subsequent deterioration of the country’s public finances, and the continuing political instability, the country has yet to fail on its debt service.

A third example would be an exporter of flat glass to the Lebanon, with a warehouse in Cyprus, which became the main entrepot base during the conflict. After each of the many ceasefires, households and businesses would repair their broken windows and glass panes. That foreign supplier never had it so good as during the civil war, and was probably paid without problem too. Positive risk. In short, one country, at the same moment of time, three businesses, three different risk conclusions. Not something you could deduce from Standard and Poor’s.

This has a corollary when it comes to remedial action taken under salvation or remedial programmes from foreign lenders, bilateral or multilateral organizations. The important thing is to make sure that the right problem is diagnosed and treated. The country crisis viruses have been mutant, starting with balance of payments and currency cash-flow crises, but soon turning (not least often as a consequence of the palliative measures taken against the first problem), into fiscal crises, with several massive defaults of the banking system thrown-in for good measure.

The best example of such behavior was the handling of the Mexican crisis of 1991/92, which paradoxically was an old-fashioned currency cash flow shortage. 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 was recession, inflation, a bankrupt banking sector and a gaping budget deficit. All of these could have been avoided with a U$ 50 bn currency facility, which came partially and much later, after all the damage was done.

The Obsession with GDP

An indecent number of results, investigations and theories, are based on comparisons measured as a % of GDP. These are not approximations and orders of magnitudes, but detailed edifices with two decimals. This is ridiculous. We all know that GDP is a nebulous and capricious figure, the first estimate for which is not available until well into the following year, after which it is often corrected (up or down) in subsequent years, to which one has to add base-date and composition changes, and the impact of erratic exchange rates. Even the components of GDP are uncertain, not least when most of the countries one analyses have a substantial black economy, the quantification of which is problematic.

What matters, particularly when one is talking of debt and payments, are the actual quantities. Irrespective of how large the debt or its servicing are as a percentage of a phantom GDP, 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. Brazil’s current interest bill on its public debt of nearly U$ 1000 bn is U$ 10 million per hour (24/7).

Current vs. Trade Account

As mentioned earlier, balance of payments analysis has traditionally been the kernel of country risk evaluation. Here again, it started on the wrong foot and kept at it. Admittedly, high commodity prices and other changes in terms of trade and investment have meant that few countries today (particularly in Latin America, but also elsewhere) have severe external problems. In fact, many have record levels of reserves. However, the situation may go into reverse one day (Mexico in 2007 had a non-oil trade balance deficit of some U$ 55 bn, with a falling oil output which, barring reforms, may mean an end to its oil exporting capacity in the medium term).

Probably one of the most used and also most irrelevant ratios used in traditional country risk analysis has been Debt Service as a % of Exports. This stupidly presupposes that export revenue could and should primarily be destined to debt service. It also presupposes that export revenue (or the resulting currency) accrues to the government treasury (which is true in some countries but they are the small minority). It forgets the fact that the country also needs to import. If it only imports Champagne and Cognac, these could be done away with, but is a country supposed to stop importing the energy with which to operate, food with which to feed its population, and the intermediate and capital goods with which its various sectors develop, in order to service debt? There is only one such experiment in modern times, that of Rumania’s last Communist leader, Ceaucescu, who in his final years left the population cold and starving in order to repay all the country’s foreign debt, including penalty interest. You know what happened to him as a result. “Penalty” interest took a completely new dimension.

A more logical ratio, which nobody ever uses, would possibly be Debt Service as a % of the Trade Surplus, which is the money left after imports have been paid for. Even then it is insufficient, because the real measure of external health is not the Trade but the Current Account (which includes interest payments). A good measure of the ability to service external debt should be Interest as a % of the Gross Current Account (which I would define as all current transactions but excluding interest payments). I would then use the overall balance of payments in a similar way to deal with capital repayments.

Having said all this, the whole exercise has become somewhat sterile because in the meantime, though many analysts, journalists and politicians talk about the problems of “external debt”, the virus has mutated into a wider definition, that of Public Debt, most of which is internal and therefore irrelevant to the currency flow problems.

The Fiscal Situation

There is not a lot of in-depth dedicated literature on country risk methodology, but at the height of the 1980’s debt crisis, two prestigious publications on the subject were published. One was written by a senior director at the largest Swiss bank of the time, and another (published by EUROMONEY magazine) was from the pen of a bank economist who had also worked at all the main multilateral agencies. Both committed all the sins described above, but the major flaw they had in common was that they hardly mentioned, if at all, the main problem befalling the crisis stricken countries: the fiscal situation.

In the 1980’s, the crisis was mainly (if not entirely) due to the substantial rise in the interest bill of indebted countries, which had accumulated debt throughout the 70’s and in the early 80’s), after the post-Iranian revolution second oil shock caused a rise in inflation, and therefore interest rates. Contrary to the bond issues of the previous century and a half, these loans were at floating rates.

The rise in interest rates on public foreign debt obviously created an extra demand on currency resources, but what nearly everybody overlooked, is that it also paid havocs with budgets. Worse was to come. In an effort to stop another problem (the flight of capital), countries were coerced to increase domestic interest rates, often to stratospheric levels as they had right rates of inflation. The combined impact of costlier foreign and domestic debt service led to a rapid deterioration of fiscal balances, none of which was very healthy to start with. None of the movers and shakers appeared to notice. In fact, there were many proposals to “solve” the debt crisis by replacing foreign borrowing (say at 8 %) by domestic borrowing (costing say 20 %), with the prior effort of developing a domestic capital market.

As the situation became untenable and debt restructuring followed debt restructuring, sometimes before the previous programme could even by implemented, countries fell in and out of contravention to their IMF agreements. In the late 1980’s, in an effort to save the increasingly shaky reputation of the crisis managers, someone came up with the idea to change the definition of fiscal deficit. They invented the Primary Balance, and made it the target.

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. To the extent, as described earlier, that the interest bill had become the main expenditure element in the budget, ignoring it was akin to a clinical director to instruct all doctors and radiologists to omit from their written diagnosis any threatening illness which may turn up in the examinations.

This of course throws the baby away with the water, forgetting that the purpose of the analysis is not to show up artificially distorted figures, or apply cosmetics to a dead body, but to find out how much money the country needs in order to pay its main obligation. The interest bill is not a vague virtual notion but a real expense (and, at the risk of laboring the point), the main expense. In most cases, contrary to capital repayments or other items of expenditure, it cannot even be delayed or rescheduled.

It was to be hoped that this concept, invented as was mentioned to save face in relation to a specific Mexico-IMF agreement, will soon come to pass. On the contrary, it has not only survived, but has developed into the main statistic quoted when referring to a country’s fiscal situation. The self-delusion has been so successful that there is a strong movement to extend it even more. There is now talk of removing from expenditure figures the amounts of “investments” (as if they were not an expense either, even if their effect is a durable one). The innocent may think that such games were reserved for developing countries. Not at all, several EU members, and some of the oldest and largest, in an effort to artificially squeeze within the 3 % of GDP fiscal deficit limit, have been lobbying for years in order to change the deficit definition by excluding capital expenditure from the expense column.

The consequence of this silliness is that it is often a substantial effort to find out the exact fiscal situation of a country. Sure, it is available, if you are an Egyptologist and know your way in excavating the websites and publications of the public entities in charge of publishing the figures. It is hardly ever mentioned in the shorter versions of press communiqués.

Foreign Investment Creates Jobs?

Not necessarily. In fact, for a decade and a half, foreign investment in Latin American and other developing countries has been a very mixed blessing.

It is true that in its heyday it was hailed as the answer to a maiden’s prayer. It brought-in badly needed foreign exchange, created jobs for a young and growing population, contributed to regional development in underprivileged areas, increased the tax base, and brought-in a technological leap.

For a long time, it did many of those things, and in some countries, still does. Unfortunately, in many others, it has been doing the contrary, and even more unfortunately, the national and international statistical apparatus has not evolved to distinguish between the various types of foreign investment.

The best “positive” foreign investment is the green-field, labor intensive projects, preferably in high-tech industries. A good example of that would be the giant INTEL chip plant in Costa Rica. So good in fact that you could trace its impact on the Central American country’s GDP, though in lean years for chips, the effect was less positive. Marginally less exciting are the natural resource projects such as mining investments. Beyond the initial construction stage, they are not labor-intensive, and most of the initial cost consists of imported specialist machinery. If legislation and negotiation were well conducted, there would be fiscal benefits from royalties and income taxes.

When it stops being exciting is when a mature business is transferred from one foreign owner to the other. It appears as a foreign investment in the statistics, often inflating the totals and allowing for triumphant statements from the authorities. In practice no money or new technology enters the country, no jobs are created except during the week-end preceding the closing, when printers and sign painters redesign the premises in the new name. If the buyer has an existing operation in the target country, it will merge it with its new acquisition, and reduce the combined staff. So much for job creation.

The worst consequence for jobs were the series of privatizations carried out by many Latin American countries since the 1980’s, as part of their debt workout programmes. Admittedly, the buyers (some more than others), brought in new management and technology, and badly needed investment. What is sure is that they started by reducing the payroll. Essential? Probably, but the point I am trying to make is that contrary to legend, foreign investment does not always equate with job creation. Many times, it does not even equate with better management, or is not “privatization” at all, hence the original sale of the Chilean telephone monopoly to a Spanish state-owed company (idem for its Armenian equivalent), or the Peruvian steel complex to a government-owned Chinese group.

Banking Sector’s Health

As a cause or consequence of systemic crises, major crises in the banking sector have often accompanied a wider deterioration in a country’s situation. Though there has been some improvement in the monitoring of the banking sector in developing countries, most past crises have come as “surprises”.

Something as easy as keeping an eye on the percentage of past-due loans in the portfolio, is a good start, though it is insufficient. A close examination of the real quality and efficiency of the supervisors, beyond the impressive regulations, handbooks and legislative texts proudly handed out to visiting delegations, is a better approach. The gap between texts and realities in the developing world is a wide one.

Inflation and Monetary Policy

Monetarists have dominated economic policy-making for the best part of three decades, and they have perdured for longer than the undemocratic governments under which most initially flourished.

It would be very useful if analysts spent some time in the souks, shops and luxury malls of the countries their visits, and learn something about the real situation of interest rates. With most countries in Latin American having inflation rates within the 3 to 10 % range, and official intervention rates often double that level or more, what the borrowing businessman or consumer actually pays to his bank, finance company (or loan shark) has no relation at all with either inflation or the Lombard rate. Even with countries where single-digit inflation has been achieved (at a great cost), borrowers pay from 20 to 200 % on mortgage or consumer credits, depending on the country, their status and the nature of the borrowing instrument.

Why does it matter? It affects the public impact of monetary policy to the point of irrelevance. Reducing or increasing the central bank rate by half a point to “boost” or “restrict” consumption, is really neither here nor there for consumers paying up to 120 % on their in-store credit cards. In many countries, such levels of interest are actually illegal, but authorities turn a blind eye.

Similarly, using monetary policy as a way of controlling inflation, as per the textbook, is often wholly or partially sterile. The current bout of inflation is mostly caused by the increase in world energy and food prices. In many countries, those who have money will use their cars irrespectively of the cost, because they can afford it, and much of the rest of the population will similarly continue because it is essential and they have no alternative forms to transport themselves or their goods. Similarly, to the extent that the increases have affected basic staple foods, which constitute the bulk of the consumption of the lower strata of the population, there is little they can do short of starving. Putting up interest rates, whatever the book says, is not going to influence how much bread the poor eat in these countries.

Other Considerations

I started this note by stating that it had no ambitions to be comprehensive. Its aim is to sensitize analysts as to the necessity to adopt a new approach. Much can be added about the need to study political and social aspects, ranging from the sheer possibility to successfully implement some policies in certain societies, to the background of the economic managers which is a good indication of their future performance (finding out the subject matter of their doctorate thesis is one way of doing it).

I would be the first to admit that much of this is influenced by my Latin American experience of over three decades, but I think I have tried to make the points conceptually, because I am convinced they have a more universal application.

4 Responses to "Country Risk Analysis: Time for a New Approach"

  1. Gabriel   February 16, 2008 at 8:09 pm

    Where do you get that the rating agencies did not see the Argentina crisis coming? Argentina was rated well into non-investment grade at the time of default.

  2. Author of article   February 19, 2008 at 7:24 am

    Gabriel, not being “Investment Grade” and “forecasting an imminent disaster” are not the same thing. If my memory does not fail me, only Chile had investment grade rating at the time of the Argentine crisis so it is hardly akin to perceptive warning. I do remember however that a few weeks before the proverbial hit the fan, a very respected (and oft quoted) Latin American “specialist2 on Wall Street was sending out under hisp restigious employers’ notepaper a report which started :”The worst is over in Argentina”.

  3. Gabriel   February 19, 2008 at 12:31 pm

    Armen,Rating agencies and Wall Street analysts are two very different things. It doesn’t surprise me that some Wall Streeter sent out a “worst is over’ report but that tells us nothing about the rating agencies.Rating a country non-investment grade is telling the investors that they run substantial risks. Argentina wasn’t just spec grade at the time of the default, it was in the “B” and “Caa” categories (depending on the agency), which is telling you that they were a sneeze away from default. The rating agencies certainly could have done a better job on Asia (although people forget there were no sovereign defaults) but it is wrong to say the same of Argentina. Moody’s, for example, put Argentina in the “B” category two years before the crisis. You can’t be clearer than that.

  4. Guest   August 6, 2009 at 4:42 pm

    Armen,i am a final year finance student in Malaysia. Your article very well articulate the necessary considerations to be corporate into the country risk analysis. I believe this would help in my coming final exam. Thank you.