CHAPTER 11: COUNTRY RISK ANALYSIS
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CHAPTER 11
COUNTRY RISK ANALYSIS
I moved this chapter from the section on foreign investment analysis to this section because I have
concluded that the international economic environment is heavily dependent on the policies individual
countries pursue. Given the close linkage between a country’s economic policies and the degree of
exchange risk, inflation risk, and interest rate risk that multinational companies and investors face, it is
vital in studying and attempting to forecast those risks to understand their causes. Simply put, attempts to
forecast exchange rates, inflation rates, or interest rates are helped immensely by a deeper understanding
of how those economic parameters are affected by national policies. At the same time, no one can
intelligently assess a country’s risk profile without comprehending its economic and political policies and
how those policies are likely to affect the country’s prospects for economic growth.
I spend some time discussing the nature of property rights and their implications for political risk and
economic development. The chapter examines the experiences of Latin American countries and Eastern
European countries and addresses the question of what it takes to promote economic growth. A good
discussion of property rights and their effects on economic growth can be based on the end-of-chapter
problems. This discussion serves to introduce the topic of country risk analysis – the assessment of the
potential risks and rewards associated with making investments and doing business in a country. This is a
vital task for multinational firms and international banks, who must constantly assess the business
environments of the countries they are already operating in as well as the ones they are considering
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SUGGESTED ANSWERS TO CHAPTER 11 QUESTIONS
1. What are some indicators of country risk? Of country health?
ANSWER. The chapter points to the following indicators of country risk:
— A large government deficit relative to GNP
2. What can we learn about economic development and political risk from the contrasting
experiences of East and West Germany, North and South Korea, and communist China and
Taiwan, Hong Kong and Singapore?
ANSWER. These countries provide us with as close to a controlled economic experiment as we are ever
3. What role do property rights and the price system play in national development and economic
efficiency?
ANSWER. With property rights, people have a strong incentive to husband their assets and utilize them
4. What indicators would you look for in assessing the political riskiness of an investment in
Eastern Europe?
ANSWER. Here are some key indicators to look for in assessing the political riskiness of investing in
Eastern Europe:
i) Do they free prices quickly or continue the old system of administered prices that are based
heavily on state subsidies? Although a free economy will need free prices, the public still expects
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ADDITIONAL CHAPTER 6 QUESTIONS AND ANSWERS
1. How might a government budget deficit lead to inflation?
2. What political realities underlie a government budget deficit?
3. What obstacles do Third World countries like Argentina, Brazil, and Ghana face in becoming
developed nations with strong economies?
4. What is the link between a controlled exchange rate system and political risk?
5. Milton Friedman has suggested that public–sector firms in Latin American countries should
simply be given away, possibly to their employees. How do you think workers would feel about
being given (for free) ownership of the public sector firms that employ them? Why?
6. How did capital flight contribute to the international debt crisis?
SUGGESTED SOLUTIONS TO CHAPTER 11 PROBLEMS
1. Comment on the following statement discussing Mexico’s recent privatization. “Mexican state
companies are owned in the name of the people, but are run and now privatized to benefit
Mexico’s ruling class.”
ANSWER. Historically, Mexican state companies have been run to benefit politicians as well as their
2. Between 1981 and 1987, direct foreign investment in the Third World plunged by more than
50%. The World Bank is concerned about this decline and wants to correct it by improving the
investment climate in Third World countries. Its solution: Create a Multilateral Investment
Guarantee Agency (MIGA) that will guarantee foreign investments against expropriation at
rates to be subsidized by Western governments.
2.a. Assess the likely consequences of MIGA on both the volume of Western capital flows to Third
World nations and the efficiency of international capital allocation.
ANSWER. By lowering the risk-adjusted return required by investors, MIGA will increase the flow of
2.b. How will MIGA affect the probability of expropriation and respect for property rights in
Third World countries? Consider this question from an option pricing perspective.
2.c. Is MIGA likely to improve the investment climate in Third World nations?
2.d. According to a senior World Bank official (Wall Street Journal, December 22, 1987, p. 20),
“There is vastly more demand for political risk coverage than the sum total available.” Is this
a valid economic argument for setting up MIGA?
ANSWER. In general, a shortage of a good or service reflects underpricing. This situation is no exception.
2.e. Assess the following argument made on behalf of MIGA by a State Department memo: “We
should avoid penalizing a good project [by not providing subsidized insurance] for bad
government policies over which they have limited influence. … Restrictions on eligible
countries [receiving insurance subsidies because of their doubtful investment policies] will
decrease MIGA’s volume of business and spread of risk, making it harder to be
self-sustaining.” (Quoted in the Wall Street Journal, December 22, 1987, p. 20.)
ANSWER. MIGA’s approach to foreign investments seems to be based more on a protection of greedy
governments than on a respect for property rights. The World Bank seems to see expropriations as events
3. In the early 1990s, China decided that by 2000 it would boost its electricity-generating capacity
by more than half. To do that, it is planning on foreigners’ investing at least $20 billion of the
roughly $100 billion tab. However, Beijing has informed investors that, contrary to their
expectations, they will not be permitted to hold majority stakes in large power-plant or
equipment-manufacturing ventures. In addition, Beijing has insisted on limiting the rate of
return that foreign investors can earn on power projects. Moreover, this rate of return will be
in local currency without official guarantees that the local currency can be converted into
dollars and it will not be permitted to rise with the rate of inflation. Beijing says that if foreign
investors fail to invest in these projects, it will raise the necessary capital by issuing bonds
overseas. However, these bonds will not carry the “full faith and credit of the Chinese
government.”
3.a. What problems do you foresee for foreign investors in China’s power industry?
3.b. What options do potential foreign investors have to cope with these problems?
3.c. How credible is the Chinese government’s fallback position of issuing bonds overseas to raise
capital in lieu of foreign direct investment?
4. You have been asked to head up a special presidential commission on the Russian economy.
Your first assignment is to assess the economic consequences of the following seven policies and
suggest alternative policies that may have more favorable consequences. Note: Since this set of
questions was first written, Russia has undergone massive changes. Yet many of the policies
discussed here still persist and the consequences are as predicted.
4.a. Under the current Russian system, any profits realized by a state enterprise are turned over
to the state to be used as the state sees fit. At the same time, shortfalls of money do not
constrain enterprises from consuming resources. Instead, the state bank automatically
advances needy enterprises credit, at a zero interest rate, to buy the inputs they need to fulfill
the state plan and to make any necessary investments.
ANSWER. The system as described completely destroys all incentive to be efficient and profitable. In
effect, it penalizes success and rewards failure. At the same time, the ability to borrow unlimited amounts
4.b. The Russian fiscal deficit had risen from 2.5% of GNP when Mikhail Gorbachev assumed
power in 1985 to an estimated 13.1% of GNP in 1989. This deficit has been financed almost
exclusively by printing rubles. Concurrently, prices are controlled for most goods and services.
ANSWER. By printing money while controlling prices, the government guarantees that there will be
4.c. Russian enterprises are allocated foreign exchange to buy goods and services necessary to
accomplish the state plan. Any foreign exchange earned must be turned over to the state bank.
ANSWER. This system of foreign exchange allocation destroys any incentive to conserve on foreign
4.d. In an effort to introduce a more market-oriented system, some Russian enterprises have been
allowed to set their own prices on goods and services. However, other features of the system
have not been changed: Each enterprise is still held accountable for meeting a certain profit
target; only one state enterprise can produce each type of good or service; and individuals are
not permitted to compete against state enterprises.
ANSWER. The basic problem with this system is that without the possibility of competition, the state
4.e. Given the disastrous state of Russian agriculture, the Russian government has permitted
some private plots on which anything grown can be sold at unregulated prices in open-air
markets. Due to their success, the government has recently expanded this program, giving
Russian farmers access to more acreage. At the same time, a number of Western nations are
organizing massive food shipments to the Russia to cope with the current food shortages.
ANSWER. Although the Western nations are well-intentioned (we think; they may be using this as a
4.f. The U.S. and other Western nations are considering instituting a Marshall Plan for Eastern
Europe that would involve massive loans to Russia and other Eastern Bloc nations in order to
prop up Gorbachev and the reform governments.
ANSWER. The key here is to recognize that we are dealing with a political problem, not an economic
5. The president of Mexico has asked you to advise him on the likely economic consequences of the
following five policies designed to improve Mexico’s economic environment. Describe the
consequences of each policy, and evaluate the extent to which these proposed policies will
achieve their intended objective.
5.a. Expand the money supply to drive down interest rates and stimulate economic activity.
ANSWER. Rapid expansion of the money supply will lead to higher inflation and higher nominal interest
5.b. Increase the minimum wage to raise the incomes of poor workers.
ANSWER. Workers covered by the higher minimum wage and who keep their jobs will see their incomes
rise. However, many workers will lose their jobs since the new wages will exceed the value of their work
5.c. Impose import restrictions on most products to preserve the domestic market for local
manufacturers and, thereby, increase national income.
5.d. Raise corporate and personal tax rates from 50% to 70% to boost tax revenues and reduce
the Mexican government deficit.
ANSWER. The odds are that the Mexican government will collect less tax revenue at a 70% tax rate than
5.e. Fix the nominal exchange rate at its current level in order to hold down the cost to Mexican
consumers of imported necessities (assume that inflation is currently 100% annually in
Mexico).
ADDITIONAL CHAPTER 11 PROBLEMS AND SOLUTIONS
1. The president of Brazil has just appointed you to work with the country’s cabinet ministers to
launch a radical restructuring of the Brazilian economy. Inflation is running at over 1,000%
annually, and the federal government is running a deficit in excess of 10% of GNP (the U.S.
deficit is about 3% of GNP). To finance the deficit, the government has incurred huge debts,
both internally and externally. In your initial discussions with the cabinet ministers, you realize
that there is considerable disagreement about a number of specific program proposals. Your
job is to assess the issues and the relative merits of the proposed policies.
1.a. The Governor of the Banco do Brasil, Brazil’s central bank, wants to cease its purchases of
government bonds issued by the Ministry of Finance to fund the ongoing federal budget
deficit. The Banco do Brasil has acquired 50% to 60% of all government bonds issued in the
past several years with money expressly created for that purpose. In other words, it has been
monetizing the deficit. Other cabinet ministers are afraid that this policy will lead to higher
interest rates and wonder how the deficit can be financed otherwise.
ANSWER. Ending monetization of the deficit will reduce the growth in the money supply. This change in
1.b. The Minister of Infrastructure has proposed that his ministry begin privatizing the hundreds
of state-owned enterprises under his administration. These enterprises include virtually all of
Brazil’s steel industry, mining industry, electric utilities, the telephone company, national oil
company, chemical companies, and a wide range of manufacturers. Opponents claim that this
move will lead to massive unemployment and the bankruptcy of vital national industries.
ANSWER. Privatization is probably the single most valuable step that Brazil can take to deal with its
economic crisis. Privatization will lead to efficiency gains for the whole economy by forcing the
1.c. The Minister of Political Economy has proposed that Brazil enter into free trade agreements
with its Latin American neighbors. This would involve eliminating all tariffs, duties, and fees
on imports. A number of other government leaders oppose this move, because the Brazilian
market is larger and generally more protected than those of its neighbors. They feel that
opening the border would expose Brazil to rapid growth in imports that exceed any
incremental export activity.
ANSWER. The more protected an economy is, the greater the disruption when it opens its borders, but also
the greater the economic benefit that it reaps. Consumers will benefit because free trade will expand the
1.d. The Minister of Finance has proposed creating a new consumption tax and lowering income
tax rates. His concern is that Brazil’s personal savings rate has been close to zero over the
past several years. He believes increased savings will help to dampen inflation, lower interest
rates on the federal debt, and promote exports. Critics of this proposal argue that the vast
majority of Brazil’s population are living very near the poverty line and that a consumption
tax would be highly regressive (hit the poor relatively harder than the rich). It also would
tend to dampen domestic demand, the principal engine of economic growth in Brazil.
ANSWER. The shift from an income tax to a consumption tax will increase the incentive to save while at
the same time increasing the incentive to engage in productive activity (income, after all, is the return to
1.e. The Minister of Labor has proposed raising the minimum wage to raise the income of poor
workers and, thereby, offset the effects of restructuring on them. Other cabinet members are
concerned about the effects this policy will have on employment and competitiveness.
ANSWER. Raising the minimum wage will boost incomes for those workers who retain their jobs.
However, it will also cause higher unemployment among unskilled workers and make Brazilian industry
1.f. The Central Bank has proposed that it replace the current fixed exchange rate system with a
freely floating exchange rate system. Critics of this proposal argue that floating the real will
devalue the currency and raise the cost of living (by boosting the price of imported necessities)
for Brazilians.
ANSWER. The argument that floating the real will lead to currency devaluation implies that the real is
currently overvalued. Although devaluation will raise the cost of imported goods, it will also end the
1.g. To reduce the money supply and, thereby, suppress inflation, the Minister of Finance has
proposed freezing all bank accounts. Depositors will be able to withdraw only the real
equivalent of about $1,000. However, other cabinet ministers are concerned about possible
adverse consequences of such a freeze.
ANSWER. This policy smacks of lunacy. It destroys faith in the monetary system and discourages savings