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New challenges in Risk Management: Country Risks

Since the end of the Second World War in 1945, the world has witnessed exceptional and rapid progress in all senses, with widespread interest in researching and devising solutions to all types of human problems and inconveniences. Medicine and pharmaceutics have improved the length and quality of life; industry has been in a state of continual progress in the manufacture of all types of products, reducing costs and increasing accessibility to a large number of consumers; new transport technology has led to time and cost savings and brought markets closer; and finally, the engine of exponential progress over the last 25 years have been the information and communication technologies, which have shifted social, industrial and commercial goalposts.

All of these improvements have been developed within a context of increased market openness in the majority of countries and continents, providing companies with the opportunity to offer their products and services outside of their normal competitive habitat and thereby continue growing and generating profits. Governments in the majority of countries in the world have attempted to support the creation of this global market, through trade agreements of varying ambition, but with the clear objective of facilitating the transport of goods and reducing customs tariffs. This backdrop of openness and agreements, which is currently in force and forms the basis of our way of life, is under threat from various events that could be detrimental to it and even destabilizing. In the extreme case, they could potentially overturn these arrangements which would involve a return to international trade models based on barriers, tariffs and costs.

In recent decades, we have witnessed and suffered the effects of economic and financial crises which have taken place in some countries, but – due to globalization – have affected other countries to a greater or lesser degree. As a result of these crises the focus has turned to the need to identify global risks which extend beyond borders and would have a similar impact on a large number of countries, both socially as well as in terms of economic expectations and indicators.

Accordingly, public and private companies have added the review of global risks and their possible impacts to their risk management, so that this information will at least be included in strategic decision making processes, even if there is no effective solution to them. An example is the World Economic Forum, which since 2007 has been analyzing and preparing a scenario which identifies and classifies global risks into five main groups: Economic, Environmental, Geopolitical, Social and Technological. By way of summary, between 2007 and 2012 the major focus of concern were economic risks, while from 2012 to 2017 the focus has turned toward social and environmental risks, where the probability of occurrence and impact are highly significant. This analysis is subject to some bias, given that the studies are based on the opinion of experts and governments, and they lack a sufficient quantitative baseline. Even so they are undoubtedly useful, since they identify areas of uncertainty by region and country.

Human activity is not the exclusive source of environmental risks. Clearly there are some aspects, such as air pollution from greenhouse gas emissions, where man-made actions and government policies offer countries the ability to manage, prevent and mitigate – including even possibly avoid – directly related hazards (such as floods or natural disasters related to the gradual deterioration of the polar ice caps). However, faced with certain natural disasters – such as volcanoes, earthquakes, hurricanes, floods – which are purely related to the normal course of environmental phenomena in our planet, there is little humanity can do.

The other risk groups are man-made, both in terms of public decisions made by countries’ leaders, as well as the private decisions of companies and citizens. The worst consequences arise from armed conflicts which continue to be a source of destruction, instability, famine and displacement in many regions. These situations cause social alarm at the global level, but, unfortunately, are not easily resolved because of the large number of competing interests between different countries.

Without reaching such dramatic proportions, other events also have a direct impact on the population and its interests and outlook. This is true of events related to the economy and finances, as well as the perception of a general lack of credibility that some societies associate with specific elements of the political sphere when it comes to dealing with and finding solutions to serious problems such as unemployment or the solvency of the public accounts themselves, with increasing levels of indebtedness and its resulting implications for future generations.

Country risks

The global environment is being characterized by an increasing focus on different countries’ decisions, both democratic and authoritarian, aimed at reducing their involvement in global trade models, in order to gain economic and financial independence and to protect local models of production. It is clear that these moves will have a rapid and direct impact on economic expectations, with knock-on medium-term implications for growth and unemployment.

Following Michael E. Porter’s work on “The competitive advantage of nations”, Government intervention in private business activities through investment support, development of key sectors of the country’s economy and even through facilitating the entry of foreign investors, enables strategic sectors or the economy as a whole to benefit against competitors in other countries. An example is the protection of specific sectors, by increasing tariffs on imports of foreign products into the sector, or placing obstacles on manufacturing by other foreign companies with a headquarters in the country.

While up until now the main sources of instability tend to have focused on underdeveloped or developing countries, in recent months western countries have added their own dose of uncertainty. This applies to two specific recent events: Brexit in the United Kingdom and the change of President in the USA. In addition to these two emblematic countries – where in the first case the majority of citizens voted to split from the European Union and in the second case to move toward a much more protectionist-style of government – other counties in Europe are also joining them. Concern among citizens in these countries about their security and safety in the face of terrorist attacks or economic instability are adding ever greater weight to protectionist schools of thought and shaking the foundations of the European Union. And while not at the same level of break-up, Spain itself is not free from an unusual sociopolitical climate: in recent months the level of instability in national governing bodies has reached levels not seen for decades due to the emergence of new political alternatives and secessionist movements.

This scenario is putting an additional element of uncertainty on the table for company owners and directors, especially those whose accounts have significant international exposure. They now have to pay attention to each country’s state of affairs, even those that were not considered to be problematic. A source of uncertainty which could potentially condition or extinguish productive investment and trade activity, or the liquidity of operations, with corresponding negative consequences, chiefly disinvestment and unemployment.

The following diagram shows the main components of Country Risk, which we divide into three: Economic Risks, Sociopolitical Risk and Financial Risks:

Country Risk has traditionally been defined as the possibility of negative consequences impacting on a company’s investments and/or commercial operations in a country, due to government decisions, macroeconomic or competitive disturbances, or political or social changes in the country under analysis (or in neighboring countries that may directly affect it).

Country Risk was initially associated both with the fulfillment of financial obligations by the country itself in paying back its sovereign debt, as well as compliance with obligations to private debtors that import and have to pay in the currency agreed in the contract or in their own currency. But, as we have illustrated in the article, country risks cover a wider spectrum. As such, we divided Country Risk into three headings:

»Economic Risks, which derive both from the country’s macroeconomic structure (outlook for inflation rates, interest rates, balance of payments, GDP, etc.) and policies related to the system of Government. The latter includes the articulation of fiscal policy and therefore affects incentives and benefits for investment, as well as monetary policy, which directly impacts on inflation, interest rates and exchange rates. The economic model and the local market structure are indirectly affected by these decisions.

Risk Management departments are therefore required to assess the effect of possible risks that could emerge, for example, from a major tax hike, the disappearance of support measures underpinning an investment, or changes to legal conditions that have to be followed when setting up in the country.

This gives rise to questions and queries that should be understood by the decision-making bodies: Are local partners required when creating a subsidiary? What labor policy does the company need to adopt to avoid conflicts with the Government? Are there tariff policies which directly affect the investment?

»Sociopolitical Risks. This is possibly the most well-known group of risks with the highest level of awareness and knowledge. Even so, there is no database in existence broad enough to be able to analyze and create hypotheses on these risks enabling them to be solved quantitively.

In the case of social and political stability, the risk originates in social disruption and the lack of governmental stability. These situations can originate from social inequality, religion, ethnic differences, the development of cultural models, historical relations between countries, all of which can lead to the outbreak of disturbances – ranging from relatively peaceful protest and societal boycotts of specific products, to acts of terrorism in extreme cases – which one way or another impact on investment performance. Relations with neighboring countries could also be a source of instability with declaration of war being the ultimate recourse.

The regulatory model refers to the maturity of the legal system and the degree to which it is ingrained in social and business life. This is intimately linked to Legal Security, which involves the guarantee of compliance with the rule of law, regardless of the unilateral actions of Governments: there are very well known examples of forced nationalizations and confiscations of whole subsidiaries in Latin American countries.

However, while not reaching the same level of awareness as these unilateral actions, protectionist policies cause a multitude of lesser negative effects, which emerge in ongoing changes in regulation in specific markets and can directly harm the rights of foreign companies through the enactment of laws. This is the case, for example, of regulation in issues related to food security, health restrictions, technological models and standards, energy sources, people and merchandise transport, which affect both the primary activity but also indirectly impact on the country’s economic and social activities.

Finally, social development itself and the adoption or rejection of new cultural developments from other countries, highlight social sensitivity and fragility, which are the basis for change in future generations.

»Financial Risks, which are crucial to ensuring planned operations deliver a good outcome. When foreign companies acquire public debt, the risk is in non-payment of the principal and/or interest, which also applies to private debt. In the case of a lack of liquidity and debt repayment, the creditor will be exposed to this default risk. These can also be classified as Sovereign, when the debtor or guarantor is the State, and Transfer in the case of a private local company.

On many occasions, the country’s authorities where the company is seeking to operate, propose the acquisition of fixed income securities or equities issued by local institutions, or suggest that the company offer credit to local entities. These can impose a direct extra cost if they have not been taken into account when negotiating the operations, as well as an additional default risk.

It is also important to mention payment block in this section, both in foreign and local currencies, due to government decisions motivated by various factors. This has important consequences for the company’s cashflow, frequently involving the need to seek new finance and increasing the cost of operations. Therefore, questions rapidly arise such as: what is the regulation in regard to capital repatriation?

A prior analysis of the country’s political and macroeconomic situation in finance issues and the existence of a track record are necessary and crucial for anticipating these types of scenarios.

In light of the above, a proper analysis and assessment of risks is crucial to protecting our interests.

Analysis and Risk Management

Various companies provide Country Risk analysis services; these are specialized consultancy companies whose work goes into a high degree of detail. Among other factors, their studies focus on analysis of historical data, short, medium and long-term forecasts for political and economic scenarios and their social repercussions, as well as the impact on foreign operations and investments. There are also institutions who analyze the issue of interest to us: global organizations, such as the World Economic Forum, dedicate significant resources to preparing and publishing annual reports focused on Political Risk.

Without aiming to reach the same level of depth as these studies, Risk Management departments should ensure they have an assessment of Country Risk insofar as it affects the operations that their companies carry out overseas. By way of example, we propose considering the factors set out in the next section, which include questions that we should ask ourselves when assessing the Country Risk to which our investments and operations are exposed.

Relationship of Factors for Assesing Country Risk

When responding to the following questions, a simple five step scale can be used to express the analyst’s opinion and/or risk appetite:

Very low/Bad1
Very High/Good5

Finally, the study need not by carried out by an analyst, this task could be done by a Risk Manager, executive or any person with the right knowledge and qualifications. Therefore each question will have a score and summing the overall score should give us an initial idea of the analyst’s opinion of the country.

Economic Risk  €

1. Development of macroeconomic factorsThe progress of the country’s economy will be the first point of analysis and it will provide us with an initial quantitative perspective which will determine our decision on investing in the country.
What has the country’s macroeconomic performance been like and what is the short, medium and long-term outlook?Analysis of accessible data (GDP per capita, GDP growth, annual inflation rate, country current account as a proportion of GDP, exchange rates, etc,) should provide the basis for decision making according to the local economic environment.
2. Fiscal and monetary policyThe government’s decisions on fiscal support or monetary policy stimulus, although aimed at stimulating the economy and investment climate, may be detrimental over the medium-term if they are excessively expansionary and can lead to risks of uncontrolled inflation and economic disorder.
What is the effect of fiscal and monetary policies?The results of these actions can be disparate, ranging from improvements in the tax burden or the exchange rate to detrimental increases in expenditures.
Exchange rate fluctuations in the country have a very significant impact on multinational companies, which could be the result of expansionary monetary policy. They significantly impact on final results in the groups’ consolidated accounts. It is a risk that is inherent to international activity.
3. Economic protectionismIt is a well-known fact that governments try to protect national industry from foreign competition. However, this effort can clearly hamper foreign investment, with the imposition of import and export trade barriers in the form of tariffs and other measures. There is also the risk of sustaining unprofitable sectors with strong investment, only to maintain jobs and, on occasions, for political motives. This can constitute a long-term opportunity cost with resources being dedicated to obsolete sectors instead of cutting edge sectors.
What level of protectionism does the country have and what measures does the Government impose which could negatively affect foreign companies?It is important to point out that there are also opportunities here, given that import limits usually also involve measures to create subsidiaries, especially in underdeveloped local sectors, giving rise to capital and knowledge inflows.

Sociopolitical Risk  

4. Level of political interference in the economyThis can be reviewed by assessing private property rights, existing regulation, the impartiality of the legal system and the quality of the country’s administrative system.
Is it possible that a government intervention could take place which negatively affects investment?
Does the country have a history of these types of actions (confiscations, expropriations, forced nationalizations)?
History may weigh on the analyst’s option, but remember that risk and return go together.
5. Country political stabilityOn the basis of measurable factors, such as government legal and regulatory effectiveness, the implementation of the rule of law, and the degree of popular support for it.
What capacity does the government have to apply policies that benefit investment and avoid social conflict?We should also be mindful of local corruption indicators, given that they can be clearly detrimental to operations in the country, creating a system based on cronyism and an absence of medium to long-term certainty, as well as contributing to social discontent and the black economy.
What is the level of corruption within the institutions?This is an endemic problem in many countries, including developed economies, where events are regularly reported by the media which damage opinion of the institutions.
What level of military intervention is there in the country’s political life? What is the country’s track record in this regard?Finally, although this focuses more on specific cases, we should not forget to assess the possibility for military intervention in the country’s government.
6. Assessment of social unrestHere it is necessary to analyze the factors leading to popular discontent and disruption to public order, which can harm investment.
What is the potential for social disturbances and strikes?A way of getting an initial handle on this question is to use the human development index and its constituent parts (establishment of welfare state, unemployment rate, poverty level, quality of public services).
7. Political instabilityGoing into more detail on the previous point, we will assess the level of social harmony and sociopolitical stability, gauging factors such as religious and ethnic tensions and the existence of armed groups, separatist movements and the penetration of organized crime.
What is the level of political violence in the country and how does it affect governability?We understand political instability as events such as civil commotion, acts of sabotage and terrorism, war or civil war, rebellion, revolution, revolt, hostile actions by a belligerent power, riots or coups d’états.
8. Assessment of international relationsIt is very important to frame the country within its regional context and analyze the relationships it has with neighboring and non-neighboring countries, as well as with international organizations which are influential on economic issues.
Is there potential for violent (cross-border conflict, war) or non-violent action (trade restrictions, sanctions and withdrawal of aid, etc.) by external agents?This point should be carefully assessed given its importance for political stability and social unrest.
9. Regulatory and cultural factors affecting establishment and operationAt the initial point of drawing up the company strategy, we should consider the following questions.
What regulatory controls are there on setting up the company?It is possible that formation of Joint Ventures with local partners could be an essential requirement, or in other instances it will not be possible to acquire 100 percent of a subsidiary in a country. It will also be necessary to know the timeframe, costs and modes of finance for establishment.
Is the company able to comply with labor policy and regulation? Will compliance have a negative impact on the operation?Once the operations have been consolidated, new risk factors will also emerge in the next step of the company’s life. This time they will focus on labor regulation, cultural factors and human resources policies. Limits on the hiring of foreign personnel or very significant cultural differences (such as restrictions on women occupying management positions) could lead to reputational or operational damage which must be considered by the parent company.

Financial Risk 

10. External debt in comparison to the size of the national economyAre public and private institutions in a position to honor their payment obligations?
11. Government policies and the national financial situationAre foreign creditors paid on time?
12. Restrictions on repatriation of funds. Government policies and the national financial situationWhat is the official regulation and what are the unofficial practices in regard to repatriation of profits, dividends and investment capital?
13. Discriminatory polices/requirements in the search for financeAre foreign companies required to acquire fixed income securities or equities issued by local institutions, or offer credit to local entities?
14. Assessment of local funding sourcesHow vulnerable is the local banking sector? An analysis of the solvency and capital levels of the banking sector will be crucial for determining lending viability.
15. Exchange rate stability and currency transferIn regard to currency conversion, it will be necessary to analyze local policies, informal practices and the financial context. Do these factors affect currency conversion, restricting or effectively prohibiting currency transfers?

Risk management in the company

Risk Management is already a very common practice due to its usefulness and the benefits that it offers, primarily in preventing impact from risks facing the company or institution, which can ultimately jeopardize the achievement of objectives.

Without wishing to reproduce the risk management methodology, and as a reminder of the work typically involved, we emphasize that all the analysis involved in assessing country risks should be aligned with other risk management work, setting out a declaration of risk appetite and tolerance and developing a risk map which serves as a basis for decision making.

The assessment method used for placing Country Risk within the risk map (and therefore the scoring of factors) should also take account of the type of operations the company performs. The same analysis does not apply to a mutual fund or a company offering financial consultancy services as it does to a manufacturing company: factors such as restrictions on access to raw materials for foreign companies or a discriminatory tax regime will have different impacts depending on the company’s activity.

In order to help risk managers dive into these issues and correctly assess the importance for the company and its interests of risks arising from overseas operations, the insurance market offers specialized solutions and various resources to companies to ensure a correct analysis of the Country Risk to which their investments are exposed. The Political Risk maps published by insurer and brokers are well known. Export Credit Insurance companies also develop and publish such reports. Finally, in the public realm, it is also worth mentioning ICEX Spain Export and Investment (previously known as the External Trade Institute), which is a national public company whose goal is to promote the internationalization of Spanish companies.

This shows once again how the insurance industry is not just limited to only offering solutions based on risk transfer, but also to supporting companies throughout the process of analysis and assessment, helping to design prevention and mitigation measures and ensuring companies take the best decisions to protect their interests. The role played by insurance companies as a travel companion throughout the risk management cycle is crucial in a continually evolving global environment, which is currently showing signs of moving toward protectionism and political extremes.


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