Country Risk Analysis is the evaluation of possible risks and rewards from business experiences in a country. It is used to survey countries where the firm is engaged in international business, and avoids countries with excessive risk. With globalization, country risk analysis has become essential for the international creditors and investors.
Country risk analysis identifies imbalances that increase the risks in a cross-border investments. Country risk analysis represents the potentially adverse impact of a country’s environment on the multinational corporation’s cash flows and is the probability of loss due to exposure to the political, economic, and social upheavals in a foreign country. All business dealings involve risks.
An increasing number of companies involving in external trade indicate huge business opportunities and promising markets. When business transactions occur across international borders, they bring additional risks compared to those in domestic transactions. These additional risks are called country risks which include risks arising from national differences in sociopolitical institutions, economic structures, policies, currencies, and geography. The country risk analysis monitors the potential for these risks to decrease the expected return of a cross-border investment. For example, a multinational enterprise (MNE) that sets up a plant in a foreign country faces different risks compared to bank lending to a foreign government. The MNE must consider the risks from a broader spectrum of country characteristics. Some categories relevant to a plant investment contain a much higher degree of risk because the MNE remains exposed to risk for a longer period of time.
Analysts have categorized country risk into following groups:
- Economic risk – This type of risk is the important change in the economic structure that produces a change in the expected return of an investment. Risk arises from the negative changes in fundamental economic policy goals (fiscal, monetary, international, or wealth distribution or creation).
- Transfer risk – Transfer risk arises from a decision by a foreign government to restrict capital movements. It is analyzed as a function of a country’s ability to earn foreign currency. Therefore, it implies that effort in earning foreign currency increases the possibility of capital controls.
- Exchange risk – This risk occurs due to an unfavorable movement in the exchange rate. Exchange risk can be defined as a form of risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk if their positions are not hedged.
- Location risk – This type of risk is also referred to as neighborhood risk. It includes effects caused by problems in a region or in countries with similar characteristics. Location risk includes effects caused by troubles in a region, in trading partner of a country, or in countries with similar perceived characteristics.
- Sovereign risk – This risk is based on a government’s inability to meet its loan obligations. Sovereign risk is closely linked to transfer risk in which a government may run out of foreign exchange due to adverse developments in its balance of payments. It also relates to political risk in which a government may decide not to honor its commitments for political reasons.
- Political risk – This is the risk of loss that is caused due to change in the political structure or in the politics of country where the investment is made. For example, tax laws, expropriation of assets, tariffs, or restriction in repatriation of profits, war, corruption and bureaucracy also contribute to the element of political risk.
Country risk assessment requires analysis of many factors, including the decision making process in the government, relationships of various groups in a country and the history of the country. Country risk is due to unpredicted events in a foreign country affecting the value of international assets, investment projects and their cash flows. The analysis of country risks distinguishes between the ability to pay and the willingness to pay. It is essential to analyze the sustainable amount of funds a country can borrow.
Country risk is determined by the costs and benefits of a country’s repayment and default strategies. The ways of evaluating country risks by different firms and financial institutions differ from each other. The international trade growth and the financial programs development demand periodical improvement of risk methodology and analysis of country risks.