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Country Risk Assessment
A guide to Global Investment Strategy
By Michel Henry Bouchet Ephraim Clark Bertrand Groslambert
John Wiley & Sons
Copyright © 2003
Michel Henry Bouchet, Ephraim Clark, Bertrand Groslambert
All right reserved.
1.1 AN HISTORICAL PERSPECTIVE
Following the numerous successes it had met with during the flotation of shares and bonds
in the capital markets, Baring Brothers was eager to underwrite a loan to be issued by the
Buenos Aires Water Supply and Drainage Company. However, the demand was not there and
this operation proved to be a failure, leaving the investment bank holding the bulk of the debt.
In the meantime, after an extended period of investment boom, the major central banks had
decided to substantially increase their discount rates. This tightening of the global liquidity
prevented Barings from refinancing at affordable cost and rapidly made its situation untenable.
The deterioration of the economic conditions in Argentina hastened an international financial
crisis and drove Barings to the verge of bankruptcy. Then, because of contagion effects, Brazil
was next on the list. Its currency as well as its stock market collapsed, causing a sharpeconomic
Does this story sound familiar? Well, any resemblance to an existing situation is probably
not coincidental. However, the aforementioned events do not relate one of the recent crises
experienced by many emerging markets over the last decade, but actually refer to what is
known as the 1890 Baring crisis, more than a century ago. This example illustrates one of the
many similarities that can be found when comparing the current period with the prevailing
conditions in the nineteenth century.
With the end of Bretton Woods in 1971, and more particularly since the beginning of the
1990s, the world economy has been characterized by its globalization. The fall of communism
has permitted the rise of the single American superpower, replacing the Pax Britannica of
pre-World War I with Pax Americana. The economic liberalism that started to be implemented
in the industrialized nations by Margaret Thatcher in 1979, and later on was extended to the
developing countries by the IMF's adjustment programs, looks like the "laissez faire" policy of
the Victorian epoch. Most financial markets are now fully deregulated and capital flows freely
circulate all around the world. As a consequence, in the 1990s and for the first time since 1913,
the structure of the international capital flows was marked by the return of portfolio investments,
especially in the form of bonds and equities. Therefore, exactly like a century ago, "we enjoy
at present an undisputed right to place our money where we will, for Government makes no
attempt to twist the system into a given channel, and every borrower - native, colonial and
foreign - has an equal opportunity for satisfying his needs in London" (The Economist, 20
February 1909, in Baring Securities, 1994).
Regrettably and similarly, this also corresponds to a strong increase in the frequency of
economic crises. As stated by Krugman (2000) when comparing the current events with the
period 1945-1971: "The good old days probably weren't better, but they were certainly calmer."
The debt crisis of the 1980s, the Chilean collapse of 1982, the bursting of the European
Exchange Rate Mechanism (ERM) in 1992, the debacle of the Mexican peso in 1994, the
Asian disaster of 1997, the Russian default and the American bailout of LTCM in 1998,
the Argentine chaos in 2001/2002, all demonstrate an accrued volatility of the international
economic system. In the same vein, the nineteenth century was regularly shaken by financial
crashes. In the years 1836-1839, seven states of the then emerging United States defaulted. A
short time later, the railroad boom turned into a speculative bubble and eventually led to the
panic of 1857. Turkey, Egypt and Greece defaulted on their debt in 1875-1876. Australia and
Canada did the same in 1893, and were followed by Brazil and Mexico in 1914. All through
the nineteenth century, speculative mania, financial euphoria, and sharp crises accompanied
the economic take-off of the industrial revolution.
Does this mean we are left in exactly the same situation as the one prevalent in the age of
the gold standard? Probably not. However, many observers agree on the growing instability
of the economic system and believe that "the likelihood of escaping economic and financial
crises in the years ahead seems small" (Kindleberger, 2000).
Parallel to this increasing volatility, feeding on and fuelled by globalization, more and more
firms invest, trade and compete outside of their home market. Hitherto reserved for the biggest
companies, even the smallest firms have started to reason on a global basis. Thus, between 1950
and 2000, the ratio of merchandise exports to world GDP rose from less than 10% to almost
20%. This means that firms are more and more internationally exposed, and national economies
are increasingly interlinked. This economic integration translates into a higher sensitivity to
foreign events. Consequently, international trade is more and more crucial for companies and
countries alike. Furthermore, as the world political leadership is increasingly wielded by the
industrialized countries in general and by the United States in particular, there is evidence of
a backlash against these countries. In this context, their firms' interests abroad have shown
themselves to be especially vulnerable. As the former US Ambassador Paul Bremer outlined:
"In the past 30 years, 80% of terrorist attacks against the United States have been aimed at
American businesses" (Harvard Business Review, 2002). All this demonstrates the growing
importance of a reliable risk management system based on accurate country risk assessment
Forecasting is at the core of all decision-making in the management field. Businessmen must
plan and anticipate what the future will bring. They must then make their choices based on their
analyses, taking into consideration how today's choices are likely to affect their companies in
the future. This implies a certain amount of risk. The ability to look ahead and to take on risk is a
major determinant in the frontier between Modern and Ancient times. As Bernstein (1996) put
it, "the transformation in attitudes toward risk management has channeled the human passion
for games and wagering into economic growth, improved quality of life, and technological
Until the Renaissance, men did not generally try to forecast the future. This was reserved
for the Gods. At best, the Gods could possibly deliver their views through an oracle such
as the Pythia at Delphi. Starting in the sixteenth century, though, a series of mathematical
discoveries enabled mankind to reconsider its position on this issue. Indeed, from this date,
Pascal, Fermat, Bernouilli, de Moivre, Laplace and Gauss, to name just a few, progressively
built what became the theory of probability. This branch of mathematics created the toolbox
to deal with the future in a rational and orderly manner. At the end of the nineteenth century,
it led to the conclusion that everything could be measured, either with a deterministic or with
a probabilistic approach. Risk was thought to be under control.
However, the twentieth century was to challenge this optimistic vision. Two world wars
and the Great Depression showed that even the unthinkable could happen. This altered the
perception of risk and caused researchers to redefine it. In the 1920s, Knight introduced the
notion of uncertainty as opposed to the notion of risk. Whereas risk can be appraised with
probability, uncertainty is not measurable. This distinction was well retranscribed by Keynes
(1937) in his famous statement: "By 'uncertain' knowledge ... I do not merely distinguish
what is known for certain from what is only probable. The game of roulette is not subject, in
this sense, to uncertainty; nor the prospect of a Victory bond being drawn ... Even the weather
is only moderately uncertain. The sense in which I am using the term is that in which the
prospect of a European war is uncertain, or the price of copper and the rate of interest twenty
years hence ... About these matters there is no scientific basis on which to form any calculable
probability whatever. We simply do not know."
There may be several reasons why "we simply do not know". First, the system may be too
complex to be measured. In this case, the theory of chaos explains the situation by saying
that it contains too many degrees of freedom, and is therefore unpredictable in the long run.
Alternatively, it may be because we don't have a long enough time series to extrapolate the
underlying probability law. For instance, many economic variables follow certain probability
laws of "rare events", such as Pareto's law. In order to be accurately estimated, these types
of distributions require extremely large empirical databases, which are hardly ever found
in real life. Lastly, another argument could lie in the permanently changing and inherently
unstable nature of the environment. To draw on the past in order to infer the probability of
future occurrences would be completely misleading, if a structural change took place in the
If the size of the population under scrutiny is sufficiently large (in the billions) to be valid for
statistical appraisal and provided it is unaware of the existence of the science of Psychohistory,
then Hari Seldom demonstrated that Psychohistory could predict the behavior of human soci-eties
over at least 30 000 years. Psychohistory is "a branch of mathematics which deals with
the reactions of human conglomerates to fixed social and economic stimuli" (Asimov, 1967).
Unfortunately, or rather maybe fortunately, this science has not been invented yet, except in the
imagination of the famous science fiction novelist, Isaac Asimov. Today, organization science,
political science, economics, or country risk are still light years away from Psychohistory.
Nevertheless, we can reasonably expect from them a certain ability to anticipate social changes.
The objective of this book is to explore the question for country risk. What is the state of the art
in this field? What are the various country risk assessment methods? Do they rely on modern
science or are they merely based on intuition and subjective perceptions? Can we reasonably
measure country risk with a probabilistic view? Or do we rather face the type of uncertainty as
defined by Knight, the one which cannot be addressed with probability laws? In April 1982,
Institutional Investor ranked South Korea below Mexico. In August of the same year, Mexico
defaulted and triggered the international debt crisis of the 1980s. Meanwhile, Korea initiated
a period of unparalleled economic growth that would increase its per capita GDP in US dollars
fivefold over the next 20 years. In December 1986, The Economist tried to detect which
countries were at the greatest risk of becoming unstable in the following years. They found
that Chile was in the very high-risk category alongside Nigeria and Zaire, while Venezuela
and Brazil were in the very low-risk category, like Taiwan and Singapore. As these selected
examples clearly illustrate, risk management, and country risk in particular, has proved to be
a very difficult task. No one method is able to perfectly assess country risk. However, taken as
a whole, the methods of country risk assessment provide a framework for analysis and some
necessary guidelines to tackle the issues at hand.
When considering an investment abroad, it is essential that managers do not blindly follow
the general consensus. Based on the methods presented in this book, they must take into
account their own features, so as to derive their own evaluations. In addition, they should
regularly question the validity of their models. They should wonder what could make them
defective in the future, whatever their degree of success in the past. As Bernstein (1996)
explains: "The science of risk management sometimes creates new risks even as it brings old
risks under control. Our faith in risk management encourages us to take risks we would not
otherwise take ... Research reveals that seatbelts encourage drivers to drive more aggressively.
Consequently, the number of accidents rises even though the seriousness of injury in any one
accident declines." Furthermore, the Minsky Paradox of Tranquility is never far away, just
waiting to lull investors' awareness. This paradox postulates that after a long enough period
of relative tranquility, entrepreneurs and banks tend to become complacent about economic
prospects. Little by little, they start to take more risk, going for more debt, and hence making
the system more vulnerable. This may be what happened in South East Asia in 1997, when
so many investors were trapped, unprepared to bear such a high risk. "Only the pathological
weakness of the financial memory,... or perhaps our indifference to financial history itself,
allows us to believe that the modern experience of Third World debt ... is in any way a new
phenomenon" (Galbraith, 1994).
Finally, we should keep in mind that it is precisely the difficulty of estimating the risk
that can make the investment opportunities attractive. An anecdote by Jean-Louis Terrier, the
founder of the French rating firm Nord Sud Export, illustrates this point. A few years ago he
had a discussion with one of his clients, a wealthy and quite secretive Belgian entrepreneur,
who, every year, was very impatient to read the annual country risk ratings. To Terrier's utmost
surprise, the man confessed to him that he wanted to be sure his investments were made
effectively in the riskiest countries, those able to generate the highest returns.
1.2 OUTLINE OF THE BOOK
Various definitions and several terminologies exist to deal with the risk related to a foreign
investment. In this book, we define country risk as all the additional risks induced by doing
business abroad, as opposed to domestic transactions. When a firm starts to expand internationally,
it is faced with a new environment, composed of different risks and uncertainties,
which it is not used to dealing with. Country risk encompasses all these specific sources of
potential difficulties encountered when investing overseas, ranging from political and social
risks to macro- and microeconomic risks.
This book should allow the reader to get an insight into the nature of risk when investing in
a foreign country. Based on the three authors' experience, it combines a rigorous, theoretical
treatment of country risk with some very concrete and practical illustrations. It aims to present
and analyze most of the existing country risk assessment methods. It also provides a broad
overview of the country risk field with an emphasis on the specific nature of the emerging
countries. It should allow professionals to explore the origins of country risk, to understand
the assessment process of each method, and to grasp their limits.
Excerpted from Country Risk Assessment
by Michel Henry Bouchet Ephraim Clark Bertrand Groslambert
Copyright © 2003 by Michel Henry Bouchet, Ephraim Clark, Bertrand Groslambert.
Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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