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FUNDAMENTALS OF CORPORATE CREDIT ANALYSIS
By BLAISE GANGUIN, JOHN BILARDELLO
The McGraw-Hill Companies, Inc.Copyright © 2005The McGraw-Hill Companies
All rights reserved.
Sovereign and Country Risks
"The reality is that most emerging market corporate defaults are caused by basic country risks."
—Laura Feinland-Katz, Managing Director, Standard & Poor's
Sovereign governments can wield vast powers that shape the financial and operating environments of all corporate entities under their reign. They establish the legal rights of the people, the regulatory framework, and the fundamental rules of engagement for businesses. Of course, that means that a sovereign government can create an environment in which business truly flourishes or an environment that stifles opportunities and success. Yet while the actions and decisions of a national government certainly have a great impact on the business environment, the basic economic and business dynamics that develop within a country are influenced by more than just the government's actions.
In particular, each country has its own unique characteristics that shape the businesses and corporations in that country. This includes its infrastructure, including roads, ports, telecommunications, utilities, buildings, a labor force, an educational system, a legal system, financial markets, and natural resources, and the businesses that develop around that infrastructure.
The combination of these unique characteristics and the government's established business rules influence the country's economic performance and thus the performance of individual companies. Ultimately, the degree of corporate success or failure comes down to how well the available resources are used in conjunction with the governing business regulations. Most of the time, however, this is usually a case of the haves and the have-nots. Well-developed countries generally support business success because they have abundant natural resources, a well-trained or well-educated workforce, strong fiscal and/or monetary policy, a stable currency, a reasonable level of taxes and tariffs, a sophisticated domestic capital market, a strong banking infrastructure, and established businesses supported by an effective infrastructure.
In contrast, "emerging" countries (or lesser-developed countries) stifle business success because neither the business community nor the sovereign government has been able to utilize the nation's assets effectively. In Africa, for instance, many countries have tremendous amounts of natural resources that are valued highly by other countries, such as oil, gold, and diamonds. One could assume that numerous successful businesses would emerge from countries with such resources. Sadly though, in some of these countries, corrupt governments and a poor educational system limit or even prevent business success. As a direct consequence, corporations based in these countries are viewed as being of high risk.
This sovereign risk analysis is not just for entities in emerging countries. In 2003, the World Bank released a survey entitled "Doing Business" that found that the least amount of business regulation fosters the strongest economies. The bank, working with academics, consultants, and law firms, measured the costs of five business development functions in 130 nations. The survey identified how regulations and legal systems affected an entity's ability to register with the sovereign government, to obtain credit, to hire and terminate employees, to enforce contracts, and to utilize the bankruptcy courts. The World Bank determined that the least regulated and most efficient economies were in countries with well-established common law traditions. This includes the United States, the United Kingdom, Australia, Canada, and New Zealand. In addition, other top-performing economies were several social democracies (Denmark, Norway, and Sweden) that had recently streamlined their business regulations. See Table 1-1 for comparative growth rates of different countries.
Strong credit analysis, therefore, includes evaluating the extent to which corporations are limited or supported by the government's laws and regulations. Importantly, future business success can also be linked to the physical aspects of a country, such as the natural resources, the infrastructure, and the labor pool. This chapter breaks down the analysis into five critical drivers about the country and its sovereign government that influence the business environment. These risk drivers are the sovereign powers, the political and legal risks, the physical and human infrastructure, the financial markets, and the macroeconomic environment.
SOVEREIGN GOVERNMENT POWERS: THEY SET THE GROUND RULES
The financial condition of a sovereign government always affects the way it governs and the laws it creates. Yet not all sovereign governments are the same. There are democracies, dictatorships, and kingdoms, with different histories and with styles of governing that can be and usually are very different. As credit analysts or lenders of credit, though, we care about the main powers every government has under its control that affect the business performance of every company within that government's domain.
The main power is first and foremost the overarching right to create and change business regulations. Next, of course, is the taxing and tariff authority, and last is the ability to enact foreign currency exchange controls. Regardless of the type of government or whether the government is corrupt or upstanding, these are the issues a credit analyst cares about. Why? Simply because these are the key tools a government has that allow it to access money and affect the business environment. But sovereigns use these tools for different reasons and at different times.
A national government can establish business rules that range from invasive to vague, and it's necessary to know the difference and the impact on business. Regulations can cover a very wide range of areas, including export/import restrictions, competition boundaries, service quality guidelines, antitrust legislation, subsidies, and the percentage of local or foreign ownership. Regulations can and do affect individual companies' business strategies. Politics being what it is, analysts should investigate the extent to which any company has influence over the political process, since that could affect the form and content of regulations. Also, analysts should track a government's history of changing the rules. For example, a government could force renegotiation of tax subsidies or royalty arrangements and could change the amount of taxes on imports, exports, or foreign debt. The characteristics of a supportive government differ depending on whether one is analyzing a local or a foreign entity (i.e., the magnitude to which it supports the local entities). Still, a supportive environment would include at least consistent business regulations.
Tariffs, or taxes paid by foreign companies trying to sell their goods in a country, are another way in which a government can extract money from corporations. But tariffs typically have another purpose—to influence the economics of a foreign entity's goods and thereby reduce the demand for those goods, to the obvious benefit of local suppliers.
The most recent example was the tariffs the U.S. government placed on steel imports in the middle of 2002. The impact was to raise the price of foreign steel sold into the United States, allowing the struggling U.S. steelmakers to also raise prices. While this did benefit the U.S. steel companies for about one year, it ultimately did not improve their financial performance enough. In addition, foreign steelmakers effectively rallied their governments' support, and those governments then threatened tariffs on
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