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International Financial Management

Notes the integration into regional or global trade and financial system. Thus, the rating agencies seek
to capture the probability of the occurrence of default by focusing on the creditworthiness of
central governments and by providing an assessment of the risk of the sovereign itself.

Notes Investors and lenders, when evaluating the risks of a country, generally base their
assessment on the political and social environment of a country.

Accordingly, a large portion of past research has focused on various political and economic
factors affecting country risk assessment. Some studies have examined more specific country
risks, such as the risk of terrorist threats. Others attempted to determine which risk factors affect
foreign direct investment. One study sought to replicate Euromoney’s and Institutional Investor’s
proprietary country risk ratings using a model which consisted of various macro-economic and
political risk variables. The researchers found that both magazines’ ratings could be replicated
to a significant degree with only a few widely available economic statistics.

Serious financial crises have rocked several countries in the last two decades and have brought
to fore the issue of financial market stability. These bouts of financial market instability have
been the focus of attention of both academia and policy circles. This has alerted policy makers
and analyst to pay attention to the problem of predicting, avoiding and managing financial
crises. Calvo and Mendoza (2000) have argued that globalization is at the heart of this volatility,
with highly diversified investors not paying much attention to economic fundamentals and
following the herd in the presence of asymmetric information. Hayes (1998) argues that
globalization of world trade and open capital markets are risky elements that can cause financial
crises with rapid contagion effects, which threaten the stability of the international financial
sector.
Political risk has been identified by various researchers as a factor that seriously affects the
profitability of their international ventures. Political risk relates to the fear that governments
might interfere with the free and unencumbered flow of capital into and out of a country. Ghose
(1988) argues that political risk is analogous to sovereign risk and lies within the broader
framework of country risk. Political risk emerges from events such as wars, attitude of the host
government, internal and external conflicts, territorial disputes, stability of the local political
government and terrorist attacks around the world. Along with political factors, economic and
financial risk factors are also considered when assessing country risk.

12.3.1 Nature of Country Risk Assessment

Country risk is an indispensable tool for asset management as it requires the assessment of
economic opportunity against political odds. The list of factors to be analysed in a country risk
analysis study varies from forecaster to forecaster. For our discussion here, we can group the
relevant factors into two important categories: political factors and economic factors. The various
indicators of political factors are discussed first, followed by the indicators of economic factors.

Political Risk Indicators

“Political risk is 50% of the exercise but inseparable from economic risk”, says Hans Belesak,
President of Political Risk Consultants.

It is very difficult to measure the “political risk” associated with a particular country or a
borrower. Assessing political risk is a continuous problem and it is very difficult to identify a
few political risk factors which significantly affect the country risk.

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