Foreword by Campbell R. Harvey
2 An Overview of Country Risk .
3 The Economic and Financial Foundations of Country Risk Assessment .
4 Country Risk Assessment Methodologies: The Qualitative, Structural Approach to Country Risk.
5 Assessment Methodologies: Ratings.
6 Econometric and Mathematical Methods.
7 Risk Models.
8 International Portfolio Investment Analysis.
9 Financial Crises in Emerging Market Countries: An Historical Perspective.
10 Country Risk and Risk Mitigation Instruments.
11 Country Risk Assessment: A Matter of Information and Intelligence Gathering.
MICHEL HENRY BOUCHET is Professor of Finance at CERAM-Sophia Antipolis (France), Scientific Director of the MSc in International Finance, and Head of the Chair 'Global Finance'. He is also Managing Director of DEFI/Developing Finance, Paris. After an international banking career at BNP, the World Bank and the Washington-based Institute of International Finance, Dr. Bouchet was founder and CEO of Owen Stanley Financial, a specialized advisory firm dealing with debt restructuring strategy for country governments. Dr. Bouchet graduated in Economics from the University of Paris and IEP-Paris. He also holds an M.A. and a Ph.D from USC (Columbia-USA).
EPHRAÏM CLARK is Professor of Finance at Middlesex University, London, and Visiting Professor at ESC Lille, France, with extensive teaching experience in Europe and the USA. He is Founding Editor of the European Journal of Finance, Co-editor of Treasury Affairs, and Associate Editor of the International Journal of Finance. Professor Clark is the author of eight books and over 50 articles in academic and professional journals in the field of international risk management, and he also has extensive experience in private business and as a consultant.
BERTRAND GROSLAMBERT after working in Africa as Financial Controller with the French oil group, Total, Dr. Groslambert joined Paris-based FP Consult (now part of Fortis Group), an emerging market investment management company with a US$250 million portfolio. He was equity fund manager specializing in Latin American stock markets. Dr. Groslambert teaches International Finance Strategy and International Risk Management at CERAM. A graduate himself from CERAM, he holds a Doctorate in Economics from Aix-Marseille University, and his areas of expertise include emerging markets and international economics.
FOREWORD By Professor Campbell R. Harvey
J. Paul Sticht Professor of International Business-Fuqua School of Business -Duke University
Associate – National Bureau of Economic Research
When I began working in emerging capital markets more than 10 years ago, I experienced a feeling of loneliness. The topic was not fashionable in the academic community. These high profile markets received little academic attention mainly because of the cost associated with obtaining comprehensive data. The buzzwords then were derivatives, M&As, stock market bubbles, Eurocurrency market multiplier, global liquidity, and the like.… Emerging markets were regarded as an exotic risk specie good for portfolio diversification and return enhancement strategy but requiring stamina. All in all risk is a matter of uncertainty and the latter stems from an information deficit. Emerging market countries have for long be characterized by a lack of quality and timely data. Investors, traders, exporters, creditors and risk analysts must assess the performance of complex socio-economic systems that are highly volatile and most often unpredictable.
My research work on emerging capital markets began in the late 1980s with a study of expected international risks and returns. The result was to show that the standard world asset pricing models within the framework of the “efficient market hypothesis” failed to account for predictability of returns. The idea that expected risk/returns shift through time is well accepted today while finance, for years, had focused on models where both were constant. Actually, variances differ across countries and shift through time depending on the degree of global integration of emerging markets.
Emerging markets experienced a huge economic growth during the last decade. Economic dynamism, however, did not spare many of these countries from sharp volatility and financial crises. In the late 1990s, developing countries had barely recovered from the 1982 global debt crisis and the so-called Tequila crisis in Mexico in 1995 to then fall back into the maelstrom of the Asian crisis. None of these crises was similar to the former, and none was similar to those of more mature capital markets in the OECD, thereby taking most investors and traders off guard. Clearly, emerging markets analysis requires different views of risk and specific approaches to tackle it. One cannot shoe horn traditional models into emerging markets. In particular, these volatile markets remind scholars and market practitioners that finance cannot operate in isolation --as is sometimes possible in US and European markets.
Risk analysts must take into account a wide array of parameters including institutions, socio¬political structures, demographics, economic infrastructure, and legal and regulatory issues, to come up with a comprehensive analysis of country risk. Moreover, spill-over effect and the regional transmission of crises cannot be ignored. And today more than ever, we are all acutely aware of the importance of culture, ideology and religion in geopolitical risk and how it impacts all markets in the world. Global integration is a source of both major risks and opportunities.
All countries at some point were an emerging market. More countries will emerge in the future. In this process of integration in the global capital markets, analysts are still in demand of a unified framework for assessing risk and asset selection. They must use a variety of analytical tools to interpret domestic and international data. In that regard, this book is a welcome initiative. It presents in a clear and comprehensive way a wide range of complementary approaches to country risk, including their strengths and pitfalls. The authors describe and weigh the pros and cons of traditional qualitative and quantitative methods as well as some cutting-hedge techniques. They also show that in the last analysis risk assessment is as good as the quality of the underlying information. Their presentation and illustration of risk exposure involve not only equity and portfolio investment, but also direct investment, international credit as well as trade. Their intimate knowledge of private corporate and official lending institutions is certainly an asset for a thorough analysis with operational ramifications.
You will find the book interesting both because of the high quality of analysis and because of the topical nature of the subject.
How likely is it that Russia will default in the next five years? If Norway defaulted tomorrow, and you had lent the Norwegian government a large amount of money, how much would you expect to be able to recover? And what if you invested in the South Korean stock market, or were funding a project to deliver oil from one side of Columbia to the other?
These are just the types of questions that have been asked for centuries in banking, and even now, with the most advanced computers, hundreds of Ph.D.-trained financial engineers, and the sky-high budgets that most banks have, there is no simple answer to these questions.
As you will read in this issue’s Special Feature section, there has been an explosion in the number of risk management books published in the last few years. These publications have covered almost all areas of risk management, and while there continue to be new publications, the large majority of these new books provide more detail or even more advanced models for areas that are already reasonably well understood at the simple level.
One area in particular that has not yet been covered well in the literature is also one of the most fundamental areas of risk management, namely country risk. In Country Risk Assessment, country risk is defined by the author, in its broadest sense, as the additional risk that arises from doing business abroad. I’m sure that there are huge numbers of business deals that seemed perfect at the time, only to fail as a result of political instability or economic failing. Such cases illustrate that a good method of measuring country risk is needed, and this is not something that is intuitively easy to do.
It becomes clear early on that Country Risk Assessment is structured like a thesis, and the first chapters provide an excellent introduction and literature review. With a topic as broad as country risk, it is not surprisingly that there is some inconsistency in what has been done previously. The authors do a good job of reviewing what has already been published, highlighting the good points of historic work, and also identifying where there are differences in the approaches used.
As the reader progresses, it becomes clear that not only do the early chapters resemble a thesis, but the rest of the book continues in a similar vein. The remaining chapters cover the economic theory behind country risk, introducing the concepts of currency elasticity and absorption, and then go on to identify some of the key macro-economic variables to consider when assessing a country. Factors that measure the social factors, such as population, labor force, healthcare spending and income distribution are introduced, along with other more financial variables, such as indebtedness to overseas countries, and measures of internal investment and savings.
Having described how an analyst might produce an independent rating of a country, the authors move on to describe the ratings agencies and the role they play in supplying the markets with an independent view on countries’ likelihood of defaulting. This is a well-researched chapter, and provides useful background on the process by which ratings agencies go about their role, and also includes topical reference to some specific countries where ratings agencies have recently provided a first rating. This chapter also highlights the different focus on economic versus political risk that the ratings agencies are known to follow.
As regular readers will know, I enjoy the quantitative side of life, and it is good to see a book of what is superficially such a qualitative subject, manage to supply a number of quantitative approaches. So much so, in fact, that the authors have put together an excellent short chapter that describes a number of modelling methodologies that are used in risk modelling today. In particular, the modelling methods mentioned here (which include regression and Monte Carlo simulation) are those used in most branches of credit risk modelling.
Despite using advanced methods, it has to be said that applying standard credit modelling techniques to develop a country rating model really doesn’t work too well. The history of defaulted countries is simply too small for a standard regression-type modelling approach to work, and although there are attempts to convert a corporate equity-price-based risk model into a country risk model, the results are not convincing (not least, of course, since equity prices do not exist for countries).
The final few chapters cover a wide-ranging but disparate group of areas. There is a chapter describing how to analyze portfolios that include international aspects, closely followed by a historic overview of financial crises in emerging markets, which is in turn followed by a section on country risk mitigation. All of these chapters are solid, well-researched and interesting, but they do not sit together cohesively.
So overall, the book contains a large amount of information covering the spectrum of topics that make up country risk. It is no small feat to have covered the topic from so many different angles, and a book that had only covered half would have made a good attempt at describing the subject.
I expect that this will become a set text for both practitioners and academics, and I would strongly recommend that anybody who wants to understand the full spectrum of country risk should read this book. Readers may find the academic style and depth of coverage slow-going – it certainly isn’t a book to read on the train on the way to work – but readers looking for a single reference on all aspects of country risk could not do much better.
Country Risk Assessment – A Guide to Global Investment Strategies, by Michel Henry Bouchet, Ephraim Clark and Bertrand Groslambert. Wiley Finance ISBN #0-470-84500-7