Management of Credit Risk and Political Risk - APEC SME Crisis

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					 International Investment Decision
under Political Risk and Credit Risk

                   Dr. Hsuan-Chu Lin
   Department of Accountancy and Graduate Institute of
            National Cheng Kung University
  APEC Symposium on Enhancing SME Capacity of
Managing the Risks Associated with Trade Liberalization
  What are Political Risk and Credit
 Macro-level: non-project specific risks

 Political Risk: The risk of loss when investing in a given
  country caused by changes in a country's political structure
  or policies, such as tax laws, tariffs, expropriation of assets,
  or restriction in repatriation of profits.

 Weston and Sorge's (1972) definition is representative:
  "Political risks arise from the actions of national
  governments which interfere with or prevent business
  transactions, or change the terms of agreements, or cause
  the confiscation of wholly or partially foreign owned
  business property"
  What are Political Risk and Credit
 Micro-level: project specific risks

 Credit Risk: The risk due to uncertainty in a counterparty's
  (also called an obligor's or credit's) ability to meet its

 Generally speaking, from an international trading
  perspective, political risk should be relatively emphasized
  than credit risk.
               Why do we care?
 The two risks bring uncertainty to the expected payoffs of
  investing an international project and further affect a firm’s
  decision on whether to take the project.

 They are two possible negative effects which should be
  carefully concerned and measured by a firm which is
  planning to take an international investment project.
                 Why do we care?
 For example, Robock (1971) suggests the following
  operational definition: ... political risk in international
  business exists
 (1) when discontinuities occur in the business environment,
 (2) when they are difficult to anticipate, and
 (3) when they result from political change.

   To constitute a 'risk' these changes in the business
    environment must have the potential for significantly
    affecting the profit or other goals of a particular enterprise.
    How does political risk affect international
          business? - Some Findings
 A positive relationship between foreign direct investment
    (FDI) and intellectual property protection. (Lee and
    Mansfield, 1996)
   A negative impact of corruption on FDI flows. (Wei, 2000)
   Harms and Ursprung (2002), Jensen (2003), and Busse
    (2004) find that multinational corporations are more likely
    to be attracted by countries in which democracy is
   Kobrin (1978) finds the presence of a negative
    relationship between political instability and FDI.
   The political actions and instability may make it difficult
    for companies to operate efficiently in these countries
    due to negative publicity and impact created by
    individuals in the top government. (Okolo, 2006)
             Measuring the Risks
 (1) Political Risk
 Country Risk Rating:
 The number of country risk ratings compiled by commercial
  agencies such as Moody’s, Standard and Poor’s,
  Euromoney, Institutional Investor, Economist Intelligence
  Unit, International Country Risk Guide, Political Risk
  Services, Fitch IBCA, Business Environment Risk
  Intelligence S.A., S.J. Rundt & Associates, and Control
  Risks Group, has increased substantially since the Third
  World debt crisis in the early 1980s.
           Measuring the Risks
 According to the International Country Risk Guide
  (ICRG), its risk ratings have been cited by experts at the
  IMF, World Bank, United Nations, and other international
  institutions, as a standard against which other ratings
  can be measured. The ICRG has been acclaimed by
  publications such as Barron’s and The Wall Street
  Journal for the strength of its analysis and rating system.

 The ICRG staff collects political, financial, and
  economic data, converting these into risk points for
  each individual risk component on the basis of a
  consistent pattern of evaluation. The following is the
  ICRG measurement table of political risk:
Sequence                 Component       Points

A          Government Stability             12
B          Socioeconomic Conditions         12
C          Investment Profile               12
D          Internal Conflict                12
E          External Conflict                12
F          Corruption                        6
G          Military in Politics              6
H          Religious Tensions                6
I          Law and Order                     6
J          Ethnic Tensions                   6
K          Democratic Accountability         6
L          Bureaucracy Quality               4

Total                                      100
            Measuring the Risks
 (2) Credit Risk:
 Credit Risk Rating: From rating agencies, such as
  Moody’s, Standard and Poor’s, Fitch, etc..

 Credit risk models:
 Z-Score Model (Altman, 1968)
 O-Score Model (Ohlson, 1980) – Logistic Model
 BSM Model (Black-Scholes, 1973; Merton, 1974) – Option
  Pricing Model
   International Investment Decision-Making
      under Political Risk and Credit Risk
 Risk Adjusted NPV Method:

                      CF1        CF2                  CFN
    NPV   II                          ... 
                 (1  RADR) (1  RADR) 2
                                                 (1  RADR) N
                               II
            i 1   (1  RADR) i

    where    CFi         is the net cash flow brought by the project at time I
             II          is the initial input for taking the project
             RADR        is the risk-adjusted discount rate, the expected rate of
                         the return integrating political risk and credit risk.
             N           is the expected effective time period of the project
  International Investment Decision-Making
     under Political Risk and Credit Risk
 Capital Budgeting:
 When NPV > 0  Take the project
 When NPV < 0  Reject the project
 When NPVA > NPVB > 0  If budget is limited, take
  Project A first.

 Key: RADR
 Different from using expected rate of return which only
  concerns about the operating risk as discount rate in the
  general NPV model, both political and credit risk should
  be adjusted for the discount rate used in the NPV model
  when making an international investment decision.
   International Investment Decision-Making
      under Political Risk and Credit Risk
 Especially for the political risk…

 Since the political risk is a non-project specific risk, from
  the definition, it seems to be systematic and unavoidable.
  However, diversification is still possible…

        Economy A
        Conclusions and Suggestions

 How to manage political risk and credit risk for the modern
  international business becomes a challenging issue.
  Rating agencies and models provide helpful information
  and methods to measure the two risks.
 From the perspective of corporations (investors), the key is
  to remember to count the negative effects of the two risks
  in when making the capital budgeting decisions.
 Especially for the political risk, it is not unavoidable.
  Diversification is still possible.
 A challenge is how to more accurately integrate the
  measures of the two risks into the capital budgeting
  decision measurement.

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