2 September 2019
An article from Finance for Impact Director, Thierry Senechal, was published in the Journal of Damages in International Arbitration, Vol.5, No.2, July 2019 (ISBN: ISSN: 2327-2333).
‘A Conceptual Framework on Country Risk’ proposes to develop a conceptual framework for fulfilling the arbitrators’ and/or the parties’ goal of developing a satisfactory approach to country risk. It advocates that such an approach should be clearly principles-based, internationally consistent and converged.
Such a framework is needed to give coherence to the application of country risk and application of country risk premium when required. Thierry Senechal sought to explain options available to arbitrators and parties when deciding on the applicability of specific country risk premium. This article is written from the valuation practitioner’s perspective and not a legal one. Consequently, it does not discuss situations where the parties are legally bound to a specific approach concerning country risk, usually under constraints or prohibitions from a domestic legal system or dictated by an international treaty.
The author argues that the concept of country risk is not new or obscure. Over the past decades, the financial services or the reinsurance industries have expanded their risk management structures, building models to deal with credit risks, market risks, perorations risks, liquidity risks and more recently, country risks. The notion of country risk is now a common feature found in the valuation involving developing and emerging markets, which are typically perceived as more volatile than industrialized economies. Truly, many developing and emerging countries present a greater array of risks that are primarily of a “down-side” nature, such as currency inconvertibility, expropriation, civil unrest, and general institutional instability. Therefore, investments in these countries are generally viewed as riskier, and thus commanding a higher expected return than otherwise comparable investments made in developed markets, e.g. in USA or Europe.
While it is impossible to generalize, as risks differ from country to country and may affect businesses in myriad ways, however, evidence shows that many types of risks need to be assessed as they can significantly impact valuation. Institutional risk, for instance, should not be overlooked. This form of risk involves all of the uncertainties about how the rules of the game are likely to change. Given the recent experience of large-scale investments in Latin America or Central Europe, it is clear that these risks need to be accounted for in valuation. In many ‘frontier’ countries, the key questions are whether the overall structure of income and decision rights will remain in place, existing agreements will be honored, and the resulting claims will be enforced. Most prominent among risks are those arising from changes in inflation and the exchange rate. Of course, the extent of the investment’s exposure to such risks will depend on the terms and enforceability of the investment agreement. For instance, transfer risks can pose a serious threat to a cross-border investment if the international investor is not able to convert local currency into foreign exchange, and so be unable to make debt-service payments in foreign currency or repatriate income from the emerging market to the home country. In such a scenario, the risk normally arises from exchange rate fluctuations due to market conditions but also potentially to restrictions imposed by the government in the country in which the investment is made.
Macroeconomic risks can be disruptive as well. Ultimately, an international investment project in a developing and emerging market is a bet on the viability of the local economic conditions. Companies and cross-border investments can be negatively impacted by unfavorable economic uncertainties at the national leveleconomic instability, deficient financial markets, illiquid banking sector, distorted local supply and demand conditions, sudden changes in regulatory regimes, etc.