Whether you are considering exporting or investing in a particular foreign market, it is essential to understand country risk. And since a variety of factors affect it, country risk can rise quickly, significantly elevating your level of exposure.

Variables Affecting Country Risk

To comprehend country risk, it is necessary to understand how political, economic and social factors impact it. Generally, political risks are assessed in terms of country stability, and are sometimes measured by the level of confidence in a government. Economic risks are reflected by levels of national growth, inflation, unemployment, balance of trade, and taxes. Social risks usually involve social unrest and violence.

But with the emergence of globalization, an event in one country can have a disastrous effect on others. Consequently, country risk must be viewed in a much broader context. In addition to commercial risk, which considers the credit strength of the buyer and the credibility of his/her bank, and operational risks, which involve the documentation and customs process, nontraditional risks that don’t fit into simple categories also need to be reviewed and evaluated.

For example, if your target market becomes a member of a powerful trade bloc, your customer may decide to source your product from member countries that are subject to fewer or no trade barriers.

Risks Associated with “Hot Money”

Developing countries tend to have a higher level of risk than developed countries. For example, a change in leadership is often a time of instability. Should social turmoil envelop a nation, the disruption of activities could put your foreign buyer’s business at risk. And, a new government may impose economic policy that could prevent you from being paid for goods shipped.

A new type of risk not experienced in past decades is portfolio investment, which tends to be short-term investment. Also known as “hot money,” portfolio investment is driven by market forces and seeks the greatest returns. As such, its flows often surge, then dip, partly based on perceptions of future growth and stability. As a result, it has wreaked havoc on some developing country economies and political structures.

And rapid outflows of hot money from developing countries — as witnessed with the Mexican peso, Asian and Russian crises of the 1990s — often put downward pressure on countries’ currencies, creating even more political instability and unrest.

Currency Devaluation Risks

If your buyer’s currency is devalued by half its value and you are collecting in U.S. dollars, it will take twice as much of your buyer’s currency to pay you. This could put an enormous financial strain on your customer’s business. On the other hand, if you are collecting payment in the foreign currency, you’ll receive half of what you expected once converted into dollars. In either situation, this could put you in a very difficult position.

What Promotes Currency Volatility?

Factors affecting currency shifts are complex and are contingent on seemingly independent activities, rhetoric and highly fluid capital shifts, in addition to macroeconomic forces. As a result, predicting whether a currency will increase or decrease in value is extremely risky. In fact, rarely is an economist, trader or investor able to foresee the chain reaction or identify the complex factors that lead to currency devaluations.

For example, on December 20, 1994, an attempted currency adjustment by the Mexican government accelerated out of control. Within two days pressures mounted; currency reserves used to prop up the peso quickly dwindled, and the peso was allowed to float freely. Shortly thereafter, it nose-dived. Like falling dominoes, what began as a short-term liquidity crisis turned into a full panic. The Mexican economy fell into a recession, which significantly raised its level of country risk.

The Mexican fallout quickly spread to Brazil and Argentina, whose economies also dipped. U.S. exporters received what some refer to as a “wake-up call,” reminding them that political and economic instability in developing countries can largely affect importers’ ability to pay for goods shipped.

The Asian Financial Crisis

From 1997 through 1999, country risk in East Asia was high. With front page news of plunging currencies — beginning with the Thai baht and quickly affecting the Malaysian ringgit, the Indonesian rupiah and the Korean won — it is easy to understand the damage caused by currency fluctuations. Not only did the domino effect put pressure on traditionally strong currencies, but it also resulted in banking and financial crises, as well as economic recession in several countries.

More Recent Concerns

Today, Argentina’s and Brazil’s economies are again undergoing a severe economic challenge. As a result, the Argentine peso, which was tied to the U.S. dollar, was allowed to float freely and precipitously lost value. And with Brazilian presidential elections in October 2002, fear that Luiz Inacio “Lula” da Silva, the founding leader of the Brazilian Workers’ Party, may win the election, has caused foreign investors to pull money out of Brazil.

In an effort to stem the tide, Lula has softened the left-of-center message from his three previous presidential campaigns. If elected, he says he will fight inflation and not reverse privatization reforms. Many investors remain unconvinced.

Developed Nations Are at Risk Too

During the 1990s, foreign investment flowed into the United States at an unprecedented pace. The longest U.S. peacetime expansion on record, strong productivity gains and a stock market with exceptional returns attracted capital from all corners of the globe. Additionally, after the Asian crisis and uncertainty over the stability of the euro, investment looking for a safe haven poured into the U.S. These factors largely contributed to the rise in the dollar’s value.

But the rising U.S. current account deficit (which is the largest of any nation), less inbound investment from abroad, a volatile American stock market, and a decline in U.S. confidence were signs that the dollar likely would fall — and it did. From February through July 2002, the value of the U.S. dollar decreased 9% against major currencies. By August, it climbed 1.9%, likely indicating only a pause in its downward trend.

Although the overall decline is welcomed by U.S. exporters, whose products are now less expensive and more competitive abroad, an accelerated depreciation in the dollar could spell many problems for the U.S. economy, raising the United States’ level of country risk.

Continually Monitor Events

Evidence indicates that numerous, uncontrollable factors can increase country risk for both developing and developed countries. Consequently, it is essential to closely monitor a multitude of factors in your target markets. But since currency volatility — which is often precipitated by the flow of hot money — can be especially damaging, it is necessary to successfully manage your foreign currency exposure.

Country risk is extremely high these days. But with today’s sophisticated financial instruments and hedging strategies, the risks are manageable. And successfully managing these risks will allow you to expand internationally, generate greater wealth, and create more jobs.

This article appeared in Impact Analysis, September 2002.

John Manzella
About The Author John Manzella [Full Bio]
John Manzella, founder of the ManzellaReport.com, is a world-recognized speaker, author and an international columnist on global business, trade policy, labor, and economic trends. His latest book is Global America: Understanding Global and Economic Trends and How To Ensure Competitiveness.

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