Country Risk Analysis for Foreign Direct Investment

December 30, 2022

Country Risk Analysis for Foreign Direct Investment

Country risk analysis is performed by buyers (financial and strategic) and enterprises to assess the potential risks and rewards of investing and/or conducting business in a particular country. Several factors can affect the risk of venturing into a specific country, including social, technological, economic, ecological, and political, to name five. By analyzing these forces, businesses, investors, and financial institutions can better determine the level of risk associated with conducting business or investing in a particular country and make informed entry mode decisions or whether to invest there.   Tenarries MCG thinks that the end state of globalization is open to debate. Is globalization in retreat, slowing down due to growing nationalism in several developed and developing countries, or could it accelerate and morph into a globality phenomenon? Irrespective of the end state of the globalization juggernaut, developed market multinationals will continue to embark on foreign direct investment (FDI). About 95% of global consumers live outside North America.  Several U.S. multinationals currently generate roughly 40%-50% of global sales and profit from international markets. They also venture abroad to source raw materials, manufacture products, and recruit talented management and productive employees, to name three. FDI is inherently risky, but the risk is generally elevated if the outflow is towards emerging, developing, and underdeveloped nations in Asia, Africa, LATAM, Eastern Europe, and MENAT. Consequently, it is imperative that before undertaking FDI, companies must conduct a country and business risk analysis to arrive at a go/no-go decision. There are several country risk models and approaches to country risk analysis depending on the sources of risks and the nature of the investment. While political risk is a strong influencing force in country risk assessment, in this note, TMCG is focused on the global financial environment risk measures relevant to evaluating go/no-go decisions for FDI (specifically greenfield investments). Country Risk Analysis for Investment

• Assess the external and internal environments for international investment
• Evaluate data for determining investment opportunities and risks
• Recommend “go/no go” investment initiatives

1. Global investment risk
   • The risk-sharing potential of host country businesses
   • Capital budgeting in global investment decisions
   • Credit risk
   • Managing financial risk

 

2. Foreign exchange risk exposure
   • Translation exposure
   • Transaction exposure
   • Economic exposure
   • Managing foreign exchange risk

 

3. Foreign direct investment considerations

• Legislation (rules and regulations) governing FDI
• Government FDI policies
• Decisive factors for investing in transition economies
•        a) Market size
•        b) Potential economic growth
•       c) Economic and political stability

4. Managing the cultural differences between the home and host countries

• Elements of the socio-cultural environment
• Impact of verbal and nonverbal communication on investment negotiations

5. Determinants of go/no-go initiatives

• R&D project evaluation
• Prioritization and selection
• Increasing competition
• Distributive power
• Relative risk of opportunities available to the firm

  Global Financial Environment Foreign Exchange (Forex) Risks Forex risks refer to the risks involved when different currencies are transferred physically or translated for accounting purposes. Multinational companies’ operations are affected to some degree by exchange rate fluctuations. The primary MNC decisions that are affected by forex risks include:

• Capital budgeting
• Financing decisions
• Working Capital and cashflow management decisions
• Remittance of profits and capital

  Types of Forex  Exposures  

1. Translation Exposure (Accounting)

– Accounting-based changes in consolidated financial statements caused by a change in exchange rates. – Measures potential accounting-derived changes in owners’ equity that result from the need to TRANSLATE foreign currency financial statements of affiliates into a single reporting currency to prepare worldwide consolidated financial statements.

2. Transaction Exposure

– Impact of settling outstanding obligation entered before a change in exchange rates but to be settled after the change in exchange rates. – Measure changes in the value of the outstanding financial obligations INCURRED before a change in exchange rates but NOT DUE to be settled until AFTER the rate change – Transaction exposure deals with cash flow changes resulting from existing contractual obligations.   Causes of Transaction Exposure Transaction exposure measures gains and losses arising from settling financial obligations whose terms are stated in a foreign currency. Transaction exposure arises from:

1. purchasing or selling on credit goods and services whose prices are stated in foreign currencies (i.e. A/R and A/P)
2. borrowing or lending funds when repayment is to be made in a foreign currency
3. being a party to unperformed foreign exchange forward contract; and
4. otherwise acquiring assets or incurring liabilities denominated in foreign currencies.

 

3. Economic Exposure (Operating)

– Changes in expected cash flows arising because of an unexpected change in exchange rates – Measures the change in the firm’s present value that results from changes in future operating cashflows caused by unexpected exchange rate changes. – The change in value depends on the effect of the exchange rate change on future sales volume, prices, and costs.   HEDGING Currency hedging reduces the risks related to a foreign currency position due to conducting business in a foreign market. Generally, hedging involves creating an offsetting position in a currency, either a long position to reduce a short position or short position to reduce a long one. For example, if a German firm exports machine tools to a British company and accepts a six-month note for 2 million British pounds, it has a long-pound exposure. The firm can reduce this risk exposure by creating a short position in pounds by selling the pounds in the forward or futures market or borrowing pounds. Suppose the original export transaction is denominated in Euros so that the British firm has a short Euros exposure. In that case, the British firm can hedge by either buying Euros forward or investing Euros to offset long positions in Euros.   Hedging can reduce or eliminate risk, but this comes at a cost:

• Transaction costs
• Managerial time
• Reduction in average cashflow

If price forecasts can be made ACCURATELY, selective hedging can be more profitable than ALWAYS hedging. A firm that practices selective hedging will reduce its currency risk through hedging except when the opportunity to profit from the currency exposure is attractive.