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Lecture VI

Lecture VI. Country Risk Assessment Methodologies: the Qualitative , Structural Approach to Country Risk - The Macroeconomic Fundamentals -. The Qualitative Approach. A robust qualitative approach leads to comprehensive country risk report that tackle the following six elements:

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Lecture VI

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  1. Lecture VI Country Risk Assessment Methodologies: the Qualitative, Structural Approach to Country Risk - The Macroeconomic Fundamentals -

  2. The Qualitative Approach • A robust qualitative approach leads to comprehensive country risk report that tackle the following six elements: • Social and welfare dimension of the development strategy; • Macroeconomic fundamentals; • External indebtedness evolution, structure and burden; • Domestic financial system situation; • Assessments of the governance and transparency issues; • Evaluation of the political stability.

  3. Global GDP Contraction

  4. Country-Specific Economic risk • Macroeconomic Risks: • Inflation and Hyperinflation; • Exchange rate; • Terms of Trade; • Debt Service.

  5. GDP in value and in volume

  6. The Inflation Rate • Inflation = increase in the general level of prices; • How to measure inflation? • Consumer Price Index; • Producer’s input and output prices Index; • GDP deflator. • Causes of Inflation: • Demand Pull  the Economic Cycle! • Supply Shocks; • OPEC I (1970s)  oil prices from 3$ a barrel to 11.65$; • OPEC II (1980s)  over 36$ a barrel; • Nowdays.

  7. The Inflation Rate (2)

  8. The Inflation Rate (3)

  9. The Cost of Inflation • Real Interest Rate; • Inflation tax; • Menu costs; • Relative Price VS General Price Level  ↓ Economic Efficiency; • Volatitlity of Inflation: • Reduces investment; • Income Redistribution. • Nominal Illusion.

  10. Deflation • DEF: Decrease in the general level of prices  Japan since 1999 • The Cost of Deflation: • Effect on Real Interest Rate, Savings and Investment; • Effect on the real burden of debt.

  11. Hyperinflation • Inflation is running at more than 50% at month; • CAUSE: large fiscal deficit that, without tax or bond issues, led govs to finance their activities through the inflation tax and by printing money. • Unless the gov reforms its fiscal position it has to print money and create inflation. • It has origin in fiscal policy (government’s decision about spending and taxation) and not monetary policy (gov’s decision for investing and loaning money);

  12. Hyperinflation (2) • WHERE: Latin America and Central East Europe (1920s and 1914-1918); • Government issues to finance the debt: • Hungary = 48%; • Poland = 62%; • Germany = 88%. • End of Hyperfinflation when: • New currency issue; • Fiscal reform; • Return to fiscal surplus; • Establishment of an indipendent central bank  ignore the demand of the fiscal authority!

  13. The Qualitative Approach • Country-Specific Economic risk • Macroeconomic Risks: • Inflation and Hyperinflation; • Exchange rate; • Terms of Trade; • Debt Service.

  14. Exchange Rate • Types of Exch rates: • Bilateral and effective Exch rate • Nominal VS real Exch rate. • Nominal Exchange rate determinats: • CIP • UIP • Risk Adverse Investor • Currency Crisis and the Exchange Rate System

  15. Exchange Rate: different Types • BILATERAL: rate at which you can swap the money of one country for that of another: • Indirect Approach: how many yen (amount foreign currency) to get 1$ (unit of local currency); • Example: yen*/dollar = 93.01 yen • Devaluation if we need less yen to buy 1$  the value of the ER decreases; • Appreciation if we need more yen to buy 1$  the value of the ER increases;

  16. Exchange Rate: different Types (2) • Direct Approach: how many dollar (amount local currency) to get 1 yen (unit of foreign currency)! • Example: dollar/yen*=0.0107 $; • Devaluation if we need more dollar to buy 1yen  the value of the ER increase; • Appreciation if we need less dollar to buy 1yen  the value of the ER decreases. • We would follow the INDIRECT APPROACH!

  17. Exchange Rate: different Types (3) • EFFECTIVE: measure the average appreciation/depreciation of a currency in comparison to different countries! • Trade weighted basis (see charts pag 498); • EX: Jap yen appreciate by 1% against the $ and 1% againt the Thai Baht and remain unchanged versus other currency = increase in the yen EER; • Usually expressed using an index = 100.

  18. Exchange Rate: different Types (4) • NOMINAL ER: rate at which you can swap two currencies (as above); • REAL ER: how expensive commodities are in different countries and reflect the competitiveness of a country’s export.

  19. Exchange Rate: different Types (5) • Example: • Cup of coffee = 200 yen in JPN and 1$ in USA; • Nominal Exchange rate = 100 yen per $ (Yen/$); • BUT real exchange rate = 0.5  you can only buy half as much with your money in Japan as you can in the US; • Yen-US dollar RER is low! Goods in the US are cheaper than in Japan!

  20. Exchange Rate: different Types (6) • RER is based on a basket of commodities and not just 1!!! RER=NER * domestic price level overseas price level; Example: - 1$ in US buy the same amount of goods as 3 pesos in Argentina; - NER: 3 pesos/$ • RER = 3 * 1US$/3pesos = 1 If price increases in Argentina (1$ in US buy the same amount of goods as 5 pesos in Argentina): • RER = 3 * 1US$/5pesos = 0.6 • i.e with 1$ in Argentina you can buy only the 60% of goods that you could buy in US.

  21. Nominal Exchange rates Determinants • Converted Interest Parity: • Value of foreign investment (yen) in local currency (dollar) at the end of the period: Yen(1+r*)(F(0)/S(0)) • S(0) = spot exchange rate (current exchange rate); • F(0) = forward exchange rate (exchange rate in the future)  forward exchange rate is prefectly forecast in the CIP;

  22. Nominal Exchange rates Determinants (2) • Equilibrium (i.e the investor is indifferent between yen and dollar investment): • Yen(1+r*)(F(0)/S(0)) = $(1+r) • If we put F(0)/S(0) = 1+ fp • Where fp is the forward premium (proportion by which a country’s gorward exchange rate exceeds its spot rate) we get: • (1+iJPN)(1+fp) = (1 + iUSA) • = iJPN - iUSA = fp • OR iJPN +fp = iUS i.e. as a result of arbritage, the return on the dollar investment will equal the return on the yen investment when evaluated using the forward rate!

  23. Nominal Exchange rates Determinants (3) • Uncovered Interest Parity: • The investor takes a risk because he doesn’t cover his position by a forward transition F(0) = Se(1); • Expected Appreciation of the dollar = interest rate gap; • [Se(1) – S(0)]/S(0)=iJPN- iUS • What drives the Exhange rate? • Change in the overseas interest rate; • Change in the domestic interest rate; • Change in expectation of the dollar.

  24. Nominal Exchange rates Determinants (4) • Risk Adverse investor: • Premium at risk; • US return = iUS+expected dollar apprec = ijpn+ risk premium • Change in the risk premium would impact on the NER!

  25. Reference • Bouchet, Clark and Groslambert (2003): “Country Risk Assessment”, Wiley finance (Chapter 4). • Colombo, E. and Lossani, M. (2009): “Economia dei Mercati Emergenti”, Carocci Editore. • Miles, D. and Schott, A. (2005): “Macroeconomics. Understanding the Wealth of Nations”, eds. Wiley (Chapter 11,19, 20). • The Economist (2009): “Guide to Economic Indicators. Making Sense of Economics”, eds. The Economist.

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