Sovereign risk is a subset of credit risk investors, financial institutions, and corporations incur when doing transnational or cross border business. In our increasingly global world, sovereign risk is becoming more prevalent for companies, banks and individuals. Therefore, what are the different financial risks one incurs when we go outside our country and do business in another? Foreign Exchange Controls We discussed recently what causes currencies to go up and down and how one can lose money in foreign exchange markets. However, we didn’t discuss how taking money out of one country and investing it in another can cause additional risks beyond the movement of the currency. For a start, in many countries you need local government permission to bring foreign currency in and out of a country. Therefore, a US multinational who wants to build a factory in China needs to get permission from the Chinese government to bring in for example$10 million dollars to build a factory. If after ten years of operating the factory, it wants to sell it to another company (either Chinese or foreign), it may receive the equivalent of $10 million in local currency, but be told it cannot take the money out. In some countries’ cases, it may be able to take the money out, but at a very disadvantaged exchange rate – ie a non-market rate set by the government which may result in a significant loss. Basically, in some countries that have strict exchange rate controls, you are at the mercy of government investment and foreign exchange policies which could mean that you may be able to bring money in easily, but have great difficulty taking money out. Now, if let’s say, you retire to Costa Rica and you have no intent in taking money out of the country, buy a house, and live happily after, you have in essence avoided the risk because the intention was to stay local. For companies that have a long term view, say in China, they may be willing to invest knowing full well that it may be very difficult to get out dollars in the next few years. However, their view of the Chinese market is very long term and they expect to be reinvesting profits so as to continue to build their China business. Hence they may have a 50 year or longer perspective and not care about what the current laws are. Instability, Leadership Change and Expropriation A company can research the laws of the country to find out that it is perfectly permissible to come in with foreign currency, purchase local currency, make a fast buck and then take the currency out. However, if the country has a history of instability, the company may find that the laws change and that its investment is not grandfathered (i.e. a law at time of investment applies, not the new law). The law may change because the country is having serious economic troubles and the government is essentially bankrupt in terms of its foreign currency position. This means that the country has been importing (depleting its foreign currency by purchasing imports from foreign countries) much more than it is exporting (generating foreign currency by selling locally made goods to foreigners). Therefore, even if the company is making goods that it actually exports and brings in foreign currency from these goods, the country as a whole does not generate enough net foreign currency to allow the exporter here to have foreign currency to take out of the country. In other words, when the company asks to sell its local investment and take all of its profits to repatriate back to its own country, the government says: “sorry but we can’t give you any currency” so you will just have to wait (which could be years!). The other approach a government may take is to offers the company a US dollar bond (i.o.u.) which is in face value for the amount of the money that the company wants to take out. However, given the countries economic predicaments, its risk is considered very high. Hence, its foreign currency bonds require a very high premium for foreigners to purchase. Unfortunately, the interest rate the country actually offers the company is so low that when the company tries to sell the bond to someone else, the market price (steep discount) is very low (I have seen 30% of face value). In either case, the company has a problem which at its center is sovereign risk. In extreme cases such as Iran, Venezuela and Bolivia, we have seen government simply seize foreign assets from foreign investors. The leaders of these countries typically argue that the investments were done under previous governments and done at terms that were disadvantageous to the people of the country (they often may have a point!). Hence, the investors find that their property, plant and equipment are all seized from them (oil companies are among the most common victims of expropriation). Debt Repudiation versus Debt Rescheduling Foreign countries often borrow money from banks in other foreign countries including the US. They may also receive loans directly from governments or international organizations. These are foreign currency debts which they need to repay in foreign currencies (typically dollars, euro and yen). Governments typically borrow these monies to invest in infrastructure and to help balance their import and export bills/receipts. However, if they borrow too much and cannot repay, their lenders have a very different situation than what they usually encounter when a borrower cannot repay. You simply cannot easily take a foreign government to court. Imagine sending an arrest warrant to the leader of Iran and telling him he has to show up in court on Wednesday; or telling a country that they must pay their $20 billion in debt or else we will seize your oil fields? You can send all the pieces of paper you like. Unless, however, you actually use force (we call that war!), you are not going to succeed in dragging a foreign country into your domestic court system. In other words, there is the universal concept of sovereign immunity. We cannot say that what a country or a country’s people do in their country is illegal because it is illegal in our country. It is for each country to determine the legality of what it does within its own borders. The issue here is that we don’t want foreign countries interfering with our judicial process. Hence we shouldn’t do that to them either. Therefore, if a country decides not to repay its debts, private companies and other sovereign states have limited recourse. They can try to go to the country itself and use their judicial system to force repayment – not easy in countries where dictators control the judicial system. You can also try to win judgments in your own court system. However, once you win how do you enforce the judgment? It is the difficulty of enforceability that creates the challenge. As suggested before one way is to go to war which would be viewed as a barbaric approach for most of the cases that we have encountered. In other words, it would have been absurd for the United States to have invaded Mexico when Mexico refused to repay tens of billions of dollars in debt in the early 1980’s. The costs would have been enormous with what benefits? Mexico couldn’t pay because they had mismanaged their economy. War would have cost the US a fortune (look at the costs in Iraq and Afghanistan) and would have just ruined further ruined Mexican economy. Fortunately, our policy makers generally have a strong moral code so as to not even consider such a reprehensible strategy. So in a sense we are somewhat at the mercy of the sovereign state in terms of whether or not they decide to stop paying their debt or only repay what they want to repay. The former we call debt repudiation – refusal to pay while the latter we call debt rescheduling. It is very rare that a country chooses simply to repudiate its debts since such an action effectively cuts off their future access to credit. It also may cut off trade with other countries and create even worse economic problems for the country. Therefore, there is a natural incentive for most indebted countries to try and negotiate a fair settlement with its lenders and trading partners. Like a judge in a Chapter 11 bankruptcy, negotiators will look to come up with what they feel is a reasonable amount that a country can repay and then have the remaining portion forgiven. This may mean that debts that are past due and/or are owed in the short to medium term may get rescheduled over a much longer time period e.g. 30 years. Typically, such negotiations involve changes in the debtor country’s behavior which means that the citizens of the country may suffer further economic hardships. For example, governments in poor countries may offer food subsidies to their citizens which allow those citizens to buy food at below market prices. However, such subsidies can create economic distortions – for example in Egypt years ago a loaf of bread cost about US$0.02. As a result of such subsidies, farmers started buying bread to feed their animals instead of grain because the bread was cheaper. Wealthy people benefited unnecessarily from the subsidy too so it proved to be extremely costly. Unfortunately, removing such a subsidy can cause some people to starve. Suffice it to say that it is in the interest of both parties to come up with a workable solution. How to Evaluate a Country Much like a company, one needs to understand a country’s competences and financial means. By competence, we look at: How well does the government operate? Is it answerable to its people? Does it have an educated and skilled work force? Is the economy run efficiently? Is it in a “good neighborhood”? Is it prone to natural disasters? etc… As for the financial side, we are looking at similar issues to leverage and cash flow generation: DEBT SERVICE RATIO: Interest plus principal due on debts/Exports i.e. is the country generating enough exports to handle its foreign debts? Import Ratio: Imports/Exports i.e. does the country have the ability of reducing debt by exporting more than it imports? Investment Ratio: Real Investment/GDP i.e. is the country taking money that it earns in the economy and reinvesting in R&D and Capital projects for future wealth generation? Variance of Export Revenue (standard deviation) i.e. does the country have a stable and reliable source of export revenue or is it tied to highly volatile commodities? Domestic Money Supply Growth i.e. is the country managing inflation? The softer side of evaluating countries can be extremely complex. How can we predict whether a government can remain stable and achieve its electoral mandate? Look at Italy that has had over 50 governments since World War II. What are the underlying social and ethnic tensions in a country? The Bush administration would appear not to have really understood what the US was getting into in Iraq. What kind of government will a population elect? In Algeria, in the 1980s the people voted for a party that vowed to turn Algeria into a theocracy that would have done away with the democratic electoral process. Does democracy and capitalism equate to higher standard of living? Look at China’s economic success where there really isn’t what the West would consider a freely elected democratic government. Look at South Korea, Japan, and some of the Scandinavian countries who have been quite successful at mixing socialism with economic prosperity. Might is Right Despite all of the challenges we face in international business, there are still international laws, accords, treaties, and tribunals that can help solve many disputes. However, many in smaller countries will argue that these laws as well as resolutions by international bodies are biased in favor of the United States and Europe. They argue that the laws often represent Western values and traditions. The reason this is probably true is because many of the laws have been created in a period of history where Western powers have dominated. Therefore, when we look at trade laws the rich countries that purchase a lot of imports from poor countries and invest in these poor countries may take advantage of the poorer countries’ dependence on the trade and investment. Hence the poor countries are forced to accept laws that are less favorable to their situation. Also, when it comes to remedying disputes a rich country that decides to cut off trade from a poor country has much more power to punish the poor country than the other way around. In fact, courts in large countries can sometimes enforce judgments on smaller countries, because smaller countries need to keep assets in the large country in order to be able to do business globally. For example, a small country may purchase US treasury bonds with surplus foreign exchange from a good export season. In a dispute between a private US company and this sovereign entity the private company might be able to take the small country to a US court, win and then enforce a judgment in the US. The US court could then have the Treasury Bonds handed over to the private company. If this were a dispute between a private company from small country operating in the US and the US government, the US government would probably have no reason to hold assets in that country. Hence even if the foreign court awarded against the US, it would have no assets to seize and transfer to its private citizen.