Expert Commentary

Anticipating Country Risk

To those who may think the world has become both more dangerous and more complicated—you are right. The financial crisis 5 years ago serves to emphasize how much more interconnected countries, companies, and consumers are. The political changes that have accompanied the crisis and lingering impact of the Arab Awakening are daily reminders that political change can be unforeseen and unpredictable, while its impact can be both long-term and potentially devastating to a business.


Political Risk
June 2014

Making matters worse, much of the impact of economic and political change is completely outside a risk manager's control. It has always been the case that expropriations, currency restrictions, acts of political violence, and embargos can arise at any time, but, given recent history, businesses must now also anticipate not only when such incidents may arise but how many at one time.

Rarely in the 25 years since communism collapsed has the world been such a perilous place for risk managers. The plethora of political and economic upheaval—particularly since 2008—has made the need for anticipatory risk management essential, yet few small and medium-sized companies have the resources necessary to be able to address the problem. What follows are some guidelines for how to stay on top of country risk when trading or investing abroad in today's evolving landscape.

A Sound Cross-Border Risk Management Platform

To the extent that international companies devote any resources at all to understanding cross-border trade and investment climates (and, in my experience, most do not), they tend to over-rely on externally generated country risk analyses, which are more often than not produced generically and are not entirely appropriate for specific transactions. This is perhaps the most common mistake risk managers make. They believe that, because they may have some recent information about the general political and economic profile of a country, they have a true handle on the nature of the risks associated with doing business there.

What about gauging legal and regulatory risk, the country's friendliness toward foreign trade and investment, and other companies' experience there? Too often, companies get caught in an "investment trap": they commit long-term resources to a country only to find that the bill of goods they were sold—or thought they understood—turned out to be something completely different.

There are plenty of stories out there about companies whose investments turned into disaster because the regulatory environment changed, a legal issue arose, international sanctions affected their ability to operate, or they selected the wrong joint venture partner. After the investment has been made, it is often too late to pull out without incurring large losses and experiencing reputational risk once the story hits the press.

A sound cross-border-oriented risk management process will include certain basic elements that result in the creation of an environment conducive to effectively managing risk:

  • Adequate risk management policies and procedures
  • An accurate system for reporting country exposures
  • An effective process for analyzing country risk
  • A country risk rating system
  • Established country exposure limits
  • Regular monitoring of country conditions
  • Periodic stress testing of foreign exposures
  • Adequate internal controls and an audit function
  • Effective oversight by a well-informed board of directors

Regardless of the extent to which your organization can fully comply with this "ideal" checklist, given limited resources, it is important to establish clear tolerance limits, delineate clear lines of responsibility and accountability for decisions made, and identify in advance desirable and undesirable types of business. Policies, standards, and practices should be clearly communicated and enforced with affected staff and offices. Quarterly reporting should be imposed—more frequently if foreign exchange exposure impacts a given investment.

It is naturally also important that analyses be adequately documented and conclusions communicated in a way that gives decision-makers an accurate basis on which to gauge exposure levels and that sufficient resources be devoted to the task of assessing risk. Since the crisis, some banks have centralized the analytical process and engage in periodic assessments of risk on a more regionalized basis (as opposed to strictly on a country-specific basis).

Best Practices

Best practices dictate that a number of actions should be taken to create a transactional risk management program. Among them:

  • The risk management function should be centralized.
  • Risk guidelines should be established and widely disseminated.
  • Country/sector limits should be established.
  • A system to better delineate the severity of perceived risks should be established.
  • Quarterly transactional risk reporting should be implemented.
  • Maximal use should be made of internal information capabilities while incorporating a wide array of external information sources into analyses.

The ability to obtain primary knowledge through inputs from local offices, as well as by regular visits on the part of country risk officers, cannot be overemphasized. Best practices should encourage in-house assessments before relying on external sources of information in order to build internal rating applications.

In most organizations, the country risk function operates autonomously, as there tends to be diverging interests between the operating side of the business and risk management. It is therefore important for senior management to effectively oversee interaction between the two sides. The risk assessment decision chain should be transparent and independent of compromise by business unit practices.

Another common issue is that the lines of communication among risk management personnel, between risk management and decision-makers, or among decision-makers is bypassed, convoluted, or just plain wrong. I have seen instances where:

  • Risk management is given only cursory participation in the transaction approval process.
  • Sales teams bypass risk management entirely, or ignore risk management's recommendations, because they fear a transaction will be canceled as a result of unacceptably high levels of risk.
  • A CEO delivers a presentation to a board of directors that is false, but he believes it to be true, because the risk manager's staff said it was.

A risk manager may have the right information, but it is based on a short-term assessment of the risks. The long-term view may be completely different. In the absence of knowing what questions to ask and having clear lines of communication, the right information may not be taken into consideration.

A board of directors often has no idea what questions they should be asking of corporate decision-makers. Executive education on the subject of country risk can be invaluable to decision-makers up and down the chain and could save an organization millions of dollars by having a better ability to avoid costly mistakes.

Staying Ahead of the Curve

Much of what determines whether a country risk manager can do a good job will ultimately be outside his or her control. No one, no matter how experienced, can know or anticipate precisely where a country is heading all the time. All we can do is make educated guesses based on what history teaches us and what we have learned in the process. That said, to be effective, a country risk manager must have the tools necessary to do the job and have the backing of senior management to both integrate the country risk function into the decision-making process and take that process seriously. Whether that occurs may also be outside the risk manager's control.

In the end, the ability to anticipate what the future will bring using a combination of knowledge, insight, and a healthy sixth sense can make all the difference. Listening to your gut and sense of smell are, in the end, as important as all the other tools at one's disposal. A good risk manager knows when to listen to it.

 


Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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