Country Risk Assessment: A Guide to Global Investment Strategy by Michel Henry Bouchet, Ephraim Clark and Bertrand Groslambert

Country Risk Assessment: A Guide to Global Investment Strategy by Michel Henry Bouchet, Ephraim Clark and Bertrand Groslambert

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Introduction
1.1 AN HISTORICAL PERSPECTIVE
Following the numerous successes it had met with during the flotation of shares and bonds
in the capital markets, Baring Brothers was eager to underwrite a loan to be issued by the
Buenos Aires Water Supply and Drainage Company. However, the demand was not there and
this operation proved to be a failure, leaving the investment bank holding the bulk of the debt.
In the meantime, after an extended period of investment boom, the major central banks had
decided to substantially increase their discount rates. This tightening of the global liquidity
prevented Barings from refinancing at affordable cost and rapidly made its situation untenable.
The deterioration of the economic conditions in Argentina hastened an international financial
crisis and drove Barings to the verge of bankruptcy. Then, because of contagion effects, Brazil
was next on the list. Its currency as well as its stock market collapsed, causing a sharp economic
recession.
Does this story sound familiar? Well, any resemblance to an existing situation is probably
not coincidental. However, the aforementioned events do not relate one of the recent crises
experienced by many emerging markets over the last decade, but actually refer to what is
known as the 1890 Baring crisis, more than a century ago. This example illustrates one of the
many similarities that can be found when comparing the current period with the prevailing
conditions in the nineteenth century.
With the end of Bretton Woods in 1971, and more particularly since the beginning of the
1990s, the world economy has been characterized by its globalization. The fall of communism
has permitted the rise of the single American superpower, replacing the Pax Britannica of
pre-World War I with Pax Americana. The economic liberalism that started to be implemented
in the industrialized nations by Margaret Thatcher in 1979, and later on was extended to the
developing countries by the IMF’s adjustment programs, looks like the “laissez faire” policy of
the Victorian epoch. Most financial markets are now fully deregulated and capital flows freely
circulate all around the world. As a consequence, in the 1990s and for the first time since 1913,
the structure of the international capital flows was marked by the return of portfolio investments,
especially in the form of bonds and equities. Therefore, exactly like a century ago, “we enjoy
at present an undisputed right to place our money where we will, for Government makes no
attempt to twist the system into a given channel, and every borrower – native, colonial and
foreign – has an equal opportunity for satisfying his needs in London” (The Economist, 20
February 1909, in Baring Securities, 1994).
Regrettably and similarly, this also corresponds to a strong increase in the frequency of
economic crises. As stated by Krugman (2000) when comparing the current events with the
period 1945–1971: “The good old days probably weren’t better, but they were certainly calmer.”
The debt crisis of the 1980s, the Chilean collapse of 1982, the bursting of the European
Exchange Rate Mechanism (ERM) in 1992, the debacle of the Mexican peso in 1994, the
Asian disaster of 1997, the Russian default and the American bailout of LTCM in 1998,
the Argentine chaos in 2001/2002, all demonstrate an accrued volatility of the international

economic system. In the same vein, the nineteenth century was regularly shaken by financial
crashes. In the years 1836–1839, seven states of the then emerging United States defaulted. A
short time later, the railroad boom turned into a speculative bubble and eventually led to the
panic of 1857. Turkey, Egypt and Greece defaulted on their debt in 1875–1876. Australia and
Canada did the same in 1893, and were followed by Brazil and Mexico in 1914. All through
the nineteenth century, speculative mania, financial euphoria, and sharp crises accompanied
the economic take-off of the industrial revolution.
Does this mean we are left in exactly the same situation as the one prevalent in the age of
the gold standard? Probably not. However, many observers agree on the growing instability
of the economic system and believe that “the likelihood of escaping economic and financial
crises in the years ahead seems small” (Kindleberger, 2000).
Parallel to this increasing volatility, feeding on and fuelled by globalization, more and more
firms invest, trade and compete outside of their home market. Hitherto reserved for the biggest
companies, even the smallest firms have started to reason on a global basis. Thus, between 1950
and 2000, the ratio of merchandise exports to world GDP rose from less than 10% to almost
20%. This means that firms are more and more internationally exposed, and national economies
are increasingly interlinked. This economic integration translates into a higher sensitivity to
foreign events. Consequently, international trade is more and more crucial for companies and
countries alike. Furthermore, as the world political leadership is increasingly wielded by the
industrialized countries in general and by the United States in particular, there is evidence of
a backlash against these countries. In this context, their firms’ interests abroad have shown
themselves to be especially vulnerable. As the former US Ambassador Paul Bremer outlined:
“In the past 30 years, 80% of terrorist attacks against the United States have been aimed at
American businesses” (Harvard Business Review, 2002). All this demonstrates the growing
importance of a reliable risk management system based on accurate country risk assessment
methods.
Forecasting is at the core of all decision-making in the management field. Businessmen must
plan and anticipate what the future will bring. They must then make their choices based on their
analyses, taking into consideration how today’s choices are likely to affect their companies in
the future. This implies a certain amount of risk. The ability to look ahead and to take on risk is a
major determinant in the frontier between Modern and Ancient times. As Bernstein (1996) put
it, “the transformation in attitudes toward risk management has channeled the human passion
for games and wagering into economic growth, improved quality of life, and technological
progress”.
Until the Renaissance, men did not generally try to forecast the future. This was reserved
for the Gods. At best, the Gods could possibly deliver their views through an oracle such
as the Pythia at Delphi. Starting in the sixteenth century, though, a series of mathematical
discoveries enabled mankind to reconsider its position on this issue. Indeed, from this date,
Pascal, Fermat, Bernouilli, de Moivre, Laplace and Gauss, to name just a few, progressively
built what became the theory of probability. This branch of mathematics created the toolbox
to deal with the future in a rational and orderly manner. At the end of the nineteenth century,
it led to the conclusion that everything could be measured, either with a deterministic or with
a probabilistic approach. Risk was thought to be under control.
However, the twentieth century was to challenge this optimistic vision. Two world wars
and the Great Depression showed that even the unthinkable could happen. This altered the
perception of risk and caused researchers to redefine it. In the 1920s, Knight introduced the
notion of uncertainty as opposed to the notion of risk. Whereas risk can be appraised with

Country Risk Assessment: A Guide to Global Investment Strategy by Michel Henry Bouchet, Ephraim Clark and Bertrand Groslambert