THE ROLE OF CORRUPTION Corrupt practices by government officials have long reduced economic

THE ROLE OF CORRUPTION Corrupt practices by government officials have long reduced economic

growth. Payment of money or gifts in order to receive a government service or benefit is quite widespread in many countries. Research shows that there is a definite negative relationship between the level of corruption in a country and both investment and growth.

Research shows that corruption thrives in countries where govern- ment regulations create distortions between the economic outcomes that would exist with free markets and the actual outcomes. For instance,

a country where government permission is required to buy or sell foreign currency will have a thriving black market in foreign exchange where the black market exchange rate of a U.S. dollar costs much more domestic currency than the “official rate” offered by the government. This distor- tion allows government officials an opportunity for personal gain by providing access to the official rate.

Generally speaking, the more competitive a country’s markets are, the fewer the opportunities for corruption. So policies aimed at reducing corruption typically involve reducing the discretion that public officials have in granting benefits or imposing costs on others. This may include greater transparency of government practices and the introduction of merit-based competitions for government employment. Due to the sensitive political nature of the issue of corruption in a country, the IMF has only recently begun to include this issue in its advisory and lending functions. When loans from the IMF or World Bank are siphoned off by corrupt politicians, the industrial countries providing the major support for such lending are naturally concerned and pressure the international organizations to include anticorruption measures in loan conditions. In the late 1990s, both the IMF and World Bank began explicitly includ- ing anticorruption policies as part of the lending process to countries when severe corruption is ingrained in the local economy.

Direct Foreign Investment and International Lending 217

can also become nonperforming because of capital controls or exchange rate policies. In this regard, even operating subsidiary units in foreign countries may not be able to transfer funds to the parent multinational firm, if foreign exchange controls block the transfer of funds.

It is important for commercial banks and multinational firms to be able to assess the risks involved in international deals. Country risk analysis has become an important part of international business. Country risk analy- sis refers to the evaluation of the overall political and financial situation in

a country and the extent to which these conditions may affect the coun- try’s ability to repay its debts. In determining the degree of risk associated with a particular country, we should consider both qualitative and quanti- tative factors. The qualitative factors include the political stability of the country. Certain key features may indicate political uncertainty:

1. Splits between different language, ethnic, and religious groups that threaten to undermine stability.

2. Extreme nationalism and aversion to foreigners that may lead to preferen-

tial treatment of local interests and nationalization of foreign holdings.

3. Unfavorable social conditions, including extremes of wealth.

4. Conflicts in society evidenced by frequency of demonstrations, violence, and guerrilla war.

5. The strength and organization of radical groups. Besides the qualitative or political factors, we also want to consider the financial factors that allow an evaluation of a country’s ability to repay its debts. Country risk analysts examine factors such as these:

1. External debt. Specifically, this is the debt owed to foreigners as a fraction of GDP or foreign exchange earnings. If a country’s debts appear to be relatively large, then the country may have future repayment problems.

2. International reserve holdings. These reserves indicate the ability of a country to meet its short-term international trade needs should its export earnings fall. The ratio of international reserves to imports is used to rank countries according to their liquidity.

3. Exports. Exports are looked at in terms of the foreign exchange earned as well as the diversity of the products exported. Countries that

218 International Money and Finance

Although no method of assessing country risk is foolproof, by evaluat- ing and comparing countries on the basis of some structured approach, international lenders have a base on which they can build subjective evaluations of whether to extend credit to a particular country.

Recognizing the desire of investors to have reliable information about country risk, BlackRock Investment Institute launched a new ranking of country risk in 2011. This ranking ranks countries according to the likelihood of debt default, devaluation of the currency or above-trend deflation. Foreign investors would not only be concerned about a country defaulting on the debt, but would also be concerned about a sharp loss of the foreign currency value by a high inflation or devaluation of the currency.

There are four components to the index: • Fiscal Space, with a 40% weight, examines several macroeconomic factors that could lead to a debt path that is unsustainable. • External Finance Position, with a 20% weight, examines the vulnerabil- ity of a country to external shocks. • Willingness to Pay, with a 30% weight, measures how a country’s insti- tutions can handle debt payment. • Financial Sector Health, with a 10% weight, measures the risk exposure

that the private sector banks impose on the country’s financial health. Figure 11.4 shows the results of the June 2011 ranking of country

risk.

2.0 x score

1.0 isk inde 0.0 vereign r

k so –1.0 kRoc Blac –2.0

Direct Foreign Investment and International Lending 219

The Scandinavian countries are ranked very high in the index. Norway leads the index, with Sweden, Finland and Denmark also in the top ten. Norway has extremely low levels of debt, and has strong institu- tions backing the country. On the other extreme are Greece and Portugal, who are having serious debt problems already. Most of the bottom ten countries are European countries that are struggling with high debt problems. The U.S. is about in the middle of the 44 ranked countries.