Lecture V

Country Risk Assessment Methodologies: the Qualitative, Structural Approach to Country Risk

–The Welfare and Social Dimension and the Macroeconomic Fundamentals -

“Risk management is not a program but an ongoing process that must be developed over time. Our models are constantly reviewed and improved. On the whole, they have proven their worth. But good risk management isn't just about mathematical models and systems – it also requires an understanding of the market, intuition and the ability to weigh up what proportions of risk are healthy. In that respect, the abbreviation CS in my opinion doesn't just stand for Credit Suisse, but also for common sense, which plays a key role in risk management.”

Hans-Ulrich DoerigChairman of the

Board of Directors of Credit Suisse

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.

Inequality

Inequality

The richest 10% of the population in a European nation may receive 20.1% of national income, as they do in Sweden, or 27.3%, as they do in the UK and Ireland.

USA (2005):The top 10 percent of the population carried away some 48.5 percent of all reported income in the US in 2005—also the highest percentage since 1928, on the eve of the Depression—an increase of 2 percent from 2004, and up from 33 percent of the reported total in the late 1970s.

Poverty VS Inequality

Multi-dimensional concepts: income, wealth, assets, opportunities;

Poverty people below the poverty line;

Inequality whole population.

We will focus on INCOME as an indicator for inequality.

Inequality: definition

DEF: “Distribution of income and wealth among different groups in the society and it concern variation in living standards and in wealth itself across a whole population.”

Why inequality matters? Philosophical and ethical reasons; Functional level

Three Concepts of Inequality

Concept 1: Unweighted inter-national inequality Unit of observation: country; Measure: income per capita; within country distribution is equal; country size doesn’t matter; converging issues.

Concept 2: Weighted inter-national inequality The same features as the previous one but COUNTRY

SIZE matters;

Concept 3: True world inequality Unit of observation: individual (no matter the country

of origin); Our benchmark!

Measurement Issues

Which currency unit? Convert local currency into dollar;

International purchasing power Purchasing Power Parity exchange rate

This purchasing power rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods.

Measurement Issues

Survey based mean income from survey or GDP per capita? Mean income from survey ≠ GDP per

capita: Key factors: taxes and consumption; Gap is bigger in developed countries.

Concept 1 and 2 GDP per capita Concept 3 distribution of income

across individuals

Measurement Issues

Income or Expenditure? Expenditure actual living standards; Income potential living standards

Per Capita or Equivalent Adult? World income distribution per-capita

basis Equivalent adult: more complex, more

precise but difficult comparison across countries.

Measurement Indicator (1) Variation of income distribution (among nations or among individuals):

Concept 1 & 2: refers to the average world income (weighted or non weighted); N refers to the number of countries.

Concept 3: refers to the average income from the survey; N refers to the number of people in the world.

Within a country: refers to the average income from the survey, based in the

population of ONE country;

2

1

)(1

n

ii yy

NV

y

y

y

Problem with V:If I double everyone’s income V would

quadrupleIf country i is richer than country j

inequality is higher in j Solution standardize V:

y

Vc

Measurement Indicator (2)

Measurement Indicator (3)

Lorenz Curve: The greater the inequality, the further the

Lorenz curve will be from the 45° line.

Gini Coefficient: It’s the area between the Lorenz curve and the

45°line; Range [0,1]; the greater the inequality, the bigger the area,

the greater the Gini coefficient.

Wealthiest 10% share of national income (%).

Trend in Inequality: Concept 1 VS Concept 2

Trend in Inequality: Concept 1

Why 1952? First Year China’s data are available; Sharp increase in C1 after 1980s (i.e.

divergence): Lost decade in Latin America; Decline in income in Eastern Europe and former

Soviet Union; Disastrous economic performance of many African

Countries; Good economic performance of rich countries.

Since 2001: ↓ divergence! High economic growth rate!

African Countries > 4%; Post-Communist countries > 6%; Latin America ≈ 3%

BUT level of Inequality is much higher today than in 1960s!

Trend in Inequality: Concept 2

Higher level of Inequality if we account for country’s size!

Decreasing trend mainly driven by China’s economic growth (late 1980s);

BUT after 2000 the decline take place even without China! Mainly due to India great performance!

Trend in Inequality: Concept 3

Trend in Inequality: Concept 3

Trend in Inequality: Concept 3

Inequality has increased between 1988 and 2002;

Why? Increasing GAP between rich countries

and large rural countries in Asia (Bangladesh, rural India, rural China)

Rural china VS Urban china Decline in income in Eastern Europe

Inequality and Poverty

Small change in income distribution can have a large effect on poverty: If the income of the poorest 20% of

population increases from 6 to 6.25% it represents an increase of 4% in their total income it has the same effect on poverty as doubling the annual growth of GDP from 4% to 8%

Inequality, Poverty and Growth High Inequality may have a dampening effect on

growth:

Political Reasons: lobbies inefficiency;

Demand Mechanism: low demand for domestic products and high imports

Human capital: lower investment in HC and less positive externalities;

Conflict Mechanism

✔ Social Discontent and Uncertainty Lower Investment Higher Social rRisk = higher country risk!higher country risk!

CRA and Social/Welfare Indicators

To decrease the Country Risk Level a country should: Boost Development; Favour Gender Equality and

Empowerment; Control Demographic Trend; Reduce Poverty; Reduce Inequality.

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 and internal indebtedness

evolution, structure and burden; Domestic financial system situation; Assessments of the governance and

transparency issues; Evaluation of the political stability.

Macroeconomic Structures of Growth

Country’s main challenge = capacity to preserve sustainable growth!

Excessive growth (of spending, debt, money supply, GDP, investment, domestic credit) is NOT POSITIVE because it creates bubbles and costly imbalances!

Macroeconomic Structures of Growth: GDP def

GDP combines in a single figure, and with no double counting, all the output (or production) carried out by all the firms, non-profit institutions, government bodies and households in a given country during a given period, regardless of the type of goods and services produced, provided that the production takes place within the country’s economic territory.

It’s calculated quarterly or annualy or monthly.

Macroeconomic Structures of Growth (2)

Macroeconomic Structures of Growth (3)

Macroeconomic Structures of Growth (4)

Macroeconomic Structures of Growth (5)

Growth is the product of: Capital accumulation:

Physical (land and infrastructure); Human (education, incentives); Institutional;

Factor Productivity technology! ( Growth Theory? The Solow Model!)

Globalisation (Trade and capital inflow); Good governance; Solid macroeconomic environment.

References

Bouchet, Clark and Groslambert (2003): “Country Risk Assessment”, Wiley finance (Chapter 4).

Human Development Report –UNDP web site-

Milanovic, B. (2009): “Global Inequality Recalculated: the effect of new 2005 PPP estimates on global inequality”, World Bank.

Grusky, D.B and Kanbur, R. (2000): “Poverty and Inequality”, Stanford University Press, Stanford, California.

Miles, D. and Scott, A. (2005): “Macroeconomics : understanding the wealth of nations” Chichester; Wiley.

The Economist (2007): “Guide to Economic Indicators: Making sense of economics”. - 6th ed. - New York : Bloomberg.