Country risk March 2006


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Oil producers strike it rich, but long-term issues remain

The high price of oil highlights the fact that many economies are too reliant on raw materials exports, with governments creating unfavourable conditions for foreign investment through neglect or for political reasons. Florian Neuhof looks at the main drivers behind Euromoney’s latest country risk poll.

Find out which countries remain the key focus, why there is a concern over leftward shifts in certain regions, how oil producers strike it rish, but long- term issues remain, who is a big risk factor and most importantly how each country rank.

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For historical country risk data please visit the Euromoney Country risk website

By Florian Neuhof

THE SOARING PRICE of oil is a key risk to the global economy, but it has boosted the national balance sheets of the emerging market countries that are major producers of crude.

This is reflected in Euromoney’s latest country risk rankings, which indicate that despite geopolitical problems such as terrorism the world is a less risky place than it was six months ago.

Overall, the total score has increased by 1.41% since the survey, based on the views of 47 analysts, was last published in September 2005. And it is noticeable that most of the commodity-rich countries improved their rankings. Thierry Apoteker, managing director of economic and financial risk consultancy TAC Financial, emphasizes that “structural improvements in key emerging markets are still supporting country risk measures”, but that TAC has discerned signs of an economic deceleration that will become visible in mid-2006.

Foreign investment in China is unlikely to stagnate, though, with the government undertaking initiatives to liberalize the banking sector and reform the legal system. Other emerging markets, such as those in eastern Europe, are seemingly in good health, while in the long run the reliance on commodities might prove to be dangerous for countries in Latin America and especially in Africa.

China remains the key focus

The Chinese economy is expected to continue its strong growth, which the government is facilitating with economic and financial reform measures. China has committed itself to opening up its banking sector to full-fledged competition from foreign banks. “The government is fully aware of the inefficiency of its capital markets, as it owns 65% of total market capitalization in the country,” says Saruhan Hatipoglu, director of Business Environment Risk Intelligence (Beri). As a consequence, he expects more attempts to open up the capital markets to foreign investment.

The huge volume of non-performing loans that Chinese banks have on their balance sheets, estimated at roughly $350 billion by UBS, is a further incentive for change. Hatipoglu adds: “Public officials are fully aware that foreign investment will be needed to further alleviate the problem. That is why I would not be surprised if the government allowed the Citigroup $3 billion bid for 85% of the shares in Guangdong Development Bank.” The bid was made in December last year, and since then the South China Morning Post has cited sources that claim that the deal has been approved by Chinese regulators.

This would mean a departure from the current restriction on foreign ownership of Chinese banks, capped at 20% for a single investor, and good news for foreign banks that are keen to tap into the retail banking sector, which holds $1.5 trillion of savings deposits. How China copes with fulfilling WTO accession terms in this sector will be “one to watch for investors”, says Linda Yueh of the London School of Economics, as it will be a good indicator of progress in the banking sector.

Other areas that will continue to demand attention include judicial reform and intellectual property rights, issues that have proved tricky to foreign investors in the past. A recent ruling by a Shanghai court that found Starbucks justified in its lawsuit against a domestic company that was using its logo and name. “This is a prominent sign that China will take measures to improve its image on that front as well,” says Beri’s Hatipoglu. According to Yueh, changes in the regulatory framework will be more prompt than legal reforms, making them a better indicator of short-term improvement.

China has substantial structural problems left to tackle, warns Farid Abolfathi, director of the risk centre at Global Insight. In the medium and long term, these include the “rust belt-type industries that are kept afloat with government investment and unviable loans, which produce unpopular products and contribute to the inflationary process,” he says.

Similarly, unemployment has to be tackled to preserve political stability. Yueh also believes that the legacy of the central planning system needs to be tackled by the government. The challenge lies in preserving stability while addressing uneven growth and social exclusion. “Because the Chinese government is playing a key role in the gradual transition of the economy, political instability would undermine that reform process,” he says.

Concerns over leftward shift

Latin American countries are profiting from strong demand for their natural resources. But although Brazil and Mexico have been pursuing moderate policies, some analysts are concerned about what Abolfathi calls “a new wave of popular socialism, united by anti-American sentiment”, of which Venezuelan president Hugo Chávez is only the most extreme example. Abolfathi believes that high commodity prices are masking some unsustainable economic programmes run by socialist governments.

Brazil has improved its economic policy management . . .
Robert Kelly, chairman of research company CountryWatch, argues that foreign investors are not impressed by populist rhetoric and infeasibly high taxes. “That trend looks set to go on, and will shrink the willingness to invest,” he says. Hans Belcsak, president of Rundt’s World Business Intelligence, sees a general trend away from the opening up of the markets in the 1990s to a more inward looking region that is protective of its natural resources.

There are also concerns about the economic resurgence of Argentina. Beri’s Hatipoglu warns of complacency. “Having paid off all of its IMF debt early this year and recorded three years of sustained growth, economic problems might look like they are far and distant in Argentina; however, this is not the case,” he says. High and rising inflation rates – 12.3% overall in 2005 and rising by 1.3% in January 2006 are a worry. And with the IMF now out of the picture, analysts have little faith that the administration of Néstor Kirchner will stick to policies that will foster long-term stability.

Belcsak points out that growth had come on the back of access capacity created by the crash at the beginning of the millennium. This source of growth is now exhausted. With the government engaging in the sort of rhetoric that is starting to undermine the confidence of investors in the region, Belscak is “finding it difficult to see where future investment will come from”.

In contrast to its neighbours, Brazil has improved its economic policy management, according to Apoteker. As a consequence, and because of the political moderation of the Lula government as well as the size of the market, foreign investments are still coming in. Belcsak notes, however, that falling inflation has encouraged the government to increase spending, and to consider reattaching wages and pensions to the consumer price index.

Africa fails to make best use of windfall

Oil-rich countries in Africa are profiting from high crude prices. But a failure to make use of the revenues wisely is still hampering economic development, especially in sub-Saharan Africa, where economic performance is highly dependent on commodity production. North African governments are placing more emphasis on developing infrastructure. Cyril Widdershoven, political risk and energy consultant at the Mediterranean Energy Political Risk Consultancy, points out that theses investment have been calculated on the basis of oil prices remaining high in the future. If these were to fall, state finances would run substantial deficits. Furthermore, north African countries are still relying on their “oil and gas cushion”. Widdershoven continues: “At the moment, these economies are not heading in the right direction. They need to be diversified, liberalized and privatized.”

. . . while Côte d’Ivoire has slipped dramatically amid rioting and violence
China’s insatiable appetite for energy is making itself felt in Africa. Chinese FDI has been flowing into almost all oil-producing countries. Mauritania, which only started oil production in February this year, is a recent example.

Although China’s seemingly insatiable thirst for oil is an important reason for high prices, its competitiveness is a problem for African producers, says Francis Nicollas, head of emerging countries analysis at Crédit Agricole. He mentions Morocco’s fiscal problems, a consequence of domestic oil subsidies and the inability to match China’s low prices on retail products, as an example.

As investment in the continent is primarily commodity-related FDI, and revenues are often not reinvested, neither the banking sector nor the equity markets are profiting from the money generated by commodities.

Political risk has decreased in most countries in the region, but several are still faced with political instability. Current tensions in Nigeria over the distribution of revenues from commodities have the potential to flare up into a full-blown military conflict in the Niger Delta, according to Widdershoven. In Côte d’Ivoire, described by Alex Vines, head of the Africa programme at Chatham House, as “a great success story a decade ago”, riots and violence against peacekeepers have weakened the fragile peace process in the world’s largest cocoa producer even further. Vines expects this to have an impact on the price of cocoa.

Emerging Europe’s FX risk

International investors have been pouring money into emerging Europe for most of this decade, but according to Apoteker this has led to excessive currency valuations in many countries. Therefore, he expects higher volatility in exchange rates. David Snowden, senior emerging Europe analyst at Business Monitor International, says one example is Hungary, where many mortgages are taken out in Swiss francs rather than florints, so exposing these loans to fluctuations in the exchange rate.

But current account problems that southeast European countries, such as Bulgaria, Croatia or Romania, have been facing are not a cause for concern, according to Snowden. As most countries are running a deficit, and spending is exceeding national income, both governments and banks are borrowing heavily from the international capital markets. But Snowden is not overly concerned about this imbalance. “A lot of foreign investment and remittance flows are coming into the area, and these flows will keep on coming,” he says. “The current imbalances are a symptom of growth.”

The high level of credit expansion in the region’s emerging markets could have an adverse affect on financial stability, argues another analyst who wanted to remain anonymous, as there are concerns about the quality of credit screening procedures. If exposed to an external shock to the market, there are doubts whether assets are going to perform, or whether banks have misjudged the risks.

An increasingly assertive government is set to have a negative effect on foreign investment in Russia. James McLeod-Hatch, intelligence analyst at the AKE Group, speaks of a trend towards nationalism, with the government making it more difficult for foreigners to do business in the country. As a result, there is an increased need to cooperate with Russian partners, which can raise further complications.

The government is also adopting a more authoritarian approach. “President Putin is seeking to return power to the state, and using a variety of mechanisms to this end,” says McLeod-Hatch. Apart from a crackdown on human rights, NGOs and the last vestiges of the independent media, the state is also trying to curb the power of the oligarchs. Abolfathi points out that this development spells an increased risk for investors, as the legal framework is becoming more arbitrary and there are concerns over ownership rights.

Iran a big risk factor

Despite the noise that has been emanating from Iran and the Middle East recently, analysts do not seem overly concerned about the possibility of major new destabilization. Valerie Marcel, principal researcher on oil and energy at Chatham House, speaks of a “protracted situation of possible instability” in Iran, with the western powers hesitant to take action for fear of driving oil prices even higher. On the other hand, a spill-over of the Iraqi insurgency into Saudi Arabia or Syria has not materialized. Nor has the Arab-Israeli conflict provoked a strong reaction in the region, although Marcel concedes that the election of Hamas could generate sufficient conflict to change this.

There is also the possibility that Mahmoud Ahmadinejad, the Iranian president, will stage a coup against the moderates that have had a restraining influence on him. The resultant increase in political risk would make it harder for Iran to fulfil its ambitions of increasing oil production, which, Marcel points out, will depend on foreign investment as well as technology.

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