MBA (Finance specialisation)

&
MBA Banking and Finance
(Trimester)
Term VI
Module : International Financial Management
Unit IV: Country Risk Analysis and International Taxation
Lesson 4.1

(Country Risk Techniques /indicators and Transfer pricing)

Country Risk
Introduction
The concepts of country risk and creditworthiness have become important over
the years and despite analytical difficulties there has been a growth in interest in
recent years among private and official lending institutions in the systematic
valuation of country risk.
Definition of Country Risk
Robock and Simmons (1973) assert that political risk in international
investment exists when discontinuities occur in the business environment
when they are difficult to anticipate, and when they result from political change.
Levi (1990) defines country risk as the risk that, as a result of war,
revolution or other political or social events, a firm may not be paid for its
exports.
Levich (1998) defines country risk as the deviation from interest rate
parity.
Eun and Resnick (2004) assert that country risk is a broader measure of
risk than political risk, as the former encompasses political risk, credit risk,
and other economic performances.
Objectives of Country Risk Ratings
Country risk, which reflects the ability and willingness of a country to
service its financial obligations, has become a topic of major concern for
the international financial community.
Investors and lenders, when evaluating the risks of a country, generally
base their assessment on the political and social environment of a country.
Some studies have examined more specific country risks, such as the
risk of terrorist threats.
Political risk has been identified by various researchers as a factor
that seriously affects the profitability of their international ventures.
Political factors, economic and financial risk factors are also considered
when assessing country risk.
Nature of Country Risk Assessment
Country risk is an indispensable tool for asset management as it requires the
assessment of economic opportunity against political odds.
For our discussion here, we can group the relevant factors into two important
categories: political factors and economic factors.
Political Risk Indicators
i. Stability of the local political environment
ii. Consensus regarding priorities
iii. Attitude of host government
iv. War
v. Mechanisms for expression of discontent
Cont.
Economic Risk Indicators
1. Inflation rate
2. Current and potential state of the countrys economy
3. Resource base
4. Adjustment to external shocks
Techniques to Assess Country Risk
I. Debt Related Factors
II. Balance of Payments
III. Economic Performance
IV. Political Instability
V. Checklist Approach
Cont.
Raters of Country Risk
Rating of a countrys creditworthiness is mainly compiled by two
magazines,
Institutional Investor and Euromoney. Institutional Investor has been
publishing the ratings since 1981 while for Euromoney the ratings are
available since 1982.
The ratings of both the magazines are based on an evaluation of a
number of macro economic financial and political variables.
Share of top Investing Countries in FDI Inflows
Rating agencies: criteria for assessing country risk
Rating agency Criteria for ratings
Institutional Investor Information provided by 75100 leading banks that grade each
country on a scale of 0100, with 100 representing least chance
of default.
Individual responses are weighted using a formula that gives
more importance to responses from banks with greater worldwide
exposure.
Euromoney Assessment based on the following indicators. (Total score 100)
Political risk (25 per cent)
Economic performance (25 per cent)
Debt Indicators (10 per cent)
Credit Ratings (10 per cent)
Rescheduling (10 per cent)
Access to bank finance (5 per cent)
Access to capital markets (5 per cent)
Access to short-term finance (5 per cent)
Discount available on forfeiting (5 per cent)
Source: Finance and Development, March 1997.
Transfer Pricing
Introduction
Transfer pricing is a mechanism used by MNCs to
price intra corporate exchange of goods and
services so as to minimise taxes and maximise
after tax profit. Transfer pricing involves charging
of different prices for intra corporate transfers and
sale to third parties for identical goods and
services. The latter are called as arms length
prices.
Transfer Pricing
Example
Consider a company A Ltd. which produces goods at
a cost of Rs 10 per unit and it can be sold in a market
at a price of Rs 50 per unit. The profit will be Rs 40
per unit. Now, if the company does not want to show
entire profit in its books , it can first sell these goods
to its subsidiary company B Ltd. at a price of Rs 15
and the subsidiary company B Ltd. can later sell it in
the market at price of Rs 50. The profit to B Ltd. will
be Rs 35 per unit. In this manner, A Ltd. is able to
divide total profit of Rs 40 per unit into two parts Rs
5 in its own books and Rs 35 in the books of B Ltd.
Transfer Pricing
Example contd.
Such a practice is adopted when A Ltd. is situated
in an area having higher tax rate and B Ltd. is
situated in the area having lower tax rate. This will
help in minimizing total tax liability of the group
forming A Ltd. and B Ltd.
The MNC also follow this kind of practice by
transferring goods from one of their subsidiary to
other subsidiary or parent to subsidiary or vice
versa.
Transfer Pricing
The important issue in this case is
-Whether such transfer of goods at a price desired
by any company be allowed or not.
The issue of transfer pricing arising in these type
of cases that such transfers cannot be done at
arbitrarily desired price by one company. The
price shall be justified and be close to market
price to prevent any tax evasion. Such prices are
called Arm length price.
Transfer Pricing
Apart from tax savings transfer pricing may be
used for one or more of the following:
1) Positioning funds at such locations which suits
corporate working capital policies.
2) Reducing exchange rate exposure and
circumventing exchange control restriction on
profit repatriation.
3) Reducing custom duty payments and
overcoming quota restriction in imports.
4) Window dressing of operations of subsidiaries.