Wednesday, August 16, 2006

On country risk?

Who's afraid of country risk? Apparently, the newest UI econ Ph.D, Ferry Irawan is not one. I asked Irawan the following:

So Bank Indonesia has just [the exam was on Aug 11] lowered again its policy rate to 11.75 percent. Given the current Fed rate of 5.25 percent, there is a 650 basis points differential. If, the current "rule of thumb" holds, i.e. Bank Indonesia should maintain at least 600 bps above the Fed rate, then we still have a room of 50 bps. That means, we're fine if BI again cuts the rate to 11.25, provided that Mr. Bernanke keeps his words. Bank Indonesia officials yesterday have indicated their intention to make further cut, since the inflation rate is increasingly manageable. You agree?

Capital flies to wherever it can get the highest returns. High interest rate is of course more attractive than the lower ones. Theoretically, dictated by the law of one price, interest rates between two countries equilibrate. But the prices should take into account all other differences between the two countries, most of which is attributed to "country risk premium". I don't have scholarly references right now, but it seems that some BI officials still assign a 600 bps (6 percent) rule. That means, all else constant, the Indonesian country risk is somewhere near 6 percent equivalent of interest rate.

But, as Irawan rightly responded, we should not be too religious on the so-called "600 bps"-rule of thumb. The "all other differences" is a dynamic concept. It can not be always 6 percent. Improvement in investment climate contributes to a reduction in the differential. Price stability is another factor, as pointed out in Irawan's dissertation.

As an afterthought, however, I would ask: why bother too much with all this "country risk"? After all, as finance people like to say, "the riskier the crispier". In fact, Cornell's Assaf Razin has shown that the share of FDI in total inflows is higher in riskier countries since "the micro-management superiority of FDI investors over their domestic counterparts is more pronounced when the corporate governance in the host country is weak and financial institutions are not well developed."

That is, riskier countries are sexier to exploit. You agree?


Anonymous said...

As the SAS will say: "Who dares wins". It sure gives some people reason to believe that risk marks the spot...

random walker said...

the law of one price is theoretically beautiful. however I would argue that only works in an efficient market. In addition the way to exploit the discrepancy must in place for adjustment to the "fair value" take place. although I might agree that the risk premia is not constant, it needs enough participants to adjust the mispricing.