An Illustration of the Impact of Economic and
Political Risk Using the Country Credit Rating
Model for Japan, Malaysia and Russia
Carl B. McGowan, Jr.
In this paper, we demonstrate the use of the country credit rating model
in Japan, a developed economy, Malaysia, an upper middle-income
economy, and Russia, a lower middle-income economy. We find that
the country credit rating model tracks the gradual and minor dete-
rioration of the economic condition of Japan, the financial crisis that
occurred in Malaysia in 1997-1998, and the shock that hit the Russian
economy in 1998 when the government defaulted on bonds, and the
subsequent recoveries in both Malaysia and Russia.
Key Words: corporate finance, foreign direct investment, economic
growth, government policy, political economy
jEL Classification: F43, gi8, G31, pi6
Introduction
The objective of this paper is to demonstrate the use of the country
credit rating model to determine the opportunity cost of equity capital
for multinational corporations for foreign direct investment decisions in
specific countries, as shown in exhibit 1. In the context of the us econ-
omy, corporations are able to determine a cost of equity capital using the
capital asset pricing model. For foreign direct investment, the capm does
not hold for a number of reasons. In particular, international stock mar-
ket segmentation and the absence of an international risk free rate of re-
turn, make computing systematic measures of risk difficult, if not impos-
sible. Alternative methods of computing an international cost of equity
using a risk free rate plus a risk premium based on sovereign bond rates
such as proposed in Mariscal and Lee (1993) is not applicable because
neither a risk free rate nor a bond rate is available for most countries. An
alternative risk premium model using a bond rating plus a risk premium
composed of a political risk premium and a business risk premium such
as proposed in Godfrey and Espinosa (1996) is not applicable because
neither bond ratings nor stock markets are available for all countries. The
Dr Carl B. McGowan, Jr., is a Professor of Finance at the School
of Management, Norfolk State University, usa.
Managing Global Transitions 6 (2): 143-156
The value of the firm is determined by
the risk and return characteristics of
the firm which are determined by the
investment and financing decisions of
the corporate decision makers. Capi-
tal budgeting is the method by which
firms evaluate long-term investment
decisions. The weighted average cost
ofcapital is used in the capital budget-
ing process to calculate the discounted
present value of the future cash flows
of a capital budgeting project. The
Country Credit Rating Model is used
to determine the cost of equity for for-
eign direct investment in a country.
exhibit 1 The relationship between the country credit rating model
and the value of the firm
country credit rating proposed by Erb, Harvey, and Viskanta (1996) does
not require a risk free rate of return, a bond rating, or even a stock mar-
ket. This model uses country credit ratings and returns on stock markets
where available to determine a market price of risk. This market price of
risk can be used to determine the risk premium for any country with a
credit rating. The risk premium is simply the country credit rating (sub-
tracted) from 100 times 0.35, from McGowan and Tessema (2004) which
is added to the risk free return of 10.4%.
Valuing the Multinational Corporation
The objective of corporate financial management is to maximize the
value of the firm. The value of the firm is the market capitalization of the
firm, that is, the number of shares outstanding multiplied by the price
per share. The value of the firm is determined by the risk and return
characteristics of the firm. Firms that want to earn higher rates of re-
turn must be willing to assume greater levels of risk and firms that want
to have lower levels of risk must be willing to accept a lower rate of re-
turn. The risk and return characteristics of the firm are determined by
the investment and financing decisions made by the corporate financial
managers.
The process that multinational corporations use to make long-term
asset decisions is called capital budgeting. Farragher, Kleiman, and Sahu
(1999) define an eight step capital budgeting process. Stage one involves
Value of the firm
t
Risk and return
t
Investment and financing decisions
t
Capital budgeting
t
Weighted average cost of capital
t
Country Credit Rating Model
strategic analysis - determining areas in which the firm has a competitive
advantage, Porter (1980) and Myers (1987). Stage two involves determin-
ing investment goals - minimum required rates of return and maximum
levels of risk for investments. Stage three is the process of finding in-
vestment opportunities. Stage four is forecasting future cash flows from
projects. Stage five is determining the value of the project under consid-
eration. Stage six is the determination of which projects are acceptable.
Stage seven is the implementation of accepted projects. Stage eight is the
post-audit of accepted project outcomes.
When making long-term investment decisions, wealth maximization
is achieved when the firm invests in all available projects that have a pos-
itive net present value. To compute the net present value, the firm needs
to know the appropriate discount rate to use to discount the future cash
flows from the project. This discount rate is the cost of capital, which is
the minimum required rate of return on investment. The cost of capital
represents the opportunity cost of funds for the firm, that is, the mini-
mum rate of return that the firm or investors could achieve in another
investment.
Modigliani and Miller (1958) develop a model of the overall cost of
capital for the firm that is computed as a market value weighted av-
erage of the costs of each of the components of capital used by the
firm. Modigliani and Miller use long-term debt and common stock as
the components of capital. The weights used in the computation of the
weighted average cost of capital are the market value proportion of the
capital structure represented by each of the cost of capital components.
The component cost of each component of the weighted average cost of
capital is the marginal cost of capital for each of the capital components.
To determine the cost of equity, we use the capital asset pricing model
in which only market wide risk is priced which is systematic or non-
diversifiable risk. Systematic risk reflects the covariance between returns
on the investment and the return on the market. Markowitz (1953) shows
the gains from portfolio diversification and Grubel (1968) shows the
gains from international diversification in an environment with two
countries and two assets. The effect of portfolio diversification increases
as the covariance between the investment and the market decreases,
that is, the gains from international diversification are greater between
countries that have less correlated stock markets. Since segmented stock
markets have lower covariances with respect to external stock markets,
market segmentation leads to greater gains from international diversi-
fication. The types of barriers that lead to market segmentation would
include differences in trading costs, information availability, generally
accepted accounting principles, legal and political systems, taxes rates,
investor expectations and preferences, and government restrictions on
stock ownership. For examples, see Errunza and Losq (1985), Errunza,
Losq, and Padmanabhan (1992), and Bekaert and Harvey (1995). Block
(2000) reports for a survey of Fortune 1000 firms, that 68.7 percent of
the 146 respondents indicate that foreign investment increases the risk
exposure of the firm and 31.3 percent indicate that foreign direct invest-
ment decreases the risk exposure of the firm. Myers (1998) finds that
companies use higher cost of capital rates for foreign investment relative
to domestic investment.
The Gains from International Diversification
The World Bank defines emerging markets as those that are ranked as ei-
ther low-income economies or middle-income economies. Hooke (2001)
finds 156 countries in the emerging market category, that is, with gross
national product per capita below $9000. Keppler and Lechner (1997)
find that only sixty of these countries have functioning stock markets
and only twenty-five countries meet the International Financial Corpo-
ration definition of having functioning and regulated stock exchanges.
There are also a number of opec countries that meet the gross domestic
product requirement for developed markets but do not meet the institu-
tional criterion of having a functional stock market as defined in Khanna
and Palepu (1997).
The benefits of international investing are numerous. First, as Grubel
(1968) has shown in a two country, two-asset model of portfolio theory,
that international investment provides more efficient portfolios. That is,
internationally diversified portfolios provide a higher rate of return for a
given level of risk or a lower level of risk for a given rate of return than
strictly domestic portfolios. Levy and Sarnat (1970) show that adding de-
veloping markets to the investment universe improves the efficient fron-
tier, even if the developing markets provide poor performance individ-
ually. More recently, Barry, Peavy and Rodriguez (1997) use the Sharpe
Index to show that emerging markets out performed developed market
during the period from 1986 to 1995, but under performed developed
markets during the period from 1990 to 1995. The advantage of a low
correlation portfolio effect is evident, returns for developing and emerg-
ing stock markets are offsetting.
Reeb, Mansi, and Allee (2001) find that international firms have bet-
ter credit ratings and lower cost of debt. The cost of firm debt financing
is inversely related to the degree of firm internationalization while firm
credit rating is positively related to the degree of firm internationaliza-
tion. Firms with a higher degree of internationalization have better credit
ratings and a lower cost of capital. The authors state that the existence of
market imperfections and the ability of firms to exploit market imperfec-
tions are necessary for multinational diversification to benefit the firm,
i. e. reduce the cost of capital. Caves (1971) and Hymer (1976) develop
the concept of internalization and Errunza and Senbet (1981) suggest the
need to be able to exploit international imperfections.
Reasons for a lower cost of capital for multinational firms revolve
around increased cash flow that results from exploiting international
market imperfections and the risk reduction benefits of the portfo-
lio effect on cash flow. Barriers that would allow multinational firms
to achieve a lower cost of capital would be such things as controlled
interest rates, credit restrictions, market segmentation, and variable
prices of risk. Robbins and Stobaugh (1973) suggest numerous means by
which multinational enterprises can exploit market imperfections. The
weighted average cost of capital can be reduced by the effect of interna-
tional diversification. By investing in a number of markets, multinational
firms benefit from the portfolio effect of international diversification. Di-
versification leads to lower cash flow volatility and reduced probability
of insolvency both of which lower the riskiness and cost of debt.
Emerging markets are more volatile than developed markets but
the volatility varies across time and across markets, Errunza, Hogan,
and Jung (1999), Solnik, Bourcelle, and Le Fur (1996), and Michaud,
Bergstom, Frashure, and Wolahan (1996). Erb, Harvey and Viskanta
(1996) argue that emerging markets are segmented because of infor-
mation problems, institutions shortcomings, less transparent account-
ing standards, and barriers to foreign investment. Bekaert, Harvey, and
Lumsdaine (2002) show that real regulatory environment changes lead
to increased foreign portfolio investment. Reduced segmentation leads
to larger and more liquid markets and returns that are both more volatile
and more correlated with global markets. Increased market integration
leads to a lower cost of capital, a higher credit rating, real foreign ex-
change rate appreciation, and increased real economic growth.
The Country Credit Rating Model
Erb, Harvey and Viskanta (1996) provide a simple model for estimating
the required rate of return for investments in a particular country:
50
30
ä 10
0	10 20 30 40 50 60 70 80	90 100
Country credit rating (100-CCR)
exhibit 2 The International Capital Market Line
The International Capital Market Line (McGowan and Tessema 2004, 40) is a graph of
the required rate of return as the dependent variable and (ioo-country credit rating) as
the independent variable. The United States has a country credit rating of 93.5 and a
long-term equity market rate of 12.7 percent and the international capital market line
has a slope of 0.35. Thus, a country with a country credit rating of 100 would have a
cost of capital of 10.4 percent. Countries with lower country credit ratings would have a
higher cost of capital. The cost of capital for different countries increases by 0.35 percent
for each one-point increase in the variable (100-country credit rating). A country with
a country credit rating of 80 would have a cost of capital of 17.4 percent and a country
with a country credit rating of 40 would have a cost of capital of 31.4 percent.
40
20
Ri,t = a0 + bi • CCRi,t + ,	(1)
where, Ri,t, is the expected return in us dollars for country i, a0, is the in-
tercept term, bi is the regression coefficient for the country credit rating,
CCR i,t, and £i,t is the residual term. Erb, Harvey and Viskanta show that
the country credit rating model can be used to estimate a cost of capital
in emerging markets, even if the particular country does not have a stock
market.
McGowan and Tessema (2004) apply the Country Credit Risk Model
of Erb, Harvey, and Viskanta (1996) to develop an International Capital
Market Line that can be used to determine the required rate of return
for investments in emerging markets, even if those markets do not have
stock markets. The Country Credit Rating Model used in this paper uses
country credit ratings by Institutional Investor, Euromoney and Interna-
tional Country Risk Guide to develop an International Capital Asset Pric-
ing Model. The results of this model are used to construct an Interna-
tional Capital Market Line that uses the United States long-term equity
market return of 12.7 percent and the Euromoney Country Credit Rating
of the United States that is 93.5. The slope of the International Capital
Market Line is 0.35, which is the standardized regression coefficient for
the regression between the required rate of return and the Euromoney
Country Credit Rating. Thus, we can determine the required rate of re-
turn for any country for which a country credit rating is available.
Exhibit 2 shows the International Capital Market Line (McGowan and
Tessema 2004, 40) which is a graph of the required rate of return as the
dependent variable and (100-country credit rating) as the independent
variable. The United States has a country credit rating of 93.5 and a long-
term equity market rate of 12.7 percent and the international capital mar-
ket line has a slope of 0.35. Thus, a country with a country credit rat-
ing of 100 would have a cost of capital of 10.4 percent. Countries with
lower country credit ratings would have a higher cost of capital. The cost
of capital for different countries increases by 0.35 percent for each one-
point increase in the variable of (100-country credit rating). A country
with a country credit rating of 80 would have a cost of capital of 17.4 per-
cent and a country with a country credit rating of 40 would have a cost
of capital of 31.4 percent.
Euromoney Country Credit Ratings
The country credit ratings used in this study are taken from the World
Bank's World Development Indicators 2002, which publishes country
credit ratings from a number of sources, including the Euromoney rat-
ings. The World Development Indicators 2002 is the source of the country
credit ratings used in this study that are from Euromoney that reports
country credit ratings twice a year, March and September. The following
discussion of the Euromoney variables is taken from Euromoney, Septem-
ber 2002, pages 207-14. The country credit ratings are from zero to one
hundred with one hundred representing less risk. The overall country
credit risk score is a weighted average of nine variables. For each cate-
gory, the highest rated country is given the full variable value and the
lowest rated country is given a value of zero. Intermediate countries are
given a value equal to [a - (a/(b - c)) • (d - c)] where a is the category
weighting, b is the lowest value, c is the highest value, and d is the in-
dividual value. Debt indicators represent ten percent of the index value.
Assume that the highest value is nine and the lowest value is one. The
country with the nine would receive ten points and the country with one
would receive zero points. A country with a rating of five would receive
[10 - (10/(1 - 9)) • (5 - 9)] = 5. The overall country credit rating is the
sum of the nine weighted indices.
Both political risk and economic performance have weights of 25 per-
cent. Political risk measures the likelihood of non-payment of financial
obligations with countries rated from ten to zero, with a higher rating
indicating less political risk. Economic performance is based on gni per
capita (Atlas method) and a poll of economic forecasts with both factors
weighted equally. Debt indicators, debt default or rescheduled, and credit
ratings each have weights of ten percent. Debt indicators are a weighted
average of total debt to gnp (a), debt service to exports (b), and cur-
rent account balance relative to gnp (c). The Debt indicator value is
equal to a + 2b + 10c. The debt default value is the proportion of debt
in default to total debt. oecd countries receive a rating of ten and de-
veloping countries that do not provide complete debt reports are rated
zero. Credit ratings are based on ratings of bond rating agencies. Access
to bank finance, access to short-term finance, access to capital markets,
and discount on forfaiting are each weighted five percent. Access to bank
financing is measured as loans to gnp. As with the debt indicator, oecd
countries are rated five and non-reporting developing countries are rated
zero. Both access to short-term finance and access to capital markets are
rated by experts from zero to five. Discount on forfaiting is measured by
the average, maximum tenor for forfaiting and the average spread over
riskless countries. Countries where forfaiting in not available are given a
rating of zero.
Application of the Country Credit Rating Model
Table 1 contains the values of the Euromoney Country Credit Ratings for
Japan for 1992-2003. The overall country credit rating for Japan fell from
a high of 99.55 in 1992 that ranked Japan as number 2 in the world to,
88.30 in 2003 that ranked Japan as number 19 in the world. The financial
crisis in East Asia in 1997 to 1998 led to a five point decrease in the country
credit rating for Japan to 88.03 and a rank of number 23 in the world
in 1998. The political risk ranking fell from 24.65 to 23.39 in 1998. The
economic performance rating fell from 20.80 in 1997, to 15.85 in 1998 as
a result of the regional and world-wide recessions. The debt indicator
value fell from 30.00 in 1998 to 28.96 in 2003. Credit indicators fell from
20.00 in 1997 to 19.63 in 2003.
Figure 1 contains a graph of the Euromoney Country Credit Ratings for
Japan from 1992 to 2003 and the required rate of return. Although debt
indicators and credit indicators have recovered all but 1.3 points to the
pre-crisis level, political risk is still 1.5 points below the pre-crisis level
and the economic performance indicator is 6.0 points below the pre-
crisis level. The economic performance indicator will likely recover as the
world economy recovers. Figure 1 shows the required rate of return for
Japan based on the Euromoney Country Credit Rating. The Euromoney
table 1 Euromoney Country Credit Ratings: Japan (1992-2003)
Year	PR	ep	di	ci	ccr	RRoR
1992	20.00	19.50	30.00	20.00	99.55	10.56
1993	24.47	22.71	30.00	20.00	97.18	11.39
1994	24.70	21.65	30.00	20.00	96.35	11.68
1995	24.84	21.88	30.00	20.00	96.72	11.55
1996	23.21	20.80	30.00	20.00	94.01	12.50
1997	24.65	18.38	30.00	20.00	93.03	12.84
1998	23.39	15.85	30.00	18.79	88.03	14.59
1999	23.26	19.31	29.58	18.71	90.86	13.60
2000	23.51	18.41	29.58	19.19	90.69	13.66
2001	23.45	18.94	29.17	19.01	90.57	13.70
2002	21.50	19.26	28.75	19.17	88.68	14.36
2003	22.95	16.76	28.96	19-63	88.30	14.50
notes PR - political risk, ep - economic performance, di -debtindicators, ci - credit
indicators, ccr - Euromoney Country Credit Rating, rror - required rate of return.
16	-
14--- -
12	- -
10--
8 -
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
figure 1 Required rate of return for Japan (light gray) based on Euromoney Country
Credit Ratings (dark gray, divided by ten), 1992-2003
Country Credit Rating for Japan has dropped from 99.55 in 1992 to 88.30
in 2003. This reduction in the Country Credit Rating implies an increase
in the required rate of return for investment in Japan from 11.39 percent
in 1993 to 14.50 percent in 2003.
Table 2 shows the values of the Euromoney Country Credit Rating for
Malaysia from 1992 to 2003. The overall country credit rating rose from
73.61 in 1992 to 83.31 in 1997 just prior to the Asian Financial Crisis of
1997-1998. After the financial crisis, the rating dropped to 41.90, then
rose to 63.80 in 2001, before falling to 61.00 in 2003. The financial crisis
in 1997-1998 led to a decrease in the political risk rating from 21.49 in
1997 to 15.25 in 1998, and a further decrease to 14.25 in 1999, before rising
to 16.42 in 2001 and then dropping to 15.47 in 2002, and again rising to
table 2 Euromoney Country Credit Ratings: Malaysia (1992-2003)
Year	pr	ep	di	ci	cor	rror
1992	8.60	15.30	24.40	25.30	73.61	19.64
1993	22.49	18.09	25.58	12.36	78.50	17.93
1994	22.78	20.93	25.59	12.61	81.90	16.74
1995	22.45	18.59	26.32	11.26	78.60	17.89
1996	20.98	17.59	27.09	14.52	80.20	17.33
1997	21.49	18.78	26.70	16.36	83.32	16.24
1998	15.25	12.47	5.93	8.24	41.90	30.74
1999	14.25	9.22	24.09	9.50	57.05	25.43
2000	15.86	10.08	24.30	10.89	61.11	24.01
2001	16.42	10.86	25.35	11.15	63.80	23.07
2002	15.47	9.67	24.25	11.42	63.05	23.33
2003	15-74	9-57	24.97	10.74	61.00	24.05
notes pr - political risk, ep - economic performance, di - debt indicators, ci - credit
indicators, cor - Euromoney Country Credit Rating, rror - required rate of return.
35
30
25
20
15
10
5
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
figure 2 Required Rate of Return for Malaysia (light gray) based on Euromoney
Country Credit Ratings (dark gray, divided by ten), 1992-2003
15.74 in 2003. The economic performance rating rose from 15.30 in 1992 to
20.93 in 1994, but then fell to 9.22 in 1982 and rose during 2000 and 2001
to 10.08 and 10.86, respectively, but fell 9.57 by 2003. The debt indicator
ratio rose from 24.40 in 1992 to 27.09 in 1996 before falling to 26.70 in
1997,	and 5.93 in 1998, but returned to 24.97 by 2003. Access to short-
term financing rose from 12.36 in 1993 to 16.36 in 1997, but fell to 8.24 in
1998,	before returning to a level of 10.47 in 2003.
Figure 2 provides a graphic representation of the required rate of re-
turn and the Euromoney Country Credit Rating over the study period
An Illustration of the Impact of Economic and Political Risk 153
table 3 Euromoney Country Credit Ratings: Russia (1992-2003)
Year	pr	ep	di	ci	ccr	rrqr
1992	2.90	6.80	6.00	6.00	21.77	37.78
1993	7.49	7.18	8.77	1.25	24.69	36.76
1994	7.75	5.28	10.00	1.25	24.28	36.90
1995	9.68	5.48	8.26	3.99	27.40	35.81
1996	11.47	8.33	17.99	4.83	42.62	30.48
1997	9.66	8.09	20.70	5.53	43.97	30.01
1998	5.35	8.26	1.20	2.86	17.67	39.22
1999	4.40	4.98	11.76	1.88	23.02	37.34
2000	8.02	6.65	17.30	5.91	37.88	32.14
2001	7.35	5.15	18.99	5.88	37.60	32.24
2002	11.74	8.26	18.97	6.05	45.03	29.64
2003	9-74	8.15	21.79	6.14	45.98	29-31
notes pr - political risk, ep - economic performance, di -debtindicators, ci - credit
indicators, ccr - Euromoney Country Credit Rating, rror - required rate of return.
40
35
30
25
20
15
10
5
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
figure 3 Required Rate of Return for Russia (light gray) based on Euromoney
Country Credit Ratings (dark gray, divided by ten), 1992-2003
for Malaysia. The required rate of return fell to 16.24 percent in 1997, be-
fore rising to 30.74 in 1998, and then dropped to 24.05 by 2003. Thus, one
can track the influence of the steady improvement of the country credit
rating prior to the Asian Financial Crisis in 1997-1998 which caused a
decrease in the country credit rating and a subsequent increase in the
required rate of return, which has not dropped substantially since then.
Table 3 shows the values of the Euromoney Country Credit Rating for
Russia from 1992 to 2003. The overall country credit rating rose from
21.77 in 1992 to 43.97 in 2003. After the bond default, the rating dropped
to 17.67 in 1998 and then rose to 45.98 in 2003. The financial crisis in 1998
led to a decrease in the political risk rating from 9.66 in 1997 to 5.35 in
1998, and a further decrease to 4.40 in 1999, before rising to pre-crisis
levels by 2003. The economic performance rating rose slightly in 1998 to
8.26 from 8.09 in 1997, but then fell to 4.98 in 1999, before rising to 8.15
by 2003. The debt ratio rose from 6.00 in 1992 to 20.70 in 1997 before
falling to 1.20 in 1998, but returned to 21.79 by 2003. Access to short-term
financing fell from 5.53 in 1997 to 2.86 in 1998, and 1.88 in 1999, before
returning to a level of 6.14 in 2003.
Figure 3 provides a graphic representation of the required rate of re-
turn and the Euromoney Country Credit Rating over the study period.
The required rate of return fell to 30.01 percent in 1997, rose to 39.22 in
1998, and then dropped to 29.31 by 2003. Thus, one can track the influ-
ence of the steady improvement of the country credit rating with the
interruption of the 1998 financial crisis.
Summary and Conclusions
In this paper, we demonstrate the use of the country credit rating model
in Japan, a developed economy, Malaysia, an upper middle-income
economy, and Russia, a lower middle-income economy. We find that the
country credit rating model tracks the gradual and minor deterioration
of the economic condition of Japan, the financial crisis that occurred
in Malaysia in 1997-1998, and the shock that hit the Russian economy
in 1998 when the government defaulted on bonds, and the subsequent
recoveries in both Malaysia and Russia. The Euromoney Country Credit
Rating for Japan gradually increased over the test period from 1992 to
2003, reflecting the lack of economic performance. For both Malaysia
and Russia, the Euromoney Country Credit Rating changed dramatically
in response to financial crises, a general financial crisis in Asian - in the
case of Malaysia - and a specific default in the case of Russia. In the
case of both Malaysia and Russia, the required rate of return increased
because of the crisis.
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