Introduction to Political and Economic Risk/Economic Risks
|Unit 1.1- Intro to Political and Economic Risk||
Economic risks can endanger the ability of a seller to get payment for goods or services in many ways. This type of risk can sometimes be forecast but is often completely out of the control of either the buyer or seller. Purchasing transaction insurance is essential for a buyer to minimize economic risk. Elements of economic risk include but are not limited to:
- convertibility risk
- foreign exchange risk
- translation risk
- central bank activities (interest rate fluctuation, availability of funds)
- economic indicator movement (GDP, unemployment, purchasing power, inflation, etc.)
Convertibility risk is an issue when a buyer has received the goods promised and is now ready to make payment but can’t because, for any number of possible reasons, the buyer’s government bars the conversion of its local currency to that of any other country. The reasons for this action could be a possible war, a major building infrastructure program, or a massive negative trade balance. The buyer naturally has the currency of his own country in his bank account. When the buyer goes to the bank to exchange the local currency to the currency specified in the purchase contract or to the currency of the seller’s country – or for that matter the currency of any “hard currency” country, the conversion cannot be made without proper authorization. Convertibility risks usually occur when the buyer’s currency does not have a ready world market. Although the transfer of the local currency out of the buyer’s country may not have been specifically barred, it provides little value since the seller may not be able to find a buyer for the funds.
Foreign Exchange Risk
Foreign exchange risk is not the same as either transfer risk or convertibility risk. Foreign exchange risk occurs when the rate of exchange between the seller’s currency and the buyer’s currency changes dramatically between the time the order is quoted and the time the final payment is received. When payment is not made in a cross-border transaction, the difficulty of collection can be compounded significantly, especially if the transaction is hedged. Therefore, it is much better to assess the level of risk and know ways to mitigate, manage, transfer or accept the risks.
For example, a seller and buyer agree that the seller will be paid in the seller’s currency. The buyer has the financial strength and character at the time of the contract to be willing and able to make payment when the goods are delivered. Between the time the order is placed and the time the buyer is to make payment, however, the buyer’s currency drops significantly in value against the seller’s currency. The cost of the goods may now be more than the profit margin of the buyer, or the buyer may have to pay much more than anticipated in the buyer’s local currency. It may take the buyer much more time to obtain enough local currency to buy enough of the seller’s currency to make full payment. It may be that the buyer will never be able to make a full payment for the purchase. Hedging against foreign exchange risk is the best solution for this type of problem.
Translation risk involves the revaluation of foreign assets that are held in a foreign currency. There may be a difference in the current foreign exchange rate from the time of the original transaction to time of the fulfillment of the sales contract. Assets held on the balance sheet in foreign currency must periodically be revalued to the current market price of that currency. This kind of revaluation to the current market will create an exchange loss or gain. This exchange gain or loss is unrealized but still impacts the value of the assets held overseas. An example follows:
Plant and equipment of an international company are marked to market at year-end for financial reporting purposes. Conditions throughout the year have caused a decline in the value of the currency of their foreign holdings of 20%. This decline has the immediate affect of reducing the value of these assets by 20%, which then has the direct impact of reducing the company’s profitability for the year by the same value even though no direct transaction has occurred other than the revaluation to create this loss.