Introduction

From a U.S. or West European perspective investment in the Second and Third Worlds looks very much riskier than investment at home. Recent events in Poland and Mexico, among other places, seem to provide dramatic confirmation that this perception is well founded. There is a lot to worry about: The increased internationalization of investment in the last decade has enormously raised the exposure of investors to risks associated with events in many different countries.

As a consequence of this situation, institutional investors and public organizations concerned with international investment are devoting substantial resources to analyzing the risks of investment abroad. There have been significant improvements in the collection and dissemination of data on foreign investment. Some investors have developed statistical models that attempt to evaluate the safety of loans to particular countries.

We believe, however, that this activity is unfortunately taking place without an adequately articulated conceptual framework that identifies the fundamental sources of country risk. This analysis is unlikely to be very robust if it is not based on appropriate theoretical notions. Without a good specification of what motivates borrowers and lenders it is difficult to identify which data are important for analyzing country risk. In addition, there is no reason to believe that apparent regularities derived from past data using econometric models will continue in the future unless these models are specified using an appropriate theory.