Introduction – Sources of Country Risk

• Many large firms have business interests all over the world. Though these firms may have incorporated in one country, it is important for them to assess the risks associated with the foreign countries they operate in. These risks are collectively referred to as country risk. There are numerous sources of country risk such as –
  • GDP growth rate – An important consideration in assessing country risk is how the GDP of a nation is impacted by economic cycles.
  • Political risk – It is the risk that political structure, nationalization, level of corruption and violence in a country will affect the profitability of a business or an investment.
  • Legal Risk – It is the risk of losses due to inadequacies or biases in a country’s legal system. Property rights and contract enforcement are important aspects of a legal system.
  • Economic structure – Another important consideration when investing in a country is the extent to which its economy is diversified. Countries that produce fewer commodities or  services can be devastated when their prices or demand plummets.

Evaluation of Risk – GDP Growth Rates

• Corporations can invest in various developed and developing countries. Many developing economies have a higher GDP growth rate than that of various developed economies. However, an economic swing has far greater impact on developing markets than on developed markets. While assessing country risk it is important to understand how a country’s economy will react to economic cycles.
• Developing countries get squeezed by lower prices and demand during global recession because they tend to rely more heavily on commodities. Hence, developing countries often see larger declines in GDP than their developed counterparts during stressed periods or recession.
• This suggests that investments made in developing countries will have a higher risk exposure than a developed country, even if it is well governed with solid legal system.

Evaluation of Risk – Political Risk

• Political risk is the risk that changes in governments, decisions made by governments, or the way governments operate will significantly affect the profitability of a business or an investment. Assessing political risk is not easy, but investors tend to value government stability.
• First aspect of political risk is to understand the type of government that creates more risk. Whether democracies or authoritarian governments create more political risk, is debatable.
  • Authoritarian governments do not change frequently  and can therefore pursue the same policies for a longer period. However, when there is a coup and one dictator takes over from another, there can be a sharp discontinuity in policy. 
  • In the case of democracies, governments may change relatively often, but the impact of the change is not usually as dramatic as it is with authoritarian governments.
• Studies comparing democratic and authoritarian governments in the context of faster GDP growth rate have produced mixed results. While some studies suggest that countries with democratic governments grow faster, others argue in favor of authoritarian governments.
• Another aspect of political risk is corruption. When a business invests in a foreign country, it will almost certainly have to deal with the government bureaucracy. In some countries, it may be impossible to do business without bribing public officials. Bribes are an implicit tax on income that reduce profitability and returns for businesses operating in a country.
• Bribery is a problem because it is illegal in many developed countries. The amount of money spent on bribes is typically uncertain, and a firm may suffer (both financially and reputationally) if it is prosecuted in its home country.
• Transparency International is an organization that uses surveys of experts living and working in different countries to compile a corruption index. The lower the index, the more corrupt the country is perceived to be. This table shows an excerpt of corruption index published in 2016.

Country	Corruption Index
Denmark	90
New Zealand	90
Finland	89
Sweden	88
…	…
…	…
Syria	13
North Korea	12
South Sudan	11
Somalia	10

• Another aspect of political risk is violence. Violence makes it difficult for businesses to operate, leading to higher insurance  costs, difficult or totally unsatisfactory work environment for employees.
• An index measuring violence is the Global Peace Index. In this case, low scores are better than high ones. Doing business in countries with good value of peace index should lead to few corruption and violence problems. In contrast, countries with poor value of peace index are not as easy to operate in.
• Another source of political risk is nationalization or expropriation. This is a significant problem for firms working with natural resources. This may have the effect of discouraging future investment in the country, and thus hurting its economy in the long term.

Evaluation of Risk – Legal Risk

• Business activities inevitably generate legal disputes, so firms hesitate from investing in a country where the legal system is biased, subject to government interference, and/or slow to the point of ineffectiveness.
• Investors and businesses favor legal systems that respect their property rights and enforce those rights in a timely manner. The country should have a legal system where a firm and its management can be sued in the event of insider trading, actions that hurt shareholders, or attempts to deceive the market about the firm’s financial health.
• The International Property Rights Index is published by the Property Rights Alliance to help individuals and firms understand the risks they are taking when they invest abroad. A country’s total (overall) index is made up of following –
  • Legal and Political Index – This can further be subdivided into Rule of Law, Political Stability, and Control of Corruption.
  • Physical Property Index – This can further be subdivided into Property Rights, Registering Property, and Ease of Access to Loans.
  • Intellectual Property Index – This can further be subdivided into Intellectual Property Protection, Patent Protection, and Copyright Protection.
• This table is a snippet of the indices that were compiled in 2017 for few countries from different regions of the world. Large numbers indicate a better legal system.

Country	Overall Index	Legal and Political Index	Physical Property Index	Intellectual Property Index
Argentina	4.57	3.81	5.05	4.84
Australia	8.24	8.27	8.24	8.22
Brazil	5.43	4.44	6.12	5.75
Canada	8.18	8.37	7.91	8.26
China	5.71	4.52	7.00	5.61
Germany	7.96	7.84	7.66	8.38
Ghana	5.65	5.26	5.88	5.79
India	5.56	4.49	6.33	5.87
Indonesia	5.17	4.34	6.92	4.24

Evaluation of Risk – The Economy

• It is important to understand the economic risks associated with investing in a foreign country. GDP per capita and the real GDP growth rate tell part of the story. It is also important to assess the country’s competitive advantages and its level of economic diversification.
• Based on several years of research, Michael Porter argued that key determinants of a country’s competitive advantage are –
  • Factor Conditions – The nation’s position in factors of production (such as skilled labor or infrastructure) necessary to compete in an industry.
  • Demand Conditions – The nature of home-market demand for the products or services.
  • Related and Supporting Industries – The presence (or absence) of supplier industries and other related industries that are internationally competitive.
  • Firm Strategy, Structure, and Rivalry – The conditions governing how firms are created, organized, and managed, as well as the nature of domestic rivalry.
• Some countries developing competitive advantages are Hong Kong, Singapore, South Korea, and Taiwan (known collectively as the four Asian tigers).
• An important consideration when investing in a country is the extent to which its economy is diversified. Large countries such as Brazil, India, and China can broaden their economic bases without too much difficulty. Some small countries, however, rely on a small number of goods or services. This can create additional risks for investors and businesses because a drop in the demand for the goods and services produced can create a severe economic distress.

Total Risk

• There are services that attempt to formulate a reliable composite risk measure (the equivalent of VaR or expected shortfall for countries). Some services that attempt to construct a composite risk measure are –
• Political Risk Services (PRS) – It uses 22 measures of political, financial, and economic risk to calculate its index. Individual firms can customize the PRS forecasting model according to their own projects or exposures by adjusting the weights attached to each of the variables, adding or subtracting variables, or tailoring the model to emphasize specific potential sources of risk.
• Media outlets – Some media outlets that measure country risk are Euromoney and The Economist. Euromoney bases its scores on a survey of 400 economists, whereas The Economist develops country risk scores internally based on currency risk, sovereign debt risk, and banking risk.
• The World Bank – It provides country risk data by measuring corruption, government effectiveness, political stability, regulatory quality, the rule of law, and accountability.

Total Risk – Limitations

• These services provide some reliable details about default risk across countries, but their usefulness for business firms and investors are limited due to following reasons –
• Scoring methods – It is difficult to compare these services because they use different scoring methods and consider different aspects of country risk. Some of these aspects may not be relevant for businesses and investors.
• Standardization – The convention for scoring countries is not standardized. PRS and Euromoney assign higher scores for lower risk but, The Economist, on the other hand, assigns lower scores for lower risk. The World Bank uses negative numbers to indicate higher risks.
• Misleading scores – The rankings of countries are more important than  their numerical scores. It could be threatening to say that a country with risk score of 60 is twice as risky as a country with risk score of 30.

Sovereign Credit Risk

• One measure of a country’s risk is the risk that it will default on its debt. There are two types of sovereign defaults –
  • Foreign currency default – This is a scenario wherein a country defaults on that part of its debts, which is denominated in a foreign currency.
  • Domestic or local currency default – This is a scenario wherein a country defaults on that part of its debts, which is denominated in a domestic currency.

Sovereign Credit Risk – Foreign Currency Defaults

• Debt issued in a foreign currency is attractive to global banks and other international lenders. The risk for the issuing country, however, is that it cannot repay the debt by simply printing more money.
• There have been many defaults on sovereign debt over the last 200 years. Most of the defaults involved exchange of old bonds for new bonds with some net present value loss to lenders.
• Greece was the biggest borrower to default during the 2010-2016 period. According to estimates made by Moody’s the first Greek  default in 2012 resulted in investor losses of more than 70%, whereas the second default resulted in losses of more than 60%.
• Defaults are caused by a combination of financial, economic, and political issues that were largely unforeseen at the time when the loans were originally made. A default may make it impossible for a government to finance itself for a certain period. In long term, however, debt markets have been proved to be remarkably forgiving.

Sovereign Credit Risk – Local Currency Defaults

• Some countries have defaulted on debt issued in their own currency. Few notable examples are, defaults of Brazil  in 1990 and Russia in 1998.
• It is difficult to identify the reasons for countries defaulting on local currency debt because it seems reasonable that countries can print more of their own currency to pay the debt without defaulting. But three reasons for such defaults can be –
  • In the decades prior to 1971, currencies had to be backed by gold reserves. The amount of these reserves, therefore, limited  a country’s ability to print more money.
  • Another reason is shared currency. Member countries of the European Union use Euro as domestic currency. But they do not have the right to print Euros. So, Greece was unable to pay its debt by printing money.
  • Printing more money debases the currency and leads to inflation. This would have negative consequences for the local economy. But it can be attractive in short term as it will not affect the country’s reputation and credit ratings.

Sovereign Credit Risk – Impact of a Default

• When a country defaults, it cannot be liquidated. Usually, the old debt is replaced by new debt or is restructured either by lowering the principal, by lowering the interest payments, or by extending the life of the debt.
• In the past, a default on debt might have been  followed by military action. But this is not true in the modern world. The modern consequences include –
  • A loss of reputation along with an increased difficulty in raising funds for several years.
  • Investors’ unwillingness to buy the debt and equity of corporations based in the country.
  • An economic downturn.
  • Political instability as the population loses faith in its leaders.
  • Credit rating downgrade of defaulting country for  many years.
  • Decrease in the volume of exports.
  • Fragility in banking systems.
• Defaulting on debt should be taken seriously by countries as it can severely impede their economic development and growth. Defaults can be very expensive if it leads to a banking crisis and currency devaluation.

Factors Affecting Sovereign Default Risk

• There are several factors that help in determining a country’s default risk.
  • Total indebtedness – It is important to consider the amount of debt a country already has because equity measures ( Such as, debt to equity ratio) are meaningless for countries. A country’s total indebtedness is also affected by the debt held by local governing bodies within the country.
  • Social security commitments – Governments make commitments to their citizens to pay pensions and provide health care. As the size of these commitments increases, government has less free cash to service debt. This, in turn, increases the country’s default risk.
  • The tax base – A rating agency must assess the size and reliability of the tax base. Countries with diversified economies will tend to have a more stable tax base than those that depend on one or two industries. So, a stable and reliable tax base reduces the chance of default.
  • Political environment – It is sometimes argued that autocracies are more likely to default than democracies. Sometimes, alternative to default is printing money. Thus, it is important know the extent to which the central bank is independent of the government.
  • Implicit guarantees – It is also important to consider the implicit backing of a country by other stronger countries. For example, weaker members of EU may be helped by rich member countries when they get into financial difficulties. However, there is no explicit guarantee that this help will always be given.

Credit Spreads

• The credit spread for sovereign debt in a specific currency is the excess interest paid over the risk-free rate in that currency.
• One source of credit spread data is the credit default swap market. Credit default swaps (CDS) are traded on countries as well as corporations. They are like insurance contracts as they provide a payoff to the holder if the country defaults within a certain period (usually five years). Roughly, the payoff is designed to put the bondholder in the same position as he or she would have been if the bond had not defaulted.
• Unlike an insurance contract, a CDS can be used by speculators. There has been some controversy about the actions of speculators in the sovereign credit default swap market. Speculators are blamed (partly) for driving up Greek CDS spreads in 2010. It is also claimed that this drove up the credit spread for bonds issued by Greece, making the country’s financial problems more severe.

Credit Spreads – Advantages and Disadvantages

• There is a strong correlation between credit spreads and ratings, but credit spreads have certain advantages over credit ratings.
  • Credit spreads are more granular than ratings. Hence, they can provide extra information on the ability of a country to repay its debt. For example, a country with a given rating might have a lower credit spread (and therefore be perceived as less risky) than another country with the same rating.
  • Credit spreads have the ability to adjust more quickly to new information than ratings.
• Some disadvantages of credit spreads are –
  • Although credit spreads adjust more quickly (in real time) to new information, this quick reaction makes them more volatile than ratings.
  • Factors, which have little or nothing to do with default risk, (for example, liquidity and investor demand) can also cause shifts in spreads.