Country Risk: A Mid-year 2019 Update
The Sources of Country Risk
When companies invest outside their domestic markets, the most immediate risk that they are exposed to is exchange rate risk, since revenues, profits and cash flows are affected by changing exchange rates. That risk, though, is but a piece of the puzzle, a symptom of economic fundamentals and affected by political crises. Digging deeper, the factors that make some countries riskier than others can be broadly classified into the following groups:
1. Life Cycle: I have used the construct of a corporate life cycle to talk about companies at different stages in the life cycle, and how they differ on cash flow generation and growth potential. It is also generally true that younger companies, deriving more or most of their value from future growth, are riskier than more mature companies, where the bulk of their value coming from investments already made. The same construct can be applied to countries, with emerging economies that are growing rapidly being more exposed to global shocks than mature countries. It should come as no surprise, therefore, that in almost every market crisis over the last decade, emerging markets have paid a much large price in terms of lost economic growth and lower market value than developed markets.
2. Political Risk: If the last few years have taught us a lesson, it is that politics can affect economic and market risk, not just in emerging markets, but also in developed ones. While there are many forms of political risk, ranging from abrupt changes in fiscal and monetary policy to regime change, there are at least two measurable manifestations of this risk in the form of corruption risk and exposure to violence.
- Corruption Risk: There are parts of the world where the costs of doing business include greasing palms and paying off intermediaries, and the roots lie deep, resisting feel-good quick fixes. While anecdotal stories of corruption and its consequences are plentiful, there are services to try to measure corruption levels across countries. Transparency International, for instance, derives a corruption score, by country, and in its 2019 report, provides a listing of the ten least and most corrupt countries in the world in the figure below, with higher scores indicating less corruption) for 2018.
Source: Transparency International The effect of corruption upon business is insidious, making winners of those most willing to play the bribery game and losers of those who resist. In an earlier post, I argued that corruption creates the equivalent of an informal tax, pushing down after-tax income to companies.
- Physical Violence: When talking about risk in investing or business, we tend to focus on financial risk, but it is undeniable that adding the threat of physical violence, from war, terrorism or crime, makes it more difficult to operate a business. There are services again that measure exposure to violence in different countries, and while each brings its own biases, the Institute of Economics and Peace has created and reports on a Global Peace Index, measuring exposure to violence, by country.
Source: Institute of Economics and Peace The map summarizes their findings from the most recent year. I must confess that I am surprised to see Botswana at the top of the list, but having never been there, that may be a reflection of my regional biases.
Source: UNCTAD |
Measures of Country Risk
To the extent that country risk comes from different sources, you need composite measures of risk to help in decision making. This section begins with a look at country risk scores, where services, using proprietary factors, measure country risk with a number, followed with financial measures of country risk, primarily designed to measure default risk.
Source: Political Risk Services (PRS) |
Sovereign Ratings
Moody’s, S&P and Fitch all estimate and publish ratings for countries, ranging from Aaa (AAA) for countries they view has having no default risk to D for countries already in default. The figure below provides a map of sovereign ratings across the world in July 2019, using Moody’s ratings where available and S&P to fill in some gaps. While the sovereign ratings themselves are alphabetical (and thus are difficult to incorporate into financial analysis), they can be converted to default spreads by looking at traded bonds in the market.
Source: Moody’s Sovereign Ratings |
Note that while the Aaa rated countries (in dark green) are predominantly in North America and Northern Europe, there are shades of green in Asia, reflecting the region’s improvement on risk and that much of Africa remains unrated.
Source: Bloomberg (10-year $ Sovereign Spreads) |
Equity Risk
While default spreads may represent adequate measures of country risk if you intend to lend to a sovereign or buy bonds issued by it, you are exposed to more and sometimes different risks, if you plan to expand your business into a country, or invest in equities in that country, and you need equity risk premiums that capture that risk. It is true that many practitioners use default spreads as proxies of additional country equity risk and add it to a mature market premium (often a historical US premium) to arrive at country-specific equity risk premiums. As readers of this blog know, I use a mild variation on this approach, replacing the historical equity risk premium with an implied premium for the US and augmenting the default spread by a scaling factor, to reflect the higher risk of equity:
Source: Damodaran Online (Current Data)
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There was a time a few decades ago when the line between developed and emerging markets was a clear one. On one side were developed markets, with independent central banks, rule-following governments and stable fiscal policies, and on the other side were emerging markets, with unstable and unpredictable political leadership and central banks that did their bidding. The last decade has seen a blurring of lines, as some “developed markets” mimic emerging market behavior and some emerging markets mature. There are some (companies and investors) who have decided that this convergence is a reason to ignore country risk, but I think that they do so at their own peril. Notwithstanding globalization and convergence on some dimensions of risk, we face wide variations in risk across the world, and prudence and good sense demand that we incorporate these differences into our decisions.
Paper on Country Risk
Country Risk: Determinants, Measures and Implications – The 2019 Edition
Data Links
- Measures of Corruption, by Country (Transparency International)
- Measures of Violence, by Country (Institute for Peace and Economics)
- International Property Rights Index
- Commodity Dependence, by country (UNCTAD)
- Country Risk Scores (PRS Group)
- Sovereign Ratings, by Country (Moody’s, S&P)
- Sovereign CDS Spreads (10-year) on 7/21/2019
- Equity Risk Premium, by country (Damodaran Online)
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Source: http://aswathdamodaran.blogspot.com/2019/08/country-risk-mid-year-2019-update.html
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