4.3.3 Country Risk

4. Country Risk

4.1 Sources of Country Risk

4.1.1 Economic Growth

The growth of a country’s economy is measured its Gross Domestic Product (GDP).

GDP is the total value of goods and services produced by all the people and firms in a country.

Real GDP growth rate looks at the growth rate in GDP after allowing for the impact of inflation.

The growth rate (measured in $3\%$ per year domestic currency).
Inflation (in the domestic currency) $2\%$ per year.
The real growth rate $1\%(=3\%-2\%)$ per year.

An important consideration in assessing country risk is how a country will respond to economic cycles. During economic downturn, developing countries often see larger declines in GDP than their developed counterparts.

4.1.2 Economic Structure

It is also important to assess the country’s competitive advantages and the extent to which its economy is diversified.

Competitive advantage:

• Factor conditions: skilled labor or infrastructure.
• Demand conditions: the nature of home-market demand for the industry’s product or service.
• Related and supporting industries: supplier industries/ 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.

Economic diversification:

• Some small countries, however, rely on a small number of goods or services.
• High dependence on a single commodity: If the price of that commodity declines, the country and the value of its currency will suffer.

4.1.3 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.

Authoritarian governments often do not change as frequently as democratically elected governments and can therefore pursue the same policies for a longer period. When there is a coup and one dictator takes over from another, there can be a sharp discontinuity in policy.

Democratic governments may change relatively often, but the impact of the change is not usually as dramatic as it is with authoritarian governments.

Corruption: bribes are an implicit tax on income that reduce profitability and returns for businesses operating in a country (and for investors in those businesses).

Violence makes it difficult for businesses to operate, leads to higher insurance costs, and may lead to a difficult or totally unsatisfactory work environment for employees.

Nationalization or expropriation is a particularly significant problem for firms working with natural resources.

4.1.4 Legal Risk

Legal risk is the risk of losses due to inadequacies or biases in a country’s legal system.

Because business activities inevitably generate legal disputes, firms do not want to invest in a country where the legal system is biased, subject to government interference, and/or slow to the point of ineffectiveness.

Property rights and contract enforcement are important aspects of a legal system.

4.1.5 Composite Risk Measure

Political Risk Services (PRS) uses 22 measures of political, financial, and economic risk to calculate its index.

Euromoney bases its scores on a survey of 400 economists.

The Economist develops country risk scores internally based on currency risk, sovereign debt risk, and banking risk.

The World Bank provides country risk data measuring corruption, government effectiveness, political stability, regulatory quality, the rule of law, and accountability.

It is difficult to compare these services because they use different scoring methods and consider different attributes of country risk.

The rankings of countries are more important than their numerical scores.

4.2 Sovereign Default Risk

4.2.1 Classification of Sovereign Default

Foreign currency defaults:

• Cannot repay the debt by simply printing more money.
• Many of the largest defaulters have been South American countries.
• Defaults are caused by a combination of financial, economic, and political issues that were largely unforeseen at the times the loans were originally made.

Local currency defaults:

• Gold standard was a system prior to 1971 in which a country’s currency was converted into fixed amounts of gold so that there was a limit on how much currency could be printed.
• Shared currency such as Eurozone.
• Currency debasement printing more currency will devalue the currency and may result in inflation even hyperinflations. Some countries would choose to default.

4.2.2 Impact of a Default

A loss of reputation along with an increased difficulty in raising funds for several years.

A lack of investors willing 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.

A default has a negative impact on GDP growth, has a negative impact on the country’s credit rating for many years; can hurt exports; can make the defaulting country’s banking systems more fragile.

4.2.3 Sovereign Credit Rating

Rating agencies typically provide both local currency ratings and foreign currency ratings.

The local currency rating is typically one or two notches higher than the foreign currency rating.

Rating agencies consider several factors determining a sovereign credit rating:

• Social security commitments: more commitments, less free cash to service debt.
• The tax base: the size and reliability.
• Political risk: whether central bank is independent of the government.
• Implicit guarantees: help from rich member countries

2.4 Sovereign Default Spread

Sovereign default spread is the difference between the yield on sovereign bond in a specific currency and the risk-free rate in that currency.

There is a strong correlation between credit spreads and ratings but credit spreads are more granular (i.e., there is a range of credit spreads associated with a credit rating).

Credit spreads can adjust more quickly to new information than ratings. However, they can be more unstable.

One source of data on credit spreads is the credit default swap market.

Credit default swap is traded on countries as well as corporations. They are like insurance contracts in that they provide a payoff to the holder if the country defaults within a certain period (usually five years).

• A CDS can be used by speculators as well as hedgers.
• CDS market: illiquidity problems and clustering.