It’s been an eventful few weeks. Greece’s extended dance with default has left even seasoned players of the European game exhausted and hoping for a resolution one way or the other. In Latin America, Brazil’s political and business elite are in the spotlight as the mess at Petrobras spreads its poisonous vapors. On the other side of the world, the Chinese government, which finds markets useful only when they serve its purposes, is trying to stop a full fledged rout of its equity markets. For investors everywhere, the events across the world, discomfiting though they might be, are reminders of two realities. The first is that globalization, while bringing significant benefits, has created connections across markets that make any country's problem a global one. The second is that notwithstanding this globalization, some parts of the world are more prone to generate political and economic surprises than others. As companies and investors are forced to look outside their borders, I thought it would be a good time to examine how and why risk varies across countries and at updated measures of that risk.
The Sources of Country Risk
There is risk in every market for investors and businesses, but some countries are more exposed to risk than others. While there are few people who would contest this notion, I think it is still worth examining the drivers of country risk as a prelude to measuring it. Broadly speaking, these drivers can be broken down into political, legal and economic groupings.
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I. Economic Risk
- Stage in Development Life Cycle: When looking at companies, it is generally true that companies early in their life cycles, with evolving markets and business models, will be more volatile and risky than companies that are further alone in the life cycle. The same concept can be extended to countries, with emerging market economies, exhibiting higher growth and more uncertainty than more mature economies.
- Economic concentration: Countries that are dependent upon one or a few commodities or industries for growth will have more economic volatility than countries with diversified economies. In particular, smaller countries (and economies) are more likely to face this problem since their small sizes require them to find niches in the global economy and specialize. In the map below, I report concentration measures for countries estimated by UNCTAD to capture this dependence, with high values correlating to more concentrated economies (and higher risk) and lower values to more diversified economies.
II. Political Risk
- Continuous versus Discontinuous Change: The debate about whether risk is higher or lower in democracies or autocracies is an old one and one that is sure to evoke a heated response. On the one hand, democracies create more continuous change, where newly elected governments often feel few qualms about replacing policies that were put into place by prior governments, than autocracies, where governments can promise and deliver stability. However, change in an autocracy, while less common, is also more likely to be wrenching and difficult to plan for.
- Corruption and Side Costs: In an earlier post on the topic, I argued that corruption and bribery create side costs for businesses akin to taxes and make it more difficult to operate. Operating a business in a corrupt environment generally exposes you to more risk, since the costs are unpredictable and rules are unwritten. In the map below, I use a corruption measure from Transparency International to compare countries across the globe:
- Physical Violence: Operating a business exposes you not only to economic risk but physical risk in some countries, as war, violence and terrorism all wreak havoc. The extent of this danger varies across the world and the map below reports on a violence measure developed by the Institute forPeace and Economics.
- Nationalization/Expropriation Risk: While less prevalent than it was a few decades ago, it is still the case that businesses in some countries are more exposed to the risk of being nationalized or having assets expropriated by the government, acting in the “national” interest.
III. Legal Risk
Investors and businesses are dependent upon legal systems enforcing their ownership rights. If you operate in a country where ownership rights are not respected or where the legal system enforcing it is either ineffective or unreliable, it is riskier to start and operate a business in that country. The International Property Rights Index tries to measure the degree of protection, by country, and the summary results, by country, are reported below:
The Measurement of Country Risk
Given that economic, political and legal risk can vary across countries, it is no surprise that investors and businesses seem out measures of country risk that they can use in decision making. We look at three variants of these measures below.
- Risk Scores
With country risk scores, a service weights (subjectively) the importance of each of the many determinants and comes up with a score for country risk. While there are many services that attempt to do this, the picture below uses the scores from Political Risk Services (PRS) to map out hot spots in the globe.
Euromoney, The World Bank and the Economist also have country risk scores but the problem with these scores is three fold. The first is that many of them are intended for general use, rather than for businesses. The second is that there is no standardization in the process; thus, a high score is a reflection of low risk in the PRS system but of high risk in the Economist. Finally, the scores themselves are more rankings than true scores; thus a country with a PRS risk score of 80 is not twice as safe as a country with a PRS risk score of 40.
- Default Risk
The most widely used measures of country risk are those that try to capture the risk that the country’s government will default on its obligations. While this is undoubtedly a much narrower measure than the political/economic risk scores described in the last section, it is more focused and easily usable in businesses.
a. Sovereign Ratings: Ratings agencies such as Standard and Poor’s, Moody’s and Fitch have long rated sovereign debt, assigning ratings to countries for both their foreign currency and local currency borrowings. In July 2015, Moody’s provided sovereign ratings for 129 countries and the map below summarizes these ratings:
While ratings are easy to get (and costless for the most part) and can be easily converted into default spreads that can be utilized as risk premiums, ratings measure only default risk, can be erroneous and often reflect risk changes with a lag.
b. Credit Default Swaps (CDS): In the last decade, the credit default swap market, which I described in this post, has provided updated, market-driven estimates of default risk. In July 2015, there were 62 countries with default risk measures available on them and the map below provides those market judgments.
Credit default swaps are more likely to reflect real world concerns in a timely fashion, but as with any market-driven numbers can also be volatile and prone to over reaction.
It is a cliché to state that the world is full of risk and that risk exposure varies across countries and time, but it is critical that investors and businesses make their best efforts to measure these risks and bring them into their decisions. In the next post, I will look at bringing the risk measures (country risk scores, ratings and CDS spreads) into investment and valuation decisions and also at how the market is pricing these risk measures in equity markets today. If you are interested in exploring this topic in more detail, you are welcome to download and read my paper on country risk.
- Country Risk Measures by Country
- My paper on the determinants and measures of country risk
- UNCTAD (for concentration index measures)
- Transparency International (for corruption scores)
- Global Peace Index (for violence scores)
- International Property Rights Index
- Moody's Sovereign Ratings
- Political Risk Services (PRS)
- Post on Country Risk from January 2015
- Valuing and Pricing Country Risk: Pictures of Global Risk - Part II (Companion Piece, to be posted soon)