SOURCES OF COUNTRY RISK #
Key sources of country risk include:
- where the country is in the economic growth life cycle,
- political risks,
- the legal systems of countries, including both the structure and the efficiency of legal systems, and
- the disproportionate reliance of a country on one commodity or service.
COUNTRY RISK EXPOSURE #
The key sources of country risk affect a country’s risk exposure in the following ways:
- Economic Growth Life Cycle: More mature markets and companies within those markets are less risky than those firms and countries in the early stages of growth. Early growth and emerging market countries are more vulnerable and are thus exposed to higher levels of risk than mature countries.
- Political Risk: Political risk is broad and includes everything from whether a country is a democracy or a dictatorship to the smoothness with which a country transfers political power (e.g., military coups vs. democratic elections). There are at least four components of political risk, including: Continuous Vs. discontinuous risk, corruption, physical violence, nationalization & expropriation risk.
- Legal Risk: The protection of property rights (i.e., the structure of the legal system) and the speed with which disputes are settled (i.e., the efficiency of the legal system) affect risk. If disputes cannot be settled in a timely fashion, it is in essence the same as a system that does not protect property rights at all.
- Economic structure: A disproportionate reliance on a single commodity or service in an economy increases a country’s risk exposure. For example, the economies of some countries rely almost exclusively on oil production. A downturn in the demand (and/or price) for the good or service on which the country is dependent can devastate the economy, increasing risks for businesses and investors.
EVALUATING COUNTRY RISK #
There are numerous services that attempt to evaluate country risk in its entirety, including:
- Political Risk Services: This for-profit firm evaluates more than 100 countries on the key areas of country risk. Political, economic, and financial risk dimensions are evaluated using 22 variables to measure risks. The firm provides a composite score as well as a score on each of the three dimensions.
- Euromoney: The magazine surveys 400 economists who assess country risk factors and rank countries from 0 to 100 with higher numbers indicating lower risk.
- The Economist: Currency risk, sovereign debt risk, and banking risks are assessed by the magazine to develop country risk scores. In this risk measure, low scores indicate lower risk and high scores indicate higher risk.
- The World Bank: The World Bank compiles risk measures from several sources on 215 countries. Risk measures assess six areas, including the level of corruption, government effectiveness, political stability, rule of law, voice and accountability, and regulatory quality.
SOVEREIGN DEFAULTS #
Sovereign default risk refers to the risk that holders of government-issued debt fail to receive the full amount of promised interest and principal payments during the specified time period. Sovereign default categories include foreign currency defaults and local currency defaults.
- Foreign currency defaults: The debt, denominated in the foreign currency, is called foreign currency debt. Countries often default on foreign currency debt. Countries may be without the foreign currency to meet the obligation and are unable to print money in a foreign currency to repay the debt.
- Local currency defaults: There are three reasons that help explain local currency defaults.:
- The gold standard: Some countries were required to have gold reserves to back currency. The gold standard thus limited the amount of currency a country could print, reducing its flexibility in terms of printing currency to repay debt.
- Shared currency: It eliminates the costs of converting currencies and increases transparency. However, a shared currency limits the abilities of individual countries to print money.
- Currency Debasement: Printing money may devalue and debase the currency. It also leads to higher inflation, sometimes exponentially higher inflation.
CONSEQUENCES OF SOVEREIGN DEFAULT #
An examination of research on sovereign defaults leads to the following conclusions:
- GDP growth: Gross domestic product (GDP) growth falls between 0.3% and 2.0% following a sovereign default.
- Sovereign ratings and borrowing costs: Ratings of countries that have defaulted at least once since 1970 are one to two grades lower than the ratings of similar countries that have not defaulted. Also, borrowing costs are 0.5%—1.0% higher. The effects lessen over time.
- Trade retaliation: Sovereign default can cause trade retaliation. Export businesses are most affected. An average 8% drop in bilateral trade following a default.
- Fragile banking systems: Based on 149 countries between 1975 & 2000, that there is a 14% probability of a banking crisis following a sovereign default, which is 11% higher than for non-defaulting countries.
- Political change: Sharp currency devaluations often follow defaults. Countries that default on debt are more likely to see a change in the president or prime minister & the top finance minister or head of the central bank.
FACTORS INFLUENCING SOVEREIGN DEFAULT RISK #
- The country’s level of indebtedness: One must consider not only the country’s debts to foreign banks and investors, but also the amount the country owes its own citizens.
- Pension funds and social services: Countries with greater pension commitments and health care commitments have higher default risk.
- Tax Receipts: The greater the tax receipts, the more able a country is to make debt payments.
- Stability of tax receipts: Countries with more diversified economies are more likely to have stable tax receipts.
- Political Risk : Autocracies may be more likely to default than democracies because, defaults put pressure on, and may cause a change in, the leadership of the country.
- Backing from other countries/entities : It is assumed that stronger countries like Germany will help weaker countries and not allow them to default. However, there is no guarantee. It is an implicit, not explicit, backing.
RATING AGENCIES & DEFAULT RISK
The market for sovereign bonds has increased dramatically since 1994. Moody’s, S&P, and Fitch currently rate more than 100 countries each. Moody’s and S&P have improved the ratings, currently providing two ratings for each country, a local currency rating for domestic currency bonds and a foreign currency rating for borrowings in a foreign currency. Generally, the local currency rating is at least as high as the foreign currency rating, because, as noted, countries can print money in local currency to repay debt.
HOW RATING AGENCIES MEASURE RISK
The ratings process includes:
- Evaluating factors that may contribute to default.
- Ratings recommendation.
- Foreign currency versus local currency ratings: Agencies use two approaches to arrive at the foreign versus local currency ratings:
- Notch up approach : The foreign currency rating is the key indicator of sovereign default risk and the l ocal currency rating is “notched up” based on the domestic debt market and other domestic factors.
- Notch-down approach. The local currency rating is the key indicator of sovereign credit risk and the foreign currency rating is “notched down” based on foreign exchange issues and constraints.
DO RATINGS MEASURE RISK?
Rating agencies have been criticized on a number of counts. These include:
- Ratings are biased upward
- Herd behaviour
- Not timely enough.
- Overreaction leads to a vicious cycle.
- Ratings failures : The study offered several possible explanations for the ratings failures:
- Bad information
- Overburdened analysts
- Conflicts of interest resulting from revenue challenges.
- Other conflicts of interests.
THE SOVEREIGN DEFAULT SPREAD #
There has been significant growth in the sovereign bond market, beginning in the 1980s. More countries are deliberately avoiding bank debt and issuing bonds instead. As a result, there is another measure of sovereign default risk that may be used, the sovereign default spread. This measure is generated by the market and is continuously updated as sovereign bonds are traded.
ADVANTAGES OF DEFAULT RISK SPREADS:
- Changes occur in real time.
- Adjust quickly to new information.
DISADVANTAGES OF DEFAULT RISK SPREADS:
- Need for a risk free security
- Cannot compare local currency bonds
- Greater Volatility.