What is Country Risk?
Country risk is a risk that denotes the probability of a foreign government (country) defaulting on its financial obligations as a result of economic slowdown or political unrest. Even a small rumor or revelation can make a state less attractive to investors who want to park their hard-earned income in a place that is reliable and significantly less likely to default.
Example of Country Risk Analysis
Let us assume Two Countries – the US and Algeria. Assuming both have some up-and-coming projects coming up for which they intend to issue bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually. to raise finance. Which bonds are safe and which are more likely to default? Here comes the assessment part. An investor has to scrutinize various factors attributing to the country’s stability, like its political situation, inflation rates, economic health, tax systems, and many other factors.
Upon careful assessment, investors might find that the US is a far better investment option than Algeria owing to its solid political structure, demographics, tax system, technological advancement, and economic wellbeing. Hence, it can be said that Algeria has a much higher country risk than the US. The US is found to have the lowest country risk in the world.
Types of Country Risk
This can be categorized into the following types of country risks:
#1 – Sovereign Risk
This refers to the probability of a central bank bringing in rules that might adversely impact the value of investor’s holdings. It also includes the possibility of a foreign government defaulting on its sovereign debtSovereign DebtSovereign debt is the money borrowed by a country’s central government, primarily achieved by selling government bonds and securities. Treasury notes, bonds, and bills are some examples of sovereign debt issued by the United States..
#2 – Economic Risk
This refers to the chance of a country defaulting on its debt obligations in a broader sense. This is most often a factor of the economic health of a nation. Sovereign risk is a type of financial troubleA Type Of Financial TroubleEconomic Risk is the risk exposure of an investment made domestically or abroad. These risks could be macroeconomic factors like government policies or collapse of the current government and major swing in the exchange rates..
#3 – Political Risk
This type of risk is mainly associated with the losses resulting due to the political situations of a country. Even a politician’s comment might not settle down well in the international community, thus contributing to country risk.
Measurement and Analysis of Country Risk
Measuring and analyzing country risk isn’t a straightforward task. Investors can adopt several different ways of assessment. In most cases, a combination of other risk measures like debt-to-GDP ratio, beta coefficientsBeta CoefficientsThe beta coefficient reflects the change in the price of a security in relation to the movement in the market price. The Beta of the stock/security is also used for measuring the systematic risks associated with the specific investment., and country ratings might prove to be very useful. OECDOECDOECD is an abbreviation for Organization for Economic Co-operation and Development. It is a 38-member international organization established for the purpose of encouraging economic development and world trade by making essential policies. (Organization for Economic Cooperation and Development) has outlined two ways of analysis:
#1 – Quantitative Analysis
Risk measures like beta coefficients and risk denoting ratios (e.g., debt-to-GDP ratioDebt-to-GDP RatioThe debt to GDP ratio is a metric to compare a country's debt to its GDP and measures its capability to repay its debt. A country with a high ratio would not have difficulty repaying its debt but will not seek debt due to higher chances of defaulting.) can be classified under quantitative methods. The Morgan Stanley Capital Investment Index or the MSCI Index is the most commonly used benchmark for many stocks, thus representing the entire global market under one roof. The beta coefficient for the MSCI Index of a country can be used as a measure of country risk. A total of 23 countries are represented through this index.
#2 – Qualitative Analysis
The qualitative analysis leans more towards the subjective aspects of measurement. This will not provide investors with a risk number but can give an obvious idea about the risk environment of a country. Any sudden political upheaval or changes in the market statistics can render a country’s economy unstable, thus increasing its risk. Checking sovereign ratings and being updated with the latest changes helps investors to a great extent.
- As indicated earlier, country risk assessment keeps investors warned and aware of what to expect from an investment in a particular country.
- Not only investors but such analysis also helps corporations in formulating strategies suited to a particular country’s environment. Such strategic planning helps them treat different countries differently.
- It includes both economic and political risksPolitical RisksPolitical risk is defined as a risk that emerges as a result of a change in a country's governing body, posing a risk to investors in financial instruments such as debt funds, mutual funds, and equities.. Measurement provides a tentative idea of the financial health and the political environment of a country. This 2-pronged approach to risk assessment is very beneficial for governments who can devise their foreign policies accordingly.
- Many corporations and publications use their own country risk analysisRisk AnalysisRisk analysis refers to the process of identifying, measuring, and mitigating the uncertainties involved in a project, investment, or business. There are two types of risk analysis - quantitative and qualitative risk analysis. tool. By using this tool, they can devise different methods to get insured against such risk.
- This is dependent on hundreds of factors, making its assessment difficult and not so accurate. The error of measurement or error of omission is bound to happen. Even the most sophisticated algorithms fail to capture all the factors accurately.
- Qualitative assessment is primarily based on the availability and inclusion of information. However, the report found is never perfect. So, it doesn’t aptly capture everything.
Country risk models so far have failed to properly contain the continually changing economic and political environment of countries. It is also a tedious process to determine the exact size and nature of exposure.
- Investors and financial corporations should devise a proper framework that includes segregates between different parts of country risk.
- It is also governed by a country’s resources and the primary occupation the economy is based on. Setting up teams to closely monitor these areas will also be beneficial in the assessment.
- Risk exposureRisk ExposureRisk Exposure refers to predicting possible future loss incurred due to a particular business activity or event. You can calculate it by, Risk Exposure = Event Occurrence Probability x Potential Loss should continually be monitored and updated to stay abreast.
- Using ratings to evaluate a country’s standing in the global markets.
With increasing globalization and expansion of trades between nations, it has made financial organizations, including banks and other investors, very uneasy. It is a known fact that up until now, not much has been done to properly manage and contain country risk exposure since the 2007-08 crisis unfolded, many were under oblivion.
Apart from the assessment and avoidance of countries with excessive risk, diversification and hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market. can also help mitigate this risk. Country risk maps have also been developed to give a fair idea of the riskiness associated with different geographical regions. But the nature of risk is such that a varying degree of uncertainty will continue to exist.
This has been a guide to what is Country Risk, and it’s Definition. Here we discuss how to measure and analyze country risk and its types, advantages, and disadvantages. You can learn more about accounting from the following articles –