Country Risk (Definition, Types)| How to Measure & Analzye Country Risk?

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 country less attractive to investors who want to park their hard-earned income in a place which is reliable and very less likely to default.

Example of Country Risk Analysis

Let us assume Two Countries – the US and Algeria. Assuming both have some very promising projects coming up for which they intend to issue bonds to raise finance. Which bonds are safe and which are more likely to default? Here comes the assessment part, where 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 hundreds of 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 much higher country risk than the US. In fact, 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 debt.

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#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 country. Sovereign risk is a type of economic risk.

#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 a number of different ways for assessment. In most cases, a combination of different risk measures like debt-to-GDP ratio, beta coefficients, and country ratings might prove to be very useful. OECD (Organization for Economic Cooperation and Development) has outlined two ways of analysis:

#1 – Quantitative Analysis

Risk measures like beta coefficients and risk denoting ratios (for e.g. debt-to-GDP ratio) can be classified under quantitative methods. The Morgan Stanley Capital Investment Index or the MSCI Index is the most commonly used benchmark for a wide number of stocks, thus representing the entire global market under one roof. 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 a very clear 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 the country risk. Checking sovereign ratings and being updated with the latest changes helps investors to a great extent.

Advantages

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 risks. Measurement provides a tentative idea of the economic health and the political environment of a country. This 2-pronged approach to risk assessment is very beneficial for governments also who can devise their foreign policies accordingly.
Many corporations and publications use their own country risk analysis tool. By using this tool, they can devise different methods to get insured against such risk.

Disadvantages

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 largely based on the availability and inclusion of information. However, Information found is never perfect. So, it doesn’t aptly capture everything.

Limitations

Country risk models so far developed have failed to properly contain the constantly changing economic and political environment of countries. It is also a tedious process to determine the exact size and nature of exposure.

Managing Exposure

Investors and financial corporations should devise a proper framework that includes as well as 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 exposure should continually be monitored and updated to stay abreast.
Using ratings to evaluate a country’s standing in the global markets.

Conclusion

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 until the 2007-08 crisis unfolded, many were under oblivion.

Apart from the assessment and avoidance of countries with excessive risk, diversification and hedging can also help mitigate this risk to some extent. 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.