Country risk

From CEOpedia | Management online

Country Risk is an uncertainty in a country’s politics and economy as a whole that affects the value of loans or investments made in that country. The variability of a country's terms of trade and the readiness of the government to permit the national economy to quickly react to shifting economic fortunes are major factors that define country risk (Shapiro, 1985).

Country Risk Categories

D. Meldrum (2000) suggested the following list of country risk categories:

  1. Economic Risk
  2. Transfer Risk
  3. Exchange Rate Risk
  4. Location or Neighborhood Risk
  5. Sovereign Risk
  6. Political Risk

Economic Risk: a radical change in the economy's growth or structure that has a considerable impact on predicted investment returns. Risk is the possibility of harmful changes to key economic policy objectives (fiscal, monetary, international, or wealth distribution or production) or a dramatic shift in a country's comparative advantage (e.g., resource depletion, demographic change, industry decline,). In some assessment systems, political risk and economic risk frequently overlap since both concern policy.

Transfer Risk: the chance that a foreign government will decide to limit capital movements. It could be challenging to repatriate profits, dividends, or cash due to restrictions. Transfer risk pertains to all sorts of investments since a government might alter capital movement regulations at any time.

Exchange Rate Risk: an unanticipated shift in the exchange rate that is negative. A sudden shift in currency regime, such as from a fixed to a floating exchange rate, is one example of exchange risk. Longer-term (greater than one to two years) exchange rate risk analysis is guided by economic theory. In the short-term, risk associated with currency changes can be reduced using different hedging strategies and future contracts.

Location or Neighborhood Risk: spillover effects brought on by issues in an area, a nation's economic partner, or nations with perceived similarities.

Sovereign Risk: a government defaults on debts it guarantees or becomes unable or unwilling to fulfill its lending obligations. Transfer risk and sovereign risk are related in that a government may run out of foreign currency as a result of unfavorable changes to its balance of payments. In that a government might decide not to uphold its pledges for political reasons. This type of risk is strongly connected with political risk.

Political Risk: risk of political institution changes brought on by shifts in governmental authority, societal structure, or other non-economic factors. Expropriation risk, the potential for internal and external conflict, and conventional political analysis are all included in this category (Meldrum, 2000).

As the author underlines, the following list may not be upon agreement among all of the country's risk analysts, due to the fact that often each service may use different criteria and methodology for assessing the country's risk.

Characteristics of country risk analysis and examples of analytic agencies

Analyzing country risk is a difficult task. By using reputable and practical sources of data, such as rating agencies, official organizations, and other numerous sources, the analyst can ensure the consistency of its investigations by adhering to established processes. To establish a risk level and, therefore, a price for the asset in risk, the analysis must first address the macroeconomic, sociopolitical, and financial factors before addressing the strengths and weaknesses of a country.

Numerous rating agencies publish their own country risk reports (e.g. Political Risk Service, Institutional Investors, Lloyds, The Economist, Euromany, Moody’s, Standard and Poor’s or Coface). These reports reflect the major risk concerning particular countries. Most often, measures of each are based on various methodologies by different types of experts; the reports are highly correlated (Toma, Alexa, 2012). Important factor to mention is the fact that the country risk models are often different for emerging markets and advanced economies (Ahuja et al., 2017).

Political Risk Service (PRS) methodology example

Model called The International Country Risk Guide (ICRG) rating consists of 22 different variables in 3 subcategories of type of risk: political, financial and economic. Each subcategory has its own index made. Both Financial and Economic Risk categories are based on 50 points scale, while the Political Risk index on 100 points. To determine the weights to be used in the composite country risk score, the combined points from the three indices are divided by two. These scores (ranging from 0-100) are then classified by categories from Very Low Risk (80-100 points) to Very High Risk (0-49.9 points).

Political Risk index include (among others) components such as Government Stability, Socioeconomic Conditions, Investment profile and many others. Which may consist of more subcomponents that are measured. In the Economic Risk index we can find measures such as Gross domestic product per head, Real GDP growth or Inflation Rate (annual). While in the Financial Risk Rating as an exemplary variables Foreign Debt as a Percentage of GDP or Exchange Rate Stability can be mentioned (for full explanation of this methodology see ICRG Methodology).

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Author: Wojciech Kleszcz