Country risk makes every investment different.
Investors routinely forget to take into account country risk. As a result, not all returns are created equally, and we must always consider the risk-reward relationship.
What is Country Risk?
Country risk is reflected in the difference between the interest rate paid by the local government and the interest rate paid by the US Department of the Treasury on bonds issued with the same maturity and conditions.
The higher interest rate means that credit for the local government is costlier because investors suppose that lending it money is riskier than lending money to the US government: they perceive that the country's risk is more significant and that the local government’s payment capacity is lower; consequently they require a greater return to compensate for this additional risk.
The level of country risk sets an interest rate floor, or minimum, at which companies and consumers will be able to borrow money, both domestically and internationally. So the higher the country's risk, the higher the interest rates will be for the private sector.
Country risk calculation refers to the risk that political, business, or economic developments in a foreign country will adversely affect the value of an investment. This can include anything from a change in government to a country's credit rating being downgraded by a primary agency. This type of risk is typically correlated with investments in frontier and emerging markets, where governance may be less stable, and legal protections for investors may be weaker. However, country risk can and has affected investments in developed countries during economic or political turmoil.
Factoring in Country Risk While Investing
When making investment decisions, country risk should always be considered as it can negate the potential reward of investment. While there are several methods to incorporate country risk into an asset's expected returns, leveraging a combination of qualitative and quantitative analysis is often seen as the most effective way to do so. Qualitative analysis generally comes from country risk ratings from agencies like the World Bank and expert analyses of a country's history, current conditions, and prospects. In contrast, quantitative analysis typically relies on economic indicators to generate risk assessment models. Firms like Euromoney have simplified this process for investors by providing country risk scores that consider both qualitative and quantitative factors. Generally, country risk scores are lowest for emerging and frontier markets, while scores are relatively high for developed countries.
Equipped with these scores, investors can more accurately compare the risk and potential reward of investments in different countries. Unsuspecting investors may initially be attracted to a country because it offers a higher rate of return. Still, if the country is unstable, there is a greater chance that the investment will not perform as expected.
This method of assessing risk-adjusted expected rates of return can be applied to all asset classes, including stocks, bonds, real estate, and commodities.
For example, let's say an investor is considering two investments - one in the United States with expected returns of 10% and one in Brazil with expected returns of 16%. Without considering country risk, the Brazilian investment appears to offer a much higher return. However, when country risk is factored in, 16%*0.40 = 6.4%, the expected return on the US investment becomes higher.
Alternatively, let's say we take a 10% return as a baseline in the US. What return would it take in other countries to adjust for the country's risk:
This is what many investors forget to factor in. To be compensated for the country's risk, investors in Ecuador need to make 20% returns to make the same 10% in the US.
One of the primary sources of country risk is a political risk - the risk that a country's government will take actions that adversely affect the value of an investment. This can include anything from changes in taxation to outright expropriate of assets. For example, following a failed coup attempt in 2016, the Turkish government began a crackdown on suspected dissidents that included the seizure of assets, businesses, and real estate. This created significant uncertainty for foreign investors, many of whom saw the value of their investments plummet as a result. In some cases, the political risk may be mitigated by investing in companies that are seen as supportive of the current regime or by signing contracts with the government that stipulate certain protections for investors. However, these measures are not always effective, and political risk should always be considered when assessing the potential return of an investment in a foreign country.
While measuring political risk isn't a perfect science, there are several methods that can be used to evaluate the stability of a country's government. These include reviewing a country's history of coups or other major political disruptions, monitoring changes in public opinion, and tracking the activities of opposition groups. More advanced measuring tactics, like political risk spreads, can also be used to get a more granular understanding of the level of risk in a country.
Another major source of country risk is an economic risk - the risk that adverse macroeconomic conditions in a country will lead to lower than expected returns on an investment. This can include anything from a country's currency depreciating to the country defaulting on its debt obligations. Investors assessing economic risk typically turn to independent credit ratings from companies like Moody's or Standard & Poor's to evaluate how likely a government is to default on its debts. A country that is unable to meet its debt obligations can lead to a loss of confidence in the country's economy, and a decline in the value of its currency and assets. In 2018, Pakistan's credit rating was downgraded by Moody's due to concerns about the country's high debt levels and declining foreign exchange reserves. This led to a massive sell-off of Pakistani assets, and a sharp decline in the value of the Pakistani rupee. Similarly, the United Kingdom's vote to leave the European Union in 2016 created significant uncertainty about the country's future economic prospects, and led to a sharp decline in the value of the British pound. The pound plunged to a 31-year low, falling more than 10% against the US dollar overnight and bringing the UK's corporate bond stock markets down.
This type of risk is most often associated with countries with large debts, high levels of inflation, or weak currencies. However, country risk can also be present in otherwise stable countries during periods of economic uncertainty. For example, during the 2008 financial crisis, economic-country risk spiked in several developed countries as investors worried about the health of the global economy. This led to widespread panic and a 40% contraction of assets in the US in a single year.
The Bottom Line
While country risk assessment is not an exact science, it is an important consideration for any investor with international holdings. Investors can choose to evaluate a combination of qualitative and quantitative factors or rely on country risk scores from organizations like Euromoney to help assess country risk. By accounting for country risk, investors can make more informed decisions about allocating their assets based on risk-adjusted expected returns and how to best protect their investment portfolios from potential losses.
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