One of the consequences of globalization is that investors, analysts too companies tin lav no longer remain focused on merely their domestic markets, but select to besides empathize the risks too opportunities elsewhere inwards the world. When developed marketplace companies outset embarked on the journeying of expanding into emerging marketplace increment economies, investors pushed upwards their stock prices, primarily because of the potential that they saw inwards these markets for expansion. Over time, though, nosotros select learned that, every bit amongst much else inwards business, this strategy comes amongst additional risk, non merely from changing telephone substitution rates, but from unstable economical too political forces. This growth/risk merchandise off explains why some companies select gained from value from globalizing too others select lost. In this post, I expect at dry soil adventure through many lens, but amongst the halt game of existence able to comprise it into conclusion making both for investors too businesses.
The Sources of Country Risk
When companies invest exterior their domestic markets, the most immediate adventure that they are exposed to is telephone substitution charge per unit of measurement risk, since revenues, profits too cash flows are affected past times changing telephone substitution rates. That risk, though, is but a slice of the puzzle, a symptom of economical fundamentals too affected past times political crises. Digging deeper, the factors that brand some countries riskier than others tin lav endure broadly classified into the next groups:
The Sources of Country Risk
When companies invest exterior their domestic markets, the most immediate adventure that they are exposed to is telephone substitution charge per unit of measurement risk, since revenues, profits too cash flows are affected past times changing telephone substitution rates. That risk, though, is but a slice of the puzzle, a symptom of economical fundamentals too affected past times political crises. Digging deeper, the factors that brand some countries riskier than others tin lav endure broadly classified into the next groups:
1. Life Cycle: I select used the construct of a corporate life cycle to verbalize nearly companies at unlike stages inwards the life cycle, too how they differ on cash menstruation generation too increment potential. It is besides to a greater extent than oft than non truthful that younger companies, deriving to a greater extent than or most of their value from futurity growth, are riskier than to a greater extent than mature companies, where the mass of their value coming from investments already made. The same build tin lav endure applied to countries, amongst emerging economies that are growing apace existence to a greater extent than exposed to global shocks than mature countries. It should come upwards every bit no surprise, therefore, that inwards almost every marketplace crisis over the final decade, emerging markets select paid a much large cost inwards terms of lost economical increment too lower marketplace value than developed markets.
2. Political Risk: If the final few years select taught us a lesson, it is that politics tin lav touching on economical too marketplace risk, non merely inwards emerging markets, but besides inwards developed ones. While in that location are many forms of political risk, ranging from acuate changes inwards financial too monetary policy to regime change, in that location are at to the lowest degree 2 measurable manifestations of this adventure inwards the shape of corruption adventure too exposure to violence.
- Corruption Risk: There are parts of the footing where the costs of doing draw of piece of occupation concern include greasing palms too paying off intermediaries, too the roots prevarication deep, resisting feel-good quick fixes. While anecdotal stories of corruption too its consequences are plentiful, in that location are services to travail to mensurate corruption levels across countries. Transparency International, for instance, derives a corruption score, past times country, too inwards its 2019 report, provides a listing of the x to the lowest degree too most corrupt countries inwards the footing inwards the figure below, amongst higher scores indicating less corruption) for 2018.
The effect of corruption upon draw of piece of occupation concern is insidious, making winners of those most willing to play the bribery game too losers of those who resist. In an before post, I argued that corruption creates the equivalent of an informal tax, pushing downward after-tax income to companies.
Source: Transparency International - Physical Violence: When talking nearly adventure inwards investing or business, nosotros tend to focus on financial risk, but it is undeniable that adding the threat of physical violence, from war, terrorism or crime, makes it to a greater extent than hard to operate a business. There are services i time to a greater extent than that mensurate exposure to violence inwards unlike countries, too spell each brings its ain biases, the Institute of Economics too Peace has created too reports on a Global Peace Index, measurement exposure to violence, past times country.
The map summarizes their findings from the most recent year. I must confess that I am surprised to run into Republic of Botswana at the exceed of the list, but having never been there, that may endure a reflection of my regional biases.
Source: Institute of Economics too Peace
3. Legal Risk: Influenza A virus subtype H5N1 draw of piece of occupation concern derives its value from the assets it owns, physical ord intangible, too to hold to derive value, it has to non exclusively save its ownership but select a legal scheme that enforces it’s rights. The character of this protection varies across countries, either because holding rights select fewer protections inwards some countries or because those rights are non enforced inwards a timely mode inwards others. Influenza A virus subtype H5N1 grouping of non-government organizations has created an international holding rights index, measurement the protection provided for holding rights inwards unlike countries. The results inwards 2018, past times region, are provided inwards the tabular array below:
4. Economic Structure: Just every bit diversification helps investors spread their bets too trim back adventure exposure, countries amongst to a greater extent than diversified economies are less exposed to global macroeconomic shocks than countries that derive their value from i or 2 industries, or every bit is oft the representative from i or 2 commodities. In a comprehensive study of commodity subject countries, the United National Conference on Trade too Development (UNCTAD) measures the degree of dependence upon commodities across emerging markets too the figure reports the results.
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| Source: UNCTAD |
Note the disproportional dependence on commodity exports that countries inwards Africa too Latin America have, making their economies too markets really sensitive to changes inwards commodity prices.
Measures of Country Risk
To the extent that dry soil adventure comes from unlike sources, you lot postulate composite measures of adventure to assist inwards conclusion making. This department begins amongst a expect at dry soil adventure scores, where services, using proprietary factors, mensurate dry soil adventure amongst a number, followed amongst financial measures of dry soil risk, primarily designed to mensurate default risk.
Measures of Country Risk
To the extent that dry soil adventure comes from unlike sources, you lot postulate composite measures of adventure to assist inwards conclusion making. This department begins amongst a expect at dry soil adventure scores, where services, using proprietary factors, mensurate dry soil adventure amongst a number, followed amongst financial measures of dry soil risk, primarily designed to mensurate default risk.
Country Risk Scores
There are services, ranging from the World Bank to the Economist that mensurate dry soil adventure amongst scores, though each i uses unlike criteria too scalars. The PRS Group provides numerical measures of dry soil adventure for to a greater extent than than a hundred countries, using xx variables on 3 dimensions: political, financial too economic. The scores attain from null to i hundred, amongst high scores (80-100) indicating depression adventure too depression scores indicating high risk. The figure below captures the June 2019 update, every bit good every bit the 10 countries that emerged every bit safest too riskiest inwards that update.
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| Source: Political Risk Services (PRS) |
Default Risk Measures
Country adventure scores select the practise goodness of existence comprehensive, but they are besides hard to interpret into business-friendly metrics. There are dry soil adventure measures inwards markets, albeit focused primarily on default risk, too the most populace of these are sovereign ratings, in that location are similar a shot besides marketplace based measures, sovereign CDS spreads.
Sovereign Ratings
Moody’s, S&P too Fitch all guess too discover ratings for countries, ranging from Aaa (AAA) for countries they persuasion has having no default adventure to D for countries already inwards default. The figure below provides a map of sovereign ratings across the footing inwards July 2019, using Moody’s ratings where available too S&P to fill upwards inwards some gaps. While the sovereign ratings themselves are alphabetical (and thus are hard to comprise into financial analysis), they tin lav endure converted to default spreads past times looking at traded bonds inwards the market.
Sovereign Ratings
Moody’s, S&P too Fitch all guess too discover ratings for countries, ranging from Aaa (AAA) for countries they persuasion has having no default adventure to D for countries already inwards default. The figure below provides a map of sovereign ratings across the footing inwards July 2019, using Moody’s ratings where available too S&P to fill upwards inwards some gaps. While the sovereign ratings themselves are alphabetical (and thus are hard to comprise into financial analysis), they tin lav endure converted to default spreads past times looking at traded bonds inwards the market.
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| Source: Moody's Sovereign Ratings |
Sovereign CDS Spreads
Ratings agencies select come upwards nether fire, peculiarly since the 2008 crisis, amongst i of the primary critiques existence their perceived bias. I am non existence dismissive of that critique, but I believe that their bigger sin is that they are deadening to reply to changing fundamentals, causing rating changes to lag existent changes on the ground. In the final 2 decades, a marketplace has risen to fill upwards inwards the gap, where investors tin lav purchase protection against default adventure past times buying sovereign credit default swaps (CDS). If the insurance against default is complete, the cost of a sovereign CDS tin lav endure viewed every bit a default spread for the country. On July 23, 2019, the map below summarizes the sovereign CDS spreads for the 81 countries that they were available for.
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| Source: Bloomberg (10-year $ Sovereign Spreads) |
While these market-set default spreads furnish to a greater extent than timely readings of sovereign default adventure than the sovereign ratings, they endure from the measure problems that all market-set numbers are exposed to. They are volatile, affected past times momentum too mood too tin lav attain misguiding signals on risk.
Equity Risk
While default spreads may correspond adequate measures of dry soil adventure if you lot intend to lend to a sovereign or purchase bonds issued past times it, you lot are exposed to to a greater extent than too sometimes unlike risks, if you lot computer programme to expand your draw of piece of occupation concern into a country, or invest inwards equities inwards that country, too you lot postulate equity adventure premiums that capture that risk. It is truthful that many practitioners piece of occupation default spreads every bit proxies of additional dry soil equity adventure too add together it to a mature marketplace premium (often a historical US premium) to brand it at country-specific equity adventure premiums. As readers of this weblog know, I piece of occupation a mild variation on this approach, replacing the historical equity adventure premium amongst an implied premium for the US too augmenting the default spread past times a scaling factor, to reverberate the higher adventure of equity:
Equity Risk
While default spreads may correspond adequate measures of dry soil adventure if you lot intend to lend to a sovereign or purchase bonds issued past times it, you lot are exposed to to a greater extent than too sometimes unlike risks, if you lot computer programme to expand your draw of piece of occupation concern into a country, or invest inwards equities inwards that country, too you lot postulate equity adventure premiums that capture that risk. It is truthful that many practitioners piece of occupation default spreads every bit proxies of additional dry soil equity adventure too add together it to a mature marketplace premium (often a historical US premium) to brand it at country-specific equity adventure premiums. As readers of this weblog know, I piece of occupation a mild variation on this approach, replacing the historical equity adventure premium amongst an implied premium for the US too augmenting the default spread past times a scaling factor, to reverberate the higher adventure of equity:
The equity adventure premiums that outcome from this procedure inwards July 2019 are reported inwards the film below, amongst the implied equity adventure premium of 5.67% for the S&P 500 on July 1, 2019, representing the base of operations number.
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Source: Damodaran Online (Current Data) |
The film continues a story that has been edifice over the final decade. While Africa too Latin America remain hotbeds of dry soil risk, Asia has acquire safer over fourth dimension too parts of Southern Europe select regressed.
If you lot are a developed marketplace fellowship or investor, too believe that adventure inwards Africa, Latin America or parts of Asia don’t apply to you, you lot may desire to recall again. The adventure exposure of a fellowship does non come upwards from where it is incorporated but from where it does business. Thus, Coca Cola too Royal Dutch may endure US too UK-listed companies respectively, but their draw of piece of occupation concern models expose them to adventure unopen to the world. With Coca Cola, that adventure comes primarily from where it sells its products. With Royal Dutch, the adventure is derived from where it extracts its crude too gas, making it to a greater extent than exposed to emerging markets than many emerging marketplace companies. By the same token, Vale too Infosys may endure Brazil too India-based companies, but in that location are both global companies that are exposed to adventure inwards the balance of the globe. In addition, when multinationals travail to guess hurdle rates for projects, it should reverberate non merely the currency you lot practise the analysis inwards but besides the dry soil inwards which the projection volition endure located. Influenza A virus subtype H5N1 Royal Dutch refinery investment inwards Nigeria volition select a higher hurdle charge per unit of measurement than an otherwise similar refinery investment inwards the United States. If you lot notice these concepts intriguing, I select my annual update on dry soil adventure available for download at this link. Be warned! It may operate every bit a narcoleptic to those who are slumber deprived.
Conclusion
There was a fourth dimension a few decades agone when the draw betwixt developed too emerging markets was a clear one. On i side were developed markets, amongst independent key banks, rule-following governments too stable financial policies, too on the other side were emerging markets, amongst unstable too unpredictable political leadership too key banks that did their bidding. The final decade has seen a blurring of lines, every bit some “developed markets” mimic emerging marketplace behaviour too some emerging markets mature. There are some (companies too investors) who select decided that this convergence is a ground to ignore dry soil risk, but I recall that they practise then at their ain peril. Notwithstanding globalization too convergence on some dimensions of risk, nosotros human face upwards broad variations inwards adventure across the world, too prudence too expert sense need that nosotros comprise these differences into our decisions.
There was a fourth dimension a few decades agone when the draw betwixt developed too emerging markets was a clear one. On i side were developed markets, amongst independent key banks, rule-following governments too stable financial policies, too on the other side were emerging markets, amongst unstable too unpredictable political leadership too key banks that did their bidding. The final decade has seen a blurring of lines, every bit some “developed markets” mimic emerging marketplace behaviour too some emerging markets mature. There are some (companies too investors) who select decided that this convergence is a ground to ignore dry soil risk, but I recall that they practise then at their ain peril. Notwithstanding globalization too convergence on some dimensions of risk, nosotros human face upwards broad variations inwards adventure across the world, too prudence too expert sense need that nosotros comprise these differences into our decisions.
YouTube Video
Paper on Country Risk
Country Risk: Determinants, Measures too Implications - The 2019 Edition
Data Links
- Measures of Corruption, past times Country (Transparency International)
- Measures of Violence, past times Country (Institute for Peace too Economics)
- International Property Rights Index
- Commodity Dependence, past times dry soil (UNCTAD)
- Country Risk Scores (PRS Group)
- Sovereign Ratings, past times Country (Moody's, S&P)
- Sovereign CDS Spreads (10-year) on 7/21/2019
- Equity Risk Premium, past times dry soil (Damodaran Online)
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