Country Risk
Key sources of country risk include where the country is in the economic growth life cycle, political risks, the legal systems of countries, including both the structure and the efficiency of legal systems, and the disproportionate reliance of a country on one commodity or service.
Country’s Risk Exposure
Regarding economic growth life cycle, more mature markets and companies within those markets are less risky than those firms and countries in the early stages of growth.
Regarding political risk, there are at least four components of political risk, including the level of corruption in the country, the occurrences of physical violence due to wars or civil unrest, the possibility of nationalization and expropriations, and the continuity and severity of risks versus discontinuous risks.
Regarding legal risks, the protection of property rights and the speed with which disputes are settled affect default risk.
Regarding economic structure, a disproportionate reliance on a single commodity or service in an economy increases a country’s risk exposure.
Evaluating Country Risk
Companies such as Political Risk Services (PRS) and organizations such as The Economist and Euromoney evaluate more than 100 countries on key areas of country risk. Some are critical of these composite risk measures because they are not readily comparable with each other due to a lack of standardization across the information providers. Also, the methodologies used to generate scores are often developed by non-business entities and may have more relevance to economists and policymakers than to businesses and investors. Finally, the scores are better used as rankings than as a way to interpret the relative risk of countries.
Sovereign default risk
There are many causes of sovereign defaults. It is easier to understand foreign currency defaults than local currency defaults. Countries are often without the foreign currency to meet the debt obligation and are unable to print money to repay the debt. This makes up a large proportion of sovereign defaults.
Many of the countries that defaulted on foreign currency debt over the last several decades were simultaneously defaulting on local country debt. Three reasons may explain local currency defaults: (1) the use of the gold standard prior to 1971 made it more difficult for some countries to print money, (2) shared currencies, such as the euro, make it impossible for countries to control their own monetary policy, and (3) some counties must conclude that the costs of currency debasement and potentially higher inflation are greater than the costs of default.
Consequences of Sovereign Default
Historically, defaults were often followed by military actions. Research suggests the following additional consequences of sovereign defaults:
- GDP growth falls between 0.5% and 2.0% following a sovereign default.
- Borrowing costs are 0.5% to 1.0% higher following default.
- Sovereign default can cause trade retaliation.
- One study finds, based on 149 countries between 1975 and 2000, that there is a 14% probability of a banking crisis following a sovereign default, which is 11% higher than for non-defaulting countries.
- Sharp currency devaluations often follow defaults.
Factors Influencing Sovereign Default Risk
Several factors determine a country’s sovereign default risk. The country’s level of indebtedness, obligations such as pension commitments and social service commitments, the country’s level of and stability of tax receipts, political risks, and backing from other countries or entities all impact a country’s likelihood of defaulting on sovereign debt.
Rating agencies consider several factors when evaluating default risk. These factors are related to the economic, political, and institutional characteristics of a country with respect to its ability to repay debt. The ratings process includes an analyst preparing a draft report and recommending a rating. A committee votes on a score and decides the final rating. Ratings are reviewed periodically and may also be reviewed following a news event that could affect the likelihood of default.
Rating agencies have been criticized on a number of counts, including the fact that ratings are biased upward, there is herd behavior among the major rating agencies (i.e., S&P, Moody’s, and Fitch), sovereign rating changes are too slow to change, rating agencies often overreact to news about a country, and ratings are simply wrong in some cases.
The Sovereign Default Spread
Advantages of default risk spreads relative to sovereign bond ratings are that changes occur in real time, risk premiums adjust to new information more quickly, and there is more granularity in default risk spreads than in risk ratings.
Disadvantages of default risk spreads include the fact that a default risk-free instrument is required with which to compare the sovereign yield, spreads are more volatile and may react to factors that have little to do with default risk (e.g., changes in liquidity and investor demand), and local currency bonds cannot be compared with each other because differences may reflect differences in expected inflation rather than differences in default risk.
