VRM 5: Country Risk

Gross Domestic Product, or GDP, totals the value of the goods and services that a country’s people and firms turn out. Growth in that total is measured in domestic currency, which loses purchasing power, so economists strip inflation out first. What remains is the real GDP growth rate.

Downturns are not shared equally

An important question is how an economy behaves when the global cycle turns, and developing economies usually give up more ground. They lean harder on commodities, so a recession squeezes them twice, on price and on demand. In 2009 the United States went through its worst recession since the 1930s and real GDP fell by 2.8%. Mexico, whose economy depended heavily on exports to its northern neighbour, saw real GDP shrink by 4.7% that year. Not everyone fared badly in the 2007-2009 recession: China held its real GDP growth rate above 6% in 2009.

Growth and politics feed each other. A stalled economy breeds dissatisfaction, which turns into political turmoil, which holds growth down further. Fast growth in a developing market is real, and so are the higher economic risks that come with it.

Source: IMF World Economic Outlook database, www.imf.org. The gap column is calculated here.

Vietnam, India and China all cleared 6% in 2019, while Libya and Venezuela recorded the worst rates. Venezuela is rich in oil and still contracted by more than a third in one year, held back by political turmoil and internal strife.

Political risk means that a change of government, a decision a government takes, or simply the manner in which it operates can move the profitability of a business, or of an investment, by a material amount. It is the hardest component to put a number on, because the trigger is a human decision rather than a price.

A single change of leadership can redraw the political map and lift several other risks at once, which is why investors value government stability. Whether democracies or authoritarian governments generate more political risk is genuinely arguable. Authoritarian governments turn over less often and can hold a course for years, but when a coup installs one dictator in place of another the break in policy can be abrupt. Democratic governments change hands more often, and each change shifts policy by less. Studies comparing growth under the two systems come out mixed, and causality complicates them further, since several authors argue that growth creates the appetite for democratic government.

When the host government takes the asset

Nationalization and expropriation form a separate strand, and they bite hardest on firms in natural resources. A mining company owns the mine; an oil company holds the drilling rights. If that operation is visibly profitable while the host economy is faltering, seizing it can be a popular policy, and the compensation paid may be very small. The government gains an asset and loses a reputation: investors read the episode as a precedent, capital stops arriving, and the long term cost can exceed the value of what was taken.

Corruption is one face of political risk. A firm investing abroad deals with the government bureaucracy sooner or later, and in some countries nothing moves without payments to public officials. That is an impossible position, since bribery is a criminal offence in many developed countries: the Foreign Corrupt Practices Act, a statute in the United States, prohibits the bribing of foreign officials.

Treat a bribe as an implicit tax on income. It lowers profitability and the return to whoever owns the business, and unlike an ordinary tax the amount is unknown in advance, which adds risk on top of cost. If the payments are later prosecuted at home, the firm pays twice, financially and reputationally. Transparency International compiles a corruption index from surveys of experts living and working in each country, publishing the top twenty and the bottom twenty each year. A lower index marks a country perceived as more corrupt.

Violence and the Global Peace Index

Violence damages a business in ordinary ways: operations become hard to run, insurance costs rise, and the working environment for employees can become difficult or wholly unsatisfactory. The Global Peace Index, which the Institute for Economics and Peace produces, scores countries on this dimension, and here a low score is the good outcome.

Source: Global Peace Index, Institute for Economics and Peace, reproduced here by permission. The final column is calculated here.

The corruption and violence rankings overlap heavily. Denmark, New Zealand, Switzerland and Canada sit near the top of both, so a firm operating in any of them should meet few of these problems, while many African and Middle Eastern countries appear near the bottom of both.

Legal risk covers the losses that follow when a legal system is inadequate or biased. Business activity generates disputes, so a system trusted and seen to be fair pulls foreign investment in, while one that is biased, open to government interference, or slow to the point of ineffectiveness pushes it away. Russian oligarchs settle their quarrels in British rather than Russian courts, which shows how the parties themselves rank the two.

Two features matter most: property rights and the enforcement of contracts. Buying shares in a firm domiciled abroad only makes sense if the country has fair rules on shareholder entitlements and on how firms are governed, and if a firm and its management can be sued over insider trading, over actions that hurt shareholders, and over attempts to deceive the market about its financial health.

The Property Rights Alliance publishes the International Property Rights Index so that individuals and firms can see what they take on when they invest abroad. It has three parts: a Legal and Political Index built from control of corruption, political stability and rule of law; a Physical Property Index built from ease of access to loans, registering property and property rights; and an Intellectual Property Index built from copyright protection, patent protection and intellectual property protection. Larger numbers indicate a better legal system, and in 2019 the overall index ran from Yemen at 2.67 to Finland at 8.71.

Source: Property Rights Association (www.internationalpropertyrightsindex.org). The final column is calculated here.

The final column shows where the legal and political pillar drags the total down, and the gap is widest for Brazil at 1.91 and Russia at 1.73: in both, intellectual property law scores far better than the rule of law and control of corruption needed to make it worth anything.

GDP per capita and the real GDP growth rate cover only part of the picture. Neither says what would happen if one price moved against the country, and that is where economic structure comes in. Some countries are highly dependent on a single commodity, and when its price declines the country suffers and the value of its currency suffers with it. A good number of African and Latin American economies sit in that position.

Size makes diversification easier. Brazil, India and China are large enough to broaden their economic bases without much difficulty, while a small country living on a handful of goods is exposed to every swing in demand for them. In theory it could hedge with long term contracts for what it sells and for what it must import. Very little hedging of that kind actually happens.

A timing choice is buried in the structure. Extracting and exporting a commodity may maximise growth over the next few years, while building other industries sustains growth over decades. Saudi Arabia intends to restructure the oil-dependent economy of the Kingdom by privatising state assets and diversifying its focus, that trade-off made explicitly.

Where competitive advantage comes from

Countries build competitive advantages as firms do. Michael Porter argued that national advantage rests on how well an industry can innovate and upgrade, and his research led him to four determinants. Factor Conditions cover where the nation stands in factors of production, such as skilled labour or infrastructure, that an industry needs in order to compete. Demand Conditions cover what home-market demand for that industry looks like. Related and Supporting Industries cover the presence or absence of internationally competitive supplier and related industries. Firm Strategy, Structure, and Rivalry covers how firms are created, organized and managed, and the nature of domestic rivalry.

Hong Kong, Singapore, South Korea and Taiwan, the four Asian tigers, are the standard illustration. Real GDP growth rates above 7% per year were sustained there from the 1960s through the 1990s. Hong Kong and Singapore became world-leading international financial centres, while South Korea and Taiwan became world leaders in manufacturing and information technology. The advantage was built rather than inherited, which is why economic structure is a risk factor that can improve.

Once country risk has been split into economic, political, legal and violence components, the natural question is whether the pieces reassemble into one composite risk measure, the equivalent for a country of a value at risk or an expected shortfall. Several services attempt it. Political Risk Services calculates its index from 22 measures of economic, financial and political risk, and a firm can customise that forecasting model by adjusting the weighting on each variable, adding or subtracting variables, or otherwise emphasising the risks that matter to it.

Media outlets publish scores too. Euromoney surveys 400 economists to build its scores, while The Economist develops country risk scores internally from banking risk, sovereign debt risk and currency risk. The World Bank provides data measuring accountability, the rule of law, regulatory quality, political stability, government effectiveness and corruption.

What a composite score can and cannot tell you

Comparing these services is awkward, since they use different scoring methods and different attributes, and not every dimension is relevant to every user. Then there is scaling. If one score is double another, what exactly has doubled? Nothing in these indices answers that. The ranking usually carries more information than the score, and the narrative behind it can be worth more than either.

A score earns its keep in setting a required return. A composite score, or more often the sovereign credit spread that moves with it, becomes a country risk premium added to the discount rate applied to cash flows earned in that country.

One direct measure of the risk of a country is the chance that it fails to pay its own debt. Sovereign debt comes in two forms: debt issued in a foreign currency, the USD for example, and debt issued in the currency the country itself prints.

Foreign currency debt appeals to global banks and other international lenders because it removes their currency exposure, moving it to the borrower. The United States can always repay debt issued in USD by increasing the money supply, at the cost of inflation. Argentina has no such option on the USD it has borrowed.

Sovereign borrowers have defaulted many times over the last 200 years. Moody’s reported the defaults below between 2010 and 2018 where at least some foreign currency was involved, the euro counting as foreign for Greece and Cyprus. Most were exchanges of old bonds for new at a net present value loss to lenders.

Source: Moody’s. The cumulative column is calculated here from the published amounts.

Greece was the biggest borrower to default in that window, the two Greek events accounting for 303.6 of the 372.4 billion running total. Moody’s estimated that the first 2012 Greek default cost investors more than 70%, and the second more than 60%. The 2014 Argentine episode is sometimes included, though it was a technical default: the funds sat with a trustee, and proceedings in the United States prevented disbursement.

Defaults come from financial, economic and political troubles combined, largely unforeseen when the lending was done, and South American countries dominate the record. Working backwards, Argentina defaulted in 2001, 1982, 1930, 1915, 1890 and 1830; Brazil in 1983, 1931, 1914, 1898 and 1826; Paraguay in 1986, 1932, 1920, 1892, 1874 and 1827. A default shuts a government out of the market for a period, and yet debt markets have proved remarkably forgiving.

Why a country would default in its own currency

Several sovereigns have also defaulted on debt denominated in their own currency, Brazil in 1990 and Russia in 1998, and research from Moody’s indicates that simultaneous default on both types is becoming more common. Why take that route when the printing press is available? Before 1971 the currency in issue had to be covered by gold reserves, which capped how much a country could create. A currency union removes the option outright: members of the European Union, Greece among them, use the euro domestically but cannot print euros, which is the responsibility of the European Central Bank, so printing money was never a way out of the Greek debt problems of 2012. Third, printing money debases the currency and leads to inflation, and firms carrying foreign currency debt while earning profits in a weakening local currency find it very hard to repay.

Printing money still looks attractive over a short horizon, because reputation and credit rating do not suffer immediately. Rating agencies answer the asymmetry with two ratings, one for local currency debt and one for foreign currency debt, and the local currency rating is typically one or two notches higher. A notch is one step on the finer scale the agencies use: BB+ from S&P sits one notch above BB, and Ba3 from Moody’s sits one notch above B1.

When a firm defaults, its creditors can normally force a liquidation, and they may recover less than face value but the matter ends. A country cannot be liquidated. The old debt is replaced by new debt instead, or restructured in some other way, by lowering the principal or the interest payments, or by extending the life of the obligation. In earlier centuries a default might be answered with military action, as Venezuela found in the 1900s, but that does not happen in the modern era.

Four consequences follow a default by a sovereign nation today. Reputation is lost, and raising funds becomes harder for several years. Investors turn away from the debt and the equity of corporations based in the country, not only from government paper. An economic downturn tends to follow, and political instability grows as faith in the leadership drains away. Researchers have added to that list: a default depresses GDP growth, weighs on the credit rating for many years, can hurt exports, and can leave the banking system more fragile.

So, defaulting is not something a country does lightly, since it can seriously impede economic development and growth. The International Monetary Fund is often drawn in to restructure the debt and impose strict austerity conditions, insisting for example that budget deficits come down through spending cuts, tax increases, or both. Defaults also arrive only after severe economic conditions or political upheaval have taken hold: the large Argentine default of 2001 followed an economic depression that began in the third quarter of 1998 and brought widespread unemployment, riots and the fall of a government.

Moody’s, S&P and Fitch all publish country ratings, and the starting point is how much the country already owes. For a firm the familiar leverage ratio is the book value of debt over the book value of equity; countries have no equity, so agencies look instead to government debt over GDP.

Source: International Monetary Fund, www.imf.org. The multiple column is calculated here.

Japan looks like an outlier for a reason. The Japanese government holds assets on a scale no other matches, among them cash, securities and real estate, and it holds some of its own bonds, the Japanese Government Bonds known as JGBs. Adjusting for holdings not earmarked for pension payments and the like brings the ratio down to the 40% to 90% range.

The path matters as well as the level. The United States debt-to-GDP ratio sat in the 30% to 40% range from 1966 to 1984, moved into the 40% to 60% range across most of 1985 to 2005, and passed 100% by 2018. Government debt is also not the whole indebtedness of a country: California among the states and New York City among the municipalities borrow in their own right, and debt held internally differs from debt held externally by foreign investors.

The other inputs to a sovereign rating

Social security commitments come first: pension and health care promises grow over time, and the larger they become the less free cash a government has for debt service. The tax base is second, assessed for size and reliability, since a diversified economy delivers a steadier tax take than one resting on one or two industries. Political risk is third, with the argument that autocracies default more readily than democracies, and with central bank independence mattering because the alternative to default is printing money. Implicit guarantees come fourth: a Eurozone member in trouble may be helped by a rich member such as Germany or France, though no explicit guarantee exists.

Sovereigns at AAA and AA have come through the following ten years very well, while A-rated sovereigns have not. Foreign currency sovereign debt rated BBB, BB and B has behaved about like corporate debt at those ratings, while local currency sovereign debt has behaved better, its ten-year default rate around half that on foreign currency debt. At the CCC to C level the two diverge, sovereign foreign debt far worse than corporate and sovereign local debt better.

Source: S&P Global Market Intelligence and Standard & Poor’s Financial Services, 2019 corporate default and rating transition study, used with permission. Direction columns grouped here.

Every investment grade category holds its rating in at least 87 years out of 100, and the sovereign tables for both currencies show higher probabilities of staying put than the corporate table does, except in the lowest category. The bottom row inverts: those sovereigns are likelier to be upgraded than to stay.

A sovereign credit spread is the interest a country pays above the risk-free rate, measured in the currency the debt is denominated in.

Spreads and ratings are strongly correlated, and yet a spread carries information a rating does not. It is more granular, since a range of spreads sits behind any single rating, so two countries rated the same can trade at different spreads. Spreads adjust to new information far more quickly too, at the price of being more volatile, because rating agencies pursue stability and move a rating only when the long run financial condition of an issuer has changed.

Reading the credit default swap market

Credit default swaps trade on sovereign names as well as corporate ones, and they supply a second source of spread data. A sovereign CDS resembles an insurance contract in that it pays off if the country defaults within a certain period, usually five years, and the payoff puts the bondholder roughly where a bond that never defaulted would have left them. Unlike insurance, it requires no insurable interest, so an entity with no exposure to Brazilian debt can still buy protection against a Brazilian default, paying the premium and collecting nothing unless Brazil actually defaults.

Some observers held speculators responsible for the rise in Greek CDS spreads during 2010, and for pulling the credit spread on Greek bonds up with them, making the financial problems of the country more severe.

The European Union legislated on the concern, banning the purchase of uncovered sovereign CDS contracts, meaning contracts bought by someone who holds none of the bonds of the country and carries no default exposure to it. Most researchers argue that Greek bond yields were not in fact driven by CDS spreads.

For measuring country risk, government bonds are often the better source of spread data. In a CDS the seller of protection may itself default, a concern that rose during the 2007-2008 credit crisis, and the CDS market is prone to illiquidity and to clustering, where whole groups of countries see their spreads move as one without that reflecting default risk. The three measures work best read together: the rating for a long term view, the bond spread for a current one, and the CDS spread as a cross-check.