Wednesday, July 15, 2015

Groundhog day in Greece, Hijinks in Brazil and Market Chaos in China: Pictures of Global Risk - Part I

It’s been an eventful few weeks. Greece’s extended dance with default has left even seasoned players of the European game exhausted and hoping for a resolution one way or the other. In Latin America, Brazil’s political and business elite are in the spotlight as the mess at Petrobras spreads its poisonous vapors. On the other side of the world, the Chinese government, which finds markets useful only when they serve its purposes, is trying to stop a full fledged rout of its equity markets. For investors everywhere, the events across the world, discomfiting though they might be, are reminders of two realities. The first is that globalization, while bringing significant benefits, has created connections across markets that make any country's problem a global one. The second is that notwithstanding this globalization, some parts of the world are more prone to generate political and economic surprises than others. As companies and investors are forced to look outside their borders, I thought it would be a good time to examine how and why risk varies across countries and at updated measures of that risk.

The Sources of Country Risk

There is risk in every market for investors and businesses, but some countries are more exposed to risk than others. While there are few people who would contest this notion, I think it is still worth examining the drivers of country risk as a prelude to measuring it. Broadly speaking, these drivers can be broken down into political, legal and economic groupings.

I. Economic Risk
  1. Stage in Development Life Cycle: When looking at companies, it is generally true that companies early in their life cycles, with evolving markets and business models, will be more volatile and risky than companies that are further alone in the life cycle. The same concept can be extended to countries, with emerging market economies, exhibiting higher growth and more uncertainty than more mature economies.
  2. Economic concentration: Countries that are dependent upon one or a few commodities or industries for growth will have more economic volatility than countries with diversified economies. In particular, smaller countries (and economies) are more likely to face this problem since their small sizes require them to find niches in the global economy and specialize. In the map below, I report concentration measures for countries estimated by UNCTAD to capture this dependence, with high values correlating to more concentrated economies (and higher risk) and lower values to more diversified economies.
II. Political Risk

1. Continuous versus Discontinuous Change: The debate about whether risk is higher or lower in democracies or autocracies is an old one and one that is sure to evoke a heated response. On the one hand, democracies create more continuous change, where newly elected governments often feel few qualms about replacing policies that were put into place by prior governments, than autocracies, where governments can promise and deliver stability.  However, change in an autocracy, while less common, is also more likely to be wrenching and difficult to plan for.
2. Corruption and Side Costs: In an earlier post on the topic, I argued that corruption and bribery create side costs for businesses akin to taxes and make it more difficult to operate. Operating a business in a corrupt environment generally exposes you to more risk, since the costs are unpredictable and rules are unwritten. In the map below, I use a corruption measure from Transparency International to compare countries across the globe:

3. Physical Violence: Operating a business exposes you not only to economic risk but physical risk in some countries, as war, violence and terrorism all wreak havoc. The extent of this danger varies across the world and the map below reports on a violence measure developed by the Institute forPeace and Economics.
4. Nationalization/Expropriation Risk: While less prevalent than it was a few decades ago, it is still the case that businesses in some countries are more exposed to the risk of being nationalized or having assets expropriated by the government, acting in the “national” interest. 
III. Legal Risk
Investors and businesses are dependent upon legal systems enforcing their ownership rights. If you operate in a country where ownership rights are not respected or where the legal system enforcing it is either ineffective or unreliable, it is riskier to start and operate a business in that country. The International Property Rights Index tries to measure the degree of protection, by country, and the summary results, by country, are reported below:

The Measurement of Country Risk
Given that economic, political and legal risk can vary across countries, it is no surprise that investors and businesses seem out measures of country risk that they can use in decision making. We look at three variants of these measures below. 

1. Risk Scores 
With country risk scores, a service weights (subjectively) the importance of each of the many determinants and comes up with a score for country risk. While there are many services that attempt to do this, the picture below uses the scores from Political Risk Services (PRS) to map out hot spots in the globe. 
Euromoney, The World Bank and the Economist also have country risk scores but the problem with these scores is three fold. The first is that many of them are intended for general use, rather than for businesses. The second is that there is no standardization in the process; thus, a high score is a reflection of low risk in the PRS system but of high risk in the Economist. Finally, the scores themselves are more rankings than true scores; thus a country with a PRS risk score of 80 is not twice as safe as a country with a PRS risk score of 40. 

2. Default Risk 
The most widely used measures of country risk are those that try to capture the risk that the country’s government will default on its obligations. While this is undoubtedly a much narrower measure than the political/economic risk scores described in the last section, it is more focused and easily usable in businesses. 
a. Sovereign Ratings: Ratings agencies such as Standard and Poor’s, Moody’s and Fitch have long rated sovereign debt, assigning ratings to countries for both their foreign currency and local currency borrowings. In July 2015, Moody’s provided sovereign ratings for 129 countries and the map below summarizes these ratings: 
While ratings are easy to get (and costless for the most part) and can be easily converted into default spreads that can be utilized as risk premiums, ratings measure only default risk, can be erroneous and often reflect risk changes with a lag. 
b. Credit Default Swaps (CDS): In the last decade, the credit default swap market, which I described in this post, has provided updated, market-driven estimates of default risk. In July 2015, there were 62 countries with default risk measures available on them and the map below provides those market judgments. 
Credit default swaps are more likely to reflect real world concerns in a timely fashion, but as with any market-driven numbers can also be volatile and prone to over reaction. 

It is a cliché to state that the world is full of risk and that risk exposure varies across countries and time, but it is critical that investors and businesses make their best efforts to measure these risks and bring them into their decisions. In the next post, I will look at bringing the risk measures (country risk scores, ratings and CDS spreads) into investment and valuation decisions and also at how the market is pricing these risk measures in equity markets today. If you are interested in exploring this topic in more detail, you are welcome to download and read my paper on country risk.



derMensch said...

One country-specific risk element which probably requires deeper dive is 'domestic favoritism'. I would classify this as a subset of political/legal risk. The definition I would give is of that when a country's legal and political system are either/both undeveloped or display an inclination to rule in support of domestic stakeholders. Such as with the big Chaebols (conglomerates) in Korea and Japan, or to a more extreme example the small US-listed China companies. Many of them trade at significant discounts and can remain fundamentally undervalued for extended periods but few investors and activists invest in them knowing that even if they were to obtain majority shareholder support there would be little action they could take that would result in any real changes to governance or policy.

Anonymous said...

Alex said...

You defined very well the situation in Brasil: "Brazil’s political and business elite are in the spotlight as the mess at Petrobras spreads its poisonous vapors".

The Petrobras's crisis has arrived at the congress this week. Some political are under investigation. You can say that there is an political war in the air between president Dilma e some congressmen.

But despite the negative image of this scandal (you probably think it is awful), I can tell you it has been an wonderful oportunity for Brasil. For the first time after a long period of time (I am talking about decades), the government has started to invest (massively) in infrastructural (roads, railroads, ports) in an hope (or in a despair) to increase the country's growth.

Infrastructural investments are crucial to decrease the production's cost. The Crisis's pressure has forced the government to take right decisions.

For the country, this crisis has been good, very good. However, for those who want to keep the power, it has been terrible.

Sure, for Petrobras has been terrible also, unfortunately.

Aswath Damodaran said...

Can good come out of a crisis? Sure, and I hope that this is a wake up call not only to the Brazilian government but the Brazilian business elite that they need to open the system to young enterprising Brazilians without family or political connections. There are plenty of bright people in Brazil and I am optimistic about the future of the country.

Anonymous said...

Lisa said ...

I really like how clearly and concisely you spell out each risk. My only question is what is the method used to arrive at those rankings for each risk?

Anonymous said...

This is an interesting post. One of the problems with discussions of country risk is that there is sometimes confusion over what is meant by “risk”. In particular there a conflation between “risk” in the finance theory sense (variance in actual returns around an expected return) and “risk” in everyday language (the chance of a bad outcome).

Questions when considering adjustments to the discount rate should be: to what extent does investing in this country increase the variance in actual returns around an expected return? Is it diversifiable? How can I measure it? And therefore what adjustment should I make to the discount rate? But those questions often get confused with questions such as “what bad things can happen to an investment in this country”?

Nationalisation/expropriation ‘risk’ is a good example of this. The chance of an adverse outcome through expropriation should be factored into cash flow expectations, but I would be surprised if it should also affect the discount rate (in other words, there is a bad outcome, but not additional variance). This is because even if the possibility of expropriation increases variance around the expected return, that should be diversifiable across investments (unless you believe that the risks of expropriation are correlated across countries).

It would be interesting to get your views on this. In my experience this confusion often leads to the substitution of a metric designed to act as a proxy for country “risk” in a finance theory sense being used to try to account for bad outcomes that should be considered in cash flows.

Isabel said...

Alex said..
"For the country, this crisis has been good, very good."

How can a caotic crisis like Brazil is facing has been "very good"? Obviously you know nothing about Brazil's economic situation. The Brazilian middle class is becoming poorer since the PT Goverment (which is Lula and Dilma Political Party) has come to power. The Selic interest rates are now 14,13%, one of the highest interest rates in the world. Inflation has become the worst nightmare for Brazilians, price of goods and services are even higher, and we don't know when is going to stop. Brazil Federal Reserve are not making a good job on stopping inflation. People are scared to loose their jobs because most companies are heavily indebted and aren't profiting anymore because of the crisis. There has been no investment in infrastructural, healthcare, education from 12 years. During the Fernando Henrique Cardoso Goverment the brazilian economic situation was in order, the public debt was stable, spending was controlled. After Lula become President the economy was being destroied gradualy with corruption and now got even worst with Dilma Rousself incompetence. There has no good come out of a crisis, we are now living on this awful situation because most people like Alex voted in bad political parties and can't see they are heading Brazil to commit suicide.