It has been my practice for the last two decades to take a detailed look at how risk varies across countries, once at the start of the year and once mid-year. In most years, the differences between the two updates are small, and often ignorable, but this year's update brings significant changes for many reasons. The first is the retreat of risk capital, which I talked about in my last post, not only affects the flow of capital and repricing of the riskiest assets (high yield bonds, money losing companies) within each asset class, but also has consequences for the flow of capital across geographies, with riskier countries feeling the effect more than safer countries. The second is that this has been a consequential year for country risk shifts, with Russia's invasion of Ukraine upending risk not only for those countries, but also in the region, and tumult in Sri Lanka and Pakistan playing out as risk to investors in both countries.
Country Risk: Drivers and Measures
An investment in Nigeria or Turkey clearly exposes a firm or investor to more risks than an otherwise similar investment in Germany or Canada, but why? Some of the differences can be traced to the stability and growth prospects of the underlying economies, some to political and legal structures and some to geography. Rather than provide a laundry list, I attempted to summarize the four key drivers of country risk differences in the table below:
Let’s start with political structure, i.e., the extent of political freedom and democracy in a country, a sensitive topic and one that is open to subjective measurements, and draw on a democracy index score computed by the Economist Intelligence Unit (EIU) every year, with the most recent one mapped below:
|Source: Economist Intelligence Unit (EIU)|
|Source: Institute for Peace and Economics|
|Source: Transparency International|
|Source: International Property Rights|
Based on the PRS composite risk measures, Africa remains the most risky region of the world for businesses to operate in, whereas Northern Europe, North America and Australia offer the most safety.
Country Risk: Default Risk and Ratings
For investors, the most direct measures of country risk come from measures of their capacity to default on their borrowings. At the start of 2022, for instance, there were several countries that were in technical default, on at least portions of their debt, and the Russian invasion of Ukraine has exacerbated sovereign default concerns around the world:
To measure sovereign default risk, ratings agencies (S&P, Moody’s, Fitch) estimate sovereign ratings for countries, designed to capture risk exposure in both local and foreign currency borrowing. The picture below reports on Moody’s ratings, as of June 30, 2022:
Comparing the sovereign CDS spread picture to the sovereign ratings picture, you can see the overlaps, with the ratings agencies and CDS market mostly in agreement.
Country Risk: Equity Risk
For equity investors, the price of risk is captured by the equity risk premium, and equity risk premiums will vary across countries. I use a template that starts with the implied equity risk premium that I compute for the S&P 500 and then adds on a country risk premium that is computed based upon the sovereign default spread (either from the CDS market or based upon a sovereign rating), to get equity risk premiums for countries:
If you compare the numbers in this picture to the equivalent one that I reported at the start of the year, you can see the surge in risk premiums across the board, starting with a higher base premium (6.01%, up from 4.24%) for the US and higher spreads for country risk. Looking at individual countries, the graph below summarizes the countries that saw the biggest increases in equity risk premiums (on a percentage basis) over the six months (from Jan 1, 2022 - June 30, 2022):
Country Risk: Currency and Cost of Capital
As a final part to this post, to see the shifts in country risk that we have seen in 2022, let’s start with an assessment of risk free rates. In my last post, I noted that concerns about inflation have played a big role in pushing up the US ten-year treasury bond rate from 1.51% on Jan 1, 2022, to 3.02% on June 30, 2022. That increase in interest rates is not restricted to the US dollar, as local currency government bond rates have risen around the world. In the graph below, I use these government bond rates as a starting point to estimate riskfree rates in multiple currencies, with adjustments for default risk in governments, using the sovereign default spreads from the last section: