Country Risk in Finance: Core Drivers, Sovereign Default & ERP

The speaker, a finance professional, discusses their annual update on country risk, a topic they've covered every July since 2009. This update is crucial for financial analysis, particularly for valuing companies and projects.

The Evolution of Country Risk in Financial Analysis

Historically, during the speaker's MBA in the US, country risk was largely ignored. This was due to two main assumptions: 1. Geographic Focus: It was assumed that graduates would work in developed markets like New York or London, thus avoiding direct exposure to emerging market risks. 2. Diversification: The belief was that operating in multiple countries would average out risks, a diversification argument.

Both these assumptions have proven incorrect. * Globalized Revenue Streams: Companies incorporated in developed markets, such as Coca-Cola (US) or Nestlé (Switzerland), derive significant revenue from risky markets, making country risk unavoidable even for seemingly "safe" companies. * Increased Correlation: Globalization has led to higher correlations across countries, especially during crises. This means country risk can no longer be diversified away as markets tend to move together.

Therefore, country risk is now an integral part of financial analysis.

Core Factors Driving Country Risk

The speaker identifies four primary factors that cause risk to vary across countries, emphasizing a business perspective rather than moral or ethical judgment:

1. Political Structure: Whether a country is a democracy or an authoritarian regime impacts business risk.

   • Democracies: Create continuous risk due to frequent government changes, leading to shifts in policies, tax laws, and regulations.
   • Authoritarian Regimes: Offer more stability in policies until a major event occurs. Risk is discrete and potentially catastrophic when it does materialize.
   • Global Trend: The world is becoming more autocratic, with only about 7% of the global population living in purely democratic parts by the end of 2025.

2. Corruption: Acts as an implicit tax on businesses, increasing operating costs and making it difficult to run operations efficiently.

   • Measurement: Transparency International provides a corruption score.
   • Geographic Distribution: Least corrupt regions include parts of Europe, the US, Canada, Australia, and Singapore. Most corrupt areas are found in Africa, parts of Latin America, and Eurasia.
   • Causes: Less about culture and more about underpaid bureaucrats and a perception that rules are not followed by those in power.

3. Exposure to Violence: Internal or external violence necessitates increased spending on security and insurance, eroding profit margins.

   • Measurement: The Vision of Humanity measures global peace.
   • Geographic Distribution: Most peaceful regions include parts of Europe, Canada, Australia, and surprisingly, southern Latin America. The US scores relatively low due to gun violence.

4. Legal Systems: The timely enforcement of property rights and contractual obligations is crucial. A slow or capricious legal system is detrimental to business.

   • Measurement: The Property Rights Alliance provides scores on property rights protection.
   • Correlation: There's a strong correlation across these four factors; countries that are red (high risk) in one area tend to be red in others.

Climate Change as a Risk Factor

While not yet central to the speaker's country risk analysis, climate change is monitored. Currently, it's not a significant differentiator across countries because: * Most countries are exposed to climate risk. * Its impact on companies' profitability is not yet tangible enough to significantly alter country risk assessments. This could change in the future.

Sovereign Default Risk

Lenders to governments are concerned about default risk. * Historical Defaults: Sovereign defaults were high in the 1980s and 90s, decreasing but remaining substantial in the 21st century. * Local Currency Debt: Governments can default on local currency debt, even though they can print money. This happens when they face a choice between hyperinflation and default, often choosing default as it's easier to recover from. * Geographic Distribution: Historically, Latin America was the epicenter, but now defaults are widespread across Asia, parts of Europe, and Russia.

Measuring Sovereign Default Risk

Lenders use forward-looking estimates of sovereign default risk:

1. Sovereign Ratings: Provided by agencies like S&P, Moody's, and Fitch.

   • Strengths: Generally good on average, covering most of the world.
   • Weaknesses: Can have regional biases and are often slow to react.
   • Frontier Markets: Some markets (e.g., Syria, Afghanistan, North Korea) lack ratings due to difficulty in collecting information.

2. Sovereign CDS Market: A market-based measure where insurance against sovereign default can be purchased.

   • Strengths: Provides a market-driven spread reflecting default risk.
   • Weaknesses: Only available for about 80 countries, limiting its comprehensive use.

Composite Risk Scores

Services like Political Risk Services (PRS) and The Economist provide composite risk scores for countries. However, these scores can be idiosyncratic: * Inconsistent Scales: Some services use low scores for safe countries, others use high scores. * Varying Methodologies: Different factors and weightings are used, leading to disparate scores for the same country (e.g., the US being riskier than Ghana according to PRS).

Estimating Equity Risk Premiums

The speaker's methodology for estimating equity risk premiums (ERP) for corporate financial analysis:

1. Mature Market Premium:

   • Historically, the implied ERP for the S&P 500 was used, assuming the US was a AAA-rated, mature market.
   • Current Adjustment: Following Moody's downgrade of the US to AA1, the T-bond rate now includes some default risk (0.22%).
   • Calculation: The implied ERP for the S&P 500 (8.65%) is derived by discounting expected cash flows (dividends and buybacks) to match the index level. Subtracting the risk-free rate (T-bond rate minus default spread, 4.23%) yields a US ERP of 4.42%.
   • Mature Market Baseline: The risk-free T-bond rate (4.45%) minus the default spread (0.22%) gives a truly risk-free rate of 4.23%. This 4.23% is then used as the mature market premium for AAA-rated countries.

2. Country Risk Premium for Non-AAA Countries:

   • Default Spread: For countries not rated AAA, a default spread based on their sovereign rating is determined.
   • Equity Multiplier: This default spread is then multiplied by a factor (currently 1.55, based on the ratio of equity volatility to bond volatility in emerging markets) to convert it into an equity risk component.
   • Total ERP: This equity risk component is added to the 4.2% mature market premium to get the country's total ERP.
   • Unrated Countries: For about 20 unrated countries, the PRS score is used to find comparable rated countries, and their ERPs are extrapolated.

Company-Specific Equity Risk Premiums

• Beyond Country of Incorporation: It's crucial to consider where a company generates its revenues and conducts operations, not just its country of incorporation.

  • Example: Coca-Cola (US) gets 60% of revenues from outside the US; Infosys (India) gets 90% of revenues from outside India.
  • Revenue/Production Weighting: For consumer product companies, revenue location is key. For natural resource companies, production location is key. Manufacturing companies might use a mix.

• Country Life Cycle: The importance of the country narrative in valuation depends on the country's stage in its "life cycle."

  • Risky Countries (e.g., Venezuela): The country story is paramount.
  • Emerging Markets (e.g., Brazil, India): The country story is still very important, especially for companies deriving most revenues domestically.
  • Mature Markets (e.g., Germany): The country story is less critical.

Hurdle Rates for Projects

• Multinational Complexity: For multinational companies, hurdle rates for projects will vary based on both the business type and the country where the project is located.
  • Example: A GE appliance project in India would use an appliance business beta and India's equity risk premium. A GE aircraft project in Hungary would use an aircraft beta and Hungary's equity risk premium.

Currency and Country Risk

• Currency as a Measurement Device: Currency is a reflector of country risk, not its driver. Political and legal risks manifest as currency volatility.
• Risk-Free Rates and Currencies: There is no global risk-free rate; risk-free rates are currency-specific.
  • Calculation: Risk-free rates in various currencies are estimated by taking the local currency government bond rate and netting out the government's default spread.
  • Consistency is Key: When performing financial analysis, cash flows and discount rates must be in the same currency. High inflation in a currency will lead to a higher discount rate but also higher growth in cash flows, resulting in a consistent valuation if done correctly.
  • Inflation Estimates: Risk-free rates in any currency can be estimated by starting with a base currency (e.g., USD) and adjusting for differential expected inflation. Even if inflation estimates are imperfect, consistency ensures self-correction.
  • Currency Pegs: Trustworthy only if inflation rates are similar between the pegged currency and the base currency.

Conclusion

Ignoring country risk is no longer an option due to globalization. While country risk is complex and often carries emotional baggage, it's essential to incorporate it into financial analysis as accurately and unbiasedly as possible. The speaker continuously refines their methodology, acknowledging it's a work in progress.