Not all returns are equal

Country Risk makes every investment different

Investors frequently fail to consider country risk. Because of this, not all returns are the same, and we must always consider the relationship between risk and reward.?

What is Country Risk?

The difference between the interest rate paid by the local government and the interest rate paid by the US Department of the Treasury on bonds with the same maturity and conditions shows how risky the country is.

The higher interest rate means that credit for the local government is more expensive. Investors think lending money to the local government is riskier than lending to the US government. They think that the country's risk is higher and the local government's ability to pay is lower, so they want a higher return to compensate for this.

The level of country risk sets an interest rate floor, or minimum, at which companies and consumers can borrow money domestically and internationally. So the higher the country's risk, the higher the interest rates will be for the private sector.

The risk that political, business or economic changes in a foreign country will hurt the value of an investment is called "country risk." This can include anything from a change in government to a country's credit rating being downgraded by a primary agency. This risk is often linked to investments in frontier and emerging markets, where the government may not be as stable, and investors may have less legal protection. But investments in developed countries have been hurt by country risk when the economy or government is in trouble.

Factoring in Country Risk While Investing

When deciding what to invest in, you should always consider country risk, since it can cancel out any potential return. Even though there are many ways to include country risk in the expected returns of an asset, it is often thought that a mix of qualitative and quantitative analysis is the best way to do so. Qualitative analysis is usually based on country risk ratings from organizations like the World Bank and expert reviews of a country's past, present, and future. In contrast, quantitative analysis typically relies on economic indicators to generate risk assessment models. Firms like Euromoney have made it easier for investors to do this by giving country risk scores that consider both qualitative and quantitative factors. Most of the time, the country risk scores for emerging and frontier markets are the lowest, while the scores for developed countries are usually pretty high.

With these scores, investors can compare the risk and possible return of investments in different countries more accurately. At first, investors who don't know what's going on may be drawn to a country because it has a higher rate of return. Still, if the country is unstable, there is a greater chance that the investment will not perform as expected.

This way of figuring out risk-adjusted expected rates of return can be used for all asset classes, such as stocks, bonds, real estate, and commodities.

For example, let's say an investor is considering two investments: one in the United States with expected returns of 10% and one in Brazil with expected returns of 16%. Without taking into account country risk, the Brazilian investment appears to offer a much higher return. However, when country risk is factored in (16%*0.40 = 6.4%), the expected return on the US investment becomes higher.?

Alternatively, let's say we take a 10% return as a baseline in the US. What return would it take in other countries to adjust for the country's risk?

This is what many investors need to remember to factor in. To be compensated for the country's risk, investors in Ecuador need to make 20% returns to make the same 10% in the US.?

Political Risk

Political risk, which is the risk that a country's government will do something that hurts the value of an investment, is one of the main sources of country risk. This can include anything from changes in taxation to outright expropriation of assets. For instance, after a failed coup attempt in 2016, the Turkish government started a crackdown on people they thought were dissidents. Part of this was seizing their assets, businesses, and real estate. This made foreign investors very uncertain, which caused the value of many of their investments to go down. In some cases, political risk can be reduced by investing in companies that are seen as supporting the current government or by signing contracts with the government that give investors certain protections. But these steps only sometimes work, and political risk should always be considered when figuring out how much money an investment in a foreign country could make.

While measuring political risk isn't a perfect science, several methods can be used to evaluate the stability of a country's government. These include looking at the history of coups and other major political upheavals in a country, keeping an eye on how public opinion changes, and keeping track of what opposition groups are doing. More advanced measuring tactics, like political risk spreads, can also be used to get a more granular understanding of the level of risk in a country.

Economic Risk

Another major source of country risk is economic risk. This is the risk that bad macroeconomic conditions in a country will make an investment return less than expected. This can be caused by anything from a country's currency decreasing in value to the country not paying its debts. Investors who want to determine how likely a government will not pay its debts usually look to independent credit ratings from companies like Moody's or Standard & Poor's. If a country can't pay its debts, people will lose faith in its economy and the value of its currency and assets will go down. In 2018, Pakistan's credit rating was downgraded by Moody's due to concerns about the country's high debt levels and declining foreign exchange reserves. This caused many Pakistani assets to be sold and the value of the Pakistani rupee to drop sharply. In 2016, when the UK voted to leave the EU, this caused much uncertainty about the country's future economic prospects and caused the value of the British pound to drop sharply. The pound plunged to a 31-year low, falling more than 10% against the US dollar overnight and bringing down the UK's corporate bond stock markets.

Most of the time, this kind of risk is linked to countries that have high debt, high inflation, or weak currencies. But during economic uncertainty, country risk can also be present in otherwise stable countries. For example, during the 2008 financial crisis, investors worried about the health of the world economy, which caused economic-country risk to rise in several developed countries. This scared many people, and in one year, assets in the US dropped by 40%.

The Bottom Line

Assessing a country's risk is not an exact science, but any investor with more than one country needs to consider it. Investors can choose to look at qualitative and quantitative factors or use country risk scores from groups like Euromoney to help them figure out how risky a country is. By considering country risk, investors can make better decisions about how to divide up their assets based on expected returns and how to protect their portfolios from possible losses.

Works Cited?

“Assess Country Risk.” International Trade Administration | Trade.gov, https://www.trade.gov/assess-country-risk.

Adrian, Tobias. Market Liquidity after the Financial Crisis. https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr796.pdf.

Bekaert, Geert, et al. “Political Risk Spreads.” NBER, 3 Jan. 2014, https://www.nber.org/papers/w19786.

“British POUND2022 Data - 1957-2021 Historical - 2023 Forecast - Quote - Chart.” British Pound - 2022 Data - 1957-2021 Historical - 2023 Forecast - Quote - Chart, https://tradingeconomics.com/united-kingdom/currency.

“Country Risk Classification.” Country Risk Classification, OECD, https://www.oecd.org/trade/topics/export-credits/arrangement-and-sector-understandings/financing-terms-and-conditions/country-risk-classification/.

“How to Assess Country Risk: The Vulnerability Exercise Approach Using …”, ?International Monetary Fund, https://www.imf.org/-/media/Files/Publications/TNM/2021/English/TNMEA2021003.ashx.

“Political Risk and Exchange Rates: The Lessons of Brexit.” VOX, CEPR Policy Portal, Paolo Manasse, https://voxeu.org/article/political-risk-and-exchange-rates-lessons-brexit.