What is Country risk?
The country risk is an index that attempts to measure the degree of risk associated with a country for foreign investment. Investors, when making their choices of where and how to invest, seek to maximize their profit factors, but also take into account of risk, that is, the probability that the gains will be lower than expected or that there are loss. In statistical terms, earnings are usually measured by the expected return and risk by the standard deviation of expected return.
Due to the large amount of information available and the cost of obtaining it, problems of imperfect information and asymmetric information, and mainly when it is impossible to predict the future, it is impossible to know exactly what is the expected yield and the standard deviation of a investment. However, indexes are compiled to reduce the cost of obtaining the information, taking advantage of scale of economies in search of desired information.
Country risk index
The country risk index is a simplified indicator of the status of a country, used by international investors as one of the element to make a decision before investing. Country risk indicator is a simplified and imperfect situation of an economy .
(Country Risk Map 2014)
Country risk is the surcharge that a country pays for its bonds in relation to the rate paid by the treasure of the United states. In other words, it is the difference between the performance of a public security issued by the national government and a similar title issued by the Treasury of the United States.
The country risk index is actually an index that is calculated by different financial institutions , usually international rating agencies. The best known of them are Moody’s, Standad & Poor’s, and JP Morgan. There are also companies that calculate country risk, like Euromoney Institutional Investor. They have their own method of calculating the country risk. But usually they project similar results.
|Debt Default or Rescheduled||10|
|Access to Finance Banking||5|
|Access to Finance Short Term||5|
|Access to Capital Markets||5|
How the country risk is expressed?
Country risk is expressed in basis points. 100 units equivalent to a spread of 1%.
Methods used by various institutions to calculate the country risks are based on the same grounds; regressions on quantitative and qualitative variables. Obviously, the choice of variables and weighting of each is subjective and imperfect .
For under developed countries within the global financial market, the country risk has become a key variable because,
- It is an indicator of the economic situation of the country concerned and the expectations of irrigation rating with respect to the evolution of the economy in the future (in particular the ability to repay debt)
- The country risk itself determines the cost of debt faced that the Government is facing.
This is fundamental and has two important implications.
- First, the higher the country risk rating, the greater will be the cost of borrowing, and the higher the cost, the lower will be the handling of economic and higher default risk policy, which in turn raise the same country risk.
- Second, a high country risk will influence investment decisions, which will determine a lower flow of funds into the country and increased global interest rate. That not only raises the cost of borrowing by the government but also raises the cost of borrowing by the private sector, with depressing effects on investment, growth and the level of employment of human and physical resources.
Generally, the country risk indicator alone is not only able to describe the direction of the business cycle . As mentioned above, analysts usually consider that a low country risk is associated with a decrease in the cost of borrowing by the private sector and increase in investment, growth and employment. This reasoning is based on the neoclassical model under the assumption of perfect mobility of physical resources, financial capitals and perfect information.
There are situations that can improve fiscal solvency of the government (lower country risk) while worsening the future productivity expected by the private sector. This is the case of an increase in the tax burden to finance the deficit of the unproductive state, either to finance its operations, to finance investments with lower productivity and poor complementarity with private sector investments, or simply addressing the cost of borrowing in the past. In this case it may happen that the decline in the interest rate following the fall in country risk, does not offset the fall in productivity.