Country risk is defined as the exposure to a loss in cross-border lending caused by events in a particular country. These events must be, at least to some extent, under the control of the government of that country; they are definitely not under the control of an enterprise or individual.
All cross-border lending in a country – whether to the government, a bank, a private enterprise or an individual – is exposed to country risk. Country risk is thus a broader concept than sovereign risk, which is the risk of lending to the government of a sovereign nation. Further, only events that are, at least to some extent, under the control of the government, can lead to the materialization of country risk. A default caused by bankruptcy is country risk if the bankruptcy is the result of the mismanagement of the economy by the government. It is commercial risk if it is the result of the mismanagement of the firm. An interesting case is that of natural calamities. If they are unforeseeable, they cannot be considered as country risks. But if past experience shows that they have a tendency to recur periodically; such as typhoons in Southeast Asia, then the government can minimize their effects. Prudent analysts also make allowance for them in their assessment of country risk. “Control by the government” is understood in the broad sense. If the governments can, to some extent, control at least the impact of an adverse development, even though they cannot control the event itself, the possibility of that event is country risk.
One can speak about political, social, economical risks. But these refer to the nature of the event that may cause a loss and they apply to all borrowers in a country; lending to a private corporation, for instance, is certainly subject to political risk. But political risk is a narrower concept than country risk, since country risk also includes social and economic risks.
The need or compulsion to evaluate country risk (political risk, environmental risk) is not quite the same in the case of lending and direct investment. Country risk assessment is a complex, tedious and costly exercise. A respectable body of opinion holds that the benefits do not justify the costs. Assessment of country risk is thus an exercise in futility: “The market knows the best.”
Events of the last decade demonstrated that, just as the stock market, the international financial market can in the short term be disastrously wrong in its collective evaluation of country risk. Like stock market analysts in their evaluation of the company’s long-term prospects, individual banks can be ahead of the market in their evaluation of country risk if they have insight based on information and its interpretation as well as analytical ability superior to the market average. The purpose of country risk evaluation is to improve the individual bank’s performance relative to the market average. If the bank can in the short term assess country risk situation ahead of the market, it can move into countries where the risk is better than the market’s perception, or where the bank perceives an improvement before its competitors, it can fund at the most favorable rates, and have smaller losses and wider average spreads than its competitors.
Quantifying Country Risk: A Comprehensive Example
To develop an overall country risk rating, it is necessary to first construct separate ratings for political and financial risk which depend on a variety of factors. First, the political factors can be assigned values within some arbitrarily chosen range (such as values from 1 to 5, where 5 is the best value/ lowest risk). Next, the political factors are assigned weights (representing degree of importance), which should add up to 100 %. The assigned values of the factors times the respective weights can then be summed up to derive a political risk rating.
The process described for deriving the political risk rating can then be repeated to derive die financial risk rating, That is, values can be assigned (from 1 to 5, where 5 is the best value/ lowest risk) to all financial factors. The assigned values of the factors times their respective weights can be summed up to derive a financial risk rating.
Once the political and financial ratings have been derived, a country’s overall country risk rating as related to a specific project can be determined by assigning weights to the political and financial ratings according to the perceived importance. For example, if the political risk were thought to be much more influential on a particular project than a financial risk, it would receive higher weight than the financial risk rating (both weights must total to 100%). The political and financial ratings multiplied by their respective weights would determine the overall country risk rating for a country as related to a particular project.
Use of Country Risk Assessment
The first step for a firm after it has developed a country risk rating is to determine whether that rating suggests the risk is tolerable. If the country risk is too high, then the firm does not need to analyze the feasibility of the proposed project any further. Some firms may contend that no risk is too high when considering a project. Their reasoning is that if the potential return is high enough, the project is worth undertaking. However, there are cases in which the degree of country risk could be too high regardless of the project’s expected return. Consider a proposed development of a subsidiary that appears very profitable in Country Z. If Country Z is often engaged in war, this places a threat on the life of any employees who would be transferred to that subsidiary. In this case, Country Z should be off limits, and the proposed project should not receive further consideration.
If the risk rating of a country is in the tolerable range, any project related to that country deserves further consideration. Capital budgeting analysis would be appropriate to determine whether the project is feasible.