Country Risk: Determinants, Measures, and Implications

Country Risk: Determinants, Measures, and Implications

After completing this reading you should be able to:

  • Explain how a country’s position in the economic growth life cycle, political risk, legal risk, and economic structure affect its risk exposure.
  • Evaluate composite measures of risk that incorporate all major types of country risk.
  • Compare instances of sovereign default in both foreign currency debt and local currency debt, and explain common causes of sovereign defaults.
  • Describe the consequences of sovereign default.
  • Describe factors that influence the level of sovereign default risk; explain and assess how rating agencies measure sovereign default risks.
  • Describe characteristics of sovereign credit spreads and sovereign credit default swap (CDS) and compare the use of sovereign spreads to credit ratings.

Country risk could be attributed to the following:

  • A country’s position in the economic growth life cycle.
  • Differences in political risk.
  • The legal system.
  • The country’s economic structure.

A Country’s Position in the Economic Growth Cycle

The value of all goods and services produced within a country’s borders is known as GDP. When we look at the economic growth rate with regard to an increase in the price of goods and services, then this is called real GDP. The GDP, therefore, gives us a clear snapshot of the economic performance of a given country.

Countries in early growth are more exposed to risk than larger, more mature countries. For example, a global recession hits small, emerging markets harder than it does mature markets. For instance, while countries like Japan and the U.K. experienced a 1-2% dip in GDP following a recession, early growth economies like Kenya and Panama can record a dip as high as 5%.

Emerging markets are also hit hard in case of an economic shock. Even in the face of a robust legal framework and good governance, there’s an upper cap on the powers that countries have over their risk exposure. Some risks may simply be unavoidable. This is why it’s important to thoroughly analyze a country’s risk profile before making critical investment decisions.

A country’s competitive advantage depends on:

  • Factors of production;
  • Demand for the products of given industries;
  • The availability of other related industries that produce high-quality products; and
  • The structure and management of the industries.

Differences in Political Risk

The political environment in a country can have a major bearing on its risk exposure. This can particularly be explained in four main ways:

  1. Continuous vs. Discontinuous Risk: Countries deeply rooted in democracy and free speech have continuous risk in the sense that rules and regulations governing are continuously being changed and amended. As such, regulations enacted for the long-term may remain in place only for a while before new laws and bills are introduced and signed into law. This means that an investor may have to contend with new capital requirements, for example, at a time when they are faced with a crippling cash crunch.

    In authoritarian states, on the other hand, dictatorial policies create discontinuous risk. That means it may be difficult to amend rules and regulations, however good or bad they might be, from the investor’s perspective. In practice, the strength and reliability associated with stable policies are usually undermined by corruption and ineffective legal systems.

  2. Corruption and Side costs: The rules and regulations governing business and operations in a country are only as good as the systems put in place to enforce them. High levels of corruption make it easy to circumvent regulations or ignore them outright. An investor defending a certain move or arguing against an unfavorable regulation may have to part with huge sums of money to get the job done.
  3. Physical violence: Internal conflicts or civil war expose investors to both physical harm and high operational costs, including high insurance costs and depreciation of physical assets.
  4. Expropriation risk: Expropriation risk is the risk that a government may seize ownership of a firm’s assets or impose certain rights that collectively reduce the firm’s value. This could also happen when firms are subjected to specific taxes either by virtue of their presence in a country or the nature of their core business. Compensation for expropriation may be well below the value of rights or assets relinquished. Mining firms would be a good example of firms constantly under expropriation risk.

Legal Risk

Legal risk has much to do with the enforcement of property/contractual rights and fidelity to the rule of law. Laxity toward enforcement of rules and regulations not only disadvantages current investors; it also serves to discourage potential investors from coming in. At best, those who decide to invest in the face of a legal system’s failure have to incorporate similar outcomes in their expectations for the future.

Legal risk is also a function of how efficiently the system operates. For example, if enforcing a contractual right takes years in a given country, investors will most likely shun that country.

Businesses and individual investors would not tolerate legal limbo for too long.

Some countries are known to have (and enforce) very robust property rights, especially in North America. Others have very weak enforcement, especially African and South American countries.

The Country’s Economic Structure 

A country that depends too much on one product or service exposes investors to additional risk. A decline in the price or demand of the product or service can create severe economic shocks that may reverberate well beyond the companies immediately affected. For example, a country whose oil proceeds amount to, say, 50% of the GDP exposes all investors within the country to economic pain if the price of oil tumbles. In most cases, prices of other commodities shoot up.

Composite Measures of Risk: Risk Services

A good measure of country risk should incorporate all the dimensions of such risk, whether political, financial, or economic. Collectively these risks make up what we call total risk. There are several professional organizations around the world that offer country risk measurement services. These include:

  1. Political Risk Services (PRS)-PRS is a subscription-based service that offers members extensive risk analysis of over 100 countries based on three core dimensions: political, financial, and economical. These three dimensions are made up of 22 distinct variables. PRS gives both dimensional and composite scores. The maximum score is 100, while the minimum score is zero. For example, in its report dated July 2015, Switzerland was rated the least risky country with a score of 88.5. Syria took the bottom spot with a score of 35.3
  2. Euromoney- Euromoney is an organization that uses surveys of 400 prominent economists to come up with a composite risk score of a country or region. The score ranges from 0 to 100.
  3. The Economist- The popular media house develops in-house country risk scores built upon currency risk, sovereign debt risk, and banking risk.
  4. The World Bank- The World Bank develops country risk scores based on six key indicators. These are corruption, government effectiveness, political stability, regulatory quality, the rule of law, and accountability. The WB’s scores are scaled around zero, with negative numbers indicating more risk and positive numbers less risk.

Limitations of Risk Services

Risk services greatly help to understand and keep track of country risk, but they are not devoid of limitations. These include:

  1. Some of the models used to churn out the final risk score incorporates risks that have very little impact on business. The final score could be appropriate for policy-making or economical reading but otherwise irrelevant for investors.
  2. There’s no standardization of scores, and each service uses its own protocol and calibration techniques.
  3. The scores can be quite misleading when used to measure relative risk. For example, if a country has a PRS score of 80, that doesn’t imply it’s twice as safe as another country with a score of 40.

Sovereign Default 

A sovereign default is the failure or refusal of the government of a sovereign state to pay back its debt in full. Sovereign default risk is, therefore, the risk that a country will default on its debt. Sovereign debt can be denominated in either local or foreign currency. 

Foreign Currency Defaults

Foreign currency defaults are defaults that occur on the sovereign currency that’s denominated in foreign currency. In most cases, governments find themselves unable to raise the amount of foreign currency required to meet contractual obligations. And the worst thing about foreign currency debt is that governments cannot print foreign currency to make up for the shortfall.

In the last few decades, a majority of sovereign defaults have been based on foreign currency. In addition, countries have been more likely to default on bank debt owed than on sovereign bonds issued. And in dollar value terms, Latin American countries have accounted for much of sovereign defaulted debt in the last 50 years.

Local Currency Defaults

Some countries have previously defaulted on debt denominated in local currency. Examples include Argentina (2002-2004) and Russia (1998-1999). Local currency defaults could be traced down to three main reasons:

  1. Mandatory gold backups: In the years prior to 1971, the printed currency had to be backed up with gold reserves. Without enough reserves, countries could not print enough cash to pay up debts.
  2. Presence of shared currencies: When a country shares a currency with other countries, it lacks the freedom to print cash to prevent a sovereign default. This scenario played out in 2015 whereby the Greek government could not print more Euros even in the face of a crippling economic meltdown punctuated by a huge sovereign debt. The country defaulted on a USD1.7 billion IMF payment – becoming the first country to do so since Zimbabwe in 2001.
  3. A reluctance to print cash purely for debt repayment: Printing cash to meet debt obligations is fraught with dangers, including reputation risk, political instability, and the very real possibility of an economic recession. The local currency can dramatically lose value, forcing investors to shun financial investments in favor of real assets such as real estate and precious stones.

Consequences of Sovereign Default

  1. Reputation loss: Sovereign default can lead to a dramatic deterioration of both diplomatic and economic ties between states. The defaulting government suffers a loss of trust, making it incredibly difficult to negotiate debt in the future.
  2. Political instability: Following a sovereign default event, the populace may lose its confidence in their leadership, leading to wave after wave of demos, unrest, as well as coups in extreme cases.
  3. Real output declines:? As investors increasingly shun financial assets in favor of real assets, domestic consumption may also decrease. This, in turn, may lead to a drop in production.
  4. Capital markets are thrust into a state of chaos and turmoil: Following a default event, investors increasingly grow reluctant to commit their funds in long-term investments. The demand for long-term securities such as bonds declines, making it difficult for firms to raise funds for expansion and other operations.

Factors that Influence the Level of Sovereign Default Risk

  1. Degree of indebtedness: The larger the debt a sovereign state has, the more likely it is to default on the part of the debt.
  2. The size of revenue: A high amount of revenue reduces the chances of a sovereign default event occurring. If a government has regular cash inflows in the form of taxes and other revenue streams such as income earned from the sale of state-owned natural resources, the less likely it is to default on a payment. The opposite is true.
  3. Stability of revenue: Countries with more stable revenue streams have less default risk. Normally, stability in the revenue collected increases as a country’s economic activities become more diversified. Countries that depend too much on a specific source of income have higher exposure to default risk.
  4. Political risk: If the leadership of a country is somewhat immune from public pressure – something common in autocracies like Iran and other Middle East nations, default events can easily occur. In such situations, the leadership enjoys the stability of tenure, giving them a free hand to dictate the nation’s financial priorities. Democracies, on the other hand, are less likely to default because their leadership is constantly under pressure to deliver.
  5. The level of backing/support a country enjoys courtesy of other sovereign states: Countries that form part of a regional economic block usually offer each other some implicit backing on matters of debt. For example, an EU member state is unlikely to default on a sovereign debt because other EU countries are likely to chip in. In fact, when countries like Spain and Portugal joined the EU, renowned credit rating agencies reduced their assessment of default risk in these countries. However, such support is not guaranteed. That’s why investors don’t read too much from this kind of backing.

How Rating Agencies Measure Sovereign Default Risks

Rating agencies offer opinions on a firm or country’s ability to incur and/or pay back the debt. While assessing sovereign risk, agencies consider:

  • Political and social risks – including issues like public participation in political decision making, respect for the rule of law, transparency in government, and long-term stability of political institutions.
  • International security – including the safety and security of a country’s borders.
  • Regime legitimacy
  • Power and governance structures in place
  • Existing government obligations –including both local and foreign debt

Shortcomings of Ratings and Rating Agencies

  1. Ratings are upward biased: In the aftermath of the 2007/2008 financial crisis, rating agencies were widely criticized for having awarded unduly high credit ratings to banks and other financial institutions. In general, rating agencies have been accused of being far too optimistic in their assessment of sovereign ratings. An upward bias on corporate ratings could be explained by the fact that the same corporates double up as the credit agencies’ remunerators. This argument, however, does not hold when it comes to sovereign ratings because individual governments are not required to pay the rating agencies.
  2. They are at times reactive rather than proactive: Rather than updating their ratings before an actual credit event occurs, rating agencies sometimes downgrade countries after a problem has become evident. This does little to protect investors.
  3. Too much interdependence: Although rating agencies claim to work independently albeit using similar risk indicators, they have been accused of exhibiting herd behavior so that an upgrade/downgrade by one agency is soon replicated by other agencies. As such, independence is lost.
  4. Vicious cycle: Sometimes rating agencies have been accused of worsening a crisis by unduly downgrading ratings – painting a situation as being worse than it actually is.

Sovereign Default Spread

Sovereign default spread describes the difference between the rate of interest on a sovereign bond denominated in a foreign currency and the rate of interest on a riskless investment in that currency. For example, suppose that country A has a 10-year dollar-denominated bond with a market interest rate of 8%. At the same time, the 10-year U.S. Treasury bond is trading at 2%. This implies that the sovereign default spread for country A is 6%. The sovereign default spread represents the market’s assessment of a government’s credit risk.

Advantages of Using the Sovereign Default Spread as a Predictor of Defaults

  • Compared to rating agencies, the market differentiation for risk is more granular. In other words, the market has an even more refined understanding of country risk compared to credit ratings. For example, countries A and B could have the same Moody’s rating, but the sovereign spread for A may be greater than the spread for B. That could mean the market sees more default risk in A than in B.
  • Market-based spreads reflect changes in real-time, unlike credit ratings which can be reactive rather than proactive. As such, market-based spreads can be more effective at predicting imminent danger.

Disadvantages of Using the Sovereign Default Spread as a Predictor of Defaults

Market-based spreads tend to be far more volatile than credit ratings and can be affected by variables with little or no correlation to default. For example, liquidity and market forces of supply and demand can trigger shifts in spreads that have nothing to do with default.


Both credit ratings and market spreads are useful measures of default. Sovereign bond markets usually price bonds guided by credit ratings. In addition, credit rating agencies also leverage market data to make changes in ratings.


Question 1

In the context of sovereign default spread, which of the following statements is least accurate?

A. It describes the difference between the rate of interest on a sovereign bond denominated in a foreign currency and the rate of interest on a riskless investment in the local currency

B. A higher spread represents greater sovereign risk

C. Market-based spreads tend to be far more volatile than credit ratings

D. There is a strong correlation between sovereign ratings and market default spreads

The correct answer is A.

Sovereign default spread describes the difference between the rate of interest on a sovereign bond denominated in a foreign currency and the rate of interest on a riskless investment in that currency. For example, suppose that country A has a 20-year dollar-denominated bond with a market interest rate of 8%. At the same time, the 20-year U.S. Treasury bond is trading at 2%. This implies that the sovereign default spread for country A is 6%.

Question 2

Which of the following statements is most accurate in reference to the effect of a country’s position in the economic cycle on its risk exposure?

A. Mature growth countries are insured from economic shocks

B. Young, growth companies are more exposed to risk partly because they have limited resources to overcome setbacks

C. In markets, a shock to global markets will travel across the world, but mature market equities will often show much greater reactions, both positive and negative, to the same news

D. A country that is still in the early stages of economic growth will generally have less exposure than a mature country, provided it is well-governed and has a solid legal system.

The correct answer is B.

Young, growth companies are more exposed to risk partly because they have limited resources to overcome setbacks and also because they rely too much on a stable macroeconomic environment so as to register success in terms of GDP.

Choice A is inaccurate: Mature growth countries are not insured from economic shocks. They are still exposed to risk but on a lower scale compared to young, emerging markets.

Choice C is inaccurate: In markets, a shock to global markets will travel across the world, but early growth market equities will often show much greater reactions, both positive and negative to the same news

Choice D is also inaccurate: A country that is still in the early stages of economic growth will generally have more risk exposure than a mature country, even if it has good governance backed up by a solid legal system.

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