Understanding Country Risk and How to Weigh It

What is Country Risk?

Country risk refers to the uncertainty associated with investing in a particular country, and more specifically the degree to which that uncertainty could lead to losses for investors. This uncertainty can come from any number of factors including political, economic, exchange-rate, or technological influences. In particular, country risk denotes the risk that a foreign government will default on its bonds or other financial commitments increasing transfer risk. In a broader sense, country risk is the degree to which political and economic unrest affect the securities of issuers doing business in a particular country.

Understanding Country Risk

Country risk is critical to consider when investing in less-developed nations. To the degree that factors such as political instability can affect the investments in a given country, these risks are elevated because of the great turmoil that can be created in financial markets. Such country risk can reduce the expected return on investment (ROI) of securities being issued within such countries, or by companies doing business is such countries.

Investors may protect against some country risks, like exchange-rate risk, by hedging; but other risks, like political instability, do not always have an effective hedge. Thus, when analysts look at sovereign debt, they will examine the business fundamentals—what is happening in politics, economics, general health of the society, and so forth—of the country that is issuing the debt. Foreign direct investment—those not made through a regulated market or exchange—and longer-term investments face the greatest potential for country risk.

Weighing Country Risk

Most investors think of the United States as the benchmark for low country risk. So if an investor is attracted to investments in countries with high levels of civil conflict, like Argentina or Venezuela for instance, they would be wise to compare their country risk to that of the U.S. Professional analysts who must assess such risk will often peruse MSCI index data, looking for correlation coefficients to find ways of measuring the effect of country risk in a particular location.

Getting Help in Assessing Country Risk

Some international organizations evaluate the country risk on behalf of their member nations. For example, the Organisation for Economic Co-Operation and Development (OECD), as part of its arrangement regarding officially supported export credits, publishes an updated list of countries and their associated risks for the purpose of setting interest rates and payment terms. In addition, the major credit rating agencies—Standard & Poor's (S&P), Moody's, and Fitch—all have their own lists of sovereign ratings, which also analyze fundamentals such as effectiveness of institutions and government, economic structure, growth prospects, external finances, and fiscal and monetary flexibility. Large investment-management firms also rate country risk in their specific business lines. BlackRock Inc., for example, publishes the BlackRock Sovereign Risk Index (BSRI), a quarterly sovereign risk index that tracks current risk levels and trends for various countries and regions.