COUNTRY RISK: THE 2019 MID-YEAR UPDATE

Aswath Damodaran

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Globalization’s side effect

¨ A New World Order? Analysts , investors and companies can no longer stay focused on just their domestic markets but have to understand the risks and opportunities elsewhere in the world.

¨ A Trade Off? When developed market companies first embarked on the journey of expanding into emerging market growth economies, investors pushed up their stock prices, primarily because of the growth potential, but this strategy comes with additional risk, not just from changing exchange rates but from economic and political forces.

¨ The other shoe: A sensible assessment of foreign expansion has to incorporate the additional risk in the analysis in the form of country risk.

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If you ignore it, will it go away?

¨ Pass it through: Until the mid-1980s, the conventional wisdom was that country risk should not be a factor in investment decisions.

¨ A Diversification Argument: As a company expands into many markets, it was argued that the risks in the different markets would average out, leaving it unaffected.

¨ The Correlation Question: That premise broke down in the last few decades, partly as a result of globalization on the part of investors and companies.

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The Sources of Country Risk

¨ The obvious added risk: When companies invest outside their domestic markets, the most immediate a risk that they are exposed to is exchange rate risk, since revenues, profits and cash flows are affected by changing exchange rates.

¨ Is not the big risk: That risk, though, is but a piece of the puzzle, a symptom of economic fundamentals and affected by political crises. Put simply, there are good reasons why some countries are riskier than others, and it is not always a consequence of poor governance.

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1. Life Cycle

¨ Corporate life cycle: Companies at different stages in the life cycle differ on cash flow generation and growth potential. It is also generally true that younger companies, deriving more or most of their value from future growth, are riskier than more mature companies.

¨ Country life cycle: The same construct can be applied to countries, with emerging economies that are growing rapidly being more exposure to global shocks than mature countries.

¨ Global Shocks: It should come as no surprise, therefore, that in almost every market crisis over the last decade, emerging markets have paid a much large price in terms of lost economic growth and lower market value than developed markets.

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2. Political Risk

¨ Politics can affect economic and market risk, not just in emerging markets, but also in developed ones.

¨ While there are many forms of political risk, ranging from abrupt changes in fiscal and monetary policy to regime change, there are at least two measurable manifestations of this risk:¤ Corruption Risk: Generally countries with more unstable

political environments seem to lend themselves more to corruption and bribery.

¤ Violence Risk: Again generally, more political instability seems to lead to more violence within countries.

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2a. Corruption across Countries

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2b. Exposure to Violence

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3. Legal Risk

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4. Structure of Economy

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Measuring Country Risk

¨ There are broad measures of country risk available that take the form of country risk scores. ¤ The pluses of these measures is that many of them are

comprehensive and cover all aspects of country risk.¤ The minus is that they do not follow the same scalar and are

not easily convertible into investment decision criteria.¨ There are financial market measures of country risk,

which are more easily incorporated into investment decisions but they tend to focus primarily on default risk:¤ Sovereign Ratings, assigned by “independent” ratings

agencies, convertible to default spreads¤ Sovereign credit default swaps, measuring the cost of buying

insurance against sovereign default in the market.

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1. Country Risk Scores

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2a. Sovereign Ratings

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2b. Sovereign CDS Spreads

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Equity Risk Premiums

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Global ERP

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From Country To Company…

¨ The risk exposure of a company does not come from where it is incorporated but from where it does business. Thus, Coca Cola and Royal Dutch may be US and UK-listed companies respectively, but their business models expose them to risk around the world.

¨ When multinationals try to estimate hurdle rates for projects, it should reflect not just the currency you do the analysis in but also the country in which the project will be located.

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Conclusion

¨ A gray line? There was a time a few decades ago when the line between developed and emerging markets was a clear one. The last decade has seen a blurring of lines, as some “developed markets” mimic emerging market behavior and some emerging markets mature.

¨ No convergency (yet): There are some (companies and investors) who have decided that this convergence is a reason to ignore country risk, but I think that they do so at their own peril.

¨ Caveat emptor: Notwithstanding globalization, we face wide variations in risk across the world, and prudence and good sense demand that we incorporate these differences into our decisions.