As indicated in part one of this series, country risk reflects a country’s overall risk situation, and a comprehensive formulation of the underlying country risk theory is still in the works. The reasons for the complexity of this topic include the extent of the country risk scope, the diversity and interactions between country risk factors, the multiplicity of risk sources, and the variety of academic sciences and practical fields involved. However, there is a general understanding and an implicit assumption that country risk is primarily affected by imbalances in the economic, social, and political areas.
While crises can never be eliminated, country risk analysis and management strategies may help moderate the impact of that risk.
Uncertainty and risk We need to keep in mind that risk concerns the future and what may happen in the future. It is about the outcomes that are unknown. While past and present events (i.e. materialised risks) are indeed incidents with which we must deal, from a risk assessment point of view, they are sources of information about the future.
See also: Part one of this report
The complexity of the country risk phenomenon implies that there are many instances of uncertainty that can arise from the political and socio-economic circumstances of a country. For this reason, it is essential to examine the wider meaning of uncertainty in the context of risk.
The term ‘risk’ is frequently used interchangeably with ‘uncertainty’. While there is no universal definition or unanimous differentiation, it is important to be aware of the interpretations and connotations.
Uncertainty is a general term used to describe any condition whose particular outcome is unknown:
Risk may be considered as a special case of uncertainty in which both the set of possible outcomes and the probabilities of those outcomes is known. This has often been referred to as measurable risk, or ‘Knightian risk’ under Frank Knight’s distinction between risk and uncertainty;
Ambiguity is another specific case of uncertainty; it is when we know the potential outcomes, but the probability of those outcomes is unknown;
Fundamental uncertainty is a subset of uncertainty describing the situation in which we do not even know the possible outcomes. This is sometimes called ‘Knightian uncertainty’.
Although we often associate uncertainty and risk with potential losses, they can have either positive or negative outcomes. This means that the concept of risk can be understood as either performance variance (with positive or negative outcomes) or as the likelihood of adverse effects that reduce the initially expected return (with only negative outcomes). However, for regulatory purposes, financial institutions must only consider downside risk; and, therefore, country risk is observed in relation to its negative outcomes.
Country risk management framework Establishing a country risk management framework typically includes certain common steps:
1) Developing a strategic plan
2) Identifying country exposures and assessing the nature of country risks
3) Conducting a cost/benefits analysis
4) Examining the available options and determining country risk treatment
5) Implementing the chosen treatment
6) Monitoring the results and periodically reviewing the strategy
The country risk management framework of financial institutions should meet their specific needs. The ultimate goal is to create a common classification system for all the relevant countries which would categorise them according to country risk, based on a composite of available information.
Country risk assessment The main objective of country risk assessment was concisely articulated by Michel Henry Bouchet, Charles A. Fishkin and Amaury Gougel as “ignoring the impossible while scrutinising the possible in order to anticipate the inevitable”.
The significance of political risk in the post-WWII period resulted in the creation of political stability indexes. The growth of developing countries’ public debt during the 1970s raised concerns among the key private and public international stakeholders, including the Bank for International Settlements (BIS) and the International Monetary Fund (IMF). Those concerns brought about the concept of ‘country risk’ and the creation of country risk ratings. One of the characteristics of those early country risk assessment methods was the predominant reliance on qualitative approaches.
However, following the financial crises of the 1980s and 1990s, more quantitative approaches started to be applied for country risk measurement. Furthermore, after the global financial crisis (GFC), counter-cyclical elements were built into the methodologies for country risk assessment.
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An especially difficult aspect of the models is the introduction of a hierarchy between subsets of categories or indicators relevant to country risk. For example, as Mina Toksoz warned in The Economist Guide to Country Risk, “There may be a country, such as Russia, where sovereign risk is low because of low public debt and high foreign-currency reserves but jurisdiction risks are high because of the weakness of the rule of law. In this case, an investment decision based on the sovereign ratings on any transaction other than one involving sovereign bonds would be severely understating the risks.”
Currently, the majority of country risk practitioners advocate a combined approach that integrates both quantitative and qualitative methods. There is a wide variety of available tools, and it is considered best practice to apply a combination of different measures.
When developing an internal financial institution’s country risk assessment methodology, it can be helpful to determine the risk factors that should be covered first. Some of the subtopics to be considered are:
- Macroeconomic environment (monetary stability, fiscal imbalances, deficits)
- Currency risks (conversion and transfer regime, currency rate fluctuations)
- Investment climate (trade restrictions, capital controls)
- Political stability (including geopolitical aspects)
- Legal and regulatory risks (rule of law, central bank independence, judiciary independence)
Information sources about country risk factors Country risk analysis can be only as good as the quality of the information on which it is based. Nowadays, a wide range of information is available to country risk practitioners but choosing the relevant information can still be a challenging task.
The following is a list of some of the publicly available sources:
International organisations such as the Organisation for Economic Co-operation and Development (OECD), the International Monetary Fund (IMF), the United National Conference on Trade and Development (UNCTAD), the United Nations Program for Development (UNDP), and the Bank for International Settlements (BIS)
Central bank websites
Government sources such as embassies, commerce and state departments, and export credit agencies (ECAs)
Multilateral development banks (MDBs) such as the World Bank Group (which includes the International Bank for Reconstruction and Development – IBRD and the International Finance Corporation – IFC), the European Investment Bank Group (EIB, which includes the European Investment Bank and the European Investment Fund), the European Bank for Reconstruction and Development (EBRD), the African Development Bank (AfDB), the Asian Development Bank (ADB), and the Islamic Development Bank (IDB)
Specialist research divisions and publications such as the Business Monitor International (BMI), The Economist Intelligence Unit (EIU), the Euromoney Country Risk, Eurasia Group, IHS Global Insight, and Political Risk Service
Alternative sources such as the Institute of International Finance (IIF), Transparency International, think tanks, and private research
Credit rating agencies (CRAs) and credit risk guarantee agencies (e.g., Coface)
Country risk ratings
Country risk ratings summarise the conclusions of the country risk assessment process. They are an important component of country risk management because they provide the basis for setting country risk exposure limits that reflect a bank’s risk appetite and tolerance levels.
Country risk ratings can be obtained internally, in the financial institution, or from external providers. An institution’s internal ratings are used, for example, when deciding on the extension of new loans or the strategy for managing existing exposures. Internally, most institutions use a combination of information from external sources mentioned above in this article.
Some of the better-known external country risk rating methodologies include those of Euromoney (ECR), the International Country Risk Guide (ICRG), the OECD, Credendo, and the Global Competitiveness Reports and the Global Risk Reports published by the World Economic Forum (WEF).
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For instance, the OECD country risk classification was established in 1997 and aims to reflect country risk. The OECD states that “country risk encompasses transfer and convertibility risk (i.e., the risk a government imposes capital or exchange controls that prevent an entity from converting local currency into foreign currency and/or transferring funds to creditors located outside the country) and cases of force majeure (e.g., war, expropriation, revolution, civil disturbance, floods, earthquakes).” Furthermore, it is emphasises that “the country risk classifications are not sovereign risk classifications and therefore should not be compared with the sovereign risk classifications of private credit rating agencies (CRAs). Conceptually, they are more similar to the ‘country ceilings’ that are produced by some of the major CRAs.”
The OECD country risk classification is carried out in two steps, integrating quantitative and qualitative methodologies:
1) Quantitative element: the Country Risk Assessment Model (CRAM) generates a quantitative assessment of country credit risk based on the following three groups of risk indicators:
a. the payment experience reported by the participants,
b. the financial situation, and
c. the economic situation.
2) Qualitative element: a qualitative evaluation of the CRAM results is conducted by country risk experts from the relevant OECD member countries. This evaluation aims to add factors that were not fully considered by the CRAM model, which could lead to an adjustment (upwards or downwards) of the CRAM results.
Early warning signals As stressed previously, risk is about the future. Accordingly, country risk ratings are expected to be forward-looking. However, country risk research is often triggered by actual events (i.e. materialised country risks). This could pose a problem because contemporary methodologies and policies are based on experience and could give a false sense of complacency. Similar situations have already happened in the past on several occasions, as shown in the historical overview in Part 1[CJ(2] .
One of the major challenges is the improvement of early warning indicators for country risk. Some of the potentially relevant forward-looking variables include domestic savings patterns, capital inflows and outflows, economic cycles, credit cycles (e.g., credit growth rate compared to GDP growth rate), and monitoring potential market bubbles (e.g., rise in commodity or real estate prices).
Country risk treatment Based on the results from the country risk assessment process, and in accordance with the institution’s risk appetite and risk management strategy, there needs to be a decision on the treatment of the identified country risk. Risk treatment encompasses a range of responses, including avoidance (that is, choosing not to pursue certain activities), risk control measures, and risk transfer.
In order to control and monitor country risks, financial institutions usually establish cut-off points for country approvals, which also considers sanctions and embargos (e.g., the United Nations and AML/CFT lists such as OFAC).
Generally, risk transfer refers primarily to insurance and is available for country risks with a known set of outcomes and probabilities, i.e. ‘Knightian risks’.
