HOW TO MEASURE COUNTRY RISK: MARKET INDICATORS VERSUS COUNTRY RISK RATINGS
Pap Máté
Financial Risk Management Expert MOL Group, Group Risk Management*
ABSTRACT
The economic outlook for the future is greatly influenced by long-term corporate investments, where risk indicators are essential inputs for current business decisions. Due to country risk, companies should demand higher returns in some countries, for the same investments, than in others. Sovereign risk and country risk ratings also provide information about the country risk, but the methods are different. The paper has two objectives. The first is to introduce the most common alternatives to measure country risk. The second is to examine the relationship between country risk and sovereign risk, than compare the stability of the two measures. The analysis is based on the IHS Global Insight (GI) score and five-year sovereign credit default swap (CDS) spreads.
Keywords: Country risk, Country risk score, Credit default swap, Sovereign risk
1 INTRODUCTION
In past decades risk management became one of the most important areas of financial economics. Since the early 1990s, financial deregulation, innovation, and liberalization have contributed to the increase in global financial integration and cross-border trading. In international business, also the geopolitical environment drives firm strategy, beside the global market and investment conditions. The economic outlook for the future is greatly influenced by long-term corporate investments, where risk indicators are essential inputs for current business decisions. Due to country risk, companies should demand higher returns in some countries, for the same investments, than in others. However, estimating country risk premium poses many challenges since country risk can come from many different sources. We need to take account of economic risk, financial risk, political risk, and also social developments [3].
Furthermore, there is no standard way to quantify country risk, compare and find the optimal weighting of the different risk indicators. In the literature, there is really no consensus on which factors should be taken into account more weight and which are less. It is also important how we interpret the numbers and the results of modeling. We often faced with the lack of information and data. Without the appropriate data the country cannot be modeled properly.
Sovereign risk refers to the risk that a state could default on its debt or other obligations. Sovereign risk includes the properly quantified financial and
*This paper reflects solely the opinion of the author, and do not necessarily reflects the official view of MOL Group.
MultiScience - XXXI. microCAD International Multidisciplinary Scientific Conference University of Miskolc, Hungary, 20-21 April 2017
ISBN 978-963-358-132-2
DOI: 10.26649/musci.2017.118
macroeconomic indicators, such as GDP, budget deficit, public debt ratios, bond yields or credit default swap (CDS) spreads. The most common way of measuring sovereign risk is based on sovereign credit ratings provided by credit rating agencies.
Contrarily, country risk is mostly scoring-based, including also the economic structure, the degree of integration, the macroeconomic performance, legal environment, levels of corruption and socioeconomic factors. Political risk measures the inherent uncertainty of political system, political stability, social developments and security. Summarizing geopolitical risk indicators the most relevant questions are the followings. Are there any ongoing or expected armed conflicts in the region? How stable is the local government and how large is the corruption in the country? Based on the above, during country risk analysis it is needed to consider both quantitative and qualitative aspects as well [3].
In our paper we analyze the most common alternatives to measure country risk, than we examine the relationship between country risk and sovereign risk. In our analysis we found that sovereign risk and country risk are diverging for some nations. For instance, Greece has a much better geopolitical risk assessment, than its economic performance indicate. The analyses are based on the IHS Global Insight (GI) score and five-year sovereign CDS spreads.
2 MEASURING COUNTRY RISK Market indicators
Sovereign risk refers to the risk that a state could default on its debt or other obligations. Sovereign debt default can occur when the government is either unable or unwilling to make good on its fiscal promises or honour its foreign debt repayment obligations. The most frequently used market indicators, which provide information about sovereign risk are sovereign debt spreads and credit default swap (CDS) spreads. The sovereign spreads are calculated as a difference between bond yields of dollar-denominated sovereign debt and 10-year US treasury bonds. [8].
CDS is one of the most popular over-the-counter traded credit derivative. CDS is a kind of insurance against credit risk, where the buyer of credit protection pays a periodic premium on top of the risk free rate, known as spread, to the seller during the contract’s life. In return for fee, the seller assumes an obligation to compensate the buyer if a credit event occurs. The typical credit events are bankruptcy, non- payment, non-fulfilment of obligations by a company or sovereign issuer [6]. For instance, if the Hungarian sovereign CDS spread for a five-year contract is 150 basis points, this means that the periodic payment is 1,5% and the loss expected equals the sum of the premium received until the contract expires, which is 750 bps [2]. Figure 1 shows the Hungarian 5 year CDS over a ten-year horizon. We can observe a 226 bps ten-year average with high volatile. During the observed period the relative standard deviation is 60% and the range is 615 bps. The extreme values
identified with economic crisis in 2008, the failed negotiations between the Hungarian government and IMF and the credit rating agencies downgrades.
Figure 1. Hungarian 5-year CDS Source: own compilation
Credit ratings for sovereign and corporate bonds are published by rating agencies.
The Big Three credit rating agencies are Moody’s, Standard & Poor’s and Fitch Ratings, which control the 95% of the market. The Moody’s has its own scale, while Standard & Poor’s (S&P) and Fitch Ratings use the same rating scale [8].
The best rating in Moody’s is Aaa, after that come Aa, A, Baa, Ba, B and Caa. In S&P and Fitch the corresponding ratings are AAA, AA, A, BBB, BB, B and CCC.
Both method divide the categories, except Aaa and AAA, into subcategories.
Moody’s divides Aa category into Aa1, Aa2 and Aa3, it divides A into A1, A2 and A3, etc. While S&P and Fitch divide their AA category into AA+, AA and AA-, and so on [6]. Ratings above Baa3 and BBB- mean investment grade ratings, below these the categories are speculative. Currently Hungary has investment grade ratings in all three credit rating agencies. Considering the last ten year, the worst rating from Moody’s was Ba1 between the period from November 2011 to November 2016 and the best valuation was A1 in September 2016. The rating in S&P and Fitch moved between BB and BBB+.
Country risk ratings
The score based country risk ratings reflects qualitative analysis, where experts assigned subjective scores for each risk factors. The scoring is based on economic modeling results, open sources country information and market data. The overall country risk scores are calculated as a weighted average of the different risk indicators. There are several institutions which calculate country risk ratings.
0 100 200 300 400 500 600 700
CDS (BPS)
CDS Average CDS
Insurance companies such as Aon and Marsh publish regularly their Political Risk Map. IHS and Heritage Foundation also have own scoring system to measure country risk. In our paper, we examine in detail the method of IHS GI score.
According to IHS methodology the country risk is divided into the following categories: political, economic, legal, tax, operational and security risk. As shown in Table 1 these categories are divided into further subcategories. The IHS strategic risk methodology gives equal weight to each category and subcategory. The overall country risk scores are calculated as equally weighted average of the categories and the categories scores are calculated as equally weighted average of their subcategories [7].
Table 1. Risk categories and their subcategories Source: IHS Strategic Risk Methodology [7]
Political Economic Legal Tax Operational Security
Government
instability Capital transfer Contract enforcement
Tax
incosistency Corruption Civil war Policy instability Currency
depreciation Expropriation Tax increase Infrastructure
disruption Interstate war State failure Inflation State contract
alteration Labour strikes Protests and riots
Recession Regulatory burden Terrorism
Sovereign
default
Under-
development
Political risk measures the government and policy stability. The relevant questions are what is the probability that the government could be removed by political opposition in a year, how the government wants to control the private sector and monetary policy, how protectionism is the economic policy. Elements of economic risk include macroeconomic indicators, growth prospects, currency strength and sovereign default risk. Operational risk reflects the level of corruption, the level of employee representation and the rate of the regulatory burden. Security risk included the risk of ongoing or expected armed conflicts and acts of terrorism. Tax risk assigned scores to the tax environment, while legal indicators measure the risk that the government will expropriate or nationalise assets.
Risk is scored on a 0.1-10 scale for each subcategory, with intervals of 0.1 magnitude. The IHS Global Insight (GI) scores split the country risks into seven bands. Table 2 shows the ranging from Low to Extreme risk.
Table 2. IHS Country risk bands Source: IHS Strategic Risk Methodology [7]
Low Moderate Elevated High Very high Severe Extreme 0.1 - 0.7 0.8 - 1.5 1.6 - 2.3 2.4 - 3.1 3.2 - 4.3 4.4 - 6.4 6.5 - 10.0
The scale is logarithmic, which means that the ranges of risk bands are different.
Consequently it implies more effective differentiation between countries at both lower and higher ends of the scale. IHS publishes its ratings for 211 countries worldwide. Significant events and changes in risk environment indicate the movements in country GI scores, which are published quarterly [7].
3 DATA ANALYSES
In our analysis the sample contains 62 countries from all over the world region. Our aim is to compare the last half-year average of 5 year country CDSs with the latest available GI scores. The observation period is from July 2016 to December 2016.
We examine the relationship between the country risk measures with linear regression, where the independent variable is the GI score and the dependent variable is the country CDS. The estimated regression equation is y=182.53x- 164.48, which means that 1 unit increase in GI score induces 182,53 bps increase in CDS. The coefficient of determination (R2) is the quotient of the variances of the fitted values and observed values of the dependent variable. In our model R2 is 0.5495, which implies moderate relationship between CDS and GI score. Figure 2 shows the scatter diagram of country CDS and GI score of the observed countries.
The dashed line is the linear regression line, while we get the red lines, if we shift parallel the regression line up and down with 1 standard error, which is 133 bps. In our opinion, the countries within the red lines do not indicate major discrepancy between CDS and GI score. However, that countries which located above or below the red lines are considered outliers. Figure 2 indicate the corresponding name for extreme countries. Those countries, which lie above the red line, for instance Greece, Portugal, Argentina, Ukraine or Iraq the CDS spread is higher in relative terms than the corresponding GI score, below the line the opposite holds [1], [5].
Figure 2. Comparison of CDS spread versus GI score Source: own compilation
Considering a long-term period it is relevant to examine how volatile are the different indicators, which method gives us a more stable and predictable country risk rating. Figure 3 shows the evolution of Hungarian 5-year CDS and GI score rating in a ten-year horizon. Comparing the relative standard deviations (RSD), we get a more volatile result for CDS with 60% RSD, than for the GI score with 11%
RSD. This implies that GI score is more stable to economic and financial shocks, it gives a general overview about the geopolitical situation.
Figure 3. Comparison of the evolution of Hungarian CDS spread versus GI score Source: own compilation
Based on the y=182.53x-164.48 regression equation we estimated above, we can calculate theoretical CDS spreads for the corresponding GI scores. In Figure 3 the red line shows the estimated CDS values. The estimation, which reflects to the fundamental underlying, gives significantly lower CDS time series, than the real market values. During the period between 2007 and 2016 we can observe that after the economic crisis and financial shock the real CDS spread converged to the estimated values. Therefore in a stable economic outlook the estimated regression equation gives better fitting for the two country risk measure.
4 CONCLUSION
In our paper, we analysed two main approaches to measure country risk. Using statistical data analysis we examined the relationship between CDS spread and GI score and compared the long-term stability of the two measures. Our linear regression model showed moderate correlation between CDS and GI score, most of the countries located within our tolerance threshold. However we found some outlier countries, which have much better geopolitical risk assessment, than its economic performance indicate or have a very bad political judgement with stable economic outlook. For instance, Greece belongs to the first group, while Russia is
0,00 0,20 0,40 0,60 0,80 1,00 1,20 1,40 1,60 1,80 2,00
0 100 200 300 400 500 600 700
07 Q1
07 Q3
08 Q1
08 Q3
09 Q1
09 Q3
10 Q1
10 Q3
11 Q1
11 Q3
12 Q1
12 Q3
13 Q1
13 Q3
14 Q1
14 Q3
15 Q1
15 Q3
16 Q1
16 Q3
GI score
CDS (BPS)
GI score CDS (bps) Estimated CDS (bps)
the part of the second group. For these countries the two measure give significantly different risk profile. Comparing the long-term stability, we found that the GI score is more stable to economic shocks, than the CDS spread.
ACKNOWLEDGEMENT
I would like to thank the valuable advice and comments of Dániel Homolya, Group Financial Risk Manager of MOL Group, Assistant professor of Karoli University Institute of Economics and Management.
REFERENCES
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– The 2015 Edition, Stern School of Business,
http://pages.stern.nyu.edu/~adamodar/
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[5] Heinrichs, M. and Stanoeva, I. Country risk and sovereign risk – building clearer borders, Euromoney Handbooks, Chapter 3, p. 15-24.
[6] Hull, J. and Predescu, M. and White, A., 2003. The relationship between credit default swap spreads, bond yields, and credit rating announcements, University of Toronto
[7] IHS, 2017. IHS Country Risk Ratings – Strategic Risk Methodology, 17 January, 2017, http://connect.ihs.com
[8] Iranzo, S., 2008. Delving Into Country Risk, Banco de Espana Eurosistema, Madrid, Documentos Ocasionales N. 0802
