Credit analysts are struggling to keep pace with current global events, especially when it comes to their impact on corporate creditworthiness. The sovereign debt crisis continues to cause uncertainty in Europe and last year’s ‘Arab spring’ has rocked the Middle East and North Africa (MENA) region’s emerging financial markets. With the increasing strength of other emerging economies, such as China and Brazil, this confusion is set to increase.
One reason this is proving such a challenge is that there is no uniform way to quantify country risk. Instead, many analysts use sovereign debt ratings as a proxy. But credit rating agencies (CRAs) do not intend their sovereign debt ratings to address country risk; these two risk sources are conceptually distinct:
- Sovereign ratings capture the risk of a country defaulting on its commercial debt obligations. In other words, a sovereign rating asks if a sovereign can repay its debt.
- Country risk covers the country’s business environment including legal framework, levels of corruption, and socio-economic variables such as income disparity. Essentially, a country risk assessment aims to establish the rules of the game put in place by a sovereign within its jurisdiction, and asks if they are conducive to the success of private business.
This conflation is starting to cause meaningful difficulties in corporate credit analysis where levels of sovereign and country risk are diverging. For instance, using Greece’s sovereign rating as a proxy for country risk assessment can be too harsh, while Saudi Arabia’s high sovereign rating would be generous if applied to its business environment.
Country Risk and Sovereign Risk: An Uneasy Alliance
Nonetheless, one reason for location mattering to corporate credit analysts is indeed related to sovereign risk. Fragility in a sovereign’s finances and the diminishing strength of its currency can lead to all kinds of instability in a corporation’s operating environment, especially if a crisis precipitates government intervention to control capital flows, a change either in the policy of (pegged) exchange rates, or the tax structure, or a reason to suspend needed investment on infrastructure.
Nevertheless, many other important location-driven risk factors can have little direct effect on national finances, including local levels of corruption, legal environment (especially contract enforcement or intellectual property rights) and political stability. In addition the general effectiveness of government in creating a supportive business environment, such as the quality of national infrastructure, is important. These are the risks best thought of as ‘country risks’ proper, distinct from sovereign and sovereign intervention risk.
However, credit analysts working to tight schedules often simply note the location of a corporation’s headquarters and impose a ceiling on their view of corporate creditworthiness equivalent to the relevant country’s sovereign debt rating.
Going Separate Ways
This established approach has now begun to show worrying inadequacies in relation to fast track emerging market economies, such as modern China or Brazil. The present sovereign ratings reflect newly robust national finances and a fast-growing economy, but do not account for continuing high levels of country risk. This divergence of sovereign and country risk can be seen to some degree in nearly all the world’s fastest-growing economies including Russia and India.
At the same time, divergence in the opposite direction is evident in certain eurozone countries. The dramatic rise in the perceived sovereign risk of countries such as Greece has not, so far, been associated with an equivalent rise in country risk. As such, using assessments of Greek sovereign risk to cap the credit rating of a corporation headquartered in Greece is likely to result in an overly pessimistic rating.
Capturing Country Risk Accurately
S&P Capital IQ recently embarked on a project to improve the assessment of country risk in its credit risk models. The first step was to define country risk and identify its key components.
From this research, we selected the following reputable third party and publicly-available references to define a solid framework for estimating country risk:
- The corruption perceptions index (CPI), published annually since 1995.
- The ease of doing business ranking, created by the World Bank.
- The World Economic Forum’s (WEF) global competitiveness report.
- Income inequality metrics.
- The United Nations’ (UN) human development index (HDI).
- Political risk indicators.
How are these indicators used to assess and score country risk? Once each risk factor is weighted and an aggregate score for each country computed, analytical interpretation is used to translate this number into a credit rating-inspired letter or score.
For example, in recent years an index-driven approach would have been likely to generate a relatively low country risk score for some Middle Eastern countries. However, the events of the ‘Arab spring’ clearly introduced a fresh degree of political instability across the region that needs to be incorporated into the final up-to-date score.
Middle Eastern countries such as Kuwait and Saudi Arabia have national finances and sovereign ratings shored up by the exploitation of one or more major natural resources, such as oil or gas. Using the system, it can be seen that their relatively high sovereign ratings do not directly or predominantly reflect what might be a difficult business environment, or country risk, faced by their domestic corporations. Kuwait has a sovereign rating of AA, but a country risk score equivalent to bbb+, while Saudi Arabia’s ratings are AA- and bbb respectively.
Overall, this new approach to assessing country risk suggests there is a strong divergence from sovereign risk for around half of the countries traditionally regarded as developing or emerging. This represents, very roughly, around 80% of emerging market gross domestic product (GDP). These results put some hard numbers around the problem of using sovereign rating ceilings to capture country risk and help to illustrate why this practice can be so misleading.
Indeed, estimations of country risk scores observed by S&P Capital IQ show clear dislocations between sovereign and country risk. Some nations appear to benefit from misguided current practice, while others are disadvantaged. But given the increasing need to find new pockets of growth in relatively unexplored markets, establishing a similar framework that allows for the analysis of countries without public rating coverage is crucial.
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