Country Risk 2025: The Story behind the Numbers!

Key Concepts

Country Risk: The multifaceted risks associated with operating or investing in a particular country, encompassing political, economic, legal, and social factors.
Equity Risk Premium (ERP): The excess return that investors expect to receive for investing in equities over a risk-free rate, reflecting the additional risk taken.
Political System: The structure of governance in a country (e.g., democracy, authoritarian regime) and its impact on business operations.
Exposure to Violence: The level of internal or external conflict within a country, affecting operational costs and security.
Corruption: The illicit practice of abusing public office for private gain, acting as an implicit tax on businesses.
Legal and Property Rights: The strength and enforceability of laws protecting private property and contracts, crucial for business stability.
Default Risk: The risk that a government or entity will be unable to meet its debt obligations.
Sovereign Ratings: Credit ratings assigned to countries by agencies like Moody's, S&P, and Fitch, indicating their creditworthiness.
Sovereign CDS Spread: A market-based measure of the cost of insuring against a country's default.
Composite Country Risk Scores: Scores from services that attempt to quantify country risk by incorporating multiple dimensions.
Mature Market Equity Risk Premium: A baseline ERP for developed, stable economies.
Implied Equity Risk Premium: An ERP calculated based on current market prices and expected future cash flows, rather than historical data.
Risk-Free Rate: The theoretical rate of return of an investment with zero risk.
Beta: A measure of a stock's volatility in relation to the overall market, indicating systematic risk.
Synthetic Rating: An estimated credit rating for a company that does not have an official rating, derived from its financial statements.
Currency Choice: The decision to conduct financial analysis and valuation in a specific currency, impacting risk-free rates and cash flow projections.

Dimensions of Country Risk

The speaker identifies four primary dimensions of country risk:

Political System:
- Types: Democracies, flawed democracies, hybrid regimes, and authoritarian regimes.
- Trend: The world has become more authoritarian over the last two decades, with a significant portion of countries under authoritarian rule.
- Business Perspective:
  - Democracies: Offer continuous policy change risk due to electoral cycles, which can be challenging for businesses to navigate.
  - Authoritarian Regimes: Can offer policy stability and long-term promises, but face the risk of discontinuous and significant change if the regime collapses. Businesses may favor these for perceived stability, but this can be a miscalculation due to the potential for drastic shifts.
Exposure to Violence:
- Measurement: Assessed by institutes measuring internal and external violence.
- Impact on Business: Violence increases operational costs due to the need for insurance, security, and disruptions to operations. Peaceful regions are generally easier and less costly for businesses.
- Geographic Variation: Significant variations in violence exposure exist globally, with large parts of the world experiencing high levels of conflict.
Corruption:
- Nature: Viewed as an "implicit tax" on businesses, increasing operating expenses through bribes and illicit payments.
- Drivers: Often linked to the complexity of licensing and permission systems and underpaid bureaucrats.
- Geographic Variation: Corruption is more prevalent in parts of Asia and Latin America, while Europe, North America, and Australia tend to be less corrupt.
Legal and Property Rights:
- Importance: Essential for businesses to have a legal system that enforces private property rights and contracts.
- Enforcement: The timeliness of legal enforcement is as critical as the quality of the laws themselves. Delays in legal processes can be as detrimental as a lack of legal recourse.
- Global Disparity: Significant differences exist in the quality and enforcement of legal systems worldwide, with some regions lacking effective legal frameworks.

Measuring Country Risk

Two broad categories of country risk measurement are discussed:

Default Risk:
- Sovereign Ratings:
  - Agencies: Moody's, S&P, Fitch.
  - Scale: Ranges from AAA (safest) to D (default).
  - Trend: The number of rated sovereigns has increased significantly over the past four decades, but the number of AAA-rated countries has shrunk. The US has recently lost its AAA rating from Fitch and S&P, and Moody's.
  - Types: Foreign currency ratings and local currency ratings.
  - Limitations: Ratings agencies can be slow to react to changes and may have biases.
- Sovereign CDS Spreads:
  - Function: Market-based measure of the cost of insuring against a country's default.
  - Example: A 2.55% CDS spread for Brazil implies an additional annual cost of 2.55% to insure against default on Brazilian government bonds.
  - Advantages: Reflect market sentiment and changes almost instantaneously.
  - Disadvantages: Can be volatile and are not available for all countries.
Composite Country Risk Measures:
- Providers: Services like The Economist, World Bank, and PRS (Political Risk Services).
- Methodology: These services attempt to capture a broader range of country risks by incorporating multiple dimensions.
- Limitations: Scores can vary in methodology, subjectivity, and standardization, making cross-service comparisons difficult. Some use low scores for riskiest, while others use high scores.
- Example (PRS): In July 2025, the safest countries were Denmark, Switzerland, Norway, Singapore, and Ireland, while the riskiest included Lebanon, Sudan, Yemen, and Syria.

Estimating Equity Risk Premiums (ERPs)

The speaker outlines a methodology for estimating country-specific ERPs, moving away from traditional approaches:

Mature Market Equity Risk Premium:
- Traditional Approach: Using historical ERPs for the US, which the speaker considers backward-looking and noisy.
- Speaker's Approach:
  - Starts with an implied equity risk premium for the S&P 500, calculated using forward-looking cash flows and a discount rate.
  - Adjusts this premium to reflect the risk-free rate, which is now derived by subtracting the default spread of the US government's rating (AA1) from the T-bond rate.
  - The resulting implied market premium for a mature market is 4.21% (as of July 2025).
  - This 4.21% is used as the ERP for any AAA-rated country (e.g., Germany, Switzerland, Singapore, Australia, New Zealand, Canada).
Country-Specific ERP Calculation (for non-AAA rated countries, including the US):
- Step 1: Determine Default Spread:
  - Use the country's sovereign rating or its sovereign CDS spread (if available).
- Step 2: Scale for Equity Risk:
  - Recognize that equities are riskier than government bonds.
  - Multiply the country's default spread by a factor of 1.5 (based on the observed volatility difference between emerging market equities and government bonds).
  - Formula: Scaled Default Spread = Default Spread * 1.5
- Step 3: Calculate Country ERP:
  - Add the scaled default spread to the mature market ERP.
  - Formula: Country ERP = Mature Market ERP (4.21%) + Scaled Default Spread
Handling Countries Without Ratings:
- Utilize composite country risk scores (e.g., from PRS).
- Identify countries with similar PRS scores.
- Use the ERPs of rated countries with comparable risk profiles.

Practical Application: Using Equity Risk Premiums in Valuation

The speaker provides a five-step framework for using ERPs in corporate finance and valuation:

Understand What the ERP Represents:
- It's the additional return investors demand to compensate for risk, not greed.
- Higher ERPs lead to higher required returns and lower valuations for investments.
Make a Currency Choice:
- Valuation can be performed in any currency.
- The choice of currency impacts the risk-free rate due to differing inflation expectations and default risks.
- Example: For Turkey, a high government bond rate (around 30%) is adjusted by subtracting the default spread to arrive at a risk-free rate in Lira (around 26%).
Estimate the Equity Risk Premium:
- Project Analysis: Use the ERP of the country where the project is located, regardless of the company's incorporation country.
- Company Valuation: Use a weighted average of ERPs for all countries where the company operates, weighted by revenues, production, or a mix thereof. The key is to reflect where the risk originates.
Estimate Company-Specific Risk Exposure:
- Equity: Use a measure of relative risk, such as beta, to adjust the ERP for the company's specific risk profile compared to the average company in the market.
- Debt: Estimate the company's default risk and convert it into a default spread, potentially using a synthetic rating derived from financial ratios like the interest coverage ratio.
- Double Burden: Companies in countries with sovereign default risk face both their own default risk and the country's risk.
Align Cash Flows with Currency Choice:
- If valuation is done in a specific currency, cash flows must be projected in that currency.
- Consistency is Key: High inflation in a local currency will inflate both discount rates and cash flow growth. Using a foreign currency will result in lower discount rates and cash flow growth due to lower inflation expectations.

Conclusion and Resources

The speaker emphasizes that their approach to country risk and ERP estimation is a pragmatic pathway and encourages users to adapt and refine it based on their own needs and insights. They offer further resources for those interested in deeper dives:

Annual Country Risk Update: A comprehensive, detailed paper (around 140 pages).
Spreadsheets: Containing ERP data and methodologies for calculating implied ERPs.

The session aims to provide a clearer understanding of country risk components and a more robust method for incorporating them into valuation, moving beyond simplistic black-box applications of ERPs.