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Measuring country risk from the bottom up results in opportunities
In the wake of COVID-19, uncertainty has risen globally, and businesses and individuals are trying to figure out how different the future will look.
One key question is how risks to the profitability of operations and new investments will change globally, and how this will differentiate between countries and sectors. The depth of the recession will have a dramatic effect on prospective business income. However, companies also have to assess the likelihood of even these expected returns not being obtained. A key metric in making these calculations is the country risk premium (CRP).
In March 2020, IHS Markit released an interim update to our CRP calculations, with an update to our Country Risk Investment Model. This represents the first update of country risk premium measures since the COVID-19 pandemic spread outside of Asia, and so now is an apt time to evaluate the difference between our approach and a market-led approach, and in doing so understand the additional cost due to country risk that is likely to follow this pandemic.
We find that a "bottom-up" approach, as employed by the Country Risk Investment Model, is less volatile and more nuanced than a markets-led approach, and result in the potential for investment opportunities going forward, alongside the inevitable risks brought by recession.
Country Risk Investment Model versus Market-led Approach
The difference of approach is important to note to understand the comparison below.
Our Country Risk Investment Model uses a "bottom-up" methodology to estimate the CRP, assessing the potential impact on investment returns of risks in the following areas: political, economic, legal, tax, operational, security.
By comparison, a market-led approach uses credit spreads and ratings as the basis for their results. This therefore takes into the possibility of default, but also volatility of the market.
One further important difference between our method and a market-led method is that our method distinguishes between sectors, while the Stern method produces a single CRP for a country.
A "bottom-up" approach to calculating a country risk premium shows less volatility in the cost of country risk following COVID-19 but does highlight some key risks that will drive increases globally: notably recession risk and strikes and protests. A markets-led approach shows far more volatility as the market prices in COVID19 but doesn't allow us to dig into the drivers of this risk or distinguish between which sectors will see the biggest impact on country risk costs. It conversely assumes that a Triple-A credit rating means no additional cost due to country risk, despite the higher risk of disruption to business at global and national level.
In our view, using CRPs derived from current market data risks killing potentially sound investments through double counting. On the one hand, the recession will cause volatility and uncertainty that will deflate cash flow forecasts for future business due to the crisis; on the other, that same volatility will negatively impact credit ratings, which when applied to discount rates further reduces the valuation of those cash flows.
However, this doesn't consider the fundamentals of the operating environment, which in many cases remain robust. By relying on more direct measures of country risk, investments can be considered in the context of the post-COVID-19 reality without overstating the impact of economic recession, leading to sounder decision-making and potential opportunities for investment.
Learn more about our model and download our whitepaper outlining how to calucate the cost of country risk following COVID-19.
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