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A key metric informing investment decisions are country risk premiums (CRP):
the additional returns a project must generate to cover the risks
arising from its particular operating environment. Commonly used
sovereign risk indicators are misleading proxies for these risks.
Consider, the sovereign ratings of the UK next to uncertainties of
its operating environment given Brexit; the structural fiscal
deficit of India next to the financial strength of major Indian
companies; or the creditworthiness of the Chinese sovereign next to
the recent defaults of major state-owned enterprises.
Our
Country Risk Investment Model (CRIM) integrates the full
spectrum of commercially relevant political, economic, legal, tax,
operational, and security risks and models their impact on future
cash flows by sector, and by project phase (development,
production, and income). This results in a more accurate and
actionable forecast of future cash flows allowing for more precise
valuation and comparison of potential investments in a single
country, across sectors, across a region, and/or around the
world.
Recession premiums: Automotive and
manufacturing
COVID-19 has had a large impact on automobile production, having
been affected both on the supply side by national lockdowns and
supply chain disruptions, and by the collapse in demand. National
recessions around the world were inevitable and drove the greatest
expected cash flow losses due to country risk (adjusting the net
present value of a hypothetical 25-year for political, economic,
legal, tax, operating, and security risks). The losses associated
with a reduction in sales caused by economic slowdown is derived
from our 'recession' risk score. Positively, CRIM calculated that
CRPs recovered strongly overall in Q3 and broadly converged to
pre-COVID-19 levels in Q4.
However, automotive revenues were already affected by policy and
regulatory risk factors in major markets prior to the COVID-19
pandemic, such as trade disputes between the US and China,
finalisation of the United States-Mexico-Canada Agreement, and
continued uncertainty around the future trading relationship
between the UK and European Union. The impact of COVID-19 was
particularly acute for the automotive sector, to which IHS Markit
assigns a higher Weighted Average Cost of Capital (WACC) than for
general manufacturing given the sector's greater volatility in the
global economy, such as the potential for disruption to automotive
companies' highly interconnected and dependent 'just in time'
supply chains.
Light vehicle production was severely disrupted as major auto
plants across Europe shutdown from March-May and vehicle dealers
and showrooms remained closed due to the imposition of
COVID-19-related restrictions. Consequently, the automotive sector
recorded a larger increase in total expected cash flow losses
(USD112.9 million over the project's life cycle) than general
manufacturing (USD105.6 million) across the top 10 automobile
producers in Q2 given the deeper and longer-lasting impact of
recessions on this sector.
Country risk fundamentals
Expected cash flow losses cannot be fully accounted for by a
recession-induced reduction in sales. While other automotive
producers converged to pre-COVID-19 levels in Q4, Mexico's CRP
increased by 1.55% (q-on-q) and 0.88% (q-on-q) for the automotive
and manufacturing sectors respectively.
Cash flow losses for Mexico's automotive sector remained
elevated into Q4 2020 despite recession-induces losses beginning to
subside. This is primarily because President Andrés Manuel López
Obrador's support for cancelling electricity and natural resource
contracts, advancing contract renegotiations to support state-owned
over private companies, and the role of local referenda in forcing
contract alterations for projects facing community opposition, have
all increased state contract alteration risks. Consequently,
estimated losses stemming from contract alteration increased from
USD12.79 million in Q3 to USD16.2 million in Q4.
Sovereign misperceptions
Market-based approaches to calculating country risk tend to miss
such commercially significant risks and over-emphasise sovereign
default and market volatility. Typical approaches to calculating
country risk premiums use government bond and credit default swap
spreads, in addition to factoring in equity market volatility. This
method is especially problematic in the context of emerging and
frontier markets, where credit fundamentals do not necessarily
reflect the health of the real economy or the full range of risks
that impact project cash flows, such as criminal violence, strikes
and protests, and state contract alteration.
Miscalculating country risk in frontier
markets
Across the 27 MSCI-classified frontier markets (excluding
Benin), using a sovereign risk proxy results in the overestimation
of CRPs for 26 countries by 4.24 percentage points on average.
To take one example, a market-based approach undervalues cash
flow losses for automobile projects in Mexico by 5.56% compared to
the CRP calculated by CRIM. Despite Mexico having a comparatively
strong sovereign credit rating (rated at 30 on IHS Markit's scale),
this rating does not account for the combined risks of criminal
violence, strikes and protests, and state contract alteration - all
of which would require a higher estimated return of investment to
compensate for any potential cash flow losses.
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Premium scores and special report to see for yourself.
Posted 17 December 2020 by Alexia Ash, Associate Director, Country Risk Consulting and
