Do you agree that the analysis on country risk is no longer important once a project is accepted? Why or why not?
NO
Many investors place a portion of their portfolios in foreign securities. This decision involves an analysis of various mutual funds, exchange-traded funds (ETFs), or stock and bond offerings. However, investors often neglect an important first step in the process of international investing. The decision to invest overseas should begin with determining the riskiness of the investment climate in the country under consideration.
Country risk refers to the economic, political and business risks that are unique to a specific country, and that might result in unexpected investment losses. This article will examine the concept of country risk and how it can be analyzed by investors.
Economic and Political Risk
Consider three main risk sources when investing in a foreign country:
Developed, Emerging and Frontier Markets
There are three types of markets for international investments:
Measuring Country Risk
Just as corporations in the United States receive credit ratings to determine their ability to repay their debt, so do countries. In fact, virtually every investable country in the world receives ratings from Moody's, Standard & Poor's (S&P) or the other large rating agencies. A country with a higher credit rating is considered a safer investment than a country with a lower credit rating. Examining the credit ratings of a country is an excellent way to begin analyzing a potential investment.
Another important step in deciding on an investment is to examine a country's economic and financial fundamentals. Different analysts prefer different measures, but most experts turn to a country's gross domestic product (GDP), inflation and consumer price index (CPI) readings when considering an investment abroad. Investors will also want to carefully evaluate the structure of the country's financial markets, the availability of attractive investment alternatives, and the recent performance of local stock and bond markets.
Sources of Information on Country Risk
There are many excellent sources of information on the economic and political climate of foreign countries. Newspapers such as The New York Times, The Wall Street Journal and the Financial Times dedicate significant coverage to overseas events. Many excellent weekly magazines also cover international economics and politics. The Economist is generally considered the standard-bearer among weekly publications. International editions of many foreign newspapers and magazines can also be found online. Reviewing locally produced news sources can sometimes provide a different perspective on the attractiveness of a country under consideration for investment.
The Economist Intelligence Unit (EIU) and the Central Intelligence Agency's (CIA) "The World Factbook" are two excellent sources of objective, comprehensive country information with more in-depth coverage of countries and regions. Both of these resources provide a broad overview of the economic, political, demographic and social climate of a country.
However, the most common method used by investors with time or resource restrictions that don't allow them to do the analysis themselves is to rely on experts who spend all their time doing that type of analysis. Calculating debt service ratios, import/export ratios, money supply changes and other fundamental aspects of a country, and attempting to incorporate them all into the big picture, requires a significant commitment if you do it by yourself. Sourcing these tools from organizations focused on analyzing country risk allows more energy to be focused on investing.
Euromoney Country Risk Survey
This survey covers 186 countries and gives a comprehensive picture of a country's investment risk. The rating is given on a 100-point scale, with a score of 100 representing virtually zero risk.
In general, the calculation of the ECR rankings is split between two overall factors: qualitative (70% weighting) and quantitative (30% weighting). The qualitative factors are derived from experts who assess the political risk, structure and economic performance of the country. The quantitative factors are based on debt indicators, capital market access, and credit ratings. The rating for the qualitative and quantitative factors are available separately, so if you believe the weighting importance to be different than 70/30, you have the flexibility to manually adjust the weighting yourself.
Economist Intelligence Unit's Country Risk Service Report
The EIU is the research arm of The Economist and one of its best offerings is its Country Risk Service Report. These ratings cover over 130 countries, with an emphasis on "emerging and highly indebted" markets. The rating analyzes factors similar to the ECR rating, such as economic and political risk, and provides a rating on a 100-point scale; however, unlike the ECR rating, higher scores mean higher sovereign risk.
A benefit of the EIU ratings is that they are updated on a monthly basis, so trends can be caught much earlier than other, less frequently updated methods. In addition, the EIU format offers investors more analysis and provides an outlook for the country, as well as two-year forecasts for several key variables. So, if you want to get a sense of the direction a particular country is headed in the near future, this may prove to be a useful tool.
Institutional Investor's Country Credit Survey
This rating service is based on a survey of senior economists and analysts at large international banks. The uniqueness of this approach is appealing because it surveys people from companies that are at the ground level, lending and providing capital directly to these countries. In a sense, this adds a degree of credibility to the ratings because major international banks typically do a significant amount of due diligence before exposing themselves to certain countries. Similar to the other approaches, this rating is based on a scale of 0 to 100, with 100 being virtually risk-free and zero being equivalent to certain default.
Important Steps When Investing Overseas
Once a country analysis has been completed, several investment decisions need to be made. The first is to decide where to invest by choosing among several possible investment approaches, including investing in:
Remember that diversification, a fundamental principle of domestic investing, is even more important when investing internationally. Choosing to invest an entire portfolio in a single country is not prudent. In a broadly diversified global portfolio, investments should be allocated among developed, emerging and perhaps frontier markets. Even in a more concentrated portfolio, investments should be spread among several countries to maximize diversification and minimize risk.
After deciding where to invest, an investor must decide which investment vehicles to invest in. Investment options include sovereign debt, stocks or bonds of companies domiciled in the country(s) chosen, stocks or bonds of a U.S.-based company that derives a significant portion of revenue from the country(s) selected, or an internationally focused ETF or mutual fund. The choice of investment vehicle depends on each investor's individual knowledge, experience, risk profile and return objectives. When in doubt, it may make sense to start out by taking less risk. More risk can always be added to the portfolio later.
In addition to thoroughly researching prospective investments, an international investor also needs to monitor his or her portfolio and adjust holdings as conditions dictate. As in the United States, economic conditions overseas are constantly evolving, and political situations abroad can change quickly, particularly in emerging or frontier markets. Situations that once seemed promising may no longer be so. And countries that once seemed too risky might now be viable investment candidates.
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