During our recent webinar, Paolo Spadotto, Risk Specialist at S&P Capital IQ and I discussed the country risk and sovereign risk conundrum.
Despite the fact that sovereign ratings are distinctly different from country risk scores, the former is widely used as a proxy for risk in a given country. The differences in the two risk scores are well demonstrated in the graph below.
As discussed during the webinar, factors such as political and economic risks are important drivers of both sovereign risk and country risk. However, there are factors that play a key role for a sovereign’s creditworthiness, while their impact on the operating environment in the country (i.e. country risk) is more remote.
Low leverage and strong external creditor position may support a strong sovereign rating but does not directly affect country risk; and the other way around. For example, contract’s enforceability, creditor rights and level of corruption can significantly influence country risk, while their direct impact on sovereigns’ ratings is limited. Thus, whenever there is a change in a sovereign’s credit quality this might not necessarily mean a direct parallel change in the operating environment and vice versa.
It is always critical to understand what is driving the change. For example if we hear the news of a sovereign downgrade we need to understand the reasons for it: What were the driving factors? Was it a combination of factors? Which of the sovereign credit risk factors were impacted? We can then make an educated decision as to whether or not those factors can have a similar impact on the level of country risk.
Entities operating in a country are exposed both to direct sovereign risk and indirect sovereign risk (country risk). However, depending on the type of entity, the overall impact varies. Entities such as banks or financial institutions, in general, are much more sensitive to changes in the operating environment, and thus country risk is a very important driver of their credit quality. In addition they are much more exposed to direct sovereign risk through existing regulation as well as the capacity and willingness of the sovereign to support systemically important banks.
Listen to the replay of “The Country Risk and Sovereign Risk Conundrum” to hear myself and Paolo discuss the above and more.