Country and sovereign risks are often conflated, say S&P Capital IQ’s Heinrichs and Stanoeva

Many analysts use sovereign ratings as a proxy for country risk, despite the fact they are two distinct risk types, say Marcel Heinrichs and Ivelina Stanoeva at S&P Capital IQ.

The sovereign debt crisis and other fast-paced economic trends trouble credit analysts trying to evaluate the effects on corporate creditworthiness. This process can be extraordinarily problematic – especially considering few financial institutions take a rigorous approach to quantifying country risk.

Many analysts simply fall back on existing sovereign ratings – used as a “ceiling” or “cap” on the creditworthiness of domestic businesses – when the two risk types are conceptually distinct. Indeed, sovereign ratings are intended to capture the risk of a sovereign default, while country risk seeks to quantify the negative aspects of a country’s business environment.

Location matters

Even so, it is true that a sovereign’s fiscal weakness can lead to volatility in its business environment.

Yet there are many other important risk factors specific to individual countries that have little-to-no bearing on national finances, such as corruption, legal frameworks and political stability, not to mention the general effectiveness of government in creating a business environment conducive to growth (e.g., through infrastructure). These are the risks best thought of as country risks proper, distinct from sovereign risk.

Yet conflation remains widespread, perhaps because the conventional approach delivered satisfactory results in certain situations. For example, developed countries such as Switzerland attract the highest ratings for their sovereign debt. Meanwhile, the country risk is so low that it becomes practically irrelevant.

Certainly, the same methodology also produced acceptable outcomes for some developing countries such as Kenya, which attract non-investment grade ratings for their sovereign debt while suffering from high levels of country risk. Therefore, using sovereign ratings as a cap has worked reasonably well here, too.

But of course, levels of sovereign and country risk differ for many other countries, and their confusion can lead to problems in corporate credit modelling. For instance, it is difficult to identify a recent rise in country risk in Ireland, even as fiscal problems led the so-called “Celtic tiger” to seek a bailout from the Eurozone.

Furthermore, there are some developing countries with national finances – and sovereign ratings – backed up by natural resources such as oil or gas. These countries can also suffer from opaque or underdeveloped legal and political systems, leading to high country risk. 

Natalie Tetteh
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