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.
Failings in the conventional approach are also demonstrated in some fast-track emerging markets, such as China, where current sovereign ratings reflect its robust public purse and fast-growing economy. Yet levels of country risk remain high.
Indeed, this discrepancy exists in nearly all of the BRICs (Brazil, Russia, India and China), even as these economies create a plethora of new, globalized corporations. As a consequence, credit analysts can struggle to incorporate accurate measurements of country risk in their independent credit assessments.
Accurately accounting for country risk
Such trends have encouraged an initiative to improve the assessment of country risk in S&P Capital IQ's credit risk models. The new method involves a combination of indices already publicly available, such as:
1. Corruption Perceptions Index (CPI) - created by Transparency International,
2. Doing Business rankings - by The World Bank,
3. Global Competitiveness Index (GCI) - by the World Economic Forum (WEF),
4. Gini coefficient (income inequality metric) - by the U.S. Central Intelligence Agency (CIA),
5. The U.N.'s Human Development Index (HDI),
6. World Bank Political Risk Indicator.
Discretion is required to convert the various scores into corresponding numbers or letter grades, which must be directly comparable. And, importantly, each index needs to be weighted according to its suitability for the task in hand.
For example, the Gini coefficient corresponds to the level of wealth inequality in a country. Its inclusion is worthwhile because inequality can not only increase political instability, but it often reduces the size of the addressable domestic market accessible to businesses.
In countries with a high Gini coefficient, large elements of the population can live without access to domestic consumer markets, although this doesn't hold in all cases.
For example, the United States, the United Kingdom and Hong Kong each have relatively high Gini co-efficients, yet maintain low levels of country risk. The entire population of each has access to domestic consumer markets.
Therefore, converting the coefficient into useable score must account for this complexity - and the same question must be addressed for every index listed above.
Having completed its methodology in this way, S&P Capital IQ's results - compared with sovereign ratings below - demonstrates a discrepancy between country risk scores and sovereign risk ratings in many instances. Indeed, this divergence is particularly strong for most of the BRIC countries, as well as some European nations.
S&P Capital IQ's country risk scores vs Standard & Poor's Ratings Services' sovereign ratings
This final country risk score can then be folded into the standalone analysis of each individual company's credit risk, becoming one of various risk factors that produce the standalone corporate evaluation, in combination.