Since Russia’s outright aggression on Ukraine began on February 24th, there had been speculation on when, and by how much, the credit rating agencies would adjust Russia’s investment grade rating of BBB, Baa3 and BBB-. Just over 30% of the respondents to Moritz Kraemer’s LinkedIn poll suggested that S&P would be the first mover. That indeed materialized.

Each major credit rating agency, i.e., Fitch, Moody’s and S&P, brought its ratings down by several notches and currently stand at B (negative watch), Ca (negative) and CCC- (negative), respectively at the time of writing. But prior to these changes, CountryRisk.io's rating simulation had already brought Russia’s sovereign rating to the brink of default.

Whilst everyone has been fixated on the sovereign credit rating – an assessment of a country’s ability and willingness to repay foreign currency debt obligations – little had been said about the country risk rating – which, broadly speaking, refers to the risk of doing business in a country and ability to repatriate capital. 

Given the relatively low amount of outstanding Russian sovereign bonds but large involvement of foreign companies in the Russian market, one can make the case that country risk is more important than sovereign risk at the current juncture. CountryRisk.io has always made a distinction between these two, which you may find in our Methodology. Here's a recap: 

Sovereign versus Country Risk

Although the terms are often used interchangeably, it is useful to distinguish between sovereign and country risk since they measure different things. We define sovereign risk as the probability that a national government will default on its debt obligations. Meanwhile, country risk includes transfer and convertibility (T&C) risk. This represents the likelihood of the government imposing capital and exchange controls that would impede the ability of its non-sovereign sector to convert local currency into foreign currency, thereby inhibiting the ability of those borrowers to honour their obligations to foreign creditors. Transfer risk also includes forces majeures, such as wars, expropriations, revolutions, civil disturbances and natural disasters.

In its rating simulation, CountryRisk.io's Transfer & Convertibility rating currently stands at 6, the highest transfer risk rating a country could be assigned (We use a scale of 0 – 6). This is justified by Russia’s central bank’s imposition of capital controls [1].

Applying Country Risk

But how is country risk vs. sovereign credit risk impact investors? For companies that are doing business and are investing capital into a country, say, a commercial entity like a pharmaceutical or retailer, for a longer haul, it matters. They would want to know that (a) their initial investments would be profitable based on a hurdle rate that includes country risk premium and project risk premium, and (b) they could repatriate capital without government interference or difficulty.

To assess the attractiveness of a new project (e.g., setting up a production facility in a foreign country or entering a new market for sales activities) and compare it with other projects, one typically calculates a hurdle rate that is the sum of the country risk premium, sector risk premium and the project risk premium. If the expected internal rate of return (IRR) of a specific project is above the hurdle rate, the project is attractive and the difference between the hurdle rate and IRR is used to rank project opportunities at hands.

Calculating Country Risk premium

So, how does one calculate the country risk rate/premium? There is no perfect way, just approximations. One well known approximation is put forward by New York University professor Aswath Damodaran. Simplified, one takes a risk-free rate (e.g., US T-Bills or US Treasuries) and adds a premium for the difference in terms of country/business risk between the US (or your reference market) and the foreign country. Often one either uses historical default probabilities or market-based measures (i.e., CDS or bond spreads) to derive this premium. Both approaches have the obvious limitation that it refers to sovereign risk (CDS and sovereign default probability are sovereign risk) and not country risk. 

As of the last update of Damodaran’s Country Default Spreads and Risk Premiums [2] on January 5, 2022, Russia’s country risk premium was just 2.18%, comparable to those of Italy and Romania and better than those of Brazil and India. At this level, the country risk premium was negligible and didn’t matter because it was extremely low. In hindsight, country risk was clearly underpriced. And this can be explained by the fact that it was based on sovereign risk and not country risk.

How Russia fares

Fast forward to today, Moody’s Ca rating and 5-year CDS spreads 1,672 bps [3], the country risk premium is around 17%. At such a level, basically all projects become unattractive. But let’s assume that spreads would decline some time this year if, or when, Russia decides to cease aggression against Ukraine. Where would it stabilize? Let’s assume between 5-7%. Around these levels, the attractiveness of engaging in Russia remains severely restricted. In compliance to recent sanction against Russia and in support of Ukraine as well as a reflection of poor business prospects, many companies such as Ikea, Apple and Disney have already pulled out of Russia, and energy companies - from Shell, Exxon, BP and Equinor, are abandoning their stakes or presence.

Political risk or country risk can be insured to a large extent. An important assessment for that is the OECD country risk classification, and Russia’s is currently at 4. It will be important to monitor how this assessment changes although CountryRisk.io assumes it would be revised upward.  

Russia is just one example out of many countries where a clear distinction between sovereign credit risk and country risk matters. It’s often ignored or overlooked but could be very costly to companies making long-term investments into a country. CountryRisk.io believes that many more companies will leave Russia should it remain in its destructive path.

Footnotes:

[1] Source:https://www.reuters.com/markets/europe/russian-central-bank-scrambles-contain-fallout-sanctions-2022-02-28/)

[2] Source: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html

[3] As of 10:30 EST on March 7th