DATA UPDATE 4: COUNTRY RISK AND CURRENCY QUESTIONS

Risky Countries? Risky Currencies?

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Country Risk and Value

¨ In my last post, I looked at the risk premiums in US markets, and you may have found that focus to be a little parochial, since as an investor, you could invest in global markets, if you believed that you would receive a better risk-return trade off there.

¨ For some investors, in countries with investment restrictions, the only investment options are domestic and US investment options may not be within their reach. I

¨ In this session, I want to first talk about country risk, and how it affects investment decisions not only on the part of individual investors but also of companies, and then address the currency question, which is often conflated with country risk, but has a very different set of fundamentals and consequences.

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Why Risk varies across countries

¨ Life Cycle: Countries go through their own version of the life cycle, with developed and more mature markets having more settled risk profiles than emerging economies which are still growing, changing and generally more risky. High growth economies tend to also have higher volatility in growth than low growth economies.

¨ Political Risk: A political structure that is unstable adds to economic risk, by making regulatory and tax law volatile, and adding unpredictable costs to businesses. While there are some investors and businesses that believe autocracies and dictatorships offer more stability than democracies, I believe that autocracies do offer more temporal stability but they are also more exposed to more discontinuous change.

¨ Legal Risk: Countries with dysfunctional legal systems will create more risk for investors than countries where the legal systems works well and in a timely fashion.

¨ Economic Structure: Some countries have more risk exposure simply because they are overly dependent on an industry or commodity for their prosperity, and an industry downturn or a commodity price drop can send their economies into a tailspin.

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Measuring Country Risk: Country Risk Scores

¨ There are services that measure country risk with scores, trying to capture exposure to all of the risks listed above.

¨ The scores are subjective judgments and are not quite comparable across services, because each service scales risk differently. ¤ The World Bank provides an array of governance indicators

(from corruption to political stability) for 214 countries (https://databank.worldbank.org/source/worldwide-governance-indicators#)

¤ Political Risk Services (PRS) measures a composite risk score for each country, with low (high) scores corresponding to high (low) country risk.

2nd column: Moody’s Local Currency Rating (Dec 2019)3rd column: Sovereign 10-yr CDS in Dec 2019

Rat

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& So

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CD

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Aswath Damodaran

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Measuring Country Risk Premium

Black #: Total ERPRed #: Country risk premiumAVG: GDP weighted average

ERP

: Jan

202

0

Aswath Damodaran

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Company Risk Exposure: Revenues

¨ Put simply, the exposure to country risk does not come from where a company is incorporated or where it is traded, but from its operations.

¨ For a company like Coca Cola, where production costs are low and facilities can be moved, you can base it on revenues:

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Company Risk Exposure: Production

¨ For companies where production costs are higher and facilities are less moveable, your weights for countries should at least partially based on production. At the limit, with natural resource companies, the operating exposure should be based upon where it produces those resources.

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Bringing in Currencies

¨ When the discussion turns to country risk, it almost always veers off into currency risk, with many conflating the two, in their discussions. While there are conditions where the two are correlated and draw from the same fundamentals, it is good to keep the two risks separate, since how you deal with them can also be very different.

¨ With currencies, it is very easy to get distracted by experts with macro views, providing their forecasts with absolute certainty, and distractions galore, from governments keeping their currencies stronger or weaker and speculative trading.

¨ To get past this noise, I will draw on the intrinsic interest rate equation that I used in my last post to explain why interest rates in the United States have stayed low for the last decade,¤ Intrinsic Riskfree Rate = Inflation + Real GDP Growth

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Risk free Rates

¨ There are a few dozen governments that issue ten-year bonds in their local currencies, and the search for risk free rates starts there.

¨ To the extent that these government bonds are liquid and you perceive no default risk in the government, you can use the government bond rate as your risk free rate. It is that rationale that we use to justify using the Swiss Government’s Swiss Franc 10-year rate as the risk free rate in Swiss Francs and the Norwegian government’s ten-year Krone rate as the riskfree rate in Krone.

¨ When the government is perceived as having default risk, I compute a risk free rate by netting out the default spread:¤ Riskfree Rate in currency = Government bond rate – Default Spread for sovereign

local-currency rating¨ Using this approach on the Indian rupee and the Brazilian reai,

¤ Riskfree Rate in Rupees on January 1, 2020 = Indian Government Rupee Bond rate on January 1, 2020 – Default spread based on Baa2 rating = 6.56% - 1.59% = 4.95%

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Government Bond Rate based Risk free Rates

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Synthetic Risk Free Rates

¨ If you have doubts about one or more of three assumptions needed to use the government-bond approach to getting to risk free rates, there is an alternative that I will call my synthetic riskfree rate.

¨ To use this approach, let’s start with a currency in which you feel comfortable estimating a risk free rate, say the US dollar. If the key driver of risk free rates is expected inflation, the risk free rate in any other currency can be estimated using the differential inflation between that currency and the US dollar.

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Useful in these contexts

¨ Currencies with no government bonds outstanding: There are more than 120 currencies, where there are no government bonds in the local currency; the country borrows from banks and the IMF, not from markets. Without a government bond rate, the approach described above becomes moot.

¨ Currencies where the government bond rate is not trustworthy: There are currencies where there is a government bond, with a rate, but an absence of liquidity and/or the presence of institutions being forced to buy the bond by the government that may make the rates untrustworthy.

¨ Pegged Currencies: There are some currencies that have been pegged to the US dollar, either for convenience (much of the Middle East) or stability (Ecuador). While analysts in these markets often use the US T.Bond rate as the risk free rate, there is a very real danger that what is pegged today may be unpegged in the future, especially when the fundamentals don't support the peg.

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Currency Choice in Investing and Valuation

¨ If you are consistent about dealing with inflation in your valuation, the value should be the same in every currency.

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Currency Miscalculations

¨ Casual Dollarization: In casual dollarization, you start by estimating your costs of equity and capital in US dollars, partly because you do not want to or cannot estimate risk free rates in a local currency. You then convert your expected future cash flows in the local currency and convert them to dollars using the current exchange rate.

¨ Corporate hurdle rates: I have long argued against computing a corporate cost of capital and using it as a hurdle rate on investments and acquisitions, and that argument gets even stronger, when the investments or acquisitions are cross-border and in different currencies.

¨ Mismatched Currency Frames of Reference: We all have frames of reference that are built into our thinking, based upon where we live and the currencies we deal with. Consequently, it behooves us to be explicit about currencies, when talking about growth rates and costs of capital.

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In closing..

¨ I looked at two variables, country and currency, that are often conflated in valuation, perhaps because risky countries tend to have volatile currencies, and separated the discussion to examine the determinants of each, and why they should not be lumped together.

¨ I can invest in a company in a risky country, and I can choose to do the valuation in US dollars, but only if I recognize that the currency choice cannot make the country risk go away.

¨ In other words, a Ukranian or Guatamelan company will stay risky, even if you value it in US dollars, and a company that gets all of its revenues in Northern Europe will stay safe, even if you value it in Russian Rubles.