Evaluating Country Risk For International Investing

Many investors choose to place a portion of their portfolios in foreign securities. This decision involves an analysis of various mutual funds, exchange-traded funds (ETF), or stock and ond offerings. !o"ever, investors often neglect an important first step in the process of international investing. #hen done properly, the decision to invest overseas egins "ith a determination of the riskiness of the investment climate in the country under consideration. $ountry risk refers to the economic, political and usiness risks that are uni%ue to a specific country, and that might result in unexpected investment losses. This article "ill examine the concept of country risk and ho" it can e analy&ed y investors. (For more, read Finding Fortune In Foreign-Stock ETFs.) Economic and Political Risk The follo"ing are t"o main sources of risk that need e considered "hen investing in a foreign country. Economic risk' This risk refers to a country(s a ility to pay ack its de ts. ) country "ith sta le finances and a stronger economy should provide more relia le investments than a country "ith "eaker finances or an unsound economy. Political risk' This risk refers to the political decisions made "ithin a country that might result in an unanticipated loss to investors. #hile economic risk is often referred to as a country(s ability to pay ack its de ts, political risk is sometimes referred to as the willingness of a country to pay de ts or maintain a hospita le climate for outside investment. Even if a country(s economy is strong, if the political climate is unfriendly (or ecomes unfriendly) to outside investors, the country may not e a good candidate for investment. Measuring Economic and Political Risk *ust as corporations in the +.,. receive credit ratings to determine their a ility to repay their de t, so do countries. -n fact, virtually every investa le country in the "orld receives ratings from Moody(s, ,tandard . /oor(s (,./), or the other large rating agencies. ) country "ith a higher credit rating is considered a safer investment than a country "ith a lo"er credit rating. Examining the credit ratings of a country is an excellent "ay to egin the analysis of a potential investment. )nother important step in deciding on an investment is to examine a country(s economic and financial fundamentals. 0ifferent analysts prefer different measures, ut almost everyone looks at a country(s gross domestic product (10/), inflation and $onsumer /rice -ndex ($/-) readings "hen considering an investment. -nvestors "ill also "ant to carefully evaluate the structure of the country(s financial markets, the availa ility of attractive investment alternatives, and the recent performance of local stock and ond markets. (For more insight, see The Consumer Price Index: A Friend To In estors and The Im!ortance "# In#lation And $%P.) Sources of Information on Country Risk There are many excellent sources of information on the economic and political climate of foreign countries. 2e"spapers, such as the &ew 'ork Times, the (all Street )ournal and the Financial Times dedicate significant coverage to overseas events. There are also many excellent "eekly maga&ines covering international economics and politics3 the Economist is generally considered to e the standard earer among "eekly pu lications. For those seeking more in-depth coverage of a particular country or region, t"o excellent sources of o 4ective, comprehensive country information are the Economist -ntelligence +nit and the $entral -ntelligence )gency ($-)) #orld Fact 5ook. Either of these resources provides an investor "ith a road overvie" of the economic, political, demographic and social climate of a country. The Economist -ntelligence +nit also provides ratings for most of the "orld(s countries. These ratings can e used to supplement those issued y Moody(s, ,./, and the other

6traditional6 ratings agencies. Finally, the internet provides access to a host of information, including international editions of many foreign ne"spapers and maga&ines. 7evie"ing locally produced ne"s sources can sometimes provide a different perspective on the attractiveness of a country under consideration for investment. Developed Markets, Emerging Markets and Frontier Markets #hen considering international investments, there are three types of markets from "hich to choose. 0eveloped markets consist of the largest, most industriali&ed economies. Their economic systems are "ell developed, they are politically sta le, and the rule of la" is "ell entrenched. 0eveloped markets are usually considered the safest investment destinations, ut their economic gro"th rates often trail those of countries in an earlier stage of development. -nvestment analysis of developed markets usually concentrates on the current economic and market cycles3 political considerations are often a less important consideration. Examples of developed markets include the +.,., $anada, France, *apan and )ustralia. Emerging markets experience rapid industriali&ation and often demonstrate extremely high levels of economic gro"th. This strong economic gro"th can sometimes translate into investment returns that are superior to those that are availa le in developed markets. !o"ever, emerging markets are also riskier than developed markets3 there is often more political uncertainty in emerging markets, and their economies may e more prone to excessive ooms and usts. -n addition to carefully evaluating an emerging market(s economic and financial fundamentals, investors should pay close attention to the country(s political climate and the potential for unexpected political developments. Many of the fastest gro"ing economies in the "orld, including $hina, -ndia and 5ra&il, are considered emerging markets. (For related reading, see (hat Is An Emerging *arket Economy+) Frontier markets represent 6the next "ave6 of investment destinations. Frontier markets are generally either smaller than traditional emerging markets, or are found in countries that place restrictions on the a ility of foreigners to invest. )lthough frontier markets can e exceptionally risky and often suffer from lo" levels of li%uidity, they also offer the potential for a ove average returns over time. Frontier markets are also not "ell correlated "ith other, more traditional investment destinations, "hich mean that they provide additional diversification enefits "hen held in a "ell-rounded investment portfolio. )s "ith emerging markets, investors in frontier markets must pay careful attention to the political environment, as "ell as to economic and financial developments. Examples of frontier markets include 2igeria, 5ots"ana and 8u"ait.

Important Steps W en Investing !verseas 9nce country analysis has een completed, there are several investment decisions that need to e made. The first choice is to decide "here to invest, y choosing among several possi le investment approaches, including' -nvesting in a road international portfolio -nvesting in a more limited portfolio focused on either emerging markets or developed markets -nvesting in a specific region, such as Europe or :atin )merica -nvesting only in a specific country(s) -t is important to remem er that diversification, "hich is a fundamental principle of domestic investing, is even more important "hen investing internationally. $hoosing to invest an entire

portfolio in a single country is not prudent. -n a roadly diversified glo al portfolio, investments should e allocated among developed, emerging and perhaps frontier markets. Even in a more concentrated portfolio, investments should still e spread among several countries in order to maximi&e diversification and minimi&e risk. )fter the decision on "here to invest has een made, an investor has to decide "hat investment vehicles he or she "ishes to invest in. -nvestment options include sovereign de t, stocks or onds of companies domiciled in the country(s) chosen, stocks or onds of a +.,.- ased company that derives a significant portion of its revenues from the country(s) selected, or an internationally focused exchange-traded fund (ETF) or mutual fund. The choice of investment vehicle is dependent upon each investor(s individual kno"ledge, experience, risk profile and return o 4ectives. #hen in dou t, it may make sense to start out y taking less risk3 more risk can al"ays e added to the portfolio at a later date. -n addition to thoroughly researching prospective investments, an international investor also needs to monitor his or her portfolio and ad4ust holdings as conditions dictate. )s in the +.,., economic conditions overseas are constantly evolving, and political situations a road can change %uickly, particularly in emerging or frontier markets. ,ituations that once seemed promising may no longer e so, and countries that once seemed too risky might no" e via le investment candidates. Conclusion 9verseas investing involves a careful analysis of the economic, political and usiness risks that might result in unexpected investment losses. This analysis of country risk is a fundamental step in the process of uilding and monitoring an international portfolio. -nvestors that use the many excellent sources of information availa le to evaluate country risk "ill e etter prepared "hen constructing their international portfolios.