Latest update: 11 March 2020
What is country risk? Why does it matter?
Country risk refers to the conditions that exist in a country that could lead to losses for investors. There are many different factors to consider but key ones include currency depreciation, political and regulatory changes, economic conditions, the reliability of the legal system, corruption, and respect for property rights. All of these factors can cause borrowers to default. Collateral assets can fall in value, and become difficult to sell or recover. Loan originators can lose their licences or become insolvent.
Country risk is probably the most under-analysed risk that exists for P2P investors right now. Some platforms like Mintos offer loans from more than 30 different countries. Most investors realise that some countries are higher risk than others. But which ones? And how much riskier? Many of our readers have asked us to analyse this, and our initial findings are below.
Investors have been impacted by country risks recently
In the last few months, both Russia and Kosovo cancelled the licences of many payday lenders operating in the country, seemingly without warning. This led to a huge increase in the rates of non-performing loans, as borrowers are much less likely to repay when they believe that a company is operating ‘without a licence’, even if they are still legally liable for their debts.
In Denmark, we have also seen political moves to cap interest rates at 35%. While we understand the political and ethical reasons for this, it essentially kills the business model of all payday/short-term lenders operating in the country almost instantly, as the high default rates and cost structure cannot be covered by a 35% interest rate. This shows that country risk is very real, and needs to be considered by all sophisticated P2P investors. It also shows that even wealthy, sophisticated countries like Denmark can take actions that are potentially negative for investors and businesses, instead taking the view that the social benefits are more important.
These factors are critical for P2P investors
What’s the risk here? There are now many P2P Loan Originators (‘LO’s’) from outside the Eurozone, that fund themselves from European P2P sites. They usually borrow funds denominated in Euros. But the actual underlying loans are issued in home currencies such as Polish Zloty, Russian Ruble, Georgian Lira, or Kazakhstani Tenge. That means the LO’s potentially carry big currency risks. If their home currency depreciates against the Euro, they could lose a lot of money. This risk can be addressed by entering into FX hedges. However hedging can be expensive for these LO’s, and their disclosures about the amount of hedging they are doing is usually nil or very poor. It seems to us that most non-Eurozone based LO’s operate with some degree of currency risk. This means that investors have some risk that the LO will become insolvent if the local currencies depreciate significantly against the Euro. That’s why we in the table below, we show the volatility against the Euro in the last 12 months (measured by % movement over the last 12 months from highest conversion rate to lowest) and also the overall change in exchange rate today versus 12 months ago.
There is a strong correlation between economic conditions and the number of loan defaults. When an economy starts to fail, people lose their jobs, and businesses fail. These people and businesses are then quick to default on their loans. That’s why keeping an eye on economic conditions in a country is worthwhile before buying loans in a country. In the table below we have used GDP growth over the previous 12 months as a proxy for economic conditions. But there are many other metrics that can be used such as unemployment changes, forecast growth, and so on. The clear trend here is that economies in most emerging markets are growing much faster than in Europe. That is a positive factor for investors buying loans outside of Europe.
Sovereign risk is the assessment of whether the national government is likely to repay its debts. This risk is typically measured by two key metrics – credit ratings from bureaus such as S&P, and the yield that government bonds trade at. P2P investors are not buying government bonds, so why should they care about this? Firstly, government bond yields give a good indication of how risky a country appears to investors, and what the inflation expectations are. For example, we can see that a low risk country like Germany has a negative yield (i.e very, very low risk), a medium/high risk country like Russia has a yield of 6.9%, and a high risk country like Kenya has a yield of over 10%. Under the concept of the sovereign ceiling, investors nearly always expect to earn higher returns than government bond yields in each country if they are investing in other asset classes such as corporate debts. In the tables below, we show the 10 year government bond yields for each country, as well as a rating score, which is derived from external credit ratings (i.e Moodys, S&P). The credit ratings score comes from the excellent site Trading Economics. Yields were sourced from Bloomberg where possible, and other specialist sites if not available from Bloomberg.
How likely is it that a government will nationalise an industry or company? How reliable are the courts? How easy is it to run a successful company? How much corruption is there? Will the government introduce capital controls? These are all important questions investors should consider, that we could not possibly hope to analyse fully for each country that originates P2P loans. Luckily for us, there are some great sources available to provide us with shortcut answers to these questions. In the tables below we use two of the best and most closely followed sources available – the World Bank Doing Business Study, and the Euler Hermes Country Risk ratings.
Where would you feel safer investing your savings? In Switzerland or Swaziland? We think the answer is clear. Why is Switzerland safer? There is a very strong correlation between country risk and the wealth within an economy and its people. Wealthy countries tend to (but not always) have stronger property rights, reliable legal systems and more stable economies. These are all things that matter deeply to credit investors. That doesn’t mean that less wealthy countries should be avoided. It just means that they are higher risk prospects, and the returns need to reflect this. In the tables below we show the GDP (in US Dollars) per person in each country.
Key country risk metrics
|Country||Currency volatility vs Euro||Currency change vs euro in 1 year||GDP growth||Sovereign credit rating||10 year sovereign bond yields||World Bank DB score||Euler Hermes rating||GDP $ per person|
|Lower better||Higher better||Higher better||Higher better||Lower better||Higher better||AA best, D worst||Higher better|
|Bosnia & Herzegovina||2.7%||0.3%||2.6%||27||N/A||65||D||6056|
Note: All data is as of 11 March 2020
Our Country Risk scores
Below we have scored each country based on the 5 variables we outlined above – currency strength, economic conditions, sovereign risk, qualitative factors, and wealth. We have provided a score out of 20 for each factor, with an overall score out of 100.
|Country||Currency||Economic conditions||Sovereign risk||Qualitative||Country wealth||Total|
|Bosnia & Herzogivina||14||14||5||4||4||41|
Country risk ratings are never perfect. You need to take your own view
The goal of this post is to provide P2P investors with some relevant data, risk factors to consider, and a framework to assess the relative risks between countries. Country risk assessments are always going to be subjective. There’s no right or wrong answers. Every investor should develop their own view on how important each factor is, and their assessment of each country. The key thing is to actually take a view one way or another. The number of potential countries to invest in has started to grow dramatically for P2P investors. It seems that many are now buying loans from countries which they have very little knowledge of. Hopefully the ratings above can help investors to make more informed decisions, and assess what is an appropriate yield to expect when investing in each country.
We also want to make clear that it is almost impossible for us, and anyone else, to closely follow relevant emerging regulatory and political developments in every country that originates P2P loans. Unexpected events can and will happen, as we have seen in places like Kosovo recently. Instead, the analysis above can simply help to identify the countries in which these unexpected adverse events are most likely to happen.
Over time, there will be an opportunity to refine and improve the above approach, add additional countries (requests in comments below!) and open a debate between investors.
Changes and updates
March 2020 – we have added some new countries – Netherlands, Nigeria, Bosnia & Herzegovina, Ireland and Slovakia. We’ve also changed the data provided relating to the World Bank Doing Business survey. We had previously shown global ranking, but we’ve now shown the score provided by the World Bank. We think this makes it easier to compare results between countries. We have not made any adjustments or changes to scores relating to the ongoing Cornonavirus situation but of course this should be monitored and considered.