Originally from the Journal of Damages in International Arbitration

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Country risk generally reflects the greater exposure to the risks of assets that are located in less efficient or more vulnerable environments than those in stable economies. This means jurisdictions that, for example, have less sophisticated institutions protecting property rights, are more prone to impose profit repatriation restrictions, exhibit high volatility of regulatory and legislative changes, or may impose ad-hoc trade restrictions.  Country risk also refers to social unsteadiness such as debilitating strikes, criminality, riots, risks of civil war, bureaucratic and technical competence issues, poor infrastructure, corruption, and general expropriation risks, among others. 

The sovereign spread approach to measure country risk is based on the concept that the incremental risk affecting investors in more vulnerable jurisdictions can be approximated as the additional risk of default on the sovereign debt of the target country, as compared to the (lower) default risk of sovereign bonds that are considered safe, such as US Treasuries, German bonds, or Japanese bonds.  The country risk premium under this approach is most frequently computed using the JP Morgan Emerging Market Bond Index (EMBI) or credit default swap (CDS) spreads, or through indirect measures of spreads calculated from other sovereign bonds that share the same debt rating as the sovereign under consideration.

EMBI spreads or CDS spreads are indicative of the risks of sovereign debt default, which in turn depends on several types of risks.  These risks can be broadly grouped as those related to the overall health of the economy, which are evaluated through indicators such as the debt/GDP ratio, the exposure of private and public debt to foreign currency, GDP growth perspectives, trade flows, and others. For example, the risk of sovereign debt default, reflecting the market’s perception of the likelihood that a government will be unable to service its debt in full, is highly reliant on the market’s perception of the state’s fiscal discipline.  Fiscal revenues, in turn, are quite dependent on the overall growth of the economy, as economic growth directly enlarges the tax base.  The healthier the prospects of the overall economy, the higher the fiscal revenues will be and thus in general, the lower the risks of sovereign debt default. This interrelationship between the various types of risks present in the measurement of the sovereign spreads explains why such spreads can be used as a first-order approximation of the market perception of the health of an economy, and thus of the country risk exposure of private investors.