Here’s how to assess sovereign risk when investing and why it is so crucial

Blind Freddy could tell you assess sovereign risk when investing is one of the most important things to do. But too many investors don’t do it. The recent case studies of Leo Lithium (ASX:LLL) and Resolute Mining (ASX:RSG) depict it. Now you could just say don’t invest in countries where coups are almost a way of life and be done with it…but even countries with long-standing regimes can prove tricky for investors, China being on example. So here’s how investors can consider sovereign risk when investing.

What is sovereign risk?

Sovereign risk refers to the risk that a government may default on its debt or be unable to meet its financial obligations, or that political or economic instability in a country may negatively affect investments. Specifically it could hinder the ability for shareholder value to be realised. A country could confiscate an asset, impose taxes or other levies on the company with little to no notice or otherwise just make life difficult to do business. We won’t name and shame any more countries beyond the ones we already have, because sometimes countries can clean up their reputation and others can suddenly make a bad name for themselves. Let’s dive right into the steps investors need to take.

Here’s how to assess sovereign risk when investing

1. Assess the Political environment

A stable political environment reduces the likelihood of sudden changes in government policies or leadership that could affect investment returns. Political risk can arise from factors such as corruption, civil unrest, or abrupt changes in leadership. Of course, sometimes leadership can make sudden U-Turns and this can catch many investors unaware.

Also consider the Legal and Regulatory Environment – specifically strength and predictability of the rule of law are important. Countries with a robust legal framework are less likely to expropriate assets or violate contracts. And finally consider geopolitical risks: Regional conflicts, trade wars, and diplomatic tensions can all influence sovereign risk.

2. Examine the Country’s Economic Fundamentals And Fiscal Health

Look at traits such as GDP Growth, inflation and unemployment levels. Collectively these may signal weakness or strength in the economy, giving greater sovereign risk. A government may introduce anti-business measures as a consequence of the economic outlook. They may be keen for a higher tax take in good times. Alternatively, a lack of government action on underlying problems can make life more difficult than if a government actually did intervene.

Also look at a country’s debt. Not just the levels, but the structure of its debt (i.e. foreign denominated or in local currency) and also the debt as a proportion of GDP.

One underrated measure to look at is the Current Account and whether it is in a deficit or a surplus. A persistent deficit can indicate that a country is borrowing from abroad to finance consumption rather than investment, which can be a warning sign of future default risk.

3. Analyse Currency Risk

Countries with volatile currencies or a history of devaluation can increase the risk for foreign investors. A sharp devaluation can result in losses for foreign investors holding assets denominated in the local currency. Also consider Capital Controls and Currency Restrictions: Governments can impose restrictions on the movement of capital or foreign exchange, which could limit an investor’s ability to repatriate profits or exit investments. This is particularly crucial for mining companies and a reason why many in particular African countries as well as companies with operation in China have copped heat. What’s the use in making money abroad if you cannot take any of it out of the country?

3. Monitor ‘others’

We’ve focused heavily on governments here, but they are not the only ones to watch. Watch the local people too. Poor economic conditions amongst the population may lead to protests, strikes, and social movements which can destabilise governments and hinder economic progress, thus increasing sovereign risk. For mining companies, poor relations with local Indigenous people can jeopardise their projects.

Look at the country’s relations with international investors. Countries with access to capital markets at favorable rates are generally in a better position to service debt and manage economic crises. Don’t forget NGOs either – a country receiving aid or a bailout from institutions like the International Monetary Fund (IMF) may be facing severe fiscal stress, which could increase sovereign risk.

Always assess sovereign risk

Investors in companies with operations overseas need to assess sovereign risk before making investment decisions. We hope we’ve given investors a starting point to do their due diligence.

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