Measuring Political Risk Just Got Easier

February 28, 2014

Political risk is a fascinating yet not entirely objective field. As a result, it's hard for financiers and businesses to systematically or accurately incorporate political risk into decision-making. Foreign direct investment (FDI) has grown by a factor of 25 from 1980 to 2010, making it imperative that we get accurate measures of country risk. That's why a new NBER working paper may prove an important step forward.

The paper's authors take the spread between one country's sovereign debt yields and U.S. Treasury bonds and, using risk rating data and an assortment of economic variables, extract the political risk component. The result is the "political risk spread." Each country gets assigned a number reflecting its risk. In the chart below, you see how the authors apply this measure to countries without sovereign spread data—in other words, places for which we didn't have a good way to measure political risk before.

On average, political risk accounts for one-third of sovereign debt spreads. In fact, it's the most important determinant of credit risk. Political risk also appears to have a large and measurable impact on investment. In a typical country, a 1% drop in the political risk spread leads to a 12% rise in net FDI inflows. 

This political risk measure can also predict adverse events that could impact investment. In the chart below, you see the probabilities of political risk for select countries over the next ten years.

In light of this study, it seems that current methods used by businesses and financial firms to measure political risk exposure are flawed. Most analysts are unsure just how much sovereign debt yields are influenced by political risk, so they use various workarounds to get a ballpark measure. A measure, as this study finds, that overstates discount rates of future cash flow by 2-5%, a result that is "potentially leading to substantial misallocation of global investment."

It will be interesting to see how this measure could be used to hold political leaders to account for their policy decisions. As the authors find, "The cost of particular future policy actions that are known to increase political risk spreads can now be directly quantified."

International investors and multinational corporations now have a useful benchmark for measuring their political risk, which in turns helps in managing that exposure. The authors also see a benefit in digging deeper into the political risk spread to find out how much it's affected by, say, ethnic tensions or government instability. Using their methodology, this is finally possible.