What Is Economic Risk?
Economic risk refers to the possibility that changes in macroeconomic conditions will negatively impact a company or investment. For instance, political instability or exchange rate fluctuations can impact losses or gains.
In practice, the term “economic risk” is most commonly used to describe the potential pitfalls associated with investments in fledgling foreign markets, especially those with a history of political upheaval or governmental mismanagement.
Investing always comes with risks, but economic risk is usually the most difficult to predict.
How Is Economic Risk Measured?
Economic risk is often measured by how likely it seems that a government can pay back its debts. Measuring macroeconomic risk for entire nations is a complicated process, so many investors rely on objective measurements compiled by companies like Standard & Poor’s (S&P).
These companies publish sovereign credit ratings, which are assessments of a country’s creditworthiness. In other words, these ratings represent the probability that a government will be able to fulfill its debt obligations.
S&P publishes Economic and Industry Trend scores which use several qualifiers to indicate economic risk in a host of countries. These ratings include:
Positive: The country’s economic risk may decrease within two years.
Stable: The economic risk is projected to remain the same within two years.
Negative: The economic risk could increase within two years.
What Are 5 Economic Risk Factors?
Every country has economic risk factors, and even the most resilient economy can fall into a recession or have its growth derailed by them. The severity of these factors varies from country to country, but some are easier to prepare for than others.
1. Unemployment or Underemployment
Even short stints of unemployment or underemployment can have dire consequences for an average standard of living. High unemployment levels mean that countries will need to increase their benefits spending, placing more pressure on the national budget. Prolonged periods of unemployment – and of unemployed citizens struggling to return to the workforce – make this a massive global economic risk.
2. Cyber Attacks
As hackers and cyber thieves become more sophisticated in their technology and techniques, companies are forced to spend more to protect themselves online. Entire economies are put at risk due to the costs necessary to investigate breaches, as well as the decreased productivity for affected entities. If hackers reach government systems, it can be even more disruptive.
3. Foreign Exchange Risk
Foreign exchange risk refers to the risk companies take when conducting transactions in foreign currencies. All currencies can fluctuate and this type of volatility can affect the profit margins of businesses which provide products and services to different countries, as well as investors who invest in foreign markets.
4. Failure of National Governance
There may be significant risks to the economy and society at large for countries that can’t successfully manage public affairs and resources. Everyone, including private companies, will have to pitch in to ensure national governance is strong. Otherwise, they may face higher costs such as increased taxes or less subsidies.
5. Fiscal Crises
Fiscal crises are drastic drops in economic activity (e.g. when a country owes more money than it generates through tax revenue). These tend to have a huge impact on the financial and socioeconomic well-being in a country since it could mean drastic cuts on benefits and increased taxes on its citizens. It’s also hard for countries to predict and plan for potential fiscal crises.
Economic Risk Examples
There are many real-life examples of economic risk that have affected investors. Let’s take a look at some of them.
Economic Risk Example #1: Greece and the 2007 Financial Crisis
From 2009 to late 2018, the Greek government faced a debt crisis. This was partially due to the aftermath of the 2007 financial crisis, where there was no flexibility in monetary policies and improper management of funds, but also because Greek banks weren’t able to repay their debts. US financial rating agencies rated Greek bonds with an extremely low grade, adding to the growing problem.
As a result, the Greek government reduced benefits to its citizens and increased taxes, triggering an outrage, impacting international trade, and leading the country to default on their sovereign debt. The government was finally able to climb out of the crisis after negotiating a 50% drop in the amount owed for its existing debts and receiving new loans from European banks.
Economic Risk in Business Example #2: Hyperinflation in Venezuela
In 2013, the prices of goods and services in Venezuela went up by 41% and increased their money supply by 14%. By 2018, inflation rose by 65%. Since the country couldn't afford to print new paper currency – and the Venezuelan bolivar lost almost 100% of its value against the USD – it began promoting "Petro", a type of cryptocurrency.
With continued hyperinflation, the country's economy collapsed, leading to massive issues with debt repayment and an unemployment rate of more than 20%.
Can Economic Risk Be Managed?
Though economic risk is one of the most challenging types of risk to predict, there are ways to plan for it.
Can Economic Risk Be Anticipated?
Though it’s possible, monitoring and predicting economic risks still proves to be challenging. There are plenty of tools to help you spot things like market imbalances or early recession warnings. However, this depends on whether the decision makers (e.g. large companies, policymakers) will react in time.
How to Reduce Your Economic Risk
For investors, mitigating economic risk can be done by investing in assets such as international mutual funds. This can increase the amount of diversification simply by investing in a wider range of international securities. Hedging activities against exchange rate fluctuations are also a possible solution.
Economic Risk vs. Financial Risk
Like economic risk, financial risk is the chance of losing money on an investment. Some common types of financial risk include liquidity risk, operational risk, and credit risk
Economic Risk vs Risk Tolerance
Economic risk is the chance that macroeconomic conditions will affect investments. Risk tolerance, however, is the ability and willingness of an investor to handle volatility in the market. Someone with a greater risk tolerance is usually better able to handle larger swings in the value of their investments. Someone with a lower tolerance should opt for more stable investments (e.g. bonds).
What Is a Good Level of Economic Risk?
There isn’t a benchmark for a “good” level of economic risk. Countries all have varying economies and what may be good for investors may be considered very risky for others. For instance, a country with a higher economic risk right now may lead to potentially higher returns from the companies operating there if it stabilizes over the long term.