Country Risk Analysis

This page shows how to evaluate the country risk. When a government issues bonds, denominated in a foreign currency, the interest rate on the bond can be compared to a rate on a riskless investment in that currency to get a market measure of the default spread for that country. In estimating the country risk premium, NEPRA has used a method where the premium on Pakistani government bonds issued in USD is measured relative to bonds with similar maturities. This premium or spread on government bonds is essentially the same as the credit spread on a corporate bond and it is also the came as the credit default swap for Pakistani bonds. Using the NEPRA approach, this credit spread that has been presented in Figures 5 and 12 on Pakistani bonds versus USD bonds with the equivalent maturity is added as the country risk premium. As the premium is measured for debt investors, the NEPRA approach uses an additional premium for equity which is supposed to be riskier than debt (in general one should be careful in comparing debt and equity returns because debt only has downside and equity has upside). This NEPRA adjustment to equity is computed using a standard deviation ratio.  If you believe that the yield on Pakistani bonds with debt service paid in USD reflects the probability of default and the loss given default and also that the default on Pakistani bonds would probably mean that the Pakistani government would default on PPA agreements would occur with a Pakistani default on the USD bonds, then the country risk premium derived from USD default spreads makes sense.

I present a case study of applied data from reports written by Aswath Damodaran. I disagree with many of the techniques developed by Damodoran (which generally overestimate the cost of capital), and I have published some of my critiques on my website. However, for comparison and reference, I present alternative views of the cost of capital. Damodaran’s cost of capital estimates for Pakistan for typical companies are shown below. The table is an estimate of the general cost of capital in Pakistan (if the company had a beta of one) and not specific to the energy industry. Updates of the Damodaran cost of capital estimates produce a decline in the cost of capital from 19.96% in 2014 to 10.99% in 2021.

The decline in cost of capital for Pakistan is largely driven by a dramatic decline in the country risk premium.  The 2021 cost of capital of 10.99% which includes default credit spreads as the basis for the country risk premium is lower than the recommendation that I made (even if it is a general number and not directly associated with the specific generation companies).


The data from historic Damodaran reports is inclded in the file below. I hope you are asking why if the real risk of governement default can have these kind of swings from year to year. If you are asking whether the dramatic changes in country risk premium represent swings in true risks faced by investors of contract defaults (what country risk is supposed to measure), I think you are correct.

The final part of the risk premium involves the country risk premium or CRP.  The CRP is a controversial item that suggests the risks of investing in countries like Pakistan are greater than investing in developed countries because the country of Pakistan may not repay debt. In the context of price regulated electricity where payments are made by the government, it may reasonable to expect that if the government cannot pay foreign debts, that it will also not be able to make payments associated with the PPA contracts. In addition to the credit spread that corresponds to the default risk, it can be argued that equity experiences added risk because of the priority for debt in paying cash flow.  The CRP has been derived from differences in the borrowing rate between Pakistan and the yield on US bonds in other studies (e.g., Damodaran). This credit spreads that are shown in Figure 5 show that credit spreads have come down since the beginning of the pandemic. Current spreads for Pakistani government default risk vary between 4.5% and 7.5%. If markets were efficient, these spreads which are theoretically driven by the risk of default on government debt. These spreads imply very high implied probabilities of default and are driven by questionable assessments of risk made by credit rating agencies.  would be a reasonable representation of the true default probability.

Some of the literature on Country Risk Premium suggests that it is better to make direct assessments about the cash flow loss from country risk rather than making an arbitrary premium adjustment.  Unfortunately, these assessments are often made using vague statements rather than an illustration of how the analysis would work. Table 13 illustrates that you could set-up a cash flow table and include scenarios where country policies result in lower cash flow.  If you put a probability on the loss of cash flow, you can compute the IRR that is realised and evaluate back into the country risk premium. Table 13 demonstrates in a hypothetical example, that if you make an assumption about the probability that cash flows will be reduced and also the time period of the reduction, that you can back into the country risk premium. The issue with this method is that NEPRA would have to make an assessment that defaults occur because of its own actions.

Table 13 – Direct Calculation of Country Risk