What is economic risk? Definition and example

Economic risk refers to the likelihood that macroeconomic conditions (conditions in the whole economy) may affect an investment or a company’s prospects domestically or abroad.

The economic risks may include exchange rate fluctuations, a shift in government policy or regulations, political instability, or the introduction of economic sanctions.

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Doing business and investing money always comes with an element of risk. Economic risks are often the most difficult to foresee. While today the horizon at home or in a specific foreign country may seem clear and promising, dark clouds can rapidly bubble up, thus changing the whole business environment.

In project financing, economic risk is the likelihood that a project’s output will not have a sale value that will cover its operating and maintenance costs, as well as its debt service requirements.

An example of economic risk

Imagine a new left-of-center political party wins the general elections in a country where your oil & gas company, XYZ Inc. operates and has invested heavily.

After two years, the party’s policies shift further to the left, and the president and cabinet members start aiming their rhetoric at the private sector, particularly foreign-owned companies.

One day the president announces that the oil & gas industry will be nationalized. Your company is offered compensation which significantly undervalues its true worth.

The risk of losing that operation abroad due to nationalization has become a reality. Your company loses a lot of money and is unlikely to recoup its investment, even if you take the foreign government to international tribunals.

Companies that operate or operated in Venezuela have suffered similar problems, as well as a plummeting local currency and a raft of new anti-business legislation.

Economic risk is an important factor

Before considering whether to go ahead with a new project, it is vital to factor in the economic risk, and to only proceed if the potential risks are significantly outweighed by the likely benefits.

While economic risk tends to refer to doing business or investing abroad, things can also go wrong at home – the term applies to any country, including your own.

According to ft.com/lexicon, economic risk is:

“The risk that a company may be disadvantaged by exchange rate movements or regulatory changes in the country in which it is operating.”

S&P Economic and Industry Trends

American financial services company Standard & Poor’s (S&P) publishes Economic and Industry Trend scores, which estimate economic risk in a number of countries.

It uses the following qualifiers to signal trends in economic and industry risk:

Positive: it thinks the country’s economic or industry risk score may improve over the next six months to two years.

Stable: it believes the score will remain unchanged over the next six months to two years.

Negative: it thinks the score will deteriorate over the next six months to two years.

According to S&P:

“We apply a positive or negative qualifier when we believe there is at least a one-in-three likelihood that a trend may lead to a change in economic or industry risk scores in a banking sector, typically in the next six months to two years.”

Video – Economic risks and Peruvian Banks’ creditworthiness

This Standard & Poor’s video looks at the economic risks in Peru and how they might affect the creditworthiness of five banks.