Definition of Economic Risk
Economic risk is the risk faced by a business organization or a company that has a foreign branch or investment in a foreign country due to factors such as a change in government policies, change in government, reduction in the credit rating of foreign investment or significant movements in the exchange rates affecting the business of the entity.
- Economic risk means risk related to the economy in which the business operates. Thus, if the company is located in a foreign country, then the economic factors of that foreign country will affect the business set up therein.
- So, this concept is related to international economics. Businesses located outside the domestic country bears more risks than those located in the domestic country. Such corporate forms holding an investment in many countries is called as Multi-National Company (MNC).
- Every business carries some or the other form of risk. Businesses without risk are like “shoe without lace”, you may be able to walk, but you carry it for the longer term. So, the risk is the part & parcel of carrying a business. Such risk increases when the business is widespread in a foreign country.
- Estimation of risk is very essential for the successful operation of a project or a company located in another country. Quantification or listing down the risk helps the company to manage the risk effectively.
Example of Economic Risk
Let’s have few examples which explain the real-life economic risks:
- We all know the financial crisis of 2008, which was a result of stringent monetary policies and weak management of funds. However, things did not stop here. The Greek government in early 2009 failed to repay its debts in time. This was the sovereign risk, which further widened the financial crisis. In effect, the government had to pass on the burden to the general public by an increase in tax rates. Thus, it affected the overall wellbeing of the public in the country and also the businesses.
- Say A manufacturer located in the US needs to import a few items from China. The rate of Chinese Yuan per USD is currently trading at 6.5641. The order amount is CNY 6,50,000 with a credit period of approximately 3 months. If it is received today, the amount to be received is $ 99,023.48. It may happen the US rate appreciates further in the next 3 months to 6.8012. In that case, the actual receipts would be $ 95,571.36, and the company needs to suffer the loss of $ 3452. This happens with all countries engaged in imports & exports.
- Amazon Inc is diversified into various countries for business purpose. It has face taxation issues, change in the inflation rates, significant changes in exchange rates around the globe, political unrests, economic growth, etc., in various countries. Almost 1/3 of the revenue of the company comes from international markets. It also reports net loss from foreign currency exchange rates. In 2017, Amazon faced the newly introduced internet tax from the domestic country.
Types of Economic Risk
- It may happen that the minimum wage rate for laborers has been increased by the government, resulting in an increase in the cost of manufacture. Thus, one of the economic risks is an increase in the cost of labor.
- An increase in the interest rates can affect the financial parameters of the project resulting in reduced performance.
- Another type of economic risk is an increase in the prices of basic inputs, i.e. raw materials and other consumables. It increases the cost of production.
- The firm may face the risk of an increase in taxes or the introduction of new levies, which decreases the take away profits of the holding companies. The firm may also face a transactional level of risk in the form of an increase in duties for imports and exports.
- Sovereign risk is another critical risk in a bunch of economic risks. It arises when the government is unable to pay for its debt & defaults at the time of the due date. Sovereign risk affects the business entities a lot due to political unrest in the country.
- In case of significant change in exchange rates, it has an impact on international trade. The exchange rate change is a result of change in government policies, the market rate of interest, change in the inflation rate, etc.
How to Manage Economic Risk?
- Economic risks can have devastating effects on the business as well as the lives of individuals. In the case of individuals, economic risk can be in terms of loss of a job, reduction in the value of investments, unusual events such as accident, etc. Everything can be managed by exercising proper due diligence.
- Business organizations exposed to economic risks should be aware of the current affairs that may have a short-term or long-term impact. Change in FED reserve rate or unpleasant news can affect markets globally.
- An entity should get regular updates about the operations of the foreign entity. This will help the company to stay in touch with the operations.
Economic Risk Factor
- If the government is unable to fulfill its role in providing effective policies, it has a significant risk to the economy. National governance, if compromised, can risk to the economy.
- Countries suffer from financial crisis after any scandal is turned out. The financial crisis of 2008 has affected many economic risks to the developing economies. It has an impact on the businesses therein. Thus, this is the unknown devil for economic risk.
- A sudden increase in energy rates can be a shock for certain companies, which are capital intensive and survive their operations on energy. Such an act may lead to a significant increase in production expenses, which has an impact on profitability.
- In the digital world, many corporates rely on electronic maintenance of data, electronic exchange of documents, payments, etc. This is another factor in economic risk due to the chance of cyberattacks affecting books, banks, documents, etc.
- Unemployment is linked to the financial crisis, and thus, it is another factor for economic risk. This may be linked to increased wage rate & companies need to cut down the cost of production.
Economic Risk Management
- One of the easiest ways to manage economic risk is to invest in international mutual funds. This fund invests money in different stock markets around the globe. It comes with higher risk with higher rewards. It also provides diversification into various economies. Thus, the MNC is financially protected from getting affected due to the economic factors of a specific country.
- To protect against foreign party default, the company can enter into an insurance contract that will cover probable loss due to such default.
- The further company can take the letter of credit from foreign banks before dispatching goods to a foreign country.
- In order to hedge against fluctuations in the exchange rates, the company can enter into forward contracts or deal with money market instruments. It will help the company to reduce the unknown loss due to foreign exchange rates.
- Monthly reporting of financial activities and operational activities is essential for the management of economic risk abroad.
Economic risk arises in the case of investment in a business venture across the boundaries. As discussed above, there are many factors that affect economic risk. Expertise knowledge is essential to tackle economic risk in a strategic manner. Many investors who love taking a risk invests in a venture which is exposed to economic risk. Such investors are called as risk-loving investors. On the other hand, risk-averse investor will restrict their money only to the domestic parts. Using different tools, this risk can be mitigated & such mitigation comes with a cost.
This is a guide to Economic Risk. Here we also discuss the definition and how to manage economic risk? Along with types and an example. You may also have a look at the following articles to learn more –