Updated July 14, 2023
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, a 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 outside the domestic country bear more risks than those in the domestic country. Such corporate forms holding an investment in many countries are called Multi-National Companies (MNCs).
- 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 part & parcel of carrying a business. Such risk increases when the business is widespread in a foreign country.
- Risk estimation is essential for successfully operating a project or a company in another country. Quantifying or listing the risk helps the company manage the risk effectively.
Example of Economic Risk
Let’s have a few examples which explain the real-life economic risks:
- We all know the financial crisis of 2008, which resulted from stringent monetary policies and weak funds management. However, things did not stop there. The Greek government in early 2009 failed to repay its debts in time. This was the sovereign risk, which further widened the financial crisis. The government had to pass on the burden to the general public through increased tax rates. Thus, it affected the overall well-being of the country’s public and 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, it will be $ 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 a loss of $ 3452. This happens with all countries engaged in imports & exports.
- Amazon Inc is diversified into various countries for business purposes. It has faced taxation issues, changes in the inflation rates, significant changes in exchange rates around the globe, political unrest, 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 government has increased the minimum wage rate for laborers, increasing the cost of manufacturing. Thus, one of the economic risks is an increase in the cost of labor.
- An increase in interest rates can affect the project’s financial parameters, resulting in reduced performance.
- Another type of economic risk is increased 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 takeaway profits of the holding companies. The firm may also face a transactional level of risk in the form of increased duties for imports and exports.
- Sovereign risk is another critical risk in a bunch of economic risks. It arises when the government cannot pay for its debt & defaults at the time of the due date. Sovereign risk greatly affects business entities due to political unrest in the country.
- In case of significant change in exchange rates, it impacts international trade. The exchange rate change results from changes in government policies, the market rate of interest, changes 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 accidents, 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. Changes in the 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 cannot fulfill its role in providing effective policies, it has a significant risk to the economy. National governance, if compromised, can risk the economy.
- Countries suffer from financial crises after any scandal is turned out. The financial crisis of 2008 has affected many economic risks to 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 shock 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 impacts profitability.
- In the digital world, many corporates rely on the 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; thus, it is another factor for economic risk. This may be linked to increased wage rates & company’s need to cut down the cost of production.
Economic Risk Management
- Investing in international mutual funds is one of the easiest ways to manage economic risk. 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 covering probable loss due to such default.
- The company can take a letter of credit from foreign banks before dispatching goods to a foreign country.
- 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 and operational activities is essential for managing economic risk abroad.
Economic risk arises in the case of investment in a business venture across boundaries. As discussed above, many factors affect economic risk. Expertise knowledge is essential to tackle economic risk strategically. Many investors who love taking a risk invest in a venture exposed to economic risk. Such investors are called risk-loving investors. On the other hand, the 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 –