This project was submitted by Blythe Wright for GF510-01 Risk Analysis and Management under William Hudson at Harvard. The case study focuses on identifying any hidden assumptions or price rigidities present in one or multiple countries that could inhibit market force indicators from revealing the true economic health of the nation. This could prevent government policy actions from correcting such issues or make them ineffective and counterproductive.

The case study data suggests that price rigidity is not a crucial factor in market force indicators. An analysis of the consumer price index reveals elastic price trends across all countries. Taxes, rates, and regulations also seem to have little or no impact on foreign investments. Governments use taxes to boost revenue, but they are unlikely to fall onto companies due to competitive tax policies among countries. This assumption holds for international companies, which are usually exempt from double taxation.

The study also examines the current international and domestic economic status of each country, relative to benchmark performance measures. Country A's economic growth is largely government-supported in terms of spending as a base percentage of the GDP. However, domestic investments are low, inflation is high, and the currency is volatile. Foreign investments are meager at 2.89%, and the annual lending rate is 47%.

Country B has experienced volatile economic performance over the last decade, with private investments up and the government's influence trending downwards. However, the upcoming political leadership changes could pose a problem or a solid opportunity for Tower Associates, depending on how the transition proceeds.

Country C is currently in the development stages. The government is attempting to relinquish control of market processes, resulting in increased GDP. However, they still exert influence on pricing, exchange, and interest rates. Country D is similar to Country C, with limited infrastructure and cautious government control over consumer prices, exchange, and interest rates. By managing the exchange rate, the government is protecting the currency from devaluation.

The case study then evaluates whether the countries are following appropriate economic policies from both domestic and international perspectives. According to the data, Country A seems to follow appropriate economic policies both domestically and internationally. Indicators for an impending crisis, such as a foreign debt ratio above 30% and trade deficits close to 6% of GDP, are relatively low in Country A. Although the country's interest rate is high, it compares favorably to the exchange rate of the local currency to USD.

Finally, the study applies country risk analysis methods to each country to determine which is more likely to face a crisis and why. Financial institutions (FIs) can use a range of methods, from quantitative to qualitative, to evaluate sovereign risk. FIs may utilize outside evaluation services or develop their own risk scoring models based on economic ratios such as debt service, imports, investments, and variance of export revenue.

Country B has experienced a break-even growth for the last five years, however, in recent years, its GDP percentages have turned negative due to payments. On the other hand, Country C has high exchange rate risk, and its domestic currency growth rate is approximately 21%. Country D, although having high reserves, has a low percentage of balance of payments per GDP. Unfortunately, all three countries are currently facing a foreign debt crisis. However, they all have a conservative nature, holding more than ten months of international currency reserves.

If Tower Associates were to proceed with a transaction with one of these countries, we would recommend following a foreign exchange hedging strategy. Country A appears to be the safest choice and it would be wise to use forward contracts to hedge the foreign exchange risk when investing in this country. This would help Tower Associates gain a profit on the local currency and offset any foreign exchange rate they could potentially lose. A forward contract would also protect the investment should the currency fall.

While Country B represents a higher risk due to its political turnover, monitoring its political leadership and how they impact its economy would be essential.

To mitigate and manage risks, Tower Associates must keep an eye on foreign exchange, sovereign, and political risks. They must monitor the exchange rates between the local currency and the US Dollar to mitigate any possible increase in foreign exchange risk. Additionally, banks' ability to alter foreign exchange regulations could result in null contracts, making sovereign risk a concern. Finally, political risk needs to be monitored for potential investment loss due to political changes or instability in the target country.

Overall, Tower Associates should focus on Country A for the time being. However, they should also consider investing in Country B in the future if the political situation becomes favourable. In taking this information into consideration, it becomes vital for Tower Associates to come up with a plan to pursue growth and trade while arming themselves against potential risks like credit, foreign exchange, liquidity, market, sovereign, and insolvency.

References:

Mathis, F. J., Keat, P., & O'Connell, J. (2007). Country risk analysis and managing crises:

Tower associates. Thunderbird: School of Global Management. 1-9. Retrieved from https://store.hbr.org/product/country-risk-analysis-and-managing-crises-tower-associates/TB0087

Saunders, A., & Cornett, M. M. (2018). Financial Institutions Management: A risk management approach (9th ed.). McGraw-Hill Education.