Are there any hidden assumptions or price rigidities in the country or countries that might inhibit market force indicators from revealing the true economic health of the country, thereby either preventing government policy actions from correcting the problems or otherwise making them ineffective and counterproductive?
Hidden assumptions that may have an influence on revealing the true economic health of a country include the level of labor in the countries. Most of wages in an economy are controlled by the market economy, and this determines the growth of the economy. Additionally, foreign investments levels are quite low. Information concerning the political climate of the countries is not illustrated fully. According to Baek and Qian (2011), political risks for a country significantly influence the level of foreign direct investment. Therefore, such information becomes critical in conducting a country risk analysis. Additionally, competition in the market economies has not been identified. This is key in promoting and strengthening market. Financial analysts use competition to determine how an economy is actively growing. Taxation levels for the different countries have not been provided, and this is likely to influence the decision of a company in investing in either of the countries. Further, foreign investors will use a country’s policies towards foreign investors to establish the need of investment (Vij and Kapoor, 2007).
The influence of regulatory control by the government seems to be hidden. Currently, government regulation has a huge influence in determining the level of investment by a foreign company (Henisz and Zeiner, 2010). The effect of government regulation in the financial market may be undermined by several factors. Governments may try to regulate the market through price ceilings and floors. This is usually aimed at limiting inflation and protecting producers’ income. However, these policies may be curtailed by private investors with major shareholding such that they can dictate prices to the government. Corruption is another factor limiting the implementation of government policies in the financial market.
What is the current domestic and international economic situation of each country relative to the benchmark performance measures for that country?
Country A
Country A has improved on its economic growth. This has been facilitated by the governments’ influence with respect to the spending levels. However, the domestic economic situation is not that good. The levels of government expenditure are more than the incomes. This may create a situation where the country may be forced to borrow foreign funds to support the economy. The exchange rate for the country is stable. This can be attributed to the presence of a free market where exchange rates are determined by the market.
Country B
Country B has a more diversified portfolio compared to the other countries. Domestically, the levels of private business investments are high. This has been attributed to the decline in government spending and an increase in the domestic private investments. Foreign investments look promising and because of the diversification the foreign direct investments are expected to grow. Political climate is likely to influence the economic growth of the country especially since a change in the political leadership is expected.
Country C
The economy of country C is not yet stable. Levels of infrastructure development are low. The government has more influence in the market. The government controls the interest rates, consumer prices and the exchange rate. The consumption levels of the country are high and is almost three-fifths of the country’s GDP. Import levels are low owing to the country being endowed with abundant natural resources. The government revenue is low due to the low level of economic growth.
Country D
Despite the governments influence in the economy of this country, expenses are not that high. The government has managed to stabilize the inflation rate. The market is stabilizing owing to the decline in the exchange rate.
Is the country currently following appropriate economic policies from a domestic as well as an international perspective? Provide supporting justification for your answer.
Economic policies are supposed to improve the economy especially where the government intervenes, but this has not been the situation in some of the countries.
Country A
The levels of government spending for country A seem to disagree with the country’s economic situation. The domestic levels of private investments are low. Thus, to ensure the market economy remains stable the government is supposed to spend in order to provide goods and service not provided by the private sector. However, the spending has failed to maintain or reduce the level of inflation in the country.
Country B
Inflation for country B is high owing to the declining influence of the government in the market economy. Consumption levels have gone up, which indicates that the country’s economy is getting stronger. The government needs to intervene in the market as a way of controlling and stabilizing the inflation levels.
Country C
The government’s liberalization of this country’s market has led to a decline in the consumption. Additionally, economic policies have not been implemented appropriately owing to the increase in the inflation levels. Furthermore, the low level of infrastructure development provides evidence that government spending is not aimed towards increasing and improving infrastructure development. The country also seems to have low private domestic investment and the government levels of spending are low.
Country D
Implementation of economic policies has greatly changed or increased investment levels in the country. However, the level of implementation of economic policies is not highly experienced due to the lack of a proper economic infrastructure. In addition, the policies set by the government have not been able to lessen the gap in income distribution.
When the tools of country risk analysis are applied to the different countries being analyzed, which country is more likely to have what kind of crisis and why?
Country crises fall into different categories namely: banking, financial, currency, and foreign debt crises. Country A is experiencing financial crises due to its fiscal deficiencies. This is backed up by the fact that the inflation rate is quite high. This will lead to a fall in the domestic currency , and this may be advantageous to the foreign exchange rate for an overseas firm. Country B is in a transition stage, and the possible crises are quite uncertain. However, political crises might arise, and this may lead to crises that may affect the firm. Country C cannot be said to be in a crisis as it is. However, its main drawback is the underdeveloped infrastructure that may limit accessibility of the area hence leading to investing and banking crises. There is also some limitation of the financial market since it is closely monitored by the government. Country D may have constraints in its financial market due to government control and this may stabilize the domestic currency.
If you recommend that Tower Associates proceed with a transaction in one of the selected countries, which strategy would you suggest they follow a foreign exchange hedging strategy or a country risk crisis management strategy? Explain and justify your recommendation
Country crises strategy utilizes the scrutiny of different financial and economic factors, which pertain to an economy and the risk factors that may accompany investment in such a company. A firm transacting business in one of the countries cannot elude the exchange risks that exist. This may arise due to changes in the exchange rate between the two countries. Hedging is a management technique that aims at making the risk more bearable. According to Henisz and Zeiner (2010), using financial hedges becomes quite applicable due to its ability to encourage multiple parties to participate. Hedging uses different tools to achieve its objectives. The most common is the forward contract that involves a customized contract between two firms to set the exchange rate at a predetermined rate for a future date. As such, it involves the transfer of the risk to other firm. Banks have been known to enter into forward contracts with firms since they easily manage the forwarded risks.
The tools used in hedging are advantageous since they are very liquid due to the fact they are traded in the central market. As time progresses towards the date of expiration of the contract, the future price (rate) and the spot price, tend to converge or meet. However, future contracts are also disadvantageous since they are rigid and binding due to their legal nature. They are also standardized that is, they have predetermined periods and rates. This means that they are not continuous, and they do not attract the benefits, which could accrue should the exchange rate decrease in favor of Tower Associates.
Country risk crisis management is whereby one opts not to use hedging as a way of mitigating the risk. Therefore, the firm accepts to bear the foreign exchange risk with the expectation of benefiting from this stand. Country risk crisis would mean a scrutiny of the country’s financial trends and decision-making concerning investments based on these trends. This is a very risky mode of operation, therefore, I think the firm should opt for the use of a hedging strategy, despite its drawbacks.
What are some of the steps that Tower Associates can take to help mitigate and manage some of the risk involved if they proceed with the transaction, such as foreign exchange risk, sovereign risks, liquidity risks, market risks, insolvency, and credit risks?
Tower Associates can mitigate the foreign exchange risks through several ways. The firm may opt for a foreign exchange contract whereby it will be able to transact at an agreed exchange rate. This will involve the stipulation of agreed duration during which the contract will be enforceable. This protects the firm from incurring extra costs if the exchange falls in their disfavor. However, the firm stands to lose if the rates become advantageous since they have to stick to the agreed rate.
Alternatively, Tower Associates may attempt foreign currency options. This usually involves an agreement for an importer to transact at a spot price or any price above this set price. Any other rate, lower than the spot price is not an allowable purchase price for the product. When there exists a mismatch between the inflows and outflows, loan facilities and bank accounts offer a good method of managing foreign exchange risk. This involves the depositing of surplus currency in a foreign currency account. One can then borrow from this bank so as meet the foreign currency expenses. This may also involve the use of hedging instruments such as forward contracts. Forward contracts allow a company to preset on a certain rate that it will use in future. These contracts are especially advantageous since they do not attract any purchase price.
Tower Associates may also use swaps to match its receipts and payments. This involves the sale of foreign currency and commitment to purchase the same amount of currency on a future date for a pre-determined exchange rate. Tower Associates can mitigate the liquidity risks by holding liquid assets. However, there should be a preset limit on the amount of the assets that should be made liquid. This involves an in-depth analysis of the ability of the market to absorb the liquidated assets, the currency, and type of assets under consideration. The organization should also assess its ability to obtain both local and foreign currency. This enables it to ensure that it can issue or borrow market securities when need be.
Insolvency is closely related to credit risk. Therefore, these risks are mitigated in similar ways. Risk management provides an effective and preventive method of mitigating the risk of a company suffering from insolvency problems. This involves the keen supervision of business risks. This will function as a control for ensuring there are set limits, procedures, and controls in an organization prior to indulging in a business risk. It pre-empts possible losses that could arise and liabilities that could accrue. This may include credit risk whereby other institutions owing Tower Associates money may default in payments of amounts due.
Credit risk may arise due to fraudulent misrepresentation or insolvency of the borrower. This risk can be mitigated by conducting sufficient research on other companies prior to entering into any contractual activities with them. If need be, the firm may hire private investigators to look into the validity of the existence of the other company. The firm may also choose to work on a cash-only basis. However, this may prove difficult especially if the amount of money in the transaction is quite large. Through effective risk management of the credit risks, the firm will be able to mitigate other risks such as insolvency and other market risks.
References
Baek, K., & Qian, X. (2011). An Analysis on Political Risks and the Flow of Foreign Direct
Investment in Developing and Industrialized Economies. Economics, Management & Financial Markets, 6(4), 60-91.
Henisz, W., & Zelner, B. (2010). The Hidden Risks in Emerging Markets. Harvard Business
Review, 88(4), 88-95.
Vij, M., & Kapoor, M. C. (2007). Country Risk Analysis. Journal of Management
Research, 7(2), 87-102.
