Country Risk Analysis and Managing Crises Tower Associates Case Solution

c. The tables below list the interest rates for different countries over 2002-2007. The US interest rates used are annual prime rates taken from US Federal Reserve website.

                                            (US data source: Federal Reserve website)

Now international fisher effect can be calculated by using formula E1/E0 =(1+RX)/(1+R0 ) where E1 is expected rate of exchange rate for IFE to hold, E0 is spot exchange rate, Rx is current interest rate in countries A, B, C, and D and Ro is interest rate in US. The table below calculates the left hand side and right hand side values of the equation by using data from the tables above.

This table shows the value of expected exchange rate over period 2003-2007 required for IFE to hold. As in PPP case, IFE also doesn’t hold in most of the case. Though, country D is an exception where the difference between actual and expected exchange rates is not very large over period 2003-2007. Moreover, the trend observed is also similar to PPP exchange rate. Here too, in general, country A’s exchange rate is over-valued, Country B’s exchange rate is over-valued, Country C’s exchange rate is also over-valued as for these all, the expected exchange rate is greater than actual exchange rate.

d. Based on IFE and PPP exchange rate calculation, we expect country, B’s and C’s exchange rate to depreciate. The currencies for these two countries are over-valued for year 2007 as explained above and hence, to bring in IFE and PPP equilibrium, the currencies are expected to depreciate. However, the case for country A and D is different. The actual exchange rate for country D in 2007 is 7.616 whereas PPP exchange rate and IFE expect rates for 2007 are7.779 and 7.69 respectively. Though, the currency is slightly over-valued, we don’t expect the currency to depreciate significantly in near future as the difference is not major. Country A is a special case. The actual exchange rate is 2.221 for 2007. The PPP exchange rate and IFE exchange rates are 2.131 and 2.91 respectively. By IFE, we expect the currency to depreciate whereas from PPP exchange rate equilibrium, we expect it to appreciate. So overall, effect is ambiguous. However, we must be cautious before making any predictions. Here, we are using only two theories for the analysis. The real world is much more complex and much more deepen analysis is required before making any prediction.

2. In the case study, Susan from Tower Associates is not familiar with the financialization literature. Discuss how financialization can be a possible cause of country crises by referring to the arguments and evidences in Ertürk (2003), Gabor (2010) and Kaltenbrunner (2010).

Although, Susan kept in mind all kinds of crises when determining the most potential country to invest in, she, however, was unaware of one factor that over the last few decades have been the cause of the financial crisis. This factor is known as financialization. In Financialization, due to the increasing significance of financial sector, financial market dominates economic policy and economic outcomes in a country. 

Ertürk (2003) especially mentions in his paper that government policies as one of the major reason for financialization. Governments liberate capital markets and undertake privatization to attract investment, to provide new opportunities for private entrepreneurs and to increase competition. Consequently, banking, which emerges as an increasingly dominant sector in the economy post-liberalization, has led to the creation of updated exchanges and has caused the stock market to lure investors. Also, Government actions to counter inflation caused increased interest rates leading to growing capital inflow and international financial arbitrage.   

Furthermore, Ertürk goes on to explain how debt financing is another source of financialization. With or without direct government intervention to channel funds to deficit financing, banks may be able to attract willing investors by giving attractive return on the risk-free assets i.e. securities backed the state. When the return on these risk free asset exceeds that of the investment in private projects, Banks prefer to invest in financial obligations of the state. At very attractive rates, the Banks can raise funds internationally as well. As a result, the banking system gets bigger as a percentage of GNP, even though the ratio of private loans to bank assets keeps declining. Consequently, the banking system has transformed into a mechanism to finance public deficit that itself, over the years, became a Ponzi scheme. Furthermore, these high returns offered by government set unrealistic rate of return targets for companies by using the stock market performance as a benchmark and also increases the interest burden of private companies due to high interest rates which leads them to bankruptcies. Finally, even the companies are encouraged to improve their financial performances by investment in short-term coupons rather than employment generating long-term projects. This intensifies the risk of financial bubbles and instability. Hence, the huge public debt market and high return on risk free assets discourages firms from long-term investment activities causing financialization.

Financialization is also due to the rapid changes triggered by the rise of securitization and wholesale finance. Securitization allows banks to diversify their risk of previously illiquid assets and to expand their balance sheets. The derivatives created in the process enable investors to determine which type of risk they want to take and to what extent. Additionally, these liquid derivatives can be used for hedging purposes by the firm. It also shifts the banks’ liquidity management actions from the unsecured inter-bank segment to repo a market which helps in funding leveraged activity by rolling over short-term borrowings using issued collateral. As the banks’ assets and liabilities are mismatched in maturity and currency to an increasing degree without hedging, Banks carry out arbitrage activities, between domestic and international debt market. Hence, the attractiveness of domestic asset markets for short-term speculative activity in the international market increased. As a result, there is a risk of destabilization of financial markets due to an abrupt increase in interest and foreign exchange rates.

Foreign investment is, further, facilitated by the feasibility of actively participating in the money markets. Over the years, the developing financial markets and the technological innovation has led to lower transaction cost and has improved availability of information. The standardization and securitization of the derivatives products worldwide has increased the accessibility for many individuals through reduced uncertainty (better estimation of risk).