The Possible Causes of the Current Crisis and the Ways of Ameliorating It - Term Paper Example

Current Financial Crisis THE WORLD ECONOMY TODAY Economy, by definition is the study of how economics agents or societies choose to use scare productive resources that have an alternate uses to satisfy wants which are unlimited. Economics can also be defined as the social science. It deals with the study of production, distribution and consumption of goods and services. It is a chain which deals with balancing the above in order to satisfy the wants of individuals. The importance of the chain is that there is a balance of all the following. 1. Production. 2. Distribution. 3. Consumption. Any imbalance to either of the above creates an issue and impacts the entire economy. The scenario in today’s world is the same. World Economy United States The last twelve years has seen USA as the main engine of global economical growth and between1995 and 2002, USA accounted for 96 percent of the cumulative increase in world GDP. As USA has 22 percent of world GDP, USA is by the largest economy on the planet. During 2000 and 2001, after the stock market crash in March, US got into a recession for about 18 months and it officially ended in November 2001 the next year saw very little sign of recovery. Company profits remained flat. This was largely due to the excess capacity and huge debts accumulated as a result of excessive investments during the 1990s. Then, in the last three months of 2002, a cyclical recovery began. This year it has gathered some momentum as GDP rose 3.1 percent on an annual basis in the second quarter. Profits have risen by 65 percent to the summer of this year. Business investment rose in the second three months at its fastest rate since spring 2000. After 2001, although the US economy was stabilizing and the Bush Government was doing everything to keep the financial security of the country stable, the beginning of September 2008 saw a huge dip in the national economy of the country. The dollar devaluation was one of the worst in the American history. There were fears of unemployment. US households spends were hit hard by the stock market crash because a major portion of the assets were tied up in equities. The crash threatened to put an abrupt halt to this but the Government in order to help the public lowered interest rates and allowed consumers to spend to keep the economy afloat in the short term. This was allowed, even though businesses were retrenching. Low interest rates allowed consumers to refinance their huge debts and also allow spends. However, these low interest rates have created a long term problem because it has allowed cash-strapped consumers to borrow time. This has also allowed house prices to rise steadily in these years as lower interest rates fuelled demand for mortgages. As a result of this consumers haven’t been able to pay their mortgages and this resulted to major banks declaring them bankrupt and causing bank crisis, thereby creating FINANCIAL CRISIS for the nation and the WORLD. European Union The prospects that the Eurpoean Union taking the role of a trendsetter in the world economy from the US Economy are quite slim simply because the European industries which were hit hard by the collapse of the stock market during 2000 are yet to recover. These have taken a relatively longer time and this has again been hit by the crisis now and the recovery period after two major recession or the financial crisis are determined to be longer. Also the macroeconomic policies being followed by the European Central Bank and national governments are also less reflationary than those of the USA. Also there is an inherent division within the looser unions of nations making the co-ordination more difficult than the US. Moreover the labor and the product markets is less organized. At this stage of the economic cycle, Europe is barely helping to sustain global capital accumulation at all. GDP in the Europe as a whole union has shrunk drastically in the last quarter of 2008 and ever since gone on a downfall. The EU is suffering from the crash in several important ways. During the second half of the 1990s, EU business investment rose sharply, from 14 percent of GDP to 23.6 percent – more than the USA experienced. A large chunk of this was financed by banks rather than the stock markets.. Hence, company debt rose from 58 percent of GDP in the Euro zone, in 1996, to 72 percent in 2000 and this has not improved one bit in the last eight years, prompting a major financial crisis. This was a clear writing on the wall, which the government failed to notice. On top of that, when the US Economy is compared with that of Euro zone it has very timid and slow to use fiscal and monetary policy to prime the pump and inject demand into the recession bound economies of Europe. These are the major reasons why Euro business is finding it more difficult to escape recession, restore profitability and boost demand. Japan The Japanese economy received a major boost from the massive speculative bubble in land prices in the 1980s. This however ended gravely around 1989 when land prices have collapsed by 90 per cent. Ever since the Japanese economy has been on turmoil and has never recovered. The original prices of the land during the 1980s were entered as assets to the banks and company balance sheets. The crash has been followed by a wave of bankruptcies as weaker companies, however the close outs didn’t happen. Although it was presumed that fitter companies and banks would buy out weaker ones, this didn’t happen. Although theoretically, the banks were supposed to be closed, in actual this didn’t happen and the government, in a bid to save the fear the end of consensual and model of patriarchal capitalism, kept under writing their losses. In the meantime, banks have refused to lend or borrow much for investment, preferring to write off their non-performing loans gradually. Similarly companies haven’t borrowed and instead relied on state aid. Economy is driven by private investment and consumer investment and spends. However, each successive governments injected huge amounts of money from the government fund trying to kick start the economy – mainly in the form of massive building programmes. Although this did briefly increase domestic demand but its effect soon faded. In addition to all this, the Bank of Japan, pushed interest rates ever lower to ease the debt burden of the stricken companies. This was to such an extent that some rates have been negative for some time. This, however, has introduced deflation into Japan. Growth has averaged just 1 percent a year since 1992. In the last couple of years, Japan has spent more than $80bn on dollar assets to keep the yen low, thereby, supporting the export sector. Such a policy has forced Japanese industry and banks into the restructuring they have avoided for so long. However, it has done nothing to raise the global demand and has pushed Japanese capitalism back into recession. CHINA With the US, Europe Zone and the Japanese economy failing, China has the world’s most dynamic capitalist economy. With most of the world in the doldrums or experiencing recession, industrial output had gone up to more than 17 percent. Similarly exports have surged by 32 per cent and the Chinese exports have doubled in the last five years. As per the figures, this economic performance outstrips Britain in the 1840s or Germany and Japan in the 1960s and 1970s respectively. As China is seen as a high productive and low cost country, Guangdong, one of China’s biggest economy boosters, has a huge component of foreign investment like Microsoft, BP, Honda and General Electric. These companies have some of their most modern and technologically sophisticated plants in the world and also a major chunk of manufacturing units have set up their base in China. 23,000 Japanese Companies operate in China. Such is the capability of China in a depressing time. Some examples of China and in particular Guangdong’s economy’s breathtaking impression: 40% of the world’s microwaves are made in one factory in Shunde; Midea is the world’s biggest maker of air conditioners; Shenzen special economic zone makes 70 percent of the world’s photocopiers; Dongguan has a single factory employing 80,000 workers, mainly women, producing 100 million trainers a year for Nike, Adidas, Reebok and the rest The centre of the world’s lighting industry is in Zhongshan and the region as a whole monopolizes the world’s supply of computer game consoles and golf clubs. China consumes more steel and copper than the USA, an economy eight times larger, and Shenzhen’s container port is now bigger than Los Angeles and Rotterdam. During the time when the entire world is reeling under the recession, China’s exports have tripled from US$121 billion to more than $365.4 billion in the last couple of years. This is indeed surprising as “foreign-invested enterprises” (FIE), Chinese subsidiaries of global multinationals and joint ventures with foreign partners, have accounted for fully 65 percent of the cumulative increase in Chinese exports over the last couple of years. Supply of new labor keeps wage costs low and prices rock bottom. In terms of mass production is concerned, no one can compete with China’s new capitalist enterprises. This has indirectly or directly impacted the global economy positively and negatively as well. Jobs have been lost in many countries because of the low labor cost in China. Factories have been shut down elsewhere to set up these in China. However the downsize is, China has to create more than 10 million urban jobs each year in order to absorb all the rural migrants, in addition to 6-8 million jobs per year to cope with the exodus from the closing state-owned enterprises, and a further 2 million for the young people entering the workforce. Deutsche Bank estimates that with unemployment in China’s cities probably between 8 and 10 per cent, “China has to maintain 15 to 20 percent export growth per year to be in a position not to increase the urban unemployment rate a lot.” Rapid economical developments in China have had destabilizing consequences for the world economy. Particularly, they have made China a major source of deflationary pressure. The saturation of the domestic market has already led to savage price competition. However, the world market is unable to absorb a continuously growing volume of Chinese goods and even a leveling off of export volumes, has already started a serious repercussion within China and although it has not been a major impact, recession has started to show signs in the Chinese Economy. This just goes to show how the entire world is depended on each other’s economy for stability and smooth functioning. INDIA Contrary to most of the world’s expectations, India has been one of the best performers in the world economy in recent years, however, rapidly rising inflation and the complexities of running the world’s biggest democracy are proving challenging. For over a century USA has been the largest economy in the world but major developments have taken place in the world economy since then, and this has lead to focus being shifted to major Asian giants - India and China. India’s economy has been one of the best in global economics in recent years, growing 9.2% in 2007 and 9.6% in 2006. The tremendous growth had been ably supported by markets reforms, huge inflows of FDI, rising foreign exchange reserves, both an IT and real estate boom, and a flourishing capital market. India is now the fourth largest economy in terms of purchasing power parity. Like most of the world, however, India is facing testing economic times in 2008. The inflation is running at 11%, the highest level seen for a decade. The rising costs of oil and uncertainty of the price, food and the resources needed for India’s construction boom are all playing a part. In the last six months, the Indian stock market has fallen more than 40%. An approximate $6b of foreign funds has flown out of the country in that period, reacting both to slowing economic growth and perceptions that the market was over-valued. There are still major issues around federal vs state bureaucracy, corruption and tariffs that require addressing. India’s public debt is 58% of GDP according to the CIA World Fact book, and this represents another challenge. FINANCIAL CRISIS AND EFFECTS OF GLOBAL RECESSION Finance, which is one of the subfield o economics, is one of the most important factors of determining the balance of any economy. Finance in economics deals with the behavior of investors, international capital flow and also asset valuation. Finance deals with special focus on the mathematics and analysis of market behavior. Globalization: Global economy is very greatly uneven and there is a great difficulty of bringing greater equilibrium and equality to sustain growth. There are clear signs of the adoption of protectionist measures. These measures are more so to form regional and bilateral measures rather than moves towards economic autarky and self sufficiency. None of the major economies, as mentioned above, are in a position to play the role of the locomotive that could pull the entire global economy. All these economic powers are more integrated and interdependent than ever before, into sustained growth. Any retreat into protectionism will ensure a decline in global production. It is clearly evident that “globalization” far from having established a new economic paradigm, free of crises and contradictions, is the cause of the recession. An example is Europe and America are at each other’s throats over GM crops, steel and bananas The US Market recession and the global meltdown termed as Global recession has engulfed the complete world economy and has had a varying negative degree of recessional impact. The impact has diversified and its impact can be observed from the very fact of falling Stock market around the world, recession in jobs availability and companies following downsizing and cutting staff in the existing available staff and cutting down of the perks and salary corrections. Globally the financial sector has been hit the most. Sacking the existing base of employees in high numbers. Major example is the CITI Group. The macroeconomic effects of the financial market crisis is a very serious issue and that no regions has escaped entirely unscathed. Looking at the current financial crisis, it is clearly understood that what began as a problem in a single sector in a single economy—the housing market in the United States—has become a global problem. This was first manifested as a problem for financial institutions is now becoming a problem for economies. This is obviously the case in the United States. The interaction of economic and financial market developments is also influencing the way the crisis unfolds .As we drill down to the causes of the financial crisis leading to major recession, below are some of the best known and unattended reasons: The present financial crisis is the result of a perfect storm and it had started showing signs much longer than a year or so: the stage was set with macroeconomic environment and a prolonged period of low interest rates, high liquidity and low volatility. Financial institutions underestimated the risks, Also credit and risk management practices in many financial institutions were not in place and there were shortcomings in financial regulation and supervision. Failure of financial regulatory agencies (FSA): Financial Institutions and regulation bodies have not been able to put into place supervisory and regulatory frameworks. This is applicable to both crisis prevention frameworks and crisis resolution frameworks. Citing an example relating to crisis prevention, is that in the US, unregulated entities that originated mortgages were not subject to appropriate disclosure and consumer protection requirements. Failure to Supervise Financial Market: Many financial institutions and banks have weakened their lending standards and policies and have taken excessive and unwarranted risks. The most obvious example is the US sub-prime mortgage market where holders of such risks are not necessarily from US. Problems also surface in other kinds of lending—for example leveraged loans and consumer credit—or other countries. The problem is not just confined to industrial countries. The interaction of economic and financial market developments is also influencing the way the crisis unfolds. The financial problems of banks also raise the risks of a credit crunch. Example is the housing correction which is lowering growth in the United States. Lehman Brothers and Northern Rocks are two of the most affected banks. Failure of Integrated financial regulation: This is applicable to the UK. In 1997, the British Chancellor of the Exchequer moved the responsibility of supervision of financial institutions into the hands of a new regulatory authority, the Financial Services Authority (FSA). This new authority replaced the Securities and Investments Board and took over responsibility for the supervision of banks, listed money market institutions and clearing houses from the Bank of England. However, the regulation of the financial system in the UK is not as explicit as the system in the US. Because of this failure, a lot of banks have been operating without proper governance. CORRECTIVE MEASURES The first thing required to overcome this FINANCIAL CRISIS with regard to the financial markets, is to restore confidence. In order to run down the financial crisis and over-come the same, the challenges being faced is that in the past crises were mostly current account crises. Large scale capital movements between countries were very rare, and financial institutions and transactions were at a national level rather than international. This was the main reason why transmission of the problem from a national to a global issue was relatively lower and the risk was bare. In today’s present day scenario, that is no longer the case. The main goal is to promote a cooperative approach between nations to secure economic stability and growth and do away with the crisis. Central banks of each country have to provide continued support for provision of liquidity to ensure smooth functioning of interbank money and financial markets. They should at the same time also seek more convergence on what kind of institutions they provide liquidity to, what collateral they will accept and what maturity they provide liquidity on. Auditors and supervisors need to encourage consistency across financial institutions on how assets are valued and how write downs are determined. Financial institutions on their part must also act. Full disclosures of exposures to sub prime and related securities, both on and off their balance sheets have to be made which will help investors and boost their confidence. They should also raise capital and restore liquidity cushions to reassure investors about their financial soundness. Sustained strong growth has to be based in part on stronger policy frameworks. Banks are to be regulated as per the FSA and all frame works and policies have to be adhered to. As per the Journal of Banking regulations, “the regulatory responses to the sub-prime crisis ought to be guided by the fundamental principle that bank regulation is justified by the adverse consequences of banks taking excessive risks. It therefore proposes three reforms: requiring banks to retain a proportion of any loan that they originate, so as to reduce the risks of moral hazard; insisting that the risks involved in the financial products in which banks trade are transparent; and reforming Basel II so that the amounts of regulatory capital that banks are required to hold are less procyclical than is currently the case”. This also further goes on to define three areas of reforms for financial institutions to minimize systematic risks: Minimize the moral hazard involved in the’ originate and distribute’ model of banking. Transparency of risk in financial products is essential if regulation is to work. Reform Basel II so that it is not so pro-cyclical. Corporate Governance and Banking Regulation: Financial regulation in influencing the development of corporate governance principles has become an important policy issue. As on date, most research and studies on corporate governance have addressed issues that affect companies and firms in the non-financial sector. In the case of banking regulation, traditional and standard policy and principal agent model analyzing the relationship between shareholders and directors and managers has to be done away with. Broader policy concerns to maintain financial stability and ensure that banks operate have to be promoted and regulated. In economic policy, emerging economies have to consider options of responding to a downturn: in terms of estimating scopes for monetary easing in some countries; or for a fiscal stimulus in others. This is also true for some emerging economies which can help support global growth—through policies to strengthen domestic demand and growth engine, including greater exchange rate flexibility. These policies help to bring about an orderly unwinding of global economic imbalances. All markets must build regulatory capacities to safeguard against the risks associated with non-transparent instruments and excessive lending. Frame works must be changed for liquidity management and collateral. Countries whose domestic banks have borrowed excessively from foreign banks to support domestic credit should prepare for sudden changes in market sentiment that could occur if financing conditions in global markets tighten significantly. SUMMARY As we summarize the causes and remedies for the on-going Financial Crisis, the common factor is the lack of risk mitigation tools and non adherence to or non-availability of stringent frame works and policies for the financial sectors and banks. The world economy has entered a difficult phase, with the financial crisis spreading to the real economy and bringing in recession to the world. As a global problem, it requires a global solution. Emerging markets like India and China also need to join industrial countries in the macroeconomic and regulatory policy response and risk management. This collaborative approach offers the best hope for ensuring the stability of the global economy and ending the Financial Crisis. Reference List 5 League for the fifth International: http://www.fifthinternational.org/index.php?id=167,750,0,0,1,0 Economics for Managers: The Institute of Chartered Financial Analysis Feb 2006 David Halliday McIlroy 3 Paper Buildings, Temple, London EC4Y 7EU, UK.E-mail: avid.mcilroy@3paper.co.uk Lessons from the Financial Market Crisis: Priorities for the World and for the IMF Speech by Dominique Strauss-Kahn Journal of Banking Regulation (2008) 9, 284–292. doi:10.1057/jbr.2008.15 Read More