Interest Rate Convergence - Dissertation Example

? Dissertation, Finance and Accounting The enduring global financial crisis has led to a sharp reduction of international trade, involving ashort term decrease in global agriculture trade value around 20%. The crisis is leading to a rearrangement of exchange rates, and the definitive declaration of the crisis depends on the alteration in the exchange value of the U.S. dollar. It has started in the United States (U.S.) and rapidly spread to Europe, United Kingdom (U.K.), Asia and other economies around the world in the late 2008 will have a broad impact, particularly in the short term (Peters, 2010, pp.1-2). It is having strong consequences through the bank lending channel such as the banks of U.K. made significant losses on acquisitions of foreign institutions and on holding of asset-based securities (OECD, 2009, p.30). By mid 2007, the financial disorder with its rigorous liquidity and credit crunch seemed to detain to financial markets and institutions in the U.S., U.K., Western Europe, Asia and many other countries. It resulted in the failure of key businesses, downturn in the economic activity and decline in the consumer wealth. During this period economies globally slowed, as international trade declined and credit tightened. This paper will focus on the effect of financial crisis on U.K. and other developed nations like USA, Europe and Asia and will also compare the impact of crisis on U.K. with these nations. Table of Contents Abstract 2 Table of Contents 2 Introduction 4 Chapter 1 6 Impact of the Financial Crisis 6 United Kingdom 6 United States of America 7 Europe 8 Asia 9 Comparison 10 Chapter 2 10 Steps towards Recovery 10 United Kingdom 10 United States of America 11 Europe 12 Asia 13 Chapter 3 14 Interest Rate Convergence 14 Conclusion 15 Reference 16 Bibliography 19 Appendices 20 Reflective Essay 24 Question 25 Introduction The economy of United Kingdom and average household incomes, after 1992, has experienced a period of continuous growth. But in 2008, like many OECD economies, U.K. has also experienced a rigorous recession as a result of a sequence of global shocks which has resulted in the fall of gross domestic product (GDP) growth by -2.4% (See Appendix A). The financial crisis has rigorously weakened the supply of credit and house prices have also fallen to a great extent. It also resulted to an increase of unemployment. The increase in the government deficit has provided support to but led to an increase of debt to GDP ratio (See Appendix B) (OECD, 2009, p.21). The financial crisis has initially started in the USA and resulted in the bursting of housing bubble and the following of subprime mortgage crisis in the USA. Investment houses, banks and customers suffered huge amount of leveraged debt. In world markets, investors deployed hot money seeing higher rate of return. It has also affected the stock market of the USA (Nanto, 2009, p.32). In the plunge of 2008, Eastern Europe (EU) was also considered as the one of the most inflamed region in the world economy. It has also resulted in the large decline in output in 2009. The country that was affected most by the crisis in Eastern Europe was Latvia. The three main crisis countries i.e. Latvia, Romania and Hungary together resulted for only 2% of EU GDP. The major impact of the financial crisis was on the European banking system. Before the start of this crisis only, the financial alarm had been ringing since 2006 due to the huge current account deficit in many of these countries (Aslund, 2010, p.1). Asia is also affected by the financial crisis and resulted in a considerable drop in growth due to the sharp reduction in exports. In spite of the actions taken in response to the lessons drawn from recurring crises which have took place in 1997-98, more or less all Asian developing emerging economies now evident to increased propensity to financial boom–bust cycles and turn in property, equity and currency markets due to their closer integration with major financial centers (Akyuz, 2010, pp.1-2). Financial Services Authority (FSA) of U.K. played important role in bringing back the liquidity and growth in the U.K. economy. Besides this, U.K. fiscal and monetary policy also played crucial role in stabilizing the economy of U.K. including the U.K. work on leading the G20 (Reid, 2009, pp.5-7). The Internal Monetary Fund (IMF) played an important role in reestablishing the economy of Eastern Europe. Counter cyclical policies have been established to promote recovery in Asia. This paper will focus on the impact of the crisis on the economy of U.K. USA, Europe and Asia and the role of the financial and monetary policies including other financial measures towards the recovery of the economies of the above mentioned countries. Chapter 1 Impact of the Financial Crisis United Kingdom The financial crisis has rigorously weakened the supply of credit and house prices have also fallen to a great extent in U.K. The housing prices has decreased by 12%, equity prices has reduced by 50% on October 2008 which was the worst monthly fall in 300 years and the output has decreased by 2%. Further, unemployment and government debt has resulted in an increase of 2% and 61% (See Appendix B) (Reid, 2009, p.2). The GDP has resulted in the decline of 1.5% in fourth quarter of 2008 which was the worst since 1991. Consumer spending has decreased by 0.5% and budget deficit was assumed to rise from 43 billion pound in 2008 to 70 billion pound in 2009; therefore resulting in higher taxation and decrease in public spending. All sectors i.e. manufacturing, utilities, mining and construction sectors were representing declining growth. Imports have decreased by 5.5% and exports has also resulted a decrease of 5.9%. Rise in inflation has lead to an increase in the energy and food prices (Reid, 2009, p.3). The financial system of U.K. was exposed to the money market turmoil. The banks in the United Kingdom were deeply exposed to the subprime mortgage instruments of the United States and therefore experienced moderately heavy losses. Moreover, U.K. banks were more dependent on borrowing in financial markets, instead on deposits which are also one of the reasons accountable for the expose of U.K. markets towards financial crisis (OECD, 2009, p.28). United States of America The impacts of the financial crisis on the USA are that the consumers and households were at the decisive receiving end of huge proportion of the global saving surplus, under the easy monetary regime. They lost trillions of dollars of wealth (Russo and Katzel, 2010, p.1). This led to quick growth of uncontrolled acceleration of asset inflation and consumer credit (Muller, 2011 p.1). After the dot-com bubble of 2000-01, the asset inflation had occupied the form of a housing boom in USA and had a special lethal element for future troubles in the form of sub-prime mortgages, which were sold to low-income people with no down payments (Nissanke, 2010, p.4). The sub-prime mortgage crisis affected the liquidity of the banking system and stormed the international financial market (Sharan, 2009, p.60). These were traded worldwide through poorly regulated financial markets and over-the-counter transactions. In place of a traditional buy and hold model, a dynamic originate to sell trading model of securitization was adopted. Therefore, the leverage ratios increased as much as 30 of some of the financial institutions, which were above the ceiling of 10 normally imposed by deposit banks (Nissanke, 2010, p.5). The GDP has also fallen at an annual rate of almost 7% (Russo and Katzel, 2010, p.1). The crash of demand transparency in the off-balance sheet activities on the part of supervisory oversight agencies as well as ineffectiveness of the credit rating agencies to feature in market wide systematic risk aggravated the situation (Nissanke, 2010, p.5). Credit risk were underpriced by all parties, thereby given ease money and availability of default risk insurance which was proposed to debt holders through credit default swap facilities. In spite of the interventions by a series of large scale liquidity injections by the Central bank and the Federal Reserve in Europe, the inter-bank money markets have been largely frozen leading to liquidity crunch and credit crunch in many financial institutions (Nissanke, 2010, p.5). The collapse of financial institutions and other banks in USA and the bankruptcy of Bears Steams and its takeover by JP Morgan Chase indicated the credit freeze and the depth of the crisis resembling the normal operations of financial markets in these economies (Nissanke, 2010, p.6). Then came the news of take-over of Merrill Lynch by Bank of America and the bankruptcy of Lehman Brothers gave rise to more problems (Muller, 2011 p.1). Due to switch from equity markets to purchase of safe investment by investors, stock market began to drop globally. Financials papers such as commercial papers and money market funds which were generally regarded as low-risk and liquid instrument were no longer considered as safety asset. Carry trade related flows, expected on betting on interest rate differentials and exchange rate movements between emerging market currencies and major currencies were fast loosening (Nissanke, 2010, p.7). Europe Due to the tremendous shock of financial crisis, the EU economy was expected to shrink by 4% in 2009, the sharpest reduction in the history of EU. Recoveries are expected to be lethargic as demand was declining because of deleveraging across the economy and also due to the inevitable structural adjustments. The crisis was expected to raise four challenges. First is the growth potential was likely to suffer as some parts of capital stock are outdated and enlarged risk aversion will reflect on research and development and on capital formation. Second is the rising level of unemployment. Where the labor markets were still stiff, the weak unemployment reaction was possibly not sustainable and more lay-offs were expected to be in the pipeline. It will lead to social hardship for highly indebted household who have been already hit hard by decline in housing markets. The unemployment rate and hours worked in EU is reflected in Appendix C (See Appendix C). Third is the debt and fiscal deficit has increased, as tax bases minimize permanently and contingent liabilities curtailing from bank releases may materialize. The boost of the deficit is compared to previous financial crisis (See Appendix D). The increase in the public debt was expected to about 20% of GDP at the end of 2010 (See Appendix E). Fourth is the crisis has resulted in a housing bubble and the countries that are having large current account surplus need to lessen their export reliance and work off their balance sheet problems (Szekely and Noord, 2009, p.1). Asia The five Asian countries i.e. Indonesia, Malaysia, South Korea, Thailand and the Philippines have suffered nominal currency reduction of more than 50%. In these countries, the onshore rates or offshore nominal interest rates reached at least 25%. The nominal interest rates of other five East Asian countries i.e. Hong Kong, China, Japan, Singapore, Thailand and Taiwan remains below 20% and have also suffered nominal depreciation of less than 25% (Barro, 2001, p.1). The financial crisis has increased the recession and the risk of financial contamination in Asia. There is a short of dollar liquidity, an increase in risk aversion and bond spreads have widened. These have decreased the assets’ value held by bank. Credit has tightened and economic growth was slowing down in many Asian economies (Bautista, 2008, p.1). The financial crisis has resulted in the decline in export earnings, decline in bank lending and decline in financial inflows (Pham, 2010, pp.1-2). At the end of 2008, growth of the Asian economies has slowed down and half of the countries have suffered a negative growth in 2009. The Asian countries have also suffered losses on foreign asset holdings (Akyuz, 2010, pp.10-11). Comparison The financial crisis of 2008 has affected tremendously the economies of developed countries. In terms of credit cycle U.K. is the most affected region followed by USA, Europe and Asia (See Appendix F). The equity prices in European region is maximum followed by U.K. USA and Asia, so the most affected country in terms of rise in equity prices is the EU. In terms of the rise in housing prices, UK is the most affected region followed by USA, Europe and Asia (See Appendix G). The real GDP has decreased in almost same proportion in these countries and the export performance has also shown a downfall which is more in the U.K. and then in the Europe (See Appendix H). The effect of the crisis on Asia is not as dangerous as the effects in Europe or in USA. Though, most of the Asian countries has resulted a slower GDP growth, but still the Asian economies are growing (Bautista, 2008, p.1). Chapter 2 Steps towards Recovery United Kingdom Financial Services Authority (FSA) of U.K. recommended that there are three main areas which need to be reformed. First is better capital adequacy methods should be launched for responding to pro-cyclicality and a more efficient risk evaluation approach should be reformed that looks further than the VaR model. Second is, for liquidity purpose there is a need of globally recognized system which assists uniformed standardization methods for its measurement. And, third is the exclusion of shadow banking system, with more rigorous disclosure requirement for all financial institutions, thus minimizing the risks to wider financial stability (Reid, 2009, p.5). The fiscal and monetary policies of UK have also played an important role in reestablishing the economy of U.K. The Monetary Policy Committee i.e. Bank of England have reset the lower interest rates in order to stabilize prices and therefore resulting in balancing the wider economy. Quantitative easing has resulted in 75 billion pound injection of money in order to stimulate demand (Reid, 2009, p.6). U.K. is working on leading the G20 summit which objectives are to return confidence and trust to financial markets; retain and construct on the benefits which is brought by the open financial markets to the world economy; and Financial Stability Forum has to be set up in order to reduce the probability of systematic risk. Tighter financial scrutiny systems have to be put in place which will make possible closer association between Indian Monetary Fund and Financial Stability Forum. There would be also the creation of a international financial architecture where the principles of transparency, openness and disclosure will persuade the behavior of those institutions which participate in financial cross-border activities (Reid, 2009, p.7). United States of America The role and responsibility of FSA in USA in reference to the event of the collapse of the global financial services industry in 2007 is as follows: protecting consumers generally while encouraging their understanding about the financial system and therefore helping to reduce financial crime and maintaining market confidence in the financial system. Therefore the Financial Services Authority promotes efficient orderly and fair markets, improves business effectiveness, provide public and political accountability and assist in providing legal accountability. It has the power in relation to unfair contract terms and brings fairness within consumer contracts for financial product and services. In this way, it can protect the investors who were inattentive in their understanding of what they were actually purchasing and also the sub-prime borrowers who were insincere in taking out loans that they should have known they could not finally meet the repayments on. FSA is the lead regulator for financial services as it reduces the administrative burden on firms and make information available to firms and consumers and delivers risk-based regulation. Financial Services Authority also takes on responsibility to design short-term policies in order to restrict the adverse impact of deflation and deleveraging on the real economy in order to solve the problem of the financial institutions and the over-leveraged banks United States of America which have gone bankrupt. Europe The financial crisis has revealed the significance of coordinated crisis-management structure. It should include the following factors: First is crisis deterrence in order to avoid a future repeat. This should be planned on the basis of communal judgment as to what the main reasons of the crisis were and how changes in regulatory, macroeconomic and supervisory policy frameworks could help to avert their recurrence. Second is crisis control and alleviation in order to reduce the damage by avoiding systematic defaults and lessening the social hardship stemming from recession. Thus, its main aim is to stabilize the economic activity and the financial system in the short run. Third is crisis resolution in order to bring crises to a permanent close and at the lowest probable cost for the taxpayer, while include systemic risk and sheltering consumer protection. This needs overturning temporary support measures and action to re-establish economies to sustainable growth. This involves policies to restructure the banking sector, restore bank’s balance sheet, and a systematic policy exit, including from expansionary macroeconomic policies (Szekely and Noord, 2009, p.1). In December 2008, the European Union Recovery Plan has also been launched to strengthen demand and assemble trust in the European Union (Orendt, 2010, p.1). Asia In most East Asian economies, easing of monetary policy is needed. In order to support liquidity, Central banks need to take extensive steps, including developing the types of assets to be purchased, using lender of last resort facilities, and developing multilateral and bilateral currency swap measures. Central banks should assess their monetary policymaking in order to reinforce macro-prudential structures so that the systematic risks, asset price developments and the goods price inflation could be taken into account. The fiscal policy involves that the East Asian governments should hasten investments in those sectors which is supported with high growth potential. Government programs also strengthen social safety nets, support employment expansion schemes and advance income distribution in order to support consumer spending from longer term viewpoint. Governments of East Asia must take strong action in order to repeat their commitment towards regional economic cooperation and free trade and refrain from import restriction or undue export promotion (Adbi, 2009, p.1). The leaders of East Asia should participate in international forum like the G20 in order to put their impression on reforms of the global financial system and also to shore up regional initiatives (Adbi, 2009. p.13). The East Asia’s policy should adopt the measures to reinforce and maintain the impetus of reform in financial markets (Drysdale, 2008, p.1). Chapter 3 Interest Rate Convergence When the European Monetary Union (EMU) was formed, it was supposed that the ensuing interest rates convergence would lead to economic convergence across European Union. Given the monetary restrictions of the European Monetary Union, and the lack of exchange rate adjustments, the whole burden of adjustment to the crisis was transferred on to labor market and the national fiscal policy. The EMU was formed in order to eliminate the risk of devaluation and to implant the single market in Europe. It was expected that market convergence in interest rates would result in the economic convergence. And, this was regarded as the fundamental mistake. Political and institutional differences between nation-states construct divergent employment and economic growth patterns. This fact was completely ignored by the financial markets. A monetary policy of one size fits all did not resulted in the economic convergence but it stimulates reckless investment, thereby leading to credit and housing bubbles. This does not mean that the problem which was aroused was associated with the EMU. Domestic policy choices have contributed to the crisis in the European Union countries. But the main point is that interest rates convergence stimulates rather than eradicating economic divergences within the Euro zone (Regan, 2012, p.1). By investigating well recognized international parity conditions of Uncovered Interest Parity, Covered Interest Parity, Purchasing Power Parity etc, co-integration procedures was adopted in order to test the validity of these hypotheses entailed by the co-integration association between interest rates and inflation rates for Germany, Canada, U.K. and Japan against USA. The co-integration test favors the long run association between the real interest rate and exchange rate differentials. Similarly, bilateral real interest rate convergence was found between the rest of the G7 countries and the USA. Moreover, interdependence was found between the Australian short term interest rates and those of U.K., Japan, USA, Germany and Canada after holding regime shifts in the time series (Wang, 2008, p.59). U.K. decided not to join the Euro Zone and the reasons behind this was the interest rates and deficient of convergence in economy. The interest rate of U.K. was higher than the Europe. So, the significant efforts were made in order to allow the U.K. to join. The only reason why U.K. decided not to join is that they were not sure that whether the rate of convergence will pertinent for long term or not. The central element included is the inflation rate and the housing market prices which was the strong key factors against the Euro zone. Most countries loosen up international capital controls through the acceptance of more flexible exchange arrangements. In integrated markets, inflation and nominal and real interest rates across countries should display a long run convergence trend. The escalating degree of integration is anticipated to enhance convergence among economies, whereas, the financial crisis and turmoil are expected to enhance divergence (Kisswani and Nusair, 2011, p.3). The impact of Asian crisis reveals less number of convergences before the crisis and more after the crisis (Kisswani and Nusair, 2011, p.21). Conclusion The financial crisis has rigorously weakened the supply of credit and house prices and has also lead to sub-prime mortgage crisis. This paper took into account the impact of financial crisis on U.K., USA, Europe and Asia and has also compared the situation of U.K. with other three countries. Further it focuses on the role of fiscal and monetary policy and also the role of FSA towards the recovery from financial crisis. And at last it takes into consideration the convergence of interest rates across different countries. Reference Adbi., 2013. Impact of the Global Financial and Economic Crisis on East Asian Trade. Available at: http://www.adbi.org/working-paper/2010/02/02/3450.regional.trade.policy.east.asia/impact.of.the.global.financial.and.economic.crisis.on.east.asian.trade/. [Accessed 15 May 2013]. Adbi., 2009. Recommendations of Policy Responses to the Global Financial and Economic Crisis for East Asian Leaders. [pdf]. Available at: http://www.adbi.org/files/2009.03.18.keydocs.policy.recommend.global.financial.crisis.east.asian.leaders.pdf. [Accessed 15 May 2013]. Akyuz, Y., 2010. The Global Economic Crisis and Asian Developing Countries: Impact, Policy Response and Medium-Term Prospects. Malaysia: Third World Network. Aslund, A., 2010. The Last Shall be the First: The East European Financial Crisis, 2008-10. Washington: Peterson Institute. Barro. R.J., 2001. Economic Growth in East Asia Before and After the Financial Crisis. Cambridge: National Bureau of Economic Research. Bautista, M.S.G., 2008. The Effect of the Global Financial Crisis on Asia and on the Philippines. Philippines: Institute of Development Studies. Drysdale, P., 2008. East Asia and the Global Financial Crisis. Asia: East Asia Forum. Kisswani, K.M. and Nusair, S.A., 2011. Non-linear Convergence in Asian Interest Rates and Inflation Rates. Kuwait: Gulf University for Science and Technology. Muller, A., 2011. Financial Crisis-Impacts and Reactions. Munich: GRIN Verlag. Nanto, D.K., 2009. The Global Financial Crisis: Analysis and Policy Implications. United States of America: DIANE Publishing. Nissanke, M., 2010. The Global Financial Crisis and the Developing World: Transmission Channels and Fall-outs for Industrial Development. Vienna: United Nations Industrial Development Organization. OECD., 2009. OECD Economic Surveys: United Kingdom 2009. United Kingdom: OECD Publishing. Orendt, M., 2010. Consequences of the Financial Crisis on Europe. Turkey: Wise Man Center for Strategic Studies. Peters, M., 2010. What the 2008/2009 World Economy Crisis Means for Global Agricultural Trade. United States of America: DIANE Publishing. Pham, T.H.H., 2010. Effects of the Financial Crisis on Developing Asia’s Economic Growth. Vol. 30. France: University of Rouen. Regan, A., 2012. The Convergance of the Interest Rates in the Eurozone has Fuelled Rather than Removed Economic Divergences Between the North and South. Amsterdam: European University Institute. Reid, M., 2009. The UK Response to the Global Financial Crisis. [ppt]. Available at: http://www.academia.edu/300053/UK_Response_to_the_Global_Financial_Crisis. [Accessed 15 May 2013]. Russo, T.A. and Katzel, A.J., 2010. The 2008 Financial Crisis and its Aftermath: Confronting the Next Debt Challenge. United States of America: Thomas Russo. Sharan, V., 2009. International Financial Management. 5th edn. New Delhi: PHI Learning Pvt. Ltd. Szekely, I.P. and Noord, P.V.D., 2009. Economic Crisis in Europe: Cause, Consequences and Responses- A Report by European Commission. Available at: http://www.voxeu.org/article/economic-crisis-europe-cause-consequences-and-responses. [Accessed 15 May 2013]. Wang, P., 2008. Financial Econometrics. 2nd edn. United Kingdom: Routledge. Bibliography Aksoy, Y. et al., 2006. A Quantitive Exploration of the Opportunistic Approach to Disinflation. Journal of Monetary Economics 53. Baba, C., 2007. Price Dispersion Across and Within Countries: The case of Japan and Korea. Journal of the Japanese and International Economies 21. Baharumshah, A. Liew, V. and Mittelhammer, R., 2010. Non-linearities in Real Interest Rate Parity: Evidence from OECD and Asian Developing Economies. Global Economic Review 39. Baharumshah, A. Liew, V. and Choudhary, I., 2010. Asymmetry Dynamics in Real Exchange Rates: New Results on East Asian Currencies. International Review of Economics and Finance 19. Balke, N. and Fomby, T., 1997. Threshold Co-integration. International Economic Review 38. Berman, N., 2009. Financial Crisis and International Trade: The long way to Recovery. European University Institute – Economic Working Paper. Kaminsky, G. and Reinhart, C., 2001. Financial Markets in Times of Stress. NBER Working Paper 85. Ma, Z. and Cheng, L., 2003. The Effect of Financial Crises on International Trade. NBER Working Paper. Akyuz, Y., 2009. Exchange Rate Management, Growth and Stability: National and Regional Policy Options in Asia. Colombo: UNDP. Appendices Appendix A Appendix B Effects of financial crisis on U.K. Sourse: Reid, M., 2009. The UK Response to the Global Financial Crisis. Appendix C Unemployment and hours worked in EU. Appendix D The fiscal position compared to previous crisis Appendix E Government debt comparative to previous crisis Appendix F Appendix G Rise in equity and housing prices Appendix H Reflective Essay The research process focuses on the fact that how strong the financial crisis was and how strong was its consequences that led the banks of U.K. to make significant losses on acquisitions of foreign institutions and on holding of asset-based securities and the bankruptcy of Bears Steams and Lehman Brothers gave rise to more problems. Further the research process lays stress on the role of Financial Services Authority, and various monetary and fiscal policies that came into practice to solve these problems. FSA of U.K. recommended three main areas which need to be reformed. The FSA provides public and political accountability and assist in providing legal accountability in USA. Through the research, it was revealed that the interest rates convergence stimulates rather than eradicating economic divergences and that’s why U.K. decided not to join the Euro Zone. The knowledge which was gained from this report is that in spite of the following measures adopted by the countries in order to overcome the problems, they are still facing certain complexities in their development process. So, further measures are still required in this field, such as some reforms should come into existence to strengthen demand, most proficient risk evaluation approach should be developed and lower interest rates should be set by the government to make the price stable. Question What are the steps towards the recovery from the financial crisis and does the interest rate convergence have resulted in the economic convergence? Read More