Effects of Financial Crisis on the World Economy - Essay Example

?The Financial Crisis and Its Effects on the World Economy Table of Contents Reasons behind the Crisis of 2007/2008 3 The Effects on the World Economy 5 Aftermath of Financial Crisis (US, Germany and China) 7 Measures taken after Crisis 9 Future Possibility 11 Reasons behind the Crisis of 2007/2008 The financial crisis of 2007-2008 has been regarded as the worst financial crisis after the Great Depression of 1930s. The financial crisis of 2007-08, not only led to the collapse of several banks and financial institutions, but turned down the stock markets in most of the countries. There are several specific reasons for the financial crisis which is discussed below in detail. Subprime Lending Subprime involves the credit status of the borrowers of subprime loans and does not correspond to the interest rates of such loans. Any type of loans offered to the subprime borrowers which do not satisfy the prime guidelines of a loan are termed as subprime loans. It is a process of lending money to a group of borrowers who are classified as subprime borrowers and they do not qualify for obtaining loans at market interest rates because of the fact that their credit ratings are too low (Duhigg “Pressured to Take More Risk, Fannie Reached Tipping Point.”). However, the underwriting standards were relaxed by the mortgage lenders because during the phase of strong competition, the availability of the creditworthy borrowers was limited. So the mortgage became risky because they were allowed to less creditworthy borrowers. A crisis situation created in the subprime mortgage market of United States intensified during 2007 and led to global recession (Labaton “Agency’s ’04 Rule Let Banks Pile up New Debt”). Housing Bubble It has been noticed that from 1997-2006, the housing price in USA has increased by 124 percent. In 2006 the housing prices in USA was very high, which started declining considerably in the year of 2006 and continued in 2007 too. In 2008, the Case-Shiller home price index revealed that the highest drop in the housing prices was seen in 2008 (Schmuecker). This resulted in the subprime crisis due to the obligation created by the Alt-A collateralized debt, Hedge funds, credit, and other mortgages. It heavily affected the new construction, as about 1,283,000 American families sold off their houses, in comparison to 609,000 during 1990-1995. Mortgage finance is one of the most important components in the property debt market. In the year 2008 the US government did offer special loans of about $900 million to rescue the country from housing bubble, but the amount of loss was already far beyond this amount (Barker 3). Weak Underwriting Practices The failure of the mortgage underwriting principles was prevalent in USA, as stated by Tichard M. Bowen III, the chief underwriter of Citigroup. He himself stated that among 1600 mortgages by Citi, about 60 percent of the mortgage loans were defective in nature (Morgenson “Raters Ignored Proof of Unsafe Loans, Panel is told”). This means that the underwriters did not perform their duties based on the policies. Apart from this, the Financial Crisis Enquiry Commission also scrutinized about 900,000 mortgages that were issued from 2006-2007. They found that barely 54 percent of the mortgage loans met the required underwriting standards. Among them about 28 percent mortgage loans even did not met the minimum standards of borrowing (Olin). Collapse and Boom of the Banking System There are various evidences that the risky mortgages were financed by the banking systems. The superfluous pressure from the showed banking system also led the financial institutions lower their underwriting standards and support the initiation of risky loans. The CEO of the Federal Reserve Bank directly blamed the parallel banking or shadowed banking system for freezing the credit market. During 2007, the securitization market which was supported by the parallel banking system started to collapse and shut down by 2008. In this situation, the private credit market was not available to sources such funds. Even the traditional institution did not have the strength to cover such huge financial gap. The market of securitization was totally damaged and investors started expecting further loan losses (Krugman; Federal Reserve Bank of San Francisco “President's Speech”). Easy Credit Provisions The interest rates were low and this encouraged the borrowers to opt for mortgage loans. The Federal Reserve lowered the fund rates from 6.5 percent to 1.0 percent from the year 2000 to 2003 (Bernanke “The Global Saving Glut and the U.S. Current Account Deficit” ) This step was taken to reduce the outcome of dot-com bubble, risks arising for deflation and the terrorist attack that took place in 2001. The addition pressure of the rate of interest was due to the current account shortage of USA and the rising risk of the housing bubble (The Economist “When a Flow Becomes a Flood”). It was recorded that the current account shortage increased to $650 million by 2004, which was 5.8 percent of the GDP. This created the demand for the financial assets and the idea was to increase the price of those assets in order to decrease the interest rates. Apart from this, the borrowers also received loans from the banks and financial institutions on easy term. The verification of documents or the creditworthiness of the borrower was not paid much attention (Max “The Bubble Question”). The Effects on the World Economy The world experienced the financial crisis of 2007-2008 in the form of global recession. Various analysts and economist are of the view that if the financial crisis in the world continues, then it may lead to an extended recession. The financial crisis has led to one of the largest banking shakeouts due to the meltdown of loans and savings. The United Bank of Switzerland predicted that global recession was very close and the global economy would require more than two years to recover from such shocks. A few days after this statement, the crisis was on its full swing. Necessary actions were taken to fix the crisis situation, such as huge among of capital was injected in the economy by the government, interest rates were cut down for the borrowers, but the matter went out of hands. According to the Brookings Institution, USA accounted for more than one-third of growth in the global consumptions. It was also revealed that since many years, the economy of US has been involved in spending more and too much borrowing. The rate of turn down in Germany was 14.4 percent, in UK was 7.4 percent, in other European countries was 9.8 percent, and in Mexico was 21.5 percent, and so on (Baily and Elliott “The US Financial and Economic Crisis: Where Does It Stand and Where Do We Go from Here”). Some of the country which experienced growth was also affected by the financial crisis. For example Kenya achieved a growth of only 3-4 percent in 2009, which was about 7 percent in 2007. Similarly Cambodia’s growth rate fell to 0 from 10 percent due to financial crisis (Baily and Elliott “The US Financial and Economic Crisis: Where Does it Stand and Where Do We Go from Here”). The World Bank report revealed that middle-east countries were comparatively less affected by the financial crunch because the position of their balance of payment was good and they also has alternative sources to cover their current account deficits if required. The Arabian countries have access to provisions like remittances, Foreign and Foreign Direct Investments to suck up the economic shocks. The only loss that they had to face is due to the decreasing prices of oil and gas. The European commission in the year 2008 predicted that the economic growth in the year 2009 would be extremely weak and countries like Italy, France, Belgium, Germany, etc would even see negative growth rates, as can be seen in Table 1. Figure 1: GDP Rate Source: (Sreenilayam, and Mathew “The Global Financial Crisis and its Impact on India's External Sector”) Aftermath of Financial Crisis (US, Germany and China) The effect of the global economic downturn includes insolvency, bankruptcy, and declining revenue of the employers, decreasing purchasing power of the people, and most importantly unemployment, downsizing. Three major consequences of the financial crisis can be stated, which has affected the global economy. Firstly, the asset market had suffered badly and the housing prices plunged by 35 percent. The effect of such an outcome is expected to affect the global economy for a minimum stretch of six years. The equity prices also lost about 55 percent in a span of three years. Secondly, the rate of unemployment increased and the GDP reduced by 9 percent approximately. Thirdly, the government debt exploded and increased to 86 percent. In this study the after effect of financial crisis of US, Germany and China would be specifically discussed. The demand for collateral debt obligation (CDO) declined after 2006. The vendors such as Merrill Lynch, UBS, Deutsch Bank, etc retained the CDOs but they were getting any buyers to sell them. The balance sheet of these vendors showed huge balances of unsold inventory due to this reason. Those CDO which were sold moved with large discounts, which resulted in further loss for the vendors. The US vendors heavily invested in the CDO’s in 2007. Even the demand for the asset backed commercial papers (ABCP) has also collapsed due to the risk of mortgage defaults and the decreasing value of the housing industry. The banks and the hedge funds which were exposed to the instruments like CDO and ABCP started incurring huge lose. In the year 2008 the financial crisis became acute due to the collapse of Bear Stearns’ share value. This was later acquired by JP Morgan with the aid of the US government. In September 2008 even Lehman Brothers filed for bankruptcy. The US government declared a bailout of about $700 billion to assist the troubled firms. Even the Federal Reserve announced to buy $540 billion of assets from the money market funds in order to easy the economic condition (McKitrick “The US Financial Crisis: Understanding the Causes and Consequences”). The financial crisis has resulted in the decrease of the growth rate of Germany too. However, the financial sector of Germany was not so badly affected by the financial crisis like the other countries such as UK or USA. So it was expected that there was less requirement of adjustment in the growth rate in the aftermath (Belka 15). The economy of Germany should realistic growth and the level of unemployment was also lower than the affected countries. The housing industry of Germany too did not get much affected and the banks too were in sustainable position. Only the banks which were mainly exposed to the US subprime were badly hit, such as Landesbanken (Puri, Rocholl, and Steffen "Global Retail Lending in the Aftermath of the US Financial Crisis: Distinguishing between Supply And Demand Effects"). The US financial crisis hit China badly and the economy of China fell by 13 percent in 2007 and 6.8 percent by the end of 2008. The economy of China is growing at the slowest pace in its past three years due to the decrease in investments and the sinking demands of products and services in its key markets such as US and Europe. This means that the exports of China have condensed. It suffered its first decline in exports in these seven years. The exports fell by 2.2 percent in the beginning. The economist depicted that the export figures of China shows the slowing economic conditions and the declining exports. China’s exports were badly affected because the biggest export buyers of China, such as Europe, Japan and US were suffering a financial crisis. The biggest buyers of China lost their purchasing power considerably, so the exports of China decreased by approximately $114.99 billion during recession. The government of China injected a stimulus package of 4 trillion Yuan to fight with the crisis and the People’s Bank of China also reduced the interest rates. The Chinese economy got badly affected by the financial crisis because of the direct losses that it faced from the reduction of exports, secondly, due to the losses that country faced in US capital markets, thirdly, due to the alterations in the cash flow across nations, and lastly, due to security of the foreign exchange reserves. China shifted its focus from being export oriented to consumption oriented economy after the crisis. However for having consumption led economy, China has to boost in high wages and also major industrial restructuring is required (Yougding “The Impact of the Global Financial Crisis on the Chinese Economy and China’s Policy Response”). Measures taken after Crisis In this section the analysis would be on the various measures taken by different countries around the world to either eliminate or protect themselves from the financial crisis and the effects of the global recession. The US Treasury introduced a Troubled Asset Relief Program (TARP) and other plans to ease the economy and provide relief to the taxpayers of the country. The US government took several steps to deal with the severe crisis situation. The government passed an emergency legislation in 2008-2009 to prevent the financial institution from failure. Several provisions were made to lessen the impact of the financial institutions on the consumer borrowing and general businesses. Immediate stimulus was also provided to the consumers spending through augmentation of the household income after the tax. The temporary funds to the local and state government are provided to boost taxes and condense spending during the global recession. Decisions were also taken to protect the health and income insurance of the workers who were laid off during the crisis (Balakrishnan “Financial Crisis: Action Taken by Central Banks and Governments”). The European countries such as Germany, Italy, France and other 12 countries were planning to reveal comprehensive plans to recover the banking system of their country. The European Central Bank (ECB) also took active part in boosting the liquidity. Three major revival measures were planed such as guarantees on interbank lending, recapitalization of the troubled banks, and liquidity support. For Britain along a stimulus package of ?500 billion and for other countries, €2 trillion was considered. In Britain liquidity schemes of ?200 billion were given and banks have also guaranteed further debts of ?250 billion for further requirements. The saving guarantee was increased from ?35,000 to ?50,000 for the depositors, and the Bank of England had also reduced the interest rates. Similarly in Ireland the guarantees of six major banks and building societies were ensured for two years. A stimulus package of €400 billion was extended to the foreign banks that operated in Ireland. Greece was another country which suffered badly due to financial crisis. The government of Greece took the guarantee for €20,000 savings deposits, and €100,000 has been guaranteed by the parliament for a term of 3 years. In Germany €400 billion of bank lending has been guaranteed for supporting the credit markets. Short-selling for about 11 stocks were banned and further €100 billion were offered for the recapitalization of the financial institutions and banks. In China the interest rates were slashed to 0.27 percent and 5 percent tax waiver were also given on interest income. Short-selling was also banned in China. In Australia the government guaranteed the bank deposits up to $700 billion for the time period of three years. A stimulus package of A$10.4 billion was also injected to stabilize the economy (Balakrishnan “Financial Crisis: Action Taken by Central Banks and Governments”). Future Possibility It has been almost five years since the advent of financial crisis of 2007, but economist and analyst state that considerable improvement has not been seen in the world economy. The GDP of USA is still below the initial level, and unemployment rate is still remains high. This is not a matter of supervise because the recession which took place due to the collapse of the systematic banking system and financial markets was lingering and deep. So it is an obvious fact that the recovery would be very slow. It was said that the Great Depression in US during 1929 was the strongest and US economy took almost a decade to reach the same level after that. The financial crisis and recession of 2007-08 was also similar to the Great Depression, so the world economy would be requiring more time to come back to its original status. Several stimulus packages and guarantees by the government and regulatory bodies in different countries are planned with the objective of bring the ease and consistency in the financial markets and economy. The rate of unemployment would improve when the companies would be in position to stabilize and start recruiting again. However, after this situation, financial institutions have started paying more attention towards risk assessment, monitoring, and setting up teams for identification of risk and plan effective measures to either avoid them or combat if required. More innovative financial instruments and products are being planned which would be secured and chances of these going bad would be minimal. Work Cited Baily, Martin Neil and Douglas J. Elliott. “The US Financial and Economic Crisis: Where Does It Stand and Where Do We Go From Here?” Brookings, June 2009. Web. 21 December 2012. Balakrishnan, Angela. “Financial Crisis: Action Taken by Central Banks and Governments.” The Guardian, 21 October 2008. Web. 21 December 2012. Barker Kate. Review of Housing Supply: Delivering Stability: Securing our Future Housing Needs. Norwich: HM Stationery Office, 2004. Print. Belka, Marek. Germany: 2010 Article IV Consultation-Staff Report. Washington D. C.: International Monetary Fund, 2010. Print. Bernanke, Ben S. “The Global Saving Glut and the U.S. Current Account Deficit.” The Federal Reserve Board, 14 April 2005. Web. 21 December 2012. Duhigg, Charles. “Pressured to Take More Risk, Fannie Reached Tipping Point.” The New York Times, 4 October 2008. Web. 21 December 2012. Federal Reserve Bank of San Francisco. “President's Speech.” 2012. Web. 21 December 2012. Krugman, Paul. The Return of Depression Economics and the Crisis of 2008. New York: W. W. Norton, 2009. Print. Labaton, Stephen. “Agency’s ’04 Rule Let Banks Pile up New Debt.” The New York Times, 2 October 2008. Web. 21 December 2012. Max, Sarah. “The Bubble Question.” CNN Money, 27 July 2004. Web. 21 December 2012. McKitrick, Ross. “The US Financial Crisis: Understanding the Causes and Consequences.” Third Age Learning Group.19 January 2011. Web. 21 December 2012. Morgenson, Gretchen. “Raters Ignored Proof of Unsafe Loans, Panel is Told.” The New York Times, 26 September 2010. Web. 21 December 2012. Olin, John M. “Competition and Crisis in Mortgage Securitization.” Indiana Law Journal 88 (2012): 1-64. Social Science Electronic Publishing, Inc. Web. 21 December 2012. Puri, Manju, Jorg Rocholl, and Sascha Steffen. "Global Retail Lending in the Aftermath of the US Financial Crisis: Distinguishing Between Supply And Demand Effects." November 2011. Web. 21 December 2012. Schmuecker, Katie. The Good, the Bad and the Ugly: Housing Demand 2025. London: IPPR, 2011. Print. Sreenilayam, and Jomon Mathew. “The Global Financial Crisis and its Impact on India's External Sector.” Munich Personal RePEc Archive, 16 January 2012. Web. 21 December 2012. The Economist. “When a Flow Becomes a Flood.” The Economist Newspaper Limited, 22January 2009. Web. 21 December 2012. Yougding, Yu. “The Impact of the Global Financial Crisis on the Chinese Economy and China’s Policy Response.” TWN Global Economy Series, 2010. Web. 21 December 2012. Read More