Reasons Behind the Global Financial Crisis of 2008 - Research Paper Example

INTERNATIONAL BUSINESS ENVIRONMENT INTRODUCTION The “credit crunch”, although preparing since a long time, actually became evident in mid 2007 and all the way into 2008. Globally, the securities markets have gone down, and some of the biggest financial institutions have been bent or bought, and some of the wealthiest governments have had to prepare strategies to rescue their financial systems (Shah, 2009). At the outset, this paper will aim to highlight the primary and major underlying reasons behind the global financial crisis of 2008. It discusses how the adoption of the capitalist system of economy led to high levels of mortgages and securitization problems in the economy which, in turn, made way for the financial crisis to hit the world. In these economies, people were extremely indebted and their dependence on leverage increased with time. Furthermore, there was a global macroeconomic imbalance. Due to the high levels of exports of the eastern countries, they generally experienced a trade surplus. On the other hand, the high consumption patterns of the western countries caused them to experience trade deficits. To help deal with that gap, the west took advantage of the free flow of capital in the financial market and increased its dependence on leverages even more. The essay then discusses the case of China. With US$2.56 trillion worth of exports and US$870 billion worth of foreign investments according to Gu (2009), China’s dependence on the prosperity of global economy was evident. The financial crisis, therefore, hit China hard. However, China responded to the problem quickly. China made many changes in its policies. With an adoption of expansionary fiscal and monetary policies, China made investments in projects and constructions to grow employment levels and improve the conditions. These helped China deal with the problem, at least in the short run. The paper then moves on to discuss the analysis and evaluation of the policies and how, eventually, the only way for China to revive completely from this crisis is if the global economy, especially United States’, stands back on its two feet. Finally, some concluding remarks are given for China as to what kind of an economic system should China adopt. DISCUSSION CAUSES OF THE GLOBAL FINANCIAL CRISIS OF 2008 The cause of the global financial crisis can be ascribed to a number of factors like the Housing Bubble, the Subprime Mortgage Crisis, the global macroeconomic imbalances (Acharya, 2009), incorrect pricing of risk, financial innovation and complexity and heavy reliance on leverage. Capitalism Capitalism, by many is viewed inherently unstable due to the many speculations involved in it e.g. producers believe that their sole purpose is to produce and the consumers will feel the need to buy on their own and will buy the product. At the same time the competitive nature and the right to gain maximum profits, has finally shown its bad side (Katsuhito, 2008). The fact that the New Financial Architecture (NFA) is based on weak assumptions, which presumed that unregulated capital markets are “efficient” and they price risk and return accurately, hindered in understanding and addressing the financial meltdown on its onset which aggravated the matters to such an extent that the Global financial crisis of 2008 comes only next to the Great Depression of 1930’s, in terms of the financial destruction caused (Crotty, 2008). Adam Smith said, “financial market needs to be more regulated than other markets”; the subprime mortgage crisis and the incidents leading to it clearly show the significance of his words (Akrasanee, 2009). The Housing Bubble and the Subprime Mortgage Crisis In the earlier part of the 21st century, there was excess capital in the economy and investors were looking for low-risk investments. This put a lot of confidence in the mortgage market which was deemed as low-risk investments as per the credit rating assigned by the credit agencies. Given that, the U.S house prices started to rise around 2002. Hence, demand for mortgage investments got higher and at the same time the mortgage guidelines loosened. Leading from Stated Income Verified Asset (SIVA) loans, which asked people to just ‘state’ their income rather than provide prove, to No Income Verified Asset (NIVA) loans where the borrowers were only required to show some amount of money in their bank account to qualify for a loan, and eventually to No Income No Asset (NINA) where a borrower need not to state or verify his income or assets (Subprime Mortgage Crisis Explained, 2008). With the introduction of new loose credit policies, buying a home became easy. According to Second-Home Market Surges, Bigger than Shown in Earlier Studies (Anon., 2005), in the US alone, there were 72.1 million homes resided in by owners. There are 43.8 million secondary homes out of which 6.6 million are vacation homes. The demand for investment homes soared higher, which in turn increased the prices of the houses, which in turn attracted more investors. People took loans to pay their installments because of the speculation that the house prices would go higher and yield greater returns. With over 9% of house loans in 2004 given to people with poor credit histories, the housing market was signaling a crisis about to befall (Housing Bubble: Housing Statistics).The prices remain high till 2006, until borrowers started defaulting on their first loan payments. The risk involved with mortgage securities increased, people incurred heavy losses and house prices decreased. Securitization Securitization shifted the loans from the balance sheets of the banks to capital markets where they were priced precisely and distributed resourcefully. This, in exclusion to the lowering risk faced by banks, enables the bank to give out more loans as more capital is freed up. Hence the ability of the financial institutions to create loans enhanced which facilitated the mortgage loan takers (Mohan, 2009). Over-dependence on leverage The U.S households were overly indebted. And if this wasn’t enough, during the same time, the giant bank conglomerates took enormous risks under the NFA. Since the global financing system is so intricate, it is impossible to estimate risk associated with the portfolios of the giant conglomerate banks. The regulators enabled many such banks to calculate and predict their own risk, and devise a list of their own capital requirements, which in turn lead to excessive risk–taking. Hence, reliance on leverage increased (Crotty, 2008) Innovative financial products and the risks associated with them Innovations in financial products reached a pinnacle where products such as MBSs and CDOs have become so compound that they are sold “over the counter” (OTC), through negotiations between a small number of buyers and the originating investment bank. As reported by the Securities Industry and Financial Markets Association (SIFMA), MBSs accounted for $7.4 trillion in quarter one of 2008 alone. In both 2006 and 2007, more than $500 billion dollars in CDOs were issued (SIFMA, 2009). The creation of such compound products like MBSs, at one hand, allowed giant banks to make huge profits and other financial institutions but at the same time destroyed their transparency. Thus pricing the risk associated with such products correctly was impossible since no firm was willing to give the time or had the ability to price the OTC products. Therefore, they lost liquidity (Crotty, 2008) Global Macroeconomic imbalances The global macroeconomic imbalance is also said to be a factor that resulted in the Global Financial Crisis. The West consumed too much and the East produced too much. Free flow of capital and goods, coupled with the open financial market of the West that provided freedom of financial transactions and gave incentives to encourage short term gains, and enabled the West to purchase more. The structure and nature of the financial markets facilitated the accumulation of large financial reserves which could then be used to purchase commodities. This resulted in a persistent trade deficit for the U.S. The Eastern nations, on the other hand experienced surpluses, being the producers (Mohan, 2009). The free flow of capital in the financial markets helped facilitate and exacerbate these imbalances between the industrialized and the developing World. (Akrasanee, 2009) ANALYSIS OF CREDIT CRUNCH IN CHINA THE NEGATIVES Like most of the countries in the world that were moving towards a capitalist economic system, China was hit by credit crunch as well. China had been a staunch believer in the theories of Karl Marx and had strong traits of Marxism in its political, cultural and economic system. In the recent past, however, China has been moving towards a capitalist system and, like the rest of the world, experienced a phase of recession because of it. With its rapid economic growth, China has proved to be the third largest economy in the world. However, China depends heavily on international trade and its foreign reserves as a way of growing the economy. This is illustrated in Figure 1. Figure 1 China's International Dimensions (Source: Gu, 2009) According to Gu (2009), international trade in China was worth US$2.56 trillion as of 2008, and foreign direct investment, amounted to more than $870 billion. Moreover, the foreign reserves of China are at around $1.95 trillion. More than 50 percent of these are invested in US government and agency bonds. Lastly, more than 25 million employees in China are those that work for multinationals inside China (Gu, 2009). So basically, China is heavily dependent on the growth of the international markets and the development of the global economy as a way of growing its own economy. This heavy dependence on global development must mean that the pains of the global financial crisis were worse for China than any other economy that did not depend so heavily on its international dimensions. However, some actually believe that because of its closed economy it was less affected by the global financial crisis (Chiu, n.d.). The increasing trend in the Chinese international trade and foreign direct investment till the year 2005 is shown in Figure 2. Figure 2 General Trend in the a. growth of International Trade and b. Foreign Direct Investment in China (Source: Liu, J. & Diamond, J., 2005) The biggest problem for China, of the global financial crisis, was the rapid decrease in its employment levels. A number of small and medium sized businesses closed down or faced crisis, as a result. More than 20 million people living in the rural areas have lost their jobs (Gu, 2009). Moreover, around 6 million Chinese graduates are facing problems getting an employment (Gu, 2009). The revenues that China lost from a loss and shrinkage in international trade were also significant. Trade in China dropped by 24.9% one year before the crisis (Gu, 2009). This shrinkage was predicted to remain and grow in the following years. CHINAS POLICY RESPONSE Increase in Retail and Investment As discussed in the previous sections, the financial crisis hit China hard. However, China responded by looking for open opportunities. Two things, according to David Li, are increasing in China rapidly as a way to make up for the loss in international trade. The retail sector is growing rapidly and exponentially while a number of investment projects in China are also being initiated (McKinsey Global Institute, 2009). Throughout history, urbanization has been slow in China. However, it is now increasing, as evident from the growth in retail and investment. Therefore, China is now racing up to urbanization by increasing its total retail and investment. In the past few years, investment has accounted for 45 percent of GDP. It is predicted in 2009 that investment will go up as high as 60 percent of the GDP (McKinsey Global Institute, 2009). The evidence of how dependent the Chinese economy has become on investment is shown in Figure 3. Also, a glimpse of how much the online retail industry in China has grown is illustrated in Figure 4. Figure 3 Investment in China (Source: Finfacts, 2009) Figure 4 Increase in Online Retail in China (Source: Herman, 2009) David Li predicts GDP to grow by 9 percent while Tang Min and other distinguished business people of China believe it to be as high as 7 percent. (McKinsey Global Institute, 2009). According to David Li, an example of an investment project underway is the subway lines being built in the Beijing underground (McKinsey Global Institute, 2009). Fiscal and Monetary Stimuli Other than looking for opportunities in retail and investment, China also stressed on making the Chinese market bigger to insist on fuel growth. This strategy is actually what provides China with the fiscal sustenance of infrastructure and state investment projects for the public. However, its monetary policy is what proved to be more effective (Zhang et al, 2008). The Stimulus Package Figure 5 GDP Trends (Source: Chinability, 2009) As the chart shows, China faced a steep decline in the GDP growth from the end of year 2007 and 2008. The Chinese government, however, was quick to respond, introducing a huge stimulus package of Rmb4 trillion to boost in the economy in the coming years. (Yongding, 2009) Item Amount (RMB, bn) Share (%) Transportation and Power Grids 1800 45.0 Post Earthquake Reconstruction 1000 25.0 Rural Infrastructure 370 9.25 Environment Projects 350 8.75 Public Housing 280 7.0 R&D 160 4.0 Health and Education 40 1.0 Sum 4000 100 Table 1 Components of the Fiscal Stimulus Package (Source: Zhang et al, 2008) It is evident from the table that most of the investments in the package had been directed towards the uplifting of the social infrastructure through construction and other projects to have a positive impact on the growth rate and employment growth rate. According to the president of the Asian Development Bank, this stimulus package is expected to promote construction and relevant industries, create employment opportunities, and foster social balance and stability (Kuroda, 2009). According the new budget of 2009, the government would spend a total of 7.635 trillion Yuan resulting in a record government deficit of 950 billion Yuan (Yongding, 2009). Also, the Central Government deficit would rise up by 570 billion Yuan compared to the previous year. And the predicted budget deficit of 2009 would be approximately 3 percent of the total GDP (Yongding, 2009). Monetary Policy To complement the expansionary fiscal policy, China’s government also undertook an expansionary monetary policy to deal with the financial crisis. For instance, there was an increase of 7.3 trillion RMB in the bank credit. There was a huge growth in the money supply as well. (Yongding, 2009) Relative to United States and European countries, China had different financial conditions. It wrote off all non-performing loans and infused a hefty amount of money into the banking system. This ensured a great deal of liquidity increase in the inter-bank money market which resulted in a quick growth in bank credit. ANALYSIS Even though the global financial had a serious impact on the Chinese economy, it devised a strategy that seemed to work for it, for the better. It has been quick to respond to the crisis. An evidence of the fact that China has grown out of the global financial crisis successfully is shown by a steady increase in China’s foreign portfolio, which should have been the most badly affected . This is illustrated in Figure 6 below. Figure 6 China's Foreign Portfolio Trend (Source: Bsetser, 2009) Other than the general increase in the foreign portfolio, the expansionary fiscal policy proved to be very beneficial towards the revival of the economy. The fiscal position of China has been very strong. With having minimal deficits and, sometimes, surpluses, even this major expansionary policy would cause a debt of only 20 percent of GDP. Such fiscal policies would be beneficial for China to deal with the lack of demand present due to the shortage of export demand. (Yongding, 2009). More than that, the global proportions of China’s monetary policy characterize how China turned a serious crisis into a huge opportunity. Although, china was conservative in managing its resources, it seemed to work for it. Under this approach, reserves were kept safe while keeping in mind the liquidity and profitability. Also, it led to no disruption of the global markets such as that of the US. However, even though these policies have stopped the fall in growth for now, their long term impact is questionable. First of all, as a result of such heavy investment, it is likely that China will face over capacity. Secondly, even if it does not face this overdrive, the stimulus package is certainly an obstacle in the way of investment, even though it is focusing more on the infrastructure. According to Yongding, “with an investment rate of 50 per cent and a GDP growth rate of 8 per cent, the incremental capital to output ratio will be as high or more than six.” (Yongding, 2009). Moreover, infrastructure investment might be a great way to stop overcapacity in investment but combines together with a lack of investment in manufacturing might not bring any revenues. Especially because investing in infrastructure is a slow process and will take a long time to generate revenues. Finally, looking over to the monetary expansion side of China, it is easy to see that its monetary policy is too lenient. China does not need to decrease the benchmark interest rate to such a low level. With such low interest rates, there will be no motivation for small and medium sized businesses to set up against state owned monopolies. Therefore, the plan may backfire. CONCLUSIONS AND RECOMMENDATIONS Globalization has removed all boundaries and hence made the world the interconnected place that it is today. This makes one wonder what the next level of the global financial crisis is going to be; whether this next stage is going to be bettter or worse. There is no short cut to fight this. The better thing would be that the global financial crisis, especially in the US, will balance withing the next two years. People will become more confident about starting new entrepreneurship ventures. This would greatly improve the employment levels in the US, and China eventually, which depends heavily on the stablaization of US as a way of its economic growth. New entrepreneurship opportunities and initiatives is the definitive solution to fighting the global financial crisis. However, things could also go bad. If they do, the credit crunch will go on for a number of years, perhaps 10 years. Moreover, if the US prints more money as a way of fighting the credit crunch and repaying its debts, the value of the dollar will go down. This would lead to a serious imbalance in the global economies. As far as China’s policy response to the global financial crisis is concerned, it was a good one to make the economy grow again and to create jobs, but only in the short run. Its policies of increasing investment in infrastructure and loosening the monetary policy has long term implications that China needs to becareful of. China has tasted the dose of Marxism under the Mao Zedong rule (Brooks, 2009). It might be tempting, and perhaps incorrect, to conclude that because of the problems and negative consequences of that regime, Marxism should be scratched out from the list of options for China’s economical system. On the other hand, a pure marxist system might not be an ideal choice for China either. There is enough proof to see that the capitalist system has played a major role in leading the world to a financial crisis. Adopting a pure capitalist system, therefore, might be an unintelligent decision on China’s end. It would also widen the already large gap between the rich and poor in the country. China is doing the right thing by adopting traits of Capitalism to encourage some level of development and innovation combined with some attributes of Marxism for supervision. This would help China achieve the benefits of both the approaches while minimizing the risks involved. REFERENCES 1. Brooks, M. (2009) "World economy in crisis - The financial panic: where are we now?". In Defence of Marxism [Internet]. Available from http://www.marxist.com/financial-panic-where-are-we-now.htm [Accessed January 18, 2010] 2. Acharya, V. V. & Richardson, M. (2009) Restoring Financial Stability. 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