Impact of Global Financial Crisis on the Global Financial System - Essay Example

What impact did the Global Financial Crisis (GFC) have on the global financial system? How did Australian policy makers deal with the problems presented by the GFC? Introduction The global financial crisis (GFC) of 2007-2008 started in July 2007 in the United States and worsened into a full blown economic crisis in the following months. The crisis climaxed when Lehman Brothers Holding Inc., a global investment bank, collapsed in September 2008. With the collapse of this bank, the world financial system was nearly brought down. The ensuing crisis caused a destruction of many financial markets, especially in the developed countries such as the United States and others in Europe such as the United Kingdom. Against this background information, the purpose of this essay is to evaluate the impact that the GFC had on the global financial system and how Australian policy makers dealt with the problems presented by the financial crisis. The essay will analyse the effects of the crisis on various countries across the world by looking at both developed and developing countries. On how Australia dealt with the effects of the GFC, the essay will evaluate the measures that were put in place by policy makers in the country to deal with the effects of the crisis. The GFC and its impact on the global financial system A financial crisis or credit crunch, such as the GFC of 2007-2008, arises when there is an unmanageable decline in the supply of wealth and money, with participants in the financial system losing confidence in the system and refusing to fulfil their debt obligation (Gockel, 2010, p. 1). This causes an environment that stifles further creation of credit and causes lenders to ask borrowers to repay their existing loans. It was such occurrences that were unleashed in 2007, whereby investors lost confidence in the value of securitised mortgages as well as default on financial instruments that were highly rated in the US and the UK (Gockel, 2010, p. 1). Consequences of these occurrences spread quickly beyond financial markets in the US and the UK to other developed nations across the world. What commenced in the United States as a mortgage crisis thus developed into a financial and economic crisis affecting the entire world, and which forced the Federal Reserve Bank of the US, the Bank of England (BoE) and the European Central Bank to introduce unprecedented amounts of money into the financial markets to stabilise them (Gockel, 2010, p. 1). The effects of the crisis on the global financial system varied across different countries as discussed next. Overall, the GFC caused a full-blown systemic crisis to the financial markets of both emerging and advanced economies. Soon after the crumbling of the subprime mortgage sector in the US, the international financial system went through a period of mayhem (Adair, Berry, Haran, Lloyd & McGreal, 2009). According to Guinigundo (2009), the GFC not only caused enormous wealth destruction, it also reduced confidence in financial markets and financial institutions the world over. Globally, Adair et al. (2009) note that a loss of about US$7 trillion was experienced in the world’s stock markets during the year 2008. With these effects, there were concerns over liquidity and a multiplicity of bankruptcies, forced mergers between different players in the financial sector, and considerable injection of monetary assistance by financial authorities to help stabilise the financial sector. The result was a drastically reshaped global financial landscape (Guinigundo, 2009, p. 317; Adair et al., 2009). In the United States for instance, Nanto et al. (2008) argue that some of the biggest and most respected banks, insurance companies, and investment houses either declared bankruptcy or had to be rescued with financial assistance. Further, by October 2008, credit flows had frozen and lender confidence had diminished. The Dow Jones dropped by over 50 per cent from its high of 14,000 at the end of 2007 to 6,500 at the beginning of 2009, with over one trillion dollars of value lost in the stock market in roughly one year. Because of the economic slump, the United States’ government’s ability to achieve its national goals such as stability, sustaining cooperative relationships with other countries, and maintaining a financial infrastructure that facilitates smooth working of the international economy was severely affected. Similar occurrences reverberated across other countries, and one after another the economies of the affected countries went into a recession (Nanto et al., 2008, p. 2). The effects of the GFC were felt in Europe because the financial markets in the US and Europe are greatly integrated due to the cross-border operations of securities brokers, investment banks, as well as other financial companies (Nanto et al., 2008, p. 28). Because of this integration, financial and economic developments that affect national economies in one region are difficult to control and are swiftly spread across national borders. Since financial corporations respond to a financial crisis in one region, their responses can tip out to other regions as they pull away their assets from banks located in other countries to protect their domestic operations. This is what happened in some countries in Europe as firms reacted to the financial crisis in the United States (Nanto et al., 2008, p. 28). In the UK, when the BoE drew parallels between the financial crisis in the United States and the fiasco in the UK property market in April 2007, not many people were concerned. Similarly, in many nations in Europe, the financial crisis was at first dismissed (Adair et al., 2009, p. 3). This is probably one of the reasons why responses by many governments in regard to the predicament were eccentric, inept and lacking global cohesion (Adair et al., 2009). The impact of the GFC in the UK was that house prices fell noticeably (by as much as 14.7 per cent) in 2008. As well, the UK’s IPD All property Total Return Index was -28 per cent while Ireland recorded a SCS/IPD Index of -32.4 per cent in the same year (Adair et al., 2009). Japan is also one of the countries whose economies were in recession during the GFC, with its stock market declining by 42 per cent in 2008 (Adair et al., 2009). In a bid to deal with the situation, Japan, like other major economies, also decided to flood the market with additional finances. Just like the BoE and the Federal Reserve Bank, the Bank of Japan injected several billions of dollars into Japan’s financial market in 2008. The bank also announced that it would provide an unlimited amount of credit to institutions operating in Japan to shore them from the crisis (Nanto et al., 2008, p. 42). Many other less advanced economies were equally affected by the GFC. In particular, reduced foreign investment by the advanced economies that were adversely affected by the crisis coupled with reduced imports of labour-intensive commodities and products had pronounced impacts on developing countries (Abreu, 2009, p. 2). The effects of the crisis were first witnessed in the financial segments and eventually extended to the real sectors of the countries that were affected. In the financial sectors, the areas that were affected include the banking sector and stock markets. The real sector impact was experienced in areas such as trade, remittances, aid flows and foreign direct investment, and involved countries such as Ghana, whose economic growth slowed from 6.3 per cent in 2007 to 6.2 per cent in 2008 and 5.9 per cent in 2009 (Ackah, 2009, pp. 6-7; Gockel, 2010, p. 3). In Asia, developing countries experienced significant declines in their stock markets (27 per cent for Singapore and 21 per cent for both Thailand and the Philippines) (Guinigundo, 2009, p. 318). In particular, increased global market interconnectivity led to a significant drop in the stock markets in Asia, depreciation of regional exchange rates, widening of sovereign bond spreads, and a decline in offshore bank lending in the affected countries (Guinigundo, 2009; Park, Ramayandi & Shin, 2013). How Australian policy makers dealt with the problems presented by the GFC Australia is cited as a country whose economy performed particularly well during the GFC vis-à-vis other common law jurisdictions, such as the US and the UK, as well as other advanced economies around the world (Hill, 2012, p. 1; Brown & Davis, 2011, p. 1). However, although the effect of the GFC was less severe in Australia than in the two aforementioned countries, it cannot be said that Australia went through the crisis unscathed. For instance, there was a significant number of corporate collapses in the country (such as Absolute Capital and Basis Capital) in which investors from Australia lost more than $600 million (Brown & Davis, 2011, p. 2; Hill, 2012, p. 3). In addition, in the period 2007-2009, there were collapses amounting to A$66 billion, and the corporations that went down included Babcock & Brown, Allco Finance and ABC Learning (Hill, 2012, p. 15). Other collapses that resulted in significant losses to consumers included that of Opes Prime Stockbroking Ltd and Westpoint Group (Hill, 2012, p. 15). Further, even though banks in Australia were not directly impacted by the crisis in the United States, the reduced confidence in the financial services sector and the slump in global trade had some effect on the Australian economy. For instance, there was a decline in stock markets, the Australian dollar depreciated in value, the cumulative net wealth of the country declined, unemployed levels rose, and a wave of uncertainly rocked the economy (Chesters, n.d. pp. 1-2; Australian Bureau of Statistics, 2010). Australia’s success in navigating the GFC has been attributed to the country’s policy makers’ intervention through fiscal and monetary policy responses, which include significant cuts in interest rates on overnight cash lending, provision of stimulus packages from the government to both financial institutions and households, enforcement of bank guarantee mechanisms and other balancing policy strategies that were implemented as the crisis ensued (Cusbert & Rohling, 2013, p. 2). These measures were supported by surplus budgets, having a robust economy, effective prudential regulation and having considerably low levels of debt (Quiggin, 2013, p. 6; Tiernan, 2010, p. 2). In regard to prudential regulation of the banking sector in Australia prior to and during the GFC, it is argued that the measures that had been put in place by policy makers ensured that Australian financial institutions had no possession of ‘toxic’ securities like those that impacted other global financial institutions adversely (Australian Bureau of Statistics, 2010). Hence, the health of the banking system in Australia enabled effective fiscal and monetary response to the effects of the GFC on the Australian economy. For instance, quick and effective fiscal and monetary intervention allowed a great deal of the slackening in monetary guidelines to be conveyed through to rates of interest on loans to businesses and households, which is contrary to the result in other advanced economies (Australian Bureau of Statistics, 2010). Australian policy makers had also prepared for any event of a financial crisis through the concept of “inevitability, predictability, and manageability” (Littrell, 2011, p. 2). This concept implies that policy makers in Australia were cognisant of the fact that financial crises were inevitable, and had put measures in place to predict any crisis and manage it. This is unlike the situation in the US and the UK where the first indications of the crisis were ignored. Policy makers were aware that in the banking sector for instance, crises emanate from excessively rapid and inadequately sound capital growth, which ultimately causes loss of confidence and a crisis in liquidity (Littrell, 2011, p. 3). Through the Australian Prudential Regulation Authority (APRA), Australia had established a stronger capital quality and promoted effective credit underwriting practices. APRA had also worked hand-in-hand with other policy making organisations in Australia such as the Reserve Bank of Australia, the Treasury , and the Australian Securities and Investments Commission (ASIC) in preparing for the possibility of a crisis (Littrell, 2011, p. 3). This means that when the crisis eventually occurred, Australia’s economy was well prepared to deal with its impacts. Conclusion In summary, the GFC significantly altered the global financial system in that in many of the affected countries, there were concerns over a credit crunch, collapses of financial and investment institutions, depreciation of currencies, sharp declines in the equity markets and other related challenges such as increased unemployment. Consequently, many governments were forced to inject more finances into the financial markets to rescue the affected institutions and stabilise them. Australia was not affected by the crisis as much as many of the advanced economies because of the measures it had in place to deal with a possible occurrence of a crisis. Australian policy makers were aware that financial crises were inevitable in any economy, and therefore came up with ways of predicting any crisis and managing it. Thus, when the GFC eventually occurred, the Australian government intervened swiftly through measures such as reducing interest rates on overnight cash lending, providing stimulus packages, enforcing of bank guarantee mechanisms, and deploying other stabilising policy measures. References Abreu, M.P, Agarwal, M., Kadochnikov, S., Mikic, M., Whalley, J., & Yongding, Y. (2009). The effect of the world financial crisis on developing countries: An initial assessment. CIGI Task Force on Developing Countries. Retrieved from http://www.cigionline.org/sites/default/files/task_force_1.pdf Ackah, C.G., Aryeetey, E.B., & Aryeetey, E. (2009). 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Retrieved from http://www.apra.gov.au/Speeches/documents/apec-sc-speech-cwl-2-0.pdf Nanto, D.K., Weiss, M.A., Jackson, J.K., Dolven, B., Morrison, W.M., Cooper, W.H., & Donnelly, J.M. (2008). CRS Report for Congress. Retrieved from http://fpc.state.gov/documents/organization/115947.pdf Park, D., Ramayandi, A., & Shin, K. (2013).Why did Asian countries fare better during the global financial crisis than during the Asian financial crisis? In C. Rhee & A.S. Posen (Ed.), Responding to financial crisis: Lessons from Asia then, the United States and Europe now (pp. 103-139). Manila: Asian Development Bank. Quiggin, J. (2013). Macroeconomic policy after the global financial crisis. Risk and Sustainable Management Group Working Paper Series, Working Paper: P13_3. The University of Queensland, Brisbane. Retrieved from http://www.uq.edu.au/rsmg/WP/Australian_Public_Policy/WPP13_3.pdf Tiernan, A. (2010). Weathering the global financial crisis: Reflections on the capacity of the institutions of Australian governance. Paper prepared for presentation at the American Political Science Association Annual National Conference, Washington DC, September 1-6, 2010. Retrieved from http://www98.griffith.edu.au/dspace/bitstream/handle/10072/34649/64980_1.pdf;jsessionid=7BD7BAA30221CCD34A4C073BBD084AE3?sequence=1 Read More