Worlds Financial and Economic Crises - Assignment Example

Assessment 2 (Question 2) Introduction The past decade has witnessed a number of economic and financial crises that have affected the developed countries. In the mid of the turbulence of these crises, market participants and financial analysts have pointed out that there are going to be spillover effects that are going to affect the developing countries and this may have significant impact on the global financial markets. The developed countries are suffering from detrimental crisis especially after the depression that occurred in 2007. The beginning of the global financial crisis has been associated with the 2007 U.S. subprime financial crisis (IMF, 2010). The element of contagion is related mainly to the periods of crisis when the elements of transmitting shocks are largely felt. The contagion can be fast and furious in the sense that it can be significant and immediate occurring in the short term when shocks are transmitted between financial markets. At the same time, the contagion can shift and significant increase in the linkages in the cross market as a result of shock being felt in one country (OECD, 2007). World’s Financial and Economic Crises There are several financial and economic crises that have had contagious effects on other economies over the years. Some of the crises that have had great impact on world economies include: Swedish Financial Crisis of 1990 to 1994: there was a deregulation of the Swiss credit market in 1985 and this led to the bubble of commercial asset speculation. The bubble burst was observed in between 1990 and 1994 and this led to 90% of banking industry experiencing massive including the largest banks in Sweden. The impact of the crisis was felt mainly by stakeholders as the governments bailed some banks and others were destroyed by the crisis fail. However, taxpayers did not suffer because of the government recouped losses by reselling assets and dividends (DREA, 2008). Wall Street Crush of 1929: in the late 1920s, there were several investors who made contributions to speculative bubble in the stock market. Most of the investors went into debt as they purchased stock and this led to over $8.5 billion in debt in various parts of the country. In 1929 October 24, there was panic among the investors and this led to massive selloff and it tanked the stock market. Consequently, this contributed to the Great Depression that occurred in the 1930s. Although the Rockefeller family that headed major banks bought large volumes of stock, it did not build the confidence of the investors. Consequently, there was a $30 billion market loss – this was higher than the total costs that the U.S. had spent during WWI. The crisis led to the stock markets crushing, businesses closing, massive layoffs, and high level of bankruptcies. The dollar also experienced international run and therefore, there was an increase in interest rates thus driving thousands of lenders out (DREA, 2008). Japanese Asset Price Bubble of 1986 to 1990: when the Second World War ended, the domestic policies of the Japanese encouraged individuals to save money. A number of people banked their money and this made it easier for companies to access loans as well as lines of credits. The yen appreciated and investors were reaping benefits in the financial markets. In addition, the people could easily access credit to develop properties and to buy homes and this led to speculative real estate bubble. There was resultant inflation of real estate prices and there was no ceiling on stock prices but by 1990s, the bubble started sinking. As a result, there was a decrease in estate and stock values. Investments were made in other countries but investors across the globe who had invested in Japan were affected and companies lost competitive advantage on global scale (DREA, 2008). The Asian Financial Crisis of 1997 to 1999: before the crisis, Southeast Asia was a region for international investment. The short term interest rates for the ASEAN countries were high and these rates were favorable for foreign investors. There was flooding of capital into the region. The prices of assets increased and a high GDP of 12% and the phenomenon was referred to as ‘Asian Tigers’. On the other hand, South Korea, Indonesia and Thailand were experiencing deficits and borrow a high amount of money and this made them vulnerable to foreign market changes. The impact was felt on exports in China, the U.S. and Southeast Asia. This is because; there was panic among global investors who decided to withdraw credit and with time, the currencies in the region depreciated and there was domination of liabilities in terms of foreign currency. The economic sectors collapsed and this led to people living in a state of poverty. Currencies and stock markets were devalued and primarily, the entire Asian region experienced economic instability (DREA, 2008). Russian Financial Crisis of 1998: it began in 1993 when the Russian government introduced the inflation- free short term treasury bills or the GKOs. The purpose of GKOs was to fund the deficit of the country. The government wanted to increase capital and in 1997, it increased the interest rates of GKO. At the start of 1998, GKO payment interests formed about fifty percent of the government’s revenue and thus it was the main source of income for domestic banks. On the other hand, the government had not paid wages amounting to about $12.5 billion. More money was being obtained from GKOs compared to taxes. Investors’ confidence decline in regard to the Russian government and thus, they sold Russian rubles and securities. Although the central bank tried to stabilize the ruble, it was unsuccessful and it spent about $27 billion of the U.S. dollar reserves. The Russian market collapsed, globally, investors panicked and left the market, backs were closed and there was increase in inflation (DREA, 2008). Argentine Economic Crisis of 1999 to 2002: as a result of the Latin American crisis of 1980s, Argentina became volatile. The country ran low on U.S. dollars and its currency was losing confidence leading to inflation. The government was spending on lavish things and the country’s industrial infrastructure was crumbling. The impact of the crisis was largely felt by Brazil and Mexico because they were the major trading partners with Argentina. Latin America was also affected as it suffered economic crises. The country also suffered because there was a recession that lasted for 3 years. The crisis was made worse because the government did not devalue the peso neither did it un-peg the peso from the dollar. Recession became deeper and this affected investors hence forcing them to run banks to access dollars and sent it abroad for security purposes. The government responded by freezing people’s bank accounts. There were protests in major cities, fires were started, and properties were destroyed. There was violence and fatalities and by 2001, the government had collapsed. The people were affected to the extent they did not have the cash to purchase commodities and they decided to engage in barter trade. There was a shutdown of businesses. A large number of people survived by depending on cardboards that they scavenged and took to recycling plants (DREA, 2008). Evidently, from these few cases of financial and economic crises, it is apparent that, when there is economic or financial crisis, they are contagious and they affect the respective sectors, countries, and other countries as well because they affect investments made by foreigners. The financial and economic crises affect interest rates, investment and capital inflows and this means that; the citizens of the affected country as well as investors from other countries are affected. The financial sectors and banks are affected and this leads to subsequent impact on companies which means the citizens are less likely to access employment. Inflation that results also makes the situation worse for individuals and companies. Therefore, in general, financial and economic crises does not affect one region or one sectors but spreads affects the entire economic and even have global impact. Contagion of Financial and Economic Crises In the present, the world is experiencing problems of global financial and economic crisis that has severely affected the world mainly since the second part of 2008. The reason for the global financial and economic crisis has been linked to the sub-prime mortgage crisis that occurred in the United States in 2008. This problem was first observed in mid 2007. The other countries were later affected (Ghon, 2008) In the main, it is true that financial or economic crises are contagious. This is because; when one region is affected, the other regions are affected as well. For example; in the second half period of 2008, the global economy experienced immense economic and financial crisis. The 2007 United States sub- prime crisis led to global financial crisis with conditions deteriorating fast, financial and prices of real assets collapsed, and there was a sharp decline on consumer and business confidence. It became the period of the worst recession that ever occurred since the Second World War. In other words, because of the economic crisis in the United States, the other countries across the globe were also affected. The first to be affected was Europe and after that; the contagion was spread to the other parts of the world and East Asia was also affected. The state of the present global financial crisis is exceptional in regard to the scale of the problems especially in Europe and the United States. In addition, although different parts of the world are affected by the financial and economic crises, the differences occur in terms of the speed and depth of the contagion spread through trade linkages and through financial sector linkages. The severity of the recession depicts exceptionality mainly in emerging market economies, in East Asia and in small countries (McDonald & Morling, 2011). Apart from the U.S. sub-prime mortgage crisis that affected the United States, Europe and the rest of the world, there are other financial and economic crises that have been found to have contagious impact to other regions economically and financially. The Great Depression of the 1930s is one of crises. The Great Depression led to increase in unemployment rates for example; in the United States, the rate of unemployment reached 25%. Global financial and capital markets were also affected to an extent that; financial institutions and banks faced a high percentage of losses that impaired their capital. Due to the loss of credit-worthiness of the financial institutions and banks, there was a sharp decline in the interbank market transactions and a plunge in the stock prices and therefore, this led to a degradation of global financial stability. There was great financial uncertainty, a decline in stock markets, debt securities and money and as a result, it was very difficult for firms to access funds (OECD, 2007). Channels of Contagion The channels contagion include; financial conditions at the global level, financial markets affected by changes in equity prices. For that reason, financial or economic crisis in one region affects the economic situations of other regions as well because the financial markets become volatile and equity prices fall at various stages under risk aversion and heightened uncertainty (See Chart 1) Chart 1: Equity Prices The U.S. sub-prime crisis that occurred in 2007 also affected different sectors of economy especially the financial sector. The crisis in the U.S. significantly affected the liquidity and the solvency of several financial institutions in different parts of the world and in turn, this led to the share prices of banks falling sharply while other primary financial institutions experienced collapse. By affecting liquidity and solvency of financial institutions, economic crisis affects the write-downs made by the global bank which often, causes loss provisions. For example; in the 2007 case of the United States, there were loss provisions of over 2 trillion U.S. dollars at the end of 2010. This forced the banking sector in most of the developed countries to re-capitalize through injection of funds by the government (McDonald & Morling, 2011) (See Chart 2). Chart 2: Bank Loss by Region (write-downs) The other channel of contagion of economic crisis from one country to another is interest rate. When there is an economic crisis, it leads to a rise in the difference “between the yields on short- term inter- bank instruments and the expected official cash rates”. This leads to decline in the level of confidence that people have on financial institutions to offer credit and increase in the perception of the value of liquidity hoarding. Like in the case of 2007 financial crisis in the U.S., it led to global financial crisis in 2008 and difference on bank instruments of the expected cash rate reached about 100 basis points for Australia, 300 basis points for United Kingdom, and 400 basis points for the United States (McDonald & Morling, 2011). See Chart 3 Chart 3: Differences in Interest Rates Capital inflow is another channel that economic crisis uses in spreading to other regions and this is especially for the advanced economies. Between 2002 and 2007, there was about 6% global GDP increase but there was 2% global GDP in 2009. This was due to the decline in gross capital inflows from 21% of 2007 GDP to 0.7% in 2009 whereby both advanced and emerging economies were affected (McDonald & Morling, 2011). (See Chart 4). Primarily, before the sub-prime mortgage crisis occurred, the United States had actively invested in the world stock markets. Based on data, investors the United States held foreign stocks that was approximately $5 trillion by the end of the year 2007 (see Table A) and on the other hand, foreign investors were holding U.S. stocks that was approximately 3.1 trillion by the end of 2007 June (see Table B). Therefore, this is an indication that; the net investor in foreign stocks was the United States. In other words, the United States made a significant contribution to the growth of global stock markets through the expansion of investor bases of the other countries. Additionally, the United States had invested actively in European stocks and accounted for about fifty percent of the total foreign stock investment (Ghon, 2008). The United States also had the largest investment in the United Kingdom and accounted for 18% of the U.K. stock market capitalization. The other countries that the United States had invested in stock market capitalization included: Japan 12%, France 12% and Germany 15%. In east Asia, the United States Investors held stocks as well and its presence was felt. This is because in countries such as Hong Kong, the U.S. investors accounted for approximately 36% of the Hong Kong’s total value of stock being held by foreign investors. In the case of Indonesia, it was 38%, 50% for Japan, 50% for Korea, 33% for Malaysia, 43% for Singapore, and 34% for Thailand (McDonald & Morling, 2011). Basically, the United States was the largest investor in these countries and therefore, financial and economic crises in the United States meant that capital inflows would be significantly affected across the globe. Chart 4: Capital Inflows (Global) Table A: Foreign Stocks Held by United States Investors (as by the end of 2007) Region/ Country Amount (in Billion $) Percentage of Domestic Market Capitalization UK 638 18 Japan 526 12 France 346 12 Germany 318 15 Korea 125 11 Hong Kong 118 10 China 96 2 Total 4,956 Percentage of Total Common Stock Europe 2,484 50 East Asia 1,182 24 Latin America 205 4 Source: U.S. Treasury Data Table B: Amount of United States Stock Held by Foreign Investors (As of June 2007) Region/ Country Amount (in Billion $) Percentage of Total Foreign Holdings UK 421 13 Canada 526 11 Cayman Islands 346 9 Luxembourg 318 8 Japan 125 7 Total 3, 130 Percentage of Total Common Stock Europe 1,594 51 Latin America 871 28 East Asia 560 18 Total Corporate Equities (U.S.) 27, 768 Source: U.S. Treasury Data In the main, as a result of the U.S. sub-prime mortgage crisis in 2007, the financial conditions were deteriorating fast and this spread and economic conditions also deteriorated. The world economic growth experienced a sharp decline and it fell from more than 5% in 2006/2007, to -0.5% in 2009. This is noted to be the first shrinkage of the global economy that had ever been experienced since the World War II. In addition, the economic activity in the developed economies declined by 3.4% in 2009 while in the case of the emerging and developing economies, the performance was even stronger as it grew by 2.8% in 2009. In Chart 5, it shows the impact that the sub-prime mortgage crisis had on the annual global economic growth. Chart 5: Annual Global Economic Growth Apart from the figures, the extent and the speed of decline especially in the second half of 2008. Basically, the global growth experienced a decline from 3.8% in June 2008 (quarter) to -2.8% in March quarter of 2009 hence there was a percentage point turnaround of 6.6%. The degree of decline during this time was similar for emerging and developed economies. In particular, economic growth for the developed economies experienced a decline from 14% in the June quarter 2008 to -0.5% in the March quarter 2009 which was the same as 6.3% point turnaround. The turnaround for the emerging economies was greater compared to the advanced economies as it feel from 7.7% in 2008 June quarter to 0.6% in 2009 March quarter hence it was a 7.1% point turnaround (McDonald & Morling, 2011). The contagion of economic and financial crisis that affected the United States was also indicated on the trade. In other words, trade linkages form another channel of contagion of economic and financial crises. The case of the U.S. sub-prime mortgage crisis significantly affected the world trade. The impact was such that; there was a sharp decline of world trade in such that; three months before 2009, the annual trade had fallen by 40% compared to the previous three months. In fact, the world trade value experienced an even sharper decline as reflected by the sharp decline in terms of prices as shown in Chart 6. In addition, the rate of world industrial production experienced a slow growth in the first half of 2008. That is, at the end of 2007, industrial production was about 4% and by June 2008, it was about 0.5%- this was reflection of a decline in industrial production in advanced economies. During the second half of 2008, industrial production on global scale had declined drastically for both advanced economies and emerging markets with a fall of more than 20% per year by the end of 2008. Furthermore, as the advanced economy experienced continued decrease in industrial production during the first half of 2009, there was a rebound in emerging markets especially in Asia with annual growth being recorded at 17% in the 3 months before June 2009 as shown in Chart 7 (McDonald & Morling, 2011). Chart 6: Impact of Financial and Economic Crises on World Trade Chart 7: Impact of Financial and Economic Crises on Industrial Production Contagious Effects of Financial and Economic Crises The main contagious effect of financial and economic crises is associated with the impact that it has on economies. For example; with the occurrence of the U.S. sub-prime mortgage crisis, Australia’s economy experienced a fall and this was reflected in the decline of equity prices that feel by about 50% from the previous year (2007). Australia was significantly affected to the extent that, Australia’s equity market declined further than that of the U.S. and global equity markets during that period. This was because; the international capital flows collapsed and therefore, it was difficult to access funding. Domestically in Australia, the contagion was exhibited by the ceasing of insurances into the Australian Residential Mortgage- Backed security or the RMBS market even though there was a rather low default rate on Australian mortgages (IMF, 2010). The contagion of financial and economic crises leads to decline in demand for exports. When there is economic and financial crises, the global economy becomes weak and therefore, there is a resultant fall in the volume and prices of exports and subsequently, the country’s terms of trade and the exchange rate decline and thus, a resultant decline in terms of trade. Contagion of economic and financial crisis is also depicted on confidence of customers and business. When there is an economic or financial crisis in one region or one country, business confidences and customer confidence fall dramatically. This is because; financial and economic crises influence investment decisions and more so, they affect business conditions causing business and customers to exhibit low levels of confidence (IMF, 2010). Complications of the Contagion of Economic/ Financial Crisis As much as it is evident that contagion of financial and economic crises is apparent in such that; when it affects one country, it also affects the others, there are some that have been complicated such as the sub-prime mortgage crisis that occurred in the United States. Compared to the other crises that had occurred in the past such as; the Great Depression in 1929 and 1930s, the Savings and Loan crisis of the 1980s and 1990s (in the United States), the Long Term Capital Management Crisis of 1998 (in the United States), and the IT bubble bursting of 2000 to 2001, the sub-prime mortgage crisis was far much more complicated (OECD, 2007). There are different reasons for the complications. First is that; there were several securitized derivatives and assets that had been sold and bought in the over- the- counter market and this affected the counter party credit. Risks of liquidity were much more severe compared to the situation of exchange- traded items. In addition, there was no precise information about the reality of the financial situations of a number of financial institutions as the crisis continued and this triggered the level of anxiety that was being experienced by investors and financial institutions. As a result, there has been curtailing of financial flows and investment and this has caused adverse effects on financial and real sectors to a large extent (Ghon, 2008). The other reason for the complication is that; adequacy requirements for capital were applicable only to commercial banks and therefore, it was not applicable to other financial institutions including; investment backs, hedge funds and financial companies. Therefore, when there is contagion resulting from financial and economic crises, financial institutions are not protected for example under insurance deposit insurance system in case there is a financial crisis. In addition, it is not easy for credit rating agencies to capture the dangers involved in collateralized debt obligations and even mortgage –backed securities. This is attributed to the fact that; the risk rating practices for these agencies are usually based on historical data and therefore, forward- looking risk analysis associated with newly developed financial assets cannot be easy. In that effect, the rating by the agencies in the face of market turmoil increases the anxiety levels of the investors and promotes fire sale of the products (Ghon, 2008). Conclusion When economic or financial crisis occurs, there are several outcomes and mainly, the impacts are contagious because they spread from the affected sector or countries to other sectors and other countries. There are several financial and economic crises in different parts of the world that have proved that financial and economic crises are contagious for example; e Great Depression in 1929 and 1930s, the Savings and Loan crisis of the 1980s and 1990s (in the United States), the Long Term Capital Management Crisis of 1998 (in the United States), and the IT bubble bursting of 2000 to 2001 and many more. The financial and economic crises lead to inflation, unemployment, decline in investment, collapse of financial institutions and banks, decline in capital inflows, increase in interest rates, decline in exports and numerous other effects. Putting into perspective the detrimental effects of financial and economic crises, it is important for respective governments to execute the most appropriate response that would help in curbing the hazardous impacts of financial and economic crises. The fiscal and monetary policies play an important role in increasing effective demand and recovering business and customer confidence. By having fiscal stimulus, financial stability is bound to occur because credit flow will be experienced in businesses and in households and therefore, governments should work on developing and implementing policies that would improve the economic situation and hedge countries from the contagious effects of economic and financial crises. References DREA. (2008). 10 of the World’s Most Dramatic Financial Crises and their Lessons. Business Pundit. http://www.businesspundit.com/10-of-the-worlds-most-dramatic-financial-crises-and-their-lessons/ (October 25, 2012) Ghon, Rhee, (2008), “The Subprime Mortgage Crisis: Financial Market Perspective,” a paper presented at the 4th APEC International Finance Conference, November 10, 2008. IMF. 2010, 'The Fund's Role Regarding Cross-Border Capital Flows', IMF Policy Paper, 15 November, IMF, Washington DC. http://www.imf.org/external/np/pp/eng/2010/111510.pdf (October 25, 2012) McDonald, T. & Morling, S, 2011, The Australian Economy and the Global Downturn, Economic Roundup Issue. http://www.treasury.gov.au/PublicationsAndMedia/Publications/2011/Economic-Roundup-Issue-2/Report/The-Australian-economy-and-the-global-downturn-Part-1-Reasons-for-resilience (October 24, 2012) Organization for Economic Co-operation and Development (OECD), 2007, Financial Market Trends, No.93, Volume 2007/2. Read More