Causes of the Global Financial Crisis 2008

✓ Paper Type: Free Assignment	✓ Study Level: University / Undergraduate
✓ Wordcount: 4317 words	✓ Published: 25th May 2020

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In 2007, banks in the US gave out huge amounts of subprime loans and mortgages to individuals who needed them. However, most of these loans defaulted which caused the US banks to slip into a deep crisis. In 2008, the crisis began to spread to the entire financial and real sectors of the US economy. The economic crisis soon started to spread from the US to other regions which caused a recession in all the advanced countries resulting in the great recession. This led to the plunge in imports from the emerging markets as the countries wanted to protect domestic productions. Moreover, by 2009, there was a reduction in foreign direct investment to the emerging markets (Salvatore, 2019). Consequently, the emerging market economies such as Russia, Mexico and Turkey fell into recession as well.

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The three main causes include deregulation, securitization and the fed raised rates on subprime borrowers. Some other causes included inadequate financial regulations, greed, and fraud. For example, the Madoff’s Ponzi Scheme (Salvatore, 2019). Despite the numerous attempts by a few countries to save banks and financial institutes from filing for bankruptcy and preventing an economic recession, efforts only cushioned the impacts.

Impacts from the Global Crisis 2008

Diagram 2.3: Real GDP growth in 2009-2010 (Salvatore, 2019)

At the time of the global financial crisis, the Group of Twenty (G-20) formed and overtook as the committee of the World Economy, replacing the Group of Seven (G-7). The advanced economies had slow growth after the recession as they were plagued with high unemployment rates, huge budget deficits, and significantly higher debts. On the other hand, emerging markets like China and India experienced a boost in their economic growth (Salvatore, 2019). Based on diagram 2.3,we can deduce that by 2010 all the economies recovered from the recession. However, the advanced economies had slower recovery when compared to the emerging markets. Furthermore, the great recession also contributed to the decline in international trade as globalization temporarily slowed down (Salvatore, 2019).

Diagram 2.: Trade Protectionism in 2008-2009 (Salvatore, 2019)

The global financial crisis leads to a rise in trade protectionism as countries aimed to protect domestic production and jobs. Slow growth and high unemployment rates exacerbated the trade restriction problem as emerging economies like China and India were growing meanwhile. Based on diagram 2.4, we can see that China has the largest number of nations imposing protectionist measures on as it was viewed as one of the biggest threats. However, imposing trade protectionism disables advanced countries to stay competitive and reap the benefits of globalisation.

Diagram 2.5: US unemployment rate and reason (National Bureau of Economic Research)

The recession had a significant impact on unemployment rates in the developed economies. Inferring from diagram 2.5 chart 1, we can see that the unemployment rates during the global recession peaked at roughly 9 percent around 2010. In chart 2,we can see that a huge contributor to unemployment was job losers which was caused by the financial crisis. The grey area represents recession, as such, we can see that job losers started to increase from the start of the recession and continued to rapidly increase during the crisis. Hence even after the crisis ended, the unemployment rates still affected millions. The unemployment problems were amplified in countries such as Greece, Ireland, Portugal, and Spain (appendix c) due to over-borrowing, unsustainable budget deficits, and loss of international competitiveness (Salvatore, 2019).

Singapore and Hong Kong – Contagion Effects & Mitigation

Contagion Effect

Previously, we discussed the causes and impacts of the Asian Financial Crisis and the Global Financial Crisis. Both of the crises started in one region and rapidly morphed into a crisis of global dimensions (OECD, 2012). This spread of an economic crisis either domestically or internationally is referred to as a contagion (Ganti, 2019). As such, the Asian Financial Crisis that started in Thailand still had an adverse effect on both Singapore and Hong Kong.

Singapore

Singapore was not directly affected by the Asian Financial Crisis in 1997. However, it did experience an economic slowdown that led to a recession in 1998 (Valerie, 2009). The first impact of the contagion was dampened economic growth. This was largely due to Singapore’s strong ties with the other Asian economies that were impacted by the crisis. Based on diagram 2.6, we can observe that the crisis caused a dip in Singapore’s GDP growth from above 10 percent to -5 percent.

The growth was affected by the contraction in the manufacturing, construction, commerce, and transportation and communication industries led to the mass retrenchment. The number of people unemployed in 1998 rose to 62,800 people from just 34,800 the previous year (Valerie, 2019).

Diagram 2.6: Singapore Real GDP Growth from mid-1996-1999 (CEIC, 2019)

Furthermore, Singapore could no longer export as most countries had been affected by the crisis, diminishing the demand for imports. Moreover, Singapore’s exports were not as price-competitive as the export from emerging markets like China (Jin, 2019).

Another impact of the Asian Financial Crisis was currency contagion. After the Thai baht depreciated, the Singapore dollar (SGD) dropped by 18.3 percent. Although the SGD was affected, other economies experienced more drastic dips in their currencies. For instance, Indonesia which experienced a 70 percent decline in the Indonesian Rupiah (IDR). Therefore, Singapore’s nominal and effective exchange rates were relatively stable (Jin, 2000).

Thirdly, the contagion contributed to the fall in asset prices due to the negative impacts on the stock and housing markets (appendix d). Both markets experienced a drastic plunge of 60 percent and 40 percent respectively from 1997 to 1998.

Singapore government implemented various measures to help ease the financial burden on individuals and businesses upon realising that stimulating domestic demand was not viable in a downturn caused by external circumstances.

A stable corporate government (appendix e) and the credibility of policymakers were the primary sources of an investor’s confidence in Singapore despite the crisis; Singapore managed to reap profits in 1998 amounting to $1.45 billion. Furthermore, corporate borrowers were able to absorb the negative shocks in asset prices and demand, resulting from a surplus economy in the balance of payments (Jin, 2000).

Singapore’s managed float system alleviated the spill over effects of the Asian Financial Crisis. The Monetary Authority of Singapore (MAS) manages the SGD against major trading partners’ currency, which means it’s not against a single currency (Jin, 2000). This is known as the NEER, the nominal effective exchange rate which floats within a band. The target band has to be consistent with Singapore’s economic fundamentals to prevent speculative attacks or overheating. This is largely due to exchange rates being allowed to move in broader bands, floating. The flexibility protects the SGD from sudden fluctuations caused by market forces, maintaining a competitive currency in the long-term.

Lastly, MAS heavily regulated SGD and discouraged internationalisation of the currency through “MAS 621”. The regulation limited the SGD credit facilities to non-residents for financial investments, third-party trade or use outside Singapore (Jin, 2000). Additionally, residents that required SGD facilities to be used outside the country have to consult MAS before granting credit. This was largely due to the fear of destabilizing capital flows and causing greater exchange rate and interest rate instability (Ngiam, 1998). Ultimately, these regulations were supported by the strong fundamentals and flexibility of the exchange. Therefore mitigating the impact of the speculative pressure on the SGD.

Hong Kong

Hong Kong’s robust financial market was not immune to the Asian Financial Crisis in 1997. The Hong Kong Dollar (HKD) at that time was pegged to the US dollar. It came under speculative attacks due to Hong Kong’s inflation rate been significantly higher than the US (Nanto, 1998). HKD experienced high capital outflows which caused the interest rates to rise (Wright, 2019). The Hong Kong stock market fell while Wall Street and other markets also took severe hits.

During the period between 20 and 23 October 1997, the HKD became volatile and the Hong Kong Monetary Authority (HKMA) raised overnight interest rates that peaked at 200% at one point (Wright, 2019). Speculators attracted to the unique currency-board system in Hong Kong. At first, the overnight interest rates resulted in a significant increase in large net sales of the HKD. However, speculators took advantage of the situation and benefited themselves by selling HKD rapidly and shorted local stocks and the Hang Seng Index. The Hang Seng Index fell by 23%.

While the HKD was pegged, Hong Kong had more than $80 billion in foreign reserves of which the HKMA spent roughly $1 billion to help defend the HKD. Furthermore, they also bought component shares of the Hang Seng Index. The Hong Kong government targeted currency speculators and deterred them by acquiring HKD 120 billion worth of shares in various companies, becoming the largest shareholders of some of those companies (Wright, 2019). In 1999, the Hong Kong government sold all the shares and made a huge profit of HKD 30 billion. Government intervention caused a boost in public confidence in the HKD and mitigated it from further economic crisis (Nanto, 1998).

In conclusion, to successfully mitigate the risk of financial contagion, credit operations must be heavily regulated, limiting cross-border bank debt (OECD, 2012). Economies can be less susceptible to contagion by maintaining copious amounts of global liquidity as central banks play a crucial role in times of the dampened economy. Furthermore, governments should practice stringent legal capital adequacy requirements to limit capital flow. Ultimately, a strong government standing will cushion financial contagion.

Question 3

Flexible Exchange Rate System

By implementing the flexible exchange rate system, the currency value will be determined by currency supply and demand (market forces), continuously adjusting to meet the equilibrium level. At the equilibrium, the quantity demanded and the quantity supplied for foreign currency will be equivalent. The adjustments are largely influenced by the elasticities on imports and exports and it eliminates disequilibrium in the balance of payments (BOP). Additionally, the central banks/government of that particular country would not intervene when the currency fluctuates as the use of this system results in the external value of currency having no target.

For example, hypotactically, if the US dollar appreciates and can buy more HKD, the Hong Kong goods are less expensive and Americans can buy more of them. Import will demand more HKD causing the HKD to appreciates. The American goods are less expensive and Hong Kong will buy more of them. Then importers will now demand more US dollars causing the US dollar to appreciate and the cycle will continue.

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Unlike the fixed exchange rate system, monetary policies are effective to solve domestic problems however, fiscal policies are relatively ineffective. Economies are free to set interest rates that benefit domestic objectives. Deters economies from relying on foreign currency reserves, preventing import inflation. The floating rates are favourable by export-dependent countries as there it provides partial automatic correction for a current account deficit making economies less vulnerable to speculative attacks.

Fixed Exchange Rate System

On the other hand, under the fixed exchange rate system, currency values are set by the market forces, where the Central Bank gives a degree of freedom for the exchange rates on a day-to-day basis. The Central Bank will intervene by buying or selling to support or weaken a currency at a perceived equilibrium by the fixed exchange rate system. Therefore, disequilibrium in the BOP will be influenced by the changes in price level among economies.

The government/Central Bank fixes the currency value as it is typically pegged to one or more currencies. The pegged exchange rates become the official rate for trade. However, there might be some unofficial trades in the black market. The peg can be adjusted in times of economic instability, by either devaluation or a revaluation. They may also implement policy changes on interest rates to affect short-term investment opportunities also known as “hot money”. In a fixed exchange rate system the currency becomes a target of policy as a higher exchange rate control inflations while lower exchange rates boost exports.

When an economy is facing a BOP deficit, it will utilise foreign reserves to resolve the deficit.

Consequently, the deficit decreases the money supply and increases the interest rate. As price level dips, imports decrease and exports increase, improving inflow for the economy. This will stabilize the capital account. If it was a BOP surplus, the economy with accumulate the foreign reserves. Ultimately, this process triggers the supply of money hence, impact price levels until BOP equilibrium is achieved.

Developing countries that aim to control inflation should adopt the fixed rate as the certainty of currency values gives confidence to investors. Stability will contain inflation if businesses are prudent to keep unit labour costs low and drive efficiency. If a fixed exchange rate is credible, the currency will be less prone to speculation. It is important to note that monetary policies are not adequate in solving domestic problems therefore, governments depend on fiscal policies.

Flexible versus Fixed Exchange Rate System

Fixed Exchange Rate System

Flexible Exchange Rate System

Advantages

+ Create more certainty in international finance and trade, increasing investment opportunities.

+ Stronger influence over inflation compared to flexible rates.

+ Automatic correction of BOP disequilibrium

+ Monetary and Fiscal Policy can be used to achieve an internal balance of full employment and price stability

+ Deters governments from manipulating a disequilibrium fixed exchange rate resulting in the misallocation of resources.

Disadvantages

– Requirements to maintain high levels of foreign reserves to preserve the fixed rate

– Speculators will attack if there are insufficient foreign reserves.

– Monetary policy is used to maintain the fixed rate. As such, only the fiscal policy is to engage in achieving an internal balance.

– There is a broad range of exchange rate swing which makes international finance and trade tough.

MAS worked with its managed float for Singapore

Singapore does not practice the use of the flexible or fixed exchange rate system but instead the managed float exchange rate system. This system combines the features of a flexible exchange rate with an occasional intervention by the Monetary Authority of Singapore (MAS) to moderate the undue short-term fluctuations. The Singapore dollar (SGD) is managed against a basket of undisclosed currencies; the basket comprises of Singapore’s top trading partners and rivals (MAS, 2004). The importance of the currency relies on the extent of trade dependence Singapore has on that specific country.

The band of fluctuation of Singapore is undisclosed. Singapore adopts a modest appreciation of the SGD (Williams, 2016). By practicing this system, Singapore is assured of some degree of exchange rate stability, leading to lower speculative activities (MAS, 2004). However, Singapore would have to maintain foreign exchange reserves because MAS would need to intervene by either buying or selling its currency to appreciate or depreciate the SGD to meet specific macroeconomic objectives. Additionally, MAS is prudent in periodically reviewing the exchange policy to guarantee its consistency with the economic circumstances. To avoid misalignment of currency value, each review cycle is 6 months (Williams, 2016).

Singapore is primarily concerned with using exchange rates centred monetary policy to promote price stability, striving for a low and stable inflation rate (MAS, 2004). Price stability serves as a strong foundation of stable economic growth as it promotes consumer and investor confidence, ultimately enhancing our export competitiveness, encouraging foreign direct investments (FDI) having a positive impact on our balance of payments (BOP). Based on the merits from 1981 to 2010, the exchange rate system has proved to be effective in maintaining healthy domestic inflation, averaging 1.9% per year. Furthermore, the exchange rate system has shielded Singapore’s economy from short-term volatility adverse effects on the real economy whilst, ensuring that the exchange rate is aligned with economic conditions (Williams, 2016).