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FIN200 Introduction To Finance Accounting

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Question:

The Global Financial Crisis (GFC) is the most significant worldwide economic catastrophe since the Great Depression of 1929. The sub-prime mortgage crisis is an example of the financial crisis that affected global financial markets worldwide. Give some other examples of financial crisis events in your discussion below.
 
Discuss the possible causes of the financial crisis. Do you think GFC could be repeated again?

Explain the scale and impact of GFC in economies of different countries including your own country. Identify some of the actual or proposed reforms which have eventuated.
 

Answer:

Introduction: 

The international financial crisis and the economic crisis of 2008-09 is not well unspoken among the government, media or in the theoretical discourse. The public hunt for the guilty without understanding the difficult causes of the disaster (Lane and Milesi-Ferretti 2018). A large part of the people believe that the culprits are the bankers, bonuses, greed, fraud, speculations and corruptions. While others have hinted that human failures in making contingent decision such as the failure of Lehman Brothers. Majority of this is neither wrong neither correct.

The credit crisis directly resulted in the decline of the mortgage market in US. When the FED (Federal Reserve of America) undertook the decision of reducing the rate of interest by 1 per cent to cover the negative impact of growth in the economy led to the commencement of the problem (Balakrishnan, Watts and Zuo 2016). The financial crisis has resulted in indebtedness and collapse of numerous banks and financial institutions not only in US but also across the world. The paper would discuss the possible causes of financial crisis and impacts of crisis on different economies. The paper would also propose reformations to avoid future crisis as well.

Examples of Financial Crisis

 

The new Triffin Dilemma: 

A system was proposed by Triffin governed by the IMF that would produce special rights of drawings as the new artificial currency basket which would substitute more for the dollars and hence transforming the IMF to central bank (Bénétrix, Lane and Shambaugh 2015). The assumption that dollar is not threatened by the hard inflation the federal reserve can pursue the fully autonomous monetary policy for external valuation of dollar. This system gave rise to number of adverse incentives. For US it flooded the economy with the inflow of capital and resulted in the overvaluation of the real exchange rate which was relative to the current account deficit of US.

The Triffin Dilemma resulted in the flooding of the US financial sector where both the risk seeking and the risk averse external capital flows led to high demand for the financial products of different types and promoted unsustainable, dangerous macroeconomic regime based on the asset bubbles (Sui and Sun 2016).

Lehman Brothers Failure and Balance of Payments: 

There was not any direct effect of Lehman failure on the domestic and the financial sector due to the limited exposure of the Indian Banks. The failure of Lehman Brothers resulted in the sell-off of the domestic markets by the portfolio investors leading to deleveraging. There was also the large amount of outflow of capital by the portfolio investors and parallel pressure from the overseas exchange market (Carson, Fargher and Zhang 2017). Whereas the overseas direct inflows reflected resilience and the access to the trade credits and commercial borrowings became difficult. The net amount of capital inflow in 2008-09 was reduced substantially with significant depletion of reserves. There was a reserve loss of US $38 billion from the US $58 billion in 2008-09 reflecting a loss of valuation.

Collapse of Financial Markets: 

The financial crisis led to direct failure in the mortgage market of US as FED’s decision of reducing the interest rate to 1% led to negative effect on the economy. The excess amount of lending resulted in the higher demand of new houses among the Americans. This gave rise to boom in housing market and price of house tripled (Lane and Milesi-Ferretti 2017). The investment banks categorized the loans and selling it as financial derivatives. However, the defaulters for Sub-prime loan increased and investment banks were unable to find buyers. This led to higher supply over demand and price of house began falling. This led the investment banks to huge loss and resulted in bankruptcies as well as closure of financial firms in US and across the world.   

 

Possible Causes of Financial Crisis:

According to the Brunn et al. (2016) it is difficult to ascertain the main reason for the international crisis. One of the main reason for the financial crisis is the dominant role of the USD. Following the Second World War the economy of US was viewed as steady and sturdiest. The rise in demand for the USD and the fear of losing out its stock of gold enabled the US to undertake the system of floating exchange rate in 1971. In order to satisfy the rising demand for USD, USA kept on printing dollar without obtaining any effective regulations. This procedure enabled the inflow of international goods and capital to the US in exchange of USD (Claessens and Van Horen 2015). More importantly, it kept the US consuming further than its capabilities resulting in consistent trade deficit. The import consumption reduced the industrial production and transformed the economy to services. The inflow of money resulted in the concept of cheaper money and higher availability of credit used in uncreative financial crisis.

Figure 1: Figure showing current account balance

(Source: Rey 2015)

Another possible factor that led to financial crisis is the unnecessary deregulation of the financial markets. US was the leader in the world of financial market liberalization. To attain this, the financial markets were excessively deregulated by the government and Federal Reserve of America relaxed its observation and monitoring procedure (Vazquez and Federico 2015). The idea of market liberalization swept the world with the push from the GATS contract. This permitted the US to expand its role as the leading player in offering financial services. Numerous financial products and derivatives was bought leading to rise in international trade and liberalization. The engagement of some financial and investment banks in the mortgage market is regarded as the instance that impact the deregulations and liberalization. This expansion gave rise to bubble which burst and frozen the entire securities market.

There was also the imbalance in the market of world trade. As noticed China has gained immensely from the joining with the WTO in 2001. China exploited the advantages of the new international system of trade and across the world it flooded with the cheaper products (Li et al. 2016). China kept its exchange rate of Yuan very low and the products of China were very competitive in the international market. China gained huge amount of surplus but US increased its trade deficit. Production of industrial and consumer goods fell down in US and the economy transformed to service economy.   

Would GFC happen again? 

As stated by DesJardine, Bansal and Yang (2017) the central banks all through the world have undertaken a quicker succession in reducing their cost of borrowing to a record of greater than $10 trillion in the negative yielding sovereign debt. This stimulates the monetary supply as the temporary measure of purchase of time and permitting the economies to recover the form the shock of 2008. But the politicians do not has the appetite of implementing the structural financial reformations for sustainable economic growth. They have only used liquidity injections from the central banks to lend the added amount of cash to meet its deficit instead of cutting the benefits or reforming it expressively.

The private sector companies have more regularly retreated from the capital investment which would normally be conducive to the economic expansion (Kerlin et al. 2016). The pullback is largely attributable to the wide range of reasons from restructuring their own balance sheets to the uncertain economic environment which has culminated in the capital planning. The net impact of this there is a rise in the international debt to -240% of the GDP. The corporate debt of US also climbed as earnings have deteriorated.

The corporate level borrowings growth is overtaking the GDP growth rate and has introduced the debt to GDP ratios in every past three US recessions (Beuselinck et al. 2017). Therefore, this makes it evident that another global financial crisis is imminent since the lead time involved among the rising corporate debt which is relative to the GDP and earlier collapses that has varied.

Impact of GFC in economies of different countries including the home country: 

The international financial crisis was notable enough to create an impact on the majority of the nations across the world. There were some of the developing nations that escaped from indulging in the recession because of having a negative growth. But the GDP of the developing nations weakened significantly from pre-crisis to post crisis level (Kenourgios and Dimitriou 2015). Brazil and Republic of Korea suffered strong devaluations ever since the outbreak of the crisis and its intensification. They were significantly affected by the crisis despite its current account surplus in 2007 that turned to deficit in 2008.

Figure 2: Figure representing decline in Nominal Merchandise of Exports

(Source: Dijkstra, Garcilazo and McCann 2015)

In Russia the GDP fell largest in the world and their international price of main exports and oil declined leading to large fall in trade and mainly beyond the global average. The current account deficit of US fluctuated in the different directions whereas the GDP of US fell to 4%. The rate of unemployment also increased to 7.2% in US while in Spain the unemployment rate increased to 11.9%.

While in the home country of Australia, the effect of financial crisis was felt on the household sector as price of house fell sharply and resulting in a 10% fall in the market Australian household economy (Ciro 2016). During the crisis of 2008-09 the Australian dollar experienced a 30 per cent fall in its value. Additionally, the bankruptcy of Lehman Brothers further worsened the foreign exchange market of Australia that forced the RBA to restrict the overseas exchange so that the liquidity position can be improved.    

 

Proposed Reformations: 

Based on the above analysis this section would present few recommendations which may assist in rectifying the mistakes of financial crisis. Firstly, there should be reformation of the WTO and global trade. The WTO is required to be more active in creating a balance in the global trade. Nations such as China must not be permitted to dominate the global trade by using unfair trade activities as there are several countries that suffer from the declining exports.

Secondly, the role of banks and rating agencies models for internal ratings suggest that these institutions must be eliminated (Gruber and Kamin 2015). The current specialized companies must reduce their entry barriers and should improve the competition. The payments by the issuer must not be allowed and payment by the investors would create a collective action problem.

Thirdly, it is proposed that the spending of government and incentive packages is considered very vital in periods of recession. However, it is proposed that the public spending must place emphasis on the construction and infrastructure activities which might result in economic growth.  

 

Conclusions: 

Opinions regarding the factors that resulted in economic crisis differs widely. The prime causes of crisis are the rising imbalance in the world trade and the parallel flow of capital during the past decades distorted the structure of globalization. The new Triffin dilemma led to flood in the financial sector with both the risk seeking and risk averse outside capital flows by creating huge demand for the financial products that gave rise to risky macroeconomic regimes. Conclusively, the international system of currency requires fundamental reformations which would reduce the international imbalance and promote orderly adjustment of exchange rate to improve the real economy.  

 

References: 

Balakrishnan, K., Watts, R. and Zuo, L., 2016. The effect of accounting conservatism on corporate investment during the global financial crisis. Journal of Business Finance & Accounting, 43(5-6), pp.513-542.

Bénétrix, A.S., Lane, P.R. and Shambaugh, J.C., 2015. International currency exposures, valuation effects and the global financial crisis. Journal of International Economics, 96, pp.S98-S109.

Beuselinck, C., Cao, L., Deloof, M. and Xia, X., 2017. The value of government ownership during the global financial crisis. Journal of corporate Finance, 42, pp.481-493.

Brunn, S., Devriendt, L., Boulton, A., Derudder, B. and Witlox, F., 2016. Assessing the impacts of the global financial crisis on major and minor cities in South and Southeast Asia: a hyperlink analysis. In Spatial Diversity and Dynamics in Resources and Urban Development (pp. 135-155). Springer, Dordrecht.

Carson, E., Fargher, N. and Zhang, Y., 2017. Explaining auditors’ propensity to issue going-concern opinions in Australia after the global financial crisis. Accounting and Finance, pp.1-39.

Ciro, T., 2016. The global financial crisis: Triggers, responses and aftermath. Routledge.

Claessens, S. and Van Horen, N., 2015. The impact of the global financial crisis on banking globalization. IMF Economic Review, 63(4), pp.868-918.

DesJardine, M., Bansal, P. and Yang, Y., 2017. Bouncing back: Building resilience through social and environmental practices in the context of the 2008 global financial crisis. Journal of Management, p.0149206317708854.

Dijkstra, L., Garcilazo, E. and McCann, P., 2015. The effects of the global financial crisis on European regions and cities. Journal of Economic Geography, 15(5), pp.935-949.

Gruber, J.W. and Kamin, S.B., 2015. The corporate saving glut in the aftermath of the global financial crisis.

Kenourgios, D. and Dimitriou, D., 2015. Contagion of the Global Financial Crisis and the real economy: A regional analysis. Economic Modelling, 44, pp.283-293.

Kerlin, J., Malinowska-Misi?g, E., Smaga, P., Witkowski, B., Nowak, A.K., Koz?owska, A. and Wi?niewski, P., 2016. European Bank Restructuring During the Global Financial Crisis. Springer.

Lane, M.P.R. and Milesi-Ferretti, M.G.M., 2017. International financial integration in the aftermath of the global financial crisis. International Monetary Fund.

Lane, P.R. and Milesi-Ferretti, G.M., 2018. The external wealth of nations revisited: international financial integration in the aftermath of the global financial crisis. IMF Economic Review, 66(1), pp.189-222.

Li, W.Y., Chow, P.S., Choi, T.M. and Chan, H.L., 2016. Supplier integration, green sustainability programs, and financial performance of fashion enterprises under global financial crisis. Journal of cleaner production, 135, pp.57-70.

Rey, H., 2015. Dilemma not trilemma: the global financial cycle and monetary policy independence (No. w21162). National Bureau of Economic Research.

Sui, L. and Sun, L., 2016. Spillover effects between exchange rates and stock prices: Evidence from BRICS around the recent global financial crisis. Research in International Business and Finance, 36, pp.459-471.

Vazquez, F. and Federico, P., 2015. Bank funding structures and risk: Evidence from the global financial crisis. Journal of banking & finance, 61, pp.1-14.

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