Causes of Global Financial Crisis

Global financial crisis (GFC, 2008-2009) is regarded as worth economic disaster since the economic depression that took in year 1929. The primary cause for occurrence of such crisis is attributed to financial industry deregulation. GFC led to the evolvement of great recessions resulting in rising of unemployment and falling of house prices. Eruption of GFC is believed to happen in year 2007 due to liquidity crisis in light of declining confidence of US investors in value of subprime mortgages. Financial crisis worsened due to high volatility and crash of global stock market by September 2008. GFC was triggered due to housing collapse in US market and it led to fall in worldwide remittance flow from 2008-2009 by 6% (Ojo 2016). It has been ascertained that according to update of IMF (International monetary fund) outlook economies of both developing and developed countries was engulfed by financial crisis and shrinking the global level of output at 2.2% in year 2009 (Attig et al. 2016). Nepal is perceived to have not been directly impacted by GFC and there are several indirect impact.

Some of the possible causes of GFC are as follows:

Global saving glut- One of the main reasons behind sharp rise in price of asset was current account deficit prevailing in US and global saving glut. Countries had modest current account and trade deficits before the crisis, there was substantial increasing in saving, and foreign borrowings were curtailed instead of becoming lender to US.  Developing countries were saving rather than buying into the capital market of world and this reversal has resulted in producing global saving glut. Advanced countries capital market were in search for investment and increasing demand resulted in rising price of assets in US including housing and stock market.

Housing prices- Substantial decline in housing price was one of the major economic shocks that triggered global financial crisis. During 1996-2006, there was increase in price of housing due to lower interest rate and demand pressures of new economy. In between middle of year 2006 and middle of February 2009, housing price started declining making it largest decline since year 1987 (Balakrishnan et al. 2016). This fall was because mortgage lending was mainly directed to rich and were not saddled to increasingly debt burdens of large mortgage.

Rising interest rate and subprime lending- Housing price rose further due to increasingly lax standards of lending and lower interest rate that is associated with saving glut. Borrowers who took out loans were largely subprime lender and the mainstream standards could not be met due to their poor credit worthiness. Fed increased rate of interest that helped in softening softly and made borrowing more costly (Dungey and Gajurel 2014). Furthermore, housing price was severely impacted due to mortgage rates moving from low rates to higher market rates.

Global Saving Glut

Credit booms- Large role played up for triggering financial crisis is the rapid credit expansion. Credit access grew at faster pace that accelerated boom in real estate market in countries such as Spain, Ireland, UK, Iceland and some other European countries. There were large cyclical fluctuations within economy due to coinciding of rapid growth in credit. Housing indebtedness rose rapidly in US after 2000 although accelerated credit growths were not much pronounced and this reflected slow growth of credit (Bauer and Thant 2015). Financial innovation, increased mortgage financing and low interest rate historically were all contributing factor in expansion of housing indebtedness.

As per business cycle theory, there is possibility of repetition of global financial crisis. It can be seen that there can be possibility of occurrence of financial crisis as the global financial system is on the expansion stage and this would lead to the chance that economy would further fall and it will reach a stage of depression.

Financial sector effects- Health of financial sector, macroeconomic performances and exposure to foreign capital market differs substantially from one country to another. The adverse impact of foreign direct investment and capital flows has adversely influenced economy of country such as India. Largest current and fiscal account deficit has affected Sri Lanka in terms of low capital inflow from outside and there was rise in spread of bond of country. Adverse impact of global financial crisis was also evident on Nepal as they are emerging from low growth situation. Fall in international fuel and food price, inflation was at its peak and financial indicators such as low capital adequacy and non-performing loans have contributed towards very weak financial sector of Nepal (Albertazzi and Bottero 2014).

Impact of remittance- GFC led to decline in flow of remittance from 2008-2009 by 6% and countries that were list hit are that of Asia pacific region at 2% compared to fall in Latin America, sub Saharan Africa ,Central Asia, Caribbean, north Asia and  Middle east.

However, case of Nepal was not usual and it did not experience flow of remittance. Flow of remittance to Nepal never declined from 1998 to 2010. It was the fifth largest remittances recipient in terms of worldwide share of GDP.

Foreign exchange reserve- Corporate sector of developing and emerging economies were significantly affected by financial crisis as there were increased funding problems and leading to foreign exchange loss. For lowering the overall funding needs of marketer, it is required to curtail the funding of foreign exchange activities of merging economies. Foreign exchange reserves of Nepalese banking system during financial crisis decelerated due to slowdown of interest income and inflow from remittance. Growth of Foreign exchange reserves in terms of 17.3% to USD $ 3.64 billion in year 2008-2009 and 21.9% to US $ 3.1 billion in year 2007-2008 (Abraham and Rajan 2014).

Housing Prices

Impact on macroeconomic balances- The term of trade stocks has led to worsening of macroeconomic balances of South Asian countries. For the past few months during the time and after financial crisis, commodity prices were falling. Current account tends to be hurt by slowdown of remittances and earning from exports (Vazquez and Federico 2015). Due to falling prices, there is likelihood that revenue earnings will also decline.

Import- The downward trend in the commodity price especially in terms of fuel and food is one of the redeeming features in terms of import. A further reduction on prices of commodities is caused due to recession in OECD countries and south Asian countries will be positively impacted by it.

Effect on housing industry- From the implications of real economy, downside impact of financial sector crisis are much substantial and direct in nature. Financial crisis created a biggest disruption in housing industry. It can be explained as follows:

Investment- The combined effect of increased non-performing assets in domestic banks and slowdown of foreign funding poses the main risk to growth as investment is adversely impacted by it.  This will owe low profits for companies that are producing export market products. Availability of domestic financing for the purpose of investment was reduced and there was slowdown in domestic investment rate. Growth and investment in South Asian countries was reduced due to slowdown of foreign capital and export earnings (Boychuk et al. 2012).

Financial crisis brought high degree of volatility in the stock market and the transmission of volatility varies from one financial market to another in terms of stock severity arising and in terms of magnitude. Global crisis of US in year 2009 resulting from subprime mortgage market collapse has led to liquidity crisis that contributed to collapse of stock market. It has been ascertained that this many countries were engulfed in this crash of stock market. During the financial crisis, shock that arise from US market has increased the volatility of New Zealand and Australia stock market. Stock market of US, Japan and Germany were identified with volatility transmission pattern. Stock market of these countries was influenced by the commencement of global financial crisis. This volatility in the stock market pushes up the borrowing cost that might result in losing of confidence of investors and it would affect the investment market in stock effect country (Bénétrix et al. 2015).

The financial sector of country like Nepal is not closely related to global financial system and they are not plagued with the adverse impact of financial crisis in the first instance. Share and investment market of Nepal does not have direct link with global investment market and it has second and third round of repercussions in terms of falling exports, declining tourisms, additional debt servicing burden and loss of foreign aid and all this had worsened trade deficit of country.  It is viewed that possibility of being victimized of there is higher degree of integration. Funds available in banks of Nepal is more than what is needed by nation and vulnerability of such reserves was attributable to indirect impact of financial crisis such as weakening consumer spending and declining aggregate demand (Cayon et al. 2017). 

Rising Interest Rate and Subprime Lending

Countries and financial system should retain some core principles for avoiding occurrence of global financial crisis. The possibility of reduction of impact of such financial crisis can be done by adopting some appropriate measures and they are as follows:

Capital planning and stress testing- Largest banks should have forward looking capital planning and stress testing. Federal reserve has designed annual comprehensive capital analysis and review that would help in the assessment of lending capacity of large banks at the time of economic downturn for continuing lending to companies sand household. Stress testing is another regulatory regime and conducting this test will help in making a forward looking and more dynamic risk based framework of capital (Obstfeld 2015). All this will help in creating transparency in the capital market of different countries.

Heightened capital regulations- Risk based capital requirement of banks should be heightened and they should have significantly more common equity in relation to risk-weighted assets (Haas and Lelyveld 2014). There should be higher capital standards for banks, regulations concerning capital should be based on risks, and they are required to have more equity capital against riskiest assets.

Tools formation for facilitating reorganization and failure of complex financial firms- A new specialized revolution should be created for complex and large financial banks (Kemp 2015). Some of regime such as single point of entry, orderly liquidation authority and total loss absorbing capacity would ensure that losses associated with any failures should be borne by long-term debt holders and not the taxpayers.

All these reforms are considered as major step and it is because of two reasons. Problems related “to too big to fail” will be addressed by the introduction of such reforms and the implicit guarantees for benefitting financial firm’s pre crisis will be reduced.  The likely of large financial firm to undergo an orderly failure has increased and this will make economic les vulnerable to crisis (Claessens and Van Horen 2015).

Conclusion and recommendations:

The report prepared deals with demonstration of causes and impact of global financial crisis on different countries with particular reference to Nepal. It has been ascertained that global financial crisis had created impact in second and third round in terms of remittances flow, tourism, foreign exchange reserves and commodity prices. Financial crisis created a cascading impact on economy of Nepal related to non-investment in productive sectors and unemployment. Financial system of Nepal has not been directly impacted by financial crisis. There was a downward impact on growth rate of country due to fall in global demand for manufactured product of Nepal. Service industry of country has also been adversely impacted by recession and global slowdown. Furthermore, stock market of different countries crashed and this limited the growth of stock market. From the above discussion, it can be inferred that global financial crisis influenced the financial structures of many countries and hampered small and medium firms along with large investment. High-income countries as well as developing countries experienced trauma of financial crisis in terms of declining of use of long-term debt and financial leverage of firms. It is required by large institutions and banks to adopt an implement above-mentioned reforms that will help in reducing the chances of occurrence of such crisis. 

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