The Emergence of Problems in the Us Sub-Prime Housing Loan Market

By September 23, 2016 Education

The background to financial meltdown was the emergence of problems in the US sub-prime housing loans market in the first half of 2007, which amounted to approximately 15 percent of the stock of housing loans. The failure of the US investment bank Lehman Brothers sparked a severe loss of confidence not only in financial sectors, but also in businesses and households who responded by cutting spending. This in return have a sharp fall on demand for manufactured goods, global industrial production and contractions GDP in major economy (Edey, 2009). So the explanation stresses the factors that are common to all financial crises, among which voices from China and the US are especially elevating. Former US Treasury Secretary Paulson regarded China??™s high saving rate as one of the factors resulting the crisis, while Chinese officials considered American overconsumption as a factor. This essay sets out to discuss the merits of two points respectively. The essay will firstly portray the background of the crisis, and then evaluate merits of Paulson??™s assertion from China??™s high foreign exchange reserve, namely saving, furthermore, with the capital flow from the China, it will examine trade deficit and overconsumption in the US, finally the essay will provide some response by government in respect to the complex financial situation.

When the global economy began to meltdown in 2000s, coincidentally, as the attack on September, 11th, 2001, the Federal Reserves initialed a long period of interest cut in order to attract consumption and investment (Bernard, 2007).This advances new homebuilders to enter the home mortgage market on lower credit ratings whereas with higher interest rates ??” the phenomenon now known as subprime credits. This trend of the enhancing liquidity provided with balance of payment surplus countries such as China endangers the credit spiral. With the development of credit sector, balance of payment deficit stimulates the demand of dollars, triggering the inflationary trend, in return, promoting federal to raise interest rate. As the raise of the interest rate, sub-prime mortgage thus break out as a leading edge of financial hurricane. Inappropriate interest rate sends public misleading signals of feasibility of future purchase today ignoring tomorrow. From perspective of Palson, China actually provide foundation for American to be able to overconsume or invest in light of hugh saving. China holds the view that American??™s overconsumption while inadequate saving prick the subprime credit bubble.

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China??™s owns top foreign exchange reserve, hitting $1.9537 trillion by the end of March is mainly attributable to two factors (China foreign exchange reserves at $1.954 trillion, 2009). One determinant is the low export costs. First, China??™s traditional strengthen low labor cost is notable around the world (Eghbal, 2008). Besides, Chinese government??™s willingness to facilitate export has been long attaching importance, providing large amount export subsidy. China will raise the export tax rebate for a wide range of products including clothing, light industry and finished goods since April 1st, while textiles will be increased to 16 percent (Analysts skeptical about impact of export tax rebate hike, 2009). Thirdly, it is generally believed that Chinese exchange rate is undervalued, which provide protection for domestic companies from import and give them more incentives to export (World Trade Organization, 1998). Notably, the real exchange rate is determined by supply and demand in the market for foreign-currency exchange. Net capital outflow represents the quantity of local currency supplied for the purpose of buying foreign assets. Net exports represent demanded for buying domestic net exports of goods and services (Mankiw, 2008). IMF regarded exchange rate as the rate that determines the equilibrium of balance of payment. It is necessary to give brief explanations about balance of payment. A country??™s balance of payments accounts record its international trading, borrowing and lending, among which are three accounts in which current account is regarded as the main component. By far the largest amount in current account is the value of exports and the value of import, known as net export which equals net capital outflow, just as mentioned previously (Parkin, 2005; Powell, 2005). As long as China continues to run balance of payment surplus and maintains limitations on capital outflows, there is compelling judgment that RMB is undervalued (Goldstein, 2004). This will be explained via figure below. As China experiences hugh net exports, the demand for local currency will shift right which push the real exchange rate. On the other hand, for Chinese binding restrictions on net capital outflow, the supply of local currency decreases, then the curve shifts left which will also push real exchange rate. Shifts in figure suggest the undervaluation of Chinese exchange rate (Mankiw, 2008). Three elements above binding together explain China??™s minor export costs. The second determinant is the imbalance of saving and consumption between China and foreign countries, especially America. China owns the highest saving rate in the world, now nearly 50 percent (Glick, 2008). In other words, trade surplus is a kind of saving in terms of foreign exchange reserve. China??™s strong saving desire and America??™s significant consumption in essence contribute to imbalanced trade structure between countries. This unbalanced saving and consumption result in the China??™s hugh foreign exchange reserve in return.

Real interest rate
Real interest rate

E1

E1

E2
E2

Quantity of local currency
Quantity of local currency

Reserves are used either for intervention to support local currency in the foreign exchange market and for direct payment to foreign monetary authorities (Williamson, 1976). With two determinant??™s buildup, foreign exchange reserve is presumed a much more significant role in central bank balance sheets and monetary policy operations. Indeed, central bank??™s recently reserve purchase has been the key player in allocating patterns of capital flows across the nations and the main vehicle for investment abroad( Higgins, 2004; Klitgaard, 2004). A country with a surplus saving except the need of domestic investment sends this amount to purchase foreign assets. In contrast, a country with a shortage of saving like the US would borrow abroad maintaining higher level of investment. As Chinese made goods flow into the US, which keep inflation in the US low as well as the flowing of Chinese capital, the American has the foundation to overconsume. Virtually, China provides finance for the US to consume. From this perspective, Paulson is not absolutely in fault. Also, it is one reason that American suffer from huge trade deficit, which reinforce import of the US, resulting in trade deficit. This can be demonstrated in the statistics. In the past 30 years, income in American??™s median families has boosted by about 75 percent, whereas families yield less in disposal from around 10 percent in 1970s to less than 2 percent in early 2000s. Meanwhile, they have raised 5 percent of annual income in consumer debt to 35 percent now. Saving less and future purchase, overconsumption has taken a terrible toll on American families (Warren, 2003).

Compared with the first factor which induce the trade deficit, American??™s large budget deficit is another determinant that is comparatively complex, which close in on $1 trillion just halfway through the fiscal year 2009(Bater,2009). Budget deficit occurs when public sector is dissaving, an excess of spending over receipts, where private sector is saving little as well in the US. The government deficit will conventionally lead to capital inflow and crowd out investment. Particularly, budget deficit represents negative public saving, so it will lower national saving; shift the supply curve left, increase the real interest rate and contract loanable fund. It is illustrated in figure a. As the interest rate rises in figure b, net capital outflow reduces; in return, diminish the supply of local currency in the market for foreign-exchange from S1 to S2 in figure c. This fall in supply of local currency causes the real exchange rate to appreciate from E1 to E2 and a decrease in net capital outflow. As the exchange rate increases, goods in domestic are relatively expensive than foreign goods, thus push trade deficit (Mankiw, 2008). This can be explained that a Nation??™s saving equals to the domestic investment and net capital outflow. That is to say, when citizens save their income, it is used to finance domestic investment or finance capital abroad (Adams, 1988). Namely, there is little argument about the role of investment in the long-term, presumably, saving and foreign capital inflows as determinant of economic behavior. Thus, fears of deficit that offset the economic growth always exist. When the nation experiences budget deficit, it will increase exchange rate and then run trade balance toward deficits. Inevitably, in Chinese view, lack of saving is indeed a factor that triggers the crisis.

(a) Real interest rate
Real interest rate
The market for loanable funds (b) Net capital outflow

S2
S1

R2
B

R2

R1

R1

NCO
Demand

Quantity of loanable funds
Net capital flow

S1
S2

Real exchange rate

E1
E2

Demand

Quantity of local currency
( c) the market for foreign currency exchange

Now that the crisis has taken place, the US is able to apply relative stringent money policy to mitigate its consumption. The central bank can reduce aggregate money supply, then the supply curve shift left, pushing interest rate higher. As the relationship between the price of bond and interest rate is inverse, rise in the interest rate would result in the decline in price (Carreiro, 1997). The present value is discounted at rate R from now for N years, getting amount C, can be generalized in equation as PV = C/(1 + r)n. China??™s seventy percent of foreign reserve, which is the world??™s largest, hold in US dollar-denominated assets such as Treasury bonds, also the top holder (McLancy, 2009). Consequently, as interest rate raises, present value of bond would reduce which is relative less attractive to Chinese capital, leading American??™s more saving while less consumption. So the market policy from the US to have low interest to encourage consumption and investment should also be responsible. Talking about the China, World Bank comment that $587 billion stimulus bag which invests in low-cost housing, rural infrastructure and education will help to yield growth to personal consumption and spending on services( World Bank: China stimulus to sustain Asia??™s growth, 2009).

In conclusion, the assertion from the American and Chinese official has merits respectively. From perspective of Palson, China indeed provide foundation for American to be able to overconsume or invest in light of hugh saving. While American??™s overconsumption while inadequate saving actually prick the subprime credit bubble. No one can smooth over the problem without the help of other economy in the present situation. Therefore, as long as countries could unite and be aware of the flaws in each economy and find the appropriate measures, financial meltdown will be overcome as soon as possible.

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