Analysis of The Effects of Subprime Mortgage Crisis

Analysis of The Effects of Subprime Mortgage Crisis on Chinaand Related Policies1.Subprime mortgage crisisThe subprime mortgage crisis is an ongoing financial crisis triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States, with major adverse consequences for banks and financial markets around the globe. The crisis, which has its roots in the closing years of the 20th century, became apparent in 2007 and has exposed pervasive weaknesses in financial industry regulation and the global financial system.Approximately 80% of U.S. mortgages issued in recent years to subprime borrowers were adjustable-rate mortgages. When U.S. house prices began to decline in 2006-07, refinancing became more difficult and as adjustable-rate mortgages began to reset at higher rates, mortgage delinquencies soared. Securities backed with subprime mortgages, widely held by financial firms, lost most of their value. The result has been a large decline in the capital of many banks and USA government sponsored enterprises, tightening credit around the world.2. Causes of Subprime mortgage crisis2.1 Boom and bust in the housing marketLow interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing market boom and encouraging debt-financed consumption. While housing prices were increasing, consumers were saving less and both borrowing and spending more. Household debt grew at the same time.Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.2.2 SpeculationSpeculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis.Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, this behavior changed during the housing boom. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them.Speculative borrowing contributed to rising debt and an eventual collapse of asset values.2.3 Policies of central banksCentral banks manage monetary policy and may target the rate of inflation. They have some authority over commercial banks and possibly other financial institutions. They are less concerned with avoiding asset price bubbles, such as the housing bubble and dot-com bubble. Central banks have generally chosen to react after such bubbles burst so as to minimize collateral damage to the economy, rather than trying to prevent or stop the bubble itself. This is because identifying an asset bubble and determining the proper monetary policy to deflate it are matters of debate among economists.2.4 Financial institution debt levels and incentivesMany financial institutions, investment banks in particular, issued large amounts of debt during 2004–2007, and invested the proceeds in mortgage-backed securities (MBS), essentially betting that house prices would continue to rise, and that households would continue to make their mortgage payments. Borrowing at a lower interest rate and investing the proceeds at a higher interest rate is a form of financial leverage. This is analogous to an individual taking out a second mortgage on his residence to invest in the stock market. This strategy proved profitable during the housing boom, but resulted in large losses when house prices began to decline and mortgages began to default.3.Impacts of Subprime mortgage crisis3.1 Impacts on China’s International TradeChina’s export-oriented companies have been facing a demand drop affected by the U.S. subprime mortgage crisis. The subprime crisis has reduced consumption demand and risk tolerance of U.S. and European investors, which will affect China’s exports and the operation of export-oriented companiesAffected by the subprime crisis and disastrous snowstorms, the economic growth of Zhejiang, Jiangsu and Guangdong provinces slowed down.It heavily hit Chinese exporters, especially mid-sized and small enterprises,with hundreds of thousands of workers becoming jobless.As a result, the unemployment rate is roaring. It might also add to the country's inflationary pressure due to rising asset prices.3.2 Impacts on China’s FinanceThe direct losses of Chinese banks from the U.S. subprime crisis were not especially large in the amount. The ICBC, China's largest commercial lender, suffered a loss of 1.2 billion U.S. dollars from the crisis.Meanwhile, the successive interest rate cuts by U.S. Federal Reserve "will also affect China's interest rate and monetary policy since the interest rates of different countries now have closer ties than before.3.3 Impacts on China’s Foreign Currency ReservesAt the end of 2008, China’s foreign exchange reserve had reached US$1.95 trillion. Ac cording to the preliminary report on foreign portfolio holdings of US securities at the end of June 2008, China held US$535 billion in US treasury bonds, US$544 billion in US agency bonds, US$27 billion in US corporate bonds and US$100 billion in US equities. Even considering that the PBoC sold agency bonds and bought short-term treasury bonds in the second half of 2008, it can still be concluded that China’s foreign exchange reserves are heavily allocated in US dollar-denominated assets, especially US treasury and agency bonds.Following the subprime crisis, the US government has applied very loose fiscal and monetary policies. To finance the rescue package, the US government has only two choices. The first is to issue more treasury bonds, at least US$2 trillion in 2009. If the demand for US treasury bonds is unable to keep pace with the supply, their market value will decrease. As the largest holder of US treasury bonds, the PBoC will therefore suffer a significant loss. The second choice is that, if other investors are unwilling to continue to buy US treasury bonds, the Fed will become the buyer of last resort, meaning that the US government will take up the printing of bills. Unavoidably, the inflation rate will surge and the US dollar will depreciate against other major currencies. Therefore, the international purchasing power of China’s portfolio of US dollar-denominated assets will shrink markedly.4.The Chinese Government’s Reaction to the Global CrisisFollowing the bankruptcy of Lehman Brothers, the Chinese government changed its policy emphasis from curbing inflation to ensuring stable economic growth. The macroeconomic policy combination includes an active fiscal policy, a loose monetary policy and a stable exchange rate policy.4.1Active Fiscal PolicyAt the National People’s Congress premier Wen Jiabao claimed that China’s economy would grow by 8 per cent this year.In terms of fiscal policy, a RMB4 trillion (US$588 billion) investment plan was released in November 2008, one of the largest fiscal rescue packages world-wide.To stimulate short-term economic growth and to speed up structural reforms, China is making increasing household consumption its top priority. The most effective way to boost consumption is to increase household income. Xie Xuren, China's Minister of Finance stressed that the country would continue to cut personal taxes in 2009. He added that China would not levy taxes on bank deposit interest earnings and would not increase taxes on stock trading in 2009. China will continue to lower the stamp duty for stock trades in 2009. And maintain a freeze on taxes on interest income from savings and stock accounts.Moreover, the Chinese government started to employ more fiscal resources to provide social welfare, such as education, heath care and social safety nets, which could significantly reduce the uncertainties in household expectations about future income and expenditureTo fight against the pressure of unemployment, the Chinese government is now not over-rely on maintaining export growth, due to declining external demand and soaring protectionist pressures will weaken any measure by which exports are stimulated. Alternatively, China is promoting employment by opening up and developing the service sector which is labour intensive, just like the export sector. To boost investments in the service sector, the Chinese government continue to cut corporate taxes in 2009 and increase tax rebates for exporters, especially those in labor-intensive sectors.4.2Loose Monetary PolicyChina will continue to implement a "moderatedly relaxed" monetary policy and keep sufficient liquidity in the banking system, said the PBoC (People's Bank of China).Specificaly, the RMB’s deposit and loan interest rates have been cut from 4.14% and 7.47% to 2.25% and 5.31% respectively. The required reserve ratio has declined from 17.5% to 13.5%. The credit quota applied by the central bank on commercial banks was cancelled in the fourth quarter of 2008. Bank loans increased by RMB1.62 trillion in January 2009, one third of the increment recorded in 2008.More support has been given to the agricultural sector, small and medium enterprises and other weak links, concretely resolve some financing difficulties faced by companies, strictly control lending to high-polluting, high-energy consuming industries and to those with over-capacity.What’s more, the PBOC has signed currency swap agreements with the Republic of Korea, China's Hong Kong Special Administrative Region, Malaysia, Indonesian, Belarus and Argentina since the global financial turmoil, totaling 650 billion yuan.4.3 Stable Exchange Rate PolicyAt a high level meeting of world leaders at Davos, Switzerland Premier Wen Jiabao pledged to keep the renminbi at a “reasonable and balanced level”.As for its exchange rate policy, the PBoC has increased its intervention in the foreign exchange market since the third quarter of 2008,halting the appreciation of the RMB against the US dollar. Also, The Chinese government should speed up the diversification of its foreign exchange reserves exploiting the window of opportunity thrown open by the global financial crisis.In the first place, the PBoC should stop buying US treasury bonds unconditionally. It is inevitable that China will lose some money when the dollar devalues in the future. Taking advantage of the good exchange rate now and gradually selling our U.S. treasury bonds is the only rational choice.Meanwhile,The Chinese government needs the US government to provide some sort of guarantee on the market value of US treasury bonds.Additionally , a large proportion of China’s foreign exchange reserves could be invested in the energy and commodity markets and the global stock markets, because their valuations are far more reasonable now than hitherto. Especially, investing in the energy and commodity markets now will help the Chinese economy to hedge the risk of price hikes in the future.Last but not least, China has 600 tons of gold reserves, less than 10 percent of the reserve in U.S. In the long-run, the dollar may fail but the gold will not. So to increase our gold reserve is bound to be a good choice. We may also increase other strategic material reserves as well.5. ConclusionsWe do not doubt the Chinese government’s capacity to stimulate short-term economic growth.The countermeasures the Chinese government has adopted so far might not ensure sustainable economic growth and could entail some new risks.Firstly, China should transform its growth model from export-driven to domestic demand-driven in order to sustain long-term economic growth, which means that the government should try to increase household consumption. However, the fiscal resources to increase household income and provide social welfare are very limited.Secondly, too many resources have been allocated to infrastructure and property investments, and there is a potential risk underlying them. As for infrastructure, there is already an over-investment and excess capacity in certain fields, such as motorways and hydroelectric power stations; in property investment there are still obvious price bubbles in many coastal cities. A surge in investments might aggravate resource misallocation and property price bubbles.Thirdly, the huge amount of banking loans granted from the fourth quarter of 2008 to the first quarter of 2009 might trigger a new surge in non-performing loans (NPLs) on the balance sheets of China’s commercial banks, and NPLs will eventually become a fiscal burden.Fourth, the PBoC has done little to diversify its foreign exchange portfolio from US treasury bonds and agency bonds, although these assets are becoming increasingly dangerous in the mid-term and long-term.A currency swap (or cross currency swap) is a foreign exchange agreement between two parties to exchange principal and fixed rate interest payments on a loan in one currency for principal and fixed rate interest payments on an equal (regarding net present value) loan in another currency. Currency swaps are motivated by comparative advantage. Currency swaps were introduced by the World Bank in 1981 to obtain Swiss franks and German marks by exchanging cash flows with IBM.。