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One of most important events in economics history

Financial crisis have been one of the most important events in the history of world economics. The two most important crises are the two most recent ones, these are important for number of reasons. The most important one is the scale and cotangent effects of both the crisis and the impact on the world business and economics.

The purpose of the research is to review and examine the academic literature on Current financial crisis and Asian financial crisis and attempts to identify the parallels and differences between the crises and how the lessons learned from the Asian financial crisis could have helped in minimizing the effects of current crisis.

My paper will also try to evaluate the role of governments and leading financial institutions like IMF and World Bank in these contexts. Also try to highlight the effects of these crises on the society or general public by utilizing the latest available economic data.

Furthermore, the study aims to focus on the policies that lead to these financial and economic disasters. Section I of the study will include introduction to both crisis in brief. Section II will outline the main causes. Section III will discuss the role of IMF and World Bank. Section IV will discuss the lessons were drawn from the previous crisis and current crisis and wetter or not they were applied. Sections V will fuscous on the effects of these crises on the world economy by utilizing the data from World Bank and IMF, such as the projections of world economic indicators. In last section, study will try to evaluate and summaries the result of various academic literature

Introduction

Asian financial crisis took place in 2007. It took place in Thailand when government abandon its local currency Thai Baht because it collapsed under huge speculative pressure. This caused panic amongst the investors of the region. The results were further currency collapses and wider spread capital flight from the region. This capital flight crippled the regional economies. The effects were felt all around globe. These economies were known as “Asian tigers” as they were the fastest growing economies on the planet. The crises was severe enough that even Japanese economy felt prey to it. These economies eventually recovered with help of IMF and other world economic power but the fallout meant that regional economic growth suffered terribly.

In the case of current financial crisis more commonly known as Credit crunch the main cause of the crises was the financial innovation and undervaluation of risk. Current financial crisis started taking shape on February 27, 2007 when Freddie Mac1 in one of its press releases announced that it will no longer buy the most risky sub-prime mortgages. It announced that it will only buy the mortgages with variable interest rates. This event mostly went unnoticed and most people ignored it as domestic U.S. news. They were assured that house prices in U.S. was at all times high and their investments in subprime housing sector and other CDO bonds was safe. This event was followed by few bankruptcies and then suddenly almost overnight everything fell apart, causing wide spread speculation and panic. Investors saw markets around the world crashing before their eyes.

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Nonetheless the crisis spread like wild fire and is still here after almost 2 years. This crisis has sent all of major economies into recession and investors have lost billions of dollars all over the world. No one can deny the losses and severity of the crisis. The entire world is trying to find the solution to this problem but still there are people like Chari, Christiano, and Kehoe (2008)2 who say it is nothing more than a myth. They form a small school of thought and hardly any one supports them.

Asian financial crisis originated at the closing years of last decade of the 20th century. It originated from Thailand, which until that time was dubbed as Asian tiger due to rapid growth it achieved via financial reforms after collapse of Bretton Woods system in 1973. These reforms were based upon increased liberalisation and mobility of international capital flows

The current crisis was in brewing for many years, it started when banks other financial institutions stated issuing new credit instruments like CDO’s (collateralised debt obligation). Banks and other financial institutions started high risk lending practices.

These practices included easy credit to people who had weak or adverse credit ratings. The main reason for these practices was the fact that countries like China, Japan and middle-eastern countries had large dollar reserves which were available to the US banks via central banking system. This lead to lending frenzy and profit hungry bankers started lending to people with adverse credit ratings. This frenzy was basically fuelled by increased supply of money combined with U.S. government’s policy to provide homes to people with low income. Giovanni Dell’Ariccia, Igan and Laeven (2009) argue that one of the most obvious reasons for this sudden boom in lending was the decline in standards. This meant that less mortgage applications were declined as the bankers and mortgage lenders were banking on ever increasing house prices. As measured by a decline in application denial rates. They explain that this increase in mortgage lending lead to increase in loan to income ratio, but on the other hand fundamental economic variables had not improved significantly to support this increase in loan to income ratio.

The decline in lending standards can be verified by reviewing Fitch Ratings (2007).12

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Research works by Demyanyk and Van Hemert, (2007)13, Keys et al., (2007)14 and Mian and Sufi (2007)15 also blame the unchecked rise in house prices for the crisis. They also provide insight in to securitisation of debts and how it played its part in creating this crisis. These academics have all blamed bankers for taking too much risk in time of boom, driven by personnel motives rather than considering the overall society. In the other words this rapid expansion had weak base of support in form mortgage backed securities and default insurance.

Another factor that contributed to current crisis was off course the “special purpose vehicles” commonly known as SPV’s. Banks and other financial institutions created these complex financial instruments to shield themselves from the underlying risks ofthese subprime mortgages. This is clear indication that these institutions knew about the risks associated with these practices.

By using these instruments institutions devised these instruments in such way that they combined different forms of debts into a neat little bundle and passed them on to investors who were willing to take high risk in order to gain rewards. But at same time these instruments got so complex that even the issuers lost track of them. The main attractions of these instruments were collateral and default insurances. As assurance of their worthiness these were backed by credit rating agencies who provided very good rating for these bonds many enjoyed AAA by rating. Gonzalo Fernández de Córdoba 16(2009) explains that investors and credit rating agencies did not assess the risk correctly and almost all of the investors were betting on only one prospect that house prices will continue to rise. This optimism can be illustrated by following figure which shows the rise in house prices with respect to time.

Robert J. Shiller17 (2009) argues that housing bubbles attained the magnitude because governments and other financial experts mostly failed to understand its basic dynamics and thus were unable to deal with it.

Markus K. Brunnermeier (2009)18 adds to this by saying that one of the main changes that lead to this crisis was the change in attitude of the banks i.e. their fundamental policies. He explains that originally banks used to hold their debts till maturity, that limited their capability of lending to certain extent and thus they were cautious in lending but with advent of SPV’s they embarked on policy of lend and then distribute. This in short term meant that they got rid of their debts and risks associated with them, but this practice meant that banks ignored the risk elements and thought thatmoney supply will continue to rise or would be stable in long term. Thus they ignored most of the risks.

All of these factors combined to fuel this bubble and this finally busted on August 2007 when French bank BNP Paribas on August 2007 that three of its investment funds were no longer able to value a series of complex financial instruments backed by so called “sub–prime” residential mortgages in the United States19. The pin that busted this bubble was actually already there in i.e. the announcement of The Federal Home Loan Mortgage Corporation (Freddie Mac) which announced on February 27, 2007 via its press release that it will no longer buy the most risky subprime mortgages and mortgage-related securities. This led to many casualties that included SEC’s down grading of over 100 securitised bonds. Following that many institutions became vary but still people regarded this as just U.S. internal problem as few mortgage providers filled for “Chapter11”20 protection.

This lead to high profile casualties like Bear Stearns, Northern Rock, Lehman Brothers, etc. These events deprived investors of their confidence and saw global markets crumbling down. The crisis was so severe that even banks stopped lending to each other, forcing governments to intervene and stabilise the situation.

The underlying cause was the same subprime mortgages as people started defaulting on their mortgage loans the house prices tumbled down bringing with them the whole financial and banking system.

If anyone thinks that no predicted that well they are in fool’s paradise. Nouriel Roubini and Brad Setser21 (2004) had already warned about these kinds of bets they explained the basic dynamics of the financial system and in general they warned against betting against ever increasing house prices and they also explained that this bubble will burst with two, three years but they were largely ignored and even got labelled as “Dr. Doom”. role of credit rating agencies; in current financial crisis the agencies like S&P and the others gave very good rating to these instruments (CDO’s). As mentioned House of Commons Treasury Committee’s report in following words

“The credit rating agencies have played a central role in the growth of securitised markets.........conflicts of interest in the credit rating agencies business model as well as flaws in their rating methods. The credit rating agencies must tackle these.........If, they are unable to put their house in order, then new regulation may be the only answer”30.

This factor was not influential in the Asian currency crises of 1997.

Another major difference was the role of banks, the major cause of the current financial crisis was that the banks where the main catalyst of the crisis as they

After these crises one argument that was raised by many academics and experts was that IMF should be remodelled as per Keynes suggestion. Zhou Xiaochuan, the governor of the People's Bank of China spoke of formation of centrally managed global currency. The underline reason obvious that it needs reforms. Edwin M. Truman (2009)34 stresses the vital role of IMF in the current situation. He is slightly critical of the IMF stating that it needs to increase its lending capabilities and should monitor and advice governments on their choice of economic policies. At the same time their no denying the fact that these global institutions are vital for recovery and future prosperity of the global economy. Otherwise the destructive spill over effects of these crises would continue to devastate global economies.

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Both institutions need to work closely with each other and other worldwide national and international financial institutions like central banks, in order to develop early warning system for global crisis and strategies to counter them or tackle the crisis.

The same views can be found in House of Commons Treasury Committee report (2008) 35 in following words:

“To this end: in the short term the IMF and Financial Stability Forum..............sector and how markets and regulators are responding. The IMF and FSF should also present as soon as possible proposals on how they will further enhance their cooperation”.

Besides the above mentioned measures IMF needs to not only modify but also clarify its objectives.

The effects of crisis on the developing countries

The current financial crises had devastating effects on developing countries as Global growth is projected to dropped to 2.7 percent in 2008, from 3.7 percent in 2007 and the Developing-country growth is declined from 7.8 percent in 2007 to 6.5 percent in 200839

The weakness of the has caused reduction in imports to china which has caused slowdown of Chinese economy40.The increases in food prices and along with reduction in exports have serious implications for developing countries as it has affected their capacity to reduce poverty and attain Millennium Development Goals, and Donors have made slow progress in scaling up development assistance in recent years.41

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