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Us Sub Prime Crisis On South Korean Economy Economics Essay

US sub-prime crisis was the consequence of an explosion of the house price bubble in the US economy. Out of fear of imported inflationary impacts in the nation, the US government decided to augment its market rate of interest that triggered people who had initially borrowed from the banks at sub prime rates, walk out of their agreements with the financial institutions. This widespread behaviour among the mass resulted to an eventual bankruptcy of many financial institutions in the USA. The financial crisis that engulfed the economy by the middle of the 2000s, however, was transmitted to the rest of the world, especially the emerging market economies of Asia that have actually been projected to be shrinking at an average rate of 5.6 percent. Among them, the economy of South Korea is expected to be contracting by nearly 4 percent in the forthcoming year (Boorman, 2009). The main reasons cited behind this transmission mechanism, differs between various observers and researchers, who have empirically found out the possible channels of the conduction process. Most of them stressed upon the term ‘globalisation’ while scribbling down the potential reasons, some of which have been briefed down in this section.

Literature review

Boorman discussed in the annual meeting of The Emerging Economies Forum, conducted in India on June 23, 2009, the following reasons that led to the transmission process. Firstly, he pointed out that since the sub-prime crisis in the US was followed by a large number of significant financial institutions in the economy declaring themselves bankrupt, there was a huge mobilisation of funds from their subsidiaries located in the emerging economies. The funds, which comprised of a considerable proportion of assets for the developing nations and were treated almost as a stand-in support for their financial stability, were withdrawn out of them, all of a sudden without any prior notice. The nations which used to depend highly upon dollars and Euro for their financial transactions faced a huge downfall following depreciation in the value of the currencies. Secondly, the mystery behind the success story of most of the evolving market economies was the increasing popularisation of the export-led growth strategy among them. The trend was especially alarming among a handful of East Asian economies, which had excelled in manufacturing a number of essential goods at unimaginable costs for the western population. As Eichengreen and Park (2008) noted, when the East Asian economies realised that they had procured enough foreign exchange reserves in their treasury, so that their indigenous currencies no longer remained as weak as they used to be a decade ago, and that they were actually paving a pathway towards a potential loss through maintaining a low surplus in their balance sheet, they restricted foreign exchange inflow through regulating their export activities to some extent. Gradually, the demand for dollars started declining and out of fear of a potential inflation, USA increased its market rate of interest that eventually led to the financial crisis. A third point put forward by Boorman (2009) was that, the emerging economies of the world were too much dependent on the Western developed nations for remittances or transfer payments, that accounted for a huge proportion in their GDP figures. In fact, the actual figure of the same for the whole of East Asia was 86.3billion dollars in 2006, that rose to a peak of 132.9billion US dollars in 2008, but crashed down to a mere 95billion dollars in the consecutive year. This argument is in simultaneity to the conclusion put forward by Portes (Portes, 2009), where he draws empirical evidence regarding the fact that the amount of transfer payments into the emerging economies are positively related to their income levels. He collected samples for the annual figures for the two variables from South Korea, Sri Lanka and France between 1979 and 2009, and found that there is a positive correlation trend in the relation between the annual income of the nation and its annual remittances coming from the external economies. This suggests that since South Korea is one of the fastest growing among all market economies of the world, with its GDP rising at an enormous speed, the proportion of remittances accounting among its GDP contributors is high as well. Thus, it is quite obvious that once the remittances start falling, it will affect the GDP of the concerned economy as well. When USA was submerged in a financial downfall and there was a widespread closure of firms in the nation, unemployment was an inevitable consequence. Since many workers migrate to the Western world in search of lucrative job offers, this fallback resulted to a shortage in the availability of jobs, so they were forced to move back to their native land. Moreover, USA and many other developed western economies are involved in purchasing cheap services from the emerging market economies. With a decline in the demand for labour in the US economy, the workers in the emerging nations suffered worsening the already depressed environment with an extensive unemployment over the region.

The financial crunch that surfaced in the Western economies was inevitable to be transferred to the East Asian countries, as Dooley and Hutchison have put down (Dooley & Hutchison, 2009). According to them, during the initial phase of the financial crisis, there was a high demand for CDS bonds among the financial institutions based in the emerging market economies - East Asia nations. It was empirically found by the two observers. The researchers ran a regression of the impact that various political and economic developments in USA had on the demand for CDS in a number of nations, in which South Korea was included as well. The experiment revealed an adjusted multiple correlation coefficient equal to 0.41 in case of South Korea, the largest among the group, implying that it was rather highly influenced by the external or exogenous developments. This high sensitivity was bound to be severely affected by the upcoming news of financial crisis in a region which accounts for a lion’s share of the total amount of international transactions for the nation. Given the high impact of various external shocks on the South Korean economy, it can easily be concluded that the bankruptcy of a large number of big financial houses in the USA frenzied the Korean firms and compelled them to indulge in a drastic selling off of the external CDS bonds, especially those belonging to the USA. The vigorousness that the economy showed for the same, might be a reason why the impact of the crisis was not as significant in the South Korean economy as it was with other East Asian developing economies. It did not lose much time in reselling the bonds in lieu of money, which once received were kept under the vigil of the government rather than letting them lose in the market. However, with the sale of CDS bonds, a significant avenue of money supply into the economy in the form of interest payments was closed. Consequently, the economy was dipped under a slight recessionary phase and thus stagnation for the time being.

In fact, the experiment bared the facts that, the news about the fallback of Lehman Brothers, public announcement regarding the dwindling situation of the financial assets of USA, offer to an unlimited access to US dollars for the European banks, political movements in USA, changes in financial regulatory measures of the US government, etc. had a heavy impact on the monetary decisions of South Korea that eventually resulted to the nation getting blotted amidst the financial chaos. Sussangkarn in 2009 pointed out that, following the East Asian crisis of 1997, the superpowers of East Asia formed an alliance and named their organisation ASEAN, which was supposed to provide a better financial cooperation among the neighbouring economies. But despite the attempts of the regional governments, the region faced a harsh blow on account of the US sub-prime crisis, because of the high dependability of the region on its export revenues flowing from the US economy.

South Korea was one of the most afflicted regions among all the emerging nations in the world. The nation that already had faced the brunt of a financial crisis was largely vulnerable to the various external global developments, due to the intensive export-oriented growth strategy that the nation had adapted itself to, soon after the liberalisation move. In fact, one of the primary reasons why the nation was so highly susceptible to exogenous shock factors was because it had indulged itself to a highly liberalised environment that facilitated an almost free trade of goods and services into and out of the nation, in the form of imports and exports. The almost unregulated and relaxed environment that the nation offered also assured the external economies towards strengthening their trade relations with that of South Korea. But, one serious drawback of this rapport was that any shock in one of the trading partners could fiercely affect the fundamentals of the economy and so it did with the sub-prime crisis transpiring in one of the most powerful nations of the world and also a significant trading partner of South Korea, the USA.

Theoretical framework

Sub-prime crisis is one of the most discussed of all economic events in recent global history. After the shock struck all nations, there were widespread debates and controversies about the actual reason or cause behind such a devastating process. There were simultaneous discussions about the appropriate model that would suit the phenomenon. It was quite evident that no existing model could coincide or correspond with what the sub-prime mortgage crisis had brought down to the society and thus there was need to discover or rather develop a new one, more ideal with the catastrophe. Many observers found that the traditional mortgage securities model came close to explaining the methods of the sub-prime crisis, but some stones still remained unturned and certain loopholes to the model were discovered as well, that distanced it with what the reality was. This is the reason behind a further modification of the model and the eventual development of the “Originate to Distribute” model, with some subtle differences with its predecessor.

The traditional model involved an affair with the bank and its direct customers as the sole players in the game, however, in the latter one, a third party –those who were sold mortgage backed securities (MBS), was incorporated as well. In the previous one, it was the bank where the potential borrowers went in want of loans and the former offered them so in lieu of mortgages of equal or higher values. In cases when the borrowers could not afford to deposit mortgages of such values, the banks used to charge higher rate of interest on the loans they advanced, meanwhile keeping the risk of bad loans or bad assets to themselves only. However, the present model makes room for the entry of the investors who seek out the mortgage backed securities that banks issue to procure resources for advancing them as loans. When banks realise higher profit opportunities when loan is advanced to sub-prime borrowers, they start proceeding loans to such customers. Given the fact that high returns must always be associated with high risks, they start depending on peoples’ money rather than constraining themselves just within the limits of their own assets. The source of the high profits, as already discussed above, is the high rate of interest at which the sub-prime borrowers are granted loans. This was in fact noticed in reality when the banks, after making their fill out of depositors’ money, began handing out for investors’ money through issuing mortgage-backed securities in the open market. As the name would suggest, these securities were backed by the collaterals that the borrowers kept with the banks and thus, brought with them a regular flow of interest earnings, which is why they seemed so attractive in the first place.

With the system of securitization in vogue, the banks no longer remained the owners of the mortgages and through issuing of securities they also sold away the temporary ownership rights of the mortgages. Rights were temporary since they would be transferred to their original owners as soon as the latter paid back the borrowed sum. This way, through involving investors’ money as well, in securities, there was a higher degree of involvement in the system and a greater amount of money got engaged in it, than would have been in the absence of securitization. This high involvement signified a higher vulnerability as well, which is why the impact of the crisis had been so intense globally. The introduction of the concept of MBS led to a huge flow of money in the sector worldwide and thus when a sudden shock grasped the sector, it had a widespread effect. The nations which were afflicted by the calamity were turned into shambles under the burden of bankruptcy not only in the respective nations, but in neighbouring areas as well, so that there were very slim chances of recuperation. The world was drowned under the wave of recession and the vice of unemployment that came along with it.

On the other hand, there was a boom in the housing market since these sub-prime borrowers had meanwhile invested their money in real estate. But, the boom was short-lived, since as soon as the rate of interest went up, there was a fall in the demand for real estate investments and eventually the price of real estate came down, so that the price that had previously reached such a high, shattered down and thus there was a house price bubble explosion.

Source and Methodology

Data will be on the changing real estate price in South Korea over the period between 1990 and 2008, to take a note of the rate at which the price had been changing. Data will again be collected on the prevailing market rate of interest in the nation on bank deposits over the same period. There will be a correlation study between the aforementioned elements and the relation between the two variables is expected to be negative. Again, information on the national GDP must also be collected to keep a track of the fact whether there indeed was a recessionary phase that the nation had experienced over the given period of time, or not. Besides, there also will be data on the per capita income of the nation and population growth rate over the period, so that a regression of the latter variables and rate of interest could be run on the house prices to find the variable that can significantly affect the dependent one.

Outline

Chapter 1 will be Introduction, dealing with initiation of the sub-prime crisis. The following chapter is Purpose of the Study involving impact of the shock on South Korean economy and possible reasons behind the brunt and the solutions to heal the situation. Chapter 3 is Literature Review and Theoretical Background where prior work on the topic or on significant areas related to the topic will be mentioned. Chapter 4 involves Data Collection and Methodology and the following one will be on Empirical Data Analysis. Lastly there will be a chapter on Conclude Remarks.

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