Overdose The Next Financial Crisis

Overdose:The Next Financial Crisis

Executivesummary

Theworld economy has suffered from a series of financial crises, andthere are sufficient indicators that a more severe crisis isawaiting. Although some crises have had some unique causes, most ofthe previous financial crises have some common causes. For example,asset price booms, credit boom, systemic risks and marginal loans,and poor supervision and regulation in the financial sector, and thedynamics of various bursts were common for most of the previousfinancial crisis. Although the stakeholders have made some attemptsto address these causes in the past, the complex nature of thefinancial sector has made it difficult to eliminate them completelyfrom the national as well as the global economy. For example, stockexchange and the real estate market have remained the most attractiveinvestment opportunities in many, if not in all countries, whichmeans that it is difficult for the stakeholders in the financialsector to avoid the stock market and the real estate booms.

Thedifficulty of addressing the common causes of the financial crisisimplies that some of these factors will contribute towards theoccurrence of the next financial crisis. The high rate of growth ofthe shadow banking system in China, which is out of reach of thefinancial regulations, will result in a financial crisis in China.The attractiveness of the real estate and the stock marketinvestments means that these booms will be experienced in differentcountries, including Canada, China, Brazil, India, and the UnitedStates. The increase in the use of derivatives will also contributetowards the occurrence of the next financial crisis, especially inthe United States. Although the ordinary factors will play a majorrole in the occurrence of the next financial crisis, there will besome unique causes, which include the energy crisis, abnormalincrease in the U.K. debt, a rise in the usage of the U.S. dollaroutside the country, and the cash crises.

Overdose:The Next Financial Crisis

Financialcrises are detrimental occurrences that affect the global economy,especially in the modern world where national economies areinterdependent. Financial crisis can be defined as an occurrence inwhich the value of different financial assets or institutions droprapidly, which results in a surprise panic in the banks(Investopedia, 2014). Financial crisis become, even worse when itaffects the large firms serving as the key pillars of the global aswell as the national economy. Most importantly, the financial crisisaffects banks where investors withdraw money and sell their assetswith expectations that the value of their assets is likely to drop ifthey remain the banks. Therefore, the financial crisis creates ascenario in which investors lose confidence in the financial sector.In addition, investors’ behavior and over-valuation of assets aswell as the financial institutions can contribute towards theoccurrence of the financial crisis. Delayed measures to put thefinancial crisis on check results in an economic depression orrecession. Although the world have learned several lessons from theexperience numerous financial crisis in the past, the China’sshadow banking, real estate bubble, derivatives, stock market bubble,energy crisis, rise of dollar usage, Europe debt, and currency warsindicates that another financial crisis might occur sooner thanexpected.

Background

Historyof financial crises

Thefinancial crisis has been a common and an unfortunate occurrence inthe history of the world economy. Investors, bankers, and thestakeholders in the financial sectors admit that the business is soglobal, so large, and so complex, which makes it difficult to avoidfinancial crisis, even in cases when some early warning signs havebeen detected (Anderson, 2014). Although financial crises have beentaking place over the years, the first and the most famous one wasexperienced in 1630. The crisis was named the Dutch Tulip since itwas caused by the soaring prices of tulip before a sudden downwardspiral in the price tulips could occur (Perry, 2014). Other financialcrises (such as the 1929 U.S. fall in the stock market) that occurredafter the Tulip Craze were caused by unique financial hardships thatthe global and the national economies could not sustain. However,there are some common features in nearly all financial crises thathave been experienced in the world. Some of the commonalities includeexcessive exuberance, doggy accounting, ineffective regulatoryoversights, infallibility, and herd mentalities (Anderson, 2014).Although these crises are adequately addressed and normalized, theycause catastrophic financial losses to investors, financialinstitutions, and other industries before effective measures are putin place.

Commonfeatures between the 2008 crisis and previous financial crises

Understandingthe commonalities between the latest (the 2008) financial crisis canprovide a sufficient basis of understanding the direction of theglobal financial systems. This is a prerequisite step in predictingthe possibility of the occurrence of another financial crisis in thefuture. This is because it will be possible to determine if the keyfactors that contributed towards the occurrence of the previousoccurrences have been addressed sufficiently or not. There are fourmajor commonalities between the 2008 financial crisis and theprevious crisis, all of which give the description of the factorsthat contributed towards the occurrence of these crises. These commonfeatures include the asset price boom, marginal loans, the creditboom, and ineffective supervision and regulation policies.

Assetprice booms

Thehigh-spirited pattern of an increase in the price of different assetsprior to the occurrence of a crisis is common in nearly all financialcrises that have been experienced in the past. These asset boomsoccur in the developed economies, but the effects of their bursttrickles down to other economies that interdependent with theaffected economies. For example, the trend of rapid increase in theprice of houses in excess of 30 % in the United States prior to theoccurrence of the 2008 financial crisis was similar to the pricedevelopments that happened in the previous ‘Big Five’ crisesepisodes that include the 1991 in Finland, 1992 in Japan, 1987 inNorway, 1991 in Sweden, and 1977 in Spain (Claessens, 2010). However,the only difference in price trends was the duration and strength ofprice changes. The 2008 housing boom was more significant andoccurred in several countries starting in the United Stated followedby other nations, such as Iceland, United Kingdom, and countries inthe East Europe. The fact that a sharp increase in the price ofhouses has been a common occurrence in all previous finance crisissuggest that it is an early warning sign of the financial crisis tocome.

Creditboom

Anextended credit expansion in the developed economies was a commonphenomenon that occurred a few years prior to the occurrence of theprevious crises. Research has shown that credit booms are positivelyassociated with significant cyclical fluctuations in business andeconomic activities (Claessens, 2010). These booms are characterizedby a rise above the normal trends in the consumption, real output,and investments, which are common features of a crisis build-upperiod. During the build-up period, the current account deterioratesas a result of a significant surge in the inflow of the privatecapital. These changes are often accompanied by a sharp increase inthe price of houses as well as the real exchange rate. However, boomsthat occur in the developed economies are rarely associated with asurge in the rate of inflation. Credit booms in nearly all financialcrises were preceded by significant gains in the total factorproductivity and reforms in the financial sector (Claessens, 2010).The 2008 crisis, unlike some of the previous crises was characterizedby a crash in both the currency and the entire banking system, whileother crises were only associated with a crush in currency. Theeffects of the credit boom trickled down to the emerging economies invarying degrees. Therefore, the credit boom above the normal trendssuggests an awaiting crisis.

Systemicrisks and marginal loans

Therapid increase in credit was directed towards the households, whichresulted in a sharp increase in household leverage. The boom thatoccurred in the household credit resulted in large amounts ofmarginal assets whose profitability was hedged with favorableeconomic conditions (Perry, 2014). For example, the 2008 crisis wasassociated with a boom in household mortgage loans that were extendedto sub-prime clients that is customers with short employment recordsand credit limits. The capacity of these customers to service theirloans was directly hooked on the national as well as the globaleconomic trends. Therefore, a drastic change in other economicfactors, such as a sharp decline in the price of houses couldgenerate a large portfolio of exposed assets.

Inthe 2008 crisis, a significant portion of the domestic credit wasbased on foreign currencies including Yen, Euro, Swiss, and Francs. Similarly, a significant exposure of foreign currency was a commonfeature in all financial crises that occurred in Asia (Claessens,2010). The perceived favorable economic conditions that occurredshortly before the financial crises boosted the derivative market,where financial institutions could give loans backed on mortgagesecurities, as well as collateralized debts. This implies that theborrowers’ capacity to repay the loans was based on changes inprices of the underlying assets. A sharp downturn in prices was to agreater extent responsible for the large number of loan defaulters.Therefore, a sharp growth in marginal loans and derivatives could bea risk factor to the occurrence of a financial crisis in the future.

Supervisionand regulation

Riskyepisodes of an increase in credit are reflections of deficiencies inthe policy structures in implicit or explicit government guarantees,investors’ hedging behavior, excessive competition, a decline inthe lending standards, and information asymmetries (Claessens, 2010).In some of the previous financial crisis, risky credits have beenassociated with the quick liberalization of the financial sector andfinancial innovations that are not adequately regulated. Theimbalances that caused financial crises resulted from poorlysequenced reforms in the financial sector regulations. Underdevelopedfinancial system could not intermediate excessive capital inflowsduring the period of capital liberalization (Perry, 2014).Deficiencies in supervision coupled with poor framed financialreforms resulted in maturity and currency mismatch as well asconcentrated and large credit risks. It is evident that investmentbanks, merchant banks, financial companies and off-balance sheetitems of commercial banks operated off the banking regulations(Claessens, 2010). This issue was exacerbated by unhealthycompetition among the supervisory agencies, coupled with the conflictof interest among the rating agencies. This affected consumers of thebanking system and created a chain of reaction that in turn resultedin systemic risks. Lack of proper supervision and adequate regulationin the financial sector are predisposing factors of the financialcrisis.

Dynamicsof different types of bursts

Allcrises are preceded by multiple vulnerabilities caused by incrediblelending practices, the rapid increase in credit, boom in assetprices, and incompetent supervision and regulation in the financialsector. It is only a few of all credit booms culminate in thefinancial crisis, but about 25 % of all asset booms results in acrisis (Claessens, 2010). This means that the chances of theoccurrence of a crisis increase with the increase in the boom ofasset prices. In addition, the increase in the duration of the boomincreases the chances of its culmination in a significant burst. Thekey mechanisms that link any of the previous crises with the creditboom include a decline in the standards used by the lendinginstitutions and a large number of borrowers with a high risk ofdefaulting.

Theoutcome of the asset burst in any financial crisis depends on threemajor factors. First, the size of price run-ups determines themagnitude of a fall in asset prices (Claessens, 2010). However, pricecorrections are lower for housing burst compared to equity burstsince the housing market has a lower level of liquidity andvolatility. Secondly, there is a higher correlation between a boomand a burst in the housing market than in the equity market. Thismeans that a boom in the housing market is a reliable indicator of anawaiting financial crisis. Third, a burst in the housing market lastlonger and results in more output losses compared to equity bursts(Claessens, 2010). This implies that the housing bubble is likely tocause a serious burst in the future.

Possiblecauses of the next financial crisis

Ordinarycauses

Althoughthe world has been experiencing a series of the financial crisis forsome centuries, it is evident that there are some inherent causes ofthe previous crises that have not been addressed satisfactorily.These factors will possibly continue to subject the national and theglobal economies to the risk of the financial crisis. These factorsinclude the constraints in the banking system, stock market bubble,bubbles in the real estate, and derivatives. This means that theglobal economy will possibly experience a repeat of these bubbles andfinancial challenges in the near future, which will culminate in afinancial crisis.

Thebanking system of China

Thebanking system of China has been subjected to significant challengesby the rapid growth of the shadow system. The shadow banking systemrefers to any form of lending that operates outside the formalbanking system or out of control of the financial regulators(Cogghill, 2014). China’s economy has recorded the fastest rate ofgrowth in the shadow banking system in the world. According toCogghill (2014) the shadow banking system of China grew by about 37 %in the year 2013 with a projected growth of above 37 % in thesubsequent years. This resulted in the ranking of the Chinese shadowbanking system as the third largest in the world. Currently, theChinese shadow system involves about $ 4.39 trillion (27 trillions ofYuan) of assets, which is equivalent of 20 % of the formal bankingsystem of China (Cogghill, 2014). The same report indicated that theChinese shadow banking system increased four times from 2007 to 2013,which represents s 4 % of the global show banking system. The growthrate (37 %) of the Chinese shadow banking system exceeded the world’saverage rate of 2.4 % in the year 2013 (Cogghill, 2014). This impliesthat the Chinese shadow banking system is a significant part of thenational and the global economy.

Sincethe show banking system has been contributing towards the nationaleconomy, one would ask why it is speculated as a major cause of thenext financial crisis. The shadow banking system operates outside theregulation of the banking regulations or the reach of the regulatoryagencies. This increases the risk of default, which in turn subjectsthe national as well as the global economy to the risk of anunexpected crash depending on the size of the shadow system and thenumber of defaults (Cogghill, 2014). Currently, there are some signsof massive defaults are being experienced in the Chinese economy. Forexample, China’s economy experienced $ 652 million (4 billion Yuan)default in the shadow banking system, which was backed by ChinaEver-growing Bank in 2013 (Cogghill, 2014). This implies that theexponential growth of the show banking system is a significant riskto the Chinese economy.

Althoughthe Chinese shadow banking system ranks the third, there are twofactors indicating that it is the riskiest system in the world.First, a larger proportion of lending made by the Chinese shadowsystem goes to provincial and the central governments (Bris, 2014).This is a significant risk given the stringent rules of the financialsystem put in place by the government of China. Secondly, Chinesefinancial institutions are shielded from international competition,which makes the Chinese banks the largest in the present world. Thisimplies that a crash in the Chinese financial system will be themajor cause of the next financial crisis, and its impact will beunbearable.

Figure1: Trends of the Chinese shadow banking system

Source:Cheng (2014)

Thereal estate bubble

Economicconditions that resulted in the real estate bubble between 2005 and2007 include the low-interest rates, an increase in the prices ofreal estates, and a rapid growth in demand (Bris, 2014). Although itis now globally known that the rapid increase in demand and prices ofthe real estates is an economic risk that warns of a forthcomingeconomic risk, the attractiveness of this sector reduces theeffectiveness of the government measures to protect the nationaleconomy. Consequently, the escalating prices of the real estate getout of hand and culminate in a financial crisis in most cases. Thedemand factors caused by the high rate of urbanization have made thereal among the most attractive investment.

Theprice of houses has been increasing rapidly in some countries, evenbefore the global and the national economies recover from the 2008financial crisis. A study has shown that the price of housesincreased by 80 % in Brazil, 60 % in China, and 15 % in Canada in theyear 2013 (Bris, 2014). Moreover, there are countries that have showna trend of a sharp and continuous increase in prices in the realestate sector. For example, the price of residential as well ascommercial houses has been increasing exponentially in India, goingup to 17 % per year in several cities (Modi, 2014). This suggeststhat the countries (including Brazil, Canada, China, and India) thatare experiencing an exponential increase in the price of houses arein the period of the bubble build-up, which will eventually burst andcause a significant financial crisis in the near future.

Figure2: Tends in the price of houses in Canada

Source:Schiff (2014)

Thestock market bubble

Therapid growth of the global stock market is among the key warningsigns of the possible occurrence of the financial crisis in thefuture. From the experiences of the previous financial crisis(including the 1929 and 2008 crisis), a rapid increase in the stockprices is associated with an increase in speculation of the stockprices (Perry, 2014). The sharp increases in prices tempt investorsto borrow and invest the borrowings in the stock market. A suddencrash of the stock market frustrates many investors who then defaulttheir loans. Studies have shown that the increase in the stock pricesbetween the 2013 and 2014 were above the normal level, with a highlikelihood that the market is being financed with borrowings.According to Bris (2014) the global stock market returned an averageof 18 %, but the rate of return varied with individual nationalmarkets, where the Indian market made a return of 30 % and theChinese market a rate of 8 %. This will affect the developedeconomies, such as the United States. The same study indicated thatthe market was driven by excess liquidity and a limited number ofinvestment alternatives. This created a gap between corporateearnings and stock prices larger than it was in the 2008 pre-crisisperiod. This indicates that the world stock market is headed for agreater crash than what the world experienced in 2008.

Figure3: Exponential growth in the U.S. stock market

Source:Trading Economics (2014)

Derivativesand the next financial crisis

Derivativesare dangerous financial assets that derive their value from theunderlying assets, such as bonds, stock, and other commodities.Derivatives increase the risk of the financial crisis because theyfacilitate phony accounting, obscure the market, concentrate therisk, and deceive the stakeholders that they have eliminated the risk(Cahoon, 2013). Although the United States have had a bad experiencewith derivatives during the 2008 financial crisis, this type ofassets is still widely used in the country and increase the risk ofthe next financial crisis. According to Denning (2013) lack oftransparency in the derivative trading has caused the United States atotal of $ 700 trillion, which is equated to 10 times the size of theeconomy of the whole world. There are some large individual backswith high levels of exposure, and whose fall can affect the nationalas well as the global economy significantly. For example, the Bank ofNew York has a $ 1.375 trillion, State Street Financial $ 1.39trillion, and Morgan Stanley $ 1.722 derivative exposure(Democracy.info, 2012).

Thissuggests that the banks and other stakeholders have not learnedenough lessons from the last financial crisis and have continuedsubjecting the national economy to risks by tradition on derivativesin a massive way. Trends show that the global derivative market wasvalued at $ 500 trillion in 2007, $ 648 trillion towards the end of2011, and projected to grow to $ 707 trillion in the next one year(Denning, 2013). Most importantly, the regulatory agencies havelimited information regarding the trade on derivatives, which reducestheir capacity to determine the strength of the large banks and takeprecautions against any potential risk. Trading with derivativesincreases the risk of the United States suffering from anotherfinancial crisis in the near future.

Figure4: increase in the use of derivatives

Source:Sammut (2014)

Uniquecauses of the next financial crisis

Apartfrom the common causes that have been experienced in the pastfinancial crisis, there are a number of new and complex factors thatwill contribute towards the occurrence of the next financial crisis.These factors include the energy crisis, persistent corporatefailures, geopolitical crisis, poverty, and cash crisis.

Energycrisis

Duringthe 2008 crisis, a few experts asserted that the scarcity of energy,especially the petroleum products had contributed to the severity ofthe crisis due to a significant increase in their prices. However,the next financial crisis will not be associated with the scarcity ofthese sources, but it will be caused by geopolitical war in the oilindustry. According to Bris (2014) the use of advanced frackingtechnology in the United States has resulted in a significantincrease in the supply of gas, which has rendered shale gas a potentgeopolitical weapon. This means that a decision by the U.S. congressto allow the exportation of gas would result in a drastic fall inprices. However, this would in turn create geopolitical challenges incountries (such as West Asia and Russia) that depend on the energydemand in China and West Europe. This implies that the fear ofgeopolitical wars among the energy producing countries will result inthe financial crisis in countries (including China and countries inWest Europe) where energy prices are already hurting competitiveness.

Figure5: Trends of the shale energy market

Source:Makan (2013)

TheU.K debt

Borrowingis a conventional practice that is acceptable in any country.However, there are some limits that the financial institutions shouldnot exceeded in order to protect the global and national economy fromthe risk of a financial crisis. The United Kingdom is among thecountries whose debts are alarming and indicates the possibility ofthem being hit by another financial crisis. A study shows that thefinancial system of the United Kingdom has a liability of about 1,300% of its GDP (Medway, 2014). Most importantly, the U.K. debt ishighly internationalized, implying that the national economy issubject to financial risks taking place in other countries. Forexample, the U.K. banks (including the HSBC) have loaned into Chinamore than any banks in the world (Medway, 2014). National debt is afinancial situation that can be stabilized in case the country has asustainable growth, but besides the environmental consequences ofthat growth. However, this is an unlikely event in the case of theUnited Kingdom. Instead, it is more likely that the country will callfor more debt write-off since the efforts to repay the debts in thelast four years have already failed. Therefore, it is evident thatthe U.K economy is at the risk of suffering from the financial crisisin the near future. This will be made even worse by financialchallenges of other countries given the high internationalization ofthe national debt.

Figure6: Trends for the accumulation of the U.K. national debt

Source:Pettinger (2014)

Therise in the usage of the U.S. dollar

Arapid and exponential rise in the value of the U.S. dollar relativeto other currencies has been hardly mentioned as a major cause of thefinancial crisis in the past. However, recent trends show that therate at which the U.S. dollar is rising is alarming and subjects thecountry with a significant financial risk. This trend has beenrelated to an increase in the use of the U.S. dollar by lenders andborrowers outside the countries, which has increased its demandsignificantly. According to Wessel (2014) the U.S. based bondinvestors and banks have lent $ 2.3 trillion outside the UnitedStates, while the foreign investors and banks have lent more than $6.5 trillion. The emerging markets have increased the demand for theU.S. dollar tremendously. This is because manufacturers in thesemarkets borrow their capital in dollars. These investors have aperception that selling and buying in the U.S. dollar is a usefulhedge for their investments. The increase in the strength of thelocal currency in the emerging market makes the U.S. dollar weaker.This makes the manufacturers balance sheet steadier, which in turntempts the local banks to lend more (Wessel, 2014). This has resultedin a global credit boom, which will affect the United States andemerging markets that have conjoined their economies with that of theUnited States.

Figure7: Demand for the U.S. dollar by manufacturers in other countries

Source:Handwerger (2014)

Cashcrisis

Theissue of excess liquidity in the global financial system has, for thefirst time, been cited as a potential cause of the financial crisis.In the modern world, banks and some companies are too rich to theextent that they can afford to buy countries. The possession of largesums of money by banks has now been proven to be a financial risk.According to Bris (2014) Citigroup alone is holding a cash of $ 478billion, while the Apple Corporation has $ 150 billion. A decision tounload these sums of money to the society, which is the moralobligation of the financial institutions, will create ahyperinflation, which will in turn culminate in a significantfinancial crisis. This type of crisis will mainly affect thedeveloped economies, such as the U.K. and United States. For example,research shows that the abnormal cash holding by the United Statesfirms is currently 10 % of the total holding, which represents an 87% increase from the holding level shortly before the 2008 crisis(Pinkowitz, 2013). This is attributed to an increase in the number ofcompanies that are highly profitable. The tax explanation being givenby the U.S. multinational companies fails to give a reasonable causeof these abnormal holdings.

Figure8: Trends of how companies are holding liquid cash

Source:Harrison (2010)

Alternativeviews to the occurrence of the next crisis

Althoughstudies have clearly shown that there are high chances of theoccurrence of a financial crisis in the future, there are some peoplewho believe that there is no economic crisis in waiting. For example,Rowlatt (2012) believes that the rapid growth of several sectors(such as the real estate and stock market) is a process that willresult in the rebalancing of the global economy, but not anindication of booms that will burst soon. The rapid growth anddevelopment of emerging economies (such as China) could also be aturnaround of the global economy and not a sign of the financialcrisis. The opponents of the idea of the next financial crisis seemto have reasonable arguments. However, it is important to analyze allfinancial phenomena with respect to the past happenings and predictthe future from an informed point of view.

and Conclusion

Thecurrent state of economic interdependence as made the financialcrisis an issue of concern to all nations of the world. Although thestakeholders in the financial sectors have learned many lessons fromthe previous financial crises, it is clear that there are somefinancial challenges that cannot be completely addressed. Thissubjects the nation and the global economies to the risk of yetanother financial crisis. Commonalities (including asset price booms,credit boom, systemic risks, and poor supervision as well asregulation) of the previous financial crisis prove that there somechallenge that the government agencies responsible for the managementof the national economies cannot resolve and prevent their recurrencein the future.

Thenext financial crisis will be more complex and difficult to handlecompared to the previous ones. This is because it will be caused bythe ordinary factors (such as the growth of the shadow bankingsystem, real estate bubble, stock market bubble, and derivatives) andan addition of new factors, such as the energy crisis, abnormalincrease in the national debt, unprecedented increase in the usage ofthe U.S. dollar, and the cash crisis. Moreover, it is likely that thecrisis will start in different countries at different times sinceeach boom will possibly burst at its own time. In addition, thispaper shows that the next crisis will mainly start from the majorityof the developed economies before trickling down to the emerging, andunderdeveloped economies. This will increase the duration of thecrisis and the complexity of the financial crisis since there will beno nation that will be strong enough to salvage the situation of therest of the countries. It is, therefore, probable that theforthcoming financial crisis will be more severe, affect the nearlyall nations, and take a prolonged duration before viable solutionsare identified.

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