Business and Financial Economic Environment
INTRODUCTION
The financial institutions majorly constituted by the banks, play a crucial role in providing or maintaining the flow of liquidity in the economy through the provision of credit and loans.
Liquidity can be defined as the ease at which asset can be easily exchanged or tradable with minimum loss of value (reference), for example cash. Liquidity is important in the economy as firms, households and government need cash on a frequent basis; for example, firms need cash regularly to manage their working capital used for paying their employees and suppliers and meeting other immediate obligations needed for the smooth running of their operations. There is the need for an even flow of these cash within the financial sector of any economy to ensure its smooth running and avoid any situation that might possibly lead to obstructions in the economy e.g. a credit crunch.
A Credit crunch refers to a reduction in the level of credit offered by banks and similar financial institutions that result in a decline in the level of liquidity in the economy (reference). This essay will thus concentrate on the role the banks and the financial sector played in the recent liquidity crises that led major economies in the world into recession in mid 2007.
THE HOUSING BUBBLE: The banks grant mortgage loans to consumers for them to own a home, but before it is granted, a credit check is carried out to ascertain whether the consumer can repay the loan with interest on a monthly basis. The Federal Reserve in the US kept interest rate low for several years, and this resulted in the expansion of mortgage lending by banks as the consumers found it favourable to borrow at the prevailing interest rate. The increase in mortgage lending made the average price of a house increase by 124% during 1994 to 2007 in the US (reference).
THE BANKS AND FAILURE OF THE FINANCIAL REGULATORS: The gradual increase in house prices resulted in more lending by the banks to existing consumers, through the revaluation of their homes to reflect the current increased value. This action increased their debt burden and these additional loans were used to finances consumer goods and durables. The Banks also an increase in mortgage lending to new consumers, however, the new lending policy deviated from the norm, by not conducting comprehensive credit checks on these new costumers, many of which were subprime customers .i.e. had bad credit histories. Secondly, it is usual or the banks to hold loan in their balance sheet as asset until the consumer make the full payment, however, the development of securitisation made it possible for banks to be able to sell these debts through the mortgaged bond market as Collateralized Mortgage Obligations (reference). False assessment of the true and risky nature of these assets based on the assumption that house prices where still going to rise, led to wrong valuations placed in the balance sheets of financial institutions and house prices respectively.
Investment banks like Lehman Brothers and other major banks in the UK like Northern rock got involved in the buying and selling of these unsecured debts which where not well priced to reflect the risks embedded in them.
Also recent critics have blamed the financial regulators like the US Federal Reserve for keeping interest rate to low that resulted in the expansion of lending and rating agencies like Standard and Poor’s whose function is mainly credit ratings, failed to assess the risky nature of this assets and loans learnt by the bank which encouraged investors to put more money in the system which in turn fuelled the housing bubble.
When the subprime consumers were not able to make their monthly payment there was an increase in foreclosures in the U.S,during the price hike there was also a boom in construction industry, putting an increase pressure in house supply. With the rate of repossession and construction of new houses resulted to a dip in price.
From the chart above, the price of house was at its peak in the mid of the 1st quarter and 3rd quarter of 2005 and fell by an annual rate of 4% and expected to by 10% in the year 2008 (reference).
The banks recorded heavy losses because the value of asset which comprised of mortgage asset in the balance sheet, declined significantly, and they had a recorded number of bad debts from subprime consumers.
CONCLUSION: The huge amount of bad debts held by the banks affected their role in ensuring adequate liquidity in the economy, as extension of credit facilities also declined significantly. This lack of credit reduced industrial capacity by the firms and consumption declined significantly by households due to heavy debt burden. This cumulated into a recession in the US economy; she contracted by 2.7% and 5.4 % in the 2nd and 3rd quarter of 2008,(reference) the recession spilled into other major world economies. Eg UK, France, Germany etc.
GERMANY
INTRODUCTION (GENERAL BACKGROUND):
The German economy is the 4th largest economy in the world and the biggest in Europe (reference). She is also part of the European Union and major economic policies are carried out in the European Union for example inflation. The German economy is based on a mixed market structure, with a considerable Government participation in major areas like the labour market, by providing training linked to industrial activities. The economy is export led and its major trading partner is France which accounts for 9.7%, the United States at 7.1%, and the UK at 6.7% of her export.(reference) It exports consumer goods like automobile, as well as materials mainly for industrial activities like metals and chemicals. In the winter period of 2008, the German economy went into recession due to the credit crunch crises that began in the US. This essay will explore the major economic data and look at the impact of the recent economy crises.
GDP GROWTH RATE:
The GDP looks at the value of goods and services produced in the economy by the factors of production employed i.e. the productive effort of land labour and capital in the production of goods and services.
The data below shows the real GDP growth rate quarterly from 2006 to 2009. The real GDP, accounts for the change in prices and only looks at the growth rate in output terms. As shown below, the economy has roughly been expanding but slowed significantly in the 1st quarter of 2008 by 0.7% from 0.8 in the last quarter of 2007. In the 2nd quarter in 2008, the economy expanded by 1.5% and went into recession in the last 2 quarters of 2008 declining at a rate of 0.6% and 0.3% respectively. It declined significantly by 3.5% in the second quarter in January 2009 in the height of the financial crises. The decline in GDP as largely contributed to the drop in consumption in the US and UK which account for large percentage of her export (reference).
UNEMPLOYEMENT RATE
The effects of the world recession led to a drop in demand for German goods by mostly the US, France and the UK. The drop in demand resulted in a decline in industrial activities; many of these industries had excess capacity which bore high operating cost and overheads and consequently resulted in the mass retrenchment of workers. This brought about an increase in the unemployment rate and by definition; unemployment is explained as when someone who is willing, able and actively looking for work, is unable to get one.
Unemployment rate, given as a percentage of the total labour force is a lagging indicator, i.e. it takes effect after all economic indices are heading in one direction. From the graph below the unemployment started to increase when the economy contracted (GDP) by 2.4% in January. It increased from 7.7% in January to 8.3% in July remained fairly constant but slightly declined by 0.2% in January 2010 (reference).
INFLATION RATE:
Inflation is another useful indicator which can be used in analysing the performance of the German economy. Inflation is defined as the general price increase in goods and services. It looks at the purchasing power of a given currency in terms of what it can buy. Inflation in some certain level like 2% to 3% annually is considered reasonable as it signals that, the economy is expanding. However, an exceedingly high inflation rate needs to be controlled as it can be harmful to the economy like the recent crises in Zimbabwe.
Over the last few years, the level of inflation has been under control. However, the German economy recently experienced a deflation which is defined as the reduction in prices. This can be largely attributed to the recession, as most businesses resorted to a decrease in price strategy in other to attract costumers.
From the above data, it can be seen that during the month of July in 2009, the inflation figure was -0.4% and in October was -0.3%, i.e. the economy experienced deflation basically due to the credit crunch crises. (Reference)
CONCLUSION: The effect of the subprime crises in the US affected the Garman economy, but with the injection of massive stimulus package, the Garman economy was the first in the European Union to get out of the recession with all economic indices picking up in the mid and end of 2009, in July 2009 the GDP grew by 0.4% and in December 2009 the inflation figure was 0.4%.