JOURNAL ARTICLE CRITIQUE AND REVIEW

The Impact of the US Subprime Mortgage Crisis on the World and East Asia: Through Analyses of Cross-border Capital Movements

TABLE OF CONTENTS

1.0

Introduction 1.1 1.2 1.3 Overview Purpose of This Assignment Organizational Structure of the Article

1 1 2 2 3 3 5 5 6 8 12

2.0

Review of the Article 2.1 2.2 Salient Points of the Introduction Section Salient Points of the Section II (Cross-border Capital Flows before the Subprime Mortgage Crisis) 2.2.1 Features of Cross-border Stock Investment Flows 2.2.2 Features of Cross-border Debt Securities Investment Flows 2.2.3 Features of Cross-border Banking Activities 2.2.4 Summary of Cross-border Capital Flows before the Subprime Mortgage Crisis

2.3

Salient Points of the Section III (Cross-border Capital Flows before the Subprime Mortgage Crisis) 14 2.3.1 Impact of the Crisis on Cross-border Capital Movements in the United States and Europe 14 2.3.2 Impact of the Crisis on Cross-border Capital Movements in Japan 16 2.3.3 Impact of the Crisis on Cross-border Capital Movements in Korea 18 2.3.4 Impact of the Crisis on Cross-border Capital Movements in Other East Asian Countries 20 2.3.5 Summary of the Impact of the Crisis on Capital Flows and Economics in Asia 22 Salient Points of the Section IV (Challenges for East Asia) 24 26 27 28

2.4 3.0 4.0

Critiques of the Articles Conclusion

References

1.0

Introduction 1.1 Overview

This journal article review is based on a journal article from the ERIA Discussion Paper Series, which was published on April 2009. The article was written by Sayuri Shirai with the title, The Impact of the US Subprime Mortgage Crisis on the World and East Asia: Through Analyses of Cross-border Capital Movements. The paper discusses the recent global financial and economic crisis in 2008 that was triggered by the advent of the subprime mortgage crisis in the United State. The crisis stated to rise significantly in mid-2007, spreading to Europe and the rest of the world including East Asia. The nature of the current global financial crisis was unique in terms the scale of the problems in the financial sector, the depth and speed of contagion worldwide affecting the financial sector and trade linkages, and the severity of the recession affecting emerging market economics, small countries and East Asia. The paper analyzes the cross-border capital movement by looking at the precrisis features of the United States which is regarded as the crisis hypocenter and its relationships with other countries. The paper presents detailed observations on cross-border investments in stocks, debt securities and banking activities. The paper also highlighted the impact of the subprime mortgage crisis on cross-border capital movements in the United States, the United Kingdom and East Asia. Performance indicators like exchange rates, economic growth and international trades pertaining to East Asia were discussed in this paper. The paper also examines several challenges posed for East Asia by the crisis.

1.2

Purpose of This Assignment

The purpose of this journal article review is to highlight the salient points relating to the following aspects: (a) Cross-border capital flows based on the pre-crisis features of the United States as the epicentre of the global crisis. This includes detailed observation

relating to cross-border stocks an debt securities investments as well as banking activities before the crisis (b) The impact of the subprime mortgage crisis on cross-border capital movements in the United States, the United Kingdom and East Asia. For East Asia, performance indicators such as exchange rates, economic growth and international trade were discussed (c) Several challenges posed to East Asia by the current crisis.

1.3

Organizational Structure of the Article

The article presented a short introduction to provide some background information about the recent economic recession due to subprime mortgage crisis in the United States. There are three main sections to discuss the pre-crisis features of the cross-border capital flows in the United States, the impact of the subprime mortgage crisis on the cross-border capital movements in the United States, the United Kingdom and East Asia and the challenges faced by East Asia due to the crisis. This paper presents salient points from the Introduction section and the three main sections of the article.

2.0

Review of the Article 2.1 Salient Points of the Introduction Section

In this section, the author highlighted the fact that the current global financial and economic crisis has an unprecedented nature in terms of scale of the problems in the financial sector (particularly in the United States and Europe), the depth and speed of the worldwide contagion (through financial sector linkages as well as trade linkages), and the severity of the recession (particularly in emerging market economies, small countries, and East Asia). In comparison to past recessions such as the Great Depression (1929-30), the Savings and Loans Crisis in the United States (1989-90), the Long Term Capital Management crisis in the US (1988) and the bursting of the IT bubble (2000-01), the recent crisis was even more complicated for several reasons which are: There were many securitized assets and derivatives transacted over-thecounter market, resulting in lesser information and counterparty credit. Thus, liquidity risks were greater in the case of exchange-traded products. Due to insufficient information, anxiety escalated among the financial institutions and investors resulting in restrain of investments and financial flow. Hence, the financial and real sectors were adversely affected. Other financial institutions such as investment banks, financial companies, and hedge funds did not apply the principle of capital adequacy requirement. Since there was no protection for other financial institution in the form of deposit insurance system, they were exempted from the stringent monitoring and capital adequacy requirements imposed by regulatory authorities. This lead to expansion of business relating to subprime mortgage origination, securitization, and derivatives. They created the cycle of drawing short-term funds from the market and

investing in longer-term illiquid financial assets, such as ABSs (assetbacked securities) and CDOs (collateralized debt obligations). Commercial banks established SIVs (structured investment vehicles) as off-balance units as an attempt to avoid regulatory monitoring and capital adequacy requirements. SIVs issued short-term commercial paper called ABCP (asset-backed commercial paper) to invest in longer-term and lower-quality ABSs and CDOs. There was lax in determining the affordability to borrowers or the credit rating of the borrowers. The commercial banks used an originate-to-distribute business model especially relating to subprime mortgage. Risks were increased for the commercial banks but these were underestimated by the commercial banks and by regulatory authorities. Credit rating agencies failed to capture the risks involved in the mortgagebacked securities (MBs) and CDOs. When the rating agencies suddenly downgrade the ratings of these products in the middle of the market turmoil, anxieties increased and there was more fire-sale of these products. Several internal conflicts of interest rise between the advisory businesses and the rating services within the rating agencies. Banks and other financial institutions have faced large losses that have impaired their own capital. Due to rapid loss of their creditworthiness, banks experiences a sharp decline in transactions in the interbank markets, resulting in stock prices going down and further degraded their financial stability. The money, debt securities and stock markets shrank fast resulting in difficulty for financial and non-financial firms to obtain funds. Governments in some countries stepped in to help the banks maintain liquidity as well as instituting expansionary fiscal policies (tax cuts and increased expenditure) to stimulate aggregate demand.

The current crisis was said to be unique because the US dollar has strengthened almost all foreign currencies except Japanese yen and the Chinese yuan. This happens because there was an increased demand for the US dollar in the de-leveraging process whereby many US investors withdrew from global stock investment and a decline in dollar-denominated funds for banks in Europe. The crisis reduced the prices of almost all financial assets worldwide, so that investors could have some US financial assets as safer than other foreign assets.

2.2

Salient Points of the Section II (Cross-border Capital Flows before the Subprime Mortgage Crisis)

This section is divided into four sub-sections. Salient points from each of the subsections are presented as follows: 2.2.1 Features of Cross-border Stock Investment Flows

Prior to the subprime mortgage crisis, the US was an active investor in world stock markets. In comparison, the US investors held foreign stocks of about $5 trillion (end of 2007) while foreign investors held US stocks of $3.1 trillion (end of June 2007). Hence, the US was a net investor in foreign sticks although it is also the largest net external debtor in the world. The US is a significant contributor to the global stock markets and in European stocks, accounts for half of its foreign stock investment. US made its largest investment to the UK., Japan, France and Germany. The US investment in East Asian stick was much smaller and less active than the European stocks but US investors were still the largest external source of investments in some East Asian countries such as Hong Kong, Indonesia, Korea, Malaysia, Singapore and Thailand.

In the US, foreign investors only make up 11% of the total US stock market, with United Kingdom as the most active investor and Japan as the most active East Asian investor. The US stock market was dominated by domestic individual and institutional investors. The financial assets of US household were the largest in the world and held 28% of the total US stocks. US mutual funds were the second largest investor as a group, with 22% of US Stocks outstanding. The US has lower dependence on foreign investors than does East Asia.

2.2.2

Features of Cross-border Debt Securities Investment Flows

US investors are less active in foreign debt securities compared to stocks and more focused to foreign private sector debt securities and long-term debt securities. There is also a small amount of investment in foreign government securities, implying a small amount of foreign reserves. The US debt securities are mostly from UK, the Cayman Islands, Canadian securities, French securities and German securities, focusing on private sector debt securities. The US is the largest foreign investor in UK debt securities, at 27% of the total value of UK debt securities held by foreign investors. Foreign investors on the other hand, are actively invested in the US debt securities market. The foreign investors held US debt securities equivalent to $6.6 trillion by end of June 2007; this amount exceeded the amount of US stocks they held. Japan and China are the largest investors in US debt securities with mostly longer-term securities such as treasury securities and agency-related securities which were relatively risk-free. Japan and China also hold a substantial part of their foreign reserves. UK investors are the third largest group of foreign investor in the US debt securities market. Other investors from European countries include

Luxembourg, Belgium, Ireland, Switzerland, and Netherlands. These countries hold few foreign reserves and less keen than East Asia on holding foreign government securities. East Asia accounts for more a half of the total foreign reserves accumulated worldwide. The trend implied that European investors were greater risk-takers than East Asian investors. The East Asian investors contributed to lowering US long-term interest rates by holding large amounts of US treasury securities but they were less willing to hold other debt securities, such as corporate bonds and ABSs. On the contrary, European investors were more interested in holding riskier assets, contributing to financing firms and private sector issuers of securitized assets in the United States. Hence the European investors suffered the most from the subprime mortgage crisis. US debt securities were largely issued in US dollars with about 88% of foreign-held US debt securities denominated in US dollars. US investors (76%) also purchase large quantities of foreign debt securities in US dollars. Hence, in the European market, US dollar remains the most important hard currency in cross-border market transactions. Hence the US issues and investors face little exchange rate risk. In East Asian debt securities, the nationalities of foreign investors were diverse. For Japanese debt securities, France was the largest group followed by the United States. IN China, Hong Kong was the largest investor, followed by Singapore and Mauritius. In Korea, Hong Kong is the largest investor followed by France and Singapore.

2.2.3

Features of Cross-border Banking Activities

Cross-border banking expanded globally in the early 2000s with big players from banks of the US, the UK and other European countries. Cross-border business was further increased with banks operating business with non-bank firms (including loans, corporate bonds, ABSs, MBSs, CDOs, and stocks) besides bank-to-bank transaction. The key players are UK nationality banks and affiliates of foreign nationality banks operating in the UK. Foreign bank affiliates operating in the UK are mostly from the US, France, Germany, Switzerland, and other European countries. Based on the amount of external assets and liabilities, UK offered the best location for both local and foreign banks from which to engage in cross-border bank lending and borrowing activities. About 54% of the external assets in the UK banks were made up of external assets vis--vis banks abroad (including foreign affiliates), mostly in the form of loans and deposits. The remaining 46% of external assets comprised assets related to non-banks abroad whereby 65% of these amounts were in the form of loans and deposits, while 35% were largely debt securities issued by nonbank firms in the United States (including structured credit products, and corporate bonds). Local banks and affiliates of German and Swiss nationality banks operating in the UK were active in this pattern of investment but affiliates of US nationality banks operating in the UK were not. They were more actively engaged in loan and deposit activities. About 70% of the external liabilities of banks in the UK were generated from banks abroad (including foreign affiliates), mostly from funds provided by banks in Switzerland, Singapore, Hong Kong, and the Euro area. These situations indicate a transformation of international money through the intermediation of banks in the United Kingdom, from diverse interbank funding sources worldwide to non-bank claims in the United 8

States. It implies that the UK (namely, London) was a more important focus for cross-border banking activities (where both local banks and foreign bank affiliates were active players) than the United States (namely, New York). London is comparatively better as a competitive international financial centre due to the presence of the internationally-active banking sector that circulates global money from oil-exporting and other countries to the United States and other regions of the world. It was also suggested that US nationality banks performed aggressively in the international business environment by extending business through foreign affiliates with preference for the UK followed by Germany, France, Japan, and Switzerland. A different scenario is observed in US. Banks in the US held 77% of their external financial assets in the form of loans and deposits vis--vis banks abroad (including foreign affiliates). About 72% of their external financial liabilities comprised loans and deposits obtained from banks abroad as well as from overseas non-bank entities (mainly through loans and deposits). Banks in the United Kingdom actively engaged in financing nonbank borrowers in the United States, whereas banks in the United States did not actively engage in financing non-bank borrowers in other countries. This difference fuel the explanation why UK offered the biggest market for structured credit assets, thus attracting foreign investors and banks. Banks in Germany and France also actively engaged in cross-border banking activities. Over 60% of their external assets comprised assets vis-vis banks abroad (including foreign affiliates) in Germany and France, mostly in the form of loans and deposits vis--vis banks abroad and a few in the form of debt securities issued by banks abroad. Banks in Germany and France rely mostly on funds from banks abroad. The size is smaller but the features are similar to UK.

As for East Asia, the amounts of external assets and liabilities were much smaller indicating that the cross-border banking businesses in this region are still in premature age. Banks in Japan had external assets of sizes comparable to banks in Europe and the United States but smaller external liabilities. This implies that Japan did not play an active role in the intermediation of foreign money. Japanese nationality banks were cautious after experiencing serious domestic banking sector problems in the 1990s. Japan banks only began to increase their cross-border activities from 2002, particularly in the United States, followed by the United Kingdom, France, and Germany but at a slower pace than their Western counterparts. Total external assets are mostly in the form of loans and deposits. About 63% of external assets comprised claims against nonbanks abroad. The greater exposure to non-banks abroad reflects the increased preference of banks in Japan for foreign debt securities. Japanese nationality banks had the largest exposure to US treasury securities and agency-related bonds of all the banks in the world. Banks in Japan and the UK both invested heavily in debt securities but with differing risk attitudes: banks in UK had a large exposure to structured credit products and corporate bonds. Hence these banks in the UK suffered more than those in Japan during the 2008 financial crisis. Banks in Hong Kong has small external assets and external liabilities but they were large in terms of GDP (about 4 times and 2.3 times the Hong Kong GDP respectively). About 80% of external assets in Hong Kong are loans and deposits vis--vis banks abroad. Their external liabilities are also mostly of loans and deposits with a major portion from banks abroad and the rest to non-banks abroad. Singapore also projected the same pattern with its external assets and liabilities as a share of GDP were 4.7 times and 4.8 times, respectively. This implies that the countries, specifically Singapore like the UK

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participated in intermediating global money more actively than did banks in Japan. External loans and deposits accounted for more than 90% of external assets (leaning more from banks abroad and the rest to non-banks abroad). In Korea and Malaysia, the external assets and liabilities of their banks were relatively small, both in terms of absolute terms and as a share of GDP (less than 21% in Korea and less than 24% in Malaysia). Foreign banks dominated cross-border claims from Hong Kong and Singapore. Before the Asian crisis, these two countries functioned as intermediaries in the circulation of foreign money from Japan, the United States, and Europe (through affiliates operating in Hong Kong and Singapore) to emerging East Asian countries (such as Korea, Thailand, Indonesia, and China). Apart from this, there was direct financing by Japanese, US, and European-headquartered banks to emerging East Asia. After the crisis, Hong Kong and Singapore resumed as regional financial centres but their role in intermediation was transformed from being a provider of net claims against Emerging East Asia (from Japan, the United States and Europe) to being a provider of net claims against the United States, United Kingdom and other European countries (from emerging East Asia). Investors and banks in East Asia place deposits in, and extend loans to, banks in Hong Kong and Singapore and in turn the banks in these two countries use the proceeds to financing for banks in the US, UK, and other European countries. US dollar and euro were the most frequentlyused currencies for cross-border banking activities with the US dollar being the most dominant foreign currency in cross-border banking activities.

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2.2.4

Summary of Cross-border Capital Flows before the Subprime Mortgage Crisis

Summary from Section II is given as follows: US investors investments in foreign stocks are enormous and dominant around the world, much more than the amount of foreign investors investments in the US stocks. Most of US external financing comes from debt securities, implying investors in the US as risk-takers as they have strong preferences for stock investments. Investors in Europe are also risk-takers as they are also actively invested in riskier stocks, corporate bonds, ABSs, MBSs, and CDOs in the United States. Investors in East Asia are risk-averse with preferences for foreign reserves. Japanese private sectors investors preferred investing in foreign bonds to foreign stocks. The US and Europe together contributed to the rapid growth in the structured finance industry but they were subjected to high risks. Debt securities issued by debtors in the US were mostly denominated in US dollars. The US creditors and investors faced a limited degree of currency mismatch. Foreign debt securities were largely denominated in US dollars. Most foreign bonds held by US investors were from the UK, the Cayman Islands, and Canada. The European counterparts are exposed to the foreign exchange risks. It also shows that the US dollar was the preferred hard currency in cross-border debt securities transactions. Cross-border banking activities were dominated by US- and European-nationality banks. The UK became the most prominent intermediary location in terms of circulating global banking money. Local banks and European-nationality banks affiliates managed these funds in the UK. These were then allocated largely to non-bank

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borrowers in the US. The US was a lesser important center for crossborder banking activities as the UK but US nationality banks actively engaged in international activities through establishing subsidiaries and branches residing in the UK, other places in Europe and other regions (East Asia). US banks foreign affiliates were less exposed to financing non-bank borrowers in the United States, as compared with UK and other European banks. Japanese banks were the most active players in cross-border banking activities among the East Asian banks with more preferences in external asset. In addition to deposits and loans, they also invested in a large amount of US treasury securities and agency-related bonds. Japan did not offer a place for intermediate global money. The role of Japanese nationality banks in the intermediation of global money was limited. Singapore and Hong Kong were the important locations for cross-border banking activities in East Asia (like the United Kingdom) by circulating regional money to other regions in the world. Most of active players there were affiliates of US and European nationality banks. Hong Kongs role as an intermediary for FDI has become increasingly important and more international. Hong Kongs intermediary role for FDI flows was mostly linked to China but Hong Kongs FDI flows with other East Asian countries were also growing.

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2.3

Salient Points of the Section III (Cross-border Capital Flows before the Subprime Mortgage Crisis)

This section is divided into five sub-sections. Salient points from each of the subsections are presented as follows: 2.3.1 Impact of the Crisis on Cross-border Capital Movements in the United States and Europe

The subprime mortgage crisis saw many banks in the US and Europe immediately deteriorate in assets and leading to the impairment of their capital. Many banks faced losses and were saved by other banks or the government. Various measures were done to counteract the impact of the subprime mortgage crisis. The French banking group BNP Paribas suspended withdrawals from affiliated funds that were exposed to US subprime mortgage-related assets (August 2007) while the British bank Northern Rock was provided with liquidity from the Bank of England (September 2007) and was nationalized in 2008. European banks suffered large losses from subprime mortgagerelated investments. The total amount of worldwide write-downs of financial institutions amounted to $965 billion (Dec, 2008) whereby the largest write-downs was from the US, followed by Europe (especially UK and Swiss banks). East Asia has smaller write-downs due to limited exposure to investment in structured credit assets in the United States. Citigroup was the worlds largest bank in terms of assets before the crisis but made huge losses from investment in mortgage-related CDOs. The group accepted capital injections of a total of $45 billion from the US government via the $700 billion TARP (Troubled Asset Relief Program). Merrill Lunch also incurred severe losses and eventually was purchased by the Bank of America in September 2008. UBS, the largest Swiss Bank faced the largest write-downs among European banks.

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The crisis had an immediate impact on US cross-border banking activities. Before the crisis, there was a net increase in foreign assets from the US but during the crisis, there was a net decline in foreign assets. The US banks and foreign banks affiliates in the United States curtailed their cross-border activities, mainly through cutting US dollar-denominated claims. The impact on foreign debt securities was mild compared to the decline in loans and deposits because of the shift of investment by US investors from European private sector debt securities to safer European treasury securities (such as German treasury securities). Foreign capitals inflows for US debt securities declined sharply in the third quarter of 2007 but made recovery after that as there was a shift of foreign investors investment in the United States from corporate bonds and ABSs to treasury securities. Both foreign monetary authorities and private sector investors expanded their investment in US treasury securities, suggesting a flight to quality (a shift from risky and illiquid assets to risk-free and liquid assets). China, the UK, oil-exporting countries and Switzerland increased their holdings of US treasury securities between 2007 and 2008. In UK cross-border capital movements, the biggest impact of the subprime mortgage crisis was on the loan and deposit accounts. There was an increase in foreign assets in the first quarter of 2008 due to cross-border lending by banks in the United Kingdom (possibly from foreign bank affiliates to their headquarter banks) but there was a decline in the external assets of banks in the United Kingdom commenced after this period. The debt securities account shifted from an increase to a decline in foreign assets. Investors and banks in the UK reduced their investment in US structured credit assets, corporate bonds, and other private sector financial assets. The capital inflows of foreign liability declined drastically in the first quarter of 2007 due to the cut in their dollar-denominated cross-border

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claims against banks operating in the United Kingdom as well as a cut in interbank financing by banks in oil-exporting countries, Switzerland, Hong Kong, Singapore, and the euro area. There was a serious shortage of US dollars among banks in the United Kingdom (and other European countries).

2.3.2

Impact of the Crisis on Cross-border Capital Movements in Japan

It is said that East Asia was able to escape the direct damage caused by the subprime mortgage crisis in the US because East Asian investors and banks did not invest much in the US structured credit products. The book value of structured credit products held by Japanese (nationality) banks (including major banks, regional banks, and cooperative financial institutions) amounted to only a little more than $210 billion as of September 2008 with unrealized losses amounted to $14 billion only while cumulative realized losses since April 2007 amounted to only $17 billion. Hence Japanese banks write-downs were smaller compared to those of US and European banks. Several factors explain the limited exposure of Japanese banks to the crisis that are: Deposit-taking banks (commercial banks) are dominant in Japan. Japan undertook the Financial Big Bang from 1996 which deregulated the establishment of financial holding companies, but the separate management of various financial businesses has remained a requirement. Japanese banks enjoy a large pool of deposited household savings. Thus, Japanese banks needs to obtain financing from alternative sources (such as the wholesale money market, capital market or

16

abroad) have been relatively limited, as compared with US and European banks. Many Japanese banks remained cautious about foreign investment, since it took such a long time to recover from the domestic banking crisis of the 1990s. The East Asian crisis of 1997-98 also incurred some losses and thus induced Japanese banks to withdraw from their credit exposure in East Asia. Their limited exposure to foreign liabilities prevented Japanese banks from incurring large credit squeezes arising from any reduction in cross-border financing channels, as seen in European banks. However, the subprime mortgage crisis mostly affected Japan through the loan and deposit accounts which saw a decline in the loan and deposit accounts of non-bank firms. The amounts of loans and deposit of banks were relatively stable because Japanese banks increased (largely yen-denominated) lending to their affiliates operating abroad as well as to other foreign banks in the United States and Europe that were in need of liquidity.

Japan and East Asia felt the impact of the subprime loan crisis primarily after Lehman Brothers filed for Chapter 11 bankruptcy protection in the US courts in September 15, 2008. The plunge in Lehman Brothers stock price amid growing loss of confidence by investors in the institution intensified the counterparty and credit risks among other financial institutions and investors. Hence there was increase in doubt about overall financial sector stability in the United States and Europe, leading to a rapid reversal of investors risk appetite, toward being riskaverse, and so precipitated a worsening of the credit crunch. There was an increase in loan losses. The impact resulted in worsening global macroeconomic performance especially in late 2008 where there was a

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decline in inflation rates, a rise in unemployment, a slowdown in consumption growth, and a contraction in trade growth. The declining value of the Japanese stocks held by Japanese banks put them in an extremely difficult position, as it impaired their capital. This has forced many banks to increase their capital, making them cautious about extending loans to small-sized firms. Thus, the growing demand for credit from large- and medium-sized firms and declining bank capital have made it very difficult for small-sized firms to gain access to bank loans. This situation induced the Japanese government to provide inexpensive financing and credit guarantees to Japanese firms from 2008. In addition, the Bank of Japan (BOJ) and the Banks Shareholdings Purchase Corporation (BSPC) were allowed to purchase stocks held by banks from 2009; effectively re-starting an earlier measure to revitalize the sluggish stock market.

2.3.3

Impact of the Crisis on Cross-border Capital Movements in Korea

The financial sector in Korea did not experience major losses from investment in US structured credit products. Korean banks did not engage much in securitization of mortgages and other assets. The crisis affected Korean mainly through a cut in Korean investors investment abroad particularly in foreign stocks. This differs from the US, UK and Japan scenario whereby movements were mostly loan and deposit accounts. This implies that Korean investors are more exposed to securities (stocks, bonds, and mutual funds). The shift was contributed by the liberalization of capital outflows and tax benefits in 2006 as well as increased risk appetite in search for high returns. Foreign assets in the loan and deposit accounts in Korea banks expanded slightly due to foreign bank affiliates

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operating in Korea increased lending to their headquarter banks in the United States and Europe that suffered from a sudden liquidity shortage. In terms of external liabilities, there was a decline in foreign investors investment in Korean stocks which indicates an increase in outflows by foreign investors from the Korean stock market. Korean stock market which was heavily dependent on foreign investors in the stock market was adversely affected when foreign investors began large-scale sales in 2008. The loan and accounts of Korean external liability side remained relatively stable until the fourth quarter of 2007. The local branches of foreign banks operating in Korea at that time had actively borrowed US dollars, converted them into Korean won in the swap market, and then invested in Korean debt securities (i.e., Korean treasury bonds, central bank monetary stabilization bonds). Hence, there was rapid increase in short-term external debts. In addition, domestic banks increased their foreign borrowing to meet demand for foreign currencies driven by growing foreign portfolio investment by residents. Capital inflows were also generated by the hedging activities of Korean shipbuilders and by asset management firms. Korean banks depended heavily on loans to finance their lending activities. Korea recorded high loan-to-deposit rates, which reached 130%, the highest in East Asia. The loan-deposit rate was more than Japan, China, Hong Kong, Malaysia, Singapore, and Thailand (rates below 100%) and even higher than Europe and the US. This means that Korean household shifted their financial assets from deposits to portfolio investment. This resulted in an increase of Koreas outstanding external liabilities for both long-terms and short-terms external debts. Domestic banks have larger external debt compared to foreign banks branches but the ratio of shortterm external debt to total external debt was greater for foreign banks than

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domestic ones. Debt exposure was mostly from banks in the UK, France and Germany, followed by the US. The growing dependence on wholesale financing had made Korean banks vulnerable to liquidity risks and external financial conditions. Korea faced a decline in capital inflow because of its growing external debt and also due to the unwinding of the Japanese yen-involved carry trade. Due to decreased capital inflow, the Korean won depreciated at a scale larger than Indonesia, Malaysia, Singapore and Thailand. The sharp depreciation of the Korean won reflected the large sale of Korean stocks held by foreign investors, deteriorating current account balances, and growing concerns about dollar shortages.

2.3.4

Impact of the Crisis on Cross-border Capital Movements in Other East Asian Countries

The financial accounts in Hong Kong were affected by the subprime mortgages crisis mainly through the loan and deposit accounts. Foreign asset increased prior to the crisis due to loan and deposit accounts but a shat decline in the first quarter of 2008 due to heightened financial sector uncertainty in the United States and Europe, leading to a sharp reduction in the provision of cross-border credit to banks in those places. Hong Kong differs from other countries because there are significant opportunities for the expansion of financial service provision to (mainland) China. Therefore, the risk of major retrenchment in Hong Kongs financial service business over the longer term appears relatively modest. Liability of Hong Kongs financial accounts expanded prior to the crisis also due to loan and deposit accounts leading to increased crossborder lending. The decline in external liabilities of loan and deposit accounts was due to Hong Kong banking systems close relationships with 20

the United States and Europe. Due to heightened anxiety among investors, Hong Kong interbank rates rose sharply. There was also a sharp decline in stock prices during the crisis partly due to a decline in foreign investors investment in Hong Kong. Singapore also experienced a decline in foreign assets. Before the crisis, Singapore also invested actively in foreign securities through Temasek Holdings and Government of Singapore Investment Corporation. These foreign stocks lead to huge losses to these two corporations. Capital inflows to Singapore securities dropped sharply since there is a cut in US investors in Singaporean securities (the US investors were the largest foreign investors in Singaporean stocks and debts securities). Major banks in China such as Industrial & Commercial Bank, Bank of China, and China Construction Bank were involved in foreign investments and were affected slightly by the subprime mortgage crisis as the amounts involved was small. Furthermore, the Chinese banking enjoys substantial savings accumulated by households and firms so they were not relying much in wholesale market. Nonetheless, Chinese financial institutions and domestic investors suffered large losses from investments in US and European stocks, whose prices saw a sharp drop amid growing anxiety over their deteriorating balance sheets and resultant massive sales by investors.

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2.3.5

Summary of the Impact of the Crisis on Capital Flows and Economics in Asia

The direct impact of the US subprime mortgage crisis to East Asia is smaller compared to US and Europe. There are many factors for the limitations: The loan-deposit ratios of banks were low (except for Korea). East Asian banks have a large accumulation of saving and have low level of need to obtain financing from the wholesale market. Hence, they escaped the massive dollar squeeze experienced by US and European banks. Net external liabilities of East Asian countries indicated that they are net external debtors, with sizes much smaller than those of European countries. Furthermore, a number of East Asian countries had comparatively mixed net external assets. The diverse positions among East Asian countries helped the region to stabilize financial conditions. East Asian banks had limited exposure to US structured credit products. Household debt remained relatively low in East Asia. This helped to mitigate the deflationary impact of the financial sector problems on households, thus consumption growths. East Asian countries have ample foreign reserves due to accumulated current account surpluses. External debt as a percentage of foreign reserves remained less than 100% in many East Asian countries, except Indonesia and Korea.

East Asia was however severely affected after the failure of Lehman Brothers in September 2008. Korean and East Asian emerging markets

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suffered a decline in capital inflows, particularly in terms of external borrowing and stock market financing. The loss of risk appetite and intensified liquidity shortages in the United States and Europe reversed their investment activities, causing a rapid increase in CDS premiums and interbank market interest rates, a sharp drop in stock prices and a rapid depreciation of exchanges rates in East Asia. Trade finance has also declined because many banks reduced their supply of letters of credit in the absence of sources of finance, as well as a decline in mutual trust. Most East Asian currencies depreciated against the US dollar except the Japanese yen and the Chinese yuan. The Japanese yen appreciated sharply against the US dollar (as well as the euro and other currencies), because of the unwinding of the yen carry trade that was active prior to the subprime mortgage crisis. The appreciation of the Chinese yuan reflects continuous large trade surpluses, which continue to grow because the slowdown in imports exceeded that of exports. East Asian began to face slowdown in economic growth in 2008 with most countries experiencing decline in GDP. Trade balance was also affected in these countries. The degree of economic slowdown appears to be more pronounced in Japan and the other East Asian countries than that of the United States. This is due to Japans industrial production decline. Japanese industrial production has been concentrated in three sectors: (a) transportation machinery (e.g. automobiles), (b) electrical equipment (e.g., electronic parts and devices, electrical machinery, IT equipment), and (c) general machinery (e.g., production machinery), together accounting for half of Japans total industrial production. These three sectors have been severely affected by the global crisis because of the global downturn in demand for these products. Japan also has higher export ratios as well as the yens sharp appreciation vis--vis the US dollar and other East Asian currencies, hence a greater slowdown for Japan.

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The economic slowdowns in the United States and Europe resulted in sluggish performances in trade and production in the East Asian region. The decline in capital inflows from the United States and Europe to East Asia has discouraged consumption and investment activities in East Asia, thereby undermining demand for trade products within the region.

2.4

Salient Points of the Section IV (Challenges for East Asia)

The crisis posed several challenges to East Asia. These challenges are listed and described as follows: Japan and East Asia need to make greater effort to develop a more mature internal market for final goods and services. East Asia has internal markets mainly for intermediate goods but are still heavily dependent on the United States and Europe as markets for their final products. Japan and East Asia need to examine various ways to circulate regional money within the region. Before the crisis, East Asia accumulated substantial current account surpluses, resulting in increase in foreign reserves and becoming the largest form of East Asian external assets mainly from US in the form of US treasury securities and agency-related bonds. Foreign currencies were held by private sectors allocated to banks in the UK and US through the interbank markers of Hong Kong and Singapore. Japans investment in foreign stocks was mostly allocated to US and European stocks while Hong Kong investment in foreign stocks was allocated to (mainland) Chinese stocks. This clearly shows that East Asia was dependent on capital investment from the United States (and Europe). Money was circulated within this region, bypassing the US and Europe. The US was the largest and most diverse (both liquid and illiquid) capital markets in the world and able to attract foreign money while UK

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was another internationally competitive financial center by developing relatively large capital markets and providing a place for most-competitive cross-border banking activities. However, this pattern was not productive for the perspective of developing East Asia. The author suggested that it would be better to develop attractive international financial centres within East Asia. Japan should focus on promoting greater financial activities in this region. Japan could also increase its cooperation with other international financial centres in East Asia like Hong Kong and Singapore. Coordination would include; (1) regional convergence of accounting, auditing, credit rating standards, (2) an increase in cross-listing of securities among stock exchanges, (3) joint development of new financial products, and (4) sophistication of infrastructure (e.g., clearing and settlement systems). This could lead to the achievement of more selfcomplete trade integration in East Asia resembling that which exists in Europe. Japanese banks could consider capitalizing on this opportunity by more actively engaging in cross-border banking activities. Japan and East Asia should examine the possibility of developing risk-free liquid assets, which could potentially become alternatives to US treasury securities. Alternatively, greater efforts could be made to develop East Asian bond markets, including regional currency basket-denominated bonds. .

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3.0

Critiques of the Articles The paper presented a very thorough and detailed description of the financial situations in the United States, European countries and the East Asian countries prior to the subprime mortgage crisis. Each situation in the countries was explained in terms of vulnerability to the upcoming crisis. It showed that robust economics and a high risk appetite can lead to disaster if left unchecked and unmonitored. The paper also examined the impact of the subprime mortgage crisis to the three regions: US, European countries (particularly UK) and East Asian countries in terms of financial assets and liabilities. The findings showed similarities as well as uniqueness in each region. In the East Asian countries, Korea provided a unique situation compared to other countries. It was also highlighted that the 2008 financial crisis is unique in its own way because of deviation from previous trends such as the appreciation of the US dollar instead of showing decline. In addition, it also highlighted that being riskaverse and promoting more on household savings creates a safety net that enables countries like Japan and China from severe impact. As was indicated, the Japanese yen and China yuan also appreciated in the midst of the crisis. Japan was impacted by the crisis more by indirect factors, specifically towards its industrial production. The paper presented several challenges and recommendations for East Asia to be prepared and improve its current situation against future financial disaster. The suggestions provided efforts for more regional integration and creating a financial hub within this region itself, with interest pointing towards Japan and collaboration with Singapore and Hong Kong which are already emerging financial centres in this region.

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4.0

Conclusion

Review of the journal article was able to highlight the factors and situations leading to the subprime mortgage crisis in the US and how it affected other countries in the world. It also presented an impressive amount of information to understand the impact of the crisis to the affected countries: the United States, the European countries and East Asian countries. The paper was able to highlight the importance of improving the quality of financial market integration and control in the East Asian region.

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References

Shirai, S. (2009). The Impact of the US Subprime Mortgage Crisis on the World and East Asia: Through Analyses of Cross-border Capital Movements, ERIA Discussion Paper Series, ERIA-DP-2009-10

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