The Effects of the Credit Crunch

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Introduction

The objective of this document is to gain an understanding of the effect that the credit crunch has had on international stock markets, what the different governments have done or are planning to do to alleviate this problem and the elements that precipitated such a crisis. Therefore in the document the author first begins by defining the credit crunch and the current situation. Then in the next section the author goes on to analyze the effects the crisis has had on the different stock markets across the globe – and specifically looks at the effect that the crunch has had on the American Stock Exchange (the Dow Jones Index) and the Shanghai stock market. Based on the findings the author will then continue to further analyze the specific elements that precipitated these events and look to the future of what is in store specifically for these two countries, what they can and have done to alleviate this problem and what may happen to the global economy as a whole.

The Credit Crunch

Today the word credit crunch has become a household buzzword and has been known by many different terms throughout the developed and the developing world. Credit Squeeze, Credit Freeze and Credit Crisis are some of the other terms that have been used to define the present crisis that has engulfed the entire globe and brought many economies to the brink of bankruptcy – the Icelandic economy being the best example.

So what is a credit crunch or a credit squeeze? It is the decline of available credit facilities in an economy because banks and other financial organizations have tightened their lending regulations in response to a loss of confidence in the consumers ability to pay back loans. Further in order for us to consider a certain situation as a credit crunch, the availability of credit should reduce despite changes in interest rates. By this it is meant that irrespective of an increase or decrease in interest rates there should still be a lack of credit availability in the open market. These are hallmarks of a credit crunch.

Therefore it can be stated that in a credit crunch situation there ceases to be any identifiable relationship between the availability of credit and the changes in the interest rates. Another sign of a credit crunch is when investors and bankers and all lenders in general start looking for safe, conventional and low risk investments. This obviously comes at the expense of small and medium scale enterprises, which are the ultimate victims as banks and lending organizations refuse to lend to them and thus push them out of business due to the liquidity crisis they face.

Therefore looking at everything that has been stated above it would suggest that a credit crunch in effect would reduce the supply of money in an economy facing the crisis and thus cause a reduction in the disposable income of its population due to the lack of funds, loss of jobs (caused by enterprises going out of business) and credit facilities to get them through the difficult times.

The Effects on the Market

The credit crunch that gripped the world’s developed economies throughout 2008 and is expected to continue well into 2010 has far reaching consequences. This is because a reduction in disposable income affects many different industries directly and all the industries throughout the globe indirectly. Thus it can be said that such a crisis in the developed world would eventually cause a devastating domino effect or rather a cascading effect throughout the world due to globalization and the inter-dependence of economies whether developed or otherwise on one another.

The effects of the credit crunch on the market indexes were first seen in the Dow Jones and the FTSE 100 and some other stock exchanges in the developed world. The Dow Jones, which had been at 14,000 point in 2007, saw a huge drop in September and October 2008. Today it is stated that American stocks as a whole have lost 20% of their share value. While the drop in the FTSE 100 was caused by the credit crunch that was in effect in the United Kingdom (starting with the near bankruptcy of Northern Rock) – the drop in the Dow Jones also had an indirect effect on the FTSE.

October was one of the most volatile months in the history of many stock exchanges around the world and the gloom and doom forecasts that were made by economic pundits did not help the markets either. The Russian stock exchange and the Mumbai stock exchanges had to be shut down on several occasions in October and November 2008 to stop the free fall of markets. Likewise even the world’s fastest growing economy China was faced with severe hardship as the Shanghai stock exchange dropped in value by close to 50% from its peak in July 2007.

As stated previously due to globalization all economies throughout the world are inter-dependent and co-dependent on one another[1]. Therefore when a crisis hits one large economy the consequences are far reaching and as is apparent in this case quite devastating to say the least[2].

Taken at face value one would say that there is no connection between the credit crunch and the drop in the market indexes around the world, however it does not take long to make the connection between the two. For instance the lack of available credit in the United States caused a decrease in the disposable income that is in the hands of its public. This reduced a drop in consumption, which hit the housing market, the auto market and the retail sector. The effects on the housing market then caused many banks and investment houses to go bankrupt, as they had invested heavily in mortgage related stocks. Further the hit to the auto and retail sector caused a direct hit to share prices in these industries. Add to this the almost daily occurrences of banks and other huge financial institutions either going bankrupt or desperately asking for help caused even more devastation in the stock markets, thus causing them to loose their value at previously never seen rates.

America and China

The devastation that has been caused throughout the world has caused fear throughout the world’s developed economies that globally we stand on the brink of a prolonged recession that will eventually cause a contraction of more than 10% in productivity, which will then precipitate a depression much akin to the “great depression” of the 1930s[3]. In an attempt to avoid such a situation at all costs economies throughout North America and Europe have done their utmost best to jump-start the floundering credit and stock markets through injection of funds and huge “stimulus” or “bail out” packages. In the United Kingdom alone the current Labour government has gone out on a limb to use taxpayers’ money to bail out many banks and credit organizations. Further the government has also bought stakes in all the banks and credit organizations that have been bailed out and have insisted that these organizations start lending to the general public in an attempt to increasing spending and protect other industries such as the retail, housing and auto industries from collapse.

The United States to has carried out similar steps and has even gone as far as requesting the federal reserve to buy the “toxic assets” that are held by the banks in an attempt to clean up the economy and usher in a new era of conservative economics. In the United States different stimulus packages have been provided to different sectors such as the auto sector to save the “big 3” from near collapse.

Likewise economies have taken many different steps such as reducing interest rates, increasing lending from central banks to the financial sector, guaranteeing investors funds in bank deposits etc. Even economies like China, India and Russia have not been spared and the governments in those countries too have pledged huge amounts of funds in stimulus packages.

In times of recession, usually the commodities markets do very well and as a result are not as affected by the crisis as countries that are not based on commodities markets. However in this case due to the far-reaching consequences of the credit freeze, there was a drop for demand of commodities, which has caused the Middle Eastern, African, Canadian and Australian economies to all falter. While the Canadian and Australian markets are not solely dependent on commodities with the rising oil and gas prices a huge component of the income in these economies were made up of commodities. Therefore a decline in commodities prices caused a further blow to the once robust economies that weathered the storms of the “dot com” burst[4].

Unemployment levels and home foreclosure figures in the United States currently stand at unprecedented levels and analysts say that it is worse than the devastation that was seen in the 1950s and then again to the 1980s[5]. On more than one occasion the current President of the United States, the President-Elect and head of the Federal Reserve are all known to have said that they are on the brink of a depression and will do everything within their means to avoid such a situation from happening. The very fact that these individuals even tout the term “depression” can only mean that the country is very near such a situation, which can only mean that we should expect further financial doom in the coming months and years[6]. When the world’s largest economy slows down, it has a ripple effect throughout the entire world[7]. At one time it was thought that China, India and Brazil the emerging economies would be untouchable, however the past few months and the performance of their stock exchanges have shown us in no uncertain terms, that this is not the case. America is the biggest consumer in the world. And when the American economy slows down and in this case when there is decrease in the money supply – this has a direct effect on consumption. When the consumption levels in the United States drops all countries that export into the United States are affected. China, India, Canada, Saudi Arabia, Mexico and countless other countries export goods and services in to the United States and are therefore greatly affected by the drop in consumption. When these economies are affected – then other economies that are dependent on exporting into countries like China and Canada are affected. For instance the African countries that supply steel and other commodities to China are greatly affected due to the drop in China’s export demands in the United States. And thus the domino effect goes on. The worst part is that factors exacerbate one another and cause increase devastation as the problem persists and makes it harder and harder for governments to reverse the trends as time passes by. This is why early intervention is imperative and some pundits even think that the global economy has already reached the point of no return and that we are falling into an abyss that we will not get out of in the near future and not without some creative and radical changes taking place.

In terms of solving the crisis, many economists and financial analysts have put forward different theories on what should and should not be done. There have been suggestions that China should take the lead on these issues and try to jump start the world economy by bailing out the United States and through that ensuring the growth of its own economy. It is true that the Chinese have access to over 3 trillion dollars in foreign reserves but even if they were to use up all those funds to buy up shares and stocks in the faltering US economy that still leaves the question of the “toxic assets” unanswered and unsolved. The problem in relation to “toxic assets” is not that they cannot be purchased but that their actual value is unknown and most analysts cannot put a price tag on it as the variable are volatile, ambiguous and extremely complicated.

Further it has also been stated that China should attempt to focus its energies on its domestic economy as its banking system much like India’s highly regulated banking system is in good shape[8]. While it is true that China has a huge domestic market if it were to lead the way and increase import demand, this would still lead to a very small percentage increase in the import demand when compared to that of the developed economies. Therefore it is suggested that an increase in import demand in China, India and Brazil together will still not be sufficient make up for the short fall that is caused by the recession and ensuing drop in demand in the developed economies.

Conclusion

It is apparent from everything that has been stated above that the credit crunch, which resulted from the mortgage meltdown that occurred in the United States and the United Kingdom has had far reaching consequences on the stock markets and both the emerging and developing economies around the world.

Governments have done everything in their capacity from injecting unprecedented levels of investment and stimulus packages into their economies on both sides of the globe but the effects have been lack luster or almost non-existent.

The stock markets still continue to be affected, the liquidity crisis is only getting worse and not better and there has been no solution found to wipe out “toxic assets” as analysts and economists are not able identify their real value due to the complicated nature of these investments.

Throughout the last few decades these developed countries have been preaching to the developing world[9]. This was especially true during the Asian Financial crisis toward the end of the last century[10] and now it is time that the developed economies actually practice what they preached all these years.

References

Cai, K. G. (2001). “Is a Free Trade Zone Emerging in Northeast Asia in the Wake of the Asian Financial Crisis?’. Pacific Affairs, 74(1),

Caldwell, J., & O’Driscoll, T. G. (2007). “What Caused the Great Depression?”. Social Education, 71(2), pp. 70.

Eagle, D. (1994). “The Equivalence of the Cascading Scenario and the Backward-Bending Demand Curve Theory of the 1987 Stock Market Crash”. Quarterly Journal of Business and Economics, 33(4), pp. 60.

Feridhanusetyawan, T., Stahl, C., & Toner, P. (2001). “APEC Labour Markets: Structural Change and the Asian Financial Crisis”. Journal of Contemporary Asia, 31(4), pp. 491.

Grimes, A. (1998). “The Asian Financial Crisis: How Long Will the Downturn Last?”. New Zealand Economic Papers, 32(2), pp. 215.

Jiangli, W., Unal, H., & Yom, C. (2008). “Relationship Lending, Accounting Disclosure and Credit Availability during the Asian Financial Crisis”. Journal of Money, Credit & Banking, 40(1), pp. 25.

Leightner, J. E. (2007). “Thailand’s Financial Crisis: Its Causes, Consequences, and Implications”. Journal of Economic Issues, 41(1), pp. 61.

Leijonhufvud, A. (2003). “Reflections on the Great Depression”. Economic Record, 79(246), pp. 388.

Raines, J. P., & Leathers, C. G. (1994). “The New Speculative Stock Market: Why the Weak Immunizing Effect of the 1987 Crash?”. Journal of Economic Issues, 28(3), pp. 733.

Szekely, G. J., & St. P. Richards, D. (2004). “The St. Petersburg Paradox and the Crash of High-Tech Stocks in 2000”. The American Statistician, 58(3), pp. 225.

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Footnotes

[1] Raines, J. P., & Leathers, C. G. (1994). “The New Speculative Stock Market: Why the Weak Immunizing Effect of the 1987 Crash?”. Journal of Economic Issues, 28(3), pp. 733

[2] Leightner, J. E. (2007). “Thailand’s Financial Crisis: Its Causes, Consequences, and Implications”. Journal of Economic Issues, 41(1), pp. 61

[3] Caldwell, J., & O’Driscoll, T. G. (2007). “What Caused the Great Depression?”. Social Education, 71(2), pp. 70

[4] Szekely, G. J., & St. P. Richards, D. (2004). “The St. Petersburg Paradox and the Crash of High-Tech Stocks in 2000”. The American Statistician, 58(3), pp. 225

[5] Eagle, D. (1994). “The Equivalence of the Cascading Scenario and the Backward-Bending Demand Curve Theory of the 1987 Stock Market Crash”. Quarterly Journal of Business and Economics, 33(4), pp. 60

[6] Leijonhufvud, A. (2003). “Reflections on the Great Depression”. Economic Record, 79(246), pp. 388

[7] Cai, K. G. (2001). “Is a Free Trade Zone Emerging in Northeast Asia in the Wake of the Asian Financial Crisis?’. Pacific Affairs, 74(1)

[8] Jiangli, W., Unal, H., & Yom, C. (2008). “Relationship Lending, Accounting Disclosure and Credit Availability during the Asian Financial Crisis”. Journal of Money, Credit & Banking, 40(1), pp. 25

[9] Feridhanusetyawan, T., Stahl, C., & Toner, P. (2001). “APEC Labour Markets: Structural Change and the Asian Financial Crisis”. Journal of Contemporary Asia, 31(4), pp. 491

[10] Grimes, A. (1998). “The Asian Financial Crisis: How Long Will the Downturn Last?”. New Zealand Economic Papers, 32(2), pp. 215

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The effects of the credit crunch. (2017, Jun 26). Retrieved September 25, 2022 , from
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