Road to Recovery: Singapore's Journey through the Global Crisis

2. Global Financial and Economic Crisis: Causes, Impact, and Policy Response

2 Global Financial and Economic Crisis: Causes, Impact, and Policy Response The global financial turmoil surfaced in the middle of 2007 as a result of defaults of sub-prime mortgage loans in the United States. It was blown into an unprecedented financial crisis in 2008 when a series of major financial institutions in the United States and Europe started to fail. Around the world stock markets fell, financial institutions were bought out, and massive coordinated actions by the authorities were taken to inject liquidity into money markets and restore confidence in the financial systems. Strong calls were made at the Group of Twenty (G-20)1 level for a new financial system to prevent future financial crises and to maintain global financial stability. As the U.S. sub-prime mortgage crisis spread to the rest of the U.S. financial system and other industrializedcountry financial markets, a significant slowdown was observed in economic growth of the U.S., Europe, and Japan. The financial sector crisis subsequently moved to the real economy. Although Asian financial institutionsʼ exposure to sub-prime-related products was limited, the impact was felt through capital flow and trade channels. 02฀RtR.indd฀฀฀16 7/12/10฀฀฀5:18:14฀PM Global Financial and Economic Crisis 17 Accordingly, the IMF in its World Economic Outlook (WEO) Update publication (January 2010) placed global growth at 3.0 per cent in 2008 and a contraction of –0.8 per cent in 2009. This represented a significant slide from an economic growth of 5.0 per cent observed in 2006–7. The advanced economies were in or close to recession in the second half of 2008 and early 2009, and showed some signs of recovery later in 2009. Growth in most emerging and developing economies was below trend, although key emerging economies in Asia, like China and India, showed higher resiliency. Genesis of the Global Financial Crisis The global financial crisis was triggered in August 2007 when the U.S. sub-prime loan defaults began to rise and foreclosures increased. At a fundamental level, however, the crisis could be attributable to the persistence of large global imbalances, which in turn was a result of a long period of loose monetary policy in the U.S. economy. This policy led to a prolonged period of abundant liquidity, imprudent lending in the sub-prime sector, lack of adequate regulation over financial institutions, and finally the collapse of the housing price bubble. Following the demise of the dot-com bubble and the 9/11 terrorist attacks in 2001, monetary policy in the U.S. was eased aggressively. The target federal funds rate dropped from 6.5 per cent in January 2001 to 1.25 per cent two years later and stayed around that level until 2005 (Figure 2.1). Thereafter, the withdrawal of monetary accommodation was also quite gradual. 02฀RtR.indd฀฀฀17 7/12/10฀฀฀5:18:14฀PM 18 Road to Recovery This boosted consumption and investment in the United States as desired by the U.S. policymakers. Asset prices, particularly in housing and real estate, recorded strong gains providing further impetus to consumption and investment through wealth effects. Thus, aggregate demand in the United States consistently surpassed domestic output and this was reflected in large and growing current account deficits in the United States over the period (Table 2.1). The large domestic demand of the United States was met by the rest of the world, especially China and other East Asian economies, leading to growing surpluses in these FIGURE 2.1 Federal Funds Target Rate in the U.S. Source: Bloomberg. 0 1 2 3 4 5 6 7 8 9 Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 (per cent) Federal Fund Target Rate 02฀RtR.indd฀฀฀18 7/12/10฀฀฀5:18:16฀PM Global Financial and Economic Crisis 19 TABLE 2.1 Current Account Balance of Selected Economies (% of GDP) Country 1990–94 1995–99 2000–04 2005 2006 2007 2008 2009 China 1.4 1.9 2.4 7.2 9.5 11.0 9.8 7.8 France 0.0 2.0 1.3 –0.6 –0.6 –1.0 –2.3 –1...