The securitized subprime assets only accounted for 14% of the US$6.3 trillion securitized mortgage assets. Therefore, most market participants believed that the remaining 86% of the securitized mortgage assets were safe when the crisis broke out initially. Also, the securitized mortgage assets were only one kind of financial assets. Other financial assets would not be affected. However, this logic has neglected the fact that the financial markets and the real economy are becoming more interconnected than before, especially after years of expansionary monetary environment. The credit bubble has already driven the financial and housing markets uptrend. As a result, the financial crisis broke out at the weakest link in the economy and financial system, i.e. the subprime assets, when the Federal Reserve raised rate by 17 times to tighten the monetary environment. The financial and housing markets began to correct, resulting in credit crunch. The financial markets and economies are then greatly affected.

The subprime crisis not only affected the financial and housing industries, but also the broader consumption, employment and overall economic activities. Housing correction, credit crunch and huge losses from financial institutions have led to the reduction of US payrolls over the past 8 months. Consumer and investment confidence hit the lowest level over a decade. The US economic growth, excluding net exports, should already in the brink of recession. The US economic downturn also threatened the global economic growth. On one hand, the ties between the world economies are much closer now. The effect of US housing and financial markets corrections have already spread to the world. Most of the financial markets in the world are now in the bear market. On the other hand, the weak US consumption and economic performance have already affected its imports demand in four of the last five quarters. The effect of economic slowdown also affected the Euro zone and Japan etc. In the second quarter this year, the Euro zone, Japan, Hong Kong and Singapore all registered negative quarterly economic growth, showing an intensifying downside risk to the global economy and exposing the problem of global economic imbalance.

Credit Boom and Over-consumption

The US subprime crisis reflected the economic problem brought by credit boom. Credit boom enabled the Americans to borrow easily, including credit cards, car loans, student loans and mortgages etc. Some borrowers with poor credit history and limited earning capacity could also obtain mortgages with low down-payment requirements. This laid down the root of the housing bubble and subprime crisis. Higher property prices and relaxed lending practices during the housing bubble allowed the Americans to withdraw part of their home equity for consumption through various loan products. The Americans have adapted to the habit of over-consumption instead of saving.

Over the past 15 years, the real private consumption growth rate was higher than the real disposable income, reflecting the change in the saving habit of the Americans. The Americans no longer save part of their income for future use, rather they withdraw from their assets for consumption through borrowing. In 2006, the Americans withdrew up to 9% of their disposable income from their home equity for consumption, three times more than 2001. As a result, the saving rate of US households dropped to zero or even negative, the first time since the Great Depression. However, this over-consumption model relied heavily on the asset market performance. Its weakness was clearly revealed during the current housing market correction. It is now difficult for the Americans to borrow easily for consumption while their debt burden has increased sharply after years of over-consumption.

As the US consumption pattern changed over the past few decades, the contribution of private consumption to economic growth increased continuously from around 60% in the 1950s to 72% in 2007. The US economy relied more and more on private consumption. Yet, it was rooted from an unsustainable credit bubble. The amount of debts of the US households rose to 133% of their disposable income in 2007, higher than the 90% in a decade ago. This showed the economic structural imbalance of the US economy.

Credit bubble and over-consumption also led to external imbalance. During the years of credit boom and over-consumption, the current account deficits increased from 1.5% of its GDP in 1995 to 6% in 2006. This means that the US needs more than US$2 billion from abroad every day to balance its huge deficits resulting from over-consumption.

Even though the US current account deficits were surging and the US dollar exchange rate continued to fall, the Asian developing countries, still had to buy hundreds of billion US dollar assets because of its global reserve currency position. This supplied a lot of low cost capital to the US economy and enabled the continuation of its over-consumption and global economic imbalance.

Export-oriented Model is also affected inevitably

In the past few years, the Asian developing countries expanded rapidly with real GDP growth reached 8%, 1.5 times more than the growth of other countries. The rapid growth of the Asian developing countries was mainly attributable to the strong growth in exports. Over the past twenty to thirty years, the contribution of exports to economic growth increased from less than 20% in the 1980s to more than 45% in 2007. The contribution from private consumption was then declined. However, a large portion of exports were sold to the US. Therefore, the over-consumption in the US also supported the Asian developing countries. The Asian countries then further invested in their production facilities which further boosted the economic growth.

However, there is no economic decoupling between the developed countries and developing countries, rather the rapid growth in the world economy between 2004 and 2007 was benefited from globalization. The Asian developing countries were benefited the most in globalization as their economies were supported by the rapid growth in exports. Also, over-consumption in the US led to the production and investment boom in the Asian developing countries. Their economies became more closely related to the developed countries. As a result, the Asian economy would be affected inevitably as the over-consumption model in the US is no longer sustainable which will, no doubt, affect the developing countries export performance and expose their problem of over-production and over-investment. The developing countries also need to undergo profound adjustments and its export-oriented growth model needs to be adjusted.

The Problem of Subprime and Credit Crisis will continue to surface

The effect of the subprime and credit crisis will continue to surface. The world economic growth will slow from the 30-year high of around 5% between 2004 and 2006 to its trend growth or even lower level. The future outlook remains highly uncertain.

As explained above, the subprime crisis was rooted from the credit boom. Therefore, when the Federal Reserve started raising rates in June 2004, the Americans felt the ever increasing pressure from its heavy financial burden. However, as the Americans did not have savings to counter economic downturn, the loan delinquency problem began to grow. The credit boom was then burst amid the sharp property market correction. The financial institutions then tighten their lending standards and do not have confidence in the creditworthiness of both the corporations and individuals because of the huge losses suffered. The risk bearing ability is also lowered aggressively. This led to the spread of the problems in subprime assets to a wider range of financial products. Globalization of the financial markets spread the subprime problems to the whole world.

Currently, a number of major US financial institutions are suffering from financial difficulties. Their problems would easily spread to other financial institutions. The aftermath of the financial crisis will further spread out. More and more financial institutions facing financial difficulties are mainly due to their deleveraging, resulting in lower asset prices which then affects their financial positions. In addition, it also reflected the profit-seeking model of the US financial institutions would lead to over-aggressive product innovation, financing and investing culture. This showed the defects in the US regulatory system. The regulatory regime cannot prevent the outbreak of the financial crisis and ensure the financial institutions to properly complete their risk assessment, leading to the large scale failure of several major financial institutions. The US regulatory system should be reviewed.

Based on the current situation, the credit and housing bubble is still under correction, the economic growth model driven by the credit boom is transforming. The financial institutions tighten their lending standards and raise the lending rate to cover the increased risk level. It becomes more difficult for the Americans to obtain borrowing for consumption. Additionally, the property markets decline continuously, it is also more difficult to withdraw home equity for consumption through borrowing. The subprime crisis marked the end of the relaxed lending environment. The US employment market also weakens and would, no doubt, restrain the consumption power of the Americans. The real private consumption growth is expected to lag the growth of real disposable income. The private consumption dominated economic structure should be adjusted. Private consumption growth would remain weak in the future. The US economy will continue to face the risk of recession and might have multi-year economic difficulties, like Japan which suffered multi-year economic weakness after the credit and housing bubble burst. The US economic weakness will inevitably hurt the manufacturing-based Asian developing countries as well.

Furthermore, many major financial institutions face financial difficulties, reflecting the problems of the US financial system and regulatory regime. The US government and Federal Reserve has spent hundreds billion of dollars to bailout the financial institutions and markets. It has proposed a US$700 billion bailout package. The financial institutions can sell their real estate-related bad debts to the government. The US government is seeking the Congress approval to increase the statutory limit on US national debt to US$11.3 trillion in order to stabilise the global financial markets and alleviate its impact on the economy. However, the effectiveness of the bailout plan still worth attention. The market still expects a number of small-to-medium sized financial institutions would face financial difficulties or bankruptcies. The US government still also needs to manage or dispose billions of bad assets in the future.

Additionally, the financial burden has increased sharply for the US government. If it cannot handle its financial issues properly, the credit rating of the US might even be affected, which will have serious effect on the financing cost of the US government and corporations as well as the dollar's performance. China and Japan are countries that have the most foreign reserves in the world. It is believed that they will diversity their investment portfolio and buy less US dollar assets, especially when they are investing their new capital. The US would become more difficult to attract overseas funding to balance their huge current account deficits.

The World Economy needs Profound Adjustments

Over the past year, the US government has implemented a series of economic stimulus and market stability initiatives, including sharply lower interest rates, a tax-rebate and tax reduction stimulus package amounted to US$168 billion, a guarantee up to US$300 billion of low income household mortgages, provision of a credit line to help JP Morgan acquires Bear Stearns, take-over of Fannie Mae and Freddie Mac etc. This showed that the US government would still like to provide more liquidity to the market in order to extend the over-consumption economic model. The government even considers a new round of economic stimulus program under political pressure. It is not beneficial to the economic restructuring and long-term growth of the US economy. Private consumption is expected to slow continuously under the shadow of credit crunch, asset price depreciation and weak employment market. The over-consumption model has to be adjusted.

Currently, the US economy could still avoid a technical recession that is mainly driven by the narrowing of current account deficits and improvement in net exports. However, this does not represent that the US economic structure has already been successfully transformed, rather the world economy has been weakened and the US manufacturing and exporting facilities had long been outsourced to the rest of the world. It would be difficult to establish those manufacturing and exporting facilities again competitively. It is expected that the improvement in net exports is not sustainable and could not offset the negative effects from the slowdown in private consumption.

Additionally, the subprime and credit crisis clearly exposed the problems of the financial system and regulatory regime in the US. The market concerns about whether the investment banks can stay independent and their role with other commercial banks. The credit rating agencies need to avoid conflict of interests and enhance transparency, enabling investors to understand more about the implications of different credit ratings and updating them about the latest market environment. Regulatory authorities have to string the their regulation on derivatives, enhance transparency of the financial institutions and products, ensure proper risk assessment and management in the financial institutions, prevent the financial institutions to place large bets on derivates and off balance sheet activities, and re-modify their over-aggressive profit-seeking model in order to avoid large scale failure of financial institutions. It is foreseeable that its financial system and regulatory regime will undergo large scale reforms after the crisis in order to restore investor confidence around the world.

Similarly, economic model of the export-oriented Asian developing countries could not be sustainable. In the past, the Asian developing countries over-exploited their environment, resources and land etc, in order to strive to maintain the competitiveness of their manufacturing and exporting activities. This economic model enabled them to increase exports, support faster economic growth and enhance the people's living standards, but it also laid down some internal problems, for example, the over-exploitation of land and resources, environmental pollution, uneven distribution of wealth, asset bubble and high inflation etc. Additionally, the Asian developing countries expanded their production and investment activities aggressively when the export performance was good, but resulted in over-investment and asset bubble. However, the economic performance in the US and other developed countries has already moderated, their demand for Asian products would weaken. The Asian developing countries would suffer from the problem of factory closure and unemployment. Therefore, they also need to rationalize their economic structure and growth model. The production activities should be redirected to serve the locals rather than the overseas markets. Their governments, with strong fiscal resources, can implement a wide range of policies to stimulate local consumption as well as foster regional cooperation. This can help reduce the reliance on the US and other developed countries to ensure sustainable economic growth.

All in all, both the developed economies, like the US, and the developing countries, the global financial system and regulatory regime, should face a long period of profound adjustments and rebalancing, in order to ensure a balanced, healthy and sustainable growth in the future. However, it is difficult to return to a new equilibrium in the near term. The world economy would face the problem of unemployment, stagflation and economic hardship. The Government from different countries needs to be prepared for the long-term adjustments and implement the policies that can correct the imbalance.

Choi Wing Hung
Economist