China as cause and victim of the US subprime crisis

Despite the early belief that the Asian economies were decoupled from the US subprime crisis, having pursued macroprudential policies and accumulated large and insulating foreign currency reserves after the earlier 1997 Asian Financial Crisis (described in more detail in Chapter 14 of this book), the negative impact on their exports and economic growth became intense (IMF, 2011b; Zhang and Zoli, 2014). ¹ This required dramatic intervention by Asian central banks and governments in 2008. The US subprime crisis originated with the collapse of asset-backed and other financial instruments as the US housing bubble burst. Financial institutions in the US had accumulated rising losses leading to the collapse of Bear Stearns in June 2007 and the bankruptcy of Lehman Brothers in September 2008, followed by forced mergers and bailouts for a number of other financial institutions in quick succession. Confidence in the financial system evaporated as the credit rating agencies downgraded their valuations of Mortgage Backed Securities (MBSs) and Collateralised Debt Obligations (CDOs) bringing their own credibility as assessors of assets and institutions into question. Asset prices fell rapidly, leading to calls for new capital injections; as credit and international capital markets froze, determining the “real” market price of financial assets became impossible. This further undermined the liquidity of the institutions themselves. As banks began to squirrel away cash, any financial institutions requiring funds were forced onto the overnight capital markets.