Relationship between Financial Crisis and Trade

Relationship between Financial Crisis and Trade

Beginning with the interest rate rise and housing prices decline, which led to the bust of the United States housing bubble and high default on sub prime in approximately 2005—2006, now the real economy has been suffering from the after effect of the financial crisis rising from the sub prime. Recent data shows that the unemployment rate of the United States on October was 6.5%, which is almost twice as estimated, and the index is expected to reach 8% in 2009.  What’s more, the crisis has already rippled outward U.S. and affected other countries, despite the turmoil in offshore market and the great loss brought to the investors, the reducing appetite for imports in U.S. and other developed countries also result to direct harm to those export-led growth economies due to the minification in scale of international trade. Undoubtedly, the crisis now is not just something as simple as run on a bank or even down of Leman Brother, the real economy has evolved into the crisis, too.

 

Tracing to the source, the unreasonable international monetary system is the very thing that should be blamed. It is a faulty arrangement that the U.S. Dollar, which is the bank note of a sovereign state, plays the role of the only international settlement money. The key point is that the U.S. government can pay their foreign loans simply by printing more green paper.  This is somehow like planting a bomb on the foundation of the global economic system.  Before the collapse of the Breton Wood System, the United Stated has the obligation to maintain the convertibility from dollars to gold, so the money supply is restricted under the gold reserve. At that time, the Balance of Payment shows that dollars outflows through capital and financial account and inflows through current account. The U.S. exports its productivities to all over the world to recycle the dollars outflowed, which in this way to approximately maintains the money supply in circulation and stabilizes the fixed exchange rate under the Breton Wood System. But after 1971 when the system went to an end, there came to a unique situation whereby the United States dollar became the international settlement currency, from then on , the state of its Balance of Payment went changing, the current account has been changed from surplus to deficit while the capital and financial account from deficit to surplus. In 1960, the balance on the current account and the capital and financial was only 2824 million and -1805 million, but in 2007, they changed to the unbelievable amount of -731214 million and 767849 million, respectively.

Nowadays, the United States imports goods to meet the American style of life and just pay the bill by creating more green paper.  Meanwhile, some part of these dollars flows back to U.S. to invest on capital market while others become hot money on offshore market and emerging market.  The scale of the money supply is huge, seeing from the amount of United States public debt, which has been reach the scale of 10 trillion, the world has been connected by United States dollar, so if one part of the U.S. capital market got trouble, there would be turmoil in the financial system and the whole world would be affected.

So what’s the role of international trade in the chain reaction of financial crisis? Usually, it is a route to enlarge the crisis among nations and from capital market to real economy, especially transmit the financial crisis in developed countries to the real economic crisis in developing countries.

At first, financial crisis rises in the capital market in developed countries, and then with the damage in banking system and capital market, enterprises will be affected since they find it hard to get financing support. If there was no international trade or international capital liquidity, crisis would likely to play with itself in a single country.  But in an open economy, once the financial crisis cause to damage on real economy, the reduction of people’s consume will bring about decline on demand for imports and lead to recession on real economy in developing countries, which result to further chain reactions. In the diagram, the blue parts show crisis in financial market level while the yellow parts stand for real economy crisis. In developed countries, the crisis moves from financial market to real economy and finally transmit to developing countries through international trade. In developing countries, crisis begins directly from real economy and spreads to financial system and capital market——and those damage on virtual economy will probably worsen the situation in real economy. In consequence, developing countries may suffer more than developed countries that care the source of evil.

Year	1997	1998	1999	2000	2001	2002	2003	2004	2005	2006	2007
Export-GDP Ratio	19.20%	18.04%	18.02%	20.80%	20.09%	22.39%	26.72%	30.71%	34.19%	36.61%	37.45%

 

In particular, China is a typical victim of developing countries, among the three carriages, which are consumption, investment and export, we rely much on export, the export-GDP ratio keep increasing for many years, more than one-third of the final products involve in foreign trade. It is now well known that China has become the world factory, but when crisis occurs, the export-oriented policy become the sin. The economy gets shocked when external demand declines, many enterprises has gone bankruptcy since there’s no more business at all. In Guangdong Province, which is the conglomeration of foreign trade companies, government reported 7148 companies went down from January to September. The economy has turned from inflation to deflation, and a recession can be expected next year.

 

In the short run, however, the influence maybe not so apparent, the recent Customs’ statistic still shows an increase in export. It is because there is a lag when external crisis affect our industries through international trade.  Generally, foreign trade companies make arrangement for production according to contracts signed months ago. On the initial stage of the crisis, our companies still work for these orders even though the importers abroad has already been evolved in crisis.  But on next stage, since the exporters can no longer get orders and have to diminution their production scale. The period between two stages aforementioned usually lasts for 3 to 6 month, so we are likely to see a decline on export on the first quarter of next year.

 

In the long run, if we don’t change our export-oriented policy, we will most likely to be the victim every time when crisis or recessions happens in developed countries. This time, since our economy depends too much on exportation, it is hard for us to recover from the shocks unless the U.S. and other developed countries boom again and to order products from Chinese enterprises again.

 

In conclusion, there are ways to avoid such kind of external financial shocks. To begin with, we should improve the situation of our balance of payment; we have too much surplus in current account, which is likely owing to the inadequate for domestic demand.  The insufficient of social welfare and low income of people may be the root cause of low consumption.  Also, we should change the structure of our exportations.  Our productions are mostly low technical intervention and high energy or resources consumption, which is of low profit and sensitive to price change on raw materials. If we shift to upper level of industrial chain, we can suffer less from crisis since the products are profitable and reduction on demand won’t cause a sudden collapse.

 

In a word, trade is a media to transmit crisis in developed countries like the United States to developing countries such as China.  And if we do not make change on our trade policy and economic structure, we will always have to be the one of biggest victims of global financial crisis.

 

Citation:

www.wikipedia.org

www.bea.gov

www.stats.gov.cn