From News, page 8, issue no. 386, Sept 22, 2008
Translated by Liu Peng
Original article:[Chinese]

(The author Cao Honghui is the director of International Finance Research Center of Institute of Finance and Banking, under the Chinese Academy of Social Sciences, a major think tank to the Chinese government.)

As I have pointed out in July this year, a second-episode to the US credit crisis was bound to happen.

In the recent two weeks, a series of high dramas have indeed taken place as expected, and the crisis is much more complex and shocking.

To begin with, the Lehman Brothers Inc had finally collapsed, months after news of it cracking-up emerged in June.

Then the largest insurance company AIG (American International Group) was also sinking, and the US government was forced to inject 85 billion dollars to save it, triggering a barrage of questions over why the same treatment was not extended to Lehman.

News then emerged that Morgan Stanley, another giant in the Wall Street, had held takeover talks with interested buyer; and later, all eyes turned to Goldman Sachs, doubting if it could survive the crisis unscathed.

Evolution of a Crisis
As the drama unfolded, the US government had adopted a "selective policy" in saving ailing financial institutions.

Though consideration was largely based on the degree of influence one financial institution had on the market, there were non-economic factors involved too. Moreover, the government itself was also bogged down with 10 trillion dollars of debts.

On Sept 18, the US Federal Reserve Board (FED) had signed currency swap agreements with the central banks in Europe, England, Japan, Canada and Switzerland in order to inject liquidity into the embattled financial market.

In addition, the US Treasury had drawn up an aid plan to takeover non-performing loans in banks, helping them to tie over the difficult time and prevent the crisis from worsening.

At this juncture, there is an urgency to make clear of how the crisis might evolve, and how far it might spread?

In the first phase, high default rates of residential mortgages led to contracted liquidity and ignited the sub-prime mortgage crisis.

At present, the crisis has spread beyond lending institutions and institutional investors who held mortgage-backed securities, it is now inflicting the mortgage insurance agencies.

Next, contracted liquidity would likely trigger cracks in the commercial real estate and related markets, and the risks for small and medium banks would be more apparent. Cash flow difficulties would soon force many small banks to collapse.

In addition, the climbing bad debt rate for credit card holders had also been getting on the nerves of US commercial banks. Though that may not hit the financial institutions badly, it could further impair the US economy growth, which is supported by credit spending.

When the FED raised the benchmark interest rate in 2006, it was the needle piercing the housing bubble. But even without that, the bubble would have burst sooner or later. All in all, there were too much greed on the part of financial institutions; as for the regulators, they had acted too slow.

How Should China Respond to the Crisis?
In the immediate fallout of the US crisis, it is inevitable that China's foreign exchange reserves would devalue, since dollar-denomination assets dominated the international financial market. For Chinese commercial banks, they would have to absorb the investment losses incurred.

In the short run, would it be the best opportunity to buy US investment banks or financial institutions?

In my viewpoint, it would be worthy of consideration, if Chinese enterprises could gain entry into the board of directors or decision making management team of US institutions that has mining resources or extensive financial services networks. However, if Chinese enterprises were to simply play the role of financial investor, that would be an unwise move.

The way for China to minimize negative impacts from the US credit crisis is to adopt decisive measures to maintain steady domestic economic growth, such as introducing policies that stabilize the capital market and strengthening risks management for financial institutions, as well as improving capital market regulations and supervision mechanism.

China should also use this opportunity to quicken its pace for reforms in taxation regime, pricing mechanism, and industrial sectors restructuring.

In the long run, China should seize this opportunity to push for changes in the international monetary system, that is to re-evaluate the status of US dollar as an international currency, encourage the usage of Euro, and accelerate the pace to internationalize Chinese currency.

In addition, China should advocate the establishment of an international coordination mechanism for regulating the global financial markets, and it should strengthen supervision on cross-border capital flows.