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Real Estate Bubble and Financial Crisis

Introduction The most significant economic event in 1990s was the Financial Crisis in East Asian, which also affected the world economy in the next few decades. People probably question the specificity of the East Asian Crisis. Radelet and Sachs (1998.p.1) gave a response to this question: ‘The East Asian financial crisis is remarkable in several ways. The crisis has hit the most rapidly growing economies in the world. It has prompted the largest financial bailouts in history. It is the sharpest financial crisis to hit the developing world since the 1982 debt crisis. It is the least anticipated financial crisis in years.’
In my view, Asian financial crisis is triggered by real estate bubbles. This paper is organized around the topic ‘the collapse of real estate bubble causes Financial Crisis’ as below. Section 1 introduces what is real estate bubble; what are the factors inducing the occurrence of a real estate bubble; and by what measurements to identify this phenomenon. Then, Section 2 discusses the effects of real estate bubble in Financial Crisis reflect in different approaches: theoretical economic approach statistical data and historical facts. In conclusion, besides summarize the main idea of the overall contents, the exposure of the limitation of the theoretical economic approach will be mentioned.
Real estate bubble The real estate bubble, also known as property or housing bubble is considered as an economic bubble, which is also a cyclical phenomenon occurs in the local or worldwide real estate market. Its prime feature is that the valuation of housing is growing swiftly, however, once the people’s financial situation and economic indicators unable to sustain such upward trend of price that follows the collapse of housing pricing. That implies a negative equity in investment for the proprietors. (Investor Dictionary. Com)
There are several factors that induce the burst of the real estate bubble in Asia from 1997 to 1998. The following focuses on several main reasons:
An excessive support of bank lending
The developers are unable to cope with the investment of the real estate based on their own capital due to the function of this industry-‘capital-intensive’. Thus, bank lending becomes a major source of funds. Before the mid-90s, the Asian real estate is fairly booming. However, because of the lack of a formal system of banking supervision, banks competed for developers by lowering interest rate. (Koh, Mariano, Pavlov, Phang, Tan and Wachter, 2004)
Government’s improper macro-guidance and control
Government intervention influences the real estate bubble in two perspectives: On the one hand, the land market and economic system is not mature or perfect enough. On the other hand, it is the limitation of the land resources and the market mechanism. Therefore, inappropriate regulation contributes to the growing of the real estate bubble. (An International Comparison of the Real Estate Bubble, 2009)
Some other reasons
For example, ‘the relaxed financial environment’; ‘excess international capital flows’ (An International Comparison of the Real Estate Bubble, 2009); excessive amount of house ownership; speculate in purchasing; and ‘bad lending practice’ ( Merriam, 2009)
When economists acknowledge the reasons of bubble burst, they strive to distinguish the breading real estate bubble by the measurements of financial ratios and economic indicators. That aims to prevent the bubble burst.
Housing affordability index
‘Monthly housing affordability index’ (HAI) is a method to identify whether ‘housing is becoming more or less affordable for the typical household. The HAI incorporated changes in key variables affecting affordability: housing prices, interest rates, and income.’ The formula is:
HAI= (Median Family Income/Qualifying Income)*100%
HAI ratio denotes the level of affordability. When HAI ratio is high, more people are able to buy a house. (Dr. Econ, 2003) This index facilitates banks to adjust fiscal policy. Assumed that the HAI is high, banks probably adopt liberal policies to extend loans, such as decrease the lending rates.
Price to earnings ratio
The real estate price to earnings ratio (P/E ratio) is the basic measurement to evaluate the comparatively assessment of the equities. This ratio is determined by three factors: The price of purchasing a house; the price of renting a house; and the spending on renting a house. The formula is:
Real Estate P/E Ratio: House price/ (RentExpenses)
This ratio provides an intuitive analysis that how purchasing houses restricts other family’ expenses. (The Real Estate Bubble in the 2000’s-Housing Market Indicators, n.d.)
Give an example of Washington DC House P/E ratio, which provides an integrated thinking about how purchase interacts with rent. The graph below states a rapidly grow in the ratios, which implies that the speed of raising purchasing price is extremely faster than that of renting price. It seems that such increasing trend will lead to real estate bubble, if none approaches is using to control it. (Eric, 2006)
Some other financial ratios or economic indicators:
Such as ‘real estate price to rent ratio; gross rental yield; ownership ratio; housing debt to income ratio; housing debt to equity ratio; or deposit to income ratio’. (The Real Estate Bubble in the 2000’s-Housing Market Indicators, n.d.)
Real estate bubble cause Asian Financial Crisis The growing booming economy of Southeast Asia is known as the ‘the tiger economies’ between the late 90s and early 20s. Counties in Southeast Asia such as Thailand, Malaysia, Singapore, Indonesia, South Korea and Hong Kong (China) were regarded as the states with the most remarkable economic growth worldwide. According to the Gross Domestic Product, it seems that economies of these states increased by 6% to 9% annually. However, good times do not last long, from June 1997 to January 1998, the burst of financial crisis this Asian miracle was dashed to the ground. In the end of 1997, collapses of the stock and currency markets in these state occurred frequently, then, at the beginning of 1998, the stock market lost more than 70% of their profits. (Hill, n.d.)
In the economy system, real estate, compare with other sectors, it is ‘the most highly leverage sector’ that cause a financial crisis of the utmost probability. The increasingly compound of issues or difficulties lead to the real estate deviates from the normal development. That not only generates a breeding ground of the real estate bubble, but also potential risks for financial crisis. Because of the rapidly decrease of real estate price, there was a disastrous loss of bank lending in some Asian countries, which also affects the current monetary assets. (Lanka Rating Agency Limited, n.d.)
There is a theoretical economic approach (Koh, Mariano, Pavlov, Phang, Tan, and Wachter, 2006) that analysis the correlation between the return of real estate and the fluctuation in the spreading of bank loans. If the numerical value of the correlation is below zero, which indicates a phenomenon of under pricing, which prick up the exacerbation of financial crisis. This assumption could be explained though a formula, that calculates the housing price for trade:
P=V () M (, s ()) B
Here are the meanings that each symbol denotes: V denotes the basic valuation of a house; M denotes the valuation of bank lending for having a mortgage on a house and the par valuation of bank lending for having a mortgage on a house with certain deposit rate; denotes the intending fluctuating level of a house; s denotes spreading of the bank loan according to certain deposit rate.
Assumed that set an accurate price for mortgage, a house’s marketable valuation is equivalent to par valuation, in addition, price for trade is equivalent to the basic valuation of a house. Suppose that is an independent variable, while s is a dependent variable, thus:
= 0
is equivalent to zero, as the spreading of the bank loan modulates according to recoup the bank for the transformations in the value as a result of the ‘put option’ is included in the mortgage lending.
When is equivalent to zero, it means the transformations in the growing fluctuating level of a house ( is completely spread round. However, when is below zero, it means the intending fluctuating level of a house ( has an impact on the covariance of the house return with the market. When the house price changes in response to the spreading:
= 0 ; = 0 ; 0
Thus, if the growing fluctuating level of a house ( is completely spread round, then the correlation between the house price for trade and the spreading of bank loan is equivalent to zero. Furthermore, if this correlation influences the covariance between the house and the whole market is influences, it on the verge of zero.
From another point of view, assumed that the spreading of the bank loan transforms according to under price rather than the intending fluctuating level of a house (, the house price changes in response to the spreading is completely distinctive:
= 0; = 0; and 0
Therefore, correlation between the house price for trade and the spreading of bank loan is below zero, as following equations:
= ) ) 0
These two distinctive house prices which are influenced by default spreading generate an appropriate effect of under price: ‘Under pricing of the default risk in non-recourse lending produces a negative correlation between asset returns and changes in the default spread. Correctly pricing the default risk in non-recourse lending produces no correlation between asset returns and changes in the default spread. Countries that experience under pricing, experience larger market crashes following negative demand shocks.’
On the base of this theoretical economic approach, we could analyze the practical cases, in 1997 Asian Financial crisis, to support the idea that the collapse of real estate bubble causes Financial Crisis
The financial crisis was began from Thailand and then extended over the whole Asian even the whole world. During that period, the characteristic of its economy is overheating with a deficit of 8% in 1997. The valuation of housing increased swiftly and collapsed swiftly. The main element that generated difficulties for financial institutions was the loans to real estate. (Hunter, Kaufman, and Krueger, 1999)
According to the data from the Investment Property Databank , (Koh, Mariano, Pavlov, Phang, Tan, and Wachter, 2006) the figure below is obtained.
Based on the theoretical economic approach, the numerical value of correlation below zero will lead to a result of under pricing. Such under price may cause a great amount loss of funds, which will finally deteriorate into a financial crisis. From the above figure, Thailand is the typical example that explains the real estate bubble causes financial crisis.
At the beginning of the 1990s, a massive amount of foreign funds continued to flow in the Asia market until the 1997 Asian Financial Crisis started. During that period, the lower deposit interest rate in the country encouraged people to seek investment channels with higher return. Meanwhile, foreign funds benefited the growing of the real estate industry. Additionally, because bank expanded the total amount of lending though decreasing the lending rate, under pricing became uncontrollable. (Koh, Mariano, Pavlov, Phang, Tan, and Wachter, 2006)
In the In 1996, Thailand loaned to the real estate sector US $160 billion, which accounted for 30% to 40% of the total lending. (Mera and Renaud, 2000) The figure below illustrates the amount of funds finance companies lend to industries related to the real estate and manufacturing from 1987 to 1996 in Thailand. It is obviously that the loans to real estate sector rapidly grew between 1989 and 1990, after that the percentage of real estate loan to the total loan maintained at a relative high level, which was between 20% and 30%.
(Source: Bank of Thailand)
Another support case is Malaysia. Between 1992 and 1996, over 70% of the bank lending was invested in real estate sector and stock market. (Mera and Renaud, 2000) The massive amount of funds injected into the real estate industries lead to a rapidly increase in GDP in that period. It is the fact that GDP increased by 40%, 62% 115% and 70% in Malaysia, Indonesia, Philippines and Thailand respectively, that was much greater than that in Germany (19%), United Kingdom(16%) and United States (21.5%). However, this accelerated the formation of the Asian real estate bubble. (Koh, Mariano, Pavlov, Phang, Tan, and Wachter, 2006)
It shown in the below figure that Malaysia, Philippine, and Singapore also generated an negative correlation before the occurrence of financial crisis
Conclusion To summarize this paper, at the beginning a briefly introduction of the real state bubble is given. In this part it includes the definition, the reasons for breeding real state bubble, for example banks compete by lower lending interest rates to excessive support the real estate industry, and government’s improper macro-guidance and control. Follow that are the measurements of financial ratios and economic indicators, such as housing affordability index and price to earnings ratio, which benefit to identify the signal of bubble burst.
The most important part in the paper is to analyze the relationship between the real estate bubble and the financial crisis to produce a result that the real estate bubble is a factor that triggers the start of the Asian financial crisis. A theoretical economic approach is given with some statistical data, figure and real facts of Asian financial crisis.
However, there some limitations in this theoretical economic approach, that do not agree with the reality. In the above figure, Hongkong and Japan generate positive correlation, according to theory this do not according with under pricing lead to financial crisis.
The fact is that Japan is a typical example to illustrate that governmental action has negative impacts on the real estate industries. The Nikkei 225 index increased rapidly from 10000 to 38916 (peak value) between 1985 and 1989. Facing this, the manager of the Bank of Japan focused on dealing with the inflation rather than shrinking monetary policy, which reflected a decrease trend in housing price. The real estate bubble burst. (Frankel and Tschoegl, 1993) This is one of the limitations of the economic approach, which need further improve.

Exploring The Economy Of Italy Economics Essay

According to the International Monetary Fund, in 2008 Italy was the seventh-largest economy in the world and the fourth-largest in Europe. Italy is member of the Group of Eight (G8) industrialized nations, the European Union and the OECD. According to the World Bank, Italy has high levels of freedom for investments, business and trade. Italy is a developed country, and, according to The Economist, has the world’s 8th highest quality of life. The country enjoys a very high standard of living, and is the world’s 18th most developed country, surpassing the Germany, UK and Greece. According to the last EuroHYPERLINK “” stat data, Italian per capita GDP at purchasing power parity remains approximately equal to the EU average. On addition to that, Italy has the world’s 4th (3rd excluding the IMF) largest gold reserves, that of 2,451.8 tonnes, coming after the USA and Germany, and surpassing France and China. The country is also well-known for its influential and innovative business economic sector, an industrious and competitive agricultural sector, and for its creative and high-quality automobile, industrial, appliance and fashion design.
Despite this, the country’s economy suffers from many problems. After a strong GDP growth of 8% from 1964 onwards, the last decade’s average annual growth rate lagged with 1.23% in comparison to an average EU annual growth rate of 2.28%. In addition, Italian living standards have a considerable north-south divide. The average GDP per capita in Northern Italy can far exceed the EU average (an example of this could be the Province of Bolzano-Bozen, with a 2006 average GDP per capita of €32,900 (US$ 43,861), which is 135.5% of EU average whilst some regions and provinces in Southern Italy can be considerably below the EU average. Italy has often been referred the sick man of Europe, characterised by economic stagnation, political instability and problems in pursuing reform programs.
Italy GDP Growth The Gross Domestic Product (GDP) in Italy contracted at an annual rate of 0.30 percent in the last quarter. Italy Gross Domestic Product is worth 2293 billion dollars or 3.70% of the world economy, according to the World Bank. Italy is a member of the G8 group of leading industrialized countries. Italy has a diversified industrial economy, which is divided into a developed industrial north, dominated by private companies, and a less-developed, welfare-dependent, agricultural south, with high unemployment. The Italian economy is driven in large part by the manufacture of high-quality consumer goods produced by small and medium-sized enterprises.
Interest Rate Italy is a member of the European Union. the Euro Area benchmark interest rate stands at 1.00 percent. In the Euro Area, interest rate decisions are taken by the Governing Council of the European Central Bank. The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB’s Governing Council has defined price stability as “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for The Euro Area of below 2%. The European Central Bank is the sole issuer of banknotes and bank reserves. That means it has the monopoly supplier of the monetary base. By virtue of this monopoly, it can set the conditions at which banks borrow from the Central Bank. Therefore it can also influence the conditions at which banks trade with each other in the money market. In the short run, a change in money market interest rates induced by the Central Bank sets in motion a number of mechanisms and actions by economic agents. Ultimately the change will influence developments in economic variables such as output or prices
Currency of Italy The euro is the official currency of Italy, which is a member of the European Union. The Euro Area refers to a currency union among the European Union member states that have adopted the euro as their sole official currency.
Inflation Rate The inflation rate in Italy was 1.40 percent in March of 2010. Inflation rate refers to a general rise in prices measured against a standard level of purchasing power. The most well known measures of Inflation are the CPI which measures consumer prices, and the GDP deflator, which measures inflation in the whole of the domestic economy.
Current Account Italy reported a current account deficit equivalent to 4990.0 Million EUR in February of 2010. Italy’s major exports are food, clothing, precision machinery, motor vehicles, chemicals and electric goods. Italy imports mainly engineering products, chemicals, transport equipment, energy products, minerals, textiles and clothing; automobiles, electronics, food, beverages and tobacco. Italy’s closest trade ties are with the other countries of the European Union, with whom it conducts about 59% of its total trade. Italy’s largest EU trade partners are Germany and France
Balance of Payments A Balance of payments is an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country’s exports and imports of goods, services, and financial capital, as well as financial transfers. The BOP summarises international transactions for a specific period, usually a year, and is prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as a negative or deficit item.
Current Account balance
Year Current Account Balance Rank Percent Change 2004
-5.30 %
25.02 %
-10.05 %
115.04 %
52.91 %
The Current Account deficit reflects an increase in the goods deficit, which climbed from EUR 16 billion to EUR 57 billion as a result of deterioration in the trade in cars and intermediate goods. This improvement stems from a slight increase in the travel and transport balances. The travel surplus reached nearly EUR 13 billion, close to the record surplus of EUR 14 billion recorded in 2004. Conversely, the surplus on “other services” posted a slight decrease, totalling EUR 1.3 billion.
In 2007, the Goods balance still posted a deficit, amounting to EUR 39.7 billion, compared with EUR 29.4 billion in 2006. The customs trade deficit in fob-fob terms increased further to EUR 10.6 billion. Contrary to what had been recorded the previous year, this deterioration is not attributable to the energy trade deficit. The latter actually declined by around EUR 1 billion as a result of a slight drop in average oil prices and a reduction in imported volumes. The customs trade deficit excluding energy worsened mainly on account of a deterioration of the trade balance in cars (EUR 4.4 billion) and intermediate goods (EUR 4.3 billion).
After having been on a downward trend since the start of the decade, the Services trade surplus increased by EUR 1.1 billion to stand at EUR 11 billion in 2007. This improvement results from a EUR 0.9 billion decline in the transport trade deficit and a EUR 0.7 billion rise in the travel surplus, despite a EUR 0.5 billion decrease in the surplus on other services.
In 2007, the income surplus stood at EUR 28.5 billion, down by EUR 0.3 billion on 2006, when it had increased by EUR 8.6 billion. Expenditure and receipts posted a strong rise (23.0% and 18.5% respectively). This surplus reflects the traditional surplus on direct investment income combined with the surplus on the compensation of employees. In 2007, portfolio investment income registered a surplus, after having shown a deficit for the past five years. This improvement stems from a significant rise in receipts. Conversely, the deficit on other investment income continued to widen.
Trade in Italy Italy trade is dominated by automobiles and machineries. As the country is challenged by mountainous land, cultivation is not possible. Based on the same reason, the Italian trade depends on mostly on the manufacturing sector. World over, Italy’s famous brands such as Armani, Valentino, Versace, Benetton, Prada, FIAT, Lancia, Alfa Romeo, Maserati and Lamborghini have already created their niche in the global trade scene.
Exports Recession decreases the global trade volume significantly and Italy was no exception. Its exports volume decreased from $546.9 billion (2008) to $369 billion in 2009. However, even with such a huge decline, the country remained relatively stronger and ranked 6th in the world in terms of the exports volume. Exports include mechanical products, textiles and apparel, transportation equipment, metal products, chemical products, food and agricultural products.
Year Exports Rank Percent Change 2003
7.29 %
20.96 %
10.55 %
21.03 %
11.62 %
8.86 %
Imports The imports dipped as well with the recession marred years. The figures dropped from 368.5 billion of 2008 to 176.2 billion in 2009. The country again ranked 7th in terms of imports volumes. Imports include machinery and transport equipment, foodstuffs, ferrous and nonferrous metals, wool, cotton, energy products.
Year Imports Rank Percent Change 2003
13.81 %
21.47 %
12.12 %
20.69 %
11.78 %
9.80 %
Reserves Year Reserves of foreign exchange and gold Rank Percent Change 2004
-2.78 %
7.24 %
6.90 %
33.80 %
11.63 %
The Euro value for the stock of all financial assets that are available to the central monetary authority for use in meeting a country’s balance of payments needs as of the end-date of the period specified. This category includes not only foreign currency and gold, but also a country’s holdings of Special Drawing Rights in the International Monetary Fund, and its reserve position in the Fund. Italy is Ranked 13th in terms of having the Reserves.
Financial Account Direct Portfolio 2003
In the recent years the investment in Italy is found to be increasing day by day. But in the recent years the FDI has been decreased drastically. It is due to the recession in the whole world. As a member of the EU, Italy is very active in European trade, and is part of the EU’s single market. Italy is a major trade partner of most European countries, as well as the US and much of Asia. The ongoing international merger and acquisition activity has led to an intensification of cross-border relations between affiliated companies regarding both Italy investment abroad and foreign investment in Italy. Italy net direct investment position stood at EUR 566 billion, up by EUR 44 billion in year-on-year terms. Assets and liabilities were up by EUR 159 billion and EUR 115 billion respectively. The scale of these changes are in line with observed transaction flows, reflecting the fact that the increase in the prices of shares and other equity offset the euro exchange rate effects.
In 2008, portfolio investment net outflows stood at EUR 121.09 billion, compared with EUR 85.8 billion in 2007. This swing is attributable to the sale of EUR 16.5 billion worth of foreign equities by residents (after having been net buyers in 2006) on the one hand, and the sale of EUR 61.3 billion worth Italian equities by non-residents (also net buyers in 2006).. As regards the other financial instruments, net outflows totalled EUR 87.1 billion, compared with EUR 74.1 billion in 2006. By type of instrument, outflows on mutual fund shares were significantly higher than in 2006: EUR 59.7 billion as against EUR 4.2 billion. Conversely, outflows on debt securities with maturities of over one year and money market instruments recorded a decrease, falling to EUR 22.1 billion and EUR 5.3 billion from EUR 60.2 billion and EUR9.6 billion respectively
Reasons For the Swings in the results The Italian tax system does not discriminate between foreign and domestic investors. The 2008 budget reformed the structure of the tax system, reducing corporate income tax (IRES) rates by 5.5 nominal points from 33 to 27.5 percent, and trimming the regional business tax (IRAP) from 4.35 to 3.9 percent. These tax cuts are in response to increased EU-wide competition for investment, particularly as the enlargement of the EU to 27 members ushered in various low cost, low tax East European states. Germany’s 2007 decision to cut corporate tax rates by ten basis points rendered Italy’s corporate tax rate the highest in the EU.
Italian Government took some initiative which were the key factors for the change.
Protection of Property Rights Transparency of the Regulatory System Efficient Capital Markets and Portfolio Investment Foreign participation in Italian capital markets is not restricted. While foreign investors may obtain capital in local markets and have access to a variety of credit instruments, access to equity capital is difficult. Italy has a relatively underdeveloped capital market and businesses have a long standing preference for credit financing. What little venture capital exists is provided by established commercial banks and a handful of venture capital funds. “Angel investing” has only begun to take root in 2008, after a brief existence snuffed out at the start of the century by the bust. The Italian stock exchange (“Borsa Italiana”) is relatively small — fewer than 300 companies – and is an inadequate source of capital for most Italian firms. In 2007, the Borsa merged with the London Stock Exchange, raising expectations that governance standards and transparency of the Milan market would improve. Each of the partners will continue to be regulated by its respective national securities regulatory entity.