The first financial crises can be traced back to 1825 after the Spanish empire was overthrown in Latin America resulting in the opening up of trade between England and Latin America republics. The result of this was an increase in the movement of capital flows from London resulting in a boom on the London stock exchange (Aghion & Saint Paul, 1998). The capital outflows interrupted the Bank of England’s gold reserves resulting in the stock market crashing. The banking sector, on the other hand, experienced currency crashes as well as panic that spread across to Latin America. The second crisis was experienced in 1873 after the property boom that occurred in both Austria and Germany. As a result, the US was affected as more European investors dumped US railroad stocks. The result was the Bank of England making attempts to offset the gold outflows by raising their policy rate, consequently, the country experienced a series of debt defaulters. This crisis also triggered the Peru crisis.

This was followed by the Baring crises in the 1890s which were considered the worst crisis ever (Langner, 2016). The most affected countries were the western European countries and Latin America where the European countries exported capital to finance the development of infrastructure in Latin America. In the 20^th century, the first financial crisis was experienced in 1907 which was triggered by the collapse of the US stock market. This crisis affected Italy, Japan, Denmark, France, and Sweden. However, the greatest financial crisis was the great depression in the late 1920s and was preceded by stock market booms before they crashed. Unlike the previous crises, this crisis affected all countries globally because of the fixed exchange rate links of the gold exchange standards used at the time. This resulted in many countries incurring debt and currency crises. However, after this, the world experienced a period of relative calmness until the occurrence of the Latin American Debt crises in 1982 that resulted in countries across the world experiencing financial difficulties. This was followed by the Nordic financial crises that were triggered by the property boom experienced in Sweden and Finland after the breakdown of the societal regime. The European currency crises started at about the same period.

In the 21^st century, the most recent crisis was the 2008 crises which started in the United states. Here, the mortgage interest rates were very low which attracted many people who would normally get relatively large loans with lower monthly repayment installments. Taking this into account, the home prices had also increased drastically, investing in real estate seemed like a good business venture (Dhakal, Kandil & Sharma, 1993). This is because the lenders believed that the real estate properties would offer good collateral to secure the loans they were issuing. However, home owners continued to take additional mortgages from their homes since the banks offered easy access to credit. The result of this was that borrowers eventually got into high-risk mortgages with little documentation or collateral. Risky borrowers and those with low credit scores could now access more credit. risky products like the option-ARM loans were also allowed with relatively low-interest rates.

However, the home prices started dropping drastically, and those borrowers who had over-invested in homes were unable to make their mortgage payments (Hall, 2010). The situation was worsened by the fact that as the adjustable-rate mortgages increased the monthly payments as the interest rates continued to rise. Many homeowners defaulted, and the bank was unable to recover their money since the home values also declined. The banks, therefore, took hefty losses on the defaulted loans (Obstfeld & Rogoff, 2009). Investors also begun losing money as a result and over time, financial intuitions stopped lending money altogether to reduce their exposure to risk. This cut through the flow of money that the economy needs to operate smoothly and as a result high commodity prices and as the economic conditions continued to deteriorate, so did the global economy. 

1.2 Problem statement

Ideally, the law of supply and demand stipulate that there should be a balance in the demand and supply of commodities, more so in the property markets. This helps to keep the economy in check since a strong demand helps to absorb the excess supply of property without adversely affecting the prices (Maysami, Howe & Rahmat, 2005, p. 24). This keeps the market at equilibrium and promotes positive development in the economy. However, this is not always the case as is the case with China today, among other countries that have undergone various sub prime crises in the past. It is noteworthy that the financial recessions in the past have rocked the global economy to a great extent. China is experiencing a housing boom similar to what was experienced in the US preceding the 2008 financial crisis. This is characterized by increasing property prices over the past few months. For example, in Shenshen region, the prices increased by at least 80 percent while in the Shanghai region they rose by at least 65 percent. This has seen the regulatory bodies ease up on the purchase restrictions thereby reducing the mortgage costs considerably which is a good indicator of economic growth (Langner, 2016). However, this inflation of the property bubble has raised some concerns because just like the United States and other subsequent financial crises; it is as a result of the country relaxing some of their lending standards. This has made it possible for more people to invest in real estate to capitalize on the boom a factor that could push the country into a subprime crisis if not well addressed (Langner, 2016). This study, therefore, looks into China’s volatile position in the economy and the possibility of the country experiencing a subprime crisis in the near future. It also looks at ways this can be avoided since the spillover effects of a crisis are often felt beyond the affected country.

1.3 Research objective

The study aims to determine whether China is at a risk of experiencing a subprime crisis. This will include specific aims like:

1. To determine the causes and effects of a subprime crisis in China
2. To analyze the effects of financial crises on the GDP in China

• To investigate the relationship between monetary policy, money supply, and financial crisis.

1.4 Research questions

Taking into account the research objectives of the study, the paper aims to address the following research questions:

1. is China vulnerable to experiencing a subprime crisis?
2. What factors are likely to cause a subprime crisis in an economy?

• What are the effects of sub prime crises on the economy?

1. Is there a relationship between monetary policy, money supply, and a subprime crisis?

1.5 Scope of the study

The study will be centered on China, which is among the fastest growing economies today. This decision is also prompted by the fact that during the last financial crisis, the country appeared unmoved by the spillover effects of the crisis as would have been expected. In addition to this, the country has been experiencing financial booms that put it at a risk of experiencing a crisis.

Chapter 2: Literature review

2.0 Introduction

Subprime crises have become fairly common in the modern world today, with the most recent one being experienced in 2008 in the mortgage industry. These crises are often caused by lenders who approved too many loans than what people could get under ordinary circumstances (Verick, & Islam, 2010). The result was a significant rise in financial turmoil and panic in the financial markets as they continued to become more volatile. This was accompanied by a significant rise in foreclosures and the collapse of numerous lending institutions and hedge funds. The effect was not just localized to the united states rather its effects overflowed to the global credit market resulting in increased interest rates as well as a reduction in the credit available to borrowers (Postiglione, 2011). Therefore, the subprime crises were as a result of excessive borrowing and a flawed financial model that operated on the assumption that the prices of the homes would increase and yield returns.

2.1 Current situation: Analysis of China

China is today trying to adopt sub prime banking which if not carefully handled could result in a housing crisis like that experienced in 2008. This was also noted by the China Banking Regulatory Commission which indicated that the banks in the country were beginning to violate the lending policies. This could be detrimental to provinces that are dependent on real estate business for revenue. According to Langner (2016), the crises in China has already started reaching the same proportions that have seen the U.S plunge into the mortgage debacle. According to his analysis, the country has many non-performing loans which are 51 percent higher than what was experienced in the preceding year. The ratio of soured debt escalated to 1.67 percent compared to 1.25 percent that was experienced in the previous year. In addition to this, the country’s ability to absorb potential losses reduced to 181 percent from 200 percent in the previous year (Langner, 2016). This means the country is more vulnerable to bad debts. In the last six years, the country’s bad loans have increased by 256 percent, a factor that banks are trying to resolve through increasing new lending to dilute the effect of the bad loans.

The same assertion was made by Shaffer (2016) who also noted that the country was experiencing credit crises that could result in a subprime crisis if left unchecked. In his analysis, Shaffer (2016) states that this credit crisis could be attributed to the country’s rapid credit expansion that was used to fund the country’s infrastructure to promote economic growth. The situation has been escalated by the country’s poor banking regulations that have seen banks issue loans to people who have poor credit ratings. Shaffer (2016), further stated that the country may need to print an excess of $10 trillion to recapitalize its banking sector if the country’s economy is to recover from their losses as well as save the country from devaluing the yuan. Rapoza (2016) on the other hand notes that the country’s debt market is deteriorating and investors are ending up with unsavory real estate obligations in their search for greater returns on their investments.

Dimitriou and Simos, (2012) conducted a study where they aimed to determine spillover effects in the wake of a financial crisis. Their study used data extracted from DataStream and 3912 observations in the years 1996-2011. Here, they analyzed data sample frequency daily and used the MGARCH model; they determined that the Chinese equity market is relatively stable and is characterized by a healthy fiscal position, domestic savings, a stable banking system as well as a favorable external position. As far as the spillover effects go in China. Dimitriou, and Simos, (2012) postulate, these countries are all interconnected through their international relationships and as a rest, they are vulnerable in the eventuality that the country experiences a crisis.

Ye, Luo, and Du (2014) conducted a study where they investigated the contagion of sub prime crises using the MVMQ-CAViaR method. In their analysis, they determined that stock markets often have similar characteristics irrespective of the continent increasing their vulnerability when a crisis occurs. This results in a financial contagion where he is faltering economic state of one country has the power to trouble the economy of other states despite having healthy economies. According to Allen (2000), the pattern of interconnectedness among countries determines whether or not the spillover effects of a financial crisis will spread. However, regions continue to be interconnected, and therefore the effects of the financial crisis are eventually felt by the neighboring states. This is supported in Tse and Raftery (2010, p. 9-17), who determined that the positive money supply shocks have a specific and strong effect on the output in the economy compared to negative one supplies.

 2.2 Factors that promote financial crises

As aforementioned, financial crises have occurred regularly over the centuries, and they cause many devastating effects on the economy. This is caused by a myriad of factors as supported in Kamalodin (2011) who outlines them as the accessibility to easy money, lack of proper regulation as well as the failure of speculators in the industry to curb their desire to make more money. Hence, Kamalodin (2011) noted that historical data from the last two centuries proves that financial crises and asset bubbles are common in the society and date back to the 17^th century. Kamalodin (2011) attributes these events to the lack of proper regulations, greedy financial speculators who include the bankers, hedge-fund managers and or even managers and the prospect of easy money which is as a result of reduced interest rates resulting in an increase in money supply. Therefore, Kamalodin (2011) argues that human behavior is the common denominator in causing these events.

Dimitriou and Simos, (2012) denote that there are always spillover effects when a country or region experiences a financial crisis, these effects are transmitted either through real economy effects or through the interaction of capital markets. According to Lasjkary and Kashani (2011, p. 450-456), unchecked increases in the money volume does not result in economic growth as many would assume, rather it increases the risk of inflation. Based on their analysis, Lasjkary and Kashani (2011) stated that those of the monetarist opinion that a stable growth in money supply results in a stable growth in economic activities. However, as evidenced by the findings in the study, money growth does not influence the real economic variables in the economy. This is because the real monetary variables are influenced by both the government supply and the country’s financial policies. This is however contradicted by Chaitip, Chkethaworn, Chaiboonsri and Khounkhalax (2015, p. 108-115) who stated that money supply has a positive correlation with a country’s GDP growth and therefore economic growth.

Chaitip et al., (2015) conducted a study to determine how money supply affects the economic growth. They noted that monetary policies are key macroeconomic tools that help a country to maintain its economic stability thereby promoting economic growth. However, failure to adhere to these monetary policies often results in either a surplus or deficit in money supply. As is the case in China today, the increase in money supply does not present a direct effect on the country’s GDP rather it creates a volatile situation in the market where inflation is likely to occur. The result is a financial crisis that then turns to a global recession that adversely affects the developing and already developed countries. However, there are instances when the central bank adopts expansionary monetary policies to stimulate economic growth and meet the demand. When these measures are however not well regulated, there is a surplus in money supply which exceeds the demand, and the result is a disequilibrium that results in high rates of inflation and unemployment.

Širůček, (2013) on the other hand investigated how money supply fluctuations affect stock bubbles and stock prices. Given the sensitive nature of shares and stock markets, fluctuations in any macroeconomic variables are likely to affect them significantly. Some of these factors include money supply, inflation, political shocks, legislature amendments as well as changes in interest rates among others. Širůček, (2013) determines that the amount of money in the economy plays the most influential role in determining the stock prices. This is complemented by aspects like the trade balance, the producer price index as well as the number of new residential buildings in the country. Therefore, money supply has a direct effect on the entire economy. This is because when the central bank reduces the interest rates rendering financing investment cheaper, there is a notable increase in the demand for shares or investments as well as an increase in the consumption. This means the nominal GDP rises with the increase in money supply in the economy in the short run. However, in the long run, when too much liquidity enters the market as a result of aspects like asset prices on stocks and housing, the result is often a recession. Therefore, as China continues to grapple with increasing their liquidity to facilitate fast economic growth, they are risking experiencing a bubbles burst. This is because, money supply grows at the same rate as real output, however, when the money supply grows faster, the result is inflation.

2.3 Effects of a financial crisis

Pnevmatikous et al., (2017) acknowledges that a financial crisis influences all aspects of human life and activities. For example, in Greece, the 2009 economic crises resulted in a 30 percent rise in unemployment, a 20 percent decline in GDP, a 50perecnt increase in fuel prices as well as a 38 percent decline in income. In the same way, Chaitip et al., (2015) determined that a financial crisis has many effects on the countries affected. Key among them is the reduction in the GDP growth. the recent financial crisis, for example, resulted in a decline in the global GDP thereby affecting the standard of living for all those involved. Yoon et al., (2012, p. 294-297) noted that financial crises often result in high rates of unemployment which adversely affects the socioeconomic status of a country. As noted in the study, there is a significant and inverse correlation between the GDP of a country and the suicide rate of the country. This is caused by a series of events which start when the country experiences a macroeconomic  recession affecting all its citizens.

Conclusion

Although China’s market proved to be immune to the spillover effects of the 2008 crises, today their trade balance, portfolio investment assets and their direct investment abroad have considerably increased. The country is today one of the world’s major creditors purchasing bonds from other markets especially the USA and the Euro-zone bonds making much fear that the country may experience subprime financial crises.

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