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1) Read each article and describe all relevant information; for instance, the factual elements, strategic issues, the interactions among entities and generally what the article is about.

2) Write a concluding paragraph telling the main thing you take away from the article.


1) “Hong Kong Ramps Up Intervention to Curb Local Currency,” Wall Street Journal, August 1, 2014.

2) “Crash Course, the Origins of the Financial Crisis,” Economist, September 7, 2013. For this article, write out the role of various parties and financial instruments involved in the financial crisis. Write more than one page if necessary.

Hong Kong Ramps Up Intervention to Curb Local Currency

Monetary Authority Injects Billions Into Market in July as Foreign Funds Flow In


The HKMA maintains a strict trading band for the Hong Kong dollar. Agence France-Presse/Getty Images

By Fiona Law Aug. 1, 2014 4:59 a.m. ET

Hong Kong’s de facto central bank injected $65.1 billion Hong Kong dollars (US$8.4 billion) into the foreign-exchange market in July to defend the local currency peg to the U.S. dollar as foreign funds continued to pour into the city to feed a hunger for Chinese assets.

Funds have been flowing into Hong Kong, which offers foreigners an easy way to tap Chinese stocks and bonds, at a faster pace than late 2012, when the Hong Kong Monetary Authority last intervened as investors’ risk appetite for the city’s stocks rose.

At that time, HKMA injected HK$107 billion (US$13.8 billion) into the forex market from October to December in a bid to cool the Hong Kong currency. The latest intervention totaled more than half that amount in the span of a single month.

The HKMA—obliged to buy or sell the local currency whenever it touches either side of the authority’s HK$7.75-HK$7.85 band against the U.S. dollar—said Saturday that it attributed the strength of the Hong Kong dollar to listed companies’ dividend payments, cross-border merger-and-acquisition deals such as
Oversea-Chinese Banking

HK$40 billion takeover of
Wing Hang Bank
Ltd., as well as an active market for initial public offerings.

In July, the benchmark
Hang Seng

Index had its best month since 2012, posting a 6.8% gain and hitting a three-year high, as China’s improving economy persuaded investors to snap up the city’s stocks, which are made up mostly of mainland Chinese companies.

Russia’s second-largest mobile operator, OAO

has decided to keep about 40% of its cash reserves in Hong Kong dollars because of global market instability and as the West imposes sanctions on Moscow in a bid to force President
Vladimir Putin
to end his support for separatist rebels in Ukraine, The Wall Street Journal reported this week.

The fact that China’s Huawei Technologies Co. is its main equipment manufacturer was another factor in MegaFon’s decision, according to the report.

On Friday, the Hong Kong dollar remained sticky at the strong end of its trading band—HK$7.75 per dollar—and analysts have said they expect it to stay elevated as a program that allows direct trading between Hong Kong and Shanghai shares was likely to stoke demand for the local currency.

“But funds do not flow in one direction only,” Peter Pang, HKMA’s deputy chief executive, said Saturday. “Last year’s market turmoil caused by a large-scale outflow of funds from certain emerging markets showed that the direction of fund flows could change spontaneously in response to investors’ sentiments.”

“As the U.S. economy recovers and its monetary environment normalizes, there remain considerable uncertainties in the future direction of fund flows,” Mr. Pang said.

The origins of the fina nciaI crisis

Crash course

The effects of the Enancial crisis are still being felt, 6ve years on. This article, the
first of a series of 6ve on the lessons of the upheaval, looks al its causes

over investment in emerging economies,
especially China. That capital flooded into
safe American-government bonds, driv-
ing down interest rates.

Low interest rates created an incentive
for banks, hedge funds and other inves-
tors to hunt for riskier assels that offered
higher returns. They also made it profit-
able for such outfits to borrow and use the
extra cash to amplify their investments, on
the assumption that the returns would
exceed the cost of borrowing. The low
volatility of the Great Moderation in-
creased the temptation to “leverage” in
this way. If short-term interesl rates are
low but unstable, investors will hesitate
before leveraging their bets. But if rates
appear stable, investors will take the risk
of borrowing in the money markets to buy
longer-dated, higher-yielding securities.
That is indeed what happened.

Frorir houses to money mirkets
When America’s housing market turned, a
chain reaction exposed fragilities in the
linancial system. Pooling and other clever
financial engineering did not provide
inveslors with the promised protection.
Mortgage-backed securities slumped in
value, if they could be valued at all. Sup-
posedly safe cDos turned out to be
worthless, despite the ratings agencies’
seal ol approva[. It became difficult to sell
suspect assets at almost any price, or to
use them as collateral for the short-term
funding that so many banks relied on.
Fire-sale prices, in turn, instantly dented .
banks’ capital thanks to “mark-to-market”
accounting rules, which required them to
revalue their assets at current prices and
thus acknowledge losses on paper that
might never actually be incurred.

Tiust, the ultimate glue of all financial
systems, began to dissolve in zooT-a year
before Lehman’s bankruptcy-as banks
started questioning the viability of their
counterparties. They and other sources of
wholesale funding began to withhold
short-term credit, causing those most
reliant on it to founder. Northern Rock, a
British mortgage lender, was an early
casualty in the autumn of zoo7.

Complex chains of debt between
counterparties were vulnerable to just one
link breaking. Financial instruments such
as creditdefault swaps (in which the seller
agrees to compensate the buyer if a third
party defaults on a loan) that were meant
to spread risk turned out to concentrate it.
A rG, an American insurance giant buck- r)

f HE collapse of Lehman Brothers, a
I sprawling global bank, in September
zoo8 almost brought down the world’s
6nancial system.lt took huge taxpayer-
financed bail-outs to shore up the in-
dustry. Even so, the ensuing credit crunch
turned what was already a nasty down-
turn into the worst recession in 80 years.
Massive monetary and fi scal stimulus
prevented a buddy-can-you-spare-a-dime
depression, but the recovery remains
febble compared with previous post-war
upturns. GDp is still below its pre-crisis
peak in many rich countries, especially in
Europe, where the financial crisis has
evolved into the euro crisis. The effects of
the crash are still rippling through the
world economy: witness the wobbles in
financial markets as America’s Federal
Reserve prepares to scale back its effort to
pep up growth by buying bonds.

wirh half a decade’s hindsight, it is
clear the crisis had multiple causes. The
most obvious is the financiers them-
selves-especially the irrationally exuber-
ant Anglo-Saxon sort, who claimed to
have found a way to banish risk when in
fact they had simply lost track of it. Central
bankers and other regulators also bear
blame, for it was they who tolerated this
folly. The macroeconomic backdrop was
important, too. The’Great Moderation”-
years of low inflation and stable growth-
fostered complacency and risk-taking. A
“savings glut” in Asia pushed down global
interest rates. Some research also impli-
cates European banks, which borrowed
greedily in American money markets
before the crisis and used the funds to buy
dodgy securities. All these factors came
together to foster a surge of debt in what
seemed to have become a less risky world.

Start with the folly of the 6nanciers.
The years before the crisis saw a flood of
irresponsible mortgage Iending in Ameri-
ca. Loans were doled out to “subprime”
borrowers with poor credit histories who
struggled to repay them.These risky mort-
gages were passed on to financial engi-
neers at the big banks, who turned them

into supposedly low-risk securities by
putting Iarge numbers of them together in
pools. Pooling works when the risks of
each loan are uncorrelated. The big banks
argued that the property markets in differ-
enl American cities would rise and fall
independently of one another. But this
proved wrong. Starting in 20o6, America
suffered a nationwide house-price slump.

The pooled mortgages were used to
back securities known as collateralised
debt obligations (coos), which were
sliced into tranches by degree of exposure
to default. Investors bought the safer
tranches because they trusted the triple-n
credit ratings assigned by agencies such as
Moody’s and Standard & Poor’s. This was
another mistake. The agencies were paid
by, and so beholden to, the banks that
created the coos. They were far too gener-
bus in their assessments of them.

Investors sought out these securitised
products because they appeared to be
relatively safe while providing higher
returns in a world of low interest rates.
Economists still disagree over whether
these low rates were the result of central
bankers’mistakes or broader shifts in the
world economy. Some accuse the Fed of
keeping shortterm rates too loq pulling
longer-term mortgage rates down with
them. The Fed’s defenders shift the blame
to the savings glut-the surfeit of saving

Riskon E
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ools brief The Economist September 7th 2013













Itt-founded optimism A
Weighted average for 17 gtobat bank’

Risk-neighted ossets
os % of total asseLs Leveroge mhbl

1993 95 97 99 [email protected] 03 05 07 09 11

Sourcerfhe&onker. tlBSandSA,lL llotatastets
Bank ofEngtand dividedbylier-l Bpitat

> led within days of the Lehman bankrupt-
cy.under the weight of the expansive
creditrisk protection it had sold. The
whole system wasrevealed to have been
built on flimsy foundations: banks had
allowed their balance-sheets to bloat (see
chart L on previous page), but set aside too
little capital to absorb losses. In effect they
had bet on themselves with borrowed
money, a gamble thathad paid offin good
times but proved catastrophic in bad.

Regulators asleep at the wheel
Failures in finance were at the heart of the
crash. But bankers were not the only
people to blame. Central bankers and
other regulators bear responsibility too,
for mishandling the crisis, for failing to
keep economic imbalances in check and
for failing to exercise proper oversight of
fi nancial institutions.

The regulators’ most dramatic error
was to let Lehman Brothers go bankrupt.
This multiplied the panic in markets.
Suddenly;nobody trusted anybody, so
nobody would lend. Non-financial com-
panies, unable to rely on being able to
borrow to pay suppliers or workers, froze
spending in order to hoard cash, causing a
seizure in the real economy. Ironically, the
decision to stand back and allow Lehman
to go bankrupt resulted in more govem-
ment intervention, notless. To stem the
consequent panic, regulators had to rescue
scores of other companies.

But the regulatorsmade mistakes long
before the Lehman bankruptcy, most
notably by tolerating global current-ac-
count imbalances and the housing bub-
bles that they helped to inflate. Central
bankers had long expressed concerns
about America’s big deficit and the off-

setting capital inllows from Asia’s excess
savings. Ben Bernanke highlighted the
savings glut in early zoo5, a year before he
took over as chairman o[ the Fed from
Alan Greenspan. But the focus on net
capital flows from Asia left a blind spot for
the much bigger gross capital flows from
European banks. They bought lots of
dodgy American securities, financing
their purchases in large part by bonowing
from American money-market funds.

In other words, although Europeans
claimed to be innocent victims of Anglo-
Saxon excess, theif banks were actually in
the thick of things. The creation of the
euro prompted an extraordinary expan-
sion of the financial sector both within the
euro area and in nearby banking hubs
such as London and Switzerland. Recent
research by Hyun Song Shin, an econo-
mist at Princeton University, has focused
on the European role in fomenting the
crisis. The glut that caused America’s loose
credit conditions before the crisis, he
argues, was in global banking nther than
in world savings.

Moreover, Europe had its own internal
imbalances that proved just as significant
as those between America and China.
Southern European economies racked up
huge current-account deficits in the first
decade of the euro while countries in
northem Europe ran offsetting surpluses.
The imbalances were financed by credit
flows from the euro-zone core to the over-
heated housing markets of countries like
Spain and lreland. The euro crisis has in
this respect been a continuation of the
financial crisis by other means, as markets
have agonised over the weaknesses of
European banks loaded with bad debts
following property busts.

Central banks could have done more to
address all this. The Fed made no attempt
to stem the housing bubble.The European
Central Bank did nothing to restrain the
credit surge on the periphery, believing
(wrongly) that current-account imbal-
ances did not matter in a monetary union.

This series of schoots briefs revtves fhe Econonis{s
occasionaI primers on topicaI subjects. l]e first series
(pubtished in 1975. on “Managing the British
Economy”) was intended to hetp Bri6sh economics
students prepare for schoot-leaving exams, thouqh we
hoped it wou[d atso be of wider use. Subsequent
subjects ranged wider, from American government to
science. We [ast published a schools brief in 1999. It was
on finance, :nd concbded: ‘Some of the new financiat
technotogies are, in effect, efforts to bottle up
considerabte uncertainties. If they work, the wortd
economy witl be mere stable. If no! an economic
disaster might ensue.’

The Bank ofEngland, having lost control
over banking supervision when it was
made independent in r997, took a mistak-
enly narrow view of its responsibility to
maintain financial stability.

Central bankers insist that it would
have been difficult to temper the housing
and credit boom through higher interest
rates. Perhaps so, but they had other regu-
latory tools at their disposal, such as low-
ering madmum loan-to-value ratios for
mortgages, or demanding that banks
should set aside more capital.

– Lax capital ratios proved”the biggest
shortcoming. Since 1988 a committee of
central bankers and supervisors meeting
in Basel has negotiated intemational rules
for the minimum amount of capital banks
must hold relative to their assets. But these
rules did not define capital strictly
enough, which let banks smuggle in forms
of debt that did not have the same loss-
absorbing capacity as equity.

Under pressure from shareholders to
increase returns, ban!.s operated r..r!!h
minimal equity, leaving them vulnerable
if things went wrong. And from the
mid-r99os they were allowed more and
more to use their own intemal models to
assess risk-in effect setting their own
capital requirements. Predictably, they
judged their assets to be ever safer, allow-
ing balance-sheets to balloon without a
commensurate rise in capital (see chart z).

The Basel committee also did not make
anyrules regarding the share of a bank’s
assets t}rat should be liquid- And it failed
to set up a mechanism to allow a big inter-
national bank to go bust without causing
the rest of the system to seize up.

The regulatory reforms that have since
been pushed through at Basel read as an
extended nrea culpaby central bankers for
getting things so grievously wrong before
the financial crisis. But regulators and
bankers were not alone in making mis-
judgments. When economies are doing
well there are powerfirl political pressures
not to rock the boat. With inflation at bay
central bankers could not appeal to their
usual rationale for spoiling the party. The
long period of economic and price stabil-
ity over which they presided encouraged
risk-taking. And as so often in the history
of financial crashes, humble consumers
also joined in the collective delusion that
Iasting prosperity could be built on ever-
biggerpilesofdebt. r



The Economist September 7th 2013


Schoots Brief 75

In this series
The causes of the crisis1