The current debate about contagion has stemmed from an upsurge in interest during the second half of the 1990s in the spread of financial crises from their source country to others. The following quote by Hale at the time of the Asian crisis poignantly captures policy makers’ apprehension and frustration with financial contagion: “What’s going on in Asia is nothing short of a contagion of awesome, profound effect . . . The speed and the ferocity of the crisis as it cascaded through Asia and beyond is mind-boggling.
It has hit Asian economies like a heart attack, utterly incapacitating countries otherwise endowed with strong physical constitutions. ” David Hale in “This is Different” from Barron’s (12/22/97) Contagion is, however, not a new phenomenon as the spread of financial turmoil stemming from the Wall Street Crash crossed the globe in the 1930s well illustrates. This essay looks at the channels through which financial crises are transmitted across countries and at whether there is anything that can be done by regulators to mitigate or prevent a country’s vulnerability to externally originated shocks and crises.
Definition of ‘Financial Crisis’ Mishkin (1996) defines a financial crisis as a disruption to financial markets in which adverse selection and moral hazard become much worse, so that financial markets are unable to channel funds efficiently to those who have the most productive investment opportunities. An international financial crisis is one where these disturbances and their effects spill over national borders.
Three types of crisis can be identified, Stock Market Crashes, Currency Crises and Banking Crises, which can occur singularly and as multiple crises. Definition of ‘Contagion’ Use of the word ‘contagion’ to describe the international transmission of financial crises has become overlain with disagreement, to the extent that Favero and Giavazzi (2002) and Rigobon (2003) have avoided using the word altogether. The term evokes an emotive response, as there is no general agreement over its use.
In this essay I suggest that Pritsker (1999) enlarges upon this definition as: Contagion occurs when a shock to one or a group of markets, countries, or institutions, spreads to other markets, or countries, or institutions based on the World Bank’s broad definition (see Appendix for the World Bank’s, restricted and very restricted definitions). Contagion can take place both during “tranquil” and “crisis” times, showing that it does not need to be related to crises. However, for the purposes of this essay I will be looking at contagion during crisis times.
The root causes of contagion can be divided into two theoretical categories (Pritsker 1999). The first emphasises the natural links between capital markets that can transfer crises by both real and financial linkages: so called “fundamentals-based contagion”1. The second category explains contagion as a consequence of investor behaviour or other financial agents and not by real or financial linkages. This is commonly referred to as “irrational contagion” such as financial panics, herd behaviour, loss of confidence, and increased risk aversion.
Fundamental Causes Fundamental causes of contagion can include macroeconomic shocks that have implications on an international scale and local shocks funneled through trade links, competitive devaluations, and financial links. COMMON SHOCKS. Major economic shifts in developed countries and marked changes in commodity prices can set in motion crises in emerging markets. For example, changes in US interest rates have been identified with movements in capital flows to Latin America (Calvo and Reinhart 1996; Chuhan, Claessens, and Mamingi 1998).
Fragile economies are particularly influenced by US interest rate changes. Kaminsky et al (2002) found that interest rate hikes in financial centres cause sovereign risk 50% larger in vulnerable economies than in countries with better ratings. In general, a common shock can lead to movement in asset prices or capital flows of another country. TRADE LINKS AND COMPETITIVE DEVALUATIONS. Local shocks such as a crisis in one economy can affect the economic fundamentals of other countries through trade links and currency devaluations.
Major trading partners of a country in a financial crisis could experience declining asset prices and large capital outflows or could become the target of a speculative attack as investors anticipate a decline in exports to the crisis country and hence deterioration in the trade account. Competitive devaluations can be another channel for transmitting contagion. Devaluation in a crisis country reduces the export competitiveness of countries that compete in the same third markets, putting pressure on the currencies of other countries, especially when those currencies have fixed exchange rates.
Corsetti (1999) explains how a game of competitive devaluation can bring about a sharper currency depreciation than would by required by any initial deterioration in fundamentals. Also, the non-cooperative nature of the game can cause a still greater depreciation compared with what could have been attained in a cooperative equilibrium. If market participants expect that a currency crisis will lead to a game of competitive devaluation, they will accordingly sell their holdings of securities from other countries, curtail their lending, or refuse to roll over short-term loans to borrowers in those countries.
This proposition gains some credence from the fact that during the East Asian crisis in 1997, exchange rates depreciated substantially even in economies such as Singapore and Taiwan, China, which did not naturally appear vulnerable to a speculative attack on the basis of their fundamentals. FINANCIAL LINKS. Economic integration of an individual country into the world market typically involves both trade and financial links. Thus a financial crisis in one country can lead to direct financial effects, including reductions in trade credits, foreign direct investment, and other capital flows abroad.
For example, firms in East Asia that are linked to, say, Thailand by trade, investment, and financial transactions would be adversely affected if a crisis were to limit the ability of Thai firms to sell abroad, extend credit, and so on. Thus a financial crisis in Thailand would rationally be reflected in other countries, leading, for example, to co-movements in asset prices and capital flows. Investors’ Behaviour Foreign investors’ behaviour in times of financial crisis is often credited with causing contagion. Countries that are highly integrated into global financial markets are more likely to be affected than those less integrated.
The financial markets can be seen as the mechanism through which contagion can occur but not the cause of it. Instead, investors’ behaviour, whether rational or irrational, allows shocks to spill over from one country to the next. Even if the investor behaviour of individuals can be explained as ‘rational’, other investors, by following the initial lead, can create excessive-collective-movement (excessive in the sense that it cannot be explained by weakness in countries’ real fundamentals). This behaviour can be further explained by problems of liquidity, incentives, informational asymmetry and market coordination problems.
Secondly, cases of multiple equilibrium, similar to those in models of commercial bank runs, can imply contagious behaviour among investors. Thirdly, changes in the international financial system after an initial crisis, can also cause investors to change their behaviour. LIQUIDITY AND INCENTIVE PROBLEMS. Investor behaviour can be influenced by liquidity and other constraints. If investors make heavy losses from investing in a country that is hit by a financial crisis, they would suffer from an immediate liquidity shortage. Their losses would increase their likelihood of selling off securities held in other high-risk countries.
Similarly, liquidity requirements of commercial banks that have lent to a crisis country may cause them to reduce the overall risk of their portfolios again by reducing their exposure to high-risk investments. Schinasi and Smith (2000), for example, demonstrate that the value at-risk models used by many commercial banks explain why financial institutions and other investors may find it optimal to sell their most high-risk assets when a shock affects one of those assets. The incentives for investors in mutual funds, hedge funds and proprietary traders are all to meet liquidity shortages in a crisis by selling off other assets in other markets.
By doing so foreign investors can cause the asset prices of markets, apart from the crisis country, to decrease from a reversal of capital inflows. INFORMATION ASYMMETRIES AND COORDINATION PROBLEMS. Markets are characterized by having imperfect information. In the absence of clear information to the contrary in a time of a crisis, investors may believe that countries similar to the crisis country may also be inherently unstable. This in turn can lead to a currency attack on these suspect countries as investors go short.
This reasoning can explain how a financial crisis can become contagious even if other countries at the time of the initiation of the crisis show no signs of vulnerability. Often investors do not possess full information about the countries that they are investing in due to the cost involved in gathering information and the reliability of the country in question to produce reliable and consistent information. The tendency for investors to follow-the-leader, in a herd, can be understood as ill-informed investors are likely to believe others have insights they don’t. MULTIPLE EQUILlBRIUMS.
Another model for understanding contagion is that market equilibrium can change from being regarded as stable to being described as bad. Sudden shifts in market expectations to bad equilibriums are often characterized by devaluations, drops in asset prices, large capital outflows and/ or debt default. In such circumstances it is optimal for investors to withdraw their investments first. In Diamond and Dybvig’s (1983) seminal work on a model of bank runs, they write about sunspots where self-fulfilling expectations generate disturbances, which in turn cause investor panic and hence runs on banks.
If everyone believes that a banking panic is about to occur, it is optimal for each individual to try and withdraw funds given the assumptions of first-come, first-served and costly liquidation. Since each bank has insufficient liquid assets to meet all its commitments, it will have to liquidate some of its assets at a loss. Given first-come, first-served, those depositors who withdraw initially will receive more than those who wait. Anticipating this, depositors have an incentive to withdraw immediately.
Variables or “sunspots” have no effect on real factors of the economy, they affect depositors’ beliefs in a way that turns out to be self-fulfilling. In a financial crisis, the result analogous to a bank run would be a sudden withdrawal of funds from a country sparked by investors’ fears that unless they act quickly they will be too late to claim the limited pool of foreign exchange reserves (see Dornbusch et al (2000)). CHANGES IN THE INTERNATIONAL FINANCIAL SYSTEM. Finally, contagion can occur if investors believe that there will be changes to the international financial system after a crisis.