Financial contagion
Financial contagion refers to "the spread of market disturbances – mostly on the downside – from one country to the other, a process observed through co-movements in exchange rates, stock prices, sovereign spreads, and capital flows".[1] Financial contagion can be a potential risk for countries who are trying to integrate their financial system with international financial markets and institutions. It helps explain an economic crisis extending across neighboring countries, or even regions.
Financial contagion happens at both the international level and the domestic level. At the domestic level, usually the failure of a domestic bank or financial intermediary triggers transmission when it defaults on interbank liabilities and sells assets in a fire sale, thereby undermining confidence in similar banks.
An example of this phenomenon is the subsequent turmoil in the United States financial markets.[2] International financial contagion, which happens in both advanced economies and developing economies, is the transmission of financial crisis across financial markets for direct or indirect economies. However, under today's financial system, with the large volume of cash flow, such as hedge fund and cross-regional operation of large banks, financial contagion usually happens simultaneously both among domestic institutions and across countries. The cause of financial contagion usually is beyond the explanation of real economy, such as the bilateral trade volume.[3]
The term financial contagion has created controversy throughout the past years. Some argue that strong linkages between countries are not necessarily financial contagion, and that financial contagion should be defined as an increase in cross-market linkages after a shock to one country, which is very hard to figure out by both theoretical model and empirical work. Also, some scholars argue that there is actually no contagion at all, just a high level of market co-movement in all periods, which is market "interdependence".[4]
More generally, there is controversy surrounding the usefulness of "contagion" as a metaphor to describe the "catchiness" of social phenomena, as well as debate about the application of context-specific models and concepts from biomedicine and epidemiology to explain the diffusion of perturbations within financial systems.[5]
Causes and consequences[edit]
Financial contagion can create financial volatility and can seriously damage the economy and financial systems of countries. There are several branches of classifications that explain the mechanism of financial contagion, which are spillover effects and financial crisis that are caused by the influence of the four agents' behavior. The four agents that influence financial globalization are governments, financial institutions, investors, and borrowers.[6]
The first branch, spill-over effects, can be seen as the negative externalities. Spillover effects are also known as fundamental-based contagion.[1] These effects can happen either globally, heavily affecting many countries in the world, or regionally, affecting only neighboring countries. The big players, who are more of the larger countries, usually have a global effect. The smaller countries are the players who usually have a regional effect. "These forms of co-movements would not normally constitute contagion, but if they occur during a period of crisis and their effect is adverse, they may be expressed as contagion."[1]
"Fundamental causes of contagion include macroeconomic shocks that have repercussions on an international scale and local shocks transmitted through trade links, competitive devaluations, and financial links."[1] It can lead to some co-movements in capital flows and asset prices. Common shocks can be similar to the effects of financial links. "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."[1] Financial links come from financial globalization since countries try to be more economically integrated with global financial markets. Allen and Gale (2000),[7] and Lagunoff and Schreft (2001)[8] analyze financial contagion as a result of linkages among financial intermediaries. The former provide a general equilibrium model to explain a small liquidity preference shock in one region can spread by contagion throughout the economy and the possibility of contagion depends strongly on the completeness of the structure of interregional claims. The latter proposed a dynamic stochastic game-theoretic model of financial fragility, through which they explain interrelated portfolios and payment commitments forge financial linkages among agents and thus make two related types of the financial crisis can occur in response.
Trade links is another type of shock that has its similarities to common shocks and financial links. These types of shocks are more focused on its integration causing local impacts. "Any major trading partner of a country in which a financial crisis has induced a sharp current depreciation 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 a deterioration in the trade account."[1] Kaminsky and Reinhart (2000)[9] document the evidence that trade links in goods and services and exposure to a common creditor can explain earlier crises clusters, not only the debt crisis of the early 1980s and 1990s, but also the observed historical pattern of contagion.
Competitive devaluation is also associated with financial contagion. Competitive devaluation, which is also known as a currency war, is when multiple countries compete against one another to gain a competitive advantage by having low exchange rates for their currency. "Devaluation in a country hit by a crisis reduces the export competitiveness of the countries with which it competes in third markets, putting pressure on the currencies of other countries; especially when those currencies do not float freely."[1] This action causes countries to act irrationally due to fear and doubt. "If market participants expect that a currency crisis will lead to a game of competitive devaluation, they will naturally sell their holdings of securities of other countries, curtail their lending, or refuse to roll over short-term loans to borrowers in those countries."[1]
Another branch of contagion is a financial crisis, which is also referred to irrational phenomena. A financial crisis as a branch of contagion is formed when "a co-movement occurs, even when there are no global shocks and interdependence and fundamentals are not factors."[1] It is caused by any of the four agents' behaviors who influence financial globalization. Some examples that can cause contagion are increased risk aversion, lack of confidence, and financial fears. Under the correlated information channel, price changes in one market are perceived as having implications for the values of assets in other markets, causing their prices to change as well (King and Wadhwani (1990)).[10] Also, Calvo (2004) argues for correlated liquidity shock channel meaning that when some market participants need to liquidate and withdraw some of their assets to obtain cash, perhaps after experiencing an unexpected loss in another country and need to restore capital adequacy ratios.[11] This behavior will effectively transmit the shock.
Out of the four agents, an investor's behavior seems to be one of the biggest one that can impact a country's financial system.[1] There are three different types of investor behaviors, which generally are considered rational or irrational and individually or collectively.
The first type of behavior is when "investors take action that is ex-ante individually rational but lead to excessive co-movements – excessive in the sense that they cannot be explained by real fundamentals."[1] It breaks down into two sub-categories, liquidity and incentive problems and information asymmetries and coordination problems. The first sub-category is liquidity and incentive problems. A reduction of equity prices can result in a loss of money for investors. "These losses may induce investors to sell off securities in other markets to raise cash in anticipation of a higher frequency of redemptions."[1] These liquidity problems are also challenges for banks, specifically commercial banks. Incentive problems can also have the same effects as liquidity problems. For instance, the first signs of a crisis may cause investors to sell their holdings in some countries, resulting in equity and different asset markets in economies to decline in value. This causes the value of currencies in these economies to also decrease. The second sub-category is information asymmetries and coordination problems. This type of investor behavior can either be considered rational or irrational. This sub-category is when one group, or country, has more or significantly better information compared to another group or country. This can cause a market failure problem, which could potentially cause a financial crisis.
The second type of investor behavior concentrates on multiple equilibriums. It focuses on the investor's behavioral changes when the financial market can have multiple equilibrium changes. Thus, "contagion occurs when a crisis in one financial market causes another financial market to move or jump to a bad equilibrium, characterized by a devaluation, a drop in asset prices, capital outflows, or debt default."[1] The third type of behavior is when there is a change in the international financial system, or in the rules of the game. It can make investors adjust their behaviors after a financial transaction occurs internationally or an initial crisis occurs. These behaviors can lead to spillover effect, causing contagion.
In addition, there are some less-developed explanations for financial contagion. Some explanations for financial contagion, especially after the Russian default in 1998, are based on changes in investor "psychology", "attitude", and "behavior". This stream of research date back to early studies of crowd psychology of Mackay (1841)[12] and classical early models of disease diffusion were applied to financial markets by Shiller (1984).[13] Also, Kirman (1993) analyses a simple model of influence that is motivated by the foraging behavior of ants, but applicable, he argues, to the behaviour of stock market investors.[14] Faced with a choice between two identical piles of food, ants switch periodically from one pile to the other. Kirman supposes that there are N ants and that each switch randomly between piles with probability ε (this prevents the system getting stuck with all at one pile or the other), and imitates a randomly chosen other ant with probability δ.[15] Eichengreen, Hale and Mody (2001) focus on the transmission of recent crises through the market for developing country debt.[16] They find the impact of changes in market sentiment tends to be limited to the original region. They also find market sentiments can more influence prices but less on quantities in Latin America, compared with Asian countries.
Besides, there are some researches on geographic factors driving the contagion. De Gregorio and Valdes (2001) examine how the 1982 debt crisis, the 1994 Mexican crisis, and the 1997 Asian crisis spread to a sample of twenty other countries.[17] They find that a neighborhood effect is the strongest determinant of which countries suffer from contagion. Trade links and pre-crisis growth similarities are also important, although to a lesser extent than the neighborhood effect.