Contagion Essay

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Contagion is related to extremely high levels of international financial co-movements. However, there is not consensus in academic literature about what contagion represents. It denotes an increase in probability that a crisis in one country is caused by a crisis in another country. Second, it involves the asset price spill-over effect from a crisis-stricken country to others. Third, if fundamentals do not provide any justification for a significant increase in cross-country price and quantity co-movements there must a contagion involved. Finally, international transmission mechanisms will have stronger impact during the financial crisis. Nevertheless, the contagion effect must change the level of co-movements and unconditional market volatilities. Otherwise, a strong cross-country conditional correlation during a shock does not constitute contagion.

Recent Crises

The frequent outbreaks of crises in recent financial history have led to a widespread interest in academic circles. The Mexican crisis commenced on December 20, 1994, initiated by a 12.7 percent decline in the national currency’s value. The peso was allowed to freely float in order to avoid the depletion of foreign exchange reserves. In addition, the financial system was supported by a $52 billion rescue package provided by the U.S. government. Even though this incident did not have global repercussions, the so-called Asian crisis initiated by the Thai baht’s 10 percent devaluation in June 1997 did send a ripple throughout the region. Other currencies in the vicinity were severely hit, with the exception of the Singaporean dollar and the Taiwanese dollar. Due to its currency board policy, the Hong Kong dollar was pegged to the U.S. dollar, but the economy suffered deflation, which was an alternative correction mechanism. The International Monetary Fund (IMF) provided substantial bail-out packages to help these countries restructure economies and introduce more effective market models.

The Malaysian prime minister, Dr. Mahathir bin Mohamad, blamed wealthy speculators like George Soros for destabilizing emerging markets. However, a study conducted in the Korean Stock Exchange (KSE) indicates that during the crisis foreign investors were not buying (selling) stocks based on the previous increase (decrease) in the market. In addition, the stock return of the previous day did not have any predicting power about the foreign investors’ trade the next day. By contrast, before the onset of the crisis foreign investors demonstrated positive feedback trading at KSE. The root of the Asian crisis may be found in the short-term lending of banks exposed to these markets. When Korea stopped defending its foreign exchange parity on November 14, 1997, exposed banks had a minus 1.5 percent abnormal return (compared with minus 0.71 percent for unexposed counterparts). When the bailout agreement with IMF became evident on December 1, 2007, the abnormal return was 2.07 percent (as opposed to 1.22 percent for parties unexposed to the Korean market). Nevertheless, the differences between these bank groups were statistically insignificant.

The impact of the Asian crisis was mainly regional, unlike the subsequently ensuing Brazilian currency and Russian bond crises in 1998. Speculators diverted their attention from Asian currency to the Brazilian real, assuming that the strong currency policy was not matched by appropriate fiscal and monetary austerity.

The doubling of interest rates to 43 percent and belated tax reforms were not sufficient to reverse the decline. Immediate investors’ response was capital flight and an apparent loss of confidence in emerging markets. On August 17, 1998, the Russian government devalued the ruble and publicly announced its decision to place a moratorium on debt repayments, which was conducive to an increase in spreads between bond issues in emerging and developed economies, respectively. Foreign investors, such as the Long Term Capital Management (LTCM) hedge funds, were severely affected. In order to counteract the loss of $550 million on August 21, 1998, LTCM decided to seek recapitalization. In view of the size of this fund (notional principal in excess of $1 trillion) the Federal Reserve decided to support the $3.65 billion bailout package provided by 15 financial institutions in September 1998. The Brazilian real crisis did not only have short-term ramifications. As part of efforts to improve deteriorating terms of trade with the largest trade partner in South America and support economic growth, Argentina was forced to devalue its national currency in 2001.

In order to evaluate the ramifications of the LTCM bailout, market participants can be separated into companies that took part in the LTCM bailout, financial companies that were directly exposed to LTCM but never participated in the bailout deal, banks that do not have any exposure to hedge funds, and banks that do have exposure to hedge funds but not LTCM. It was found that following the bailout announcement on September 24, 1998, the largest negative abnormal return was recorded by banks directly involved in the bailouts and those that had been exposed to hedge funds. Financial institutions with either indirect exposure to LTCM or no exposure to hedge funds were not as adversely affected.

Bibliography:

  1. Choe, B.-C. Kho, and R.,M. Stulz, “Do Foreign Investors Destabilize Stock Markets? The Korean Experience in 1997,” Journal of Financial Economics (1999);
  2. J. Forbes and R. Rigobon, “No Contagion, Only Interdependence: Measuring Stock Market Movements,” Journal of Finance (2002);
  3. M. Halstead, S. Hedge, and L. S. Klein, “Hedge Fund Crisis and Financial Contagion: Evidence from Long Term Capital Management,” Journal of Alternative Investments (2005);
  4. -C. Kho, D. Lee, and R. M. Stulz, “U.S. Banks, Crises, and Bailouts: From Mexico to LTCM,” American Economic Review (2000);
  5. Pericoli and M. Sbracia, “A Primer on Financial Contagion,” Journal of Economic Surveys (2003);
  6. C. Shapiro, Multinational Financial Management (John Wiley & Sons, 2006).

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