Professional Documents
Culture Documents
157–178
Thomas Moser
International Monetary Fund.
Abstract
I. Introduction
Blaming financial crises on contagion has proved to be highly contagious
among economists and politicians alike. For each of the international
financial crises of the 1990s, financial contagion has increasingly received
more credit, and some believe this to be an indispensable consequence of
I thank Barbara Döbeli, Morris Goldstein, Werner Hermann, Maria Rueda Maurer, Jakob
Schaad, Umberto Schwarz, Charles Wyplosz, Fritz Zurbrügg and an anonymous referee for
valuable comments and suggestions. The views in this paper are my own and do not
necessarily reflect those of the IMF or IMF policy.
r Blackwell Publishing Ltd. 2003, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA
158 Thomas Moser
the ‘new global economy’ (IMF 1999, p. 66; Summers 2000, p. 6). This
popularity has led to a flood of research on the topic.1 If it were true that
financial crises can now easily spread across countries like contagious
diseases, the consequences would be serious. It has been claimed that in the
new global economy sound economic policies may not be enough to prevent
financial crises, as ‘the threat of contagion makes even the virtuous
vulnerable to currency runs’ (Feldstein 1999, p. 93). A financial crisis in any
country may be a threat to the stability of the global financial system. The
large international financial rescue packages of the 1990s and the
subsequent call for a new international financial architecture have been
responses to these concerns. To cure or at least mitigate financial contagion
is one of the main aims of the ongoing efforts to reform the international
financial system (Fischer 1999a, p. 557).
Despite the advanced stage of the policy debate, however, and the large
body of research it has generated, financial contagion remains an elusive
concern. Economists do not agree and are often not clear about what they
mean when they refer to it. Without a clear understanding of financial
contagion and the mechanisms through which it works, though, we can
neither seriously assess its importance nor design appropriate policy
measures. This paper organizes and evaluates recent research on the
subject.2 The main finding is that the mechanisms by which a crisis can
spread greatly differ both in their causes and implications. This is of
practical importance: Appropriate policy measures against contagion
depend on the specific contagion mechanism. Otherwise, they may do
more harm than good.
B. Interdependence of Fundamentals
In the recent Argentine crisis, the devaluation of the peso in early 2002
followed by a severe economic contraction had clear repercussions for
Mercosur, the trade bloc including Argentina, Brazil, Paraguay and
Uruguay. It is no coincidence that the other three members approached a
financial crisis in 2002, particularly Uruguay with Argentina its second
largest trading partner. In turn, Brazil’s devaluation in 1999 was an
important reason for the protracted period of contraction that Argentina
and Uruguay suffered in the run up to the crisis.
Kindleberger (1985, p. 227) has argued that such trade propagation
mechanisms are ‘too strung out with lags to explain the near simultaneity of
y crises’, but agents in financial markets respond in anticipation of real
impacts causing immediate corrections in asset prices. However, asset prices
and capital flows do not react only to anticipated trade shocks. Independent
financial linkages can be either bilateral direct cross-border investments, or
indirect through common investors. As an example of a bilateral linkage, the
Argentine crisis of 2002 led many Argentines to withdraw dollar deposits
held in Uruguay, causing banks in Uruguay to withdraw required reserves
and accelerate the decline in central bank reserves, finally leading to the
floating of the peso in June 2002.3
Regarding indirect links, international investors including banks and
institutional investors such as mutual funds, hedge funds and pension
funds, diversify their portfolios over financial assets of numerous
countries. Even if they hold only a small fraction of their portfolio in
emerging markets, these fractions can represent a significant proportion of
the relatively small capital markets in those countries, and portfolio
rebalancing may cause significant capital flows (Kaminsky et al. 2001).
Several authors have pointed out that international investors could
undertake such portfolio rebalancing in response to a crisis in one country,
and thereby put other emerging economies in trouble by selling their assets
or calling loans.
Schinasi and Smith (2001) show how cross-country transmission of
shocks can be explained by basic portfolio theory as an optimal portfolio
rebalancing response to a financial crisis in one country. They show that an
adverse shock to a single asset’s return distribution can lead to a reduction
in other risky asset positions, depending on the portfolio management rule
and the parameterization of the joint distribution of asset returns. In the
presence of leverage, the optimal response to a realized loss on a specific
position is to deleverage and reduce risky asset positions in all markets.
3
However, the withdrawal of deposits by Argentines also contained a significant element of
‘domino effects’. Many Argentines were forced to raise liquidity due to the fact that their
government imposed a freeze on withdrawals from domestic banks, the corralito.
A. Information Effects
Wake-up call
A different story as to why a crisis in one country could lead to a
reassessment of objectively unchanged fundamentals in other countries is
what Goldstein (1998, p. 18) calls the ‘wake-up call’ hypothesis. A crisis in
one country may serve as a ‘wake-up call’ for market participants if it causes
them to take a closer look at fundamentals similar to those in the crisis
country. Contagion occurs if this leads them to detect problems or risks they
failed to see before.4 The difference to the former explanation is that, in the
signal extraction story, the initial crisis makes market participants assume
problems that do not exist, whereas, with a wake-up call, it makes them
aware of existing problems. This sort of contagion is the result of an efficient
correction and leads towards a more accurate assessment of fundamentals.
4
See Goldstein (1998, p. 18): ‘I refer to it as a wake-up call because to judge from most
market indicators of risk, private creditors and rating agencies were asleep prior to the
outbreak of the Thai crisis.’
Expectations interaction
This line of argument takes a crowd psychology approach and employs a
form of ‘mental contagion’ in the tradition of the classical financial panic
view, depicting financial crises as self-fulfilling expectations phenomena or
coordination failures among agents in the presence of multiple equilibria.
Contagion arises if a crisis elsewhere serves as the ‘sunspot variable’ that
leads agents to co-ordinate their expectations on crisis equilibria. A crisis in
one country may cause the loss of public confidence in financial markets or
international investments in general, setting off runs in other countries.5
Alternatively, such a story would be consistent with Bayesian updating in
which market participants raise the probability they assign to the
occurrence of a crisis in similar circumstances on the basis of drawing
another favourable observation (Drazen 2000).
There are two frameworks for modelling self-fulfilling financial crises, one
along the lines of the Diamond–Dybvig (1983) model of bank runs, the other
along the lines of the Obstfeld (1986) model of speculative attacks. Chang
and Velasco (2001) and Marshall (1998) apply the Diamond–Dybvig
approach to countries, and the cause for financial crises are simultaneous
liquidity withdrawals, not driven by economic fundamentals, which result in
costly liquidations and asset price collapses. Two equilibria arise when a
country’s financial system has potential short-term obligations in foreign
currency that exceed the amount of foreign currency it can access on short
notice. The crisis equilibrium occurs if international creditors stop lending
and withdraw funds for fear that all other will do so, forcing the financial
system to liquidate potentially profitable investments at a loss. Alternatively,
in the Obstfeld (1986) model, the multiplicity of equilibria arises because
expectations feed back in an adverse way into the fundamentals, eventually
inducing the government to change its policy. For instance, expectations of
devaluation affect aggregate demand, debt servicing costs and bank balance
sheets through higher interest rates. Consequently, a country will abandon
the exchange rate peg if coordinated behaviour of speculators raises the
costs of maintaining the peg sufficiently high.
Common to both approaches is the implication that such crises are appa-
rently unnecessary as they are not determined by underlying fundamentals,
but every agent will find it individually advantageous to participate in an
expected run or attack. Both frameworks, however, require initial funda-
mentals to be in a range of ‘discomfort’. Consequently, while self-fulfilling
crises seem possible, not just any country can be subject to such a crisis. The
Obstfeld model requires a sufficiently unfavourable initial state of the
5
Note that contagion across different markets or institutions requires more than herding
behaviour with respect to one market or institution, explaining the notion ‘in general’.
Membership contagion
Drazen (2000) provides an explanation for contagion in currency crises that
focuses on the actions of policy makers. Countries with fixed exchange rates
B. Domino Effects
Counterparty defaults
The most straightforward version is the one of ‘cascading defaults’ and is a
matter of ordinary credit risk (Marshall 1998). High exposure to troubled
private or sovereign debtors may lead to cross-border transmission of
failures if losses for creditors are large enough. This is particularly likely if
banks are among the major creditors, as they operate with relatively low
capital-to-asset ratios. Accordingly, a country could experience a banking
crisis if major banks suffer large losses from defaults on foreign loans or
cross-border settlements. Concerns over loan defaults were one of the main
motivations for the international rescue operations during the Latin
American debt crisis of 1982, with claims on troubled debtors heavily
concentrated in the hands of few leading banks.6 A famous example for
cross-border settlement failure is the closure of the Herstatt Bank in
Germany in 1974, which occurred during the business day in New York and
led to counterparty losses for banks that had already fulfilled their side of
foreign exchange transactions with Herstatt.
6
See, for example, Fischer (1987, p. 166). In 1982, the nine large US money centre banks had
more than 250% of their capital in loans to less developed countries.
even between advanced countries has been provided by Peek and Rosengren
(1997) who show that risk-based capital requirements associated with the
Japanese stock market decline resulted in a significant decrease in lending by
Japanese banks in the USA in the early 1990s. Peek and Rosengren (2000)
further show that this loan supply shock had real effects on economic activity
in the USA in that it was not compensated by lending from other sources.
8
The intuition behind this is that, due to an increase in the variance of xt, a greater
proportion of the fluctuations in yi,t is explained by xt and, therefore, estimated correlation
between yi,t and xt increases, even if the value of a remains unchanged.
9
For a critical discussion of the Forbes–Rigobon approach, see also Corsetti et al. (2001) who
find the Forbes–Rigobon test to be biased towards the null hypothesis of interdependence.
in US interest rates and US inflation alone explain about half of the variation
in the aggregate number of crises over time. Overall, their results suggest
that common shocks are responsible for a large fraction of the simultaneous
occurrence of currency crises.
10
In fact, Froot et al. (2001), exploring data on daily international portfolio flows from 1994
through 1998, find that institutional investors did not abandon emerging equity markets
during the Mexican or the Asian crisis.
1990s. They find that financial linkages with the major creditor of the crisis
country appears to substantially raise the probability of a crisis. Rather than
looking at prices, Van Rijckeghem and Weder (2000) test the common
lender effect by looking at volumes, studying panel data on bank flows to a
subset of 30 emerging markets disaggregated by 11 creditor countries. Their
regressions point to the existence of a common lender effect in the Mexican
and Asian crises of the 1990s. For the Russian crisis, they find a more
generalized withdrawal of funds, interpreted as an increase in perceived risk
or a general increase in risk aversion.
V. Policy Implications
While much goes by the name of financial contagion, empirical research
suggests common shocks rather than contagion explain an important part of
the simultaneous occurrence of financial crises. As to the other part, there
are good reasons for discriminating between shock propagation through
fundamentals and shock propagation unrelated to fundamentals (pure
contagion). Although the role of pure contagion seems to be rather limited,
this paper identifies eight potential mechanisms that differ sharply in causes
and implications. For instance, contagion may equally stem from an
inefficient reassessment of fundamentals or from efficient correction toward
a more accurate assessment. Policy makers had better take these differences
into account.
A case in point is the call for an international lender of last resort as a
defence against financial contagion (Fischer 1999b). Some authors have
pointed out that policy implications differ with regard to common shocks
and interdependence of fundamentals versus pure contagion (Chang and
Majnoni 2001; Forbes and Rigobon 2002; Baig and Goldfajn 1999). They
conclude that liquidity assistance is an appropriate response only to pure
contagion, while common shocks and interdependence, matters of economic
fundamentals, have to be dealt with through policy measures that seek to
improve the fundamentals. Otherwise, liquidity support might only delay
necessary adjustment. This paper suggests that, even in the case of pure
contagion, the advisability of short-term liquidity assistance depends on the
specific contagion mechanism.
If contagion is channelled through information effects, liquidity
assistance is an appropriate response only in the case of signal extraction
failures and expectations interactions. With signal extraction failures, if
market participants either misjudge interdependence or falsely lump
apparently similar countries together, it is reasonable to assume such
contagion will only give rise to temporary market pressure either because
Thomas Moser
Advisor to Executive Director
IMF, OEDSZ
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