Financial Contagion: Financial Contagion: What do we Mean? What do - - PowerPoint PPT Presentation

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Financial Contagion: Financial Contagion: What do we Mean? What do we Mean? What do we Know? What do we Know?

Mardi Dungey

Australian National University and CERF

Demosthenes Tambakis

Pembroke College Cambridge University and CERF

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Roadmap for seminar Roadmap for seminar

• 1. Introduction – Definitions of Contagion
• 2. Why does Contagion arise: Theory
• 3. Contagion Case Studies
• 4. Empirical Evidence
• 5. Generalisations by Asset Market
• 6. Contagion in Developed and Developing Markets
• 7. Summary and Policy Implications

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1.Introduction and background 1.Introduction and background

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Background factors Background factors

• Financial crises seem to occur together
• Observe big shifts in financial markets

– Large changes in exchange rates: SE Asian crises 1997- 1998 – Large changes in equity prices (October 1987 DJIA crash, 2000 dot.com bubble burst) – Shifts in bond markets: Russian crisis 1998, Brazil 1999

• Policy concern is that they occur across many

countries – HOW?

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Some important recent dates Some important recent dates

• Devaluation of Mexican peso – 20 Dec 1994
• Devaluation of Thai baht – 2 July 1997
• Russian default – 17 August 1998
• LTCM recapitalisation begins – 23 Sept 1998
• Hong Kong stock market crash – 28 Oct 1998
• Brazil devaluation – 13 Jan 1999
• Collapse of Argentine currency board – Dec 2001
• Brazil – runup to presidential election – 2003

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And some that didn’t seem to And some that didn’t seem to attract as much attention attract as much attention

• US and EU dot.com collapse – April 2000
• Brazilian election – October 2002
• Turkey banking and currency crises – 2000
• What will be the final outcome for the current

Argentine problems – seems no contagion

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Thai baht against US dollar

10 20 30 40 50 60 Jan-97 Apr-97 Jul-97 Oct-97 Jan-98 Apr-98 Jul-98

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Indonesian rupiah against US dollar

2000 4000 6000 8000 10000 12000 14000 16000 18000 Jan-97 Apr-97 Jul-97 Oct-97 Jan-98 Apr-98 Jul-98

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Korean won against US dollar

500 1000 1500 2000 2500 Jan-97 Apr-97 Jul-97 Oct-97 Jan-98 Apr-98 Jul-98

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East Asian currencies against USD

100 200 300 400 500 600 700 800 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03

Indonesia rupiah Thai baht Korean won index: Jan 1 1997 =100

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East Asian equity indices 1990-2003

50 100 150 200 250 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 Thailand Hong Kong Indonesia Index: Jan 1997=100

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Returns: Hong Kong equity index 1996-1999

• 8
• 6
• 4
• 2

2 4 6 8 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 %

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Returns: Indonesian equity index 1996-1999

• 8
• 6
• 4
• 2

2 4 6 8 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99

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Returns: Thai equity index 1996-1999

• 8
• 6
• 4
• 2

2 4 6 8 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 %

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Bond spread: Russian sovereign - US Treasury

1000 2000 3000 4000 5000 6000 7000 8000 Feb-98 Apr-98 Jun-98 Aug-98 Oct-98 Dec-98 basis points

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Bond spread: Bulgarian sovereign - US Treasury

500 1000 1500 2000 2500 Feb-98 Apr-98 Jun-98 Aug-98 Oct-98 Dec-98 basis points

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Bond spread: Argentinian sovereign - US Treasury

200 400 600 800 1000 1200 Feb-98 Apr-98 Jun-98 Aug-98 Oct-98 Dec-98 basis points

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Policy makers’ and market Policy makers’ and market participants’ views participants’ views

• “Malaysia is concerned that the risks of

contagion from the Asian crisis have increased….”

Mustapa Mohamed Malaysian Finance Minister 4/10/98

• “It’s like there are two businesses here. The
• ld business, which works fine under normal

conditions, and this stand-by business, when the world goes mad.”

Eric Rosenfeld of Long-Term Capital, New York Times Magazine, January 24, 1999[1]

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Why is contagion a ‘problem’? Why is contagion a ‘problem’?

• Contagion is seen as a feature of financial crises.
• Internationally diversified portfolios to protect

against country risk.

• In times of financial crisis the relationships used

to diversify break down through unanticipated shocks = CONTAGION

• How do we cope with this?

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Defining contagion Defining contagion

• Myriad of definitions
• Problems across theory and empirical work
• Attempt to draw this together using the

World Bank’s definitions

• First, taxonomies of transmission paths

during crises

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Financial linkages Flight to Safety Cash in effects Portfolio adjustment Herd behavior Shifts in Investor sentiment Wake up call Demonstration Effects Heightened Awareness Spillovers Competitive Dynamics Demand Effects Competition Effects Economic Linkages IMF 99 Goldstein 98 Perry & Lederman 98 Lowell et al 98

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Broad definition of contagion Broad definition of contagion (World Bank) (World Bank)

• “Contagion is the cross-country transmission of

shocks or the general cross-country spillover effects”

• This is very broad. Includes fundamentals linkages such as

due to trade, terms of trade effects, things which we can name.

• Most of the literature distinguishes ‘fundamental’ linkages

from contagion.

• Eg Lowell, Neu and Tong (1998), Reside & Cochoco-Bastista (1999),

Calvo and Reinhart (1996) ‘fundamentals-based’ contagion, Kaminsky and Reinhart (2000)

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Restrictive Definition Restrictive Definition (World Bank) (World Bank)

• “Contagion is the transmission of shocks to other

countries or the cross-country correlation, beyond any fundamental link among the countries and beyond common shocks.”

• Excludes herding behavior and so forth.
• Fundamental links include:

– Financial - Real (- Political) more on these later

• Eg. Eichengreen, Rose and Wyplosz (1995,1996)

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Very Restrictive Definition Very Restrictive Definition (World Bank) (World Bank)

• “Contagion occurs when cross-country

correlations increase during ‘crisis times’ relative to correlations during ‘tranquil times.’”

• This needs to control for general volatility rising during

financial crises (Forbes and Rigobon (2002))

• The fundamental linkages are again not acknowledged
• Only increases in correlation are recognized as contagion

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Our preferred version Our preferred version – – akin to akin to the restrictive definition the restrictive definition

• The transmission of shocks beyond the

fundamental linkages

• Other terms:‘unwarranted contagion’, ‘pure contagion’
• Closest in the empirical literature is Eichengreen, Wyplosz

and Rose (1995,96) and Pesaran and Pick (2003) who want to control for a large variety of fundamentals first.

• Measured contagion may be relative to the particular

fundamentals chosen

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• 2. Why does contagion arise?
• 2. Why does contagion arise?

Theoretical models Theoretical models

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Micro Micro-

• foundations of contagion

foundations of contagion

• The cross-section dimension as opposed to the

time domain.

• Investors’ actions do not reveal their private

information.

• Herds arise when Information gets trapped:

underlying signals driving investment decisions are not revealed.

– For example, when traded asset prices are not market- determined.

• Investors can then rationally decide to mimic the

behavior of others.

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Rational herding Rational herding behavior behavior by by international investors international investors

• Herding arises when there is incomplete

information about a country’s fundamentals and investors are free to choose when they move.

• Different classes of investors may change

positions at the same point in time:

– Banks, corporates, multinationals, hedge funds

• The potential for destabilizing collective action by

herding investors.

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How to prevent herding? How to prevent herding?

• In a bad equilibrium, bank runs or speculative

attacks on a currency can be unrelated to fundamentals.

• Therefore unpredictable!
• The importance of enlarging the amount of public

information available.

• Need to enhance the transparency of institutions,
• bjectives and governance (see also policy

implications I).

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International illiquidity International illiquidity and ‘sudden stops’ and ‘sudden stops’

• Capital account reversals have become more

severe for developing economies.

• The availability of a rescue package (country

bailout option) can make the problem worse because of moral hazard.

• Reliance on short-term financing can lead to sharp

real slowdown if capital inflows stop.

• International creditors covering losses in other

markets can lead to contagion (portfolio links).

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The international debate on the speed The international debate on the speed

• f capital account liberalization: I
• f capital account liberalization: I
• Comparing the costs and benefits of capital market

integration.

• Against the costs, arguments for less capital

controls include:

– Increase the overall availability of funds for financing socially valuable projects – Promote transparency and accountability – Reduce moral hazard and liquidity problems – Improve the functioning of the financial system (though not necessarily deepening it!)

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The international debate on the speed The international debate on the speed

• f capital account liberalization: II
• f capital account liberalization: II
• The conventional view: the benefits
• utweigh the costs (Rogoff (1999)).
• The recent microstructure view: more

market interconnectedness is bad because it leads to cross-market hedging and contagion (Kodres and Pritsker (2002)).

• The middle way: phasing in of opening up

capital short-term flows

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The role of fundamentals The role of fundamentals

• Control variables – spillovers.
• Fundamentals-based contagion – Calvo and

Reinhart (1996), Kaminsky and Reinhart (2000).

• Usually there is a unique equilibrium for

each possible set of fundamentals.

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The role of beliefs The role of beliefs

• Control variables – expectations.
• Hard to measure and even harder to manipulate.
• Beliefs-based contagion – Calvo and Reinhart

(1996), Kaminsky and Reinhart (2000).

• There can be multiple equilibria even with

complete and symmetric information if investors are sufficiently forward-looking (Jeanne and Masson (2000)).

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• 3. Contagion Case Studies
• 3. Contagion Case Studies

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The European Monetary System’s ERM The European Monetary System’s ERM crises: 1992 crises: 1992-

• 93

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• Germany’s problems at the ‘center’ affected

‘periphery’ countries: UK, Italy, Spain, Portugal, Sweden, Finland, France.

• A case study for the self-fulfilling crisis view?

(Contagion unrelated to fundamentals)

• Not really: in most crisis countries, high

unemployment and interest rates were very undesirable, including politically. Also systemic banking sector problems in Scandinavia

• Need to distinguish the credibility of policies from

the credibility of policymakers.

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The Mexican peso crisis 1994 The Mexican peso crisis 1994

1. Driven by fundamentals

• role of weak banking, weak reserves

2. Evidence of contagion

• coined the term ‘Tequila effect’
• tests provide mixed results

3. Was it regional

• largely confined to Latin America

4. Which asset markets were affected

• currency and equities

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The East Asian crises: 1997 The East Asian crises: 1997-

• 98

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1. Driven by fundamentals

• terms of trade effects due to export competing

nations

2. Evidence of contagion

• mixed evidence from formal testing
• much commentary says that Indonesia particularly

was contagion

• 3. Was it regional
• largely
• relatively little spillover to developed markets
• 4. Which asset markets were affected?
• questions as to whether the crisis started in the equity

rather than currency market as commonly presumed

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The Russian and LTCM crises: 1998 The Russian and LTCM crises: 1998

1. Driven by fundamentals

• liqudity crisis and credit crisis
• promulgated by hedging

2. Evidence of contagion

• were these crises connected by contagion

3.

Was it regional

• very widespread
• Russia affects developing markets, LTCM affects developed
• did Russian crisis prompt the Brazilian crisis

4.

Which Asset Markets were affected

• bonds, equities

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Recent Latin American financial crises Recent Latin American financial crises

• 1. Driven by fundamentals

– Brazil 1999 – Argentina 2001

• 2. “Twin crises”: spillover from currency to banking

and vice versa

• 3. Little evidence of international contagion
• 4. Was it regional?
• 5. Which financial markets were affected?
• primarily currency and bonds

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• 4. Empirical Evidence on
• 4. Empirical Evidence on

Financial Contagion Financial Contagion

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Methods of testing for contagion Methods of testing for contagion

A taxonomy loosely based on the World Bank’s classification:

• Unexpected shocks or news

– Dungey et al (2002,2003), Favero and Giavazzi (2003)

• Correlation tests

– Forbes and Rigobon (2002), Baig and Goldfajn (1999)

• Probability tests

– Eichengreen, Rose and Wyplosz (1995), Kaminsky and Reinhart (2000)

• Extreme returns tests

– Bae, Karolyi and Stultz (2003), Baur and Schulze (2002)

• Other tests

– Glick and Rose (1999), Lowell, Neu and Tong (1998)

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Empirical Tests for Contagion Empirical Tests for Contagion

• 1. Contagion as ‘unexpected shocks’ or news

– contagion arises because transmission arises over and above the anticipated links – the reaction is beyond what could have been expected beforehand – Sometimes links are so complex so as to behave as if there is contagion (Kiyotaki and Moore (2002))

• Egs. Dungey et al (2002,2003), Favero and Giavazzi (2002)

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Empirical tests for contagion Empirical tests for contagion

• 2. Correlation Tests

Contagion as a significant increase in the correlation between assets during a period of crisis, compared with a period of calm

• Eg. Forbes and Rigobon (2002)
• consistent with World Bank’s ‘very restrictive’ definition

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Empirical tests for contagion Empirical tests for contagion

• 3. Probability Tests
• if the probability of a domestic crisis is

affected by the occurrence of a foreign crisis this is consistent with contagion

• Eg. Eichengreen, Rose and Wyplosz (1995,1996)

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Empirical tests for contagion Empirical tests for contagion

• 4. Extreme Returns Tests
• the transmission between asset markets is

different in times of extreme returns (crisis times) from that of normal times

• Eg. Bae, Karolyi and Stulz (2003)

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Empirical tests for contagion Empirical tests for contagion

• 5. Other Tests
• encompassing spillovers (fundamental

linkages)

Glick and Rose (1999) trade van Rickjem and Weder (2001) financial links

• other things

Lowell, Neu and Tong (1998) fundamentals

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Some key practical issues Some key practical issues

• How to define the crisis sample period?

– Practically either ad hoc or data driven

• How to define the threshold at which a

crisis occurs?

– Sample dependence

• How to deal with different time zones?
• How to deal with missing observations?

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• 5. Generalisations on contagion
• 5. Generalisations on contagion

by Asset Markets by Asset Markets

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Foreign exchange markets Foreign exchange markets

1. Fundamentals

• often in conjunction with a banking system crisis;

exchange rate pressure often leads banking problems

• a large devaluation is often a trigger – used as a critical

date, eg float of Thai baht, devaluation of Mexican peso

2. Evidence of contagion 3. Regional

• crises seem to spread across wide range of currencies,

both spillovers and contagion

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Equity markets Equity markets

1. Fundamentals 2. Evidence of Contagion

• Forbes and Rigobon result that ‘no contagion, only

interdependence’

• Other methods wide ranging evidence of contagion

3. Regional nature of crises and contagion

• That developed markets act as a conduit for crises

between developing regions

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Fixed income markets Fixed income markets

1. Fundamentals 2. Evidence of contagion

• Much more limited evidence, lack of data

3. Regional effects

• seem less pronounced
• Less evidence that developed markets act as

conduits

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Cross Cross-

• market studies

market studies

• No clear causation from one market to

another

• Most work concentrated on geographical

separation (Bayoumi et al (2003))

• Evidence not yet systematic enough to be

sure

• Growing area of research, and certainly

important for the policy agenda

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Mexican and Argentine peso against Mexican and Argentine peso against the USD: 1994 the USD: 1994-

• 1995

1995

1 2 3 4 5 6 7 8 9 Jan- 94 Mar- 94 May- 94 Jul- 94 Sep- 94 Nov- 94 Jan- 95 Mar- 95 May- 95 Jul- 95 Sep- 95 Nov- 95

Mexican peso Argentine peso

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The equity indices of Mexico and The equity indices of Mexico and Argentina during the 1994 Argentina during the 1994-

• 1995 crisis

1995 crisis

20 40 60 80 100 120 140 Jan- 94 Mar- 94 May- 94 Jul- 94 Sep- 94 Nov- 94 Jan- 95 Mar- 95 May- 95 Jul- 95 Sep- 95 Nov- 95

Index: 1994:1=100 Mexican equity Argentinian equity index

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• 6
• 4
• 2

2 4 6 Jan- 94 Mar- 94 May- 94 Jul- 94 Sep- 94 Nov- 94 Jan- 95 Mar- 95 May- 95 Jul- 95 Sep- 95 Nov- 95

Mexican equity index - blue Argentinian equity index- red

Equity index returns Equity index returns

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Country 1 Equity market Currency market

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Country 1 Equity market Currency market

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60

61

62

63

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• Bonds, equities and currencies

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• 6. Contagion in Developing and
• 6. Contagion in Developing and

Developed Financial Markets Developed Financial Markets

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Relating the stage of financial Relating the stage of financial market development and market development and contagion contagion

• Developed markets seem less affected
• Developing markets have largest contagion

effects

• Regional nature of contagion and crises

usually involves regions of developing – and opening - financial markets (Latin America, Eastern Europe, East Asia)

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The Russian and LTCM crises The Russian and LTCM crises

• Did

– Russian crises mainly affect developing markets and – LTCM mainly affect developed markets As claimed by BIS (1999) ??

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Volatility Decomposition: Bond spreads in Volatility Decomposition: Bond spreads in Russian and LTCM crises Russian and LTCM crises

80% 85% 90% 95% 100% A r g e n t B r a z i l M e x i c

• I

n d

• K
• r

e a T h a i l a n d B u l g a r i a P

• l

a n d R u s s i a N e t h e r U K U S World Idiosyncratic Regional Contagion from Russia Contagion from LTCM

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20 40 60 80 100 120 140 160 180 200 U S U K N e t h e r l a n d s P

• l

a n d I n d

• n

e s i a S

• u

t h K

• r

e a T h a i l a n d M e x i c

• A

r g e n t i n a

Contagion from U.S. Contagion from Russia

Contagion in basis points

• the smaller contributions

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1,000 2,000 3,000 4,000 5,000 6,000 7,000 Argentina Brazil Russia Bulgaria

Contagion from U.S. Contagion from Russia

Contagion in basis points

• the larger contributions

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• 7. Summary and Policy
• 7. Summary and Policy

Implications Implications

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Summary of questions and Summary of questions and evidence evidence

1. Contagion is an important problem

• Statistically significant contagion occurs
• It is not usually the dominant cause of volatility (cost-benefit

trade off required)

2. Contagion is a regional issue

• Varies across crises (and asset markets)
• Some evidence that developed markets operate as a conduit

between regions

3. Asymmetry: developing countries are more affected by contagion than developed countries

• True in terms of the levels effect
• Not clear in terms of proportionate effect on volatility

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Policy Implications I Policy Implications I

If contagion is statistically significant:

• Implications of responding – moral hazard
• How can we improve the outcomes
• improved transparency (information)
• improved fundamentals (policy formation)
• improved public institutions (infrastructure,

bankruptcy laws)

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Policy Implications II Policy Implications II

If contagion is regional:

• Argument for greater regional cooperation in

terms of shared information

• concern that the current focus of the international

institutions does not adequately reflect regional concerns

• disadvantage could be parochialism

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Policy Implications III Policy Implications III

If developed markets transmit crises between developing regions:

• Do developed markets then have some

responsibility to the developing regions in helping to cope with this effect

• Possibly transmitted through portfolio

rebalancing effects

• Repeated prisoner’s dilemma game: better
• utcome for all participants if they cooperate

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Policy Implications IV Policy Implications IV

If developed and developing markets are proportionally both affected:

• What is more important, the proportion or level of

the effect?

If developing markets see the larger levels effects:

• developing markets provide profitable capital
• pportunities for capital, settling for lower global

capital allocations ultimately means lower global growth

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More resources: More resources:

• http://www.cerf.cam.ac.uk/links/index.php

Mardi Dungey Demosthenes Tambakis

mardi.dungey@anu.edu.au dnt22@cam.ac.uk