Financial Contagion: Channels and Significance in Recent Crises

Abstract

Financial contagion, defined as co-movement of extreme financial conditions between countries, has the potential to severely damage an interconnected world economy. Recognizing under what conditions contagion occurs and the channels through which it travels is central to drafting secure economic policy in the future. This paper looks at contagion across five different time periods—the emerging market crises of the late 1990s, the pre-global boom years, the boom itself (2004-2007), the global financial crisis, and the euro area financial crisis—to identify past trends in contagion and its spread. It then zooms in on two periods in particular, the global financial crisis and euro area financial crisis, to pinpoint the most recent patterns in contagion during crises. My analysis reveals that the emerging market crises and global financial crisis exhibited the highest degree of contagion and also broadly similar channels of contagion. During these periods, a country’s exposure to international trade and liquidity risk were the two most significant channels through which countries became vulnerable to financial contagion. The euro area financial crisis, on the other hand, exhibited distinct behavior and was not indicative of much financial contagion. When I interacted trade exposure and liquidity risk, however, I found increased trade mitigated the harmful effects of higher liquidity risk. During the euro area crisis, I find that contagion was more modest than generally perceived. Trade exposure and liquidity risk were also significant contagion channels (although higher trade exposure seemed to reduce contagion). But when I introduced a dummy variable for euro area countries, it was no longer possible to separately identify the effects of trade or liquidity risk. This suggests that there are many similarities among euro area countries, making it hard to discern the specific role of variables like trade and liquidity risk. While this result reflects channel behavior during the euro area financial crisis, it does not denote the presence of contagion. In all but the emerging market crises period, middle and lowest credit rated countries were more susceptible to contagion. This comes as no surprise, since countries with an average credit rating in the middle or lower end of the spectrum carry more risk in both good and bad economic times. Other channels of contagion varied in behavior. International bank exposure, when identifiable as a significant player in contagion, acted as a contributing channel to an increase in the spread of extreme market conditions. This holds for the emerging market crises and the euro area financial crisis. International portfolio investment exposure and portfolio inflows were less consistent, sometimes contributing to increased contagion and other times acting as buffers. It appears as if a portfolio driven by assets behaves differently from one driven by liabilities. Furthermore, portfolio inflows can sometimes be a stabilizing force, but if a country is too dependent on inflows its economy becomes more susceptible to the adverse effects of inflow volatility.