Contagion effect

The term contagion effect (from medical parlance: English contagion - dt. Infection , epidemic or harmful influence ) describes the infection or the transmission of a financial and / or currency crisis to apparently unaffected and possibly geographically distant countries, who often don't seem to have significant relationships with one another.

definition

Crisis-related contagion effects are a sub-case of the domino effect and a very recent object of investigation in finance. Contagion is a financial research concept that began with the spread of the financial market crises in the mid-1990s, when a local crisis suddenly spread across numerous developing countries and also included countries that were not considered to be at risk of crisis and were apparently "healthy". Since systematic financial research on the subject of contagion did not begin until the 1990s - for example before the beginning of the Asian crisis - there has so far been no uniform definition in the economic literature, but only different explanatory approaches. The World Bank tries a very broad - and therefore hardly vulnerable - definition: “Contagion is the transnational transmission of exogenous shocks, comparable to a spillover effect. Contagion arises both in crises and in non-crisis times, whereby Contagion does not necessarily have to be associated with a crisis. "

As the World Bank's attempt to define it shows, one of the main problems with a generally accepted definition lies in narrowing down the cause of infection. The risk of contagion is entirely microeconomic, so it can come from a single company and then - through its interdependence, for example - spread to the entire industry and possibly beyond. For example, the bankruptcy of Lehman Brothers in September 2008 ultimately triggered distrust among banks, which can be demonstrated by the mutual attentiveness of the banks on the interbank markets .

In the context of empirical studies dealing with the international effects of currency crises, contagion is the significant increase in the likelihood of a crisis in one country provided that a crisis occurs in another country.

In another approach, contagion is referred to as the phenomenon that occurs when the volatility of a crisis country is transferred to the financial market of another country, the so-called volatility spillover . This definition per se relates to the fact that the volatility of asset prices is a very good approximation of market uncertainty. The volatility spillover approach is based on the assumption that this can be an indicator of the spread of a crisis in financial markets in differently independent countries with above-average volatilities . In the Asian crisis z. B. the boom in the construction industry too often overvalued fixed assets in companies flourishing in the financial market, which according to the volatility spillover approach could have been a warning sign that the crisis is spreading.

Contagion sees a similar approach, which is more macroeconomic-oriented, as extraordinary fluctuations in prices and quantities of consumer and capital goods that occur in parallel in different countries . The problem that arises here is to what extent it is possible to differentiate between excessive and normal equal movements in prices and quantities through simple dependencies.

The shift contagion approach differs from the above. macroeconomic approach in that in the pre-crisis period this equal movement in terms of prices and quantities in different countries need not be a condition. The occurrence of a crisis in one market can trigger extraordinary fluctuations in the prices and quantities of consumer and capital goods in another market and thus indirectly lead to the spread of the crisis.

causes

Science has not yet reached agreement on the cause of contagion either. The following reasons are usually given for the simultaneous occurrence of financial crises in different countries or regions.

• Political decisions in industrialized countries could unexpectedly have similar effects on developing countries .

• A crisis in one developing country could affect macroeconomic fundamentals in another developing country. Examples would be when a devaluation of the currency reduces the competitiveness of other countries or when financial intermediaries in one market are forced to liquidate their investments in other developing countries due to liquidity problems.

• A crisis in one country could trigger a crisis elsewhere, which cannot be explained by a change in macroeconomic fundamentals, such as a shift in the assessments and expectations of market participants based on the information available. A crisis could then lead investors to reassess the fundamentals of other countries, even if they have not changed at all, and their risk tolerance changes.

Types of Contagion

Contagion effects are a propagation mechanism that can spread systemic risks or systemic events from one component of the system (institution, market or state) to the entire financial system. This can happen either through a domino effect or through an information effect. With the domino effect, the contagion occurs directly due to the current structure of the financial system. In the case of the information effect, however, the contagion does not happen immediately, but via (quite rationally understandable) changes in expectations among market participants.

Gerhard Aschinger describes four different types of infection:

• Contagion from fundamental variables :

A crisis spreads from one country to countries with similar fundamentals. Accordingly, investors react sensitively to countries with identical risk structures. This is also referred to as a so-called “wake-up effect”.

• Contagion through economic integration :

If two countries are closely intertwined in the real economy or if they are competitors in third markets, this results in a risk of contagion. The devaluation of the currency of one country, for example, can lead to a collapse in the competitiveness of another country.

• Contagion via the financial markets :

As a result of increasing globalization, foreign exchange and stock markets are so closely linked that falling securities prices in one country can lead to sales reactions in other sub-markets, so that a crisis can spread. This is not limited to foreign exchange and stock markets, but can affect all financial markets (money, capital and derivatives markets).

• Contagion through herd behavior :

In this type of contagion, the asymmetrical distribution of information among investors plays the main role. Due to the high costs of obtaining information or for other individual reasons, many investors assume the expectations of some (supposedly) better informed investors. In this way, a pessimistic mood can prevail that is not justified by corresponding fundamental data and that leads to a self-fulfilling effect.

Typical contagion effects using the example of the Asian crisis

Many crises originally started as regional crises and then spread to other countries. For Wirth, contagion is an important characteristic of currency crises. The currency crisis of one state can in turn affect other states, for example through its economic or political ties.

Such contagion effects also played a major role in the Asian crisis , when initially South Asian countries, but then also outside the region such as Russia or the Baltic States, were infected. Thailand is generally classified as the cause of the Asian crisis. There, on July 2, 1997, the local currency, the baht, was released from its US dollar peg for floating. On the same day the price fell by almost 14%, at the end of the month it was 23% lower. Traditional fundamental warning signs such as current account deficits, overvalued exchange rates, declining export growth or net foreign direct investment, which should have given cause for concern, were ignored. On the other hand, budgetary and monetary policy in Asia have always been appropriately conservative, inflation rates are low compared to the developing countries, households are largely under control, and national debt is generally not excessive. This meant that negative developments were at least overlaid by positive fundamental data. The crisis then spread to other states in the region, such as Indonesia in July 1997, South Korea in October 1997, and in November 1997 the entire tiger region was finally affected. This Asian crisis had also made investors in Russia nervous, so that there was an increased outflow of capital, which was accompanied by a high government budget deficit (see Russian crisis ). On May 27, 1998, the interest rate was increased to 150%. Finally, the IMF helped, as it had already done on a massive scale during the Asian crisis. The Asian crisis and the fall in the price of oil, the main export good, triggered the Russian crisis. In the Baltic States , after years of favorable economic development, the Russian crisis led to a recession in 1999.

literature

• Stijn Claessens, Kristin Forbes: International Financial Contagion. Springer, 2001, ISBN 0-7923-7285-9 .
• Michael D. Bordo, Antu Panini Murshid: Are Financial Crises becoming increasingly more Contagious? What is the Historical Evidence on Contagion? (= NBER Working Paper. 7900). Research, February 2000.
• Guillermo A. Calvo, Enrique G. Mendoza: Rational Contagion and the Globalization of Securities Markets . (= NBER Working Paper. 7153). National Bureau of Economic Research, May 1999.
• Barry Eichengreen, Andrew Rose, Charles Wyplosz: Contagious Currency Crises . (= NBER Working Paper. 5681). National Bureau of Economic Research, July 1996.
• Leonardo F. Hernández, Rodrigo O. Valdés: What drives Contagion: Trade, Neighborhood, or Financial Links? (= IMF Working Paper ). International Monetary Funds, March 2001.

Individual evidence

1. ^ Sebastian Edwards: Interest Rates, Contagion and Capital Controls. 2000, p. 1 ff.
2. ↑ World Bank, 2000, o. P.
3. ↑ Marcel V. Lähn: Hedge Funds, Banks and Financial Crises. 2004, p. 36.
4. ^ Gerhard Aschinger: Currency and financial crises. 2001, p. 181 f.
5. ^ Thomas Wirth: Country Risk Management for Banks. 2004, p. 119.
6. ^ Glenn Stevens: The Asian Crisis - A Retrospective. In: BIS Review. 82/2007, July 18, 2007, p. 3.
7. ↑ AG Malliaris: Global Monetary Instability: The Role of The IMF, The EU And NAFTA. January 5, 2002.
8. ^ Glenn Stevens: The Asian Crisis - A Retrospective. In: BIS Review. 82/2007, July 18, 2007, p. 5.