LIQUIDITY AND INCENTIVE PROBLEMS. Investor behaviour can be influenced by liquidity and other constraints. If investors make heavy losses from investing in a country that is hit by a financial crisis, they would suffer from an immediate liquidity shortage. Their losses would increase their likelihood of selling off securities held in other high-risk countries. Similarly, liquidity requirements of commercial banks that have lent to a crisis country may cause them to reduce the overall risk of their portfolios again by reducing their exposure to high-risk investments. Schinasi and Smith (2000), for example, demonstrate that the value at-risk models used by many commercial banks explain why financial institutions and other investors may find it optimal to sell their most high-risk assets when a shock affects one of those assets. The incentives for investors in mutual funds, hedge funds and proprietary traders are all to meet liquidity shortages in a crisis by selling off other assets in other markets. By doing so foreign investors can cause the asset prices of markets, apart from the crisis country, to decrease from a reversal of capital inflows.
INFORMATION ASYMMETRIES AND COORDINATION PROBLEMS. Markets are characterized by having imperfect information. In the absence of clear information to the contrary in a time of a crisis, investors may believe that countries similar to the crisis country may also be inherently unstable. This in turn can lead to a currency attack on these suspect countries as investors go short. This reasoning can explain how a financial crisis can become contagious even if other countries at the time of the initiation of the crisis show no signs of vulnerability. Often investors do not possess full information about the countries that they are investing in due to the cost involved in gathering information and the reliability of the country in question to produce reliable and consistent information. The tendency for investors to follow-the-leader, in a herd, can be understood as ill-informed investors are likely to believe others have insights they don’t.
MULTIPLE EQUILlBRIUMS. Another model for understanding contagion is that market equilibrium can change from being regarded as stable to being described as bad. Sudden shifts in market expectations to bad equilibriums are often characterized by devaluations, drops in asset prices, large capital outflows and/ or debt default. In such circumstances it is optimal for investors to withdraw their investments first. In Diamond and Dybvig's (1983) seminal work on a model of bank runs, they write about sunspots where self-fulfilling expectations generate disturbances, which in turn cause investor panic and hence runs on banks. If everyone believes that a banking panic is about to occur, it is optimal for each individual to try and withdraw funds given the assumptions of first-come, first-served and costly liquidation. Since each bank has insufficient liquid assets to meet all its commitments, it will have to liquidate some of its assets at a loss. Given first-come, first-served, those depositors who withdraw initially will receive more than those who wait. Anticipating this, depositors have an incentive to withdraw immediately. Variables or “sunspots” have no effect on real factors of the economy, they affect depositors’ beliefs in a way that turns out to be self-fulfilling. In a financial crisis, the result analogous to a bank run would be a sudden withdrawal of funds from a country sparked by investors' fears that unless they act quickly they will be too late to claim the limited pool of foreign exchange reserves (see Dornbusch et al (2000)).
CHANGES IN THE INTERNATIONAL FINANCIAL SYSTEM. Finally, contagion can occur if investors believe that there will be changes to the international financial system after a crisis. Examples of this are: -
- The Russian default in 1998, which led to unilateral policies on capital inflows. Investors were concerned that similar countries may take the same measures and that international financial institutions might not bail out creditors. This led to investor withdrawal from other countries.
- The East Asian Financial Crisis 1997. Ex-post it was the role of the IMF and its use of bailouts that influenced investors, who perceived that the ability of the IMF to continue its role of LOLR was strained –with limited funding. This saw a run on other countries in the fear that they would not be given assistance. This concern is often alleged to have caused the turbulence in 1998 in Brazil (see Dornbusch 1999).
3. CASE STUDY: INTERWAR PERIOD AND CONTAGION
International finance never recovered from the strains of World War I, which caused a dramatic increase in productivity capacity, particularly outside Europe, without a corresponding increase in sustained demand. Fixed exchange rates and free convertibility gave way to a compromise—the Gold Exchange Standard—that lacked the stability to rebuild world trade. In 1929 the world's most prosperous nation was the United States. But despite the confidence in the United States and the apparent economic well being in other countries, the world economy was in an unhealthy state.
Then the Wall Street Crash happened, the Dow Jones Index lost 20% of its value on “black” Thursday October 24th 1929. It fell another 13.5% on 28th and a further 11.5% on 29th October. Overall it lost 39.6% of its value off the market high of September 3rd. Its ultimate Low came in July 1932, by which time it had lost 89% of its value. The popular view is that the stock market got overvalued, crashed, and caused a Great Depression. In fact monetary policy tried overzealously to stop the rise in stock prices but this had the effect, as Benjamin Strong had predicted, of slowing the economy – both domestically and, through the working of the gold standard, abroad. The slowing economy, together with rising interest rates, was in turn a major factor in bursting the bubble. Keynes, Friedman and Schwartz, and other leading scholars of the Depression era share this interpretation of events (Christiano et al 2004). What followed, however, was contagion of an unprecedented scope and scale.
The USA completely ceased their loans to Europe as a consequence of the liquidity shortage at home. Purchasing power dried up all over the world causing drastic falls in prices. European debtors found that they could no longer borrow dollars to pay debts and the ability to raise money by selling commodities was reduced. By 1930 the reparations and debt payments were being made in gold, which created an artificial scarcity of gold further depressed commodity prices. There was a constant outflow of gold from the Bank of England in the summer of 1931, predominantly to France, led the UK to prohibit the export of gold in 1931. European countries then took on protectionist measures in order to save their agricultural and industrial sectors, which led to a complete interruption of international trade. By now half of Europe was bankrupt and the other have was threatened with bankruptcy (Carr 1963).
US, France and Italy were the first countries hit by banking panics and crises in 1930. In May 1931 the Kredit Anstalt in Vienna was declared insolvent and attempts to limit the damage failed. A drastic shift in expectations led to a bad equilibrium in Germany where foreign creditors called in short term loans resulting in the Reichsbank losing £50 million worth of gold in 3 weeks. The German Banks faced heavy liquidation compelling Darmstaedter and National Bank to suspend payments on June 13, 1931.The German banking crisis in June and July usually is viewed as an outcome of the Austrian financial crisis in May and the contagion of panic. The reserve ratio in German banks dropped significantly in June and July 1931 with the public converting deposits into currency. The financial crisis was particularly acute in Germany, which had borrowed heavily in the 1920s. In 1931, banking crises became contagious to Belgium, Switzerland and Scandinavian countries namely, Denmark, Finland, Norway and Sweden (Carr 1963). One by one, the pillars of the prewar economic system—multilateral trade, the , and the interchangeability of currencies—were crumbling.
Smaller states of Central and Eastern Europe (except Czechoslovakia) were all faced with defaulting on their foreign debt. Australia and Argentina had suspended payments in gold at the end of 1929 and suffered heavily from the reduction in trade and the fall of agricultural prices. Brazil followed likewise in 1930. By June 1931 the USA offered to postpone all payments due to the US government for a year provided that all inter-governmental debts including repatriations remained after this period. However, French obstruction meant that the opportunity to resolve the crisis was missed. It was not until 1933 that a gradual improvement began to occur – largely based on bilateral agreements between states (Carr 1963).
Examining the causes of contagion in 1930-1933
Common Shocks. The US government at the time of the crash decided (perhaps unwisely) to increase interest rates. The slow down of the American economy and the crash in the stock market led to a fall in world output producing a sharp decline in exports of European markets and major losses of gold reserves.
Trade Links and competitive devaluations. Protectionist impulses drove nations to protect domestic production against competition from foreign imports by erecting high tariff walls. President Herbert Hoover and the Republican Congress managed to do just this when they enacted the Hawley-Smoot Tariff Act of June 1930, which raised American tariffs to unprecedented levels. It practically closed U.S. borders and, with retaliatory tariffs from US trading partners, caused the immediate collapse of the most important export industry, American agriculture. American foreign trade seriously declined, and the volume of world trade likewise steadily decreased.
Financial Links. Post World War I, US banks began making large loans to the nations of Europe. Debts (and reparations) were being paid through augmenting old debts and piling up new ones. In the late 1920s, and particularly after the American economy began to weaken after 1929, the European nations found it much more difficult to borrow money from the United States to pay their debts. This led a credit shortage in Europe and can explain how the American Crisis soon became a European one.
Investors’ Behaviour. Banking panics were a major contributor to the spread of the crisis. A factor that could have added to the higher degree of contagion in the interwar period is the fact that the gold standard system limited central banks’ ability to act as lender of last resort, letting bank runs generate serious liquidity problems and banking crises. Central banks are now better able to adopt a role of lender of last resort. There was clearly a problem of a perceived shift to a bad equilibrium in Europe. The lack of co-ordination in dealing with the crisis meant that governments could do little to prevent its citizens from running to the banks to get their deposits out.
4. CASE STUDY: THE SOUTH EAST ASIA CRISIS 1997
The East Asian financial crisis was truly remarkable; suddenly the ‘Asian Miracle’ became the ‘Asian Crisis’. A diary of the crisis is given below: -
In September 1996, Moody’s Investors Services downgraded Thailand’s short-term debt rating, because of its over reliance on short-term debt to finance persistent current-account deficits. In December, the central bank spent about 2.3 percent of its foreign exchange reserves in defense of the baht, which had been the subject of devaluation rumors. On February 14, 1997, another speculative attack temporarily dropped the value of the baht by almost 1 percent against the dollar, and the benchmark SET index fell by 4.5 percent. Both moves were in response to a suggestion that Thailand’s sovereign credit rating might be cut. In March, a run on bank deposits led to an estimated withdrawal of more than $1.2 billion from 91 finance companies. On April 10, Moody’s Investors Services did downgrade Thailand’s long-term sovereign credit rating, as well as the bond and deposit rating for five Thai banks. Finally, despite statements by the Thai government that it would “fight to the death” to defend the baht, the Bank of Thailand eliminated the baht’s official trading band on July 2 and moved to a managed float from a previously de facto US dollar-pegged Thai currency; the baht’s value plummeted (Corsetti et al 1998).
The following victims of the crisis were The Philippines and Malaysia as Thailand had done before, they had tried unsuccessfully to maintain the value of their currencies. Then the crisis reached Indonesia and Singapore. In September it seemed that markets were stabilizing but by October, investors’ distrust also affected Northeast Asia. The devaluation of Singapore’s currency was a problem for Taiwan, which announced a possible devaluation of the New Taiwan Dollar (NT$). In October 20th the NT$ had already lost 5% of its value (Corsetti et al 1998). There were also notable contagion effects to the other, more established, economies of East Asia particularly South Korea and Japan in the form of banking crises. The IMF was invited to help-out these economies when the domestic policies failed to respond to negative shocks. The IMF intervened first in Thailand, then in the Philippines, later in Korea and Indonesia. Malaysia was not intervened by the IMF. The crisis caused Asian currencies to fall 50-60%, stock markets to decline 40%, banks to close, and property values to drop. Within a year, deep recessions replaced the famous double-digit growth rates that had been seen in the late 1980’s and early 1990’s.
The Asian Crisis challenged the very heart of the neo-liberalism. As Stiglitz (1998) noted, factors identified as contributors to East Asian economies' problems were strikingly similar to the explanations previously put forward for their success! Indeed, the recipe of Asian success closely followed the Washington Consensus on economic growth, a view supported by three key institutions in maintaining financial stability (IMF, World Bank and US Treasury).
The Asian crisis provided a case study for debate on the causes of financial crises with Krugman (1998), Corsetti, Pesenti and Roubini (1998) arguing that it was ultimately due to fundamentals whereas Sachs and Radelet (1998) saw it as a case of panic. These views are not incompatible and the debate continues, but many academics agree that South East Asia was not prepared for market liberation and that the problem was not so much with free markets as with poor infrastructure. This led to a revision of the Washington Consensus rather than its elimination:
Sources: Characteristics of the Washington consensus adapted from Reed and Rosa (n.d. [1991) and Standing (2000), and the recipe of Asian success extracted from World Bank (1993).
Examining the causes of contagion
Table 3. Possible Channels of Transmission
Common Shocks. The strengthening of the U.S. dollar against the yen in 1995-96 was an important factor in the export downturn in East Asia and the subsequent financial difficulties there (Corsetti et al 1998). Due to the effective dollar peg, the baht also appreciated against the yen in real terms. The rising yen/baht exchange rate raised the yen cost of Thai products and undermined their competitiveness in important Japanese markets. Exports fell. By the third quarter of 1996, the Thai current account deficit equaled $16 billion or 8 percent of GDP, approximately the same size as Mexico’s before the peso collapse in December 1994 (The Economist, 1997a). By February 1997, it had increased to $22.5 billion (The Asian Wall Street Journal, 1997). Real economic growth, which in 1995 averaged 8.6 percent, fell to 6.4 percent in 1996; prior to the baht devaluation.
Trade Links and competitive devaluations. Industries such as semiconductors and textiles are highly concentrated in the region, with the Southeast Asian EMCs seeing each other as their greatest competitors. Investors may have legitimately worried that, in the face of baht devaluation, firms based in Indonesia, Malaysia, and the Philippines might no longer be competitive with firms based in Thailand. Financial connections within the region are also strong; for example, Singapore-based banks had extensive foreign-currency lending commitments in Thailand and Malaysia, so that the baht devaluation had an immediate impact on their balance sheets.
Financial Links. Individual East Asian countries are heavily grouped in Asian regional portfolios by investors. Although direct investment has traditionally formed a much higher proportion of capital inflows in Malaysia (for example) than in Thailand, a stable exchange rate environment had encouraged the growth of fixed-income mutual funds throughout the region.
Investors’ Behaviour. East Asia was the darling of international investors throughout the early 1990s, many of whom were small-scale retail investors. Such sudden, huge, short-term capital inflows are highly vulnerable to changes in investor sentiment, which were probably triggered by events in Thailand.
5. Policy Implications for Market Regulation
As the case studies show the exposure of financial contagion is to a large extent conditional on past economic policy choices: liability management, exchange rate policy, structural from and stability of the economy. Market regulation can therefore, play a role, both on the domestic and international level, to facilitate better practices and guidelines for financial standards, and quality of financial supervision.
First, there is a role for protective (ex post) regulation. Deposit Insurance and the concept of a Lender of Last Resort (LOLR) were major conceptual ideas that came out of the depression era of the 1930’s. The ease with which banks had been bankrupted through runs was a major factor in spreading the financial crisis through bank linkages and shifting expectations to a bad equilibrium. The benefits of such regulation are first that it promotes depositor confidence and reduces the likelihood of a run and secondly contains the contagion if a run does take place. Such protective regulation is one of the reasons why the depression in the 1930’s has not been repeated again, at least in the developed world. Emerging countries with unsophisticated LOLR in place have looked to the international community to fill the void.
Since the $30 billion bailout of Mexico in 1995, national currency and financial crises in developing countries have increased, as has the incidence of IMF-led bailout packages (those packages have totalled some $280 billion for Latin America, Asia, Russia, and Turkey since 1997). Stanley Fischer, first deputy managing director of the IMF, argued the case in 1999 for a reformed international financial system, including “an agency that will act as lender of last resort for countries facing a crisis”. This view is held by an number of academics including Krugman (1998). Fischer asserts that there is a need for such an agency, and that “the IMF is increasingly playing that role, and that changes in the international system now under consideration will make it possible for it to exercise that function more effectively”. The IMF is only in its early stages of reform and to quote Schwartz, as yet the “IMF is only a simulacrum of a lender of last resort. It is not the real thing.”
Moreover, according to many academics the promise of a substantial IMF hand-out in the event of a crisis has caused a moral hazard, viz. the more the IMF bails countries out, the more we can expect countries to slip into crisis in future because governments and investors will engage in risky behaviour in the expectation that, if anything goes wrong, the IMF will come to their rescue. Moreover, Friedman (1998), Schultz (1998), Schwartz (1998), all argue that the IMF distorts markets when it intervenes. However, many people who recognize the practical problems of the IMF bailouts, including moral hazard, questionable policy advice, and the difficulty of enforcing conditions, still believe that the IMF is needed as an international LOLR to promote confidence and to contain contagion.
Secondly, there is also a need for preventive (ex ante) regulation. As both case studies showed there was poor management of debt. The over-reliance of foreign loans in the 1930’s and investments in Asia 1997 meant that when sentiments and market conditions changed both were faced with a massive liquidity shortage. Prudential regulation of liquidity, debt to asset and capital adequacy standards at both the domestic and international level would help prevent countries becoming over dependent on debt as a source of finance. Similarly, there is an argument for the introduction of fiscally oriented capital controls to protect emerging markets, as in the case of Chile. A model by Eicher, Turnovsky and Walz (2000) shows that one-time policy changes, such as financial liberalization, may endogenously generate initial periods of strong economic growth and "excessive" capital inflows followed by major contractions and capital outflows at a later stage as illustrated in the South East Asian and Argentine crises.
According to the World Bank (1997) data on net private capital flows to developing countries 1990-98, overall private flows increased more than six-fold from $43 billion in 1990 to $304 billion in 1997 before declining sharply to $268 billion in 1998 due to the East Asia-induced global market turmoil. This data points to the volatility of short-term capital flows and the fact that short term and long term capital flows are disparate phenomena with very little in common. Chuhan et al. (1996), Sarno and Taylor (1999) and the World Bank (1999) have argued that long term capital flows should be completely liberalized, encouraged and welcomed as such foreign direct investment has been the most resilient form of external financing. On the other hand short-term capital flows or “hot-money” is a major theme in the literature of financial crises in emerging economies (see Eichengreen).
Short-term capital flows are speculative by nature. While such “hot-money” is very useful as a lubricant on the wheels of liquid capital markets in rich countries, it can be destructive in less liquid economies in transition. Eichengreen makes suggestions for policy design to maximize the benefits of international financial liberalization while minimizing the risks of financial instability. To quote the World Bank "...foreign capital...comes with a challenge: to devise policies and institutions that tip the balance so that capital mobility benefits developing countries rather than injuring them" (World Bank 2000).
Ideally, countries need to aim at sustainable economic growth through sound and transparent macroeconomic management. Such policies aided through strong regulatory disclosure standards and reporting requirements would increase confidence and anaesthetise against asymmetries of information that can lead to contagious herd behaviour. Likewise regular inspection of financial institutions and bank examination would also facilitate greater improvements for information gathering investors.
In the Asian Crisis there was a particular problem of overvalued exchange rates (some but not all pegged). De facto exchange rate pegs to the dollar, resulting in overvaluation and large current account deficits, and excessive private sector foreign borrowing. The ‘interest rate defence’ of a currency peg will not work where there is financial fragility. Countries should if an exchange rate peg is used for stabilization, think early about how to exit.
6. Conclusion.
Contagion of financial crises is a pressing subject of our time. With the huge social and economic cost of contagion the race is now on to find solutions fast. Although contagion is a new buzzword evidence of the spread of crisis across borders can be found pre-1990’s. The 1930-1933 period and the spread of a global depression is an undeniable example of this. However, lessons appear to have been learnt; contagion appears now to be largely under control in developed economies through better safe guards, disclosure requirements and sound macroeconomic policy. Emerging markets, on the other hand, appear to be especially prone to contagion as they have not had sufficient time to build up a deep and diversified financial system. The Asian Crisis in 1997 showed this to be true. Market regulation both protective and preventative can help to combat asymmetric information and provide confidence at both the domestic and international level. But while entire economies of countries are reliant on investor behaviour, whether it is rational or irrational, they will be prone to catching the financial crisis of others.
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7. Appendix: World Bank’s Definitions of Contagion.
World Bank’s broad definition should be used where contagion can be described as the “cross-country transmission of shocks or the general cross-country spillover effect”. The World Banks more restrictive definition goes that contagion is the transmission of shocks to other countries or the cross-country correlation, beyond a fundamental link among the countries and beyond common shocks. This definition is usually referring to excess co-movement, commonly explained by herding behaviour. Their very restrictive definition even states that contagion occurs when cross-country correlation increases during "crisis times" relative to correlation during "tranquil times".
Calvo and Reinhart (1996)
At a luncheon speech at the American Economic Association 3/1/99
