Andres Kuusk works with economic modelling at the UT Institute of Economics. Last year he defended his PhD thesis on financial contagion during times of crisis.
In the recent financial crises episodes an interesting feature has been present. Crises that were initially local have spread quickly all over the world, becoming continuously bigger in the process and bringing down more and more countries – just like a rolling snowball successively grows by picking up new snow.
It is obvious that the country of origin of the crisis has to be at fault at least to some extent to be hit by the crisis – but what about the destination countries? Are these countries also at fault for the crisis spilling over and if so, then what can a country do to avoid being hit by the crises originating elsewhere?
Linkages between countries
Let’s start with the most intuitive reasons why crises propagate from one country to others. First of all, in the globally integrated world, there are strong linkages between countries – most importantly trade, financial and political ones. Let’s take trade effects, for example. If a country is hit by crisis, its main trading partners quite likely face problems as well. The direct negative effect is that there will be fewer consumers for the export of these partner countries as well as less foreign supply for their consumers.
There is also a more indirect effect which can be seen if the crisis country, as it often happens, devaluates its currency. Now goods from the crisis country will be relatively cheaper compared to its trading partners, which means a loss in competitiveness for the trading partners’ export. As trade is usually greatest between neighbouring countries, that’s why we often see crises cluster in some regions.
Secondly, countries with weak macroeconomic fundamentals are vulnerable to propagation of financial crises. As long as everything goes well, investors usually don’t worry too much about fundamentals, but when crisis hits in some part of the world, people start looking for next potential victims and the most likely candidates are the countries that have similar macroeconomic weaknesses as the crisis country.
For example, after the crisis hit Thailand, many international investors reassessed the creditworthiness of Asian borrowers and in doing so found that many Asian economies had similar weaknesses to those in Thailand (weak financial sector, large external deficit, appreciating real exchange rates and so on). This, of course, was fatal to the outlook for these countries and the crisis spread.
These logically explainable transmission channels are called ‘stable fundamental linkages’. If crises spread via these two channels, only then it is possible for countries to protect themselves against propagation of crises. Of course, it’s not feasible not to have financial or trade linkages with other countries, but having sound fundamentals and economic policies should protect against crises originating in faraway countries that have no strong linkages with us.
Financial contagion in action
Unfortunately, history has shown that stable fundamental linkages are not able to explain all transmissions of crises. Several crises in the 1980s, 1990s and in the present century were transmitted rapidly to other countries that were sometimes quite different in size and economic structure compared to the country of origin, had seemingly sound macroeconomic fundamentals and policies, and were often located on the other side of the globe. To describe this phenomenon, economists have borrowed an expression from epidemiology called ‘financial contagion’.
The issue of contagion has been one of the most debated topics in international finance since the Asian crisis (1997). Considering the events of 2008, when yet another financial crisis snowballed around the world, the phenomenon of financial contagion is perhaps more important than ever before to examine, interpret and understand. If contagion hypothesis holds, it means that every crisis may spill over to every country and there is practically nothing a country can do to protect oneself against financial contagion.
This seems somewhat counterintuitive, as it brings us out of our comfort zone. It is part of human nature to think that everything has a tangible reason and that we are able to control what happens to us. Why should a country have problems if it has absolutely no fault in it? After all, we are so used to cursing politicians for any economic crisis that it just feels wrong that they have no part in this.
So let’s check this possibility in more detail. Recent financial crises episodes have shown that the financial contagion snowball may choose its victim countries seemingly randomly, and neither good macroeconomic fundamentals nor independence from a country in crisis are enough to enable protection. If it is so, then what are the driving forces for the crises transmissions?
Herding behaviour by investors
The rapid development of financial markets in the past decades means that a huge role is played by the actions of international investors and other financial agents. In the presence of financial crisis, one specific pattern of investor behaviour is especially likely to occur and is extremely dangerous. This pattern is called ‘herding behaviour’.
Herding behaviour refers to the situation where instead of incurring expenses for obtaining missing information, under-informed investors observe the actions of supposedly better-informed investors and try to follow them (They think these actions are based on superior information). The typical conditions for herding behaviour to arise are when information about countries’ fundamentals is incomplete, asymmetrical and too expensive for less informed investors, and there are no serious restrictions on investors choosing their actions. This kind of behaviour is potentially deadly to all economies, irrespective of their fundamentals or economic policies.
Let’s take an example. If some investors take their holdings out of a country, it may seem to others that this action was due to specific information and they may also retreat from the market. One retreat leads to another and the whole market may move practically in tandem, bringing the victim country down. But it is possible that those supposedly well-informed investors did not act on the basis of information about the countries’ fundamentals, but were just making adjustments to their portfolio after having experienced losses in a country hit by the crisis. Thus, it is possible that herding behaviour by financial agents brings down countries that initially had no problems whatsoever.
It is argued that the pull effect caused by investors all behaving in the same way makes economic fundamentals unimportant and leads to the rapid withdrawal of capital from the economies concerned or possibly even from entire regions.
What makes herding behaviour so likely to occur is that it is irrational only in the collective level and in the individual level it may be wholly rational to follow the herd. Thus, it is not that straightforward to put all the blame to investors as they all might be doing the right thing individually.
Facing the risk of contagion
Now, when we know that in addition to tangible and stable fundamental channels, there is also an intangible channel called ‘contagion’ through which financial crises may spread, we would like to know whether this channel has really been present in recent crisis episodes. The fact that stable fundamental linkages seem not to be able to explain all transmissions is not yet enough – we would like the numbers to speak.
My comprehensive study in the form of meta-analysis shows that crises’ transmission channels indeed differ in crisis and non-crisis period and links being statistically significantly stronger if there is a crisis in one of the countries. As it is assumed that fundamental linkages (trade, financial or political linkages) do not change because of the presence of a crisis, this means there exists an additional transmission channel that was not present in non-crisis times. This additional channel is, of course, the irrational behaviour of financial agents, mainly herding behaviour.
So, both theory and empirical observation show that financial contagion is a very real phenomenon, and therefore the country being hit by the financial crisis snowball cannot avoid it.
It’s time to step out of our comfort zone and admit that our destiny is not in our hands only. Does it mean that we have no reason to curse our politicians for being severely damaged by a crisis? Not exactly. Knowledge about financial contagion in international markets helps to draw some guidelines for an appropriate financial architecture.
As there seems to be no good way to build a defence against the propagation of crises, countries should have tools at their disposal to deal with the consequences. So what we could hope for from the policymakers is to put aside financial reserves during good times for use when financial contagion hits.