International Financial Contagion - Example

Contagion Name: Institution: Date: CONTAGION a. Contagion definition, causes and consequences in the global financial services industry There is no accepted definition of financial contagion that is unanimous and it is closely linked to the statistical description in the manner in which spread of disturbances in the market are measured. Contagion is the spread of shocks to other countries beyond any basic connection among the countries as well as beyond common stocks. It is the escalation in the cross country correlation in the course of crises relative to the same correlations in times of stability (Murinde, 2009). Contagion happens for various reasons but it can conceptually be placed into two categories. The first category focuses on spillovers as a result of normal interdependence in market economies. The interdependence translates to shocks, whether of a global or local nature will be relayed across countries owing to their financial and real connections. The second category of contagion comes up when the co-movement cannot be explained using the fundamentals of economics. It comprises of a purely financial crisis that cannot be associated to noticeable changes on the fundamental conditions or macroeconomic conditions and is purely the outcome of investors’ behavior or other financial agents (Goodhart, 2008). This kind of contagion cannot be caused by any unique phenomenon like financial panic, with resulting reactions showing herd behavior, increase in risk aversion and a dip in confidence. Financial crisis spread from a country to another owing to market imperfection or the character of international investors (Duggar & Srobona, 2007). Asymmetries in information make investors to be more uncertain concerning the actual economic basics of a country. A crisis in one country can give a signal to international investors to reevaluation the risk in other countries, and less informed investors will find it challenging to get the informed signal from the plummeting price; and follow suit the strategies of the informed investors hence causing excess co-movements across various markets. The level of anticipation of a crisis by investors is very important for contagion existence owing to attention allocation of the investors. Abrupt shifts in market expectations and confidence have been pointed out as significant factors that cause contagion. Simultaneous crises cannot translate into contagion (Kollmann & Frédéric, 2011). Contagion needs causal connection. Financial crises that are simultaneous can be as a result of common cause or coincidence as opposed to causal links. Financial contagion occurs at both the domestic level and international level. Domestically the failure of a financial intermediary or domestic bank causes transmission if it subsequently unable to pay interbank liabilities and proceed to offset assets in a fast sale resulting in the fall of confidence in other similar banks. Financial Contagion at an International level occurs in both developing and advanced economies and it refers to the widespread of financial crisis in financial markets for indirect or direct economies (Mizen, 2008). Competitive devaluation can also result into financial contagion. Currency war happens where there are various countries competing against each other to get a competitive advantage through possessing exchange rates that are low for their various currencies. Devaluation in one country that has been struck by a crisis shrinks the export competitiveness of other countries competing with it in third market hence exerting pressure on currencies of the other nations particularly when their currencies do not freely float (Mizen, 2008). This act triggers countries to act in an irrational manner due to doubt and fear. When the participants in the market anticipate that a currency crisis will result into competitive devaluation, they instinctively sell their stock securities of other countries, avoid lending, or prevent roll over of short-term loans to borrowers found in these countries (Helleiner, 2011). Contagion can also be caused by escalated risk aversion, financial fears, and absence of confidence. Behaviour of investors apparently is the biggest agent impacting on a financial system of any country. Financial contagion can result into financial volatility hence seriously damaging the economy as well as financial systems of countries. Spill-over effects are negative externalities. The effects can occur either internationally, greatly affecting various countries across the world, or regionally, that comprising of effects being felt by neighbouring countries. Basic causes of contagion comprise of macroeconomic shocks which got consequences on an international level as well as shocks at a local level transmitted via trade shocks, financial links, and competitive devaluations. It may occasion some co-movements in asset prices and capital flows. Common shocks could be similar to the financial links’ effects (Kollmann & Frédéric, 2011). A financial crisis in one nation can cause direct financial effects, comprising of reductions in foreign direct investment, trade credit, as well as other capital flows abroad. Financial links emanate from financial globalization because countries try to be more economically integrated with financial markets globally. b. The extent of this contagion risk and the methods of managing it both on an international level and individual (institutional level) Contagion has adverse effects and impacts both the local and international finance market hence greatly affecting economic performance of each of the affected countries. Contagion compels government intervention to avoid total collapse of the financial sector of a country. Without sound fiscal policies, the consequences can be devastating to economic growth and development. The collapse of Lehman Brothers by September 2008 resulted in a wave of fear across the world financial markets. Lehman Brothers, one of the oldest and biggest investment banking firms in the entire world, filed for bankruptcy on 15th September 2008 deepening the U.S. financial crisis (Goodhart, 2008). Whereas the financial crisis may have been set off by the subprime mortgage crisis and the Lehman Brothers’ bankruptcy in the U.S., its effects were rapidly transmitted to Europe, Latin America, and Europe. The global financial markets went through sharp declines in commodity, currency and equity values. Investors, individual countries, and the international community at large have to continue to come up with measures to greatly reduce vulnerabilities’ buildup in emerging markets, hence reducing the cases of crises as well as their spread across borders (Markowitz, 2009). The global community has to upgrade information with regard to policies and institutional environments, increase risk management, come up with new kinds of international facilities for financing, as well as strengthen the composition of sovereign debt restructuring. Whereas there is no perfect way of preventing countries from experiencing crises that happen somewhere else, these measures would make a significant contribution with regard to dealing the likelihood and the degree of contagion in the future. Financial contagion is a major cause of financial regulation (Goodhart, 2008). Policy makers and officials from governments should not lapse into complacency despite the reduction in contagion in the course of recent crises. There is still a big risk from contagion in the international financial market particularly for countries that are developing. A large country crisis has the ability to spillover to other countries via financial markets, trade, and other cross-country connections (Helleiner, 2011). Better country policies, stronger global frameworks and better country police are some of the steps to be taken to reduce the risks of contagion in the near future. How to implement domestic financial regulation as well as put in place international financial structure in order to prevent contagion become the first agenda for both the international community and domestic financial regulators. The global economy has previously been affected by the European Sovereign debt crisis and US Subprime mortgage crisis forcing massive bailouts. A country can reduce contagion and minimize its effects in case of financial crises through strengthening the country’s policies. Any country with a strong macroeconomic structure having sustainable debt burdens, flexible labour markets and exchange rates, and strong financial systems, are less susceptible to shocks coming from bordering countries or the global economy (Goodhart, 2008). Studies indicate that institutions that are stronger reduce to great length country vulnerability. Financial systems that are weak contributed to several crises during the 1990s. Consequently enhancing supervision, regulation as well as the functioning of financial systems has gotten a lot of attention after the 1990s crises (Murinde, 2009). Emerging markets have to continue to welcome foreign investment within their economies particularly in the banking system. Countries have to reduce restrictions and enhance prudential as well as other regulations on investment by domestic investors and citizens. References Goodhart, C.A.E., (2008). The background to the 2007 Financial Crisis, International Economics and Economic Policy 4 pp. 331-346. Duggar, E. & Srobona M. (2007). External Linkages and Contagion Risk in Irish Banks, IMF Working Paper 07/44. Helleiner, E. (2011). Understanding the 2007-2008 Global Financial Crisis: Lessons for Scholars of International Political Economy, Annu. Rev. Polit. Sci. 14 (1): 67–87. Kollmann, R. & Frédéric, M. (2011). International Financial Contagion: the Role of Banks, Working Papers ECARES 2011-001, Universite Libre de Bruxelles. Markowitz, H. (2009). Proposals Concerning the Current Financial Crisis, Financial Analysts Journal 65 (1): 25–27. Mizen, P. (2008). The Credit Crunch of 2007-2008: A discussion of the background market reactions and policy responses, Federal Reserve Bank of St. Louis Review 90 (5): 531-567. Murinde, V. (2009). The implications of WTO and GATS for the Banking Sector in Africa, The World Economy 26(2): 181-207. Read More