Managing Contagion Risk during Economic, Financial and Political Shocks - Assignment Example

Glоbаlisаtiоn Name: Institution: Economic Contagion refers to the spread of financial crises throughout a geographic region. Contagion can be described as a situation whereby economic shock in a particular economy spreads out and affects other economic regions in terms of price increase (Valdés, 1997). Financial Contagion can be experienced at a domestic level as well as international level. Economist uses the concept of contagion to explain the spread of bank runs, strikes across industries or firms, and business fluctuations across economies. Contagions also result in the spread of wage increases secured by labour unions to non-union sectors. The increasing financial globalisation is being influenced by different forces. These forces include; investors, financial institutions, government and borrowers. The government move to liberalize regulations on the domestic financial sector and the capital account of the balance payment results to globalisation. In the last 30 years, there has been a notable lifting of regulations in developed and emerging nations. Increased borrowing abroad has made organizations and households relax their financial constraints and smoothing consumption and investment, thus, greater economic globalisation (Rijckeghem, & Weder, 2001). Financial institutions have significantly contributed to globalisation. Advanced information technology has reduced the importance of geography by enabling several international corporations to provide services to several markets from a central location. Financial crises in a particular country are usually associated with economic contraction and devaluation of the exchange rate which negatively affects exports of trading partners through a drastic fall in demand and a loss of price competitiveness. Such trade-related shock propagation work through bilateral trade links as well as indirect trade links resulting from third common markets. In order to attain cross-country diversification, International investors take advantage of financial globalisation. Liberalisation of financial markets has allowed organizations and individuals based in developing countries to invest easily in emerging markets using different tools (Dungey, & Martin, 2001). Since August 2007, the world economy has been hit by the global financial crises (Dungey, & Gajurel, 2013). The world financial crises, widely considered unprecedented since the Great Depression of the 1930s. The financial systems crisis resulted in the notable reduction in real economic activity in various countries. The financial crisis is not a new phenomenon for the emerging market and developing economies. Countries such as Mexico, Russia, Argentina, Brazil, Turkey and several East Asia nations have been affected by either currency or financial crises since the early 1990s. For instance, the fall of the Lehman Brothers in the United States is a case scenario of a domestic contagion. In 1998, following the devaluation of the Russian Rubble, Brazil experienced a 50% drop in the stock market. In this case, the transmission of the financial crisis in Russia to Brazil is referred to as contagion (Claessens, & Forbes, 2004). Each country experience is rather different due to the nature of the source of the crises; however, the profile of crises has been somewhat similar. The financial crisis is characterized by a sudden stop of capital inflows followed by a sharp drop in economic activity. Most of the countries experienced substantial currency depreciation, which greatly was effective in recovering from the crises. These countries expanded their net exports so as to reduce or compensate for the fall effects of foreign currency liabilities after devaluations also referred to as the balance sheet effects. For example, during the 1997 crisis, sharp currency reversals were a component of the recovery processes in several Asian nations (Rijckeghem, & Weder, 2001). From the viewpoint of a developing market, the recent global financial turbulence has been different in two significant ways. Question 2 First, unlike the previous experiences, the recent financial crises source of the sharp reduction in capital inflows has been the critical liquidity squeeze in the financial markets of developed nations. The reduction in financial flows to the emerging market economies followed from the virtual decline in the credit markets in the United States and the United Kingdom spreading to other key financial markets (Rijckeghem, & Weder, 2001). Secondly, emerging market economies have experienced a significant reduction in their exports due to the financial crisis affecting consumer spending habits in the developed Countries. Exports as a means out of the crisis failed due to the sharp contraction in the global economy considering that countries experienced significant devaluations of their currencies. In essence, both financial and trade channels have promoted spreading of the world financial crisis to emerging nations. The first step taken by most countries is trying to control the contagion, reduce losses to society, restore confidence in financial instruments, and fuel the economic system so as to return to normal operation. In essence, Countries concentrate on stimulating the economy and minimizing the downturn in macroeconomic conditions that is pushing institutions into bankruptcy and increasing unemployment levels globally. Statistics shows that in early 2009, more than 40% of the world's resources may have been destroyed since the financial crisis began. However, equity markets have been able to recover somewhat since then. It remains unclear whether minor system change can fix the current economic crisis, or it requires major surgery. The globe is going through the third phase of the crisis. The objective is to modify the regulatory structure and regulations, the global financial structure, and some of the imbalances in trade and capital flows to avoid future crises and minimize the effects. By observing policy proposals to control the financial crisis in both Europe and the United States, it seems that solutions are taking a multipronged approach. Nations aim their solutions at the different levels in which financial markets operate namely; globally, nationally, and by particular financial sector. Financial contagion is related to the propagation of adverse shocks that have the potential to trigger financial crises. The essential step is to determine potential propagation mechanisms and define those linked to contagion. An economic crisis threatens the stability of the global financial system. In the early 1990s, countries responded by creating International financial packages as well implementing a new global structure. Reforming the international financial system is a strategy to eradicate or at least reduce financial contagion (Moser, 2003). The economy of a specific country is a complex mechanism that is affected by both internal and external factors. A country should not be assessed as an individual item but rather in relation to other nations. Countries connections usually affect the reactions of a country's capital market to shocks, and the unbalances and the deadline for an expected stabilization. An effective contagion risk management implies determining the causes, the generators of this occurrence, and ways of reducing its impacts (Armeanu, Pascal, & Cioaca, 2014). Every financial shock in the market should be assessed in terms of dependence level and correlations between the markets. Clear understanding of this fact can help to develop practical solutions to minimize the impacts of the financial shock. In order to manage the contagion, close supervision and evaluation is required both locally and internationally (Armeanu, Pascal, & Cioaca, 2014). The investors’ behaviour and reaction to the shock are essential in managing the impacts of such a financial shock. Investors should look for portfolio diversification and understand the most sensitive markets in order to reduce such risks. High coefficient of correlation implies that investors make losses when they decide to invest in Nations affected by contagion. The government should implement policies so as to prevent the crisis spreading, to minimize the risk of contagion, to manage its effects and promote market recovery (Nanto, 2009). The steps undertaken by the government and policy makers can be classified into three broad categories: improved country policies, stronger global frameworks and enhanced investor strategies. More reliable macroeconomic frameworks, sustainable debt burdens, stable financial markets and flexible exchange rates and labour markets reduce a country's vulnerability to shocks originating from neighbouring countries or the global economy. According to recent research, stronger institutions minimize country vulnerability. Countries have implemented policies to improve the financial systems, fiscal and debt management, foreign investment and friendly regulations on domestic investment so as to reduce vulnerability to contagion (Nanto, 2009). Developing countries are at a greater risk of financial contagion (Sachs, Tornell & Velasco, 1996). A financial crisis in a large country usually spread to other states rapidly through trade, financial markets as well as other cross-country linkages. Economic integration around the world tends to bring countries closer through financial strengths and weakness phases. The international surveillance process through the joint World Bank-IMF Financial Sector Assessment Program seeks to review the quality of financial systems in order to strengthen the financial systems. This review evaluates the ability of a financial system to endure shocks origination from other Nations. Improving the corporate sector and the ability of banks to collect on defaulted loans is a part of strengthening the financial systems. The government should enhance their bankruptcy systems and corporate governance. Providing detailed information regarding corporate accounts helps banks and investors make informed decisions. References Armeanu, D, Pascal, C, & Cioaca, S, (2014). Managing Contagion Risk during Economic, Financial and Political Shocks, Proceeding of the International Management Conference Claessens, S, & Forbes, K, (2004). International Financial Contagion: The theory, evidence and policy Implications.SL Dungey, M, & Gajurel, D, (2013). Equity Market Contagion during the Global Financial Crisis :Evidence from the World's Eight Largest Economies: UTAS School Of Economics and Finance Dungey, M, & Martin V, (2001). Contagion across Financial Markets: An Empirical Assessment. New York Stock Exchange conference paper. Kaminsky, G, & Carmen R (2000). On Crises, Contagion and Confusion. Journal of International Economics 51:145-68 Moser, T (2003). International finance: what Is Financial Contagion, IMF Nanto, D, (2009). The Global Financial crisis: Analysis and Policy Implications; Congressional Research Service, SL Rijckeghem, V & Weder, B. (2001). Sources of Contagion: Is it Finance or Trade? Journal of International Economics 54: 293-308. Sachs, J, Tornell A, & Velasco, A. (1996). Financial Crises in Emerging Markets: The Lessons from 1995, Brooking Papers on Economic Activity1:147-215. Valdés, R, (1997). Emerging Markets Contagion: Evidence and Theory. Central Bank of Chile Working Paper #7. Read More