The Cause, Effects, and Implications of Financial Contagion

The Cause, Effects, and Implications of Financial Contagion

Jonathan Lhost's Entry For The 2004 Moffatt Prize in Economics

Introduction

The study of financial contagion is growing in importance with the expanding global scope of financial markets. Financial contagion is defined as a shock to one country's asset market that causes changes in asset prices in another country's financial market. How does financial contagion occur, why is it important, and is there anything that can be done about it?
Answers to these and other questions are important in developing an understanding of recent financial crises such as those in Asia and Latin America. Furthermore, it is in the world's interest to develop an understanding of how shocks can be transmitted between countries so that steps can be taken to reduce financial contagion and the instability it causes in emerging markets, markets that are already fragile and thus greatly need stability in order to develop and grow. This paper discusses a model that explains corridors of financial contagion, assesses the importance of the conclusions drawn from the model, and takes steps towards finding ways to reduce the instability of and caused by the world's financial markets.

In this paper, I start by laying out the key components of a model of financial contagion developed by Laura Kodres and Matthew Pritsker in their paper "A Rational Expectations Model of Financial Contagion."1 In this section, I will explain what financial contagion is and how it is transmitted between countries.

In the second section, I will discuss the important conclusions that are drawn from the model presented in the first section: most significantly that financial contagion can occur between two countries that do not share common macroeconomic fundamentals. In the third section, I will talk about the implications of the conclusions drawn from the model, including the market inefficiencies related to financial contagion.

In the final section, I shall discuss implications for the future-the ways in which we can attempt to reduce financial contagion, and thus reduce instability, in the future.

What is Financial Contagion and how is it transmitted?

Financial contagion, in this model, is defined generally as "a price movement in one market resulting from a shock in another market."2 Contagion can be defined more restrictively as "a shock in one country that generates price movements in other countries that are excessive relative to 'full information' fundamentals."3 The results of the model hold for both the more general and more restrictive definitions.

In the model that we are examining, it is assumed that there are three different types of investors: informed investors, uninformed investors, and liquidity traders (also called noise traders). Informed investors receive better information than all other investors about asset values and use this information in determining their optimal portfolio. Uninformed investors lack the information held by the informed investors. They try to infer the information held by the informed investors from asset prices, but are unable to do so precisely due to noise trading (the trading of noise traders explained below).

The number of informed investors is quite small relative to the number of uninformed investors. The last group of traders, liquidity or noise traders, are traders who buy and sell assets to meet personal liquidity needs. Trading done by liquidity traders has nothing to do with the fundamental value of the traded assets.4

In a market, there are several different possible types of shocks. Information shocks occur when informed investors receive information that they use in selecting their optimal portfolios. Liquidity shocks occur when liquidity traders trade to meet their individual needs for liquidity. Each shock has several ways in which it affects the market: the expectations and the portfolio balance components of the price change. The expectations component of the price change reflects uninformed investors adjusting their expectations of asset values after informed investors trade based on new information they receive.

The portfolio balance component of the price change measures the changes in asset prices due to the rebalancing of portfolios by uninformed investors based on their belief that the changes in asset prices do not reflect information.5

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So how is the demand for assets in one market affected by price changes in a different market? The Slutsky income and substitution effects from the standard Slutsky equation are two ways in which demand for assets in one market is affected when asset prices change in another market. These two effects are not the focus of the model and will henceforth be ignored.6 An effect that is present in our model is the information effect.

The information effect occurs when either informed investors' information or liquidity trading is correlated across markets, causing price changes in one market to possibly reflect information about asset values in other markets. When informed investors' information is correlated across markets, uninformed investors in one market see price changes in another market and perceive the price changes to be a result of information that is correlated with asset values in other markets.7 When liquidity trading is correlated across markets, "Price changes in one market will affect uninformed investors' assessment of whether price changes in other markets are due to informed investors' information in those markets or due to noise."8 The uninformed investors will make different decisions with regard to their portfolios if they perceive that the price changes reflect informed investors' information, which could have implications for asset values-as opposed to reflecting noise trading, in which case no information on fundamentals is revealed.9

The shocks and the effects that shocks have on various markets result in three distinct channels of contagion: the correlated information channel, the correlated liquidity shock channel, and the cross-market rebalancing channel. Shocks are transmitted through the correlated information channel when uninformed investors in one market think price changes in another market reflect informed investors' information about fundamentals, following from the information effect discussed above.

This channel of contagion is more conceivable when considering closely linked markets, but does little in explaining financial contagion between weakly linked markets. Contagion occurs through the correlated liquidity shock channel when liquidity traders seeking liquidity sell assets in multiple markets. However, seeing as liquidity is most readily available in developed markets and financial contagion hits emerging markets the hardest, the liquidity shock channel on its own cannot explain contagion. The channel that seems to best explain financial contagion is the cross-market rebalancing channel. Shocks occurring in one market are transmitted to other markets thought the cross-market rebalancing channel when investors react to a shock by readjusting their portfolios in other markets.10 Kodres and Pritsker explain, "Contagion occurs through this channel when market participants are hit with an idiosyncratic shock in one country and transmit the shock abroad by optimally rebalancing their portfolio's exposures to macroeconomic risks through other countries' markets."11

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Conclusions from the Model

The most important conclusion that can be drawn from what we have learned about financial contagion is that countries do not need to be linked directly by macroeconomic fundamentals in order to transmit shocks. All that is required for transmission of shocks is for macroeconomic variables to be shared indirectly through other countries. This explains how contagion has occurred between weakly linked markets such as those of Latin America and Asia.

The other most important conclusion about financial contagion to be drawn from our model is that information asymmetries exacerbate contagion.

The effects of contagion on asset prices are much greater in markets with greater information asymmetries. Countries with high levels of asymmetric information experience great fluctuations in asset prices, whereas countries with low levels of asymmetric information do not. When high levels of asymmetric information are present, uninformed investors perceive changes in asset prices in other countries as possibly reelecting information held by informed investors, thus inducing them to alter their expectations about the fundamental value of assets, causing asset prices to change.12

Emerging markets have higher levels of asymmetric information than do developed markets. This explains why emerging markets are affected much more severely by contagion than developed markets. In emerging markets, information about fundamentals is less readily available, thus producing situations of high asymmetric information, exacerbating financial contagion.

Financial contagion is often transmitted between emerging markets through developed markets. Because developed markets have less information asymmetry, they remain relatively unaffected by contagion, acting merely as conduits for the transmission of shocks between emerging markets. Ironically, reductions in asymmetric information in developed markets serve to worsen the effects of contagion in emerging markets where information asymmetries still persist.13

Implications of the Conclusions Drawn from the Model

Often when we consider financial markets, we consider the role they play in the efficient allocation of resources across time and space. We often neglect to consider the fact that sometimes, financial markets, while striving to facilitate efficiency, can have unintended side effects that cause instability. Through the transmission of shocks from one financial market to another through the channels of financial contagion, financial markets produce instability in emerging markets. Instability in emerging markets hinders development because emerging markets are prone to contagion-induced instability. Asset price fluctuations have worse consequences in emerging markets than in developed markets because emerging markets are relatively unstable. Often countries that are unstable financially are also unstable politically. Due to this instability, financial contagion can have wide spread harmful consequences in developing countries.

Countries with developed markets for the most part view financial contagion as an emerging market problem unrelated to developed markets. This mindset is a result of the minimal effect financial contagion has on developed markets and the great effects it can have on emerging markets.

The fact that developed markets serve to transmit shocks between emerging markets is often overlooked. We study the financial crises in Argentina, Brazil, Mexico, and Asia, and do not consider the fact that we play a role in these crises by providing channels of contagion.

The lack of information asymmetries in developed markets, while normally considered beneficial, also works as a negative externality in emerging markets. As discussed previously, the asymmetries of the information asymmetries in markets worsen financial contagion. Developed markets play a role in harming emerging markets while only minimal negative effects are felt in the developed markets-a negative externality. Since developed markets go unscathed while emerging markets are deeply affected, a type of market failure is present.

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In addition, financial contagion bears witness to market inefficiencies. As examined herein, financial markets appear to exhibit information arbitrage efficiency.14 At no point does it appear possible for any investor to earn consistently above average abnormal returns using information on financial contagion. It does not appear possible to use one country's asset prices to predict the asset prices in other markets; thus it is not possible to consistently gain profits.

While information arbitrage efficiency is present, it does not appear that this is the case with fundamental value efficiency. With financial contagion, asset prices do not reflect all available information on asset values due to the fact that asset prices fluctuate more than they should if fluctuations were based solely on fundamental values. If fundamental value efficiency were present in the world's markets, there would be no financial contagion and shocks in one market would not be transmitted to other markets, as asset prices in every market would reflect fundamental values.

Implications for the Future

What are the implications for the future to be drawn from this examination of financial contagion? A better understanding of financial contagion and an explanation of recent financial crises is a good development in its own right, but what good is our understanding if we do not use it as a tool, a tool we can use to attempt to reduce financial contagion in the future?

Reducing instability in developing countries would greatly aid in increasing their development.

One way in which instability in developing countries can be reduced is by reducing the instability of their financial markets. A great cause of instability in emerging markets is financial contagion, as witnessed by the recent financial crises in emerging markets. Reducing financial contagion would increase the stability of emerging markets, and thus lend itself to fostering stability in developing countries.

One way in which financial contagion can be reduced is by reducing information asymmetries. As we have seen, the higher the degree of asymmetric information in a market, the greater the effect of financial contagion in that market. If steps could be taken to increase the availability of information to all investors, information asymmetries could be reduced, simultaneously reducing the probability and severity of the transmission of shocks between markets.

In addition to reducing information asymmetries in emerging markets, financial contagion could be reduced if something was done to close the channels of contagion. As has been seen, financial contagion often flows between emerging markets through developed markets. If cross-market rebalancing could be limited to occurring in developed markets, which can better handle contagion, shocks would not be transmitted to emerging markets, markets that are less able to handle trauma. If information could be passed to emerging markets regarding occurrences of cross-market rebalancing and other forms of contagion, the effects of the contagion in emerging markets would be lessened.

Most of these potential reforms to the financial system would serve to push the market closer to fundamental value efficiency.

If prices better reflected fundamental values-that is, if markets exhibited fundamental value efficiency-financial contagion would cease to be the ominous threat to emerging markets that it currently is. Finding methods of reducing financial contagion and the instability it causes is of the utmost importance in facilitating the development of emerging markets and the growth of developing nations. The closer to exhibiting fundamental value efficiency markets become, the less markets will contribute to instability, allowing markets to serve their intended purpose: providing people with an efficient way to allocate resources over time and space.

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Notes

1 Kodres, Laura E. and Matthew Pritsker, April 19, 2001, A Rational Expectations Model of Financial Contagion, Forthcoming in the Journal of Finance

2 Kodres, p 4

3 Kodres, p 24

4 Kodres, p 5-7

5 Kodres, p 9-10

6 Some of the assumptions made in constructing the model, such as the assumption of CARA utility functions and the assumption that investors can borrow unrestrictedly, eliminate these effects.

Kodres, p 13

7 Kodres p 13

8 Kodres, p 13

9 Kodres, p 13

10 Kodres, p 2-4

11 Kodres, p 31

12 Kodres, p 20

13 Kodres, p21

14 As found in "On the Efficiency of the Financial System" by James Tobin

This was an entry for The 2004 Moffatt Prize in Economic Writing. See the contest rules for more information.

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