Contagion

What Is Financial Contagion?

Contagion, also often known as financial or economic contagion, is the spread of any economic crisis from one region or market to another, domestic or international.

It is often caused due to the interconnectivity between markets, mainly due to similar goods being used across markets, like labor or capital goods.

For example, any country's labor supply crisis can impact nearby countries due to their interconnectivity through financial and monetary systems.

The strength of an economy can help reduce or magnify the shocks due to contagion. If markets are very fragile economic shocks in nearby regions can amplify the negative impact on a country.

On the other hand, a robust market can cushion the shock a country faces. Thus it can be compared to the spread of disease.

A common example cited is a burst in credit bubbles that can spread to neighboring countries and often worldwide.

Understanding Financial Contagion

According to everyday vocabulary, the exact definition is spreading disease from one person to another. In economics, however, it is usually an economic crisis that occurs throughout a market, for a particular asset class, or across a particular geographical region. 

With increased globalization and the advent of an international economy, with economies becoming more interconnected, contagions have become more of a global phenomenon. 

It usually occurs when a financial crisis or negative implications of the crisis spreads from one economy to another, often like a disease. They can be both global and domestic. 

Thus just as a viral infection can spread rapidly, a crisis too may originate in one part of the world but may spread throughout the globe.

For example, domestically, this can happen if a prominent bank starts selling off its assets; the other similar banks will soon lose confidence and thus will start doing the same, which may trigger a financial collapse. 

Thus the term in economics is a metaphor for the catchiness of the economic crisis or how a crisis can spread very rapidly throughout the world in such a globalized world. 

Financial Contagion History

The term was first coined in July 1997 during the Asian financial markets crisis wherein what began as a currency crisis in Thailand soon impacted all of Asia and eventually even countries like Russia and Brazil.

The crisis started in Thailand, where the government lacked enough foreign currency to continue to peg the Thai Bhat to the US dollar, eventually leading to a collapse in the Thai Bhat. 

This, however, was not limited to Thailand alone, as the huge foreign debt that Thailand had acquired eventually impacted countries like South Korea and Japan as their economies too struggled with the stock market becoming devalued and Foreign debt to GDP ratios rising to as high as 167%. 

After the crisis, many studies were conducted to understand how a crisis can transcend borders. During the study, plenty of examples were found, and economists realized that there was a global economic crisis almost every decade since 1825. 

For example, in the 19th century, much credit poured into Latin America after its independence from Spain. Eventually fearing massive outflows, the Banks raised their discount rates, leading to enormous panic and an eventual crisis in Europe with the stock markets crashing. 

Why Does Financial Contagion Occur?

The primary reason for such a phenomenon is the interconnected nature of economies. As many goods are substitutes or complements, an effect on one good can also lead to implications for other goods. 

Thus a change in demand or supply of one particular good can impact other goods that other countries may produce. Thus changes in one economy can affect other countries too. 

Financial contagion is majorly caused due to the spillover effects of a financial crisis, which are the negative externalities of a crisis. They are macroeconomic shocks that can be transmitted through trade links and financial links. 

Similarly, competitive devaluation or a currency war can also lead to such a phenomenon; wherein multiple countries try to devalue their currency to gain a competitive advantage by lowering their foreign exchange rates. 

This eventually causes countries to act irrationally due to fear and doubt. Another reason for this phenomenon is due to the irrational behavior of 4 major agents: 

• Governments
• financial institutions
• borrowers 
• investors 

These behaviors include risk aversion, lack of confidence, and fear. In this, a fall in one market is perceived to be an indicator for prices in other markets to fall too.

Vulnerability of Economies to Financial Contagion

A robust and well-functioning economy will be less vulnerable or susceptible to the financial crisis in other markets; that is, the changes in one market will not affect the said economy very harshly, or the impact gets dampened. 

On the contrary, a very fragile economy is highly susceptible to changes in other economies or financial crises in other economies. In such economies, a large shock is amplified, and a shock can cause major damage to the economy. 

Thus markets which are too dependent on one or few commodities are more susceptible to such shocks as a fall in demand or supply of the good can lead to massive changes in the equilibrium prices. 

Similarly, an economy under much debt, like Thailand was, is more vulnerable to shocks. 

Additionally, any barriers to entry or exit for producers or conditions that do not allow free adjustment of prices can lead to less flexible or more fragile markets, making the economies more flexible. 

Additionally, the degree of interconnectedness between markets is a major factor determining a country or region's vulnerability to a shock, for example. If two regions are not connected via trade, a shock in one region will not affect the other. 

Examples of Financial Contagion

The Asian financial markets crisis is one of the first examples of such a scenario. Another popular example is the Great depression which began in the United States in 1929 and continued for almost a decade. 

It was one of the most severe crises the world has ever seen, plaguing most of the world. Moreover, it is cited as the worst financial crisis in the 20th century. 

The crisis started with a crash in the American stock market, with Dow jones dropping from 381 to 198 over two months. 

This led to panic, and there was soon a recession; to avoid losses in fear of further drops, people started clearing the market and selling their assets, further worsening the crisis. 

This soon, however, spread from the states to the rest of the world. The worldwide GDP fell by over 15%. Most countries saw personal incomes, prices, tax collection, revenues, and profits fall dramatically. 

Construction activities were halted, agricultural activities dropped by 60%, and demand for goods plummeted dramatically. 

Policy implications for Financial Contagion

Financial policies usually aim to lower the impact of financial contagion. Therefore, using sound financial regulations plans, most officials’ top priority is eliminating the chances of such an event. 

A better understanding of the reasons for financial contagion can also help financial planners make better and more organized markets to limit its effect. 

For example, studying past crises and preparing for them would help resist and limit the damage caused by any successive crisis which may happen in the future. 

Similarly, governments will try to make the markets more robust and avoid having fragile markets. 

This would mean avoiding too much debt in the economy, more liquidity, and more vital trust between financial intermediaries, investors, credit rating industries, and the government to avoid panic. 

For example, financial policymakers often try to set up capital ratios in a way wherein the profits of banks are maximized. However, they are shielded from any financial shock or financial crisis not to trigger a collapse in the economy. 

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Unemployment
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• Veblen Goods
• Voodoo Economics
• Zero Lower Bound