Financial contagion refers to the transmission of a financial shock in one entity to other interdependent entities.
Contents |
History
The study of economic contagion came to prominence in the 1990s, when a wave of currency crises affected the emerging markets around the world.[1]
With the onset of the Subprime mortgage crisis, several countries around the world have had to deal with similar currency problems. [2]
Causes and transmission
The World Bank does not offer up a singular reason as to why contagion occurs, rather they view it as an amalgamation of several distinct properties: financial links whereby two entities are connected through the international financial system, real links such as competitive trade, political links in which exchange rates are closely tied, and the propensity of a herd mentality to develop among investors.[3]
It has been proposed that financial institutions who lend to enterprises throughout multiple countries are inadvertently exposing them all to risk. If the common lender encounters financial difficulty, it will (by necessity) disseminate this risk to all those whom it has lended.[4]
Due to the highly leveraged and sensitive nature of the financial intermediaries' (broker-dealers and commercial banks) balance sheets to fluctuations in price and risk, others have argued that the idea of an economic domino effect is outdated (wrong idea) - a synchronized reaction by all of them is enough to create and subsequently amplify a feedback cycle such that it will trigger contagion.[5]
Prevention and cures
Given the dubious nature of what causes contagion, there have been several ideas about how to prevent, and cure, contagion.
It has been suggested that by restricting the flow of capital into a specific entity, it can be insulated from external shocks by way of not having large amounts of foreign capital. Consequently, it has been pointed out that capital restrictions are relatively easy to avoid.[1]
While admitting that a single "jolt" will not reinvigorate an entire economy, Jeffrey Sachs has been a proponent of Shock therapy. A framework within which to rapidly evolve a centrally planned economy into a market economy, it has been implemented in several countries around the world and has met with mixed success.[6]
See also
References
- ^ a b Edwards, Sebastian (2009-03-15). "CONTAGION" (PDF). anderson.ucla.edu. http://www.anderson.ucla.edu/faculty/sebastian.edwards/world_economy5.pdf. Retrieved 2009-03-15.
- ^ "'Financial Contagion' Spreading in Developing World". spiegel.de. 2008-10-29. http://www.spiegel.de/international/business/0,1518,587245,00.html. Retrieved 2009-03-15.
- ^ "Contagion of Financial Crises". www1.worldbank.org. 2000-09-15. http://www1.worldbank.org/economicpolicy/managing%20volatility/contagion/definitions.html. Retrieved 2009-03-15.
- ^ Árvai, Zsófia; Driessen, Karl; Ötker-Robe, İnci. "Regional Financial Interlinkages and Financial Contagion Within Europe" (PDF). imf.org. http://www.imf.org/external/pubs/ft/wp/2009/wp0906.pdf. Retrieved 2009-03-15.
- ^ Adrian, Tobias; Shin, Hyun Song (2008-02). "Liquidity and financial contagion" (PDF). banque-de-france.fr. http://www.banque-de-france.fr/gb/publications/telechar/rsf/2008/etud1_0208.pdf. Retrieved 2009-03-15.
- ^ Sachs, Jeffrey (1994-04-06). "Shock Therapy in Poland: Perspectives of Five Years after five years the economy stablizes." (PDF). earth.columbia.edu. http://www.earth.columbia.edu/sitefiles/File/about/director/documents/LecTanner0494.pdf. Retrieved 2009-03-15.
- Hacker, R. S. and Hatemi-J, A. (2005). An alternative method to test for contagion with an application to the Asian financial crisis, Applied Financial Economics Letters, Vol. 1(6), pp. 343-347.
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