Financial Contagion in Emerging Markets

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Financial Contagion in Emerging Markets

Postby Anup V » Fri Jul 13, 2012 12:40 am

The fact that there were several similarities between the financial crises in Mexico 1995 and Asia 1997 makes it interesting to examine whether a model that explained the Mexican crisis also can be applied on the Asian crisis. Thus, this thesis aim is to do a quantitative study of nineteen emerging market economies with a model consisting of three explanatory variables: appreciated real exchange rate, weak banking system and scarce foreign exchange reserves. To the best of my knowledge, a follow-up study of this model has never been made before. Contribution: if the model does a good work explaining also the Asian crisis, it may be used by the market (e.g. international investors and currency traders) as an early warning indicator
of future contagious crises in emerging markets. However, by running regressions I found that the R2values are low (adjusted R2are negative) and neither of the null hypotheses are significant at ten percents level. The conclusion is hence that the model does a poor job explaining what happened in Asia and that further research is needed in order to find a model which can explain patterns when financial crises in emerging markets becomes contagious due to creditors withdrawal of capital.

Prior to the Mexican crisis in 1995 the word contagion had not reached out to the majority of politicians and economists and did therefore only constitute a small part of the economic literature. That changed however, when the Asian crisis 1997 and Russian crisis 1998 showed the very same patterns. Hence, over a couple of years three major financial crises put large parts of the developing world under severe financial distress. The common characteristic between these three rises was the fact that investors decided to withdraw capital causing the countries to experience balance-of-payment crises and in addition, attacked currencies. This phenomenon was named contagion
One of the first explanations given subsequent to the Mexican crisis discussed whether current account deficits could be the main driver. That could not be applied for Mexico however, since they had not suffered from neglected financials in the past. Other solutions to the phenomena thus started to arise, implying that the initial literature became quite sprawling. Nowadays economists are more accustomed to these kinds of crises and the literature has thus also become fine tuned as a distinction between pure contagion and fundamental based contagion is agreed on.


The rationale behind the selection of the Asian crisis as follow up study depends mainly on the similarities that prevailed between the South American (Mexican) crisis and the Asian crisis but also on my owninterest in learning more about Asian history. The theoretical frame of reference contains mostly of articles written by internationally wellknown economists which are commonly referred to when discussing contagion. I have selected the different theory angels based upon this aspect. I have not been critical towards the actual conclusions made in the different models and studies which I am aware of. I have also accepted every theory as having an equal probability of being true. Whenever I have found a contradiction to any of the theories, I have presented the opponents view as well.

The rest of this thesis is outlined as follows; next section contains the theory part whichbegins with a discussion regarding the definition of contagion followed by a number of contagion theories with a distinction between fundamental based contagion and pure contagion. The Asian crisis is discussed in section three with special emphasis on the common characteristics among the five worst affected countries and similarities between the Mexican crisis and the Asian crisis. A caption on the relationship between a governments foreign exchange reserves, capital withdrawals and a currency’s devaluation is addressed as well. In section four I conduct my own study based on the model used by Sachs et al [1996] with a discussion regarding the obtained results as closure in part five.

Author: Louise Valentin, Stockholm School of Economics, Department of Economics

Anup V
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