Dungey-Tambakis2003 - Financial Contagion What do we Mean What do we Know Mardi Dungey Demosthenes Tambakis Australian National University and CERF

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Unformatted text preview: Financial Contagion: What do we Mean? What do we Know? Mardi Dungey Demosthenes Tambakis Australian National University and CERF Pembroke College Cambridge University and CERF 1 Roadmap for seminar 1. Introduction – Definitions of Contagion 2. Why does Contagion arise: Theory 3. Contagion Case Studies 4. Empirical Evidence 5. Generalisations by Asset Market 6. Contagion in Developed and Developing Markets 7. Summary and Policy Implications 2 1.Introduction and background 3 Background factors • Financial crises seem to occur together • Observe big shifts in financial markets – Large changes in exchange rates: SE Asian crises 19971998 – Large changes in equity prices (October 1987 DJIA crash, 2000 dot.com bubble burst) – Shifts in bond markets: Russian crisis 1998, Brazil 1999 • Policy concern is that they occur across many countries – HOW? 4 Some important recent dates • • • • • • • • Devaluation of Mexican peso – 20 Dec 1994 Devaluation of Thai baht – 2 July 1997 Russian default – 17 August 1998 LTCM recapitalisation begins – 23 Sept 1998 Hong Kong stock market crash – 28 Oct 1998 Brazil devaluation – 13 Jan 1999 Collapse of Argentine currency board – Dec 2001 Brazil – runup to presidential election – 2003 5 And some that didn’t seem to attract as much attention • US and EU dot.com collapse – April 2000 • Brazilian election – October 2002 • Turkey banking and currency crises – 2000 • What will be the final outcome for the current Argentine problems – seems no contagion 6 Thai baht against US dollar 60 50 40 30 20 10 0 Jan-97 Apr-97 Jul-97 Oct-97 Jan-98 Apr-98 Jul-98 7 Indonesian rupiah against US dollar 18000 16000 14000 12000 10000 8000 6000 4000 2000 0 Jan-97 Apr-97 Jul-97 Oct-97 Jan-98 Apr-98 Jul-98 8 Korean won against US dollar 2500 2000 1500 1000 500 0 Jan-97 Apr-97 Jul-97 Oct-97 Jan-98 Apr-98 Jul-98 9 East Asian currencies against USD index: Jan 1 1997 =100 800 700 600 Indonesia rupiah 500 400 300 Thai baht 200 Korean won 100 0 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 10 East Asian equity indices 1990-2003 Index: Jan 1997=100 250 Hong Kong 200 150 Thailand 100 50 Indonesia 0 Jan-90 Jan-92 Jan-94 Jan-96 Jan-98 Jan-00 Jan-02 11 Returns: Hong Kong equity index 1996-1999 % 8 6 4 2 0 -2 -4 -6 -8 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 12 Returns: Indonesian equity index 1996-1999 8 6 4 2 0 -2 -4 -6 -8 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 13 Returns: Thai equity index 1996-1999 % 8 6 4 2 0 -2 -4 -6 -8 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 14 basis points 8000 Bond spread: Russian sovereign - US Treasury 7000 6000 5000 4000 3000 2000 1000 0 Feb-98 Apr-98 Jun-98 Aug-98 Oct-98 Dec-98 15 basis points 2500 Bond spread: Bulgarian sovereign - US Treasury 2000 1500 1000 500 0 Feb-98 Apr-98 Jun-98 Aug-98 Oct-98 Dec-98 16 basis points 1200 Bond spread: Argentinian sovereign - US Treasury 1000 800 600 400 200 0 Feb-98 Apr-98 Jun-98 Aug-98 Oct-98 Dec-98 17 Policy makers’ and market participants’ views • “Malaysia is concerned that the risks of contagion from the Asian crisis have Mustapa Mohamed increased….” Malaysian Finance Minister 4/10/98 • “It’s like there are two businesses here. The old business, which works fine under normal conditions, and this stand-by business, when Eric Rosenfeld of Long-Term Capital, the world goes mad.” New York Times Magazine, January 24, 1999[1] 18 Why is contagion a ‘problem’? • Contagion is seen as a feature of financial crises. • Internationally diversified portfolios to protect against country risk. • In times of financial crisis the relationships used to diversify break down through unanticipated shocks = CONTAGION • How do we cope with this? 19 Defining contagion • Myriad of definitions • Problems across theory and empirical work • Attempt to draw this together using the World Bank’s definitions • First, taxonomies of transmission paths during crises 20 Lowell et al 98 Goldstein 98 Competition Effects Economic Linkages Perry & Lederman 98 Demand Effects Competitive Dynamics Wake up call Heightened Awareness Demonstration Effects Portfolio adjustment IMF 99 Spillovers Flight to Safety Cash in effects Shifts in Investor sentiment Financial linkages Herd behavior 21 Broad definition of contagion (World Bank) • “Contagion is the cross-country transmission of shocks or the general cross-country spillover effects” • This is very broad. Includes fundamentals linkages such as due to trade, terms of trade effects, things which we can name. • Most of the literature distinguishes ‘fundamental’ linkages from contagion. • Eg Lowell, Neu and Tong (1998), Reside & Cochoco-Bastista (1999), Calvo and Reinhart (1996) ‘fundamentals-based’ contagion, Kaminsky and Reinhart (2000) 22 Restrictive Definition (World Bank) • “Contagion is the transmission of shocks to other countries or the cross-country correlation, beyond any fundamental link among the countries and beyond common shocks.” • Excludes herding behavior and so forth. • Fundamental links include: – Financial - Real more on these later (- Political) Eg. Eichengreen, Rose and Wyplosz (1995,1996) 23 Very Restrictive Definition (World Bank) • “Contagion occurs when cross-country correlations increase during ‘crisis times’ relative to correlations during ‘tranquil times.’” • This needs to control for general volatility rising during financial crises (Forbes and Rigobon (2002)) • The fundamental linkages are again not acknowledged • Only increases in correlation are recognized as contagion 24 Our preferred version – akin to the restrictive definition • The transmission of shocks beyond the fundamental linkages • Other terms:‘unwarranted contagion’, ‘pure contagion’ • Closest in the empirical literature is Eichengreen, Wyplosz and Rose (1995,96) and Pesaran and Pick (2003) who want to control for a large variety of fundamentals first. • Measured contagion may be relative to the particular fundamentals chosen 25 2. Why does contagion arise? Theoretical models 26 Micro-foundations of contagion • The cross-section dimension as opposed to the time domain. • Investors’ actions do not reveal their private information. • Herds arise when Information gets trapped: underlying signals driving investment decisions are not revealed. – For example, when traded asset prices are not marketdetermined. • Investors can then rationally decide to mimic the behavior of others. 27 Rational herding behavior by international investors • Herding arises when there is incomplete information about a country’s fundamentals and investors are free to choose when they move. • Different classes of investors may change positions at the same point in time: – Banks, corporates, multinationals, hedge funds • The potential for destabilizing collective action by herding investors. 28 How to prevent herding? • In a bad equilibrium, bank runs or speculative attacks on a currency can be unrelated to fundamentals. • Therefore unpredictable! • The importance of enlarging the amount of public information available. • Need to enhance the transparency of institutions, objectives and governance (see also policy implications I). 29 International illiquidity and ‘sudden stops’ • Capital account reversals have become more severe for developing economies. • The availability of a rescue package (country bailout option) can make the problem worse because of moral hazard. • Reliance on short-term financing can lead to sharp real slowdown if capital inflows stop. • International creditors covering losses in other markets can lead to contagion (portfolio links). 30 The international debate on the speed of capital account liberalization: I • Comparing the costs and benefits of capital market integration. • Against the costs, arguments for less capital controls include: – Increase the overall availability of funds for financing socially valuable projects – Promote transparency and accountability – Reduce moral hazard and liquidity problems – Improve the functioning of the financial system (though not necessarily deepening it!) 31 The international debate on the speed of capital account liberalization: II • The conventional view: the benefits outweigh the costs (Rogoff (1999)). • The recent microstructure view: more market interconnectedness is bad because it leads to cross-market hedging and contagion (Kodres and Pritsker (2002)). • The middle way: phasing in of opening up capital short-term flows 32 The role of fundamentals • Control variables – spillovers. • Fundamentals-based contagion – Calvo and Reinhart (1996), Kaminsky and Reinhart (2000). • Usually there is a unique equilibrium for each possible set of fundamentals. 33 The role of beliefs • Control variables – expectations. • Hard to measure and even harder to manipulate. • Beliefs-based contagion – Calvo and Reinhart (1996), Kaminsky and Reinhart (2000). • There can be multiple equilibria even with complete and symmetric information if investors are sufficiently forward-looking (Jeanne and Masson (2000)). 34 3. Contagion Case Studies 35 The European Monetary System’s ERM crises: 1992-93 • Germany’s problems at the ‘center’ affected ‘periphery’ countries: UK, Italy, Spain, Portugal, Sweden, Finland, France. • A case study for the self-fulfilling crisis view? (Contagion unrelated to fundamentals) • Not really: in most crisis countries, high unemployment and interest rates were very undesirable, including politically. Also systemic banking sector problems in Scandinavia • Need to distinguish the credibility of policies from the credibility of policymakers. 36 The Mexican peso crisis 1994 1. Driven by fundamentals - role of weak banking, weak reserves 2. Evidence of contagion - coined the term ‘Tequila effect’ - tests provide mixed results 3. Was it regional - largely confined to Latin America 4. Which asset markets were affected - currency and equities 37 The East Asian crises: 1997-98 1. Driven by fundamentals - terms of trade effects due to export competing nations 2. Evidence of contagion - mixed evidence from formal testing - much commentary says that Indonesia particularly was contagion 3. Was it regional - largely - relatively little spillover to developed markets 4. Which asset markets were affected? - questions as to whether the crisis started in the equity rather than currency market as commonly presumed 38 The Russian and LTCM crises: 1998 1. Driven by fundamentals - liqudity crisis and credit crisis - promulgated by hedging 2. Evidence of contagion - were these crises connected by contagion 3. Was it regional - very widespread - Russia affects developing markets, LTCM affects developed - did Russian crisis prompt the Brazilian crisis 4. Which Asset Markets were affected - bonds, equities 39 Recent Latin American financial crises 1. Driven by fundamentals – Brazil 1999 – Argentina 2001 2. “Twin crises”: spillover from currency to banking and vice versa 3. Little evidence of international contagion 4. Was it regional? 5. Which financial markets were affected? - primarily currency and bonds 40 4. Empirical Evidence on Financial Contagion 41 Methods of testing for contagion A taxonomy loosely based on the World Bank’s classification: • Unexpected shocks or news – Dungey et al (2002,2003), Favero and Giavazzi (2003) • Correlation tests – Forbes and Rigobon (2002), Baig and Goldfajn (1999) • Probability tests – Eichengreen, Rose and Wyplosz (1995), Kaminsky and Reinhart (2000) • Extreme returns tests – Bae, Karolyi and Stultz (2003), Baur and Schulze (2002) • Other tests – Glick and Rose (1999), Lowell, Neu and Tong (1998) 42 Empirical Tests for Contagion 1. Contagion as ‘unexpected shocks’ or news – contagion arises because transmission arises over and above the anticipated links the reaction is beyond what could have been expected beforehand – Sometimes links are so complex so as to behave as if there is contagion (Kiyotaki and Moore (2002)) Egs. Dungey et al (2002,2003), Favero and Giavazzi (2002) 43 Empirical tests for contagion 2. Correlation Tests Contagion as a significant increase in the correlation between assets during a period of crisis, compared with a period of calm Eg. Forbes and Rigobon (2002) - consistent with World Bank’s ‘very restrictive’ definition 44 Empirical tests for contagion 3. Probability Tests - if the probability of a domestic crisis is affected by the occurrence of a foreign crisis this is consistent with contagion Eg. Eichengreen, Rose and Wyplosz (1995,1996) 45 Empirical tests for contagion 4. Extreme Returns Tests - the transmission between asset markets is different in times of extreme returns (crisis times) from that of normal times Eg. Bae, Karolyi and Stulz (2003) 46 Empirical tests for contagion 5. Other Tests - encompassing spillovers (fundamental linkages) Glick and Rose (1999) trade van Rickjem and Weder (2001) financial links - other things Lowell, Neu and Tong (1998) fundamentals 47 Some key practical issues • How to define the crisis sample period? – Practically either ad hoc or data driven • How to define the threshold at which a crisis occurs? – Sample dependence • How to deal with different time zones? • How to deal with missing observations? 48 5. Generalisations on contagion by Asset Markets 49 Foreign exchange markets 1. Fundamentals - often in conjunction with a banking system crisis; exchange rate pressure often leads banking problems - a large devaluation is often a trigger – used as a critical date, eg float of Thai baht, devaluation of Mexican peso 2. Evidence of contagion 3. Regional - crises seem to spread across wide range of currencies, both spillovers and contagion 50 Equity markets 1. Fundamentals 2. Evidence of Contagion - Forbes and Rigobon result that ‘no contagion, only interdependence’ - Other methods wide ranging evidence of contagion 3. Regional nature of crises and contagion - That developed markets act as a conduit for crises between developing regions 51 Fixed income markets 1. Fundamentals 2. Evidence of contagion - Much more limited evidence, lack of data 3. Regional effects - seem less pronounced Less evidence that developed markets act as conduits 52 Cross-market studies • No clear causation from one market to another • Most work concentrated on geographical separation (Bayoumi et al (2003)) • Evidence not yet systematic enough to be sure • Growing area of research, and certainly important for the policy agenda 53 Mexican and Argentine peso against the USD: 1994-1995 9 8 Mexican peso 7 6 5 4 3 2 Argentine peso 1 0 Jan94 Mar94 May94 Jul94 Sep94 Nov94 Jan95 Mar95 May95 Jul95 Sep95 Nov95 54 The equity indices of Mexico and Argentina during the 1994-1995 crisis Index: 1994:1=100 140 Mexican equity 120 100 80 60 Argentinian equity index 40 20 Jan94 Mar94 May94 Jul94 Sep94 Nov94 Jan95 Mar95 May95 Jul95 Sep95 Nov95 55 Equity index returns 6 4 Mexican equity index - blue Argentinian equity index- red 2 0 -2 -4 -6 Jan94 Mar94 May94 Jul94 Sep94 Nov94 Jan95 Mar95 May95 Jul95 Sep95 Nov95 56 Country 1 Currency market Equity market 57 Country 1 Currency market Equity market 58 59 60 61 62 63 • Bonds, equities and currencies 64 6. Contagion in Developing and Developed Financial Markets 65 Relating the stage of financial market development and contagion • Developed markets seem less affected • Developing markets have largest contagion effects • Regional nature of contagion and crises usually involves regions of developing – and opening - financial markets (Latin America, Eastern Europe, East Asia) 66 The Russian and LTCM crises • Did – Russian crises mainly affect developing markets and – LTCM mainly affect developed markets As claimed by BIS (1999) ?? 67 Volatility Decomposition: Bond spreads in Russian and LTCM crises 100% 95% 90% 85% World Idiosyncratic Regional Contagion from Russia US UK Ne th er ss ia Ru d Po lan ria Bu lga nd Th ail a ea Ko r In do M ex ico az il Br Ar g en t 80% Contagion from LTCM68 Contagion in basis points - the smaller contributions 200 180 160 140 120 100 80 60 40 20 Contagion from U.S. Ar ge nt in a ex ic o M nd Th ai la Ko re a So ut h In do ne si a Po la nd N et he rla nd s U K U S 0 Contagion from Russia 69 Contagion in basis points - the larger contributions 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Argentina Brazil Contagion from U.S. Russia Bulgaria Contagion from Russia 70 7. Summary and Policy Implications 71 Summary of questions and evidence 1. Contagion is an important problem • • Statistically significant contagion occurs It is not usually the dominant cause of volatility (cost-benefit trade off required) 2. Contagion is a regional issue • • Varies across crises (and asset markets) Some evidence that developed markets operate as a conduit between regions 3. Asymmetry: developing countries are more affected by contagion than developed countries • • True in terms of the levels effect Not clear in terms of proportionate effect on volatility 72 Policy Implications I If contagion is statistically significant: - Implications of responding – moral hazard How can we improve the outcomes - improved transparency (information) - improved fundamentals (policy formation) - improved public institutions (infrastructure, bankruptcy laws) 73 Policy Implications II If contagion is regional: - Argument for greater regional cooperation in terms of shared information - concern that the current focus of the international institutions does not adequately reflect regional concerns - disadvantage could be parochialism 74 Policy Implications III If developed markets transmit crises between developing regions: - Do developed markets then have some responsibility to the developing regions in helping to cope with this effect - Possibly transmitted through portfolio rebalancing effects - Repeated prisoner’s dilemma game: better outcome for all participants if they cooperate 75 Policy Implications IV If developed and developing markets are proportionally both affected: - What is more important, the proportion or level of the effect? If developing markets see the larger levels effects: - developing markets provide profitable capital opportunities for capital, settling for lower global capital allocations ultimately means lower global growth 76 More resources: • http://www.cerf.cam.ac.uk/links/index.php Mardi Dungey [email protected] Demosthenes Tambakis [email protected] 77 ...
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This note was uploaded on 07/18/2011 for the course ECON 3022 taught by Professor Dungey during the Spring '11 term at Università degli Studi di Verona.

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