Regional Financial Contagion

The significance of financial weaknesses along with linkages within the three crises is described as using the assumptions that they share several financial related elements. The elements include a common creditor, common shocks, trade linkages and financial linkages. To start with, once nations share a common creditor; when one country experiences a financial crisis it may result to monetary market pressures in the other nations. Secondly, a simultaneous happening regarding currency crises can originate from the association of macroeconomic fundamentals shared shock. For example, the 1980s United States increased interest rates resulted to debt crises in Latin America (Caramazza, Ricci, & Salgado, 2000).

Thirdly, the instance a nation undergoes a financial crisis steered by considerable depreciation of the local currency, this causes suffering in other states due to trade spillovers. Additionally, whenever the exchange rate collapse happens simultaneously with a depression in economic activity along with imports compression, the connected income impact often further leads to a decline in exports among it and the trading partners. Fourthly, financial linkages have the capability to cause contagion (Caramazza, Ricci, & Salgado, 2004). Once a crisis emerges in one nation or more, investors may be induced to recheck their risk management portfolios and liquidity. For example, if a crisis emerges in nation A prevailing investors in that nation will often require to decrease the risk for their investments by disposing their highly valued assets in country B. The investors might also sell their liquid assets in order to caution themselves for the existing crises. Countries can therefore undergo capital outflows fueled by a crisis occurring elsewhere since their assets are seen as highly liquid or greatly associated with portfolio in the crisis nation (Caramazza, Ricci, & Salgado, 2004)

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Fifthly, shifts in sentiment by investors may play a role in triggering a crisis. Nations having mediocre financial vulnerabilities can be subjected to contagion effects originating form a movement in market sentiment (Caramazza, Ricci, & Salgado, 2000). These shifts concerning macroeconomic and monetary fundamentals can trigger a crisis and their movement through nations attacks the most vulnerable economies (Caramazza, Ricci, & Salgado, 2004). For example, once a currency crisis in a nation induces fears regarding speculative attacks somewhere else, investors will start speculating against other currencies expected to be sold.

The common creditor is stated as being the most significant factor that explains the economic clarification regarding regional crisis concentration. The findings after undergoing various tests including the regression tests have confirmed an existing strong association between a common creditor and regional monetary crisis. For instance, the components of a major creditor such as CCA and CCB when evaluated singly through the regression model indicates a considerable impact translating that a financial linkage is a sufficient pathway in the spread of crisis (Caramazza, Ricci, & Salgado, 2004). The shared creditor seems to be playing a considerable role in three crises since evidence is found that while engaging the crises dummies, the significance of the common creditor is very high. The common creditor variable singly possesses half of the explanation or evidence of the standard regression and together with reduced output growth, offers the biggest contribution to the likelihood of a crisis (Caramazza, Ricci, & Salgado, 2004). Furthermore, the shared creditor factor explains the reason behind a regional precise pattern towards every one of the three crises, therefore, showing that the crises can be described using the financial factors. Thus, the crises experienced in the three nations through the empirical research have been majorly attributed to the common creditor and according to the evidences; this factor largely causes the contagion.

References

Caramazza, F., Ricci, L. A., & Salgado, R. (2000). Trade and Financial Contagion in Currency Crises.

Caramazza, F., Ricci, L., & Salgado, R. (2004). International financial contagion in currency crises. Journal of International Money and Finance. doi:10.1016/j.jimonfin.2003.10.001