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Since the collapse of the Bretton Woods system the integration of national financial markets grew steadily, to reach unprecedented levels. At the same time, episodes of extreme financial instability became more frequent. The latter were often extremely contagious, in the sense that country-specific episodes had hugely disruptive effects on financial markets across the globe. The literature on Financial Contagion investigates the channels through which that instability is propagated. This thesis deals with the two most recurring questions in the literature: 1) What are the channels of macroeconomic instability propagation? A theoretical model of instability propagation in presence of currency mismatches is presented. The model shows that when domestic agents' liabilities are denominated in foreign currency, exchange rate volatility raises credit costs, with negative real effects. Currency mismatches therefore create a channel through which external disturbances causing exchange rate volatility affect negatively the domestic supply. Several reasons why currency mismatches might magnify the effect of foreign disturbances have been identified by the theoretical literature on the issue. The empirical relevance of the magnification hypothesis is tested by investigating whether the degree of domestic output's sensitivity to foreign output fluctuations is higher in countries where currency mismatches are widespread than in countries able to borrow abroad in domestic currency. The analysis gives strong support to the hypothesis: currency mismatches magnify the real effects of foreign disturbances. The analysis also highlights the presence of asymmetry of propagation: negative shocks have proportionally stronger real effects than positive ones in currency-mismatches-prone countries. 2) Is the financial shocks propagation mechanism altered by major events such as banking or currency crises? The intensity of propagation of the crises in the '90s led researchers to ask whether the linkages between countries grew stronger during these turbulent times or were instead as strong before. Various tests of the instability of the propagation mechanism have been proposed since. These can be divided in two families: correlation-based and extreme-event-based tests. I propose a new approach, based on the Quantile Regression technique. It is argued that this approach retains the appealing features of the two families of test while avoiding some of their limitations. The new approach is then applied to stock market returns, finding strong evidence of instability of the propagation mechanism.
Tiivistelmä.
The recent global financial crisis was the first in recent history that was triggered by problems in the financial system of the mature economies. Existing work on financial crisis in emerging market countries, however, almost exclusively focus on the role of financial frictions in the domestic economy. In contrast, we propose a two-country DSGE model to investigate the transmission of a global financial crisis that originates from financial frictions in the rest of the world. We find that the scale of financial spillovers from the global to the domestic economy and trade openness are key determinants of the severity of the financial crisis for the domestic economy. Our results also suggest that the welfare ranking of alternative monetary policy regimes is determined by the degree of financial contagion, the degree of trade openness as well as the scale of foreign currency denominated debt in the domestic economy.
"The recent global financial crisis was the first in recent history that was triggered by problems in the financial system of the mature economies. Existing work on financial crisis in emerging market countries, however, almost exclusively focus on the role of financial frictions in the domestic economy. In contrast, they propose a two-country DSGE model to investigate the transmission of a global financial crisis that originates from financial frictions in the rest of the world. They find that the scale of financial spillovers from the global to the domestic economy and trade openness are key determinants of the severity of the financial crisis for the domestic economy. Their results also suggest that the welfare ranking of alternative monetary policy regimes is determined by the degree of financial contagion, the degree of trade openness as well as the scale of foreign currency denominated debt in the domestic economy."--Abstract.
The essays in this volume analyze causes of financial crises in emerging markets and different policy responses.
No sooner had the Asian crisis broken out in 1997 than the witch-hunt started. With great indignation every Asian economy pointed fingers. They were innocent bystanders. The fundamental reason for the crisis was this or that - most prominently contagion - but also the decline in exports of the new commodities (high-tech goods), the steep rise of the dollar, speculators, etc. The prominent question, of course, is whether contagion could really have been the key factor and, if so, what are the channels and mechanisms through which it operated in such a powerful manner. The question is obvious because until 1997, Asia's economies were generally believed to be immensely successful, stable and well managed. This question is of great importance not only in understanding just what happened, but also in shaping policies. In a world of pure contagion, i.e. when innocent bystanders are caught up and trampled by events not of their making and when consequences go far beyond ordinary international shocks, countries will need to look for better protective policies in the future. In such a world, the international financial system will need to change in order to offer better preventive and reactive policy measures to help avoid, or at least contain, financial crises.
The paper surveys the types of models producing multiple equilibria in financial markets. It argues that such models are consistent with observed phenomena, such as the greater volatility of financial asset prices than of macroeconomic fundamentals. Alternative explanations are compared with the stylized facts concerning capital flows, portfolio shifts, and exchange rate crises. Implications for crisis prediction and prevention are then discussed.
The Global Financial Crisis of 2007-2009 has highlighted the resilience of the financial markets and economies from the developing world. This title investigates and assesses the impact and response to the crisis from an emerging markets perspective including asset pricing, contagion, financial intermediation, market structure and regulation.
Currency Crises in Emerging Markets, prepared by Warsaw-based Center for Social and Economic Research (CASE), discusses various aspects of currency crises in emerging-market economies: The definitions and theoretical models of currency crises, the causes, management and propagation (contagion effect) of crises, their economic, social and policy consequences, the role of international financial institutions, and crisis prevention. In addition, five case studies of currency crises in Central and Eastern Europe are presented.
What can the international community do to prevent financial contagion?