For want of a nail the shoe was lost.
For want of a shoe the horse was lost.
For want of a horse the rider was lost.
For want of a rider the battle was lost.
For want of a battle the kingdom was lost.
And all for the want of a horseshoe nail.
Above I share a well known parable of chaos, the situation where the kingdom is eventually falls because of horseshoe nail. Financial contagion is somewhat similar to this situation whereby the small shocks which initially affect only few financial institutions or a part of any economy spread to the rest of the financial sectors and other countries whose economies were previously healthy. It spreads like an infectious disease across all aspects of the world economy. How does financial contagion occur, what is its importance and what can be done about it? To answers all these questions it is important to develop an understanding of recent financial crisis.
Financial contagion happens at both the international level and the domestic level. At the domestic level it happens when the domestic bank fails or when the financial intermediary defaults on interbank liabilities and sell assets at extremely discounted prices when they face bankruptcy. An example of this situation is the failure of Lehman Brothers in which the large part of their portfolio comprised of outstanding loans for buying real estate and with the meltdown in the property market in US there was a huge deficit and because of this most of the loans became irrecoverable leading to bankruptcy, henceforth they were forced to make fire sell. Other examples are the subsequent turmoil in the US financial markets.
International Financial contagion happens in both the advanced and emerging economies. The financial crisis here spread across all the financial markets of all the economies. In the present financial system where there is large volume of the cash flows as hedge funds & the existence of cross-regional operation by large banks makes financial contagion simultaneously both among domestic institutions and across countries.
Henceforth it is important to understand how shocks are transmitted between countries so that measures can be taken to reduce this situation and the instability it causes in emerging economies that greatly need stability in order to develop and grow. Financial markets and financial intermediaries play an important role in transmitting shocks across regions. The significant change in portfolio strategies of financial investors due to the crisis in one market may also affect asset pricing in markets that are distant in many ways from the one in which crisis originates. The transmissions of shocks are also influenced by the decisions of domestic and international policy-makers. Specifically, the international repercussions of a shock in one country may be magnified by the action of domestic policy-makers, as well as by the reactions of those in other countries. The rise in cross-country co-variance of asset prices can also results in financial contagion. Investors are concerned with the benefits of portfolio by diverging there assets and if cross-country co-variance of asset prices are significantly higher in periods of crisis, the portfolio diversification may leads to loss.
As a result it is necessary to find some methods to reduce financial contagion and the instability it causes in emerging economies to facilitate development and growth in the emerging nations. One way it can be reduced by reducing the instability of their financial markets by proper guidance and information to the investors which fosters stability in developing countries. Other way it can be reduced by reducing information asymmetries. As has been seen that higher the degree of asymmetric information in a market, the greater the effect of financial contagion in that market. Henceforth, the steps should be taken to increase the availability of information to all investors along with the transmission of shocks between markets. Apart from asymmetries information financial contagion can also be reduced by closing the channels of contagion. It is seen that financial contagion often flows between developing economies through developed economies, therefore if the cross-market rebalancing is limited within the developed economies, which can better handle the financial contagion, shocks would not be transmitted to the developing economies which are less likely to handle the trauma. If the information regarding the occurrences of cross-market rebalancing and other forms of contagion in the developed economies is passed to the developing economies, the effect on the later would be lessened. Moreover, the phenomenon of financial contagion makes a very important study regarding investor’s behavior. Financial markets are contagious in front of financial crisis of other markets because of the investor’s behavior whereby the investor’s think that shocks registered on a robust market are most likely to transmit to a smaller stock exchange market. These shocks are transmitted only if they are negative, i.e. indicating a decrease in the value of financial securities. Hence we can infer that investors are more tempted to imitate the behavior of other investors when they think they will lose otherwise.
I think financial contagion cannot be totally curbed out in the financial market but it can be reduced. The first step has to be the proper guidance, education or information to the investors as we have seen that investors play the vital role in transmitting financial contagion. It will not only help the economies but the individuals as well. By having proper report of the market one can have comprehensive knowledge and can enjoy investing in the market. The instability in the market can only be reduced if investors are well versed with the situations. The TV channels like CNBC, NDTV etc. are doing the best job in providing the crucial information but still what I feel is that, before investing this work should be make mandatory. Apart from them the educational institutions should introduce a subject regarding stocks at the school level so that the students can acquainted with the financial markets. For the long term investment one should go through the five year plans about the economy which is prepared by the planning commission of India as the companies make their policies with regard to five year plans.
While some say that strong linkages across all the economies are not necessarily contagious, and it is defined as an increase in cross market linkages after a shock to one country, which is very hard to figure out by both theoretical model and empirical work. While some scholars say that there is actually no contagion at all, it is just the irrational behavior of the investors which is the evidence of co-movement in the asset prices in all periods.
