Global contagion

The four forces already discussed—over-lending/over-borrowing, exogenous shocks, exchange rate risk, and short-term borrowing—provide major insights into why a financial crisis could hit a country.But the financial crises since 1980 were more than this.When a crisis hits one country, it usually spreads and affects many other countries.It appears that some kind of global contagion is at work.Some contagion is the result of close trade links between the affected countries; thus, a crisis downturn in one country, like Argentina, has spillover effects in another country, like Uruguay.

Contagion can be an overreaction by foreign lenders as they engage in a scramble for the exits.Herding behavior can occur.Borrowers often do not provide full information to lenders.The high costs of obtaining accurate information on their own can lead some lenders to imitate other lenders who may have better information about the borrowers, or to fear that other borrowing countries are likely to have similar problems to those of the crisis country, even if there is no evidence that this is true.

Contagion can also be based on new recognition of real problems in other countries that are similar to those in the country with the initial crisis.The financial crisis in one country can serve as a “wake up call” that other countries really do have similar problems.The crisis in Mexico led to a more severe tequila effect in countries that had problems similar to those of Mexico— currencies that had experienced real appreciations, weak banking systems and domestic lending booms, and relatively low holdings of official international reserves.In Asia the crisis in Thailand led to a recognition that Indonesia and Republic of Korea had similar problems, including a weak banking sector, a decline in quality of domestic capital formation, a slowdown in export growth, and fixed exchange rates that may not be defensible for very long.

Analysis suggests that different forms of contagion are probably important and occur together in many crises.The initial reaction to a crisis in one country is often pure contagion, as international lenders pull back from nearly all investments in developing countries.Lenders then examine the other countries more closely.International lenders resume lending to those countries that do not seem to have problems.But the financial crisis spreads to those countries that seem to have similar problems.Although the spread of the crisis has a basis in the recognition of actual problems, it is still a kind of contagion effect.Without the crisis in the first country, the other countries probably would have avoided their own crises.