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Definitions of Contagion

The literature has used different definitions of contagion. 

  • Broad Definition
  • Restrictive Definition
  • Very Restrictive Definition
  • Fundamental Links Among Countries
  • A Note on Herding Behavior
  • The Ultimate Cause of Contagio
     

Broad Definition:
Contagion is the cross-country transmission of shocks or the general cross-country spillover effects.

Contagion can take place both during "good" times and "bad" times. Then, contagion does not need to be related to crises. However, contagion has been emphasized during crisis times.

Restrictive Definition:

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. This definition is usually referred as excess co-movement, commonly explained by herding behavior. 

Very Restrictive Definition:

Contagion occurs when cross-country correlations increase during "crisis times" relative to correlations during "tranquil times."

 Fundamental Links Among Countries:

There are different categories of fundamental links:

  •  Financial links exist when two economies are connected through the international financial system. One example of financial links is when leveraged institutions face margin calls. When the value of their collateral falls, due to a negative shock in one country, leveraged companies need to increase their reserves. Therefore, they sell part of their valuable holdings on the countries that are still unaffected by the initial shock. This mechanism propagates the shock to other economies. Another example of financial link is when open-end mutual funds foresee future redemptions after there is a shock in one country. Mutual funds need to raise cash and, consequently, they sell assets in third countries.
  • Real links are the fundamental economic relationship among economies. These links have been usually associated with international trade. When two countries trade among themselves or if they compete in the same foreign markets, a devaluation of the exchange rate in one country deteriorates the other country's competitive advantage. As a consequence, both countries will likely end up devaluing their currencies to re-balance their external sectors. Other types of real links, like foreign direct investment across countries, may also be present.
  • Political links are the political relationships among countries. This link is much less stressed in the literature. One example of political link is the following. When a country belongs to an association or "club of countries," with an exchange rate arrangement, the political cost of devaluing is much lower when other countries have devalued. Therefore, crises tend to be clustered. A crisis in one country is followed by crises elsewhere.
     

When fundamentals and commons shocks do not fully explain the relationship among countries, spillover effects have been attributed to herding behavior, either rational or irrational.

 A Note on Herding Behavior:

Different mechanisms explain herding behavior by international investors. The literature has emphasized that asymmetric information is at the root of these market reactions. Information is costly so investors remain uniformed about the countries in which they invest. Therefore, investors try to infer future price changes based on how the rest of the market is reacting. The relatively uninformed investors follow the supposedly informed investors. So all the market moves jointly. Moreover, investors reassess the risks of investing abroad when they see a foreign crisis. In this context, a change in Thailand's asset prices might be useful information about future price changes in Indonesia or Brazil. These types of reactions lead to herding behavior, panics, and "irrational exuberance."

 Is it rational for investors to follow this "irrational" behavior? The literature suggests that, at a private level, it might be rational to follow the herd. Information is too costly, so each investor might benefit from looking at the market reaction. At a public level, contagion can be very costly. In a world of multiple equilibria, countries with relatively sound fundamentals might end up with balance of payments and banking crises.

 




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