Financial Contagion: An Intro

Let’s learn a financial market concept today, shall we?

Financial contagion, this is a phenomenon where financial problems spread from one country to another through several channels like trade, investment or the financial markets.

One way that financial contagion can occur is through trade linkages. If a country experiences a financial crisis that results in its inability to pay for the goods and services it imports from other countries, this can lead to a loss of income for the countries that were exporting to the troubled nation, and may cause them to experience their own financial difficulties.

Another way contagion can occur is through investment linkages. When investors in one country have less confidence in the economic situation there, they may start to withdraw their investments. This can lead to reduced asset value for the country in question and losses for international investors who own those assets. Similarly in the financial markets when investors rapidly sell off assets, the reduced value of those assets results in loss of confidence in the markets which can spread from one market to another and from country to country.

When financial problems spread across boarders through any of these channels, we can say financial contagion has occurred and usually, it has significant impact on the global economy.

To learn

Some real life examples of the occurrence of financial contagion include the global financial crisis of 2008, the 1997 Asian financial crisis and on a smaller scale the Chinese stock market crash.

The global financial crisis began in the United States, when a housing bubble burst and caused a decline in the value of mortgage-backed securities. Basically, people were easily given housing loans and at some point they couldn’t pay back, but because these loans had been packaged as securities banks and investors could trade, when people started defaulting, the value of these securities reduced drastically. This led to huge losses for financial institutions around the world and in turn a global stock market decline and a freeze in the credit market.

The 1997 Asian financial crisis began in Thailand when the government was unable to maintain the value of its currency and was forced to float it, that is, let the market decide its value. This led to a decline in the value of the currency, Thai Baht, and this spread to other countries including Indonesia, South Korea and Russia. In 2015-2016, the Chinese stock market crashed as a result of decline in the value of Chinese stocks. Investors all over the world lost some value and there was significant drop in commodity prices.

As scary as financial contagion can be, it’s a subtle reminder that the world is a global village and has been connected in several ways through globalization.