INTERNATIONAL FINANCIAL CONTAGION

INTERNATIONAL FINANCIAL CONTAGION

INTERNATIONAL FINANCIAL CONTAGION edited by Stijn Claessens The World Bank U.S.A. Kristin J. Forbes Massachusetts Institute of Technology U.S.A. SPRINGER SCIENCE+BUSINESS MEDIA, LLC

ISBN 978-1-4419-4876-2 ISBN 978-1-4757-3314-3 (ebook) DOI 10.1007/978-1-4757-3314-3 Library of Congress Cataloging-in-Publication Data A C.I.P. Catalogue record for this book is availab1e from the Library of Congress. Copyright 2001 by Springer Science+ Business Media New York Originally published by Kluwer Academic Publishers in 2001 Softcover reprint ofthe hardcover lst edition 2001 AII rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher, Springer Science+Business Media, LLC. Printed on acid-free paper.

TABLE OF CONTENTS Preface Acknowledgments Contributors vii ix Xl PART I: OVERVIEW: THE THEORY AND EMPIRICS OF CONTAGION 1. International Financial Contagion: An Overview of the Issues and the Book 3 Stijn Claessens and Kristin Forbes 2. Contagion: Why Crises Spread and How This Can Be Stopped 19 Stijn Claessens, Rudiger Dornbusch and Yung Chul Park 3. Measuring Contagion: Conceptual and Empirical Issues 43 Kristin Forbes and Roberto Rigobon 4. The Channels for Financial Contagion 67 Matthew Pritsker PART II: SPECIFIC MECHANISMS DRIVING CONTAGION 5. Crisis Transmission: Evidence from the Debt, Tequila and Asian Flu Crises 99 Jose de Gregorio and Rodrigo Valdes 6. Flight to Quality: Investor Risk Tolerance and the Spread of Emerging Market Crises 129 Barry Eichengreen, Galina Hale and Ashoka Mody 7. Mutual Fund Investment in Emerging Markets: An Overview 157 Graciela Kaminsky, Richard Lyons and Sergio Schmukler 8. Portfolio Diversification, Leverage, and Financial Contagion 187 Garry Schinasi and Todd Smith

VI Table of Contents PART III: CASE STUDIES OF CONTAGION 9. Thai Meltdown and Transmission of Recession within the ASEAN4 and NIE4 225 Tilak Abeysinghe 10. Financial Contagion in the East Asian Crisis: With Special Reference to the Republic of Korea 241 Yung Chul Park and Chi-Young Song 11. The Russian Default and the Contagion to Brazil 267 Taimur Baig and Ilan Goldfajn 12. Contagion of International Financial Crises: The Case of Mexico 301 Santiago Bazdresch and Alejandro Werner 13. Financial Market Spillovers: How Different are the Transition Economies? 329 Gaston Gelos and Ratna Sahay 14. Are Financial Crises Becoming More Contagious?: What is the Historical Evidence on Contagion? 367 Michael Bordo and Antu Murshid PART IV: IMPLICATIONS FOR POLICY AND THE INTERNATIONAL FINANCIAL ARCHITECTURE 15. International Contagion: Implications for Policy 407 Roberto Chang and Giovanni Majnoni 16. International Financial Reform: Regulatory and Other Issues 431 John Hawkins and Philip Turner PART V: ORIGINAL CONFERENCE PROGRAM 461

PREFACE 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. These questions are not simply "academic." There are a number of immediate, important issues. If there is contagion - imported crises so to speak - are capital controls the right answer as Malaysia concluded? How important is the choice of an exchange rate regime - fixed, managed or floating - on outcomes such as growth and financial stability? If contagion is not the critical issue, how can Asian countries that firmly hold that view be persuaded otherwise? If the volatility of major currencies is the problem, should the entire system be changed or should national balance sheets be better managed? These are interesting questions not only for national policy makers, but also for lenders who must contemplate their diversification and exposure risk in their emerging markets' positions. This book brings together a formidable body of research on every aspect of this problem. It approaches these questions from a number of very different vantage points. There are studies that question outright the wellaccepted contagion paradigm, while other chapters fully document the existence of contagion. There are studies focusing on fmancial channels in the transmission of crises, while other chapters highlight trade. Several studies highlight precautionary measures such as early-warning indicators, while others consider damage assessment and optimal policy responses. The strength of the volume is that it offers such a wide variety of views, rather than beginning with a common finding and imposing a common conclusion for every study.

viii Preface This book is based on a selection of the papers prepared for the conference "International Financial Contagion: How it Spreads and How it Can Be Stopped" held at the International Monetary Fund on February 3-4, 2000. The conference was jointly sponsored by the World Bank, Asian Development Bank, and International Monetary Fund, with initial funding provided by WIDER. Participants in the conference included representatives from international institutions, individuals from the private sector, leading academics and economists, and the press. The emphasis of the conference was on sharing and discussing current research on the financial market turmoil of the late 1990's. The conference concluded with a round-table discussion on how to rebuild the global financial architecture to reduce this turmoil in the future. It is difficult to avoid being impressed by the very high level of quality in this research collection. For those who attended the conference meetings, this comes as no surprise since the atmosphere was wonderfully dynamic and full of tough give and take. That flavor is not lost in this more formal rendition. The work reported here, far from resolving the issues, opens up an important area of applied research in terms of approaches and country studies. Before this conference, very little was available in this area. Policy makers, policy research departments and students of emerging-market finance will find a wealth of information in this book. They will also find some answers, plenty of controversy, and lots of open questions. The editors are to be congratulated for bringing together this important body of research. Rudi Dornbusch Massachusetts Institute of Technology

ACKNOWLEDGMENTS We would like to extend our thanks to a number of individuals. First, and certainly most important, we are extremely grateful to professors Rudiger Dornbusch and Yung Chul Park. Most of the papers in this book grew out of a research project that they started with the WIDER Institute in Helsinki. They not only initiated the project, but were actively involved in the resulting conferences and heated paper discussions. In the past few months, they have also provided guidance in publishing the conference and sharing its lessons. We would also like to thank several organizations that provided funding for this research. WIDER helped sponsor the project and finance the initial workshop in May 1999. The World Bank, Asian Development Bank, and International Monetary Fund provided further financial support, including commissions for a number of chapters in this volume. Their generous financing made this project and book possible. These papers are a selection of those presented at a conference entitled International Financial Contagion: How it Spreads and How it Can be Stopped, held in Washington, D.C. on February 3 and 4, 2000. (The full conference program is in the appendix at the end of the book.) We are grateful to the rapporteurs at that conference: Holger Wolf, Roberto Rigobon, Giovanni Dell' Ariccia, Andrew Karolyi, Enrico Perotti, Sole Martinez Perla, Peter Montiel, and Pradumna Rana. Each of the rapporteurs presented brief summaries and constructive comments on a set of papers. These comments were not only useful to the authors, but also provided an excellent overview for the audience of the main themes, agreements and differences of opinion across papers. Eduardo Borenstein and Giovanni Dell' Ariccia of the International Monetary Fund helped with the organization of the conference. Rose Vo was indispensable in making the conference run smoothly. We are also grateful to the World Bank for continued support that allowed the production of this book. Preparing this book for publication has been a challenging task. We are extremely grateful to Darcey Bartel for help with copyediting, and Rose Vo and Lynn Steele for help preparing the manuscript. Finally, thanks to Zachary Rolnik and David Cella of Kluwer Academic Publishers for production assistance. Stijn Claessens and Kristin Forbes

CONTRIBUTORS Tilak Abeysinghe - Professor, National University of Singapore Taimur Baig - Economist, International Monetary Fund Santiago Bazdresch - Economist, Banco de Mexico Michael Bordo - Professor, Rutgers University Roberto Chang - Professor, Rutgers University Stijn Claessens - Lead Economist, World Bank Jose de Gregorio- Professor, University of Chile I Ministry of Economy Rudiger Dornbusch- Professor, MIT Barry Eichengreen - Professor, UC Berkeley Kristin Forbes- Professor, MIT Gaston Gelos - Economist, International Monetary Fund Ilan Goldfajn - Professor, Pontificia Universidade Catolica Galina Hale - PhD Candidate, UC Berkeley John Hawkins- Senior Economist, BIS Graciela Kaminsky- Professor, George Washington University Richard Lyons - Professor, UC Berkeley Giovanni Majnoni- Advisor, World Bank Ashoka Mody - Lead Specialist, World Bank Antu Murshid - Professor, Rutgers University Yung Chul Park- Professor, Korea University Matthew Pritsker - Economist, Federal Reserve Board Roberto Rigobon - Professor, MIT Ratna Sahay - Advisor, International Monetary Fund Garry Schinasi -Division Chief, International Monetary Fund Sergio Schmukler- Financial Economist, World Bank Todd Smith- Professor, University of Alberta I International Monetary Fund Chi-Young Song - Professor, Kookmin University Philip Turner - Head of Secretariat Group, BIS Rodrigo Valdes - Economist, Central Bank of Chile Alejandro Werner- Economist, Banco de Mexico