Ebook Understanding the Asian Contagion: “An International Business Cycle Perspective”
“Contagion” is a loaded word. Many believe that it can explain most, if not all, dimensions of the recent economic crisis that originated in Thailand, and rapidly spread to several other countries in Asia, Russia, and Latin America. When a country with seemingly stable fundamentals suddenly collapses following an economic crisis in another country, contagion seems to be a perfect word describing the spread of the Crisis from the source country to the others.
However, there is no consensus even as to the definition of contagion. Some define contagion in a broad sense as the transmission of shocks from one country to another through various channels, even those we observe in normal times. Others narrowly define contagion as specific transmission channels that we observe only during periods of crisis and that cannot be explained by the standard propagation channels emphasized in the broad definition. The excess variation and comovement during times of economic turbulence, not captured by the standard channels, constitutes contagion.
On the other hand, some argue that contagion is a myth and that problems associated with domestic fundamentals of these economies initiated the Crisis. In other words, there is no pure contagion without some fundamental domestic economic problems that all these countries have accumulated before the initiation of the Crisis. Hence, what appears to be contagion is merely symmetric structural weaknesses.
This paper analyzes the contagious nature of the Asian Crisis by investigating the two prevailing explanations mentioned above: (1) transmission of adverse shocks through various channels, and (2) symmetric problems in domestic economic fundamentals. This paper does not intend to investigate the sources of the Asian Crisis, which has already been studied extensively. Instead, we focus on explaining why the crisis rapidly spread to several countries in the region.
To study the role of transmission of shocks, we adopt the broad definition of contagion and examine three transmission channels—trade channel, financial channel, and pure contagion. We analyze how these channels work to transmit shocks across countries and survey recent research on these issues. We also employ simple statistical methods to empirically validate each channel.
We, then, investigate whether the contagion can be explained by common fundamental economic and financial problems in this region. We study business cycle features of these countries to find any comovements of macroeconomic and financial variables. If cross-country correlations among the Crisis countries show significant increases over time in the pre-crisis period, then the comovement of domestic fundamentals during the crisis period can be explained without much difficulty. We also investigate the role of common shocks in the region that may have led to similar cyclical fluctuations in these countries.
The three transmission channels work as follows: First, transmission of shocks through the trade channel occur when the devaluation of one country in response to a country-specific shock affects the economic fundamentals of other countries through terms of trade and income effects. In particular, if a group of countries compete for the same export markets, when one devalues its currency and builds a competitive edge in export markets, the other countries might soon have to devalue. Many researchers have analyzed spillovers through the trade channel even before the Asian Crisis.
Second, the financial channel considers the role of international investors and their contribution to the spread of the Asian Crisis. When an emerging country is hit by an economic crisis, all international market participants reevaluate their positions in other emerging countries and may withdraw their funds from those countries. Possible reasons for this include restoring capital-adequacy ratios, satisfying margin calls, lack of liquidity, etc.
Finally, unlike the mechanical spillovers discussed above, pure contagion is related to shifts in market sentiments and perception towards risk. In other words, contagion takes place because the initial country-specific shock is artificially replicated in other countries by the sudden reversal in the market’s perception about the state of those economies. This type of transmission, however, should be only a short-run phenomenon.
To understand the role of domestic fundamentals in explaining contagion, we investigate the business cycle features of these countries regarding volatility and comovements of the components of national expenditure. If these countries' macroeconomic data share similar cyclical properties even before the Crisis, the contagious nature of the Asian Crisis can be explained by the synchronization of economic fundamentals. However, if the business cycles show no similarities, then the observation that the Crisis happened at the same time in Asian countries should require some other explanations specific to the crisis period.
We also examine the role of external shocks that simultaneously affect several countries. For example, oil price shocks, fluctuations in the prices of primary commodities, and exchange rates and interest rates of key countries can affect many countries at the same time. These shocks may have weakened the fundamentals of the crisis countries at the same time and make them vulnerable to crisis.
The remainder of this paper is organized as follows. We first examine three transmission channels and discuss how each channel explains the contagious nature of the Asian and other crises. Then, we survey recent empirical studies of each channel. In particular, we document the key properties of the data of Asian Crisis countries that enable us to examine the validity of trade and financial channels. Next, we analyze business cycle features of the countries that have experienced the Crisis–Korea, Indonesia, Malaysia, the Philippines, and Thailand–and investigate the similarities and differences of cyclical fluctuations of various macroeconomic and financial variables. We then study whether common shocks have contributed to the synchronization of business cycles in these countries. The final section concludes the paper.
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