Following the 1997 financial crisis in East Asia, the issue of contagion has resurfaced. Contagion has most often been associated with high frequency events; hence, it has been measured on stock market returns, interest rates, exchange rate or linear combinations of them. This paper tests for evidence of contagion between selected East Asian stock markets, thereby exploring the importance of the linkages between stock markets as a transmission channel during the crisis.
The crisis that struck Thailand when it devalued its baht in July 1997 and the subsequent contagion that crippled East Asian economies throughout the following two years surprised many due to its rapidity and its pervasiveness – by mid-1998, most of the economies in the region were in crises of a similar nature, and the effects of contagion impacted both the real and monetary sectors for the economies in which they afflicted.
Indeed, even as globalization proceeds apace, the increased capital flows between economies is likely to exacerbate, not reduce, the interdependence of economies and consequently, the heightened possibility of contagion. This was clearly illustrated by the contagion scare in late 2000 when unfavorable developments in both Argentina and Turkey threatened afresh fears of a new round of emerging market crises and contagion.
Perhaps foremost in the list of pressing questions is the extent to which contagion might affect or influence otherwise sound economies, and how these effects might somehow be mitigated. Research efforts have consequently been directed towards these two aspects: one an ex ante preventive and precautionary measure, and the other an ex post control and recovery one.
This paper proposes to address the former aspect of the question in greater detail. In particular, it will apply a range of empirical tests on the stock markets in East Asia in order to draw some tentative conclusions as to how far these markets are interrelated, and implicitly, the degree to which a collapse in one might lead to a similar phenomenon in another. Specifically, it employs two of the four strategies commonly encountered in the literature – namely, correlation methods (the most basic), and the vector autoregressive (VAR) approach (the workhorse model in the empirical literature). Its primary contribution, in employing rigorous empirical tools to study the existence and extent of contagion in the equity markets of East Asia, is to inform the policy debate, especially since the performance of stock markets are a commonly used leading indicator.
