Prevent contagion Essay

This essay has a total of 1602 words and 8 pages.

prevent contagion

Globalization has been the theme directing the future. Yet, as Mr. Henry M. Paulson,
chairman and CEO of Goldman Sachs Group Inc. recently acknowledged, national and regional
markets are linked only in “precarious ways” leading to weak spots within the economy and
fueling the possibility for regional or even worldwide financial crises (Peck Ming, 12/8,
p.1). In just the past 12 years, three major crises have caused tremors felt around the
world. All three examples represent incidences of contagion, or “the interaction between
financial sector crises and balance-of-payments crises in which a loss of investor
confidence may set off vicious cycle of capital flow reversals, a liquidity squeeze and a
depressing currency” (Internet 2, p. 2). And all three help illustrate the need for a
remaking of the international financial architecture in order to prevent future
occurrences of contagion (Garten, 1/29, p. 1).

Contagion no doubt remains a fuzzy topic for which no single definition exists. Most
scholars and economists agree that contagion is the “transmission of a crisis that is not
caused by the affected country’s fundamentals but by its ‘proximity’ to the country where
a crisis occurred. By proximity, academics refer to one of two situations. First, real
integration contagion occurs when a devaluation and financial crisis in one economy
worsens the competitiveness of others and lowers the trade balance thus devaluing those
currencies. The strength and speed to which such a crisis spreads is directly related to
the strength of the trade and investment link. The second, deemed financial integration
contagion, occurs when a crisis in one market convinces investors to pull out from other
markets either to “raise cash for redemptions or balance their portfolios” or to follow
investors to reduce losses in closely integrated financial markets therefore raising the
probability that those markets will also suffer a crisis (Internet2, Fratzscher, 12/16,
p.3). The second form suggests that investors often invest without complete information
and often apply the problems of one country onto the problems of related countries with
similar national indicators or economic fundamentals. Therefore, investors often fleet
healthy economies, and thereby help the spread of the crisis (Internet2, Fratzscher,
12/16, p.3).

The most recent crisis, the Asian crisis and the problems in Thailand that help set it
off, provides a wealth of information and insight into methods to predict, correct, and
prevent incidences of contagion in the future.

Perhaps the most perplexing feature of the Asian crisis was not its size, but that it hit
some of the best performing economies in the world. The three countries hit hardest
(Thailand, South Korea, and Indonesia) had sound economic fundamentals leading into the
crisis. All had high savings, education and skill development programs, currencies pegged
to the U.S. dollar, little inflation, and nearly balanced government budgets. In 1996,
the year before the crisis hit, they all posted GDP growth rates of 7 to 8 percent
(McCall, 4/27, p. 4-5). Capital, both in the form of bank loans and equity investments,
poured into the area as investors were attracted by these conditions and the possibility
to achieve higher rates of return. And because the baht was pegged to the U.S. dollar,
foreign exchange risk was virtually zero and companies rushed to borrow in U.S. dollars
for baht liabilities since interest rates for the U.S. dollar were about half those of the
baht rates (Peck Ming, 12/8, p.1-3). Domestic asset prices soared as investors from
primarily the U.S., Western Europe, and Japan poured in (McCall, 4/27, p. 4-5). So what
went wrong?

For starters, companies could only borrow short term money though they used it to fund
long term projects. Because of the large inflow of capital, foreign banks were allowing
the short term loans to be rolled over upon maturity. Investors deciding to pull out for
any reason could not because their money was tied up. The accumulation of large amounts
of short term debt proved to be a critical weakness as problems of “overinvestment,
inflated domestic asset prices, and deteriorating loan quality” arose (Camdessus, 1/16, p.
3). With inadequate risk assessment by foreign investors, weak bank supervision and
regulation, and access to short term capital that was not adequately monitored, the
economy became vulnerable to shifts in investor sentiment. These countries were all
export-dependent and ended up in a dead-end when China expanded its productive capacity
and devalued the yuan by 35% in 1994. Further, between 1995 and 1997, the dollar rose 60
percent relative to the Japanese yen, leaving East Asian nations with overvalued
currencies. This hurt domestic growth. As external competitiveness dropped, there was
strong downward pressure on the Thai baht that made maintaining the fixed exchange rate
difficult. As investors around the globe began taking short positions on the baht,
downward pressure intensified and on July 2, 1997, the Thai baht was depegged from the
U.S. dollar. Devaluation caused many business in Thailand to sink and pushed many into
serious debt and investors withdrew as much capital from the area as they could recover
(McCall, 4/27, p. 4-5).

The first “domino” of the Asian crisis had fallen. Not too long after, the Philippines
and Indonesia followed suit. In just over three months, the value of the baht and the
rupiah fell 30 percent relative to the dollar and the contagion spread (McCall, 4/27, p.

With trade patterns clearly defined and well-known, a case of economic contagion can often
be predicted once the first country falters. Strong trade and investment links with the
country in crisis and heavy trade competition with the country in question act as good
indicators. However, since trade partners and economic links are not easily or quickly
modified, little can be done to prevent the spread of this type of contagion other than
making rapid policy changes such as contracting the money supply or tightening
restrictions on bank lending. Therefore, real integration contagion is not difficult to
predict but is often difficult to stop (Internet 1, Anon).

On the other hand, financial integration contagion—crises spread by incomplete
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