Essays on financial contagion in emerging market economies

Matteo Cominetta

Economics PhD Theses from Department of Economics, University of Sussex Business School

Abstract: Since the collapse of the Bretton Woods system the integration of national financial markets grew steadily, to reach unprecedented levels. At the same time, episodes of extreme financial instability became more frequent. The latter were often extremely contagious, in the sense that country-specific episodes had hugely disruptive effects on financial markets across the globe. The literature on Financial Contagion investigates the channels through which that instability is propagated. This thesis deals with the two most recurring questions in the literature: What are the channels of macroeconomic instability propagation? A theoretical model of instability propagation in presence of currency mismatches is presented. The model shows that when domestic agents’ liabilities are denominated in foreign currency, exchange rate volatility raises credit costs, with negative real effects. Currency mismatches therefore create a channel through which external disturbances causing exchange rate volatility affect negatively the domestic supply. Several reasons why currency mismatches might magnify the effect of foreign disturbances have been identified by the theoretical literature on the issue. The empirical relevance of the magnification hypothesis is tested by investigating whether the degree of domestic output’s sensitivity to foreign output fluctuations is higher in countries where currency mismatches are widespread than in countries able to borrow abroad in domestic currency. The analysis gives strong support to the hypothesis: currency mismatches magnify the real effects of foreign disturbances. The analysis also highlights the presence of asymmetry of propagation: negative shocks have proportionally stronger real effects than positive ones in currency-mismatches-prone countries. Is the financial shocks propagation mechanism altered by major events such as banking or currency crises? The intensity of propagation of the crises in the ‘90s led researchers to ask whether the linkages between countries grew stronger during these turbulent times or were instead as strong before. Various tests of the instability of the propagation mechanism have been proposed since. These can be divided in two families: correlation-based and extreme-event-based tests. I propose a new approach, based on the Quantile Regression technique. It is argued that this approach retains the appealing features of the two families of test while avoiding some of their limitations. The new approach is then applied to stock market returns, finding strong evidence of instability of the propagation mechanism.

Date: 2011-06
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