International financial contagion and currency crises

International Financial Contagion in Currency Crisis

The authors in the Journal of International Money and Finance argue that market crises seem to spread from one country to another in a kind of "contagion" (Caramazza, et al., 2004). Why does this happen? They wonder first of all what makes one crisis "…spill over to others," and moreover, the factors that might account for the "…temporal clustering of crises" appear to break down into four areas of concern.

First, when a financial glitch occurs in one country -- like the increase in U.S. interest rates in the 1980s, which contributed to the 1994-95 Mexican peso crisis -- it is considered a "common shock" and deserves close observation; secondly, if a country depreciates its currency, that act can negatively impact its trading partners (Caramazza, 53). The third aspect references the fact that investors quickly rid themselves of their assets when a crisis occurs, contributing to the downslide in other countries, Caramazza continues (53); the fourth aspect relates to countries that have weakness in their financial systems can more quickly be sucked into the contagion.

On page 56 Caramazza backs up the assumptions made by pointing out that during the Mexican peso crisis, nine other countries had "substantial currency pressures" within six months of that Mexican crisis. As to how these countries fall prey to financial downslides, one important account Caramazza and colleagues embrace -- the benchmark model -- is among the more easily understood and logical explanations: to wit, if there was slow GDP growth in the three years previous to the crisis and if the exchange rate appreciated in those same three years prior to the crisis, that suggests the corrective policies were not known, or worse, were not put in place (Caramazza, 58).

On page 60,. Another variable is exposed by Caramazza, in a very adroit observation, is the fact that these three crises are linked because they have a culprit in their "common creditor"; add to that the slowdown in the GDP, and therein is to be found a good share of the spark that ignites the flames of fiscal crises. The case that Caramazza makes for the common creditor is at least as convincing as the other cases he makes, if not more so. The benchmark model is believable and well presented, but the linkage with the common creditor makes more sense. An example can be found, for example, if Trader Joe's grocery store, Ralph's, and Safeway all buy their peanut butter product from the same distributor and it turns out there is salmonella bug in that distributor's product. A common source negatively impacts all three stores, just as a common creditor can flounder and all three struggle, or the common creditor can be tightening credit to all three at a time when interest rates need to be lowered to avoid a serious interruption in financial services.

The Asian Crisis in Focus

"The Asian region did not have a comparable collective breakdown in the post-World War II period. In fact, the crisis was the first event after the Great Depression to seriously threaten the financial stability of the global economy" (Beja, 2007, p. 57).

Meanwhile, author Kanaoka wonders if the proper lessons have been learned vis-a-vis the Asian financial crisis. Those lessons should be learned and notes taken by important players lest a kind of deja vu rears its head. One scholarly opinion -- put forward by Land and Milesi-Ferretti, (2010) and Blanchard, Faruqee, and Das (2010) -- holds that the ratio of reserves to short-term external debt" explains how the crisis became so serious. Blanchard adds that short-term debt is the culprit more than reserves (Kanaoka, 2012). Another scholarly opinion -- by Llaudes, Salman, and Chjivakul (2010) -- suggests that the reserves were not the problem but in fact they helped "dampen the impact of the crisis on emerging market economies" (Kanaoka).

Still another scholarly viewpoint is expressed in this article with reference to how the Asian economies responded to shocks from other crises. By accounting for the real GDP growth changes during the two crises (in the three years prior to the crises) the author determined whether Asian economies in fact became more vulnerable or robust during the external shocks discussed earlier in this paper. Using some esoteric math, Kanaoka concludes that those lessons he wondered about at the outset of his scholarship have indeed been applied "in two areas." They are: a) the "external short-term debts that came within half of the total foreign reserves"; and b) the current accounts that had shifted from deficits to surplus improved in "almost all economies" (Kanaoka).

Mexican Peso Crisis

What was the root cause of the severe financial crisis in Mexico? Author Gonzalo Castaneda asserts that first of all Mexico "…badly managed" its financial liberalization, and secondly, because it caused disruption of the exchange rate by "overshooting," many banks became seriously overburdened with defaulted loans and hence, went bankrupt (Castaneda, 2007, p. 427). Castaneda adds that when banks simply couldn't loan money anymore, and the private sector "diminished by 72% between 1995 and 2000, things went downhill and landed in crisis.