Introduction
The increase in the rate of globalization has resulted in improvement in the economic performance of various economies. However, it has also resulted in increased chances of the financial crisis occurring. This is due to the fact that globalization results in increased financial linkages amongst various economies. This was experienced by the emerging economies during the 1990s with the occurrence of three major financial crises as the Asian, Russian and Mexican financial crises. These financial crises had economic impacts on other economies. This paper is a case study analysis of ‘international financial contagion in the currency crisis.’ The paper involves an analysis of the techniques and assumptions used in investigating the importance of financial weaknesses and linkages in the three crises.
Assumptions
The increased need for rebalancing portfolio investment
Upon the occurrence of a financial crisis in one country, there is increased demand by the investors to mitigate the chances of loss by rebalancing their portfolio. This is due to the fact that there is increased risk exposure. It is assumed that investors rebalance their portfolios for two main reasons. These include a risk management strategy and high liquidity characteristics. According to Francesco, Luca and Ranil (2004, p. 53), foreign investors in financial assets in the country where the crisis originated sell their financial assets that are positively correlated to those of the crises country.
It is also assumed that financial contagion results from the increase in a margin call. Margin call refers to an amount of money that an investor is required to raise by his or her broker so as to maintain his or her account to the required margin. For instance, upon the occurrence of a crisis in one country, the foreign investors in that country will be required to meet their margin call. One of the strategies that they consider is selling their financial assets in the domestic market due to their high liquidity characteristic. This increases the financial vulnerability of the other country.
Change in the sentiment of investors
The authors also assume that financial weakness and linkage also result from a change in the sentiment of the investors. This mainly results from changes in financial and macroeconomic fundamentals. Economies that have got weaker financial and macroeconomic fundamentals are more vulnerable to financial contagion from others suffering from a currency crisis. The occurrence of financial crises in one country results in financial markets evaluating the fundamentals of other countries. From such evaluation, investors shift their investment from countries that are deemed to have weak fundamentals due to increased speculation.
Interaction of common shocks
It is also assumed that financial contagion also results from the existence of a number of common macroeconomic fundamentals. An increase in interest rates in the US is assumed to be one of the major causes of the financial crises in Latin American countries. On the other hand, the increased appreciation of the US dollar and weak economic growth in Japan is associated with a weak external economic sector in Asian countries.
Techniques used
In analyzing the importance of financial weaknesses and linkage, the technique used is panel probit regression. Through the panel, probit regression helps in illustrating that financial linkage and weaknesses contribute towards the transmission of financial crises once the major fundamentals have been controlled (Francesco et al, 2004, p.52). In addition, the benchmark model is also incorporated. The benchmark model enables the identification of control variables. A set of two explanatory variables have been considered which include economic indicators and a surrogate of trade contagion. According to Francesco et al (2004, p.58), these two control variables make it possible to investigate the second set of variables. The second set of variables is related to the importance of the financial weakness and linkage. This makes it possible to determine the variable which indicates the highest probability of resulting in financial crises.
From the study conducted by Francesco and colleagues, it is evident that the common creditor is the most significant and significant variable in explaining the regional concentration of crises. This is evident from the fact that when there is a single creditor between countries, the existence of financial market pressure in one of the countries can easily be transmitted into another country. For instance, the common creditor can reduce her lending capacity to the other countries or recall the loans that have been advanced to the other countries. This will result in financial constrain for the particular country which might result in a concentration of financial crises.
Conclusion
Globalization has resulted in increased transmission of financial crises amongst countries. Various assumptions have been considered in analyzing the importance of financial weaknesses and linkage in the Asian, Mexican and Russian financial crises. These include the need to rebalance the portfolio investment, changes in investment sentiment amongst the investors, and the existence of common shock. The increased exposure to risk increases the need for investors to rebalance their portfolios. Common shocks that are assumed to cause financial contagion include interest rate, slow economic growth rate, and currency appreciation. Two major techniques have been used in this case. These include the panel probit regression and the benchmark model. The existence of a common creditor is one of the reasons for the existence of financial contagion. This is due to the fact that the reaction of the lender can increase the vulnerability of the borrowers.
Reference list
Francesco, C, Luca, R & Ranil, S. 2004. International financial contagion in currency crisis. Journal of international money and finance. Vol. 23, pp. 51-70. Washington DC, USA: International Monetary Fund.