Contagion is the spreading of the market disturbances from a particular country to others, a case observable through movements in the capital flows, stock prices, exchange rates, and sovereign spreads. Contagion is caused by the spillovers resulting from the countries' market economies' normal interdependencies. Claessens, Dornbusch, and Park (2001) affirm that the interdependence between countries is responsible for the transmission of shocks on the local or the global levels due to the financial and the real linkages. The market spillovers are termed as the contagion if they occur during a crisis causing adverse effects.
Contagion can also occur from the financial crisis resulting from the investors’ market withdrawal behaviors or other non-macroeconomic factors. Claessens, Dornbusch, and Park (2001) explain this type of contagion as a crisis in a particular country causing lead investors to withdraw from various countries' markets without necessarily analyzing economic fundamentals differences. In most cases, irrational phenomena including loss of confidence, financial panics, and increased risk aversion are responsible for the investors’ behaviors.
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Global shocks capable of triggering market changes at the international level include changing commodity prices and major economic shifts. More so, large capital inflows to various emerging markets have adverse effects on their economy. Claessens, Dornbusch, and Park (2001) identify East Asia's export down-turn and other financial repercussions during 1995-1996, as a result of the U.S dollar strengthening against the yen. Generally, common shocks result in co-movements in the capital flows or asset prices.
Contagion fundamental causes are macroeconomic shocks affecting countries at the international and local levels, which are transmitted through the financial links, competitive devaluations, and trade links (Classens, Dornbusch & Park, 2001). Currency devaluations and trade links act as a bridge through which crisis in a particular nation affects economic fundamentals in other nations. According to Claessens, Dornbusch, and Park (2001), a prominent trading partner of a particular country experiencing a financial crisis that has caused a significant currency depreciation tends to experience large capital outflows. Moreover, they experience reduced capital asset prices and speculative attacks, with the investors anticipating declining exports to the country with the crisis. Therefore, contagion tends to affects markets negatively, especially by causing deterioration on the trading account. More so, negative effects from the instability episodes’ in the countries of origin are quickly transmitted to different international markets.
Claessens, S., Dornbusch, R., & Park, Y. C. (2001). Contagion: Why crises spread and how this can be stopped. International financial contagion (pp. 19-41). Springer, Boston, MA.