Contagion

Journal of International Money and Finance 23 (2004) 51–70 www.elsevier.com/locate/econbase

International financial contagion in currency crises
Francesco Caramazza, Luca Ricci Ã, Ranil Salgado
International Monetary Fund, Washington, DC 20431, USA

Abstract This paper examines the role of financial linkages, especially through a common creditor, in the propagation of emerging market crisesduring the 1990s. Using panel probit regressions on 41 emerging market countries, it finds that financial linkages played a significant role in the spread of the Mexican, Asian, and Russian crises. The significance of financial linkages emerges after controlling for the role of domestic and external fundamentals, trade spillovers, and financial weaknesses in the affected countries. A strong financiallinkage to the crisis country of origin not only substantially raises the probability of contagion, but also helps to explain the observed regional concentration of currency crises. # 2003 Elsevier Ltd. All rights reserved.
JEL classification: F31; F32; F34; F41; G15 Keywords: Currency crises; Emerging markets; Contagion; Trade and financial spillovers

1. Introduction A prominent feature of thefinancial crises that have engulfed emerging market economies in recent years—the Mexican crisis of 1994–95, the Asian crisis of 1997, and the Russian crisis of 1998—was the spread of financial difficulties from one economy to others in the same region and beyond in a process that has come to be referred to as ‘‘contagion’’. Policymakers and researchers have increasingly wondered about the nature of thesecrises, the factors responsible for their spread, and, particularly, whether a country with seemingly appropriate domestic and external fundamentals can experience a crisis because of contagion.
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Corresponding author. Tel.: +1-202-623-6007; fax: +1-202-623-6343. E-mail address: lricci@imf.org (L. Ricci).

0261-5606/$ - see front matter # 2003 Elsevier Ltd. All rights reserved.doi:10.1016/j.jimonfin.2003.10.001

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F. Caramazza et al. / Journal of International Money and Finance 23 (2004) 51–70

This paper extends earlier work on indicators of currency crises by looking at factors that render a country vulnerable to contagion and enhance the risk that a crisis in one country will spill over to others. It focuses on the role of financial linkages, through common bank lenders, asan important channel of transmission of exchange market pressures from one country to another during the major crisis episodes of the 1990s. When countries have a common creditor, a financial crisis in one country (country 1) can lead to financial market pressures in some other country (country 2) if, owing to the need to adjust its loan portfolio, the creditor curtails her lending or recalls someof her loans to country 2. The contagion effects stemming from the portfolio adjustment by the common creditor will be stronger the larger the share is of the common creditor’s portfolio that is lent to country 2 and the larger the share is of country 2’s external liabilities to the common creditor. The results of panel probit regressions for 41 emerging market economies indicate that once domesticand external fundamentals as well as trade spillovers have been controlled for, financial linkages and weaknesses play a significant role in explaining the spread of crises.1 Notably, a strong financial linkage to the first crisis country through a common creditor is the most important, significant, and robust variable: it not only substantially raises the probability of a crisis but also provides aneconomic rationale for the apparent regional concentration of these crises. Section 2 briefly reviews the explanations of contemporaneous currency crises found in the literature, focusing on spillovers and contagion. Section 3 provides the empirical analysis, and Section 4 concludes.

2. Explanations of the transmission of crises across countries A large body of the empirical literature on...