The 'Big C': Identifying and Mitigating Contagion

Abstract

This paper defines “interdependence” as high correlations across markets during all states of the world and “contagion” as the spillovers from extreme negative events. Interdependence has increased dramatically over time, especially within the euro area, even after controlling for global shocks and changes in volatility. Not surprisingly, negative events in one country also quickly affect others. Regression analysis shows that a country is more vulnerable to contagion if it has a more levered banking system, greater trade exposure, weaker macroeconomic fundamentals, and larger international portfolio investment liabilities. Countries are less vulnerable, however, if they have larger international financial portfolio investment assets (which can provide a buffer against shocks) and are less reliant on debt (versus equity) for international financing.

The analysis has a number of implications for evaluating policies aimed at mitigating contagion. Instead of limiting integration through trade and financial flows, countries should focus on reducing leverage in their domestic banking systems, strengthening macroeconomic fundamentals, balancing investment liabilities with international assets, and avoiding preferential treatment for debt financing. Countries that face imminent risks of contagion should evaluate additional policies based on whether they can permanently thwart a channel for contagion versus simply delay an inevitable adjustment. Any analysis of policy options should also consider the international externalities generated by contagion. Although this paper does not provide a complete analysis of current challenges in the euro area, the analysis and framework can help prioritize various proposals. Certain policies (such as well-designed deposit insurance to prevent bank runs) can be better justified to mitigate contagion than several other proposals that could instead increase contagion through other channels.

Keywords: Contagion

JEL Classification: F3, F42, G01, G15