Exposure to International Crises: Trade vs. Financial Contagion
68 Pages Posted: 1 Sep 2015 Last revised: 28 Jul 2016
Date Written: November 2, 2015
I identify new patterns in countries' recoveries following the 2008 Global Crisis based on proximity through distance, trade, and finance to the US subprime mortgage and Eurozone debt crisis zones. To understand the causes of the cross-country variation in recoveries, I develop an open economy model with two transmission channels that can be shocked separately: cross-country trade and finance. The model is the first to include a sovereign and heterogeneous firms that can default independent of one-another, along with having a novel endogenous cost of sovereign default. I calibrate the model to the experiences of representative countries near and far from the crisis areas. When a crisis occurs abroad in the model it produces output contractions in the representative countries similar to those actually observed, without explicitly targeting the declines. Using these calibrations, disturbances on the order of those observed during the late 2000s are applied to each channel separately to study transmission through them. The results suggest credit disruption as the primary contagion driver, rather than the trade channel. Given this substantial degree of financial contagion, I run a series of counterfactuals studying the efficacy of capital controls and find that they would be a useful tool for preventing similarly severe contagion in the future, as long as there is not capital immobility to the degree that the local sovereign can default without capital being able to flee the country.
Keywords: Banking crisis, Eurozone debt crisis, Economic crises, contagion, endogenous costs of default, sovereign default, Great Recession
JEL Classification: E32, F40, F41, F44, H63
Suggested Citation: Suggested Citation