Exposure to International Crises: Trade vs. Financial Contagion

Abstract

I identify new patterns in countries’ economic performance over the 2007-2014 period based on proximity through distance, trade, and finance to the US subprime mortgage and Eurozone debt crisis areas. To understand the causes of the cross-country variation, I develop an open economy model with two transmission channels that can be shocked separately: international trade and finance. The model is the first to include a government and heterogeneous firms that can default independently of one another and has a novel endogenous cost of sovereign default. I calibrate the model to the average experiences of countries near to and far from the crisis areas. Using these calibrations, disturbances on the order of those observed during the late 2000s are separately applied to each channel to study transmission. The results suggest credit disruption as the primary contagion driver, rather than the trade channel. Given the 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, so long as there is not capital immobility to the degree that the local sovereign can default without suffering capital flight.

Keywords: Economic crises, contagion, endogenous costs of default, sovereign default, banking crisis, Great Recession, Eurozone debt crisis

JEL Classification: E32, F40, F41, F44, H63