International financial contagion

Financial contagion is the spillover of a financial crisis from one country to another. Investors flee from one country and then the capital flight starts in other countries in the region and even globally.

There are various reasons for the contagion. If one of the major economies in a region is in a recession, that may drag down the rest of the economies. Their exports decline; the firms reduce investment; and lay off people. It is reasonable for international investors to expect that the recession would spread throughout the region. Naturally, they reduce their investments in all countries.

However, the contagion may happen without an economic rationale. Foreign investors may not distinguish between various emerging markets. Because they can diversify their investments across many countries, they don’t have an incentive to stay informed about any one particular country. Instead, they spread the risk regionally and globally.

Then, even small (and possibly incorrect) news pieces can trigger capital flight. It may be easier to pull out of, say, Indonesia than to figure out if Indonesia is in any economic trouble. Even more, investors may flee an entire region because they heard that one of the countries is having a problem servicing its debts. That may have nothing to do with the other countries in the region.

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