- Fundamental based theories
- Correlated shocks across countries
- i.e. Raw material price shocks (Oil)
Trade linkages among countries
Financial linkages (Common institutional lenders ie bank/hedge funds)
1.Crisis occurs in Country A
2.Value of assets in the lender’s portfolio falls
3.To restore solvency, the lender tightens credit to borrowers in Countries A & B, C, D, … sells assets in portfolio in Countries A & B, C, D, ….
4.Country B, C, D, ….’s asset prices fall
5.Capital flight occurs in Country B, C, D, ….
6.Countries B, C, D, …. suffer a currency crisis
•Fund managers are compensated based on how they perform relative to other fund managers: it is better to fail in good company than to succeed alone!
–Withdrawal of funds in one country by one fund, may lead other managers to withdraw their funds in geographically or economically similar countries
Because information is costly, small investors find it cost effective to follow large investors with established reputations (and withdraw their funds in geographically or economically similar countries)
- •A crisis in one country effectively alerts investors to look for similar weaknesses in other countries
- •A change in international banking regulations or IMF policy might cause investors
- to reevaluate their risk exposure across several countries
•A crisis in one country leads speculators/investors to believe that other speculators/investors are going to attack/flee other counties……
•Regardless of economic fundamentals, speculators/investors begin to withdraw their funds across a range of countries and the crisis spreads