Financial Market Contagion:

Investigating Global Impact of the Asian and Russian Crises Using Multivariate GARCH Model

by

Ahmed M. Khalid*

and

Rajaguru Gulasekaran*

March 2005

Abstract

The increased episodes of the financial crises throughout the world in the 1990s have motivated researchers to identify the channels through which such crises spread from one country to the entire region and across regions and to suggest policies to avoid the worst of such crises. Researchers have identified several factors that may spark and induce contagion of the crisis. Economies closely linked to each other suffered similarly from the onset of crises. This also implies that, even economies with strong fundamentals could not escape contagion. This study attempts to identify and test three financial market variables to trace the alleged origin and the subsequent path of the contagion during the 1997 Asian crises and the 1998 Russian crises. The foreign exchange rates, stock market prices and interest rates are useful indicators for this purpose. In the preliminary phase, we use high frequency data and construct VARs for a variety of sub-samples and test the interlinkages among different market and different regions using the Granger causality and impulse responses. The evidence suggests that most of the exchange rates and stock prices within and across the regions are strongly linked and may have had provided a channel for contagions during the above stated crises. However, the evidence for interest rate linkages is less supportive. The analysis is being extended by using multivariate GARCH approach. This extension is underway and the results will be available as soon as we finish it but definitely by the time of paper presentation.

JEL Classification: F30, F31, F32, F34, F41,

Key words: Asian Crisis, Russian Crisis, Market Linkages, VAR, Causality, Contagion

Corresspondance to: Ahmed M. Khalid, Associate Professor of Economics and Finance, School of Business, Bond University, Gold Coast, QLD 4229, Australia, Fax: (617) 5595-1160, E-mail:

* Bond UniversityAustralia

Financial Market Contagion

Investigating Global Impact of the Asian and Russian Crises Using Multivariate GARCH Model

1. Introduction

The decade of 1990s witnessed significant increase in the episodes of financial crises and financial market collapses in various regions around the globe. It is argued that inappropriate and hasty financial sector reforms in many parts of the developing world in the 1990s left the markets unstable and vulnerable to even minor shocks. The increased financial and trade sectors interdependence within a region further aggravated the problem. The crises in Latin America (1994), Asia (1997) and Russia (1998) are examples of such shocks spreading from one country to another. In the literature, this is labeled as contagion. As a result, there is a growing concern among researchers and policy makers to investigate the cause and effect of such crises.

Many economists, in the recent past, have studied this phenomenon both theoretically and empirically. Recently, some studies have focused on the issue of currency contagion using data from Latin American and Asian countries. However, the existing research has several limitations. This study attempts to provide a more comprehensive and broader coverage to this issue. We argue and provide evidence that financial market contagion cannot be restricted to currency market only. We use a broader definition of financial market contagion using three important finacial market indicators. We also provide empirical which does not support the view that financial contagion is a regional issue. Our empirical results show that markets across regions are affected by a downfall in one market in a particular country or region. Depending on the extent of market linkages, policy makers in a specific country may need to take some precautionary policy measures if the crises in a closely financially linked country are imminent. As a flip side of the coin, if the markets are very much integrated, it may be possible for the whole region to enjoy positive spillovers when the crisis originated country experiences a recovery.

Specifically, this paper studies the co-movements of three market indicators namely the exchange rates, the stock price indices, and the interest rates. We use a comprehensive sample of six regions, namely, East Asia, South Asia, Latin America, Eastern Europe, Africa and the Middle East. We look at several scenarios including cross-country contagion in a single market and within and across regions in a selected sample of countries from all above stated regions. We use daily observations and focus on the crisis period comprising of three major financial crises in the 1990s namely, the 1997 Asian financial crisis and the 1998 Russian financial crisis. We construct a VAR (vector autoregression) model suitable for our analysis and apply econometric tests to investigate inter-linkages and causality. We also study impulse responses by introducing shocks to a market in one country and see the impact and duration of this shock to the countries in the region as well as across the regions.

This study is organized in the following manner. Section 2 provides a historical perspective of the crises in Asia (1997) and Russia (1998) with a focus on contagion. Section 3 reviews the theoretical and empirical literature on contagion. Data and estimation techniques are discussed in section 4. Section 5 reports the results various tests of causality and impulse responses both cross-country and cross-market-cross-country as well as Multivariate GARCH model. Finally, the conclusions are drawn in section 6.

2. Financial Market Contagion: Historical Perspective

This paper focuses on two episodes of crises in the developing world namely, the 1997 Asian Crisis due to Thai baht devaluation and the 1998 Russian Crisis originating from Russia’s default on external debt payment. It is to be noted that the negative impact of these crises were not restricted to the respective regions only but were felt to the global economy. A comprehensive study by the World Bank supports this argument.

World Economic Outlook 1999 reports the results of a comprehensive study involving 60 industrial and emerging economies to analyze the impact of some important crises during 1990s[1]. According to this study, 9 countries experienced substantial currency pressures during Latin American crises, while the number was 10 and 13 during Asian and Russian crises respectively. The study also identifies substantial rise in interest rates during all these crises. The Mexican crises resulted into a decline in stock prices by 35 percent in Argentina, Brazil and South Korea, 30 percent in Peru and 20 percent in Hong Kong while markets in Indonesia, Malaysia, the Philippines and Thailand were affected by a lesser degree. During Asian crises, stock markets in Brazil and Hong Kong fell by 30 percent, India by 17 percent while loss to the stock markets in Indonesia, Malaysia, South Korea and Thailand was around 40 percent. Finally, the study reveals that the Russian crises, which dropped stock prices in Russia by over 30 percent, left the global markets down by at least 10 percent.

The 1997 Asian Financial Crisis:

The 1997 Asian Financial Crisis originated by the move to free float Thai currency on 2nd July 1997 and resulted into a collapse of the baht. The sequence of events later spread the currency crisis into a full blown financial and economic crisis not only in Thailand but the entire East region and then to the world[2]. In a short time span of few months, most of the regional economies which were enjoying double digit economic growth were trapped into the worst recession of the last four decades. IMF was invited to help-out these economies when the domestic policies failed to respond to negative shocks. The IMF intervened first in Thailand, then in the Philippines, later in Korea and Indonesia. Malaysia was not intervened by the IMF[3].

The highlights of the events unleashed by the baht contagion may be summarized by making a few generalizations. The Thai baht experienced the initial speculative attacks as early as February 1997. A series of such attacks were defended by Central Bank intervention in the foreign exchange market including forward purchase of the baht. Eventually, on July 2, 1997, the Central Bank gave up defending the currency and decided to devalue the baht. The contagion from the July 1997 baht crisis spread quickly by August 1997 to the Philippines, Malaysia, Korea, and Indonesia.[4] The Philippines also defended the peso at the early stage of contagion but decided to allow the currency to move within a wider band on July 11 1997. Malaysia’s initial response was not different, they rather had a strong defense of ringgit but fell to the pressure in mid-July. When contagion spread to the Indonesian rupiah, the authorities decided to abandon the managed float system and let the currency freely float. Finally, the Korean won, which had been spared of the contagion, came under attack and was freely floated in December 1997.

By the end of 1997, currency depreciation in US dollar term was severe and unprecedented in Asia. At the peak of currency crisis, losses relative to June 1997 exchange rates were: Thai baht 56 per cent; the Philippines peso 54 per cent; Malaysian ringgit 40 per cent; Korean won 78 per cent; and Indonesia rupiah 76 per cent. Second, the contagion weakened those affected countries to sustain their imports, which forced them to take measures to reduce imports, and then borrow to redress the damages to the financial system to meet trading commitments. This led to the third effect: Indonesia, Thailand, the Philippines and South Korea came under IMF reconstruction schemes while Malaysia decided to not go for IMF bail-out plan.[5] Fourth, the share markets of the neighboring countries started to decline by up to half or more as interest rates were about to go up a year after the onset of the crisis. This led to insolvency of several commercial banks, a few large securities, and leasing companies and private corporations. Towards the end of year 1998 the currencies had, however, recovered from their overshot levels by about half or more.[6]

The effects on the financial systems had been very severe indeed. The banking systems came under strong IMF/world Bank restructuring program in Indonesia, Korea, the Philippines and Thailand. The lack of prudential norms in bank lending in all these countries have been seriously exposed so much so that there is strong demands to cut off the nexus of connected lending practiced in all these countries. The asset markets had also felt the impacts of the crisis. Property markets in all thesecountries lost in value, and prices went down by 30 to 60 per cent.[7] All the affected economies experienced a negative growth for one to three quarters from above 5 per cent growth rates prior to the crisis. Korea, Malaysia, Philippines, Singapore, Thailand and Indonesia experienced a recession in 1998 and part of 1999. In short, the secondary effect of what started as a currency crisis later became a full-blown economic crisis. Several years of hard earned prosperity in all these countries were rolled back.[8]’[9]

The second round of turbulence in Asian markets started when equity prices collapsed in Hong Kong in October 1997. This time the set back was not restricted to the East Asian region only. This second round of collapse of Asian markets resulted into a significant drop in stock prices throughout the world including Western markets. A number of countries in Latin America, Eastern Europe and Africa experienced outflows of capital in late 1997. Some minor shocks were also felt in the developed markets of the west[10].

Perry and Lederman (1998) study the impact of Asian crisis on the Latin American countries. They claim that the fall of Hong Kong’s stock market during October 1997 and a similar decline in the markets in US, Japan and UK did affect the Latin American countries. Specifically, currency in Brazil came under speculative attacks and international reserves declined by about US$9 billion. The Asian episode slightly affected the markets in Argentina but no major damage was done. The other major Latin American markets such as Mexico, Chile, Colombia and Peru experienced some initial negative shocks but recovered quickly due to their more flexible exchange rate regimes. It is to be noted here that Chile and Peru have relatively strong trade links with Asian countries in terms of their exports to Asia. In 1996, 17 percent of the total exports from Chile went to Asia while Peru’s share of exports was accounted for above 19 percent. The second wave of Asian turmoil that started in mid-November was more severe than the July collapse of Thai baht. This second wave severely affected the commodity markets (due to downward pressure on the commodity prices) in many Latin American countries and resulted into some depreciation of currencies in Chile, Colombia and Mexico.

The 1998 Russian Financial Crisis:

A chronology of financial crisis in Russia shows that initially, the country appeared unaffected by the 1997 Asian Crisis.[11] The crisis, however, was the result of overall macroeconomic mismanagement and specifically inadequate and inefficient management of the fiscal sector as well as a deteriorating balance of payments. The main cause of the Russian crisis was the imbalances in state finances, which resulted into a declining trend in major macroeconomic indicators as early as 1995.[12] Domestic debt, which started to rise in 1995 due to increased borrowings in the securities market rose to about 26 percent of GDP by mid-1998. The borrowings in the foreign financial market increased at the same time. However, the domestic borrowing was more of short-term maturity while foreign borrowings were of long-term nature.

The first attack on the rouble was felt in November 1997, partly a result of problems in tax collecting mechanism and high domestic debt[13] and partly due to a contagion from Asia. It is argued that the damaging effects of the collapse of Hong Kong equity prices in October 1997 were not restricted to Asia but were felt in emerging economies in Eastern Europe and Russia as well. Arkhipov et.al (1999) also attribute the downfall of Dow Jones Industrial Index which dropped to a record low of 554 points on October 1997 as the beginning of Russian economic problems. The Russian stock market followed the trend and dropped by 328.5 points during October-November 1997. This resulted into a lack of confidence and an attack on the Russian rouble. In an effort to defend the currency, the central bank of Russia (CBR) intervened in the foreign exchange market loosing US$6 billion (reached to a level of about US$17 billion) of foreign reserves between October and November 1997. The second blow to the Russian economy and financial market came when the crisis in Asia worsened in late 1997 and early 1998. The Russian market was severely affected by this global trend and the stock market index (RTS-1) dropped by about 51 percent between October 1997 and January 1998. In the absence of any far-reaching reform package to deal with the crisis, the situation continued worsening and by mid-May RTS-1 dropped by another 40 percent while international reserves went down to US$ 1.4 billion. In May 1998 the collapse of Russian rouble was very much imminent. The Russian government’s ability to sovereign its debt and maintain stable currency became questionable.

As compared to the experience in Asia during the 1997 crisis, the reaction of the government to overcome the crisis was very slow and created more lack of confidence among investors. Eventually, in June 1998, the International Monetary Fund, the International Bank for Reconstruction and Development and the Government of Japan agreed to extend an assistance of US$22.6 billion to Russia with US$5.6 billion to be granted immediately. This, however, did not help to improve the situation due to internal political turmoil and by August 1998, the country faced a full fledged crisis including currency and stock markets and the domestic banking sector. On August 17, the Russian Central Bank announced that the rouble would be allowed to float within a wider band, between 6.0 to 9.5 rouble to the US dollar. All trading in T-bills was suspended and complete capital controls were imposed. The government also declared a 90-day moratorium on foreign commercial debt.

The spillovers of Russian crises were larger than the earlier crises. The impact was felt on currencies in many emerging economies as well as equity prices in both emerging and developed markets. For example, equity markets in the United States bottomed out, in late August 1998, by about 20 percent below their high. Between August and mid-October 1998, stock prices in the European markets fell by about 35 percent.

Crisis or Contagion?

It is important to note here that the objective of this section was not to replicate the episodes of the two important crises. The details of these crises have been published extensively.[14] However, the summary of these events may help us to establish certain cross-market and cross-country linkages for each market that may have contributed to the spread of the crises. One main observation is that the above three episodes of crisis do reflect that the markets of crisis-hit economies in all three regions moved in a similar fashion during the crisis period.