The Unholy Trinity of Financial Contagion

F or reasons that are not always evident at the time, some nancial events, likethe devaluation of a currency or an announcement of default on sovereigndebt obligations, trigger an immediate and startling adverse chain reaction among countries within a region and in some cases across regions. This phenom-enon, which we dub “fast and furious ” contagion, was manifest after the oatation of the Thai baht on July 2, 1997, as it quickly triggered nancial turmoil across east Asia. Indonesia, Korea, Malaysia and the Philippines were hit the hardest—by December 1997, their currencies had depreciated (on average) by about 75 per-cent. Similarly, when Russia defaulted on its sovereign bonds on August 18, 1998, the effects were felt not only in several of the former Soviet republics, but also in Hong Kong, Brazil, Mexico, many other emerging markets and the riskier segments of developed markets.1 The economic impact of these shocks on the countries unfortunate enough to be affected included declines in equity prices, spikes in the cost of borrowing, scarcity in the availability of international capital, declines in the value of their currencies and falls in economic output. 1 The international nancial turmoil that followed Russia’s default was compounded in a signi cant manner by another negative surprise announcement: on September 2, 1998, it became public knowl-edge that the prominent hedge fund Long Term Capital Management (LTCM) had gone bankrupt owing to its large exposure to Russia and other high-yield, high-risk assets