Contagion

In this paper I analyse several issues related to 'contagion,' including its definition, recent experiences, alternative channels at work, and possible prevention mechanisms. My discussion deals with the macroeconomics implications of contagion, and concentrates on the relationship between the degree of openness of the capital account and the transmission of foreign shocks. More specifically, I ask whether restrictions to capital mobility - and, in particular, controls on capital inflows - reduce a country's vulnerability to contagion. I also deal, albeit briefly, with the connection between the exchange rate regime and the propagation of international shocks. The paper is organised as follows: Section 2 presents some important stylised facts on recent episodes of global financial turmoil. This discussion puts things into perspective, and provides background information for the analysis that follows. Section 3 deals with a number of analytical issues, including the distinction between contagion and more traditional forms of international transmission of financial shocks. I argue that, in the tradition of epidemiological studies, contagion reflects a situation where the effect of an external shock is larger than what was expected by experts and analysts. Section 4 discusses briefly the relatively less known phenomenon of 'volatility contagion.' Section 5 analyses whether, as it has been recently argued by a number of authors, capital controls provide a useful mechanism for reducing emerging countries' vulnerability to external shocks. The analysis in this section concentrates on the much-admired system of controls implemented by Chile during most of the 1990s. Finally, Section 6 contains some concluding remarks, including a brief discussion on the relationship between exchange rate regimes and contagion.