The phenomenon known as “contagion” is closely related to the concern about volatility. Put simply, when investors decide to flee one market, the “herd effect” of investors following each other can produce economic crises in other countries that previously appeared to be fundamentally sound.

During the East Asian financial crisis, the global contagion effect was driven significantly by the use of financial derivatives. These are financial instruments which typically involve calculations and risk-taking about the price of one good or economic entity against another. Investments in such instruments are often highly leveraged, that is, purchased with only a small percentage of the purchase cost coming from the buyer and the rest coming from lenders to the buyer.

Consequently, when one basket of goods fails to perform the way investors expected, the investors may be forced to sell off other assets to cover the risks they have taken. In 1997-98, when Asian economies started collapsing, many investors were forced to sell off assets held in Russia, which led to a decline in stock prices there and a weakening of their currency. The downturn in Russia helped set off a similar downturn in Brazil.

Whether contagion was a real phenomenon has been disputed since the Asian Financial Crisis, with some economists arguing that there was never a “domino effect” that caused a capital flight from economies with healthy fundamentals. However, the Asian Financial Crisis may have caused investors to take a closer look at the fundamentals of certain countries, in effect serving as a “wake-up call” to investors that their positions had been much riskier than previously believed. This reevaluation could have resulted in capital fleeing some markets that had previously been thought of as low-risk, stable destinations for foreign investment.

In fact, analysts of the East Asian financial crisis found it instructive to look at the difference in the impact discernable in two nations that were long considered economic “twins” of East Asia—South Korea and Taiwan—because their development had followed such similar paths. Although South Korea suffered a real catastrophe, with its currency losing 80 percent of its value and its stock market losing 42 percent, Taiwan emerged from the region-wide crisis relatively unscathed.

A principal difference between their economic profiles was South Korea’s much greater reliance on foreign investment, especially on portfolio investment. While Taiwan’s reliance on foreign investment over the previous four decades amounted to less than ten percent of total investment, in South Korea foreign investment accounted for sixty percent of the total. Similarly, the debt/equity ratio in the critical manufacturing sector in Taiwan was 87 percent, but in South Korea the ratio was 300 percent.

The handling of the crisis by the International Monetary Fund (IMF) was also the subject of considerable criticism. Prominent economists such as Nobel Prize-winner James Tobin argue that, when facing currency crises that endanger “both financial systems and whole economies, [the IMF and leaders of the financial community]… invariably give priority to finance.”

Under intense pressure by investors and international institutions to maintain the value of their currency, South Korea, Thailand, Taiwan, and their neighbors’ economies were forced to raise interest rates to levels which strangled large numbers of small businesses and necessitated their taking out large loans from the IMF in vain efforts to protect their currencies.

The global financial and economic crisis of 2007-2009 could correlate with a global contagion.  Whereas previous contagions were geographically limited, the high level of global economic integration at present means that any contagion related to the current financial crisis could engulf the world, reaching all sectors and all nations.27

27 “Financial crisis goes global.” The New York Times. 19 September 2008.

 Next: Problems with Capital Inflows