Exploring the Causes of Economic Contagion

Economic Contagion can occur due to various reasons, such as spillover effects and financial crises. These are often influenced by four primary economic agents: governments, financial institutions, investors, and borrowers.

Economists suggest that macroeconomic shocks with international repercussions, transmitted through trade links, competitive devaluations and financial links, are fundamental causes of an economic contagion.

Competitive devaluation or currency war, where countries compete for an economic edge by devaluing their currency , is also associated with financial contagion. This may lead to market participants selling their shares elsewhere or refusing to lend short-term loans to borrowers in those countries.

The Impact of Financial Contagion

Financial contagion can lead to financial volatility in markets and can potentially damage the financial systems and economies of countries. Global investment and cross-border trade make economic contagions more likely, especially in emerging economies.

In such markets, financial contagions can be exacerbated by asymmetric information, which leads to unsustainable investments and reactionary market downturns in response to the collapse or weakening of nearby or closely related markets. Developed markets are generally better equipped to handle financial contagions than developing markets.

Candidates can also explore the Important Economic Terms for UPSC Exam for a better understanding of the topic.

Examples of Financial Contagion

One of the well-known instances of domestic financial contagion was the Asian financial crisis of 1997, which started in Thailand with the collapse of the Thai baht and spread to other Southeast Asian countries.

On the international front, the European debt crisis in 2009, which began in Greece and spread to other Eurozone countries like Ireland and Portugal, is an example of contagion. In such scenarios, a market crash in one country can have repercussions on other countries and banks due to increased cross-border investments and trade.