Emerging Market Contagion: Evidence and Theory

Title: Emerging Market Contagion: Evidence and Theory
Number: 007
Author: Rodrigo Valdés
Date: March 1997
Abstract: Using secondary market debt prices and country credit ratings this paper provides evidence of contagion in emerging markets. It shows that fundamentals are unable to explain the cross-country comovement of creditworthiness in Latin American countries. It also shows that contagion cannot be explained by "big news" events, such as Brady announcements, and that it is asymmetric, being stronger for negative innovations in creditworthiness. In contrast, in a "control group" composed by US corporate bond prices and credit ratings of a group of medium size OECD countries, fundamentals explain all the observed correlation.
The paper presents a simple model trying to explain this puzzle. It combines illiquid countries with investors who potentially need liquidity in order to change their portfolio. The basic intuition is that if investors require liquidity and they do not find it in one country, then they will seek fims in a second country. Under two alternative equilibrium definitions the model shows that the probability of repayment of one country is negatively affected by the degree of illiquidity of other countries -an apparently country-specific characteristic.
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