Contagion in Latin America: Definitions, Measurement, and Policy Implications

The last two decades have shown that if any country in the world sneezes, Latin America catches pneumonia. A summary of Latin America's recent medical history would include the Mexican debt crisis in 1982, the Tequila effect in 1994, the Asian flu in 1997, the Russian cold in 1998, the Brazilian fever in 1999, and the Nasdaq rash in 2000. These increasingly frequent crises have attracted the attention of policymakers and academics. Of particular interest is why many of these crises, which began as country-specific events, quickly affected countries and regions around the globe. Most people describe these patterns as contagion. One peculiarity about this literature is that although there is fairly widespread agreement about which of these events led to contagion in Latin America, there is no consensus on exactly what constitutes contagion or how it should be defined.

One preferred definition of contagion is the propagation of shocks in excess of that which can be explained by fundamentals.¹ A simple example shows the practical difficulties of using this definition for a discussion of contagion. In the month after the 1998 devaluation of the Russian ruble, the Brazilian stock market fell by over 50 percent. Was this contagion? Can this impact of Russia on Brazil be explained by any fundamental linkages? A preliminary analysis would suggest not. Russia and Brazil have virtually no direct trade links; the two countries do not export similar goods that compete in third markets; and they have few direct financial links (such as through banks). Further analysis, however, might indicate that during the Russian crisis the market learned how the International Monetary Fund (IMF) would respond during the next currency crisis and what sort of rescue package it would implement. This learning process may have conveyed valuable information about potential rescue packages for the next countries that devalued their currencies or defaulted on their international debt.

An examination of stock market performance and public debt prices for countries in Latin America supports this interpretation. For example, figure 1 graphs aggregate stock market indexes for Argentina, Brazil, Chile, Colombia, Mexico, and Venezuela during the Russian crisis. Brazil and Venezuela, which were the two countries generally believed to be

FIGURE 1.

Latin American Stock Market Indexes during the Russian Crisis

most vulnerable to a currency crisis or debt default, were most affected by the Russian crisis. A graph of public debt prices displays the same pattern: the countries that had the highest probability of requiring IMF assistance soon after the Russian crisis were the countries most affected by the shock.

This example shows one practical problem with a fundamentals-based definition of contagion. How can we measure these fundamentals, especially in the short run? An issue that is potentially even more problematic is the lack of agreement on which cross-country linkages constitute fundamentals. Does learning based on IMF behavior in Russia qualify as a fundamental? Given these significant problems, the literature on this topic has adopted several alternate, and more easily testable, definitions of contagion. One of the earliest of these definitions classifies contagion as a shift or change in how shocks are propagated between relatively normal periods and crisis periods. Another common definition labels contagion as including only the transmission of crises through specific channels, such as herding or irrational investor behavior. An even broader definition identifies contagion as any channel linking countries and causing markets to move together. This paper focuses on the first of these three definitions (for reasons discussed below), although it frequently provides analysis and discussion based on the broader definitions. To clarify terms and avoid any misunderstanding, we use the phrase shift-contagion when referring to this first and narrowest definition.

This discussion of how to define contagion is critically important for this paper's goal: to discuss and analyze contagion in Latin America during recent financial crises. The next section motivates the paper by examining recent patterns and correlations in bond markets and stock markets in Latin America. It finds a high degree of comovement...