Question

The Asset Market discusses the concept of contagion. Explain how the concept of contagion impacted the country your group researched in the aftermath of the Asian Currency Crisis.

Answer 1

The emergence of the Asian financial crisis in July 1997 had a tremendous impact on the economies of the Asian countries. This study aims at linking the contagion theory and the crisis faced in Malaysia with more emphasis on the effect of the contagion volatility in the currency exchange market. This research uses the co-relation analysis, models of ARCH, GARCH and also GJR-GARCH in demonstrating the link. The results show that the crisis in Malaysia was not merely due to the weakness in its economic fundamentals, but also due to the contagion and volatility effects particularly originated from Thailand and Singapore. This study suggests the need for a more systematic management system with improved transparency in the financial sector even though the effect of the crisis contagion could hardly be prevented

Malaysian Ringgit was devaluated as a result of the emergence of the financial crisis in the mid-1997. The Malaysian economic scenario was devastated and changed drastically ever since the Thai government decided to float its currency, the Baht on 2nd July 1997. Six months prior to the crisis, Malaysia’s macroeconomic pointers did not show any sign that this country would be easily affected by such a crisis as in Thailand even though there was concern about the country’s fast developmental growth (Ishak, 2000). The economic growth achieved was seemingly too high and continuous, exceeding the country’s own potential rate and the problem of resource imbalance between funds and investments was apparent.

The financial crisis hit Thailand and as a result, the crisis spread to the neighboring countries in weeks. Indonesia, Malaysia, and Philippines for examples felt the effect of the blow directly, while Singapore, Hong Kong, and Taiwan were affected at a smaller and limited scale.

Contagion is a phenomenon when a currency crisis falls on a country which then triggers another crisis to occur in other countries where these countries show a chain of weak economies. The contagion theory shows that there is no country in the region which can parry the effect of contagion of such an economical crisis and the besetting currency problems. According to the Oxford Dictionary, the term “contagion” is defined as an infectious disease transmission through contact. The word contagion is taken from the Latin language namely con meaning 'with' and tangere which means 'touch'. However, the definition of contagion is really still vague.

The theoretical link of the financial crisis chronology that occurred in the Asian region in July 1997 has been highlighted previously. How such a crisis which started in Thailand could occur and spread to other countries in such a short period. In merely a few weeks, most economies of the Asian and South East Asian countries fell and a rather obvious destruction was experienced.

In this context, Malaysia was dragged into a dilemma when the unanticipated crisis also beset on this country. Subsequently, various opinions did arise in describing the problems which more or less answered some of the questions as to why and how Malaysia was also trapped in this difficult crisis. Some are with the opinion that the

crisis that happened in Malaysia originated from its weak basic economic fundamental and there are also views that due to globalization, Malaysia is mutually linked with other countries in many ways especially in terms of the financial market. Malaysia is said to have received the same amount of impact of this contagion crisis as other affected countries especially its neighboring countries because Malaysia is located in the same region with most of the countries hit by the crisis. Therefore, in this chapter, the analysis on empirical decision will more or less address Malaysia’s issues and the contagion volatility in the financial market.

Since the occurrence of the Asian financial crisis in the mid-1997, the contagion theory and the crisis have frequently been debated among economists. Various opinions have been presented and proposed on these issues. In such case, Malaysia is also not exempted from being a study sample and at the same time, attracting many researchers’ attention. Aside from the fact that Malaysia recovered quickly from this crisis, what has become more appealing is that whether the crisis which struck Malaysia was merely due to the weakness in the basic economic fundamentals or caused by other factors such as the contagion effect from the neighboring countries.

Previous studies also concluded that the crisis which happened in Malaysia was caused by the contagion effect which started in Thailand and Korea. However, there are also empirical results showing that the contagion effect was not only come from Thailand and Korea, but also from Singapore and Indonesia, whether directly or indirectly. These views also agree that the financial market was the most effective channel in spreading the contagion.

However, there are also views from several researchers who concluded from the results of their empirical tests that the contagion did not exist to be the cause of the spread of the crisis to the whole Asian region and several other countries in the world. Rigobon (1999) for example, suggested that in reality, the crisis that happened in the Asian region was not caused by the contagion effect but was more due to the presence of certain characteristics which created the concept of the contagion. According to him, the economic systems of most countries in this region have the same foundation or characteristics. This means that the crisis that happened in the one country is simultaneously followed by the crisis in other countries. However, this phenomenon was purely coincidental and was not caused by the contagion effect. In another case, contagion may be more obvious during the time of a crisis, though the contagion could still exist in when no crisis presents.

The differences in opinions mentioned above would become more obscure if the definition of infection or contagion is based on certain classification such as the one proposed by Rigobon because it cannot be determined specifically. However, if the definition of infection or contagion is straightforward and agreeable to most researchers which is about the collapse in one country and creates speculative attacks

onto other countries, as a transmission of volatility occurring between one country and another country, and as a change in the spread of shock among affected countries, ceteris paribus, without a more complex definition for contagion, then contagion analysis will become easier. The empirical result of this study supports the initial view that effects of the contagion crisis from the neighboring countries especially from Thailand and Singapore, did exist in Malaysia. The findings of this study also suggest that the financial sector played a very effective role in spreading the crisis from one country to another. Likewise for Malaysia,this sector became the channel in spreading the crisis to this country. The complex network links in the global financial system would spread the impact of the collapse of a country’s economy to another at such a high speed through the financial transmission channel.

From the beginning of the crisis in the mid-1997, the regional economy of the Asian countries including the economy of Malaysia became weaker due to the business networks and the interdependency in many ways. The various efforts were made but not sufficient to restore the economies of the region in a short period of time. This situation was aggravated even more by the assistance by IMF which did not help to restore Asia's economy, but instead worsen the economic situation. Apart from these, the spread of the crisis among countries in the region is also linked directly to the contagion effect which started in Thailand. Yet, it cannot be denied that the indirect contagion effects from other nations such as Singapore and others country were also parts of the spread of the crisis. Although the crisis reputedly stemmed from the weak basic economic fundamentals of the countries involved, yet this does not mean that contagion is not linked in anyway to the phenomenon. The countries’ structural economic weakness was the catalyst to further accelerate the spread of the crisis all over the region and also onto some other countries in the world. The financial crisis of which in its early stage started in Thailand probably would not have spread over so rapidly if the country had floated its currency earlier. If Thailand did float its currency earlier, then its reserves could have been used to restore the economic status for example, to repay its national debt of which was in large amount. This action could have help to resist the outbreak in other countries.