Question

How does financial openness increase contagion across countries?

Answer 1

Countries with weak fundamentals become more prone to crises when they liberalize their financial
sectors. Globalization can also lead to crises in countries with stable foundations, due to financial market imperfections or external factors. In addition, open economies are exposed to contagion across multiple channels such as physical ties, financial linkages and herding behaviour. Nonetheless, the net impacts of financial globalization are expected to be optimistic in the long run. Therefore, the key task for policymakers is to navigate the mechanism in order to take advantage of opportunities while mitigating risk..

There are various forces moving towards an growing globalization of finance. Those powers are states, lenders, creditors, and institutions of finance. Governments require globalization by liberalizing internal financial sector restrictions and balance of payments capital accounts.Globalization can also lead to crises in fundamentally stable countries. Imperfections on the international financial markets and external factors that decide the movement of capital make open economies more vulnerable to crisis. Countries that integrate into world financial markets have become vulnerable to contagion. Crises may spill over into other countries through physical ties, financial ties, or imperfections on the stock market such as herding behaviour or panic.

While there is no widely accepted concept, loosely speaking, contagion can be understood as spreading the consequences of cross-country spillover into other countries, including a crisis in one country. The transmission of crises across countries can be attributed, as in the case of domestic crises, to economic dynamics (economic relations between countries) or imperfections of capital markets. Others would contend in a more stringent context that contagion is the spillover (or cross-country co-movement) effects not linked to economic fundamentals.