Financial contagion is a situation where financial shocks spread to various regions or countries. Even though a country has a healthy economy, the contagion effects have the potential to destabilize the country’s economy.
For example, even though it happened in the United States, the 2008 financial crisis quickly spread throughout the world. Globalization increases the possibility of transmission because more countries are interconnected with international trade and capital flows.
Factors affecting financial contagion
Various conditions make contagion more likely to occur. A country is very vulnerable to the effects of contagion when it relies on foreign loans and short-term capital inflows. When there is a financial crisis in a partner country, investors become nervous and are likely to withdraw their investment.
The financial system also becomes vulnerable when businesses make investments using lots of borrowed money. Any loss can quickly render them go bankrupt because of high leverage. The situation forces them to increase cash by selling assets in other countries or markets.
Speculator activity is another factor. Their behavior is more difficult to understand. An example is the currency crisis that started in Thailand and then spread to Indonesia and caused a financial crisis in 1997/1998.