Kaminsky 2003

Journal of Economic Perspectives—Volume 17, Number 4 —Fall 2003—Pages 51–74
The Unholy Trinity of Financial

Contagion
Graciela L. Kaminsky, Carmen M. Reinhart

and Carlos A. Végh
F or reasons that are not always evident at the time, some financial events, like
the devaluation of a currency or an announcement of default on sovereign
debt obligations, trigger an immediate and startling adverse chain reaction
among countries within a region and in some cases across regions. This phenom-
enon, which we dub “fast and furious” contagion, was manifest after the floatation
of the Thai baht on July 2, 1997, as it quickly triggered financial turmoil across east
Asia. Indonesia, Korea, Malaysia and the Philippines were hit the hardest— by
December 1997, their currencies had depreciated (on average) by about 75 per-
cent. Similarly, when Russia defaulted on its sovereign bonds on August 18, 1998,
the effects were felt not only in several of the former Soviet republics, but also in
Hong Kong, Brazil, Mexico, many other emerging markets and the riskier segments
of developed markets.1 The economic impact of these shocks on the countries
unfortunate enough to be affected included declines in equity prices, spikes in the
cost of borrowing, scarcity in the availability of international capital, declines in the
value of their currencies and falls in economic output.
1
The international financial turmoil that followed Russia’s default was compounded in a significant
manner by another negative surprise announcement: on September 2, 1998, it became public knowl-
edge that the prominent hedge fund Long Term Capital Management (LTCM) had gone bankrupt
owing to its large exposure to Russia and other high-yield, high-risk assets.
y Graciela L. Kaminsky is Professor of Economics, George Washington University, Washing-

ton, D.C. Carmen M. Reinhart is Professor of Economics at University of Maryland, College
Park, Maryland. Carlos A. Végh is Professor of Economics, University of California, Los
Angeles, California. All three authors are Research Associates, National Bureau of Economic
Research, Cambridge, Massachusetts. Their e-mail addresses are 具graciela@gwu.edu典,
具creinhar@umd.edu典 and 具cvegh@ucla.edu典, respectively.
52 Journal of Economic Perspectives
Table 1 presents summary material for recent contagion episodes. The first
column lists the country, the date that marks the beginning of the episode, the
nature of the shock and currency market developments in the crisis country. The
remaining columns include information on the existence and nature of common
external shocks, the suspected main mechanism for propagation across national
borders and the countries that were most affected.
The challenge for economic researchers is to explain why the number of
financial crises that did not have significant international consequences is far
greater than those that did. It is no surprise that a domestic crisis (no matter how
deep) in countries that are approximately autarkic (either voluntarily or otherwise)
will not likely have immediate repercussions in world capital markets. The countries
may be large (like China or India) or comparatively small (like Bolivia or Guinea-
Bissau.) More intriguing cases of “contagion that never happened” are those
where the crisis country is relatively large (at least by emerging market standards)
and is reasonably well integrated to the rest of the world through trade or finance.
Along with the fast and furious contagion episodes, these cases are the focus of this
paper.
Some recent financial crises with limited immediate consequences include
these examples: Brazil’s devaluation of the real on January 13, 1999, and
eventual flotation on February 1, 1999; the Argentine default and abandon-
ment of the Convertibility Plan in December 2001; and Turkey’s devaluation of
the lira on February 22, 2001. Given that Brazil, Turkey and Argentina are
relatively large emerging markets, these episodes could have been—at least
potentially—as highly “contagious” as the Thai and Russian crises. Nonetheless,
financial markets shrugged off these events, despite the fact that it was evident
at the time that some of these shocks would have trade and real sector reper-
cussions on neighboring countries over the medium term. For example, be-
cause Brazil is Argentina’s largest trading partner, the sharp depreciation of the
real (about 70 percent between January and the end of February) clearly left the
Argentine peso overvalued. Table 2 presents some summary material for these
episodes, in a format parallel to Table 1.
This paper seeks to address the central question of why financial contagion
across borders occurs in some cases but not others.2 Throughout the paper, we
stress that there are three key elements that distinguish the cases where contagion
2
Of course, there are historical examples of fast and furious contagion before the last few decades.
Commonly cited examples of contagion include the first Latin American debt crisis—which began with
Peru’s default in April 1826 —and the international financial crisis of 1873. Going back even further in
time, Neal and Weidenmeir (2002) also discuss the “contagion” dimension of the Tulip Mania of the
1630s and the Mississippi and South Sea Bubbles of 1719 –1720. Two leading examples of financial crises
that did not lead to contagion include the well-documented Argentina-Baring crisis of 1890 and the
United States financial crisis of 1907. For detailed accounts of historical episodes of financial crises, see
Bordo and Eichengreen (1999), Bordo and Murshid (2000), Kindleberger (1997) and Neal and
Weidenmier (2002).
Graciela L. Kaminsky, Carmen M. Reinhart and Carlos A. Végh 53
Table 1
Financial Crises with Immediate International Repercussions: 1980 –2000
Origin of the shock, country Nature of common external

and date shock, if any Contagion mechanisms Countries affected
On August 12, 1982, Between 1980 and 1985, U.S. banks, heavily With the exception of
Mexico defaults on its commodity prices fell exposed to Mexico, Chile, Colombia and
external bank debt. By by about 31 percent. retrenched from Costa Rica, all
December, the peso U.S. short-term real emerging markets. countries in Latin
had depreciated by interest rates rise to America defaulted.
100 percent. about 7 percent, the
highest levels since
the depression.
On September 8, 1992, High interest rates in Hedge funds. All the countries in the
the Finnish markka is Germany. Rejection European Monetary
floated and the by Danish voters of System except
Exchange Rate the Maastricht treaty. Germany.
Mechanism (ERM)
crisis unfolds.
On December 20, 1994, From January 1994 to Mutual funds sell off Argentina suffered the
Mexico announced a December, the other Latin American most, losing about
15 percent devaluation Federal Reserve raised countries, notably 20 percent of
of the peso. It sparked the federal funds rate Argentina and Brazil. deposits in early
a confidence crisis, by about 2.5 Massive bank runs 1995. Brazil was
and by March 1995, percentage points. and capital flight in next, while losses in
the peso’s value had Argentina. other countries in
declined by about the region limited to
100 percent. declines in equity
prices.
On July 2, 1997, The yen depreciated by Japanese banks, Indonesia, Korea,
Thailand announces about 51 percent exposed to Thailand, Malaysia and the
that the baht will be against the U.S. dollar retrenched from Philippines were hit
allowed to float. By during April 1995 and emerging Asia. As hardest. Financial
January 1998 the baht April 1997. Given the Korea is affected, markets in Singapore
had depreciated by Asian currencies link European banks also and Hong Kong also
about 113 percent. to the U.S. dollar, this withdraw. experienced some
translated into a turbulence.
significant
appreciation for their
currencies as well.
On August 18, 1998, With heavy exposure to Margin calls and Apart from several of
Russia defaults on its Russia and other leveraged hedge the former Soviet
domestic bond debt. high-yield funds fueled the sell republics, Hong
Between July 1998 and instruments, LTCM is off in other emerging Kong, Brazil and
January 1999, the revealed to be and high yield Mexico were hit
ruble depreciated by bankrupt. markets. It is difficult hardest. But most
262 percent. On to distinguish emerging and
September 2, 1998, it contagion from developed markets
became public Russia and fear of were affected.
knowledge that LTCM another LTCM.
had gone bankrupt.
Sources: International Monetary Fund, International Financial Statistics, dates of the default or restruc-
turings are taken from Reinhart, Rogoff and Savasteno (2003).
Table 2
Selected Financial Crises without Immediate International Repercussions:
1999 –2001
Origin of the shock: Background on the

country and date run-up to the shock Spillover mechanisms Countries affected
On January 13, The crawling peg There is an increase Significant and protracted
1999, Brazil exchange rate in volatility in effect on Argentina, as
devalues the real policy (the Real some of larger Brazil is Argentina’s
and eventually Plan) that was equity markets, largest trading partner.
floats on February adopted in July and Argentina
1. Between early 1994 to stabilize spreads widened.
January and end- inflation is Equity markets in
February, the real abandoned. Argentina and
depreciates by Chile rallied.
70 percent. These effects
lasted only a few
days.
On February 22, Facing substantial There has been some
2001, Turkey external financing conjecture that the
devalues and needs, in late Turkish crisis may have
floats the lira. November 2000, exacerbated the
rumors of the withdrawal of investors
withdrawal of from Argentina, but
external credit lines given the weakness in
to Turkish banks Argentina’s
triggered a foreign fundamentals at the
exchange outflows time, it is difficult to
and overnight rates suggest developments
soared to close to owed to contagion.
2,000 percent.
On December 23, Following several Bank deposits fall Uruguay and, to a much
2001, the waves of capital by more than lesser extent, Brazil.
president of flight and runs on 30 percent in
Argentina bank deposits, on Uruguay, as
announces December 1st Argentines
intentions to capital controls are withdraw deposits
default. introduced. from Uruguayan
banks. Significant
effects on
economic (trade
and tourism)
activity in
Uruguay.
occurs from those where it does not. We call them the “unholy trinity”: an abrupt
reversal in capital inflows, surprise announcements and a leveraged common
creditor. First, contagion usually followed on the heels of a surge in inflows of
international capital and, more often than not, the initial shock or announcement
pricked the capital flow bubble, at least temporarily. The capacity for a swift and
The Unholy Trinity of Financial Contagion 55
drastic reversal of capital flows—the so-called “sudden stop” problem—played a

significant role.3 Second, the announcements that set off the chain reactions came
as a surprise to financial markets. The distinction between anticipated and unantic-
ipated events appears critical, as forewarning allows investors to adjust their port-
folios in anticipation of the event. Third, in all cases where there were signifi-
cant immediate international repercussions, a leveraged common creditor was
involved— be it commercial banks, hedge funds, mutual funds or bondholders—
who helped to propagate the contagion across national borders.
Before turning to the question of what elements distinguish the cases where
contagion occurs from those where it does not, however, we provide a brief tour of
the main theoretical explanations for contagion and the most salient empirical
findings on the channels of propagation.
What is Contagion?
Since the term “contagion” has been used liberally and has taken on multiple
meanings, it is useful to clarify what it will mean in this paper. We refer to contagion
as an episode in which there are significant immediate effects in a number of
countries following an event—that is, when the consequences are fast and furious
and evolve over a matter of hours or days. This “fast and furious” reaction is a
contrast to cases in which the initial international reaction to the news is muted.
The latter cases do not preclude the emergence of gradual and protracted effects
that may cumulatively have major economic consequences. We refer to these
gradual cases as spillovers. Common external shocks, such as changes in interna-
tional interest rates or oil prices, are also not automatically included in our working
definition of contagion. Only if there is “excess comovement” in financial and
economic variables across countries in response to a common shock do we consider
it contagion.
Theories of Contagion
Through what channels does a financial crisis in one country spread across
international borders? Some models have emphasized investor behavior that gives
rise to the possibility of herding and fads. It is no doubt possible (if not appealing
to many economists) that such “irrational exuberance,” to quote Federal Reserve
Chairman Alan Greenspan, can influence the behavior of capital flows and finan-
cial markets and exacerbate the booms as well as the busts. Other models stress
economic linkages through trade or finance. This section provides a selective
3
See Calvo and Reinhart (2000) for an empirical analysis of sudden stop episodes and Caballero and
Krishnamurthy (2003) for a model that traces out the economic consequences of sudden stops.
discussion of theories of contagion. The main message conveyed here is that

financial linkages— cross-border capital flows and common creditors—and investor
behavior figure the most prominently in the theoretical explanations of contagion.
Herding
Bikhchandani, Hirshleifer and Welch (1992) model the fragility of mass
behavior as a consequence of informational cascades.4 An information cascade
occurs when it is optimal for an individual, after observing the actions of those
ahead of him, to follow the behavior of the preceding individual without regard to
the individual’s own information. Under relatively mild conditions, cascades will
almost surely start, and often they will be wrong. In those circumstances, a few early
individuals can have a disproportionate effect. Changes in the underlying value of
alternative decisions can lead to “fads”—that is, drastic and seemingly whimsical
swings in mass behavior without obvious external stimulus.
Banerjee (1992) also develops a model to examine the implications of deci-
sions that are influenced by what others are doing. The decisions of others may
reflect potentially important information in their possession that is not in the
public domain. With sequential decision making, people paying attention to what
others are doing before them end up doing what everyone else is doing (that is,
herding behavior), even when one’s own private information suggests doing some-
thing different. The herd externality is of the positive feedback type: If we join the
crowd, we induce others to do the same. The signals perceived by the first few
decision makers—random and not necessarily correct— determine where the first
crowd forms, and from then on, everybody joins the crowd. This characteristic of
the model captures to some extent the phenomena of “excess volatility” in asset
markets, or the frequent and unpredictable changes in fashions.
Another story suggests that the channels of transmission arise from the global
diversification of financial portfolios in the presence of information asymmetries.
Calvo and Mendoza (2000), for instance, present a model where the fixed costs of
gathering and processing country-specific information give rise to herding behav-
ior, even when investors are rational. Because of information costs, equilibria arise
in which the marginal cost exceeds the marginal gain of gathering information. In
such instances, it is rational for investors to mimic market portfolios. When a rumor
favors a different portfolio, all investors “follow the herd.”
Trade Linkages
Some recent models have revived Nurkse’s (1944) classic story of competitive
devaluations (Gerlach and Smets, 1996). Nurkse argued that since a devaluation in
one country makes its goods cheaper internationally, it will pressure other coun-
tries that have lost competitiveness to devalue as well. In this setting, a devaluation
4
See Bikhchandani, Hirshleifer and Welch (1998) in this journal for a thoughtful discussion of this
literature.
in a second country is a policy decision whose effect on output is expected to be

salutary, as it reduces imports, increases exports and improves the current account.
An empirical implication of this type of model is that we should observe a high
volume of trade among the “synchronized” devaluers. As a story of voluntary
contagion, this explanation does not square with the fact that central banks often
go to great lengths to avoid a devaluation in the first place— often by engaging in
an active interest rate defense of the existing exchange rate (as in Lahiri and Végh,
2003) or by enduring massive losses of foreign exchange reserves—nor that deval-
uations have often been contractionary.
Financial Linkages
Other studies have emphasized the important role of common creditors and
financial linkages in contagion. The “type” of the common creditor may differ
across models, but the story tends to remain consistent.
In Shleifer and Vishny (1997), arbitrage is conducted by relatively few special-
ized and leveraged investors, who combine their knowledge with resources that
come from outside investors to take large positions. Funds under management
become responsive to past performance. The authors call this Performance Based
Arbitrage. In extreme circumstances, when prices are significantly out of line and
arbitrageurs are fully invested, Performance Based Arbitrage is particularly ineffec-
tive. In these instances, arbitrageurs might bail out of the market when their
participation is most needed. That is, arbitrageurs face fund withdrawals and are
not very effective in betting against the mispricing. Risk-averse arbitrageurs might
chose to liquidate, even when they do not have to, for fear that a possible further
adverse price movement may cause a drastic outflow of funds later on. While the
model is not explicitly focused on contagion, one could see how an adverse shock
that lowers returns (say, like the Mexican peso crisis) may lead arbitrageurs to
liquidate their positions in other countries that are part of their portfolio (like
Argentina and Brazil), as they fear future withdrawals.
Similarly, Calvo (1998) has stressed the role of liquidity. A leveraged investor
facing margin calls needs to sell asset holdings. Because of the information asym-
metries, a “lemons problem” arises, and the asset can only be sold at a low fire-sale
price. For this reason, the strategy will not be to sell the asset whose price has
already collapsed, but other assets in the portfolio. In doing so, however, other asset
prices fall, and the original disturbance spreads across markets.
Kodres and Pritsker (2002) develop a rational expectations model of asset
prices to explain financial market contagion. In their model, assets’ long-run values
are determined by macroeconomic risk factors, which are shared across countries,
and by country-specific factors. Contagion occurs when “informed” investors re-
spond to private information on a country-specific factor by optimally rebalancing
their portfolio’s exposures to the shared macroeconomic risk factors in other
countries’ markets. When there is asymmetric information in the countries hit by
the rebalancing, “uninformed” investors cannot fully identify the source of the
change in asset demand; they therefore respond as if the rebalancing is related to

information on their own country (even though it is not). As a result, an idiosyn-
cratic shock generates excess comovement— contagion—across countries’ asset
markets. A key insight from the model is that contagion can occur between two
countries even when contagion via correlated information shocks, correlated li-
quidity shocks and via wealth effects are ruled out by assumption and even when the
countries do not share common macroeconomic factors, provided that both coun-
tries share at least one underlying macroeconomic risk factor with a third country,
through which portfolio rebalancing can take place. Their model, like the rational
herding model of Calvo and Mendoza (1998), has the empirical implication that
countries with more internationally traded financial assets and more liquid markets
should be more vulnerable to contagion. Small, highly illiquid markets are likely to
be underrepresented in international portfolios to begin with and, as such,
shielded from this type of contagion.
Kaminsky and Reinhart (2000) focus on the role of commercial banks in
spreading the initial shock. The behavior of foreign banks can exacerbate the
original crisis by calling loans and drying up credit lines, but can also propagate
crises by calling loans elsewhere. The need to rebalance the overall risk of the
bank’s asset portfolio and to recapitalize following the initial losses can lead to a
marked reversal in commercial bank credit across markets where the bank has
exposure.
Other Explanations
The so-called “wake-up call hypothesis” (a term coined by Morris Goldstein,
1998) relies on either investor irrationality or a fixed cost in acquiring information
about emerging markets. In this story, once investors “wake up” to the weaknesses
that were revealed in the crisis country, they will proceed to avoid and move out of
countries that share some characteristics with the crisis country. So, for instance, if
the original crisis country had a large current account deficit and a relatively “rigid”
exchange rate, then other countries showing similar features will be vulnerable to
similar pressures (Basu, 1998, offers a formal model).
Channels of Propagation: The Empirical Evidence
Some of the theoretical models just discussed emphasized trade linkages as

a channel for the cross-border propagation of shocks, but most models have
looked to financial markets for an explanation. However, perhaps because trade
in goods and services has a longer history in the post–World War II period than
trade in financial assets, or because of far better data availability, trade links
have received the most attention in the empirical literature on channels of
contagion. Eichengreen, Rose and Wyplosz (1996) find evidence that trade
links help explain the pattern of contagion in 20 industrial countries over
1959 –1993. Glick and Rose (1999), who examine this issue for a sample of
161 countries, come to the same conclusion. Glick and Rose (1999) and
Kaminsky and Reinhart (2000) also study trade linkages that involve competi-
tion in a common third market.
While sharing a third party is a necessary condition for the competitive
devaluation story, Kaminsky and Reinhart (2000) argue it is clearly not a sufficient
one. If a country that exports wool to the United States devalues, it is not obvious
why this step would have any detrimental effect on a country that exports semicon-
ductors to the United States. Their study shows that trade links through a third
party is a plausible transmission channel in some cases but not for the majority of
countries recently battered by contagion. For example, at the time of the Asian
crisis, Thailand exported many of the same goods to the same third parties as
Malaysia. This connection, however, does not explain all the other Asian crisis
countries. Bilateral or third-party trade also does not appear to carry any weight in
explaining the effects of Mexico (1994) on Argentina and Brazil. At the time of
Mexico’s 1994 devaluation, only about 2 percent of Argentina’s and Brazil’s total
exports went to Mexico. Similarly, Brazil hardly trades with Russia, as only
0.2 percent of its exports are destined for Russian markets; yet in the weeks
following the Russian default, Brazil’s interest rate spreads doubled and its equity
prices fell by more than 20 percent.
Kaminsky and Reinhart (2000) compare countries clustered along the lines of
trade links versus countries with common bank creditors and conclude that com-
mon financial linkages better explain the observed pattern of contagion. Mody and
Taylor (2002), who seek to explain the comovement in an exchange market
pressures index by bilateral and third-party trade and other factors, also cast doubt
on the importance of trade linkages in explaining the propagation of shocks.
Conversely, many cases of crises without contagion have strong trade links.
About 30 percent of Argentina’s exports are destined for Brazil, yet in the week
following Brazil’s devaluation, the Argentine equity market increased 12 percent.
Similarly, nearly 13 percent of Uruguay’s exports are bound for the Argentine
market. Yet, the main reason why the crisis in Argentina ultimately affected Uru-
guay was the tight financial linkages between the two countries. Uruguayan banks
have (for many years) been host to Argentinean depositors, who thought their
deposits safer when these were denominated in U.S. dollars and kept across the Rı́o
de la Plata. At first, as the crisis deepened in Argentina, many deposits fled from
Argentine banks and found their way to Uruguay. But when the Argentine author-
ities declared a freeze on bank deposits in December 2001, Argentine firms and
households began to draw down the deposits they kept at Uruguayan banks. The
withdrawals escalated and became a run on deposits amid fears that the Uruguayan
central bank would either run out of international reserves or (like Argentina)
confiscate the deposits.
Other studies focused primarily on financial channels of transmission. Frankel
and Schmukler (1998) and Kaminsky, Lyons and Schmukler (2000) show evidence
to support the idea that U.S.-based mutual funds have played an important role in
spreading shocks throughout Latin America by selling assets from one country
when prices fall in another—with Mexico’s 1994 crisis being a prime example.
Caramazza, Ricci and Salgado (2000), Kaminsky and Reinhart (2000) and Van
Rijckeghem and Weder (2000) focus on the role played by commercial banks in
spreading shocks and inducing a sudden stop in capital flows in the form of bank
lending, especially in the debt crisis of 1982 and the crisis in Asia in 1997. Mody and
Taylor (2002) link contagion to developments in the U.S. high yield or “junk” bond
market. The common thread in these papers is that without the financial sector
linkages, contagion of the fast and furious variety would be unlikely.
Summing Up
Table 3 summarizes the arguments about propagation of contagion among the
five fast and furious cases emphasized earlier: Mexico in 1982, the European
Exchange Rate Mechanism crises of 1992, Mexico’s currency devaluation in 1994,
Thailand’s devaluation in 1997 and Russia’s devaluation in 1998.5 In each case, we
consider the possible trade channel, whether the affected countries shared similar
characteristics with the crisis country and with each other and whether a common
creditor was present with the possible financial channel. Indeed, Table 3 lays the
foundation for our unholy trinity of financial contagion proposition, which the
next section discusses in greater detail. Several features summarized in Table 3 are
worth highlighting. In all five cases, a common leveraged creditor was present,
making it consistent with the explanations offered by Schleifer and Vishny (1997),
Calvo (1998) and discussed in Kaminsky and Reinhart (2000). In three of the five
cases, the scope for propagation via trade links is virtually nonexistent, and in one
of the two remaining cases (Thailand), the extent of third party competition is with
Malaysia, not the other affected Asian countries. Lastly, with the exception of the
countries that suffered most from Russia/LTCM fallout, the affected countries
tended to have large capital inflows and relatively fixed exchange rates.
The Unholy Trinity: Capital Inflows, Surprises and

Common Creditors
Having summarized some of the key findings of the literature on contagion, we
now return to our central question of why contagion occurs in some instances but
not in others.
5
For a detailed discussion of the evolution of these contagion episodes, the interested reader is referred
to IMF World Economic Outlook (January 1993) for the ERM crisis, IMF International Capital Markets
(August 1995) for the more recent Mexican crisis, Nouriel Roubini’s home page, 具http://pages.stern.
nyu.edu/⬃nroubini/典, for an excellent chronology of the Asian crisis and IMF World Economic
Outlook and International Capital Markets Interim Assessment (December 1998) for Russia’s default
and LTCM crisis. Diaz-Alejandro (1984) provides a compelling discussion of the debt crisis of the early
1980s.
Table 3
Propagation Mechanisms in Episodes of Contagion
Common characteristic
Episode Trade across affected countries Common creditor
Mexico, August 1982 As the entire region Large fiscal deficits, U.S. commercial banks.
was affected, trade weak banking
links are significant, sectors,
even though there dependence on
are low levels of commodity prices
bilateral trade and heavy external
among most of the borrowing.
affected countries.
Finland, September 8, While bilateral exports Large capital inflows, Hedge funds.
1992—ERM crisis to Finland from the common exchange
affected countries rate policy as part
are small, there are of the European
substantial trade Monetary System.
links among all the
affected countries.
Mexico, December 21, No significant trade Exchange rate based Primarily U.S.
1994 links. Bilateral trade inflation bondholders,
with Argentina and stabilization plans. including mutual
Brazil was minimal. Significant funds.
Only 2 percent of appreciation of the
Argentina’s and real exchange rate
Brazil’s exports were and concerns
destined to Mexico. about
Little scope for overvaluation.
third-party trade Large capital
story. Mexico’s inflows in the run-
exports to the up to the crisis.
United States were
very different from
Argentine and
Brazilian exports.
Thailand, July 2, 1997 Bilateral trade with Heavily managed European and Japanese
other affected exchange rates commercial banks
countries was very and large increase lending to Thailand,
limited. Malaysia in the stock of Korea, Indonesia and
exported similar short-term foreign Malaysia. Mutual
products to some of currency debt. funds sell off Hong
the same third Kong and Singapore.
markets.
Russia/LTCM, August Virtually no trade with The most liquid Mutual funds and
18, 1998 the most affected emerging markets, hedge funds.
countries (bilateral Brazil, Hong Kong
or third party.) and Mexico, were
Exports from Brazil, most affected.
Mexico and Hong These three
Kong to Russia countries
accounted for 1 accounted for the
percent or less of largest shares of
total exports for mutual fund
these countries. holdings.
Sources: Direction of Trade International Monetary Fund, Bank of International Settlements, Interna-
tional Finance Corporation.
Figure 1
Net Private Capital Flows, 1985–2003
(billions of U.S. dollars)
a
Includes Argentina and Mexico.
b
Includes Indonesia, Malaysia, Philippines, South Korea and Thailand.
Source: IMF, World Economic Outlook.
Note: If the crisis occurred in the second half of the year, the vertical line is inserted in the following
year.
The Capital Flow Cycle

Fast and furious contagion episodes are typically preceded by a surge in capital
inflows which, more often than not, come to an abrupt halt or sudden stop in the
wake of a crisis. The inflow of capital may come from banks, other financial
institutions or bondholders. The debt contracts typically have short maturities,
which means that the investors and financial institutions will have to make decisions
about rolling over their debts or not doing so. With fast and furious contagion,
investors and financial institutions who are often highly leveraged are exposed to
the crisis country. Such investors can be viewed as halfway through the door, ready
to back out on short notice.
This rising financial exposure to emerging markets is not present to nearly the
same extent in the crises without major external consequences. Financial crises that
have not set off major international dominos have usually unfolded against low
volumes of international capital flows. Given lower levels of exposure, investors and
institutions in the financial sector have a much lower need to adjust their portfolios
Table 4
Capital Flows and Capital Flight on the Eve of Crises
Capital flow background in other

Episode Capital flow background in crisis country relevant countries
Fast and furious episodes
Exchange rate Net capital flows to Finland had risen In 1989, private net capital
mechanism crisis: from less than $2 billion in 1998 to flows to the European Union
Finland, September 8, $9 billion at their peak in 1990. (EU) were about $11 billion
1992 Portfolio flows, which were about (U.S. dollars), in 1992, on
$3 billion in 1988, however, hit their the eve of the crisis, these
peak prior to the crisis in 1992 at had risen to $174 billion.
$8 billion.
Tequila crisis: In 1990, private net capital flows were Net flows to the other major
Mexico, December less than $10 billion (U.S. dollars); by Latin American countries
21, 1994 1993, flows had risen to $35 billion. had also risen sharply; for
Estimates of capital flight showed a western hemisphere as a
repatriation through 1994. whole it went from net
outflows in 1989 to inflows
of $47 billion in 1994.
Asian crisis: From 1993 to 1996, net capital flows to Flows to emerging Asia had
Thailand, July 2, 1997 Thailand doubled to about $20 billion risen from less than
(U.S. dollars); in 1997, capital outflows $10 billion (U.S. dollars) to
amounted to about $14 billion. almost $80 billion in 1996.
Russian crisis: August While total flows into Russia peaked in Excluding Asia, which
18, 1998 1996, foreign direct investment peaked witnessed a sharp capital flow
in 1998, rising from about $0.1 billion reversal in 1997, capital flows
in 1992 to $2.2 billion in 1998. to other emerging markets
remained buoyant through
1997 and early 1998, having
risen from about $9 billion
in 1990 to $125 billion in
1997.
Cases without immediate international consequences
Brazil devalues and Repatriation of capital flight amounted At about $54 billion (U.S.
floats: February 1, to about 3 percent of GDP in 1996. By dollars) in 1999, capital flows
1999 early 1998, it had reversed into capital to western hemisphere well
flight. Yet net capital flows did not below their peak ($85
change much between 1997 and 1999, billion) in 1997.
currency crisis notwithstanding.
Turkey floats the lira: While repatriation amounted to about Following the successive crises
February 22, 2001 2 percent of GDP during 1997–1999, in Asia (1997) and Russia
capital flight began in earnest in 2000. (1998), private capital flows
to emerging markets had all
but dried up by 2001. At a
meager $20 billion in 2001,
flows were $200 billion off
their peak in 1996.
Argentina defaults: Until 1998, capital abroad was being (See Turkey commentary.)
December 23, 2001 repatriated. By 1999, however, capital
flight amounted to 5 percent of GDP.
After several waves of bank runs,
capital flight was estimated at
6 percent of GDP in 2001.
Sources: International Monetary Fund World Economic Outlook and authors’ calculations.
Figure 2
Emerging Market: Bond Market Issuance Around Crises
(in billions of U.S. dollars: weekly data, centered three-week moving average)
3.6
3.2
2.8
After Brazilian devaluation
2.4
2
1.6
1.2
0.8 After unilateral Russian
0.4 debt restructuring
0
⫺5 ⫺4 ⫺3 ⫺2 ⫺1 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Weeks Relative to Crisis Week (Week 0)
Note. Data prior to Russian default exclude the July 1998 Russian debt exchange.
Source: IMF staff calculations based on data from Capital Data.
when the shock occurs. In many instances, because the shock is anticipated,
portfolios were adjusted prior to the event.
In all five of the examples from Table 1, the capital flow cycle has also played
a key role in determining whether the effects of a crisis have significant interna-
tional ramifications. For example, in the late 1970s, soaring commodity prices, low
and sometimes negative real interest rates (as late as 1978, real interest rates
oscillated between minus 2 percent and zero) and weak loan demand in the United
States made it very attractive for U.S. banks to lend to Latin America and other
emerging markets—and lend they did. Capital flows, by way of bank lending,
surged during this period, as shown in Figure 1. By the early 1980s, the prospects
for repayment had significantly changed for the worse. U.S. short-term interest
rates had risen markedly in nominal terms (the federal funds rate went from below
7 percent in mid-1978 to a peak of about 20 percent in mid-1981) and in real terms
(by mid-1981, real short-term interest rates were around 10 percent, the highest
level since the 1930s). Since most of the existing loans had either short maturities
or variable interest rates, the effects were passed on to the borrower relatively
quickly. Commodity prices had fallen almost 30 percent between 1980 and 1982,
and many governments in Latin America were engaged in spending sprees that
would seal their fate and render them incapable of repaying their debts. In 1981,
Argentina’s public sector deficit as a percentage of GDP was about 13 percent,
while Mexico’s was 14 percent; during 1979 –1980, Brazil’s deficit was of a compa-
rable order of magnitude. Prior to Mexico’s default in August 1982, one after
another of these countries had already experienced currency crises, banking crises
or both. When Mexico ultimately defaulted, the highly exposed and leveraged
banks retrenched from emerging markets in general and Latin America in
particular.
During the decade that followed, Latin America experienced numerous crises,
including some severe hyperinflations (Bolivia in 1985 and Peru, Argentina and
Brazil in 1990) and other defaults. Yet these crises had minimal international
repercussions, as most of the region was shut out of international capital markets.
The drought in capital flows lasted until 1990.
Figure 1 shows net private capital flows for the contagion episodes of the 1990s,
while Table 4 provides complementary information on capital flows and capital
flight for the crisis country and those affected by it. Again, notice the common
pattern of a run-up in borrowing followed by a crash at the time of the initial shock
and lower inflows of capital thereafter. Net private capital flows to Europe had risen
markedly and peaked in 1992 before coming to a sudden stop after the collapse of
the Exchange Rate Mechanism crisis, in which the attempt to hold exchange rates
within preset bands fell apart under pressure from international arbitrageurs. The
crisis in the European Monetary System in 1992–1993 showed that emerging
markets do not have a monopoly on vulnerability to contagion, although they
certainly tend to be more prone to crisis.
In the case of Mexico, as the devaluation of the peso loomed close late
in 1994, capital flows were close to their 1992 peak after surging considerably.
(As late as 1989, Mexico had recorded net large capital outflows.) The rise in
capital flows to the east Asian countries of Indonesia, Korea, Malaysia, the
Philippines and Thailand (shown in Figure 1) was no less dramatic— especially
after 1995, when Japanese and European bank lending to emerging Asia
escalates.
The bottom right panel of Figure 1 shows the evolution of capital flows to all
emerging markets and the progression of crises. The halcyon days of capital flows
to emerging markets took place during the first half of the 1990s and held up at
least for a short time after the Mexican crisis and its contagious effects on Argen-
tina. But the east Asian crisis brings another wave of contagion along the marked
decline in capital flows in 1997. The Russian crisis of August 1998 delivers another
blow from which emerging market flows never fully recover in the 1990s. As shown
in the right bottom panel of Figure 1, this crisis is associated with the second major
leg of decline in private capital flows to emerging markets. Since Figure 1 is based
on annual capital flow data, it significantly blurs the stark differences in capital
flows during the pre- and post-Russian crisis. Figure 2 plots weekly data on emerg-
ing market bond issuance before (negative numbers) and after (positive numbers)
the Russian default (dashed line) and, for contrast, the Brazilian devaluation on
January 1999 (solid line). The vertical line marks the week of the crisis. Bond
issuance collapses following the Russian crisis and remains for over two months
following the event; by contrast, the Brazilian devaluation had no discernible
impact on issuance, which actually increases following the devaluation.
As Figure 1 highlights, the next three crises—the Brazilian devaluation of

January 1999, the Turkish devaluation of February 2001 and the Argentine default
at the end of 2001—take place during the downturn of the cycle and at levels of net
capital inflows that were barely above the levels of the 1980s drought. Indeed, the
estimates of capital flows to emerging markets in recent years shown in Figure 1
may actually be overstated because total net flows include foreign direct investment,
which held up better than portfolio bond and equity flows.
Surprise Crises and Anticipated Catastrophes

Fast and furious crises and contagion cases have a high degree of surprise
associated with them, while their quieter counterparts are more broadly antici-
pated. This distinction appears to be critical when “potentially affected countries”
have a common lender. If the common lender is surprised by the shock in the
initial crisis country, there is no time ahead of the impending crisis to rebalance
portfolios and scale back from the affected country. In contrast, if the crisis is
anticipated, investors have time to limit the damage by scaling back exposure or
hedging their positions.
Evidence that quieter episodes were more anticipated than the fast and furious
cases is presented in Table 5. Standard and Poor’s credit ratings had remained
unchanged during the twelve months prior to the Mexican and Thai currency
crises. In the case of Russia, the credit rating is actually upgraded as late as June
1998 when the broader definition that includes Credit Watch (CW) status is used.
The CW list lists the names of credits whose Moody’s ratings have a likelihood of
changing. These names are actively under review because of developing trends or
events that warrant a more extensive examination. Two downgrades eventually take
place prior to the crises on August 13, 1998, and again on August 17, the day before
the default. By contrast, Argentina has a string (five) of downgrades as it marched
toward default, with the first one taking place in October 2000, over a year before
the eventual default. Likewise, Brazil and Turkey suffered downgrades well before
the eventual currency crisis.
As further evidence that markets anticipated some of the shocks and not
others, Figure 3 plots of the domestic-international interest rate differential for the
Emerging Market Bond Index (EMBI) and the EMBI⫹ for two of the contagious
episodes (Mexico and Russia, top panels) and for two crises without immediate
international repercussions (Argentina and Brazil, bottom panels).6 The patterns
shown in these four panels are representative of the behavior of spreads ahead of
6
The Emerging Market Bond Index Plus (EMBI⫹) tracks total returns for traded external debt
instruments in the emerging markets. While the EMBI covers only Brady sovereign debt bonds, the
EMBI⫹ expands upon the EMBI, covering three additional markets: 1) Eurobonds; 2) U.S. dollar local
market instruments; and 3) performing and nonperforming loans. The country coverage of the EMBI⫹
varies over time, currently including 19 members. Current members are Argentina, Brazil, Bulgaria,
Colombia, Ecuador, Egypt, Mexico, Malaysia, Morocco, Nigeria, Panama, Peru, Philippines, Poland,
Russia, Turkey, Ukraine, Venezuela and South Africa.
Table 5
Expected and Unexpected Crises: Standard and Poor’s Sovereign Credit Ratings
Before and After Crises
Change in rating
(including Credit Watch)
12 months prior to the Change in rating after
Country Crisis date crisis the crisis
Fast and furious contagion episodes
Mexico December 21, 1994 None Downgraded two days

after the crisis,
December 23, 1994
Thailand July 2, 1997 None Downgraded in August
Russia August 18, 1998 1 upgrade and 2 1 further downgrade
downgrades (the
latter on the week
of the crisis)
Crises with limited external consequences
Brazil February 1, 1999 2 downgrades No immediate change

Turkey February 22, 2001 1 upgrade and 2 1 further downgrade
downgrades the day after the
crisis
Argentina December 23, 2001 5 downgrades between
October 2000 and
July 2001
Source: Standard and Poor’s, Sovereign Rating History Since 1975.
anticipated and unanticipated crises. (The vertical axis is measured in basis points,
so a measure of 1000 means a gap of 10 percentage points between the domestic
borrowing rate and the international benchmark.) If bad things are expected to
happen, risk increases and spreads should widen. The overall message is that fast
and furious episodes are accompanied by sharp spikes in yield differentials—
reflecting the unanticipated nature of the news—whereas other episodes have
tended to be anticipated by financial markets.
The top left panel of Figure 3, which shows the evolution of Mexico’s spread
in the precrisis period, is striking. In Mexico, spreads are stable at around 500 basis
points in the months and weeks prior to the December 21, 1994, devaluation.
Indeed, Mexico’s spreads remained below 1,000 basis points until the week of
January 6, 1995. Russian spreads, illustrated in the top right panel of Figure 3, show
remarkable stability until a couple of weeks prior to the announcement and default.
In the case of Russia, the devaluation of the ruble appears to have been widely
expected by the markets, as evident on the spreads on ruble-denominated debt.
One can conjecture that it was either the actual default or the absence of an IMF
bailout (following on the heels of historically large bailout packages for Mexico and
Korea) that took markets by surprise.
Figure 3
Emerging Market Bond Yield Spreads, 1992–2002
Mexican Russian
2500 crisis 7000 crisis
Mexico Russia
6000
2000
5000
1500 4000
1000 3000
2000
500
1000
0 0
92 93 94 95 96 98 99 00 01 02
8000 2500
Argentina Argentina Brazil Brazil
7000 crisis devaluation
2000
6000
5000
1500
4000
3000 1000
2000
500
1000
0 0
98 99 00 01 02 98 99 00 01 02
Note: Emerging market bond index plus (EMBI⫹) spreads are plotted.
Source: JP Morgan Chase.
The data presented in the bottom panels of Figure 3 illustrate the fact that
markets foreshadowed turbulence in the cases of Argentina (2001) and Brazil
(1999). The left bottom panel of Figure 3 presents evidence for interest rate
spreads for Argentina and shows that the cost of borrowing began to rise steadily
and markedly well before its default on December 23, 2001. In effect, since the
week of April 22, spreads began to settle above 1,000, and after July 20, they never
fell below 1,500. The bottom right panel of Figure 3 shows Brazilian spreads. There
is a run-up in spreads well before Brazil floats the real on February 1, 1999. This
chart also reveals that Brazil—more so than Argentina—was quickly and markedly
affected by the Russian crisis.
In sum, we have provided suggestive evidence that anticipated crises are
preceded by credit ratings downgrades and widening interest spreads before the
crisis, while for unanticipated crises, the downgrades and widening of spreads come
during the crisis or after the fact.
Common Creditors
As noted, international banks played an important role in the transmission of
some of the crises of the 1980s and the 1990s. In the 1980s, it was U.S. banks
lending heavily to Latin America, while in the 1990s, it was European and Japanese
banks lending to Asia, the transition economies and, in the case of Spanish banks,
Latin America. Here, we discuss the role that commercial banks and mutual and
hedge funds have played in the recent contagion episodes.
International bank lending to the Asian crisis countries grew at a 25 percent
annual rate from 1994 to 1997 (or at a pace of about $40 billion inflow per year).
At the onset of the crisis, European and Japanese banks’ lending to Asia was at its
peak at $165 billion and $124 billion, respectively, while the exposure of U.S. banks
was much more limited. Japanese banks had the highest exposure to Thailand,
which also accounted for 26 percent of their total lending to emerging markets (the
largest representation of any emerging market country in their portfolio). Collec-
tively, the Asian crisis countries (excluding the Philippines, which did not borrow
much from Japanese banks), accounted for 65 percent of the emerging market
loan portfolio of Japanese banks. For European banks, the comparable share was
23 percent. Following the floatation of the Thai baht on July 2, 1997, the exposed
banks retrenched quickly and cut credit lines to emerging Asia. The bank inflows
quickly became outflows of about $47 billion.
As with Asia, lending to transition economies had accelerated in the mid-
1990s. In the three years before the Russian crisis, international bank lending to the
region grew at 14 percent per annum. German banks were more heavily exposed
to Russia, with lending to Russia averaging about 20 percent of all their lending to
emerging economies. As with earlier fast and furious contagion episodes, bank
flows to the region, which oscillated around $28 billion per year in the years before
the crisis, turned into a $14 billion dollar outflow in the year following the crisis.
This retrenchment in lending helps explain why other transition economies were
affected by the Russian crisis. However, it fails to explain why Brazil, Hong Kong
and Mexico come under significant pressures at this time. To understand these and
other cases, we need to turn our attention to nonbank common creditors.
Equity and bond flows also declined sharply in the aftermath of the fast and
furious crises of the 1990s. For example, U.S.-based mutual funds specialized in
Latin America withdrew massively from the region following the Mexican crisis in
1994. As discussed in Kaminsky, Lyons and Schmukler (2002), withdrawals from
Latin America oscillated around 40 percent in the immediate aftermath of the
crisis. The countries most affected were Argentina, Brazil and (of course) Mexico,
which were the countries to which the mutual funds were most heavily exposed to
in Latin America at the time of the crisis. For example, if one examines the Latin
American portfolio of mutual funds specialized in emerging markets at around the
time of the crisis, Brazil, Mexico and Argentina account for 37, 26 and 14 percent
of their portfolio, respectively (that is, three countries accounted for 77 percent of
the Latin American portfolio!).
The Thai crisis in 1997 also triggered equity outflows through mutual funds
from Asia. The countries most affected by abnormal withdrawals were Hong Kong,
Singapore and Taiwan, the countries with the most liquid financial markets in the
region. Mutual funds were heavily exposed to these countries. Of the portfolio
allocated to Asia, 30 percent was directed to Hong Kong, 7 percent to Singapore
and 13 percent to Taiwan. Kaminsky, Lyons and Schmukler (2002) estimate that
abnormal withdrawals (relative to the mean flow during the whole sample) oscil-
lated at around 10 percent for the three economies.
Similarly, highly leveraged funds seem to have had an important role in the
speculative attack against the Hong Kong dollar in August of 1998 following the
Russian crisis (Corsetti, Pesenti and Roubini, 2001). According to a report from the
Financial Stability Forum (2000), large macro hedge funds appear to have detected
fundamental weaknesses early and started to build large short positions against the
Hong Kong dollar. According to available estimates, hedge funds’ short positions in
the Hong Kong market were close to $10 billion U.S. (6 percent of Hong Kong’s
GDP), but some observers believe that the correct figure was much higher. Several
large hedge funds also took very large short positions in the equity markets, and
these positions were correlated over time. As reported in the Financial Stability
Forum study, among those taking short positions in the equity market were four
large hedge funds, whose futures and options positions were equivalent to around
40 percent of all outstanding equity futures contracts as of early August prior to the
Hong Kong Monetary Authority intervention. Position data suggest a correlation,
albeit far from perfect, in the timing of the establishment of the short positions.
Two hedge funds substantially increased their positions during the period of the
Hong Kong Monetary Authority intervention. At the end of August, four hedged
funds accounted for 50,500 contracts, or 49 percent of the total open interest/net
delta position; one fund accounted for one third. The group’s meetings suggested
that some large, highly leveraged institutions had large short positions in both the
equity and currency markets.
Concluding Reflections
To date, what has distinguished the contagion episodes that happened from
those that could have happened seems to have had little to do with more “judicious”
and “discriminating” investors—nor with any improvements to boast of in the state
of the international financial architecture. If investors behaved in a more discrim-
inating manner in the recent crises where contagion could have happened but did
not, it is because i) those crises tended to unfold in slow motion and were thus
widely anticipated; ii) the capital flow bubble had been pricked at an earlier stage,
when those same investors were more “exuberant”; and hence, iii) the “common
creditor” we have stressed in our discussion was less leveraged in these episodes.
When looking back into history, one is struck by an overwhelming sense of déjà vu.
It certainly seems a mystery why episodes of financial crises and contagion recur, in
spite of the major costs associated with crises that would seem to provide a sufficient
motivation for avoiding them. But based on historical experience, there appears to
be little hope that during the good times, future generations of sovereign borrow-
ers or investors will remember that the four most expensive words in financial
history are “this time it’s different.”
If history is any guide, financial crises will not be eliminated—as Kindleberger
(1977) noted, they are hardy perennials. But it should be possible, based on the
understanding of what causes contagion and what does not, for countries to take
steps to reduce their vulnerability to international contagion.
Contagion appears to be linked to a substantial inflow of capital to a country.
Of course, the prospect of financial autarky as a way of avoiding fast and furious
contagion is not particularly attractive as a long-run solution. It may not even be
feasible when countries have already liberalized the financial sector and the capital
account. But before turning to the issue of capital account restrictions, it is critical
to remember that in many crises (most of those discussed here and many others),
the lead and largest borrower in international capital markets during the boom
periods are the sovereign governments themselves. As Reinhart, Rogoff and Savas-
tano (2003) observe, it is the most debt-intolerant countries with a history of serial
default that can least afford to borrow that usually borrow the most. Often the
outcome is default.
So as a first important step, the risk of contagion would be reduced if policy-
makers in countries that are integrated with world capital markets remember that
many a surge in capital inflows often ends in a sudden stop—whether owing to
home-grown problems or contagion from abroad. As a consequence, prudent
policymaking would at a minimum ensure that the government does not overspend
and overborrow when international capital markets are all too willing to lend, as
those episodes can often end in tears. In contrast, fiscal policy in emerging markets
currently tends to be markedly procyclical, with countries engaging in expansionary
fiscal policy in good times and contractionary fiscal policy in bad times (Talvi and
Végh, 2000). Fiscal reforms aimed at designing institutional mechanisms that
would discourage such procyclical behavior (particularly on the part of “provinces”
or other autonomous entities) appear as an essential ingredient in preventing
future crises from building up. However, such consistent self-discipline on the part
of governments has historically proved elusive.
As regards to curbing private borrowing from abroad, the issues are even more
complex. The best case for restrictions on international financial inflows would
seem to focus on debt contracts with short maturities that are denominated in a
foreign currency, the kind of capital flows that have been the trigger in many
modern contagion episodes. But although such policies may help in tilting the
composition of capital flows toward longer maturities, their overall long-term
effectiveness is unclear. Curbing capital outflows, once contagion and the ensuing
sudden stop has occurred, is even more problematic. Experience has shown that
capital flight has been an endemic problem for countries that have tried to turn the
clock back and reintroduce tight capital account and financial restrictions amidst
economic turmoil. More fundamentally, pervasive capital controls hardly seem

likely to be the solution in the medium and long run to the contagion and sudden
stop problem.
As to new mechanisms in financial centers that could curb these periodic bouts
of lending and “irrational exuberance” and lessen the likelihood of unpleasant
future surprises, we remain very skeptical that there are easy or obvious solutions.
Access to more information may not lessen surprises when borrowers and lenders
have often shown themselves willing to downplay worrisome fundamentals that are
in the public domain in the late 1990s under the guise of having superior infor-
mation. The economic historian Max Winkler wrote in the New York Tribune of
March 17, 1927:
The over-abundance of funds, together with the difficulty of finding the most
profitable employment therefore at home has contributed greatly to the
pronounced demand for and the ready absorption of large foreign issues,
irrespective of quality . . . . While high yield on a foreign bond does not
necessarily indicate inferior quality, great care must be exercised in the
selection of foreign bonds, especially today, when anything foreign seems to
find a ready market . . . . Promiscuous buying, however, is destined to prove
disastrous.
In 1929, a wave of currency crises swept through Latin America—it was quickly
followed by a string of defaults on sovereign external debt obligations. At the time
of this writing, with investors searching for high yields quickly snapping up emerg-
ing market bonds, Winkler’s warning rings as true now as it did then.
y The authors wish to thank Laura Kodres, Vincent Reinhart and Miguel Savastano for very
useful comments and suggestions and Kenichi Kashiwase for excellent research assistance.
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Journal of Economic Perspectives—Volume 17, Number 4 —Fall 2003—Pages 51–74

The Unholy Trinity of Financial

Graciela L. Kaminsky, Carmen M. Reinhart

y Graciela L. Kaminsky is Professor of Economics, George Washington University, Washing-

Origin of the shock, country Nature of common external

Origin of the shock: Background on the

drastic reversal of capital flows—the so-called “sudden stop” problem—played a

discussion of theories of contagion. The main message conveyed here is that

in a second country is a policy decision whose effect on output is expected to be

change in asset demand; they therefore respond as if the rebalancing is related to

Channels of Propagation: The Empirical Evidence

Some of the theoretical models just discussed emphasized trade linkages as

The Unholy Trinity: Capital Inflows, Surprises and

The Capital Flow Cycle

Capital flow background in other

Fast and furious episodes

As Figure 1 highlights, the next three crises—the Brazilian devaluation of

Surprise Crises and Anticipated Catastrophes

Fast and furious contagion episodes

Mexico December 21, 1994 None Downgraded two days

Brazil February 1, 1999 2 downgrades No immediate change

Source: Standard and Poor’s, Sovereign Rating History Since 1975.

economic turmoil. More fundamentally, pervasive capital controls hardly seem

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