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Experiences of three Eastern European Countries during the Russian Crisis - An Analysis of 'Contagion *1'

March 25, 1999
Kazunari Ohashi
Charlotte Honebon

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Views expressed in the Working Paper Series are those of the authors and not necessarily those of the Bank of Japan or its overseas representative offices.
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I. Introduction

  1. The liquidity crisis triggered by last August's Russian default made international financial markets shiver. The fallout has extended its reach to have an effect on Latin American countries. On 13th January, Brazil was driven to devalue her currency. The Brazilian crisis has served to rekindle the fear of an international liquidity crisis and global deflation 1.
  2. Despite such turmoil, however, Eastern European countries (especially Poland, Hungary and the Czech Republic) are riding over last year's Russian crisis almost unscathed. Their currencies sustained most of their value. The result has been a surprise to most market participants.
  3. Comparison among sovereign spreads alone gives a fair measurement of the aftermath. For example, Russian sovereign spreads widened by nearly 12 times. This resulted in 4 to 5 times wider sovereign spreads in Turkey and South Africa, whereas the spreads of the three Eastern European countries remained within two times the range.
  4. Some regard the phenomena as merely contingent. However, we cannot ignore that the Eastern European effort to transform themselves into market-orientated capitalist economies after democratisation, as well as the building of a stronger relationship with EU countries, have fostered the region's resilience to "contagion." Such evidence may serve as a strong reservation to the arguments that favour strengthened market intervention and re-regulation, which have gathered momentum since the Asian crisis in 1997.
  5. Given that a commonly accepted theory of the cause, occurrence and process of "contagion" has not been established, it is not easy to conduct a theoretically solid analysis of the phenomenon 2. However, the experiences by Eastern European countries could submit useful viewpoints in studying a global "contagion" process at the time when concern over the effects of a Brazilian crisis is increasing.
  6. This report tries to extract from discussions with experts and analysts on Eastern European countries' ability to shelter from global "contagion." The report focuses on three major Eastern European countries in order to make analysis simpler. We also break down different market views on contagion into three different categories of 1) views stressing market sentiment; 2) difference in fundamentals; 3) the role of short-term capital movements.
  1. Although the assessment of the Brazilian crisis since the turn of the year warrants due account of future developments, at least the contagion effect of the crisis hitherto on the securities market looks limited (Among the three Eastern European countries Hungary appears to have been the most vulnerable due to its narrow exchange rate band. This is exacerbated by relatively low foreign exchange reserves, liquidation of foreign holdings of domestic bonds and closing of futures contracts by locals). While the yields of the Polish and Czech bonds increased by a mere 20-40bp, that of the Hungarian bonds increased by 140bp.
  2. The theoretical models of contagion vary from the one that focuses on the intensity of the trade and capital transactions relationships, the one that focuses on the differences among market participants in the interpretation of the same information and the following correction processes (so-called "information cascade") to the one that focuses on the role of financial institutions as a liquidity provider (for instance, a variation of the traditional bank-run model by Diamond-Dibvig). For further detail, see Eichengreen, et al (1997), "Contagious Currency Crises."
  • *1The authors wish to thank Gabor Bognar, Alexander Perjessy and Mariko Sugi of Goldman Sachs, Steven Gilmore, Masako Matsuyama-Smith and Mitsumasa Choji of Morgan Stanley, Stuart Parkinson of Deutsche Bank, Paul Kelly, Bank of England and Cemile Geyik for their contributions to this work. Needless to say however, any remaining errors in the paper are the authors'. Views expressed here are those of the authors and do not necessarily reflect those of the Bank of Japan or any of the above companies.