Financial Contagion and Vulnerability of Asian Financial Markets

June 2010

Abstract

The global experience of the last two years has shaken conventional beliefs in the benefits of unfettered financial markets. In response to the Asian crisis of a decade ago, most Asian economies had switched to an apparently more durable system of financing economic growth. But this did not prevent Asian countries from suffering considerably from the global financial crisis. Moreover, the spread of the crisis across countries seems to have been channelled more by financial linkages than conventional trade linkages. This raises questions about the future of financial integration among Asian economies and between Asia and the rest of the world. This paper first documents some features of the propagation of the global financial crisis. It then goes on to explore a two-country theoretical model in which there is a trade-off between the risk sharing benefits of international financial markets and the contagion effects of international financial interdependence. The key resultfeature of the model is to show that financial market integration in the presence of financial constraints can generate very high macroeconomic comovement among economies, quite independent of international trade linkages.

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