Financial Contagion in the East Asian Crisis

In this chapter, we analyze empirically the existence and extent of financial contagion in the East Asian crisis. We define financial contagion as a significant increase in correlation of financial variables after controlling fundamentals and common shocks, and we develop an autoregressive model to measure contagion. In particular, we attempt to exclude the common effects of the crisis in Southeast Asia on the East Asian NIE 4, and examine the existence of pure contagion among NIE 4. Our empirical results suggest that the Southeast Asian crisis did not directly trigger the crisis in Korea, but that its fallout to Taiwan played an important role in causing the Korean crisis. This result is consistent with the argument that the crisis in Korea was precipitated by foreign banks that after Taiwan was first affected by the Southeast Asian crisis in October 1997, drastically refused to roll over short-term loans to the Korean financial institutions, rather than portfolio investors.