Trade Link, Neighbourhood and Country Size: Which is More Important in Driving Contagion?

Abstract

In this study, the relative importance of three preselected contagion channels has been tested, namely, trade link, neighbourhood effects and country size in transmitting the financial crises. Contagion is defined as the co-movements between financial markets during crises periods after eliminating the common shock impact. Major stock market indices returns have been employed from 21 countries during the 1997 Asian crisis, 1998 Russian Crisis, 1999 Brazilian Crisis and 2008 American Crisis as the contagion effect indicator, and weighting matrices have been built for each contagion channel to reflect the inter-country relationship regarding this specific contagion channel. The results show that the co-movements in our sample countries are caused by contagion effect rather than common shocks. All three contagion channels are statistically significant in explaining the contagion effect during the four crises, while the neighbourhood effect is the dominant driver. Moreover, the results across different financial crises are very consistent.