International Investors' Actions Contributed to Spreading Market Crises
ANN ARBOR, Mich.---The decade of the 1990s witnessed a series of stock-market crises in emerging markets, including the Mexican peso collapse in 1994, the East Asian meltdown in 1997 and the Russian default in 1998.
In each of these cases, the initial shock to one country or a group of countries seemed to spread extremely rapidly to other stock markets around the globe, prompting economists to theorize about the transmission mechanism of crises.
A comprehensive study of the 1997 East Asian crisis at the University of Michigan Business School led researchers to conclude that international investors, driven primarily by wealth constraints, caused the crises to spread between countries by shifting their asset holdings.
The "contagion," or increase in cross-market linkages after each shock, was not connected to changes in the crisis country¿s market fundamentals, according to the findings, which appear in a research paper, "How do Crises Spread: Evidence from Investable and Non-investable Stock Indices."
Kathy Yuan, an assistant professor of finance at the Michigan Business School, doctoral student Brian Boyer and Tomomi Kumagai of Wayne State University, reached their conclusions by examining two categories of stocks in developing countries---those eligible for purchase by foreigners (investable) and those not eligible (non-investable).
Their research shows that international transmissions of crises were more pronounced in investable stocks than in non-investable ones, providing evidence of how foreign investors contributed to the spread of market turmoil. Furthermore, the results indicate that the actions of these international asset holders were prompted by constraints on their wealth rather than the need to rebalance their portfolios.
"When international investors suffer a large loss in investment in the crisis country, they may have to liquidate their positions in other countries, thus causing equity prices to depreciate elsewhere," Yuan said. "This effect can snowball, impacting greater numbers of investors and leading to further price drops in stocks in other markets."
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