Contagion : How it spreads and How it can be stopped ?

Recent events have drawn attention to the issue of contagion. Dependencies among countries, including through trade links, will cause shocks to an individual country (or group of countries) to affect other countries, often on a regional basis. Such linkages are not contagion, but an increase in cross-market linkages after a shock to one country could be contagion. Weak countries’ economic fundamentals, macro-similarities and exposures to certain type of financial agents and associated transmission channels are found to increase the risk of spillovers. And the rules in place for the international financial system can also play a role in contagion. Much is still unknown, however, about what makes countries vulnerable to contagion and through which precise mechanisms it is transmitted. Although much of contagion need not represent irrational behavior on the part of investors, it is clear that volatility will remain. Specific measures at the national level and the international financial architecture are necessary to reduce these risks, manage their impact, and recover as efficiently as possible. * The opinions expressed are not necessarily those of the World Bank. An earlier version of this paper was prepared for discussion at the WIDER workshop on f inancial contagion held at the World Bank on June 3 -4 and reflects comments from participants.