Economic Report President

markets, and the sovereign spreads of emerging market economies.Some observers interpret this contagion in the same way they do thecrisis itself, namely, as proof that markets are irrational and prone tounjustified panic. Various explanations based on economic fundamentalscan also be adduced, however.Common ShocksContagion may be due to common economic shocks. For example,falling commodity prices hurt commodity-exporting countries. This canexplain why the same shocks affected countries as distant from eachother as Canada, Chile, Indonesia, Russia, and New Zealand.Trade LinkagesWhen one country devalues its currency, its competitive positionimproves relative to that of its major trading partners. The tradingpartners’ currencies may then experience pressure as speculators recognizethat their trade deficits are likely to rise. Another channel ofcontagion via trade occurs through income effects: a downturn inJapan depresses Asian exports to Japan, and vice versa. Trade linkagesfostered the spread of the currency crisis within East Asia in1997. Evidence suggests that contagion is related to the strength oftrade links and regional factors.Competitive DevaluationsContagion may also have resulted from the prospect, or simply thefear, of competitive devaluations among countries competing in thirdcountrymarkets. For example, the first wave of currency declines inAsia in the summer of 1997 worsened the cost competitiveness of othereconomies throughout the region that initially maintained their nominalexchange rates fixed. This led to attacks on many of these currencies.Concerns about loss of competitiveness help explain, for example,the decisions of Taiwan and Singapore to allow their currencies to fallas the other regional currencies were depreciating. The weakness ofthe yen in 1997 and much of 1998 may also have provoked fears ofcompetitive devaluations in the region.Other Real and Financial LinkagesOther links between countries’ real and financial sectors may alsoserve as a conduit for contagion. If one country invests in and lendsheavily to another, bad economic news in the latter will upset marketsin the former. Pressures in the financial and currency markets of HongKong, Korea, and Singapore, for example, were related to the fact thatthese economies had heavily lent to, invested in, and traded with firmsin Indonesia and the other crisis economies. Losses of this naturealso affected banks and other financial firms in Japan, Europe, andthe United States that had invested in East Asia, Russia, and Latin243