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The Financial Domino Effect

Prepared by: Lee Hudson Teslik
Updated: March 1, 2007

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It’s a truism to say the world’s economies are interconnected, but the aftermath of the February 27 Chinese stock market collapse was a blunt reminder of one of the darker aspects of an integrated world marketplace. Fearful that a government crackdown on illegal borrowing might dampen investment, Chinese traders pushed the country’s leading stock indices down about 9 percent, their worst trading day (Bloomberg) in ten years. A domino effect ensued. European and U.S. traders, spooked by the news, staged their own sell offs. The same thing happened at exchanges in Latin America, the Middle East, Africa, and Australia—indeed, virtually every major stock index in the world showed losses by the day’s end.

It remains to be seen whether these jitters represent a mere correction or the beginnings of a broader economic downturn. Chinese stocks bounced back on February 28, with the Shanghai index gaining a little over 3.5 percent, though nearly every other Asian stock index ended the day in the red. Some regional analysts responded to the stock stumble by labeling it a painful but necessary “major correction” (The Standard). But others worried something more serious and long-term might be afoot. One immediate concern is that a shriveling appetite (AP) for risky mortgages among U.S. lenders could dry up liquid capital. Following a period of carefree credit grants, lenders like Freddie Mac are clamping down (Reuters), and markets are taking note. "They're taking one of the cylinders out of the credit engine," says CFR Senior Fellow Roger Kubarych in a recent interview.

Even if the world’s stock markets quickly recover their losses, the specter of nearly every major exchange reacting in unison has its own ramifications. One prominent economist, Nouriel Roubini, noted the remarkable “contagion” of China’s stumble. The Financial Times, however, argues that Tuesday’s market slumps were not a case of “contagion”—in the form that riddled Asian markets in the late 1990s—but rather a healthier “correlation” based on the general overvaluation of a wide array of assets worldwide.

Call it what you will. The increasing correlation or contagiousness of financial markets—which also, at times, is called “synchronization” or “comovement”—is a major aspect of financial globalization, and one that more often than not has remained beneath the popular radar. A 2004 research paper by the economist Sébastien Wälti argues that modern market shocks—such as movements in interest rates or oil prices—are often relevant internationally, and that country-specific shocks are now more easily transmitted across borders due to increased efficiency of trade and finance.

Synchronization in financial markets is not in itself controversial, but the appropriate policy prescription is fodder for much debate. Complicating the discussion is the distinction that must be made between financial markets and underlying economies. While synchronization has increased both among the world’s financial markets and the world’s economies, the two correlations do not necessarily mirror (PDF) each other, claims an article in the World Bank journal Finance and Development. Sometimes financial markets are more strongly synchronized than real markets, and vice versa.

These questions of interdependence came into sharp focus on February 28 as Ben Bernanke, the chairman of the U.S. Federal Reserve, testified before the House Budget Committee. Some investors blamed Bernanke’s predecessor, Alan Greenspan, for igniting fears by commenting earlier this week that a recession was “possible” (AP) later this year. Bernanke sought to calm nerves, saying nothing had altered his forecast for moderate economic growth (MarketWatch) in the coming months.

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