we were not looking, economic globalisation had occurred far faster than anyone was accounting for. No longer can risk be confined to the properties of a specific security and its environmental conditions, but an investor has to look at risk on a worldwide basis. In the first decade of the 2000s, you couldn’t open a newspaper without seeing reference to the butterfly effect, whereby a butterfly flapping its wings in China results in a tornado in Kansas. Note that the formal name for the butterfly effect is sensitive dependence on initial conditions, giving rise to just about any observation about an economy becoming expandable into grand deductions about markets near and far.
Since the Asian Crisis, when a big risk event occurs, market players judge whether the risks will be contained to one country or region or are global in nature, and react accordingly. Investors’ collective attitude towards risk becomes a factor in its own right and influences how markets react to shocks. As a report of the Bank for International Settlements (BIS) put it:
“Bad news in a market situation where investor risk appetite is already low is likely to result in a much greater repricing of risky assets than in periods where it is high. The dynamic stance of the risk appetite of market participants as a sentiment could thus serve as an important contributing factor in the transmission of shocks through the financial system. Furthermore, as it might itself be influenced by the situation in financial markets, it could work as a multiplier. Accordingly, taking into account the risk appetite/risk aversion of investors and its evolution has become an important element of assessing the condition and stability of financial markets.” [4]
In recent years, larger risk aversion on a global scale has been triggered most often by events taking place in the United States. The market panicked after the NASDAQ Composite crash in 2000, in the wake of the 9/11 attack of the World Trade Center, in the lead-up to the Iraq War in 2003, following Hurricanes Katrina and Rita in 2005, and during the subprime mortgage crisis that began to unfold in late 2008.
In contrast, the euro zone, which came officially into existence in January 1999, was the root cause of fewer worldwide risk events until recently. Small effects in the euro/dollar exchange rate were occasioned by the French and Dutch No vote on the referendum in favour of the European Union’s proposed constitution in 2005 and Ireland’s rejection of the Lisbon Treaty in 2008 (later accepted in the 2009 vote), but these events were contained to Europe. Having previously avoided being the source of a shock catalyst, Europe has more than made up for it with the peripheral country debt crisis that began in the fall of 2009, with Greece admitting it had cooked the budget books on the Olympics. This set off a chain of developments that has ended up endangering the structure and composition of the euro zone itself.
Asia had a chance to offer a shock again, in the form of the Shanghai Surprise from October 2007 to October 2008. The SSE Shanghai Composite Index was already falling from a peak in October 2007 when (on 28 February 2008) it fell 9% in a single day. The S&P fell the next day by the most since 9/11/01. European and Japanese markets fell. Certain other emerging market stock markets, like Brazil, Russia and Turkey, also suffered big declines – but not all emerging markets.
The Shanghai event was curious for many reasons, not least that at the time the exchange had limited international participation and the drop was triggered by reports of impending new restriction on transactions, including a proposed tax. By what logic does this isolated market – and why do other regional markets – have such an outsized effect, such as is illustrated in Figure 2.1, globally?
Figure 2.1 – the Shanghai Surprise (SSE Shanghai Composite Index (Dark)) vs. S&P 500, Nikkei 225 and FTSE 100
Explaining large-scale contagion
Analysts don’t have a good explanation for large-scale contagion. To call it a Pavlovian or herd-instinct response is both insulting to the investor class and insufficient. Why should one market drop in sync but not others? One reasonable-sounding scenario is that economies that are already vulnerable – due to trade and budget deficits, stressed institutions, inadequate legal and regulatory institutions, etc. – will be affected the most by a shock. These are the countries that sophisticated and knowledgeable investors will exit first. But that doesn’t account for the major markets in advanced countries following the Shanghai stock index. It also doesn’t account for a shock in one asset class in one country affecting different asset classes in other countries that are linked only in the most indirect ways. Something else is going on.
The something else is perception of riskiness in the world at large, and perception of riskiness is heavily influenced by what academics call information asymmetry. At a basic level, if one party to a transaction has more information than the other party, the informed party has more power and will likely be the profitable one. Think of inside information, moral hazard and why governments impose disclosure rules on minimum safety conditions in real estate.
Information asymmetry is illustrated perfectly in every home sale – the seller knows the furnace is on its last legs, the roof will need replacement in two years, and there is some asbestos lurking in the cellar ceiling. The selling agent may or may not know these things, and the buyer certainly doesn’t know them and will not be told them unless the law requires disclosure of each specific drawback by name. The buyer is at risk of overpaying for the house, and cannot count on the agent to volunteer adverse information because the agent works for the seller.
In the home sale case, the seller is more knowledgeable about the asset than the buyer. In the case of financial market information asymmetry, emerging market investors generally tend to have less information than advanced country investors about emerging markets overall, including their home market. The foreign investors tend to have more news sources, including sources that may not be permitted in the emerging market itself. In fact, sometimes the flow of adverse information runs from one emerging market through the advanced investors to a second emerging market before the domestic investors in the original emerging market catch on. That’s just one example of how a lopsided flow of information can move.
In market contagion, the less-knowledgeable party knows that he is less knowledgeable and fears being cheated, so that he sells even when there is no evidence that the quality of the asset has changed. When an investor knows he is less-knowledgeable, he assumes the more-knowledgeable parties have information he does not have, so he joins the stampede. Thus, when the presumed knowledgeable parties started a sell-off in overvalued Thai equities, it spread to other risky assets elsewhere in Asia and then Argentina and Russia, even though Malaysians, for example, complained it was unfair to be tarred with the Thai brush.
In many instances, the domestic investors were authentically more knowledgeable about their home assets and knew perfectly well that there was, objectively, no change in the conditions that should determine their prices – except that advanced country investors were fleeing emerging markets indiscriminately (in what investment managers term cross-market rebalancing). By assuming that emerging markets share the same market and economic risks to the same degree, the managers can transmit contagion in the form of falling prices even in the absence of directly relevant news, and sometimes between markets that do not, in fact, share the same risks.
It can work the other way around, too, like the home seller failing to disclose asbestos in the cellar ceiling. Unscrupulous asset sellers can offer fraudulent products, like some Chinese companies listed on the New York Stock Exchange and other exchanges, that are the paper equivalent of knock-off Rolex watches and Hermes scarves. The buyers who know they are less-knowledgeable about the true financial condition of these companies are the first to exit on news of a regulatory investigation.
The second important point is that information flow and thus market effects are not linear – they ricochet around in the pinball motion mentioned
