How is financial contagion during the COVID-19 pandemic?

June 14,2021

Photo source: https://www.jbs.cam.ac.uk/insight/2020/covid-19-economic-impact/

The outbreak of COVID–19 has been declared as a global pandemic on March 11, 2020 by the World Health Organisation. The outbreak of COVID–19 has shaken the global financial markets. Level 1 market-wide circuit-breakers based on drops of 7% from the previous close were triggered four times on 9, 12, 16 and 18 March 2020 in the US stock market to prevent larger crashes. This mechanism has been triggered only once in 1997 since its implementation in 1988. Dow Jones Industrial Average (DJIA) and S&P500 indices dropped by 33% and 29%, respectively on March 20, 2020 from December 31, 2019, when the first confirmed case is reported by the World Health Organisation (WHO). Also, 16 March (12.93% drop) and 12 March (9.99% drop) were recorded third and sixth largest daily drops, respectively in DJIA. FTSE100, the UK main index suffered the worst quarter since 1987, recording a drop of 24.80% (The Guardian, 2020). Japan experienced more than 20% drop from December 2019 high (Bloomberg, 2020).

Following such a huge worldwide impact, the studies on the economic effects of COVID–19 has started to grow rapidly. This report highlights the effects of COVID–19 on financial firms (e.g., banks) compared to nonfinancial firms and financial contagion originated by them. It covers both pre-COVID–19 period (January 1, 2013– December 30, 2019) and COVID–19 period (December 31, 2019–March 20, 2020). The report takes the starting date of COVID–19 period as December 31, 2019, the date when the first case of COVID–19 was reported to the WHO by China. To investigate the financial contagion due to COVID–19 outbreak, the report focused on China and G7 countries for a number of reasons. First, China is a source of COVID–19. Second, China and G7 countries are among the most affected countries as they account for 68.19% of total confirmed cases as of 20 March 2020. Third, China and G7 countries account for 61.11% of global GDP as of 2018 (World Bank, 2020).

The results of this study show that Italian financial firms experienced the highest negative return during COVID–19 period, while the UK had the highest negative return for its nonfinancial firms during the same period. Negative returns are associated with the number of confirmed cases in China and G7 countries (see, Figure 1). The UK market return dropped by 40% during the period (December 31, 2019–March 20, 2020). Similarly, market indices in other G7 countries experienced a significant drop during the COVID–19 period. The volatility of financial and nonfinancial stock returns is higher during COVID–19 period compared to those during the pre-COVID–19 period. Correlations between Chinese and G7 financial and nonfinancial stock returns appear to be much higher during the COVID–19 period as compared to those during the pre-COVID–19 period, indicating the occurrence of financial contagion.

 

Figure 1: Return indices and daily changes in confirmed cases of COVID–19

Notes: USD return indices were created for the World, China, and G7 countries with a base of 100 on December 31, 2019 when the first confirmed case of COVID–19 is reported. The right axis represents daily changes in confirmed cases of COVID–19 whereas the left axis represent the base percentage of return indices.

Source: Datastream and https://www.ecdc.europa.eu/en/publications-data/download-todays-data-geographic-distribution-covid-19-cases-worldwide

The report shows that China and Japan appear to be net transmitters of spillovers during the COVID–19 period. Hence, the role of Chinese and Japanese financial and nonfinancial firms in the cross-market transmission of shocks to G7 countries may be of interest to policymakers, regulators, practitioners, and other market participants. The report also shows that investors faced higher hedging costs during the pandemic.

The report offers many suggestions to investors in optimising their portfolios and provide guidance to policymakers and regulators. During this COVID19 phase, not only international stock markets but also foreign exchange markets had extremely volatile days. More important hedging costs in equity markets combined with currency mismatches in portfolios have increased both market and credit risk for international investors. These developments force market participants (in particular banks) to reduce their risk-taking capacity and dampen the growth in both financial markets and global economies. In order to prevent these actions, policymakers should keep providing liquidity to international markets as illustrated by the recent global swap arrangements made by the Federal Reserve. 

Thuy DAO, University of Paris 8, France

The article is based on Akhtaruzzaman, M., Boubaker, S., & Sensoy, A. (2021). Financial contagion during COVID–19 crisis. Finance Research Letters, 38, 101604.
(https://www.sciencedirect.com/science/article/pii/S1544612320305754)