Market contagion refers to the spread of disturbances (usually a sell-off) from one country and one market to another. Foreign exchange rates, stock market prices and sovereign bond prices can all be quickly affected by contagion.
At the same time, capital flows happen from the geographical areas affected by the contagion.
Why does contagion happen?
Financial contagion can happen internationally and domestically. At a domestic level, the failure of a bank or financial intermediary can trigger a domino effect.
For instance, if a bank defaults on its interbank counterparty liabilities and then engages in an asset fire sale, it undermines confidence in similar banks and the banking system.
This domestic contagion can then infect international banks and markets. For example, the subprime mortgage securities crisis caused the temporary collapse of the Western Hemisphere banking system. Banks failed, cash rushed into haven currencies and assets, as many global stock markets crashed.
International financial contagion can occur in advanced and developing economies, and this global financial contagion usually happens simultaneously among domestic institutions such as banks and across countries.
The contagion can last for months and is usually brought under control by a mixture of bilateral intergovernmental fiscal and central bank monetary policy stimuli.