When Thailand abandoned its currency peg in July 1997, the immediate damage seemed contained. A single emerging market adjusting its exchange rate hardly warranted global alarm. Yet within months, the crisis had swept through Indonesia, South Korea, and Malaysia. Within a year, it reached Russia and Brazil—economies with vastly different structures and vulnerabilities.

This pattern repeats across decades of financial history. Distress in one country jumps borders in ways that seem disproportionate to the actual economic connections involved. Markets that appeared stable come under intense pressure—not because of domestic failures, but because something went wrong somewhere else entirely.

Understanding why crises cascade requires examining three distinct transmission channels. Each operates through different mechanisms, but together they form a feedback system where localized trouble amplifies into systemic disruption. The dynamics reveal how quickly confidence can unravel—and why financial contagion remains one of the most powerful forces in modern macroeconomics.

When a country's currency depreciates sharply, its exports become cheaper on world markets almost overnight. For countries competing in the same product categories—textiles, electronics, agricultural commodities—this represents an immediate competitive threat. The pressure to respond by allowing their own currencies to weaken can become intense, even when domestic fundamentals don't warrant a depreciation.

The Asian financial crisis illustrates this clearly. When the Thai baht fell, Thailand's export prices dropped significantly relative to those of Malaysia, Indonesia, and the Philippines. These economies competed directly in many of the same manufacturing sectors. Maintaining a stable exchange rate while a major regional competitor effectively discounted its entire export base meant accepting a painful and growing loss of market share—something few governments could tolerate for long.

The mechanism operates through both actual trade flows and investor expectations. As competitive pressures build, currency markets begin to anticipate that policymakers in affected countries will eventually yield. Traders start positioning for depreciation in the next most vulnerable economy. This speculative pressure itself becomes a force pushing the currency downward, creating a self-reinforcing dynamic where expectations generate the very outcome that was feared.

What makes trade-linked contagion especially difficult to contain is its sequential nature. Each depreciation in the chain shifts competitive pressure onto the next country in the network. The process doesn't stabilize until the adjustments have worked through the entire system—or policymakers intervene with coordinated force sufficient to break the cycle. Historical episodes consistently show that once this chain reaction begins, individual countries face enormous difficulty resisting the pressure alone.

Takeaway

When competitors share the same export markets, one country's devaluation becomes every competitor's crisis. Currency instability cascades along trade routes because no economy can afford to ignore the pricing power its neighbors just gained.

The second contagion channel runs through the balance sheets of international investors. When a major bank, hedge fund, or institutional asset manager suffers significant losses in one market, the damage rarely stays contained. Portfolio management rules, margin requirements, and internal risk limits force these institutions to reduce exposure elsewhere—often in markets that share no direct economic connection to the original source of distress.

The mechanism is straightforward but powerful in practice. An investment fund holding positions across multiple emerging markets takes a substantial loss when one country's currency collapses. To meet margin calls or satisfy risk management constraints, the fund must raise cash quickly. The fastest route is selling liquid assets in other markets—regardless of whether conditions there have deteriorated. This selling pressure drives down prices, potentially triggering further margin calls and additional rounds of forced liquidation.

The 1998 Russian debt crisis demonstrated this with striking clarity. Losses on Russian government bonds forced highly leveraged investors—most notably Long-Term Capital Management—to rapidly unwind positions across global markets. Bond spreads widened sharply in Latin America, emerging Asia, and even in developed-market credit. These economies hadn't suddenly weakened. The same institutions that held Russian debt simply maintained significant positions elsewhere and needed to sell.

This channel reveals an uncomfortable truth about financial globalization. The more internationally diversified the investor base becomes, the more pathways exist for distress to propagate. Diversification reduces risk for individual portfolios while simultaneously creating the connective tissue through which shocks travel between markets. The very institutions designed to allocate capital efficiently across borders become the conduits through which localized crises achieve global reach.

Takeaway

The same portfolio diversification that protects individual investors creates the wiring through which crises propagate between markets. Global capital doesn't just spread risk—it spreads contagion.

The third transmission channel is perhaps the most subtle. When a crisis hits one country, investors don't merely assess the direct spillover effects. They reassess their assumptions about every country that looks similar. A banking crisis in Thailand doesn't just raise questions about Thailand—it raises questions about any economy sharing comparable features: large current account deficits, weak banking supervision, pegged exchange rates, or heavy reliance on short-term foreign borrowing.

This wake-up call effect operates through the economics of information. Monitoring every country's financial health in real time is prohibitively expensive. Investors rely on categories and mental shortcuts to manage complexity. When one member of a perceived group—"Asian emerging markets" or "commodity exporters"—experiences a crisis, investors update their beliefs about the entire category. Countries that might have withstood individual scrutiny get swept up in a broader reassessment that has little to do with their specific circumstances.

The information channel also carries a self-fulfilling dimension. When investors withdraw capital based on perceived similarities to a crisis-hit neighbor, the resulting outflows can themselves create the financial stress that validates the initial concern. A country with adequate reserves might have weathered normal conditions comfortably. But once contagion-driven capital flight begins, the pressure on reserves and the exchange rate can push fundamentals past a tipping point that wouldn't otherwise have existed.

What makes informational contagion so destabilizing is that it punishes countries for characteristics they share with others, not for their own specific vulnerabilities. The rational response for any individual investor—reducing exposure to economies resembling the one in crisis—produces collectively irrational outcomes. Countries with sound policies and sustainable debt can find themselves facing crisis simply because the market decided they belong to the wrong category at the wrong time.

Takeaway

In a crisis, investors don't evaluate each country on its own merits—they judge it by the company it keeps. Vulnerability during contagion depends as much on perceived category as on actual fundamentals.

Currency crises cascade because modern financial markets are connected through multiple, overlapping channels. Trade competition, institutional balance sheets, and information processing each create distinct pathways for distress to propagate—often faster than policymakers can respond.

Each channel implies different policy responses. Trade contagion calls for coordinated exchange rate management. Common creditor effects demand attention to institutional liquidity and leverage. Informational contagion requires credible communication of why this economy differs from the one in crisis.

The recurring lesson across decades of financial turmoil is that no economy operates in isolation. In interconnected markets, vulnerability is as much about who your investors are and what your neighbors are doing as it is about your own fundamentals.