BREXIT: Contagion all we need to know.

BREXIT is probably the hottest topic in the media and in the country as a whole, at the moment. The country is awash with the fallout from the vote, numerous debates and discussions, a number of leave voters changing their minds, others still believing  that the strength of the economic fundamentals will keep the UK afloat without the EU, while ‘stay in’ voters are out on the streets  protesting. Nevertheless, the impact of this decision is absolutely clear and, as was predicted by many,  negative…and not only for the UK. The BREXIT shock is going to spillover to other markets across the globe. How? Let’s try to predict the knock on effects here.

First of all – contagion, without doubt, is the central issue in international finance literature at the moment. However, it seems that researchers still cannot find a consensus on what this phenomenon actually means. Generally speaking, contagion is the significant increase in cross-market linkages after a shock occurs in one of the markets, as what we now have here in the UK.  An alternative view point is that the definition of contagion should not be so restricted, and should take into account not only financial but also macroeconomic fundamentals. I would say both positions make sense, depending on the research question you are attempting to answer and what exactly it is you are aiming to explore. However, what we are observing these days I would describe not as contagion, but as “pure contagion” or “spillover effect”.  Financial markets obviously started reacting to BREXIT well before it could have had any noticeable impact on macroeconomic fundamentals. Financial panic, shock, certainly…but is it all surprising and new from a theoretical perspective? Of course not!

The results of recent research conducted on a sample of 21 emerging and developed financial markets from 2005-2015 charts the burst in “spillovers” across markets during financial turmoil (see figure above). The Credit Crunch, starting in July 2007, caused a spike in total volatility spillovers from 55% to 63% at the end of 2007 (from 67% to 75% for returns spillovers). The financial panic in stock markets during the first quarter of 2008 which followed pushed further total spillovers to 67% for volatility and to 79% for returns. The Lehman Brothers collapse on 15 September, 2008 became the starting point for the world-wide spread of the Great Recession and raised values of total volatility spillovers to its maximum level, 72% (82% for return spillovers). These values remained high until the economic recovery. Consequently, total spillovers began to decrease from the beginning of 2010 and by the middle of 2011 had reached their pre-crisis values. However, the plot of the intra-region volatility spillovers graph across the Eurozone shows that there was no decline in spillovers from the beginning of 2010 as apparent in the global trend. This was because the European Debt Crisis, which started in October 2009 in Greece, spread to several Eurozone state members, causing an increase in spillovers.

An even more interesting fact is that the highest intensity of volatility spillovers has been identified across European markets, i.e. the UK, Germany, France, Spain and Switzerland. Therefore, in answer to the question whether developed European markets will be affected by BREXIT, I would reply with a resounding “Of course they will!”

The UK is without doubt the most influential market in the sample, even more influential than the US. What about the rest of the world? The findings show that markets are generally more susceptible to domestic and region-specific volatility shocks than to inter-regional contagion; therefore EU markets will be affected in the first instance. There have been some optimistic positions taken recently suggesting that markets will calm down shortly. However, taking into account that markets are always likely to react more strongly to negative than positive news, it seems obvious that the current political uncertainty will cause further increases in volatility in the UK market, and consequently increase spillover effect. Theory tells us that that the signal receiving markets are sensitive to both negative and positive volatility shocks, and the “stabilizing role” of volatility spillovers is discussed in recent literature too. But I would not be optimistic here and would say that in the case of BREXIT we will observe the asymmetric nature of volatility transmission, i.e. transmission of negative shocks will be stronger!

For the research results and references see the article available in open access:

http://www.sciencedirect.com/science/article/pii/S1057521915001519

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