Financial contagion and attention allocation

This paper explains financial contagion between two stock markets with uncorrelated fundamentals by fluctuations in international investors’ attention allocation. We model the process of attention allocation that underlies portfolio investment in international markets using investors who face information processing constraints. Investors optimally allocate more attention to a region hit by a financial crisis, to the detriment of other markets. The resulting endogenous increase in uncertainty causes a reduction in the capacity to bear risks by international investors that induces them to liquidate their positions in all risky assets. Hence, there is a collapse in stock prices around the world. We show that the degree of non-anticipation of a crisis is crucial for the existence of contagion. Using data from the East Asian crisis and the number of news stories about Thailand in the Financial Times relative to news stories about Argentina, Brazil and Chile as a proxy for the relative attention allocated to the Asian stock market, we find evidence consistent with two key predictions of our model: first, the higher the volatility of the originator market, the more relative attention allocated to this market; and second, the more relative attention allocated to the originator market, the higher the volatility of the other markets. Our findings support the attention reallocation channel as a transmission mechanism of financial crises between regions during the period from January 1997 to July 1998.