Estimating the contagion effect through the portfolio channel using a network approach

Alessandro Schiavone

Abstract

This work studies contagion risk through the portfolio investment channel using network analysis and simulation on bilateral cross-country data. The importance of the portfolio channel in the transmission of financial shocks reflects the high interconnectedness of the global financial system, which diminished in the aftermath of the global financial crisis but has resumed in recent years. The network representing cross-country portfolio investments turns out to be highly concentrated around the main financial centers, which act as global hubs connecting with nodes that are not linked  directly.  Using a network simulation model based on the assumption that international investors rebalance their portfolios after an idiosyncratic  shock, reducing investments in countries to which they are overexposed, we find that contagion effects may be significant even when the shock originates in a peripheral country. In addition, the model suggests contagion risk has risen since the global financial crisis, owing to the greater financial integration of emerging economies.