Wealth Transfers, Contagion and Portfolio Constraints

This paper examines the co-movement among stock market prices and exchange rates within a three-country Centre-Periphery dynamic equilibrium model in which agents in the Centre country face portfolio constraints. In our model, international transmission occurs through the terms of trade, through the common discount factor for cash flows, and, finally, through an additional channel reflecting the tightness of the portfolio constraints. Portfolio constraints are shown to generate endogenous wealth transfers to or from the Periphery countries. These implicit transfers are responsible for creating contagion among the terms of trade of the Periphery countries, as well as their stock market prices. Under a portfolio constraint limiting investment of the Centre country in the stock markets of the Periphery, stock prices also exhibit a flight to quality: a negative shock to one of the Periphery countries depresses stock prices throughout the Periphery, while boosting the stock market in the Centre.