**1. Introduction**

Many economists believe that the impact of the crisis comes not only because of the country's weak macroeconomic condition but also because of the interlinkage between the country and investor perception, which has played a bigger role in the emerging market economic crisis. This is proven by the great economic crisis in 1998 and 2008. The economic crisis that hit Southeast Asia and South Korea in 1998 was a dark past in the history of the global economy. The crisis that began in Thailand due to the difficulty in paying high foreign debt spread to various countries including Indonesia. Similarly, the economic crisis in 2008, which was triggered by the subprime mortgage crisis and the subsequent bankruptcy of Lehman Brothers in the United States, transmitted rapidly to Europe, Asia, and Latin America.

As a country with a strong influence, every event that happened in the United States, including the policies taken by their government, can affect the global economic condition. In 2018, the United States decided to raise the benchmark interest rate which made the investment in developing countries look no longer attractive. The Federal Reserve's policy of raising interest rates put pressure on other countries to tighten their monetary policies and reduce US dollar liquidity. Various countries were affected, including Indonesia, but Argentina and Turkey were the worst.

Argentina has a long history of economic crisis [1]. In the period of the 1950s, Argentina experienced severe inflation, which reached 102% in 1959. Their condition improved in the 1960s because of the global booming economy. Unfortunately, in 1975, Argentina's economy was poorly managed, so the inflation at that time reached 335%. In 2001, local government policy brought Argentina to owe the IMF an amount of USD 132 billion. The economic condition of Argentina had not shown signs of improvement. In 2015, Argentina was hit by an economic crisis again. Under President Macri's leadership, the Argentine government was trying to hold capital out. The central bank raised interest rates to 40%, recorded as the highest in the world today. This condition is exacerbated by the decision of the FED to continue to increase its interest rates, so that capital for emerging markets is likely to become more expensive and/or scarce. With an aim to be free of the crisis, the government turned to the International Monetary Fund (IMF) for \$57.1 billion or around Rp700 trillion (exchange rate of Rp14,000) in 2018 [2].

Rp8500. In the past 7 years, the rupiah has experienced a weakening trend. In the previous period, the rupiah can always return or have a stationary movement. In the periods of 2000–2001, the depreciation period occurred for 16 months, 2000–2003 for 24 months, and 2008–2009 for 10 months. From 2011 until today, the period of depreciation has occurred for three phases, namely, 32, 17, and 16 months. If it is accumulated (because there is at least a period of appreciation and is very thin), the period of depreciation has more or less happened for 65 months. There is no sign of when the rupiah will strengthen at least to the range of Rp12,000–13,000. This is still far from the average exchange rate in the last 18 years in the range of Rp10,000

*Contagion, Exchange Rate, and Financial Volatility: Indonesian Case in Global Financial…*

*DOI: http://dx.doi.org/10.5772/intechopen.92275*

*Movement of the exchange rate of rupiah against the dollar. Source: Authors, 2019.*

per dollar. It can be concluded that this downturn period tends to be more

the near future (**Figure 1**).

*Source: Trading Economics [5–7].*

**Table 1.**

**39**

**Figure 1.**

persistent and longer. There is no sign that the rupiah can return to this balance in

The condition of the rupiah, which is still weakening, is due to Indonesia's current account deficit and a large and growing budget deficit. Indonesia's current account deficit in 2018 is 2.98%, greater than the deficit in 2017, which reached 2.90% [4]. This has caused Indonesia to rely heavily on capital inflows and foreign debts, so that the crisis in other countries can trigger a capital outflow from Indonesia and a depreciation of the rupiah. The percentage of capital outflow in Indonesia's GDP continues to increase. In 2017, investments coming out of

Current account to GDP 5.40% 6.1% 2.98% Exchange rate against US dollars 52% 40% 7.6% Government debt USD 27,5827.96 billion USD 466.7 billion USD 295.7 billion GDP per capita USD 11,652.57 USD 11,114.3 USD 4051.7 Debt ratio to GDP 86.2% 28.30% 29.8% Economic growth Q2 2018 4.7% 7.22% 5.27%

57.3% (May 2019)

Annual inflation 47.1% (December 2018);

*Comparison between Argentina, Turkey, and Indonesia.*

**Argentina Turkey Indonesia**

15.85% 3.18%

Apart from Argentina, the impact of the FED's decision to leave interest rates higher is also experienced by Turkey. Turkey's condition is no less severe than Argentina's because, in addition to the FED interest rate hike, their bad political relations with the United States have resulted in a trade war between the two countries. In 2018, Lira dropped 40% to the US dollar. There are at least three reasons why Turkey drowned in the current economic crisis [3]. *First*, Turkey has been experiencing the current account deficits in the 2000s. Turkey's current account deficit to gross domestic product (GDP) ratio was 5.6% in 2017 and 6.7% during the first quarter of 2018. *Second*, the Turkish economy built on external debt and high expenditure deficits. Based on the data from the Bank for International Settlements (BIS), Turkey has debts to Spanish banks of USD 83.3 billion, French banks of USD 38.4 billion, Italian banks of USD 17 billion, Japanese banks of USD 14 billion, the UK banks of USD 19.2 billion, and the US banks of USD 18 billion. As a result of Turkey's debts with other countries using the dollar, when the dollar increases, the Turkish debt will continue to swell. Gross foreign debt as a share of GDP (%) in Turkey increased from 36.7% in 2011 to 52.9% in the first quarter of 2018. In the midst of a downturn in the global economy, it will be difficult for Turkey to pay its debts and finance its government expenses. *Third*, the Central Bank of the Republic of Turkey (CBRT) gross foreign currency reserves decreased from USD 112.0 billion in December 2013 to USD 78.3 billion in July 2018 and to USD 70.4 billion in August 2018, while Turkey's foreign currency need is an increase.

The crisis that occurred in Argentina and Turkey can have an impact on other developing countries. Reflecting on the previous experience, the government of Indonesia is careful in taking steps so that the impact of the crisis experienced by Argentina and Turkey does not have an impact on the economy of Indonesia (**Figure 1**).

Liberalization of capital flows in the past two decades and an increase in the scale of financial transactions across regions have increased exchange rate movements. This has an impact on exchange rate fluctuations in Indonesia. Since 2011, the rupiah has never returned to its lowest level, which has been around the

*Contagion, Exchange Rate, and Financial Volatility: Indonesian Case in Global Financial… DOI: http://dx.doi.org/10.5772/intechopen.92275*

**Figure 1.** *Movement of the exchange rate of rupiah against the dollar. Source: Authors, 2019.*

Rp8500. In the past 7 years, the rupiah has experienced a weakening trend. In the previous period, the rupiah can always return or have a stationary movement. In the periods of 2000–2001, the depreciation period occurred for 16 months, 2000–2003 for 24 months, and 2008–2009 for 10 months. From 2011 until today, the period of depreciation has occurred for three phases, namely, 32, 17, and 16 months. If it is accumulated (because there is at least a period of appreciation and is very thin), the period of depreciation has more or less happened for 65 months. There is no sign of when the rupiah will strengthen at least to the range of Rp12,000–13,000. This is still far from the average exchange rate in the last 18 years in the range of Rp10,000 per dollar. It can be concluded that this downturn period tends to be more persistent and longer. There is no sign that the rupiah can return to this balance in the near future (**Figure 1**).

The condition of the rupiah, which is still weakening, is due to Indonesia's current account deficit and a large and growing budget deficit. Indonesia's current account deficit in 2018 is 2.98%, greater than the deficit in 2017, which reached 2.90% [4]. This has caused Indonesia to rely heavily on capital inflows and foreign debts, so that the crisis in other countries can trigger a capital outflow from Indonesia and a depreciation of the rupiah. The percentage of capital outflow in Indonesia's GDP continues to increase. In 2017, investments coming out of


#### **Table 1.**

*Comparison between Argentina, Turkey, and Indonesia.*

As a country with a strong influence, every event that happened in the United

Argentina has a long history of economic crisis [1]. In the period of the 1950s, Argentina experienced severe inflation, which reached 102% in 1959. Their condition improved in the 1960s because of the global booming economy. Unfortunately, in 1975, Argentina's economy was poorly managed, so the inflation at that time reached 335%. In 2001, local government policy brought Argentina to owe the IMF an amount of USD 132 billion. The economic condition of Argentina had not shown signs of improvement. In 2015, Argentina was hit by an economic crisis again. Under President Macri's leadership, the Argentine government was trying to hold capital out. The central bank raised interest rates to 40%, recorded as the highest in the world today. This condition is exacerbated by the decision of the FED to continue to increase its interest rates, so that capital for emerging markets is likely to become more expensive and/or scarce. With an aim to be free of the crisis, the government turned to the International Monetary Fund (IMF) for \$57.1 billion or

Apart from Argentina, the impact of the FED's decision to leave interest rates higher is also experienced by Turkey. Turkey's condition is no less severe than Argentina's because, in addition to the FED interest rate hike, their bad political relations with the United States have resulted in a trade war between the two countries. In 2018, Lira dropped 40% to the US dollar. There are at least three reasons why Turkey drowned in the current economic crisis [3]. *First*, Turkey has been experiencing the current account deficits in the 2000s. Turkey's current account deficit to gross domestic product (GDP) ratio was 5.6% in 2017 and 6.7% during the first quarter of 2018. *Second*, the Turkish economy built on external debt and high expenditure deficits. Based on the data from the Bank for International Settlements (BIS), Turkey has debts to Spanish banks of USD 83.3 billion, French banks of USD 38.4 billion, Italian banks of USD 17 billion, Japanese banks of USD 14 billion, the UK banks of USD 19.2 billion, and the US banks of USD 18 billion. As a result of Turkey's debts with other countries using the dollar, when the dollar increases, the Turkish debt will continue to swell. Gross foreign debt as a share of GDP (%) in Turkey increased from 36.7% in 2011 to 52.9% in the first quarter of 2018. In the midst of a downturn in the global economy, it will be difficult for Turkey to pay its debts and finance its government expenses. *Third*, the Central Bank of the Republic of Turkey (CBRT) gross foreign currency reserves decreased from USD 112.0 billion in December 2013 to USD 78.3 billion in July 2018 and to USD 70.4 billion in August 2018, while Turkey's foreign currency need is an

The crisis that occurred in Argentina and Turkey can have an impact on other developing countries. Reflecting on the previous experience, the government of Indonesia is careful in taking steps so that the impact of the crisis experienced by Argentina and Turkey does not have an impact on the economy of Indonesia

Liberalization of capital flows in the past two decades and an increase in the scale of financial transactions across regions have increased exchange rate movements. This has an impact on exchange rate fluctuations in Indonesia. Since 2011, the rupiah has never returned to its lowest level, which has been around the

around Rp700 trillion (exchange rate of Rp14,000) in 2018 [2].

States, including the policies taken by their government, can affect the global economic condition. In 2018, the United States decided to raise the benchmark interest rate which made the investment in developing countries look no longer attractive. The Federal Reserve's policy of raising interest rates put pressure on other countries to tighten their monetary policies and reduce US dollar liquidity. Various countries were affected, including Indonesia, but Argentina and Turkey

were the worst.

*Public Sector Crisis Management*

increase.

(**Figure 1**).

**38**

Indonesia reached 0.198% of GDP, while in 2018, it increased to 0.607% [8]. Plus, the FED's policy to raise the interest rates is also a nightmare for Indonesia because investors will consider it more profitable to invest in the United States than Indonesia, which is a developing country with more vulnerable economic conditions (**Table 1**).

crises across the national borders. Kaminsky et al. [15] explain that what happened in Asia in 1997 is an example of cross-border contagion. The Asian countries accounted for 65% of the emerging market loan portfolio of Japanese banks [15]. Because of the floatation experienced by Thai baht in 1997, the Japanese banks retrenched quickly and cut credit lines to emerging Asia. This happens because the shock can spread to other sectors or the wider regions [17]. The bank inflows quickly became outflows. This is in line with Forbes and Rigobon's [14] research that concludes transmission of return volatility and leading to speculative attacks on

*Contagion, Exchange Rate, and Financial Volatility: Indonesian Case in Global Financial…*

Fratzscher [16] analyzes the role of contagion in the currency crises in emerging markets during the 1990s. The findings suggest that in particular, the degree of financial interdependence and also real integration among emerging markets are crucial not only in explaining past crises but also in predicting the transmission of future financial crises. This paper argues that the main reason for the poor performance of the standard currency crisis model lies in ignoring the role of contagion—the fact that crises can be transmitted across countries through their interdependence with others. The empirical analysis found strong evidence that the 1994–1995 Latin American crisis and the 1997–1998 Asian crisis were contagious, spreading to countries that were not only economically vulnerable but also closely related financially. Moreover, Fratzscher [16] argues that the rapid capital account liberalization and the opening to international markets, which lead to increased real and financial interdependence among emerging markets, played a crucial role in explaining both the timing and the severity of those crises. The result is in line with Claessens and Forbes [18] who discover the occurrence of vulnerability in the

Kibritcioglu et al. [19] research is to investigate and discuss the predictability of

approach. This research concludes that the financial linkages and also investor sentiments and perceptions are the channel of transmission of East Asian crises [19]. The first generation argues that the weak fundamental role is a trigger for the currency crisis. Government budget deficits are at the root of speculative attacks on pegged exchange rates. Therefore, the currency crises are preceded by macroeconomic imbalances that are not consistent with the maintenance of fixed exchange rates. The second generation considers the fundamental aspect of the economy and the behavior of agents as the trigger of the currency crisis. This research also cites a recent study by Paul Krugman [20] and others about the third-generation model of the currency crisis. This new model considers several disputed issues such as (1) moral hazard or asymmetric information problems that lead to an underpricing of risks associated with investment in emerging markets; (2) behavior of herding bankers and portfolio managers; and (3) international contagion effects appearing in several transmission channels such as trade and financial relations between countries.

In addition to review research on contagion, there are also studies that examine the relationship between the exchange rate, interest rate, and stock market. Sensoy and Sobaci [21] analyze the dynamic relationship between the exchange rate (against the US dollar), interest rate, and stock market of Turkey from January 2003 to September 2013. The research reveals that volatility shocks create sudden changes in dynamic correlation, but these effects are only short term. Thus,

policymakers and investors do not need to react to volatility shocks to prevent longterm transmission between these markets. The sudden and severe intervention in the money market by central banks in turbulent times can cause considerable losses in foreign currency reserves, which in turn will produce the same results without intervention. On the other hand, investors can maintain their allocation because unexpectedly changing correlations are expected to restore their regular levels in

possible currency crises in Turkey by using the leading economic indicators

country as a result of shocks that occur in other countries.

other countries.

*DOI: http://dx.doi.org/10.5772/intechopen.92275*

**41**

Compared to Argentina and Turkey in 2018, Indonesia's economic condition is still better than the two countries. Only three out of the seven indicators placing Indonesia worse than Turkey, namely, GDP per capita, debt ratio, and economic growth. For Argentina, Indonesia only worse in GDP per capita indicator. Even so, as a fellow developing country, empirical study regarding the contagion of the Argentina-Turkey crisis to the economics of Indonesia is needed to become the basis for future decision-making. Moreover, empirical studies that discuss the contagion of the crisis in Indonesia are still relatively minimal. For this reason, this research will discuss the potential transmission of the Argentina-Turkey crisis in 2018 to the Indonesian economy. This study aims to identify this potential contagion as well as to explain the exchange rate and financial volatility of Indonesian financial sector.

### **2. Literature review**

There are diverse definitions of contagion. Contagion in this paper is defined as the transmission of crisis to a particular country due to its dependence or similarity with another country in crisis. This is in line with Dornbusch et al. [9] that state that contagion is the increasing correlation between countries after the crisis. Pericoli and Sbracia [10] and Forbes and Rigobon [11] define contagion as co-movements in asset prices and quantity across the market. Moreover, Masson [12, 13] says that contagion is the transmission of local shocks to another country or another financial market. Based on those definitions, it can be concluded that contagion is the rise in cross-market linkage aftershocks, measured by movements together on asset prices and financial flows across the market [9, 11, 14].

Kaminsky et al. [15] define contagion as an episode where there are significant effects that evolve over a matter of hours or days in a number of countries after an event. Meanwhile, Fratzscher [16] states that contagion is the transmission of a crisis to a particular country because of mutual financial and real interdependence with countries that have experienced a crisis. By using the vector autoregression (VAR) method, Fratzscher [16] concludes that there are two causes of financial interdependence between countries: (1) direct financial relations, that is, the fact that financial institutions may have large cross-border ownership, and (2) indirect financial relations, in particular the existence of common lenders and decisions by institutional investors, have received much attention in recent years [16].

Kaminsky et al. [15] observe the reasons for cross-border financial contagion occurred in some cases but not others. This paper emphasizes that there are three key elements that cause the contagion or commonly referred to as unholy trinity, that is, a sudden reversal in capital inflows, shocks, and contagion from creditors [15]. *First*, contagion is followed by a surge in international capital inflows, and the sudden initial announcement pricked the capital flow bubble. With rapid contagion, investors and financial institutions are exposed to the crisis of the country and ready to withdraw their investment on short notice [15]. *Second*, the announcement that triggered a chain reaction came as a surprise to the financial markets. The difference between anticipated and unanticipated events seems important because early warning allows investors to adjust their portfolios to limit the damage caused by the crises. *Third*, there are significant direct international consequences of creditor—be it commercial banks, hedge funds, mutual funds, or bondholders—spreading the

#### *Contagion, Exchange Rate, and Financial Volatility: Indonesian Case in Global Financial… DOI: http://dx.doi.org/10.5772/intechopen.92275*

crises across the national borders. Kaminsky et al. [15] explain that what happened in Asia in 1997 is an example of cross-border contagion. The Asian countries accounted for 65% of the emerging market loan portfolio of Japanese banks [15]. Because of the floatation experienced by Thai baht in 1997, the Japanese banks retrenched quickly and cut credit lines to emerging Asia. This happens because the shock can spread to other sectors or the wider regions [17]. The bank inflows quickly became outflows. This is in line with Forbes and Rigobon's [14] research that concludes transmission of return volatility and leading to speculative attacks on other countries.

Fratzscher [16] analyzes the role of contagion in the currency crises in emerging markets during the 1990s. The findings suggest that in particular, the degree of financial interdependence and also real integration among emerging markets are crucial not only in explaining past crises but also in predicting the transmission of future financial crises. This paper argues that the main reason for the poor performance of the standard currency crisis model lies in ignoring the role of contagion—the fact that crises can be transmitted across countries through their interdependence with others. The empirical analysis found strong evidence that the 1994–1995 Latin American crisis and the 1997–1998 Asian crisis were contagious, spreading to countries that were not only economically vulnerable but also closely related financially. Moreover, Fratzscher [16] argues that the rapid capital account liberalization and the opening to international markets, which lead to increased real and financial interdependence among emerging markets, played a crucial role in explaining both the timing and the severity of those crises. The result is in line with Claessens and Forbes [18] who discover the occurrence of vulnerability in the country as a result of shocks that occur in other countries.

Kibritcioglu et al. [19] research is to investigate and discuss the predictability of possible currency crises in Turkey by using the leading economic indicators approach. This research concludes that the financial linkages and also investor sentiments and perceptions are the channel of transmission of East Asian crises [19]. The first generation argues that the weak fundamental role is a trigger for the currency crisis. Government budget deficits are at the root of speculative attacks on pegged exchange rates. Therefore, the currency crises are preceded by macroeconomic imbalances that are not consistent with the maintenance of fixed exchange rates. The second generation considers the fundamental aspect of the economy and the behavior of agents as the trigger of the currency crisis. This research also cites a recent study by Paul Krugman [20] and others about the third-generation model of the currency crisis. This new model considers several disputed issues such as (1) moral hazard or asymmetric information problems that lead to an underpricing of risks associated with investment in emerging markets; (2) behavior of herding bankers and portfolio managers; and (3) international contagion effects appearing in several transmission channels such as trade and financial relations between countries.

In addition to review research on contagion, there are also studies that examine the relationship between the exchange rate, interest rate, and stock market. Sensoy and Sobaci [21] analyze the dynamic relationship between the exchange rate (against the US dollar), interest rate, and stock market of Turkey from January 2003 to September 2013. The research reveals that volatility shocks create sudden changes in dynamic correlation, but these effects are only short term. Thus, policymakers and investors do not need to react to volatility shocks to prevent longterm transmission between these markets. The sudden and severe intervention in the money market by central banks in turbulent times can cause considerable losses in foreign currency reserves, which in turn will produce the same results without intervention. On the other hand, investors can maintain their allocation because unexpectedly changing correlations are expected to restore their regular levels in

Indonesia reached 0.198% of GDP, while in 2018, it increased to 0.607% [8]. Plus, the FED's policy to raise the interest rates is also a nightmare for Indonesia because investors will consider it more profitable to invest in the United States than Indonesia, which is a developing country with more vulnerable economic conditions

Compared to Argentina and Turkey in 2018, Indonesia's economic condition is still better than the two countries. Only three out of the seven indicators placing Indonesia worse than Turkey, namely, GDP per capita, debt ratio, and economic growth. For Argentina, Indonesia only worse in GDP per capita indicator. Even so, as a fellow developing country, empirical study regarding the contagion of the Argentina-Turkey crisis to the economics of Indonesia is needed to become the basis for future decision-making. Moreover, empirical studies that discuss the contagion of the crisis in Indonesia are still relatively minimal. For this reason, this research will discuss the potential transmission of the Argentina-Turkey crisis in 2018 to the Indonesian economy. This study aims to identify this potential contagion as well as to explain the exchange rate and financial volatility of Indonesian financial sector.

There are diverse definitions of contagion. Contagion in this paper is defined as the transmission of crisis to a particular country due to its dependence or similarity with another country in crisis. This is in line with Dornbusch et al. [9] that state that contagion is the increasing correlation between countries after the crisis. Pericoli and Sbracia [10] and Forbes and Rigobon [11] define contagion as co-movements in asset prices and quantity across the market. Moreover, Masson [12, 13] says that contagion is the transmission of local shocks to another country or another financial market. Based on those definitions, it can be concluded that contagion is the rise in cross-market linkage aftershocks, measured by movements together on asset prices

Kaminsky et al. [15] define contagion as an episode where there are significant effects that evolve over a matter of hours or days in a number of countries after an event. Meanwhile, Fratzscher [16] states that contagion is the transmission of a crisis to a particular country because of mutual financial and real interdependence with countries that have experienced a crisis. By using the vector autoregression (VAR) method, Fratzscher [16] concludes that there are two causes of financial interdependence between countries: (1) direct financial relations, that is, the fact that financial institutions may have large cross-border ownership, and (2) indirect financial relations, in particular the existence of common lenders and decisions by

institutional investors, have received much attention in recent years [16].

Kaminsky et al. [15] observe the reasons for cross-border financial contagion occurred in some cases but not others. This paper emphasizes that there are three key elements that cause the contagion or commonly referred to as unholy trinity, that is, a sudden reversal in capital inflows, shocks, and contagion from creditors [15]. *First*, contagion is followed by a surge in international capital inflows, and the sudden initial announcement pricked the capital flow bubble. With rapid contagion, investors and financial institutions are exposed to the crisis of the country and ready to withdraw their investment on short notice [15]. *Second*, the announcement that triggered a chain reaction came as a surprise to the financial markets. The difference between anticipated and unanticipated events seems important because early warning allows investors to adjust their portfolios to limit the damage caused by the crises. *Third*, there are significant direct international consequences of creditor—be it commercial banks, hedge funds, mutual funds, or bondholders—spreading the

(**Table 1**).

*Public Sector Crisis Management*

**2. Literature review**

**40**

and financial flows across the market [9, 11, 14].

the medium and long terms. This research suggests the investors in Turkey have sufficient amounts of foreign currency to minimize the risk of their equity portfolio without reducing expected returns, so investors can hedge risks between the stock market and exchange rates, whether if the stock market is stable or volatile, due to sudden changes in the level of correlation (caused by volatility of shocks) between the stock markets and foreign exchange only happens in the short term.

The research witnesses a consistent negative correlation between the bonds and the stock markets [21]. Besides that, there is a consistent positive correlation between bonds and foreign exchange markets in Turkey, which is different from developed countries. This is an evidence of the negative anticipation of the investors when interest rates increase in emerging markets with a history of high budget deficits. Therefore, an increase in interest rates is perceived as a problem in the country. This event results in a severe capital outflow, thus leading to local currency depreciation against the US dollar. Regarding the stock and foreign exchange market relationship, Sensoy and Sobaci [21] discover a positive relation between dollar appreciation against Turkish lira and Turkish stock market returns.

Clark et al. [22] examine the effect of exchange rate volatility on trade over the past 30 years. The analysis shows that there is no evidence of a large negative effect of exchange rate volatility on trade. This shows that exchange rate volatility is not the major policy problem of trade, but this does not exclude the possibility that a high exchange rate volatility can affect the economy through other channels.

Kawai et al. [23] investigate the origins of the East Asian crisis and its contagion and examine the channels of contagion. The research concludes that the financial linkage and also investor sentiments and perceptions are the the channel of transmission of East Asian crises. They summarize some steps to prevent, manage, and resolve the crises. There are three ways in preventing crises and contagion, namely, (1) avoiding large current account deficits financed through short-term private capital inflows; (2) aggressively regulating and supervising financial systems to ensure that banks and nonbank financial institutions manage risks prudently; and (3) putting in place incentives for sound corporate finance to prevent high leverage ratios and overreliance on foreign borrowing. If the crises already happen, the study provides three solutions in managing crises and contagion, such as the following: (1) in the context of sound policies, mobilize timely external liquidity of sufficient magnitude to restore market confidence; (2) at times of crisis, "bail-in" private foreign creditors; and (3) there is no one-size-fits-all monetary and fiscal stance for responding to crises and contagions. The final structural focus of policymakers is to strengthen crisis resolution mechanisms that will create conditions for the initial resolution of the systemic consequences of a crisis. These mechanisms include (1) establishing domestic and international mechanisms to deal with assets and liabilities of banks and companies that cannot survive and (2) mitigating the impact of the crisis on low-income groups through social policies to correct the inevitable social tensions associated with adjustments.

There is also a study that focuses on discussing the contagion of the crisis in Indonesia. Iriana and Sjöholm [24] examine whether the contagion from the 1997 economic crisis in Thailand triggered the crisis in Indonesia. The result shows that contagion was exacerbated by increasing imbalances in the Indonesian economy. The paper also states that contagion occurs because of two reasons. The first fundamental links are related to the normal interdependence across countries. The second category is related to the behavior of financial markets, such a financial panic, herd behavior, loss of confidence, and increased risk aversion. In the case of Indonesia, this study reveals that investors' behavior rather than real links is identified as one important channel for the contagion to Indonesia (**Table 2**).

**3. Research method**

*Source: Authors, 2019.*

**Table 2.**

**43**

**3.1 VAR and OLS method**

*Literature review of contagion theory.*

The VAR model can be expressed in Eq. (1):

**No. Characteristics Author**

*Contagion, Exchange Rate, and Financial Volatility: Indonesian Case in Global Financial…*

Dornbusch et al. [9]; Forbes and Rigobon [14]; and Forbes and

Claessens and Forbes [18]

Claessens and Forbes [18]

and Rigobon [11]

Masson [12, 13]

Kaminsky et al. [15]

Kibritcioglu et al. [19]

Paul Krugman [20]

Fratzscher [16]

Kawai et al. [23]

Clark et al. [22]

Iriana and Sjöholm [24]

Forbes and Rigobon [14]

Rigobon [11]

1. The rises in cross-market linkage aftershocks, measured by movements together on asset prices and financial flows across

2. The occurrence of vulnerability in the country as a result of

7. Transmission of return volatility and leading to speculative

8. Transmission of local unanticipated shocks to another country

9. An episode where there are significant effects that evolve over a matter of hours or days in a number of countries after an

10. The research concludes that there are two generations of the

11. The research summarizes three transmissions of a crisis, such as (1) moral hazard or asymmetric information; (2) behavior of herding bankers and portfolio managers; and (3) trade and

12. The transmission of a crisis to a particular country because of mutual financial and real interdependence with countries that

13. The financial linkage and also investor sentiments and perceptions are the transmission of the East Asian crises

14. There is no strong evidence of the large negative effects of

15. Contagion occurs because there are fundamental links across countries and the behavior of financial markets

geographically separated does not have structural similarities,

4. The increasing correlation between countries after the crisis Dornbusch et al. [9] 5. The spread of the shock to the sector or the wider region Allen and Gale [17]

6. Co-movements in asset prices and quantity across-market Pericoli and Sbracia [10]; Forbes

shocks that occur in other countries

*DOI: http://dx.doi.org/10.5772/intechopen.92275*

and there is no direct linkage

attacks on other countries

or another financial market

theoretical models on currency crises

financial relations between countries

have experienced a crisis

exchange rate volatility on trade

event

3. The crisis that spread to other countries that are

the market

The research uses VAR and dynamic conditional correlation (DCC) methods to assess the three important financial and external variables including contagion, exchange rate, and financial volatility of Indonesia triggered by global turbulence and Argentina-Turkey crisis in 2018. Data used in this research are the monthly data from 2004 to 2018. The VAR method has also been conducted by Marcel Fratzscher [16] to examine the impact of exchange rate crisis and its transmission (**Table 3**).

*Contagion, Exchange Rate, and Financial Volatility: Indonesian Case in Global Financial… DOI: http://dx.doi.org/10.5772/intechopen.92275*


#### **Table 2.**

the medium and long terms. This research suggests the investors in Turkey have sufficient amounts of foreign currency to minimize the risk of their equity

portfolio without reducing expected returns, so investors can hedge risks between the stock market and exchange rates, whether if the stock market is stable or volatile, due to sudden changes in the level of correlation (caused by volatility of shocks) between the stock markets and foreign exchange only happens in the

The research witnesses a consistent negative correlation between the bonds and

Clark et al. [22] examine the effect of exchange rate volatility on trade over the past 30 years. The analysis shows that there is no evidence of a large negative effect of exchange rate volatility on trade. This shows that exchange rate volatility is not the major policy problem of trade, but this does not exclude the possibility that a high exchange rate volatility can affect the economy through other channels.

Kawai et al. [23] investigate the origins of the East Asian crisis and its contagion and examine the channels of contagion. The research concludes that the financial linkage and also investor sentiments and perceptions are the the channel of transmission of East Asian crises. They summarize some steps to prevent, manage, and resolve the crises. There are three ways in preventing crises and contagion, namely, (1) avoiding large current account deficits financed through short-term private capital inflows; (2) aggressively regulating and supervising financial systems to ensure that banks and nonbank financial institutions manage risks prudently; and (3) putting in place incentives for sound corporate finance to prevent high leverage ratios and overreliance on foreign borrowing. If the crises already happen, the study provides three solutions in managing crises and contagion, such as the following: (1) in the context of sound policies, mobilize timely external liquidity of sufficient magnitude to restore market confidence; (2) at times of crisis, "bail-in" private foreign creditors; and (3) there is no one-size-fits-all monetary and fiscal stance for responding to crises and contagions. The final structural focus of policymakers is to strengthen crisis resolution mechanisms that will create conditions for the initial resolution of the systemic consequences of a crisis. These mechanisms include (1) establishing domestic and international mechanisms to deal with assets and liabilities of banks and companies that cannot survive and (2) mitigating the impact of the crisis on low-income groups through social policies to correct the inevitable

There is also a study that focuses on discussing the contagion of the crisis in Indonesia. Iriana and Sjöholm [24] examine whether the contagion from the 1997 economic crisis in Thailand triggered the crisis in Indonesia. The result shows that contagion was exacerbated by increasing imbalances in the Indonesian economy. The paper also states that contagion occurs because of two reasons. The first fundamental links are related to the normal interdependence across countries. The second category is related to the behavior of financial markets, such a financial panic, herd behavior, loss of confidence, and increased risk aversion. In the case of Indonesia, this study reveals that investors' behavior rather than real links is identified as one important channel for the contagion to Indonesia (**Table 2**).

the stock markets [21]. Besides that, there is a consistent positive correlation between bonds and foreign exchange markets in Turkey, which is different from developed countries. This is an evidence of the negative anticipation of the investors when interest rates increase in emerging markets with a history of high budget deficits. Therefore, an increase in interest rates is perceived as a problem in the country. This event results in a severe capital outflow, thus leading to local currency depreciation against the US dollar. Regarding the stock and foreign exchange market relationship, Sensoy and Sobaci [21] discover a positive relation between dollar

appreciation against Turkish lira and Turkish stock market returns.

social tensions associated with adjustments.

**42**

short term.

*Public Sector Crisis Management*

*Literature review of contagion theory.*
