Contagion and information frictions in emerging markets: The role of joint signals

We show that information frictions can help explain financial contagion among independent markets and help explain why emerging market countries are more susceptible to contagion. Costly information may cause investors to group country signals, because such imprecise signals are cheaper. These joint signals then cause asset prices to comove, which can be observed as contagion. Furthermore, this contagion channel is more likely for emerging markets than for very developed or less developed (low income) countries. This is because incentives to demand country specific information instead of joint signals are higher in developed countries as opposed to emerging markets. Furthermore, for the least developed countries, investors have a stronger incentive to not process any information, which precludes information driven contagion. We find empirical evidence for our predictions using a novel data set on the number of joint news articles and exploit variation in news due to terrorism through an Instrumental Variable approach.