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

This work studies the contagion risk through the portfolio investment channel using network analysis and simulation on cross-country bilateral 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 centres, which act as global hubs connecting nodes that are not directly linked. Using a network simulation model based on the assumption that international investors rebalance their portfolios after an idiosyncratic shock, reducing investments in countries they are overexposed to, 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 increasing centralization of the portfolio investment network and the greater financial integration of emerging economies.