Country Risk and the Currency Contagion Effect

Contagion effects are generally thought to operate through changes in related country exchange rates. In the case of a country with a currency board, however, contagion cannot manifest itself through exchange rate changes. Instead, contagion effects of exchange rate panics in related countries should affect the beta measure of a country's risk. In this paper we examine the time variation of the beta for Argentina, a country with a currency board. Our findings indicate that exchange rate surprises of "peer countries" Brazil and Mexico, not Argentine macro variables, are the only variables that matter for variations in Argentina's beta. Thus contagion appears to be a prime determinant of changes in Argentina's country risk.