Some of the most influential theories of contagion are those based on liquidity arguments. Nevertheless, very little evidence exists on their importance. This paper shows that liquidity-based stories are responsible for 1/4 of the observed correlation in sovereign debt. Mexico was upgraded from non-investment to investment-grade in March 2000. This paper examines the impact of this event on the properties of the transmission of shocks between Mexico and several Latin American countries. It is shown that there is a statistically significant change in the propagation of shocks around the time the upgrade was announced. Moreover, the change in the estimated coefficients can explain between 1/4 and 1/3 of the unconditional co-movement that these assets experienced before the upgrade. This is strong evidence in favor of the theories of contagion based on market structure as the source of the propagation mechanism. From the methodological point of view, the paper extends existing identification procedures that solve the problem of estimation in linear simultaneous equations models.
