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Does Openness to Trade Make Countries
More Vulnerable to Sudden Stops, or Less?
Using Gravity to Establish Causality
Eduardo A. Cavallo
CID and KSG Harvard University
Jeffrey A. Frankel
NBER and KSG Harvard University
Second Workshop of the Latin American Finance Network
Cartagena, Colombia, December 3-4 2004
Motivation
 Textbook Result: Countries that trade a smaller share of
GDP are prone to larger swings in the real exchange rate
in the aftermath of external shocks (expenditureswitching) and/or to larger reductions in spending
(expenditure-reduction).
 One type of external shock is “sudden stops” in capital
flows: large and unexpected fall in capital inflows [Calvo
(1998)].
 An equal-sized shock triggers, ceteris paribus, a larger
real exchange rate depreciation and/or more expenditure
reduction in a country that trades a smaller share of GDP
than in an otherwise identical country [Calvo et al. (2003),
Cavallo (2004)].
Motivation (Cont.)
 Real exchange rate depreciations are “costly” in terms of
output-loss in countries with “balance sheets” problems
[“Balance Sheet” Literature –Krugman (1999)...]. Sharp
reductions in spending are also painful.
 In more open economies sudden stops are less “costly”
(i.e. less contractionary ex-post) …[Sachs (1985), Guidotti
et. al. (2003)].
 But…does this make sudden stops more or less likely?
 There is no reason, a priori, why something (openness)
that makes the consequences of sudden stops better (less
contractionary) should also necessarily make them less
frequent.
The Questions
(1) What is the effect of trade openness on the
vulnerability to sudden stops implemented by a
probit model measuring the probability of a
sudden reduction in the magnitude of net capital
inflows [Calvo et. al. (2003)].
(2) What is the effect of trade openness on the
vulnerability to currency crashes implemented
by a probit model measuring the probability of a
sudden devaluation [Frankel and Rose (1996)].
The Problem
 Potential identification problem: the
endogeneity of trade.
 Possible channels of endogeneity of trade:




Via income: richer countries tend to liberalize
[Frankel and Romer (1999)].
Via “Washington Consensus” forces.
Experience with crises might itself cause
liberalization.
Feedbacks between trade and financial
openness [Aizenman and Noy (2004)].
Proposed Solution
 Use of “gravity estimates” as instrumental
variables for trade quantities.
 Gravity estimates are the “predicted” trade to
GDP ratios, where the prediction is based on
geographical characteristics of the countries.
 Being based on geography, gravity estimates
are quite plausibly exogenous, yet they are
highly correlated to the “true” trade to GDP
ratios.
Empirical Investigation
 We test whether countries that trade more are (all else
equal) more or less prone to sudden stops in capital flows
or to currency crises.
 SSi,t = c + φ(Trade Openness)i,t + б1(Foreign
Debt/GDP)i,t-1 +б2(Liability Dollarization)i,t-1 + χ
(CA/GDP) i,t-1 + ω Z + µi,t
 Given that the dependent variable is binary (0,1) and
endogenous explanatory variables the method of
estimation is IV probit [Newey (1987)].
 Dataset is a stacked cross-section (141 countries, 1970-
2002).
Main Variables
 Sudden Stops: binary (0,1). A sudden stop occurs during
the year in which there is a noticeable reduction in the
current account deficit that is accompanied by a disruptive
(i.e., recessionary) reduction in foreign capital inflows.
Data: IMF-IFS.
 Currency Crashes: binary (0,1). Foreign Market
Pressure Index: % fall in reserves + % fall in the value of
the currency. The index measures the fall in demand for
the country’s currency. A crisis episode is defined when
there is an increase in the index of at least 10% over the
preceding period with an exclusion window of 3 years.
Data: Frankel and Rose (1996) updated in Frankel and
Wei (2004).
Main Variables (cont.)
 Trade Openness:
1. Instrumented variable: Trade to GDP ratio (X+M / Y).
Data: WB-WDI.
2. Instrument: aggregate of bilateral “gravity estimates”.
Data: Andrew Rose website.
 Liability Dollarization:
1. Foreign Liabilities / Money.
Data: IMF-IFS (Line 26C/Line 34).
2. Foreign Currency Deposits / Total Deposits.
Data: Arteta (2003).
Sudden Stops and Currency Crashes
are less frequent in open economies
Sudden Stops (SS1) and Currency Crises (Crash) by level of openness
350
292
300
Number of Episodes
250
200
> Mean open
< Mean open
150
127
100
52
50
34
0
SS1 (86 events)
Crashes (419 events)
...and the pattern is even more marked
with the instrument
Sudden Stops (SS1) and Currency Crashes (Crash) by level of fitted openness
350
313
300
250
200
> Mean fitted open
< Mean fitted open
150
106
100
67
50
19
0
SS1 (86 events)
Crashes (419 events)
Num ber of Episodes
Results
(Dependent variable: Sudden Stops)
Probit
IV Probit
IV Linear
IV-GLS RE
(linear)
Openness t
-0.53
(0.259)**
-2.451
(0.813)**
-0.066
(0.022)***
-0.066
(0.026)**
Foreign Debt / GDP t-1
-0.080
(0.217)
0.196
(0.275)
0.0066
(0.0182)
-0.006
(0.0155)
Liability Dollarization t-1
0.316
(0.195)
0.591
(0.256)**
0.027
(0.0169)
0.027
(0.0149)*
-4.068
(1.297)**
-7.386
(2.06)***
-0.317
(0.10)***
-0.317
(0.095)***
778
1062
Current Account / GDP t-1
Obs.
1040
1040
* Statistically significant at 10%, **5%, and *** 1%
Additional Controls: Constant term, Year FE, Regional Dummies, International Reserves /
Months of Imports, Institutional Quality, GDP per capita, Short Term Debt, FDI/GDP, Dummy
for Nominal Exchange Rate Rigidity.
Results
(Dependent variable: Currency Crashes)
Probit
IV Probit
Openness t
-0.57
(0.269)**
-1.73
(0.918)**
Foreign Debt / GDP t-1
0.23
(0.231)
0.59
(0.373)*
Liability Dollarization t-1
0.027
(0.249)
0.18
(0.234)
Exchange Rate Rigidity Index t-1
0.13
(0.094)
0.22
(0.113)*
Ln Reserves in Months of Imports t-1
-0.26
(0.082)***
-0.37
(0.099)***
Obs.
557
841
Additional Controls: Constant term, Year FE, Regional Dummies, CA/GDP, Institutional
Quality, GDP per capita, Short Term Debt, FDI/GDP.
Conclusions
 Countries that trade less are, ceteris paribus, more
prone to sudden stops and to currency crashes.
 Raising the Trade / GDP by 10 percentage points
(Argentina to Australia) reduces the probability of a
sudden stop by approximately 32%.
 At “good times” closed economies can borrow, but at
“bad times” investors seem to anticipitate that closed
economies will suffer more in the aftermath of a
shock and thereby are more likely to attack them
(self-fulfilling pessimism).
 To be “safer” remain open to trade.