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Trade, gravity, and sudden stops: on how commercial trade can increase the stability of capital flows

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Author Info
Eduardo A. Cavallo

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Abstract

The author uses gravity estimates as instrumental variables for trade to test the proposition that countries that trade less with the rest of the world are more vulnerable to sudden stops in capital flows. The author finds that, all else equal, a 10 percentage point increase in the trade-to-gross domestic product (GDP) ratio reduces the probability of a sudden stop by approximately 32 percent. ; The estimation is motivated by a model that introduces balance sheet effects to a standard small open economy. In the model, the probability of sudden stops is directly related to the temptation of the borrowers to default in the aftermath of real depreciations. Countries that trade less with the rest of the world are more vulnerable to large real depreciations and, consequently, are always more tempted to default and are more prone to sudden stops ; The policy implications of the results presented here are unambiguous: Trade protectionism does not shield countries from external shocks to their capital accounts. On the contrary, anything that increases the tradable component of a country’s GDP will, ceteris paribus, reduce the vulnerability of that country to sudden stops in capital flows. Without large quantities of trade, capital account openness that leads to indebtedness in foreign currencies is risky and should probably be avoided.

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Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 2005-23.

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Date of creation: 2005
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Handle: RePEc:fip:fedawp:2005-23

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  5. Carlos Arteta, 2006. "Exchange Rate Regimes and Financial Dollarization: Does Flexibility Reduce Bank Currency Mismatches?," Center for International and Development Economics Research, Working Paper Series 1021, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley. [Downloadable!]
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  14. Carlos O. Arteta, 2002. "Exchange rate regimes and financial dollarization: does flexibility reduce bank currency mismatches?," International Finance Discussion Papers 738, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  21. Frankel, Jeffrey & Cavallo, Eduardo, 2004. "Does Openness to Trade Make Countries More Vulnerable to Sudden Stops, or Less? Using Gravity to Establish Causality," Working Paper Series rwp04-038, Harvard University, John F. Kennedy School of Government. [Downloadable!]
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  22. Lawrence J. Christiano & Christopher Gust & Jorge Roldos, 2002. "Monetary Policy in a Financial Crisis," NBER Working Papers 9005, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  23. Carlos O. Arteta, 2003. "Are financially dollarized countries more prone to costly crises?," International Finance Discussion Papers 763, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  24. Jeffrey A. Frankel & Andrew K. Rose, 2005. "Is Trade Good or Bad for the Environment? Sorting Out the Causality," The Review of Economics and Statistics, MIT Press, vol. 87(1), pages 85-91, October. [Downloadable!] (restricted)
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  25. Luis Felipe Cespedes & Roberto Chang & Andres Velasco, 2002. "IS-LM-BP in the Pampas," NBER Working Papers 9337, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  26. Enrique G. Mendoza, 2001. "Credit, Prices, and Crashes: Business Cycles with a Sudden Stop," NBER Working Papers 8338, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Eduardo Cavallo & Jeffrey Frankel, 2007. "Does Openness to Trade Make Countries More Vulnerable to Sudden Stops, or Less? Using Gravity to Establish Causality," RES Working Papers 1063, Inter-American Development Bank, Research Department. [Downloadable!]
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  2. Eduardo Cavallo, 2007. "Output Volatility and Openness to Trade: A Reassessment," RES Working Papers 1033, Inter-American Development Bank, Research Department. [Downloadable!]
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