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Weathering the financial storm: The importance of fundamentals and flexibility

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  • Thorvardur Tjörvi Ólafsson
  • Thórarinn G. Pétursson
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    Abstract

    The recent global financial tsunami has had economic consequences that have not been witnessed since the Great Depression. But while some countries suffered a particularly large contraction in economic activity on top of a system-wide banking and currency collapse, others came off relatively lightly. In this paper, we attempt to explain this cross-country variation in post-crisis experience, using a wide variety of pre-crisis explanatory variables in a sample of 46 medium-to-high income countries. We find that domestic macroeconomic imbalances and vulnerabilities were crucial for determining the incidence and severity of the crisis. In particular, we find that the pre-crisis rate of inflation captures factors which are important in explaining the post-crisis experience. Our results also suggest an important role for financial factors. In particular, we find that large banking systems tended to be associated with a deeper and more protracted consumption contraction and a higher risk of a systemic banking or currency crisis. Our results suggest that greater exchange rate flexibility coincided with a smaller and shorter contraction, but at the same time increased the risk of a banking and currency crisis. Countries with exchange rate pegs outside EMU were hit particularly hard, while inflation targeting seemed to mitigate the crisis. Finally, we find some evidence suggesting a role for international real linkages and institutional factors. Our key results are robust to various alterations in the empirical setup and we are able to explain a significant share of the cross-country variation in the depth and duration of the crisis and provide quite sharp predictions of the incidence of banking and currency crises. This suggests that country-specific initial conditions played an important role in determining the economic impact of the crisis and, in particular, that countries with sound fundamentals and flexible economic frameworks were better able to weather the financial storm.

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    Bibliographic Info

    Paper provided by Department of Economics, Central bank of Iceland in its series Economics with number wp51.

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    Date of creation: Oct 2010
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    Handle: RePEc:ice:wpaper:wp51

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    1. Gian-Maria Milesi-Ferretti & Philip R. Lane, 2010. "The Cross-Country Incidence of the Global Crisis," IMF Working Papers 10/171, International Monetary Fund.
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    15. Hui Tong & Shang-Jin Wei, 2011. "The Composition Matters: Capital Inflows and Liquidity Crunch During a Global Economic Crisis," Review of Financial Studies, Society for Financial Studies, vol. 24(6), pages 2023-2052.
    16. Robert J. Barro & Jose F. Ursua, 2008. "Macroeconomic Crises since 1870," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 39(1 (Spring), pages 255-350.
    17. Michael P. Dooley & Eduardo Fernandez-Arias & Kenneth M. Kletzer, 1994. "Recent Private Capital Inflows to Developing Countries: Is the Debt Crisis History?," NBER Working Papers 4792, National Bureau of Economic Research, Inc.
    18. Patrick McGuire & Goetz von Peter, 2009. "The US dollar shortage in global banking and the international policy response," BIS Working Papers 291, Bank for International Settlements.
    19. Stijn Claessens & Giovanni Dell'Ariccia & Deniz Igan & Luc Laeven, 2010. "Cross-country experiences and policy implications from the global financial crisis," Economic Policy, CEPR & CES & MSH, vol. 25, pages 267-293, 04.
    20. Brahima Coulibaly, 2009. "Currency unions and currency crises: an empirical assessment," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 14(3), pages 199-221.
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