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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

Financial stability is an important policy objective, since crises are associated with large economic, social and political costs. Promoting stability requires preventing sudden stops in capital flows, which are events in which foreign financing abruptly disappears. This paper contributes to the discussion by providing new theoretical and empirical evidence on the causal connection between lack of exposure to commercial trade and proclivity to sudden stops. On the theoretical front, the paper shows how exposure to trade raises the creditworthiness of countries and reduces the probability of sudden stops. In relatively closed economies, sudden stops (when they occur) are more harmful and thus the option to default on the inherited debt is more attractive. Therefore, conditional on the amount that lenders are willing to loan, decreased exposure to trade increases the likelihood of default. A sudden stop takes place when the borrowers reject the amount that lenders want to loan: they receive no new funding and they concurrently default on the outstanding debt to ease the pain.  This proposition is tested using gravity estimates, which are based on countries geographic characteristics, as appropriate instruments for trade. The results indicate that, all else equal, a 10 percentage point decrease in the trade to GDP ratio increases the probability of a sudden stop between 30 percent and 40 percent. The policy implications are unambiguous: increasing the tradable component of a countrys GDP will, ceteris paribus, reduce the vulnerability of that country to sudden stops in capital flows.

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Paper provided by Inter-American Development Bank, Research Department in its series RES Working Papers with number 4491.

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Date of creation: Dec 2006
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Handle: RePEc:idb:wpaper:4491

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References listed on IDEAS
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.:
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Cited by:
(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 A. Cavallo & Andrés Velasco, 2006. "Quid pro Quo: National Institutions and Sudden Stops in International Capital Movements," RES Working Papers 4490, Inter-American Development Bank, Research Department. [Downloadable!]
  2. Frankel, Jeffrey, 2005. "Contractionary Currency Crashes In Developing Countries," Working Paper Series rwp05-017, Harvard University, John F. Kennedy School of Government. [Downloadable!]
    Other versions:
  3. 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!]
    Other versions:
  4. Uluc Aysun & Adam Honig, 2008. "Bankruptcy Costs, Liability Dollarization, and Vulnerability to Sudden Stops," Working papers 2008-41, University of Connecticut, Department of Economics. [Downloadable!]
  5. EDWARDS, Jeffrey, 2009. "Trading Partner Volatility And The Ability For A Country To Cope: A Panel Gmm Model, 1970-2005," Applied Econometrics and International Development, Euro-American Association of Economic Development, vol. 9(2). [Downloadable!] (restricted)
  6. Eduardo A. Cavallo, 2007. "Output Volatility and Openness to Trade: A Reassessment," RES Working Papers 4518, Inter-American Development Bank, Research Department. [Downloadable!]
  7. Joshua Aizenman & Menzie D. Chinn & Hiro Ito, 2008. "Assessing the Emerging Global Financial Architecture: Measuring the Trilemma's Configurations over Time," NBER Working Papers 14533, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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