Capital Market Openness and Output Volatility

At a conceptual level, opening of capital markets entails a number of benefits and costs. One major cost of financial openness is output volatility. In this paper, using data from 21 advanced and 81 developing countries during 1971-2010, we empirically examine the impact of capital market openness on output volatility. We find that opening of capital markets increases the output volatility of developing countries. Furthermore, we find that the main channel through which capital market openness increases volatility is currency and external-debt crisis. Finally we find that, while Asian countries are less likely to experience a crisis, they become even more unstable than other developing countries once a crisis occurs. Our evidence strengthens the case for caution in developing countries' opening up of their capital markets.