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

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  • Eduardo A. Cavallo

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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  • Eduardo A. Cavallo, 2005. "Trade, gravity, and sudden stops: on how commercial trade can increase the stability of capital flows," FRB Atlanta Working Paper 2005-23, Federal Reserve Bank of Atlanta.
  • Handle: RePEc:fip:fedawp:2005-23
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    Cited by:

    1. Eduardo A. Cavallo & Andrés Velasco, 2006. "Quid pro Quo: National Institutions and Sudden Stops in International Capital Movements," Research Department Publications 4490, Inter-American Development Bank, Research Department.
    2. Cavallo, Eduardo & Powell, Andrew & Pedemonte, Mathieu & Tavella, Pilar, 2015. "A new taxonomy of Sudden Stops: Which Sudden Stops should countries be most concerned about?," Journal of International Money and Finance, Elsevier, vol. 51(C), pages 47-70.
    3. Eduardo A. Cavallo, 2007. "Output Volatility and Openness to Trade: A Reassessment," Research Department Publications 4518, Inter-American Development Bank, Research Department.
    4. Jeffrey Frankel, 2005. "Contractionary Currency Crashes In Developing Countries," CID Working Papers 117, Center for International Development at Harvard University.
    5. Eduardo A. Cavallo & Jeffrey Frankel, 2007. "Does Openness to Trade Make Countries More Vulnerable to Sudden Stops, or Less? Using Gravity to Establish Causality," Research Department Publications 4544, Inter-American Development Bank, Research Department.
    6. Cavallo, Eduardo A. & Frankel, Jeffrey A., 2008. "Does openness to trade make countries more vulnerable to sudden stops, or less? Using gravity to establish causality," Journal of International Money and Finance, Elsevier, vol. 27(8), pages 1430-1452, December.
    7. Gordon H. Hanson & Craig McIntosh, 2012. "Birth Rates and Border Crossings: Latin American Migration to the US, Canada, Spain and the UK," Economic Journal, Royal Economic Society, vol. 122(561), pages 707-726, June.
    8. 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.
    9. Joshua Aizenman & Menzie D. Chinn & Hiro Ito, 2012. "The Financial Crisis, Rethinking of the Global Financial Architecture, and the Trilemma," Chapters,in: Monetary and Currency Policy Management in Asia, chapter 6 Edward Elgar Publishing.
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    11. Aizenman, Joshua & Chinn, Menzie D. & Ito, Hiro, 2010. "The emerging global financial architecture: Tracing and evaluating new patterns of the trilemma configuration," Journal of International Money and Finance, Elsevier, vol. 29(4), pages 615-641, June.
    12. Kurz, Christopher & Senses, Mine Z., 2016. "Importing, exporting, and firm-level employment volatility," Journal of International Economics, Elsevier, pages 160-175.
    13. Eduardo A. Cavallo, 2008. "Output Volatility and Openness to Trade: a Reassessment," ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION, ECONOMIA JOURNAL OF THE LATIN AMERICAN AND CARIBBEAN ECONOMIC ASSOCIATION, vol. 0(Fall 2008), pages 105-152, September.
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    15. Hanson, Gordon H. & Xiang, Chong, 2013. "Exporting Christianity: Governance and doctrine in the globalization of US denominations," Journal of International Economics, Elsevier, pages 301-320.
    16. 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).

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