Does Openness to Trade Make Countries More Vulnerable to Sudden Stops, or Less? Using Gravity to Establish Causality

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Does Openness to Trade Make Countries More
Vulnerable to Sudden Stops, or Less? Using
Gravity to Establish Causality

• Eduardo A. Cavallo
  Jeffrey A. Frankel
• CID and KSG Harvard University
  NBER and KSG Harvard
  University
• Second Workshop of the Latin American Finance
  Network
• Cartagena, Colombia, December 3-4 2004

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Motivation

• Textbook Result Countries that trade a smaller
  share of GDP are prone to larger swings in the
  real exchange rate in the aftermath of external
  shocks (expenditure-switching) and/or to larger
  reductions in spending (expenditure-reduction).
• One type of external shock is sudden stops in
  capital flows large and unexpected fall in
  capital inflows Calvo (1998).
• An equal-sized shock triggers, ceteris paribus, a
  larger real exchange rate depreciation and/or
  more expenditure reduction in a country that
  trades a smaller share of GDP than in an
  otherwise identical country Calvo et al. (2003),
  Cavallo (2004).

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Motivation (Cont.)

• Real exchange rate depreciations are costly in
  terms of output-loss in countries with balance
  sheets problems Balance Sheet Literature
  Krugman (1999).... Sharp reductions in spending
  are also painful.
• In more open economies sudden stops are less
  costly (i.e. less contractionary ex-post)
  Sachs (1985), Guidotti et. al. (2003).
• Butdoes this make sudden stops more or less
  likely?
• There is no reason, a priori, why something
  (openness) that makes the consequences of sudden
  stops better (less contractionary) should also
  necessarily make them less frequent.

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The Questions

• (1) What is the effect of trade openness on the
  vulnerability to sudden stops implemented by a
  probit model measuring the probability of a
  sudden reduction in the magnitude of net capital
  inflows Calvo et. al. (2003).
• (2) What is the effect of trade openness on the
  vulnerability to currency crashes implemented by
  a probit model measuring the probability of a
  sudden devaluation Frankel and Rose (1996).

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The Problem

• Potential identification problem the endogeneity
  of trade.
• Possible channels of endogeneity of trade
• Via income richer countries tend to liberalize
  Frankel and Romer (1999).
• Via Washington Consensus forces.
• Experience with crises might itself cause
  liberalization.
• Feedbacks between trade and financial openness
  Aizenman and Noy (2004).

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Proposed Solution

• Use of gravity estimates as instrumental
  variables for trade quantities.
• Gravity estimates are the predicted trade to
  GDP ratios, where the prediction is based on
  geographical characteristics of the countries.
• Being based on geography, gravity estimates are
  quite plausibly exogenous, yet they are highly
  correlated to the true trade to GDP ratios.

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Empirical Investigation

• We test whether countries that trade more are
  (all else equal) more or less prone to sudden
  stops in capital flows or to currency crises.
• SSi,t c f(Trade Openness)i,t ?1(Foreign
  Debt/GDP)i,t-1 ?2(Liability Dollarization)i,t-1
  ? (CA/GDP) i,t-1 ? Z µi,t
• Given that the dependent variable is binary (0,1)
  and endogenous explanatory variables the method
  of estimation is IV probit Newey (1987).
• Dataset is a stacked cross-section (141
  countries, 1970-2002).

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Main Variables

• Sudden Stops binary (0,1). A sudden stop occurs
  during the year in which there is a noticeable
  reduction in the current account deficit that is
  accompanied by a disruptive (i.e., recessionary)
  reduction in foreign capital inflows. Data
  IMF-IFS.
• Currency Crashes binary (0,1). Foreign Market
  Pressure Index fall in reserves fall in
  the value of the currency. The index measures the
  fall in demand for the countrys currency. A
  crisis episode is defined when there is an
  increase in the index of at least 10 over the
  preceding period with an exclusion window of 3
  years. Data Frankel and Rose (1996) updated in
  Frankel and Wei (2004).

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Main Variables (cont.)

• Trade Openness
• Instrumented variable Trade to GDP ratio (XM /
  Y).
  Data WB-WDI.
• Instrument aggregate of bilateral gravity
  estimates.
  Data Andrew Rose website.
• Liability Dollarization
• Foreign Liabilities / Money.
  Data IMF-IFS (Line 26C/Line
  34).
• Foreign Currency Deposits / Total Deposits.
  Data Arteta (2003).

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Sudden Stops and Currency Crashes are less
frequent in open economies
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...and the pattern is even more marked with the
instrument
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Results (Dependent variable Sudden Stops)
Probit IV Probit IV Linear IV-GLS RE (linear)
Openness t -0.53 (0.259) -2.451 (0.813) -0.066 (0.022) -0.066 (0.026)
Foreign Debt / GDP t-1 -0.080 (0.217) 0.196 (0.275) 0.0066 (0.0182) -0.006 (0.0155)
Liability Dollarization t-1 0.316 (0.195) 0.591 (0.256) 0.027 (0.0169) 0.027 (0.0149)
Current Account / GDP t-1 -4.068 (1.297) -7.386 (2.06) -0.317 (0.10) -0.317 (0.095)
Obs. 778 1062 1040 1040
Statistically significant at 10, 5, and
1
Additional Controls Constant term, Year FE,
Regional Dummies, International Reserves / Months
of Imports, Institutional Quality, GDP per
capita, Short Term Debt, FDI/GDP, Dummy for
Nominal Exchange Rate Rigidity.
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Results (Dependent variable Currency Crashes)
Probit IV Probit
Openness t -0.57 (0.269) -1.73 (0.918)
Foreign Debt / GDP t-1 0.23 (0.231) 0.59 (0.373)
Liability Dollarization t-1 0.027 (0.249) 0.18 (0.234)
Exchange Rate Rigidity Index t-1 0.13 (0.094) 0.22 (0.113)
Ln Reserves in Months of Imports t-1 -0.26 (0.082) -0.37 (0.099)
Obs. 557 841
Additional Controls Constant term, Year FE,
Regional Dummies, CA/GDP, Institutional Quality,
GDP per capita, Short Term Debt, FDI/GDP.
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Conclusions

• Countries that trade less are, ceteris paribus,
  more prone to sudden stops and to currency
  crashes.
• Raising the Trade / GDP by 10 percentage points
  (Argentina to Australia) reduces the probability
  of a sudden stop by approximately 32.
• At good times closed economies can borrow, but
  at bad times investors seem to anticipitate
  that closed economies will suffer more in the
  aftermath of a shock and thereby are more likely
  to attack them (self-fulfilling pessimism).
• To be safer remain open to trade.