Eduardo A. Cavallo Jeffrey A. Frankel

1. 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 UniversityNBER and KSG Harvard University Second Workshop of the Latin American Finance Network Cartagena, Colombia, December 3-4 2004

2. 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)].

3. 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)]. • But…does 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.

4. 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)].

5. 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)].

6. 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.

7. 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 + φ(Trade Openness)i,t + б1(Foreign Debt/GDP)i,t-1 +б2(Liability Dollarization)i,t-1 + χ (CA/GDP) i,t-1 + ω 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).

8. 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 country’s 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).

9. Main Variables (cont.) • Trade Openness: • Instrumented variable: Trade to GDP ratio (X+M / 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).

10. Sudden Stops and Currency Crashes are less frequent in open economies

11. ...and the pattern is even more marked with the instrument

12. Results (Dependent variable: Sudden Stops) * 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.

13. Results (Dependent variable: Currency Crashes) Additional Controls: Constant term, Year FE, Regional Dummies, CA/GDP, Institutional Quality, GDP per capita, Short Term Debt, FDI/GDP.

14. 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.