Does%20Openness%20to%20Trade%20Make%20Countries%20More%20Vulnerable%20to%20Sudden%20Stops%2C%20or%20Less%3F%20Using%20Gravity%20to%20Establish%20Causality

Working Papers

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


CODE: WP-618
AUTHOR(s): Cavallo, Eduardo A. , Frankel, Jeffrey
PUBLISHED: October 2007
LANGUAGE: English
RELATED TOPICS: Macroeconomics
DOWNLOAD FILE IN: English

Abstract:

Openness to trade is one factor that has been identified as determining whether a country is prone to sudden stops in capital inflows, crashes in currencies, or severe recessions. Some believe that openness raises vulnerability to foreign shocks, while others believe that it makes adjustment to crises less painful. Several authors have offered empirical evidence that having a large tradable sector reduces the contraction necessary to adjust to a given cut-off in funding. This would help explain lower vulnerability to crises in Asia than in Latin America. Such studies may, however, be subject to the problem that trade is endogenous. Using the gravity instrument for trade openness, which is constructed from geographical determinants of bilateral trade, this paper finds that openness indeed makes countries less vulnerable, both to severe sudden stops and currency crashes, and that the relationship is even stronger when correcting for the endogeneity of trade.

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