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Jeffrey A. Frankel, Eduardo A. Cavallo
NBER Working Paper No. 10957
Issued in December 2004
NBER Program(s): IFM
ITI
An NBER digest for this paper is available.
---- Abstract -----
Openness to trade is one factor that has been identified as determining whether a country is prone to sudden stops in capital inflow, currency crashes, 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. We use the gravity instrument for trade openness, which is constructed from geographical determinants of bilateral trade. We find 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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