Working Paper

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

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.

Bibliographic Information

Provider: Federal Reserve Bank of Atlanta

Part of Series: FRB Atlanta Working Paper

Publication Date: 2005

Number: 2005-23