Alejandro Izquierdo Second Meeting of the Latin Finance Network December 4, 2004

1. “Does Openness to Trade Make Countries More Vulnerable to Sudden Stops, or Less? Using Gravity to Establish Causality” Comments Alejandro Izquierdo Second Meeting of the Latin Finance Network December 4, 2004

2. In a Nutshell • Thorough empirical paper that builds upon results by Calvo et al (2004) • Reassuring that it confirms relevance of openness as a determinant of SS • Does a nice job in controlling for endogeneity using a gravity model (Calvo et al use a Rivers-Vuong approach to control for endogeneity of a similar variable) • Goes over a painstaking set of robustness checks to show the resilience of openness across specifications • Openness seems to be an important determinant both for SS and currency crises

3. Definition of Crisis • Looking for a credit crisis? • Originated in systemic capital market factors? • In markets that are financially integrated (or broader definition)? • Currency crisis? • Costly crisis? • Timing will vary • Determinants will vary • Groups of countries affected will vary

4. In % of total Emerging Developed Markets Economies Depreciations associated with Sudden Stop 63 17 Of which: First Sudden Stop, then depreciation 42 9 First depreciation, then Sudden Stop 21 9 Depreciations not associated with Sudden Stop 37 83 Note: The total number of large devaluations is 19 in emerging markets and 23 in developed economies. From Calvo et al (2004) Sudden Stops and Large Depreciation

5. Measuring SS • SS is a large and unexpected event • Is mean and volatility that of the whole time span, or that prevailing at time t-1? • “Costly” criterion: Ruling out positive shocks. • Criticism: This may bias the set of determinants (“disqualifies” short-term policies:not much can be done when output collapses)

6. Measuring SS • Calvo et al (2004) stress systemic factors: change in SS definition to include swings in regional spreads, besides large capital flow reversals • Interpretation: The probability of a full-fledged SS depends on both the probability of a systemic shock (or incipient SS) and the conditional probability of a full-fledged SS, given an incipient SS: P(SSF) = P(SSF/SSI) P(SSI) • The empirical exercise amounts to finding determinants of this conditional probability

7. Balance Sheet Effects • Interaction between prices and dollarization • In principle, potential price effects are missing • But are they? CADt-1/GDPt-1 is a proxy • When CADt is driven down to zero (what a country cannot avoid), given Y and S (fixed): CADt = Zt CADt-1 / Zt-1 = – Zt / Zt-1 • Combining this with standard homothetic preferences, and a constant supply of non-tradables: rert= ( / ) CADt-1 / Zt-1 = ( / ) (1-t-1) t = (Yt – St) / Zt (openness a la Calvo et al)

8. Balance Sheet Effects • Why CAD/GDP and not CAD/Z? • Openness controlled via gravity, how about CAD/GDP? • Interesting that both traditional measure of openness and CAD/GDP (proxying for the leveraged portion of the current account deficit) come out significant • What additional factors is the openness measure capturing besides potential price effects? Are more open economies subject to a quicker response from tradable sectors after RER depreciation?

9. Dollarization • Measure 1: Lacks dollar deposits (FB/M) • Measure 2 (D*/D+D*): relative measure of degree of deposit dollarization, but what about size? • Is (D*+FB)/GDP more indicative of potential contingent liabilities (a proxy for dollar loans assuming bank currency matching)? • Interesting that dollarization measure comes up significant in some specifications with SS, but not with currency crises (as in Arteta (2003)) • Are credit crises linked to balance sheet effects, but not currency crises (developed countries)?

10. Not controlling for Controlling for endogeneity of w endogeneity of w (A) (B) 1.00 1.00 Low DLD Average DLD High DLD 0.75 0.75 Probability of a sudden stop 0.50 0.50 0.25 0.25 0.00 0.00 0.75 1.00 1.25 1.50 0.75 1.00 1.25 1.50 Omega Omega Linear Probability Estimates • Probit has interactions built up given non-linear specification • But linear estimations should specify interactions (CAD/GDP and dollarization)

11. Domestic Policies - Controls • Domestic variables like debt, lag of reserves, effectiveness of government do not come up significant (similar to Calvo et al) • Criticism: This in part reflects that when GDP collapses, there may not be much room left for policies. • Measure replacing output fall criterion for regional spreads criterion yields similar results • Domestic policies don’t matter? Measures such as openness and liability dollarization may represent summary statistics of past poor trade, fiscal and monetary policies • Could control for differences between EMs and developed countries (EM dummy), and external variables such as TOT.

12. Output Loss Estimations • Openness measure is less robust • But this is consistent with the fact that output outcomes depend on the crisis resolution process and the associated transfers that go with it. • Edwards (2004) for example, finds that dollarization, interacted with a dummy for current account crisis is not significant in explaining output behavior

13. “Does Openness to Trade Make Countries More Vulnerable to Sudden Stops, or Less? Using Gravity to Establish Causality” Comments Alejandro Izquierdo Second Meeting of the Latin Finance Network December 4, 2004