Financial openness, sudden stops and current account reversals

TLDR: In this article, the authors investigated the relationship between sudden stops of capital inflows and current account reversals and showed that sudden stops and reversals have been closely related, and that the degree of financial openness does not appear to be related to the intensity with which reversals affect real economic performance.

Abstract: In this paper I use a panel data set to investigate the mechanics of sudden stops of capital inflows and current account reversals. I am particularly interested in four questions: (a) What is the relationship between sudden stops and current account reversals? (b) To what extent does financial openness affect the probability of a country being subject to a current account reversal? In other words, do restrictions on capital mobility reduce the probability of such occurrences? (C) Does openness -- both trade openness and financial openness -- play a role in determining the effect of current account reversals on economic performance (i.e. GDP growth)? And, (d) does the exchange rate regime affect the intensity with which reversals affect real activity? The empirical analysis shows that sudden stops and current account reversals have been closely related. The econometric analysis suggests that restricting capital mobility does not reduce the probability of experiencing a reversal. Current account reversals, in turn, have had a negative effect on real growth that goes beyond their direct effect on investment. The regression analysis indicates that the negative effects of current account reversals on growth will depend on the country's degree of trade openness: More open countries will suffer less in terms of lower growth relative to trend than countries with a lower degree of trade openness. On the other hand, the degree of financial openness does not appear to be related to the intensity with which reversals affect real economic performance. The empirical analysis also suggests that countries with more flexible exchange rate regimes are able to accommodate better shocks stemming from a reversal than countries with more rigid exchange rate regimes.

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NBER WORKING PAPER SERIES
FINANCIAL OPENNESS,
SUDDEN STOPS AND CURRENT ACCOUNT REVERSALS
Sebastian Edwards
Working Paper 10277
http://www.nber.org/papers/w10277
NATIONAL BUREAU OF ECONOMIC RESEARCH
1050 Massachusetts Avenue
Cambridge, MA 02138
January 2004
This paper has been prepared for presentation at the American Economic Association Annual Meetings, San
Diego, January 3-5, 2004.The views expressed herein are those of the authors and not necessarily those of
the National Bureau of Economic Research.
©2004 by Sebastian Edwards. All rights reserved. Short sections of text, not to exceed two paragraphs, may
be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Financial Openness, Sudden Stops and Current Account Reversals
Sebastian Edwards
NBER Working Paper No. 10277
January 2004
JEL No. F30, F32
ABSTRACT
In this paper I use a panel data set to investigate the mechanics of sudden stops of capital inflows
and current account reversals. I am particularly interested in four questions: (a) What is the
relationship between sudden stops and current account reversals? (b) To what extent does financial
openness affect the probability of a country being subject to a current account reversal? In other
words, do restrictions on capital mobility reduce the probability of such occurrences? (C) Does
openness n both trade openness and financial openness n play a role in determining the effect of
current account reversals on economic performance (i.e. GDP growth)? And, (d) does the exchange
rate regime affect the intensity with which reversals affect real activity? The empirical analysis
shows that sudden stops and current account reversals have been closely related. The econometric
analysis suggests that restricting capital mobility does not reduce the probability of experiencing a
reversal. Current account reversals, in turn, have had a negative effect on real growth that goes
beyond their direct effect on investment. The regression analysis indicates that the negative effects
of current account reversals on growth will depend on the country’s degree of trade openness: More
open countries will suffer less n in terms of lower growth relative to trend n than countries with
a lower degree of trade openness. On the other hand, the degree of financial openness does not
appear to be related to the intensity with which reversals affect real economic performance. The
empirical analysis also suggests that countries with more flexible exchange rate regimes are able to
accommodate better shocks stemming from a reversal than countries with more rigid exchange rate
regimes.
Sebastian Edwards
UCLA Anderson Graduate School of Business
110 Westwood Plaza, Suite C508
Box 951481
Los Angeles, CA 90095-1481
and NBER
sedwards@anderson.ucla.edu

1
FINANCIAL OPENNESS, SUDDEN STOPS
AND CURRENT ACCOUNT REVERSALS
by
Sebastian Edwards
*
Since the currency crises of the 1990s economists have had a renewed interest in
understanding the behavior of international capital flows. A number of authors have
argued that in a world of high capital mobility “sudden stops” of capital inflows can be
highly disruptive. According to these authors, sudden stops tend to result in major
current account reversals, and in costly adjustment processes (Rudi Dornbusch, Ilan
Goldfajn and Rodrigo Valdés 1995). There are two important policy issues regarding
sudden stops and current account reversals: First, what determines the occurrence of
these phenomena? And second, what are the effects of sudden stops, and current account
reversals, on countries’ economic performance. In this paper I use a panel data set to
investigate the mechanics of sudden stops and reversals. I am particularly interested in
four questions: (a) What is the relationship between sudden stops and current account
reversals? (b) To what extent does financial openness affect the probability of a country
being subject to a current account reversal? In other words, do restrictions on capital
mobility reduce the probability of such occurrences? (C) Does openness – both trade
openness and financial openness – play a role in determining the effect of current account
reversals on economic performance (i.e. GDP growth)? And, (d) does the exchange rate
regime affect the intensity with which reversals affect real activity?
I. Sudden Stops and Current Account Reversals
I define a current account reversal as a reduction in the current account deficit of
at least 4% of GDP in one year. A sudden stop, on the other hand, is defined as an abrupt

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and major reduction in capital inflows to a country that has been receiving large volumes
of foreign capital. In particular, a sudden stop occurs when net capital inflows have
declined by at least 5% of GDP in one year (see Edwards 2004 for details).
Using a panel data set for 157 countries I found that during 1970-2001 there was a
5.6% incidence of sudden stops; the incidence of reversals was 11.8%. Not surprisingly,
these two phenomena have been closely related. However, the relationship is less than
perfect. Historically there have been many sudden stops that have not been related to
reversal episodes. This indicates that when facing a sudden stop, many countries have
effectively used their international reserves to avoid an abrupt current account
adjustment. At the same time, a number of countries have gone through major current
account reversals without facing a sudden stop in inflows. Most countries in this group
were not receiving large inflows to begin with, and had financed their large deficits by
drawing down international reserves (see Edwards, 2004).
For the complete sample (2,228 observations), 46.1% of countries subject to a
sudden stop faced a current account reversal. At the same time, 22.9% of those with
reversals also experienced (in the same year) a sudden stop. The joint incidence of
reversals and sudden stops has been highest in Africa, where approximately 62% of
sudden stops happened at the same time as current account reversals, and almost 30% of
reversals coincided with sudden stops. For every one of the regions, as well as for the
complete sample, Pearson χ
2
tests for the independence of distributions have very small
p-values, indicating that although there are observed differences between these two
phenomena, the two are statistically related. For the complete sample the χ
2
statistic for
the null hypothesis of independence of distributions has a value of 159.8. These results

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do not change in any significant way if different definitions of reversals and sudden stops
are used, or if different configurations of lags and leads are considered.
II. Openness and the Costs of Current Account Reversals
I use the data set described above to investigate two issues: (a) Does the
probability of experiencing a current account reversal depend on the country’s degree of
financial openness? And (b), do the effects of current account reversals on real economic
activity (GDP growth) depend on the country’s degree of trade and financial openness?
1
Some authors have argued that “excessive” capital mobility is highly disruptive.
According to them, restricting the degree of capital mobility will reduce the probability
that a country faces an external crisis, including a sudden stop and a current account
reversal (Joseph Stiglitz 2002). Whether this is indeed the case is, of course, an empirical
issue. The results reported in this paper, then, shed some light on this policy question, as
they provide a historical assessment of the effectiveness of capital controls.
In a number of models the costs of foreign shocks – including sudden stops and
current account reversals -- are inversely proportional to the country’s degree of
openness. In Mundell-Fleming type of models the expenditure reducing effort, for any
given level of expenditure switching, is inversely proportional to the marginal propensity
to import. In these models adjustment costs are also inversely proportional to the degree
of financial integration. Countries with a higher degree of financial openness will require
a smaller reduction in aggregate income to accommodate external shocks than countries
with a lower degree of financial integration (Jacob Frenkel and Assaf Razin 1987).
Recently, Guillermo Calvo, Alejandro Izquierdo and Luis Mejia (2003) developed
a model where sudden stops result in abrupt current account reversals, and in major real

Frequently asked questions

Q1. What contributions have the authors mentioned in the paper "Nber working paper series financial openness, sudden stops and current account reversals" ?

In this paper I use a panel data set to investigate the mechanics of sudden stops of capital inflows and current account reversals. The econometric analysis suggests that restricting capital mobility does not reduce the probability of experiencing a reversal. The empirical analysis also suggests that countries with more flexible exchange rate regimes are able to accommodate better shocks stemming from a reversal than countries with more rigid exchange rate regimes. 

Q2. How many sudden stops did the data set for 1970-2001 show?

Using a panel data set for 157 countries The authorfound that during 1970-2001 there was a5.6% incidence of sudden stops; the incidence of reversals was 11.8%. 

Q3. What is the definition of sudden stops and current account reversals?

I. Sudden Stops and Current Account ReversalsI define a current account reversal as a reduction in the current account deficit ofat least 4% of GDP in one year. 

Q4. What is the coefficient of the dummy?

If reversals have a negative impact on (short-term) growth, the coefficient of the reversals’ dummy will be significantly negative. 

Q5. What is the effect of a reversal on the economic performance of countries with more?

The empirical analysis also suggests that countries with more flexible exchange rate regimes are able to accommodate better shocks stemming from a reversal than countries with more rigid exchange rate regimes. 

Q6. What is the effect of sudden stops and current account reversals on real economic activity?

Gian Maria Milesi-Ferreti and Razin (2000), for example, concluded that “reversal… are not systematically associated with a growth slowdown (p. 303).” Edwards (2002), on the other hand, used dynamic panel regressions and concluded that major current account reversals had a negative effect on investment, and on GDP per capita growth, even after controlling for investment. 

Q7. What is the probability of a reversal?

These results indicate that the probability of experiencing a reversal is higher for countries with a large (lagged) current account deficit, a high external debt ratio, a rapid rate of growth of domestic credit, lower initial GDP, and a high occurrence of sudden stops in their region.