How do trade and financial integration affect the relationship between growth and volatility?
ABSTRACT The influential work of Ramey and Ramey [Ramey, G., Ramey, V.A., 1995. Cross-country evidence on the link between volatility and growth. American Economic Review 85, 1138–1151 (December).] highlighted an empirical relationship that has now come to be regarded as conventional wisdom—that output volatility and growth are negatively correlated. We reexamine this relationship in the context of globalization—a term typically used to describe the phenomenon of growing international trade and financial integration that has intensified since the mid-1980s. Using a comprehensive new data set, we document that, while the basic negative association between growth and volatility has been preserved during the 1990s, both trade and financial integration significantly weaken this negative relationship. Specifically, we find that, in a regression of growth on volatility and other controls, the estimated coefficient on the interaction between volatility and trade integration is significantly positive. We find a similar, although less robust, result for the interaction of financial integration with volatility.
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ABSTRACT: In the wake of the Mexican and Asian currency turmoil, the subject of financial crises have come to the forefront of academic and policy discussions. This paper analyzes the links between banking and currency crises. The authors find that problems in the banking sector typically precede a currency crisis--the currency crisis deepens the banking crisis, activating a vicious spiral; financial liberalization often precedes banking crises. The anatomy of these episodes suggests that crises occur as the economy enters a recession, following a prolonged boom in economic activity that was fueled by credit, capital inflows, and accompanied by an overvalued currency.American Economic Review 02/1999; 89(3):473-500. · 2.69 Impact Factor
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ABSTRACT: The optimal timing of real investment is studied under the assumptions that investment is irreversible and that new information about returns is arriving over time. Investment should be undertaken in this case only when the costs of deferring the project exceed the expected value of information gained by waiting. Uncertainty, because it increases the value of waiting for new information, retards the current rate of investment. The nature of investor's optimal reactions to events whose implications are resolved over time is a possible explanation of the instability of aggregate investment over the business cycle.The Quarterly Journal of Economics. 02/1983; 98(1):85-106.
How Do Trade and Financial Integration Affect the Relationship
between Growth and Volatility?
M. Ayhan Kose, Eswar S. Prasad and Marco E. Terrones1
May 31, 2004
The influential work of Ramey and Ramey (1995) highlighted an empirical relationship that has
now come to be regarded as conventional wisdom—that output volatility and growth are
negatively correlated. We reexamine this relationship in the context of globalization—a term
typically used to describe the phenomenon of growing international trade and financial
integration that has intensified since the mid-1980s. We employ various econometric techniques
and a comprehensive new dataset to analyze the link between growth and volatility. Our findings
suggest that, while the basic negative association between growth and volatility has been
preserved during the 1990s, both trade and financial integration attenuate this negative
relationship. Specifically, countries that are more open to trade appear to face a less severe
tradeoff between growth and volatility. We find a similar, although slightly less robust, result for
the interaction of financial integration with volatility. We also investigate some of the channels,
including investment and credit, through which different aspects of global integration could
affect the growth-volatility relationship.
1International Monetary Fund, 700 19th Street, N.W., Washington D.C. 20431
firstname.lastname@example.org; email@example.com; firstname.lastname@example.org. We thank Olivier Jeanne, Andy Rose,
Carlos Vegh, and Kamil Yilmaz for their useful suggestions. We thank Smita Wagh for excellent
research assistance. The views expressed in this paper are those of the authors and do not
necessarily represent those of the IMF.
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The influential work of Ramey and Ramey (1995) highlighted an empirical relationship
that has now come to be regarded as conventional wisdom—that volatility and growth are
negatively correlated. This is an important result since it implies that policies and exogenous
shocks that affect volatility can also influence growth. Thus, even if volatility is considered
intrinsically a second-order issue, its relationship with growth suggests that volatility could
indirectly have first-order welfare implications.
How do trade and financial integration affect the relationship between growth and
volatility? In this paper, we attempt to answer this question, which has taken on increasing
importance in view of the significant increases in the volumes of international trade and financial
flows over the last four decades. While cross-country trade linkages have been rising steadily
over the last four decades, there has been a substantial increase in cross-border capital flows
among industrial economies and across industrial and developing economies since the mid-
1980s. However, while the spread of trade linkages has been more broad-based, only a relatively
small group of developing economies, often referred to as “emerging markets,” have undergone
significant financial integration, as measured by gross capital flows across their borders.2 Many
of these economies have experienced high growth but have also been subject to high volatility,
most prominently in the form of severe financial crises that befell many of them during the last
decade and a half.
These developments naturally lead to the question of whether, in a more integrated global
economy, the relationship between growth and volatility has changed. More specifically, do the
high growth rates in emerging markets that are presumably partly fueled by financial flows come
at the cost of higher volatility associated in part with the vagaries of international trade and
financial flows? The change over time in the relative vulnerability of industrial and developing
economies to external crises also raises questions about whether the growth-volatility
relationship is influenced by the “growing pains” seemingly associated with rising trade and
financial integration. In other words, are the level of a country’s development and the extent of
its integration into international markets important in determining the conditional validity of this
2 For an extensive documentation of changes in the volume of international financial flows, Lane
and Milesi-Ferretti (2001, 2003), and Kose, Prasad, and Terrones (2004).
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relationship? In this context, while there appears to be a general consensus that openness to trade
flows stimulates domestic growth, it also appears to be the case that such openness increases
vulnerability to external shocks, including highly volatile terms of trade shocks. The effects of
financial integration are less obvious. Clearly, a more detailed analysis of this question is
In addressing the question stated in the title, our paper has two main objectives. First, we
explore how this relationship has been influenced by different aspects of globalization. The
Ramey and Ramey results, which have become the benchmark in this literature, are based on a
dataset that ends in 1985, just when the pace of globalization began to pick up and enveloped a
number of developing countries as well. Some recent papers show that the negative relationship
between growth and volatility has persisted into the 1990s.3 However none of these papers
provide a rigorous analysis of the role of rising trade and financial linkages in influencing this
relationship. Financial globalization, in particular, is likely to have been an important factor
influencing this relationship during the past twenty years, especially as increased international
financial flows appear to have precipitated sudden episodes of high volatility in many developing
economies. A central contribution of this paper is a comprehensive analysis of the roles of both
trade and financial integration in driving the growth-volatility relationship.
Understanding the channels through which volatility could potentially influence growth is
also of considerable interest. A related issue is whether there are common factors that affect both
growth and volatility and how these common factors interact with the forces of globalization in
accounting for the empirical link between volatility and growth. Thus, the second objective of
this paper is to provide a comprehensive analysis of such determinants, including investment,
credit growth, development of domestic financial sector, and the quality of institutions. The
impact of these common factors on influencing the individual dynamics of growth and volatility
has been examined in some recent papers, which are discussed in the next section. However, our
understanding of these factors along with the role played by increased international economic
linkages in explaining the relationship between growth and volatility is quite limited.
3 Fatas (2003) and Loayza and Hnatkovska (2003) update the regressions in Ramey and Ramey
(1995) using recent data and find that the negative relationship between growth and volatility is
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In section II, we present a review of recent studies analyzing how globalization affects
growth and also how it affects volatility. In addition, we provide a summary of several
theoretical and empirical studies focusing on the relationship between growth and volatility. This
survey suggests that neither theoretical studies nor empirical ones have rigorously examined the
effects of increased trade and financial linkages on the growth-volatility relationship.
In section III, we describe the dataset used in the analysis. The main features of the
dataset are that is has a broad coverage, comprising 85 countries, both industrial and developing,
and annual data over the period 1960–2000. Another important feature of this dataset is that it
includes a comprehensive set of measures of trade and financial integration for these countries.
In section IV, considering the important implications of the timing of the intensification of trade
and financial linkages across national economies for our main question, we document some
empirical evidence about the impressive growth of these linkages over the past four decades.
In section V, we provide a variety of stylized facts about the changes in the dynamics of
growth and volatility over time and across countries. We detect a number of interesting patterns
in the relationship between growth and volatility, which has been changing over time and across
different country groups. We also use an event study approach to examine how growth and
volatility change before and after trade and financial liberalizations. Both types of liberalizations
are typically associated with increases in output and investment growth, but the changes in the
volatility of output and consumption growth after such liberalization programs do not follow a
This sets the stage for the more formal empirical analysis in section VI, where we use
various regression models to analyze the determinants of the growth-volatility relationship. We
first examine the empirical validity of the main Ramey-Ramey result when data for the post-
1985 period, which was a turbulent period for many developing economies, are included in the
analysis. We find that the basic empirical result of a negative cross-sectional association between
volatility and growth holds up even in the 1990s. More importantly, however, we find that the
result is sensitive to the choice of country groups. For example, the results indicate that, while
there is a significant positive relationship among industrial countries, the relationship is
significantly negative among developing countries. Moreover, the association between growth
and volatility in developing countries depends on the extent of financial integration. In more
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financially integrated economies, the relationship appears to be positive, whereas in less
financially integrated ones it is negative.
We then use cross-section and panel regressions to conduct a more formal analysis of the
growth-volatility relationship, including an examination of how trade and financial linkages may
have affected this relationship. Using measures of average growth and volatility in each decade,
we find that the negative relationship between growth and volatility survives when we include
standard controls from the growth literature and account for the interaction between volatility
and different measures of global integration.
The main result of the paper is that trade and financial integration appear to attenuate the
negative growth-volatility relationship. Specifically, in regressions of growth on volatility and
other control variables, we find that the estimated coefficients on interactions between volatility
and trade integration are significantly positive. In other words, countries that are more open to
trade appear to face a less severe tradeoff between growth and volatility. We find a similar,
although slightly less robust, result for the interaction of financial integration with volatility.
The results also imply a threshold in the growth-volatility relationship. Beyond a certain
level of trade and/or financial integration, this relationship appears to turn positive. This helps
reconcile the findings that the growth-volatility relationship is negative for developing countries
but positive for industrial economies, since the latter group has, on average, higher levels of trade
and, especially, financial integration compared to the developing countries in our sample.
In section VII, we report a variety of robustness checks of our main results. We first
study the impact of other control variables, representing various channels linking volatility to
growth. We then consider different regression frameworks to further examine the robustness of
our results. In particular, we employ fixed effects regressions to capture country specific effects,
Least Absolute Deviation regressions to check the role of outliers in driving the main findings,
and account for the endogeneity of the growth-volatility relationship using IV regressions. The
results indicate that the main findings of the paper are robust to potential problems associated
with fixed effects, endogeneity and the presence of outliers. Section VIII concludes with a brief
summary of results and directions for future research.
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II. Review of Economic Theory and Empirical Studies
This section provides a brief review of theoretical and empirical studies about the impact
of globalization on the dynamics of volatility and growth and about the relationship between
growth and volatility. Our review focuses on three branches of a rapidly burgeoning literature on
the role of various global forces in driving economic growth and volatility. We first review the
literature studying the impact of increased global linkages on economic growth. We then turn our
attention to the literature on the relationship between globalization and macroeconomic
volatility. Finally, we summarize the literature studying various theoretical and empirical
linkages between growth and volatility. In each sub-section, we first discuss the main predictions
of theoretical studies, and then survey the empirical research.
There are four major points to be taken from our brief survey. First, economic theory
suggests that globalization should have a positive impact on growth, but does not provide strong
predictions about its impact on volatility or about its effects on the relationship between growth
and volatility. Second, empirical research indicates that increasing trade openness is associated
with both higher growth and more volatility, but the effects of financial openness on growth and
volatility are far less clear. Third, several recent empirical studies appear to find a negative
relationship between growth and volatility, both in unconditional terms and controlling for a
variety of standard determinants of growth.
The fourth issue, which provides a point of departure for this paper from the existing
literature, is that neither theoretical studies nor empirical ones have rigorously examined the
effects of increased trade and financial linkages on the growth-volatility relationship. In our
view, rising global linkages constitute one of the most important economic phenomena over the
last two decades in terms of understanding how business cycle volatility and long-run growth are
related. Figure 1 provides a rough schematic description summarizing the results of the existing
II.1. Effects of Globalization on Growth
Various theoretical models emphasize the importance of trade openness in promoting
economic growth. Some of these theoretical models focus on static gains, including the gains
derived from comparative advantage considerations. Others consider knowledge spillovers
associated with international trade (Grossman and Helpman (1991)). Some other studies focus on
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the indirect links between trade openness and growth that operate through the positive effect of
trade on productivity and investment growth (Levine and Renelt (1992) and Baldwin and
In theory, there are various direct and indirect channels through which increased financial
flows can enhance growth.5 The direct channels include augmentation of domestic savings,
reduction in the cost of capital through better global allocation of risk, development of the
financial sector (Levine (1996) and Caprio and Honohan (1999)), and transfer of technological
know-how. The main indirect channels are associated with promotion of specialization (Kalemli-
Ozcan, Sorensen, and Yosha (2003)) and inducement for better economic policies (Gourinchas
and Jeanne (2003)).
There is a large empirical literature suggesting that openness to trade has a positive
impact on growth. For example, using a variety of methods, several researchers, including Dollar
(1992), Ben-David (1993), Sachs and Warner (1995), Frankel and Romer (1999), Dollar and
Kraay (2002) and Wacziarg and Welch (2003), show that trade openness helps promote
economic growth. Rodriquez and Rodrik (2001) challenge the robustness of some of these
findings and argue that several of these studies suffer from problems associated with model mis-
specification and the use of openness measures that may be capturing other policy or institutional
By contrast to the literature on trade and growth, recent empirical research is unable to
establish a clear link between financial integration and economic growth. The majority of
empirical studies find that financial integration has no effect or at best a modest effect on
economic growth. For example, Edison, Levine, Ricci, and Slok (2002) employ a regression
model that controls for possible reverse causality and conclude that there is no robustly
significant effect of financial integration on economic growth.
Another set of empirical studies suggests that the composition of capital flows determines
the effects of financial integration on economic growth (Reisen and Soto (2001) and Goldberg
4 Krueger and Berg (2002), Baldwin (2003), and Winters (2004) provide extensive surveys of the
literature on trade and growth. There is also a large literature studying the impact of preferential
trade agreements on economic growth and welfare (Baldwin and Venables (1995)).
5 Prasad, Rogoff, Wei, and Kose (2003) provide a review of theoretical and empirical studies that
analyze the effects of financial integration on economic growth.
- 8 -
(2004)). In particular, these studies conclude that FDI flows tend to be positively associated with
output growth in those countries that have a sufficient level of human capital (Borenzstein, De
Gregorio, and Lee (1998)) and well-developed domestic financial markets (Alfaro, Chanda,
Kalemli-Ozcan, and Sayek (2003)). Other studies focus on the impact of equity market
liberalization on the growth rates of output and investment. Bekaert, Harvey, and Lundblad
(2001) find that equity market liberalization induces a significant increase in the growth rate of
output and Henry (2000) documents that it leads to a substantial increase in the growth rate of
II.2. Effects of Globalization on Volatility
The theoretical impact of increased trade and financial flows on output volatility depends
on various factors, including the composition of these flows, patterns of specialization, and the
sources of shocks. For example, if trade openness is associated with increased specialization of
countries’ production structures (at the industry level) and industry-specific shocks are important
in driving business cycles, it could lead to an increase in output volatility. However, if rising
trade flows are associated with increased vertical specialization across countries, which would
lead to a larger volume of trade in intermediate inputs, then the volatility of output growth could
decline (Kose, Prasad, Terrones (2003a)).
In theory, financial integration could help lower the volatility of macroeconomic
fluctuations in capital-poor developing countries by providing access to capital that can help
them diversify their production base. Rising financial integration, however, could also lead to
increasing specialization of production based on comparative advantage considerations, thereby
making economies more vulnerable to industry-specific shocks (Kalemli-Ozcan, Sorensen, and
Yosha (2003)). In addition, sudden changes in the direction of capital flows could induce boom-
bust cycles in developing countries, most of which do not have deep enough financial sectors to
cope with volatile capital flows (Aghion, Banerjee, and Piketty (1999)). Results from dynamic
stochastic general equilibrium business cycle models suggest that increased access to
international financial markets should dampen the volatility of consumption while inducing an
increase in investment volatility (Mendoza (1994), Backus, Kehoe, Kydland (1995) and Baxter
and Crucini (1995)).
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Recent empirical work has been unable to establish a clear link between stronger trade
linkages and macroeconomic volatility. While some studies find no significant relationship
between an increased degree of trade interdependence and domestic macroeconomic volatility
(Buch, Dopke, and Pierdzioch, 2002), others find that an increase in the degree of trade openness
leads to higher output volatility, especially in developing countries (Karras and Song (1996),
Easterly, Islam, and Stiglitz, 2001). Kose, Prasad, and Terrones (2003a) find that, while trade
openness increases the volatility of output and consumption growth in emerging market
economies, it reduces the volatility of consumption growth relative to that of income growth,
implying that trade improves risk-sharing possibilities.
Kose, Prasad, and Terrones (2003a) document that financial integration does not have a
statistically significant impact on the volatility of output growth. They also argue that the
relationship between financial integration and consumption growth volatility is a nonlinear one--
increased financial integration is associated with rising relative volatility of consumption, but
only up to a certain threshold. Bekaert, Harvey, and Lundblad (2002) find that domestic equity
market liberalizations are associated with lower volatility of output and consumption growth.
IMF (2002) also provides evidence indicating that financial openness is associated with lower
output volatility in developing countries.
II.3. The Relationship between Growth and Volatility
Whether volatility and growth should be investigated independently, rather than studied
as related phenomena, has been the subject of some debate. Papers in the stochastic dynamic
business cycle literature have typically propounded the view that the distinction between trend
and cycles is an artificial one, since both growth and fluctuations are driven by the same set of
shocks. However, there is no clear implication that can be derived from these models about the
relationship between volatility and growth. Jones, Manuelli, and Stacchetti (1999) show that, in
an endogenous growth model, the relationship between volatility and growth can be either
positive or negative depending on the curvature of the utility function. Jovanovic (2003), on the
other hand, argues that there is a negative relationship between growth and volatility in an
endogenous growth model, since rates of growth are more volatile in recessions than in booms.
Various theoretical channels, which can lead to a negative relationship between growth
and volatility, are discussed in the literature. For example, some theoretical models argue that the
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link between growth and volatility depends on the dynamics of investment. Bernanke (1983),
Pindyck (1988), and Aizenman and Marion (1993) construct models in which irreversibilities
and/or the presence of asymmetric adjustment costs in investment could lead to higher volatility
and lower investment, which in turn reduces economic growth. Using a growth model with
learning by doing, Martin and Rogers (1997, 2000) emphasize the importance of costs associated
with learning in determining the nature of the relationship between growth and volatility. They
conclude that there is a negative relationship between economic growth and volatility because
the adverse impact of recessions on learning by doing dominates the beneficial effects of
expansions.6 In the context of an endogenous growth model, Mendoza (1997) shows that terms-
of-trade fluctuations can also affect the relationship between growth and volatility. While there is
a positive relationship between average changes in the terms of trade and economic growth,
volatility associated with terms of trade fluctuations could lead to slower growth, depending on
the degree of risk aversion.
There are some theoretical studies arguing that macroeconomic volatility could have a
beneficial impact on economic growth. For example, Aghion and Saint-Paul (1998) show that
recessions could decrease the costs associated with innovations and lead to improvements in
productivity and higher economic growth. Blackburn (1999) finds that volatility could promote
economic growth in an endogenous growth model and argues that stabilization policies could
have harmful effects on the growth performance of an economy. Tornell, Westermann, and
Martinez (2004) argue that the presence of credit market imperfections in financially open
economies could lead to increased volatility and higher growth. In particular, they argue that
financial integration leads to higher growth in developing countries, but often results in
economic crises as well because of various credit market imperfections.
Direct empirical examinations of the relationship between output volatility and growth
date back to contributions by Kormendi and Maguire (1985) and Grier and Tullock (1989), who
6 Caballero (1991) shows that the relationship between volatility and investment growth depends
on the nature of competition and scale economies. While the relationship is positive with perfect
competition and constant returns to scale in production, it becomes negative in a model with
imperfect competition and decreasing returns to scale. Stiglitz (1993) analyzes the role of capital
market imperfections and concludes that volatility could have an adverse impact on productivity
and economic growth. Bean (1991), Saint-Paul (1993), and Acemoglu and Zilibotti (1997) also
show that volatility can have a dampening effect on economic growth.
- 11 -
suggest that there is a positive relationship between volatility and growth. On the other hand, in
an influential contribution that has since acquired the status of conventional wisdom, Ramey and
Ramey (1995; henceforth referred to as RR) conclude that growth and volatility are negatively
related. Using a dataset comprising 92 countries and covering the period 1950-1985, they show
that the relationship is robust after introducing various control variables, including the share of
investment in GDP, population growth, human capital, and initial GDP. They also find that
volatility associated with government expenditure is negatively associated economic growth. The
basic RR result has intuitive appeal since volatility, especially on the order of magnitude
typically experienced by developing economies, could presumably have some longer-term
adverse implications on economic activity. RR also show that the results of earlier empirical
studies suggesting a positive relationship between growth and volatility, including Kormendi and
Maguire (1985), might be misleading since these studies include the volatility of monetary
shocks, which may be correlated with the volatility of output, as an explanatory variable.
More recent work using different methodologies and datasets tends to confirm the
negative relationship between volatility and growth. Martin and Rogers (2000) find similar
evidence using three different samples—data for 90 European regions over the period 1979-
1992; 24 developed countries for the period 1960-88; and a broader sample of 72 developed and
developing countries for the same period. Their results indicate that there is a significant
negative relationship between growth and the amplitude of business cycles in developed
countries. However, they are unable to find a statistically significant relationship for the group of
Fatas (2003), using a broad sample of about 100 countries and data over the period 1960-
98, explores the effects of using different control variables and different measures of volatility.
He concludes that the negative growth-volatility relationship is robust. He also notes that the use
of a basic volatility measure, such as the standard deviation of output growth, or an alternative
7 In a recent paper, Imbs (2004) attempts to reconcile the positive relationship between growth
and volatility at the sectoral level with the negative relationship at the country level. He notes
that how this relationship at the sectoral level translates into the relationship at the aggregate
level depends on the degree of synchronicity of fluctuations across sectors and on the relative
importance of aggregate versus sector-specific shocks.
- 12 -
measure of uncertainty, such as the residuals from a regression of output growth from a simple
autoregressive forecasting equation, makes no difference to the results.
Loayza and Hnatkovska (2003) study the growth-volatility relationship using a sample of
79 developed and developing countries over the period 1960-2000. They confirm that the
relationship is robustly negative when numerous controls from the growth literature are
incorporated into their regression framework. They also conclude that the negative relationship
has intensified in the last two decades, mostly as a result of large recessions rather than normal
cyclical fluctuations. Both Fatas (2003) and Loayza and Hnatkovska (2003) also control for trade
openness in their regressions, but their results indicate that the trade openness variable has no
significant impact on the relationship between volatility and growth.
Some other empirical studies focus on the impact of a particular source of volatility on
economic growth. For example, Fatas and Mihov (2003) find that volatility associated with the
fiscal policy induces lower economic growth. Judson and Orphanides (1996) establish a negative
relationship between inflation volatility and economic growth while Barro (1991) and Alesina,
Ozler, Roubini and Swagel (1996) study the adverse impact of political instability on growth.
Mendoza (1997) and Turnovsky and Chattopadhyay (2003) document evidence of the negative
impact of terms of trade volatility on growth.8 Tornell, Westermann, and Martinez (2004)
provide evidence indicating that, while the standard deviation of credit growth has a negative
impact on growth of GDP, negative skewness (bumpiness) of credit growth has a positive
Some recent papers have considered the roles of other factors such as financial market
development and quality of institutions in explaining the dynamics of volatility and growth.
Denizer, Iyigun, and Owen (2002) and Beck, Lundberg, and Manjoni (2001) find that economies
with more developed financial markets display less volatile output, consumption, and investment
fluctuations while King and Levine (1993) and Rajan and Zingales (1998) find that countries
with more developed financial markets are able to grow faster. Acemoglu, Johnson, Robinson,
8 Catão and Kapur (2004) find that volatility of output plays a major role in determining the
sovereign risk of several developing countries. In particular, they argue that there is a positive
association between volatility and the probability of default. This could be another channel
through which volatility has a negative impact on economic growth.
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and Thaicharoen (2003) document that countries with weak institutions are more likely to
experience high volatility and lower economic growth.
We study the relationship between growth and volatility using a large dataset that
includes industrial as well as developing countries. While the basic dataset we use is the latest
version of the Penn World Tables (Heston, Summers, and Aten, 2002), we supplement that with
data from various other sources, including databases maintained by the World Bank and IMF.
The dataset comprises annual data over the period 1960–2000 for a sample of 85 countries—21
industrial and 64 developing. It is possible to employ a more comprehensive country coverage
for the basic growth-volatility regressions used in RR. However, our main objective is to analyze
how trade and financial openness affect this basic relationship and the data on financial openness
turned out to be a major constraint to expanding the coverage of the dataset any further.
For the descriptive analysis in the next two sections, we divide developing countries into
two coarse groups—more financially integrated (MFI) economies and less financially integrated
(LFI) economies. There are 23 MFI and 41 LFI economies in our sample. The former essentially
constitute the group of “emerging markets” and account for a substantial fraction of net capital
flows from industrial to developing countries in recent decades.9 The group of industrial
countries corresponds to a sub-sample of the OECD economies for which data used in the
empirical analysis are available.
In our regressions, we use two measures of trade integration. The first measure is a binary
one borrowed from Sachs and Warner (1995), who measure openness based on the extent of
restrictiveness of a country’s trade policies.10 The second measure is a continuous one used
widely in the literature--the ratio of imports and exports to GDP. Similarly, we employ both a
9 This classification results in a set of MFI economies that roughly correspond to those included
in the MSCI emerging markets stock index.
10 The Sachs and Warner measure assumes that a country is closed to trade in a particular year if
it has one of the following features: (1) average tariff rates of 40 percent or more; (2) nontariff
barriers covering 40 percent or more of trade; (3) a black market exchange rate that is
depreciated by 20 percent or more relative to the official exchange rate, on average, during the
1970s or 1980s; (4) a state monopoly on major exports; or (5) a socialist economic system. We
also use the openness data in Wacziarg and Welch (2003), who extend the Sachs-Warner study.
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binary and a continuous measure of financial integration. Our binary measure takes a value of
one when the equity market is officially liberalized; otherwise, it takes a value of zero. The
majority of the dates of official financial liberalization for individual countries are taken from
Bekaert, Harvey, and Lundblad (2002a) and Kaminsky and Schmukler (2002).11 The former set
of authors document a chronology of official liberalizations of stock markets based on the dates
of regulatory changes and the dates on which foreigners were granted access to the local market.
The latter provide a chronology of financial liberalizations based on the dates of deregulation of
the capital account, the domestic financial sector, and the stock market. Our second financial
integration measure—the ratio of gross capital flows to GDP--is analogous to the trade openness
ratio. A detailed description of the dataset and sources are provided in Appendix A. Appendix B
includes a list of liberalization dates for the MFI economies in the dataset.
Our binary indicators can be considered as measures of de jure trade and financial
integration while the continuous measures capture de facto integration.12 The distinction between
de jure and de facto measures is of particular importance in understanding the effects of financial
integration since many economies that have maintained controls on capital account transactions
have found them ineffective in many circumstances, particularly in the context of episodes of
IV. Growing Global Linkages
This section documents some empirical evidence about the impressive growth of trade
and financial linkages across national economies over the past four decades. The timing of the
intensification of these linkages has important implications for our analysis. There has been a
11 Since these dates are not available on a consistent basis for some countries in our sample, we
use various IMF sources to complete the dates of liberalizations. We also experiment with other
binary measures of trade and financial integration which are associated with trade and capital
account restrictions. These include payment restrictions for current and capital account, export
surrender requirements, and multiple exchange rates. The use of alternative binary measures does
not affect our main findings.
12 For the panel regressions, the binary measures are averaged over each decade for each country
and can, therefore, take values between 0 and 1.
13 See Prasad, Rogoff, Wei and Kose (2003) for a discussion of the relationship between these
two concepts of financial integration and the implications of measuring them separately. That
paper also provides a more detailed discussion of the sources and construction of the financial
openness measures used here.
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substantial increase in the volumes of international trade and financial flows since the mid-
1980s. For example, private capital flows from industrialized economies to developing
economies have increased dramatically since the mid-1980s (Figures 2a and 2b). The bulk of this
increase has gone to the MFI economies. The main increase in gross capital flows to developing
countries has been in terms of FDI and portfolio flows, while the relative importance of bank
lending and other official flows has declined over time.14
The volume of international trade has also registered a dramatic increase over the last
three decades (Figure 2c). For example, Kose, Prasad, and Terrones (2004) report that the
average growth rate of trade, measured by the sum of exports and imports, has been more than
two times larger than that of GDP in the groups of industrial and MFI countries during the period
1986-1999. Reductions in trade barriers and declines in transport and communications costs have
played important roles in driving the rapid growth in trade. In particular, developing countries
reduced average tariff rates from around 30 percent in the 1980s to about 18 percent in the
late 1990s. Both developed and developing countries intensified their efforts to liberalize
external trade regimes and the number of preferential trade agreements increased from 28
in 1986 to 181 in 2002.
A number of countries have undertaken trade and financial liberalization programs since
the mid-1980s. To understand the impact of these programs, we first identify the country-specific
dates of trade and financial liberalizations. Most of the dates for trade liberalization are taken
from Wacziarg and Welch (2003), who extend the work of Sachs and Warner (1995). In these
studies, the dates of trade liberalizations are determined using various country case studies as
well as a set of indices based on changes in countries’ trade-related policies. As discussed in
section II, the majority of the dates of financial liberalizations are from Bekaert, Harvey, and
Lundblad (2001) and Kaminsky and Schmukler (2002).
Figures 3a and 3b display the shares of MFI countries in our sample that have undertaken
trade and financial liberalization programs over the last two decades, based on the liberalization
dates constructed as described above. By 1985, roughly 30 percent of the countries in our sample
14 See Lane and Milesi-Ferretti (2001, 2003) for a detailed analysis of the increase in global
financial flows. Heathcote and Perri (2004) document that U.S. holdings of foreign assets have
grown significantly since the mid-1980s, rising from 8 percent in 1986 to roughly 35 percent of
the total U.S. capital stock in 1999.