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The World Bank Economic Review Advance Access originally published online on October 4, 2007
The World Bank Economic Review 2007 21(3):359-387; doi:10.1093/wber/lhm018
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Right arrow E23 - Production
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© The Author 2007. Published by Oxford University Press on behalf of the International Bank for Reconstruction and Development / THE WORLD BANK. All rights reserved. For permissions, please e-mail: journals.permissions@oxfordjournals.org

The Structural Determinants of External Vulnerability

Norman V. Loayza and Claudio Raddatz

Norman V. Loayza (corresponding author) is a lead economist at the World Bank; his email address is nloayza{at}worldbank.org
Claudio Raddatz is an economist at the World Bank; his email address is craddatz{at}worldbank.org

JEL codes: F36, F41, F43

This article examines empirically how domestic structural characteristics related to openness and product- and factor-market flexibility influence the impact of terms of trade shocks on aggregate output. Applying semistructural vector autoregressions to a panel of 88 countries with annual observations for the period 1974–2000, the analysis isolates and standardizes the shocks, estimates their impact on GDP, and examines how this impact depends on the domestic conditions outlined above. The article finds that greater trade openness magnifies the output impact of terms of trade shocks, particularly negative ones, while financial openness reduces their impact. Flexibility of labor and firm-entry are beneficial, with labor flexibility dampening the impact of negative shocks and ease of firm-entry magnifying positive ones only. Domestic financial depth has a more nuanced role in stabilizing the economy. Analysis of interactions across structural determinants reveals complementarities among macroeconomic conditions (trade and financial openness and depth) and, separately, among microeconomic conditions (flexibility of labor markets and ease of firm-entry). Variables across these groups tend to behave as substitutes for each other.


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