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Evaluation of Exchange-Rate and Capital – Market Liberalization Regimes in the Presence of Sudden Stops

The paper challenges two established puzzles in the international macroeconomics. The first puzzle is the failure of the literature to find any systematic difference in the macroeconomic process across exchange rate regimes. The second is the absence of any empirical relation between macroeconomic performance and capital-account liberalization. We attribute the failure of the literature to address these puzzles to a fundamental flaw. We attribute the failure of the literature to a fundamental flaw of ignoring the probability of sudden stops. We develop a methodology consisting of accounting for a latent continuous variable indicating a crisis-prone state of the economy. The latent variable is summarized by a projected probability of a crisis due to sudden stops in international capital inflows. We apply the new methodology to a cross-country panel of 100 low and middle-income countries over three decades. Findings indicate that the effects of exchange rate regimes and liberalization regimes on macroeconomic performance go through two distinct channels: a direct channel that is captured in the traditional growth equation, and an indirect channel which influences growth through the probability of sudden stops. We further analyze how the projected probability of sudden stops affects the level of dollarization, and provide estimates for the effect of dollarization on growth. 1 We acknowledge useful discussions on the topics of the paper with Marianne Baxter, Giancarlo Corsetti, Alex Cukierman, Allan Drazen, Alejandro Izquierdo, Paul Mc Nelis, Gian Maria Milesi-Ferretti, Ady Pauzner, Dan Trefler, Chetan Subramanian, and we thank two referees for insightful comments.. We are indebted to Gian Maria Milesi-Ferretti, Carmen Reinhart, Federico Sturzenegger, and Romain Ranciere, for providing us with various data sets. We also thank Yaniv Yedid Levy for competent research assistance.