Sudden Stops, Banking Crises and Investment Collapses in ...
Sudden Stops, Banking Crises and Investment Collapses in
Joseph P. Joyce Malhar Nabar
Department of Economics Department of Economics
Wellesley College Wellesley College
Wellesley, MA 02481y Wellesley, MA 02481z
February 9, 2007
We evaluate whether …nancial openness leaves emerging market economies vulnerable to the adverse
e¤ects of capital reversals (“sudden stops” on domestic investment. We investigate this claim in a broad
sample of emerging markets during the period 1976-2002. If the banking sector does not experience a
systemic crisis, sudden stop events fail to have a signi…cant impact on investment. Bank crises, on the
other hand, have a signi…cant negative e¤ect on investment even in the absence of a contemporaneous
sudden stop crisis. We also …nd that openness to capital ‡ ows exacerbates the severity of the adverse
impact of banking crises on investment. The critical component of capital ‡ ight appears to be the reversal
of short duration ‡ ows, intermediated through the banking sector. Our results provide statistical support
for the policy view that a strong banking sector which can withstand the negative fallout of capital ‡ ight
is essential for countries that open their economies to international …nancial ‡ows.
JEL Classi…cation: F32, F41, F43, E44
Key words: …nancial openness, sudden stops, banking crises, investment, emerging markets
We are grateful to Margaret Settli and Yukari Koya for outstanding research assistance, and to Je¤rey Frankel, Eduardo
Cavallo and Adam Honig for their data.
z Corresponding author. firstname.lastname@example.org. Telephone: 781 283 2165.
Financial crises in emerging markets have become a central feature of the world economy in
recent times. These crises often in‡ high costs of adjustment on the economies that expe-
rience them. Calvo and Reinhart (2000) document that …nancial crises in emerging markets
became more severe in the 1990s than was the case previously. As a result, several promi-
nent researchers have questioned the merits of …nancial globalization. Stiglitz (2002) and
Bhagwati (2004), for example, argue that …nancial openness leaves emerging market coun-
tries vulnerable to external crises, which have a severe negative e¤ect on domestic economic
In this paper we examine precisely how openness and …nancial crises a¤ect investment in
a dynamic panel of 26 emerging market economies during the period 1976-2002. The crises
we study are “sudden stops” in the net in‡ of capital, de…ned as signi…cant declines in
the …nancial account of the balance of payments, and domestic banking crises. We use the
database assembled by Caprio, Klingebiel, Laeven and Noguera (2005) to date banking crises
and the criteria used by Frankel and Cavallo (2004) to record sudden stop crises. We employ
the Arellano-Bond (1991) technique to address concerns about dynamic panels.
In contrast with much of the existing empirical work on the costs of …nancial crises in
emerging markets, we focus on investment rather than output to study the e¤ects of these
crises on the domestic economy. Whereas output growth may pick up quickly after a crisis
if exports drive the recovery, investment may remain persistently low. Tracking the path
of output in the immediate aftermath of a crisis will lead to an incomplete and misleading
assessment of the e¤ects of the crisis. If investment does not bounce back, the robustness of
the recovery and the prospects for long run growth could be severely compromised. An IMF
(2005) study, for example, demonstrates that investment has not yet recovered in several
East Asian countries following the …nancial crisis that occurred in the region in 1997. Figure
1 tracks the time paths of investment for two of the countries a¤ected by the Asian …nancial
crisis of 1997 - Malaysia and Thailand. Even …ve years after the crisis, investment has failed
to recover to its pre-crisis average level.
Our contribution is two-fold. First, we establish that in the absence of a bank crisis a
sudden stop event would not by itself have a signi…cant impact on investment. The evidence
suggests that investment does not decline if the domestic banking sector can withstand the
external crisis and continue to provide …nancial intermediation services in the face of capital
reversals. On the other hand, the importance of the banking sector to the domestic economy
is highlighted by the fact that regardless of whether or not a sudden stop occurs, a banking
crisis has a signi…cant, negative impact on investment. Furthermore, the joint occurrence of
a sudden stop and a banking crisis does not have any additional adverse e¤ect on investment
over and above the direct impact of the banking crisis. Second, we …nd that capital ‡ight
can harm investment indirectly if it is the main cause of a domestic banking crisis. Our
results indicate that the impact of a bank crisis is exacerbated in economies that have a
higher degree of …nancial openness and are therefore more exposed to such ‡ows.
The rationale for …nancial openness is that it promotes domestic …nancial development
and growth (Mishkin, 2005). Our …ndings highlight the importance of a well-regulated,
transparent banking system for countries pursuing …nancial globalization. While previous
research (Calvo and Reinhart, 2000) has emphasized the role of the banking sector in trans-
mitting the e¤ects of external crises to the domestic economy, the work has mainly been
theoretical. In this paper, we provide empirical support for the view that openness to capi-
tal ‡ows does not of its own accord have a negative impact on investment. However, if the
banking sector is weak, the e¤ect of any underlying fragility in the system on investment is
worsened by a higher exposure to reversal of capital ‡ows.
The paper is organized as follows. Section 2 outlines the channels through which external
crises and banking crises a¤ect investment, and relates our work to previous research. Section
3 discusses our data and how we measure the occurrence of crises. Section 4 reports our
empirical speci…cations and results. Section 5 concludes.
2 Capital Reversals, Banking Crises and Investment
There are several compelling reasons to believe that capital ‡ reversals could potentially
in‡ serious long run economic costs on the domestic economy through the channel of
investment. Domestic investment may collapse following an external crisis if the supply of
foreign funds for domestic investment dries up. Firms that had been borrowing directly
from overseas may no longer be able to do so because their credit-worthiness goes down if an
accompanying devaluation raises the e¤ective value of their existing external liabilities. In
addition, foreign direct investment into local subsidiaries of multinational corporations or to
joint-venture domestic partner …rms might decline, inhibiting the ability of these domestic
…rms to make domestic investment (Bosworth and Collins, 1999).
If interest rates rise in the aftermath of the external crisis, domestic …rms may …nd it
too costly to borrow even from domestic sources, leading to a decline in their willingness
to borrow and a further collapse of investment. In addition, the decline in investment may
display strong persistence if the external crisis is associated with a decline in output. For
example, if the external crisis contributes to the loss of output, …rms may perceive the shock
to be a permanent change in underlying trend growth. Investment would then be scaled
down and subsequently take a long time to recover.
Furthermore, if external crises are accompanied or followed by banking sector crises, then
the allocation of resources and investment could be potentially severely a¤ected (Mishkin,
1997) while the …nancial intermediaries clean up their balance sheets. In the aftermath of
a capital reversal, the net worth of the domestic banking sector may decline if the e¤ective
value of their existing external liabilities increases on account of any devaluation that takes
place. Due to this …nancial stress, banks would now be less willing and able to extend loans
Banking crises can also have a negative impact on investment, independently of a crisis in
the external sector as well. Mishkin (1997) and Caprio and Klingebiel (1997) demonstrated
the importance of the banking sector in developing countries and the severe e¤ect of banking
crises on those economies. When the banking sector is in crisis, the economy can no longer
rely on it to perform its traditional role of screening out bad risks and mitigating adverse
selection in investment projects. Even with a high domestic saving rate, the economy may
not be able to channel this saving into investment with the banking sector in crisis.
In this paper, we examine the impact of both sudden stops and banking crises on domestic
investment. Much of the previous empirical work in this area has tended to focus on the
impact of various types of external crisis on aggregate GDP. Table 1 lists the type of crisis
and outcome studied by some of these papers. Hutchison and Noy (2006), for example,
reported that currency crises reduced output growth by about 2-3%, while a sudden stop
reduced output by 13-15% over a three-year period.
We believe that focusing on investment rather than GDP in the aftermath of a crisis
allows for a fuller understanding of its impact on the domestic economy. GDP may grow
in the short run if net exports rise in response to a currency depreciation, but investment
may remain sluggish. Indeed, previous research has established this very pattern of recovery.
Hutchison and Noy (2006) document that output su¤ers a sharp drop followed by a quick
recovery after a sudden stop crisis, a phenomenon they refer to as a “Mexican Wave” Calvo
and Reinhart (2000) note that exports recover relatively more quickly than other sectors
following a …nancial crisis.1
The di¤erential rates of recovery for key macro aggregates can be problematic for an econ-
omy coming out of a crisis. In particular, if the growth of …xed capital formation slows down
in the aftermath of a crisis, the prospects for sustained improvements in productivity and
long run growth will be a¤ected adversely. The consequences of any slowdown in investment
go beyond the strength of the recovery. If the capital stock grows slower than the labor force,
the economy may fail to create enough jobs to productively employ new entrants into the
workforce. If sustained over a su¢ ciently long duration, this mismatch could have serious
implications for income distribution and the potential to promote social unrest.
1 Other studies that examine the impact of …nancial crises on investment include Edwards (2002) and Park and Lee (2003).
Our current study attempts to bring into sharper focus the importance of tracking invest-
ment in the aftermath of …nancial crises in emerging markets. In contrast with the previous
empirical work in this area, we attempt to separate out statistically the impact of sudden
stops from that of bank crises on this key macroeconomic aggregate.
For the data analysis, we consulted the Standard & Poor’ Emerging Market Index, the Mor-
gan Stanley Capital International Emerging Market Index and the IMF’ International Capi-
tal Markets Department’ list of emerging markets. The 26 countries in our sample appeared
on at least two of those three lists. The countries are: Argentina, Brazil, Chile, Colombia,
Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico,
Morocco, Pakistan, Peru, Philippines, Poland, Russia, Slovakia, South Africa, Sri Lanka,
Thailand, Turkey and Zimbabwe. Husain, Mody and Rogo¤ (2005) have shown that emerg-
ing markets experience more banking or twin (banking and currency) crises than do advanced
or developing economies. They point out that such economies are more exposed to capital
‡ows than other developing economies, but have more fragile …nancial sectors than do the
advanced economies. Similarly, Becker and Mauro (2006), in a cross country analysis of the
“shocks that matter” found that sudden stops were particularly costly (when measured in
terms of the decline in output) in emerging markets.
Our sample covers the period 1976-2002. For ten countries in our sample, we have data
for all years during this period. The start dates for the other countries in our sample depend
on the availability of data. In addition, in the case of the transition countries the sample
periods begin at the time of changeover from a planned to market economy, using the dates
suggested by de Melo, Denzier and Gelb (1996) and de Melo, Denizer, Gelb and Tenev
(2001). Table 2 lists the countries in our sample and the years in which they experienced
either banking crises or sudden stops (or both if the crises occurred simultaneously).
The macroeconomic data were obtained from the World Bank’ World Development In-
dicators, supplemented by the IMF’ International Financial Statistics. The variables and
their sources are listed in Table 3. Our de…nition of a sudden stop is based on the work of
Frankel and Cavallo (2004). A sudden stops occurs when there is a fall in the …nancial ac-
count surplus which exceeds twice the standard deviation of the …nancial account during the
period, and it is accompanied by a decline in the current account de…cit.2 We obtained data
on episodes of systemic …nancial crises, where much or all of bank capital was exhausted,
from Caprio, Klingebiel, Laeven and Noguera (2005).
Table 4 shows the number of data points (country-year observations) of sudden stops and
systemic banking crises. There were 33 country-years with sudden stops in our sample and
a total of 137 country-years with banking crises, which had longer spans than the sudden
stops. There were 13 years where both events occurred simultaneously. If we measure the
number of multi-year spells, there were 28 sudden stops and 31 banking crises. Table 5
provides descriptive statistics of key variables.
4 Speci…cation and results
4.1 Basic speci…cation
In our basic model, investment gcy (gross capital formation as a fraction of GDP) is deter-
gcyit = i + t + j xijt + 1
SSit + 2 BAN KCRIit + it
where SS and BAN KCRI are dummy variables that take on a value 1 if there is a sudden
stop or a bank crisis respectively in country i at time t, xj is the j th element of the vector
of control variables, i is a country …xed e¤ect term that captures time-invariant in‡uences
speci…c to country i; is a vector of calendar-year dummies, and it is a mean zero, constant
variance disturbance term.
In selecting the control variables, we followed the empirical literature on the determinants
of investment spending in developing economies, including papers by Aizenmann and Marion
2 This corresponds to Frankel and Cavallo’ (2004) de…nition SS4.
(1993), Attanasio, Picci and Scorcu (2000), Bleaney (1996), Bosworth and Collins (1999),
Ghura and Goodwin (2000), Greene and Villanueva (1991), Larrain and Vergara (1993),
Mody and Murshid (2005), Pindyck and Solimano (1993), Servén (1998, 2003) and Servén
and Solimano (1993). Much of the choice of variables in these works is determined by the
availability of data.
Table 6 presents the results of our estimations. The dependent variable, gross capital
formation as a percentage of GDP, appears with a lag on the right-hand side. There is a
consensus in the literature that investment displays persistence, which may re‡ partial
adjustment in investment behavior.3 We also include lagged income growth (in keeping with
the widespread evidence of a ‡exible accelerator e¤ect from real output, which often appears
with a lag), in‡ation as measured by the growth rate of the Consumer Price Index, trade
openness measured by the sum of exports and imports as a fraction of GDP, Foreign Direct
Investment (FDI) as a percentage of GDP,and total debt service scaled by GDP. In‡ation can
a¤ect investment because it adds to uncertainty. Trade openness can in‡uence investment
since countries that are more open to trade could also be more e¢ cient and generate higher
returns on investment. Furthermore, it is possible that countries more open to trade develop
more sophisticated …nancial intermediation, involving a deeper network of supplier credit and
risk-sharing intermediaries, and that this …nancial development generates investment. FDI
can provide an external source of funding important for domestic investment. Debt service
may also have an impact on investment by in‡uencing the supply of loanable funds: potential
borrowers in countries that have higher debt service ratios may …nd themselves relatively
more credit-rationed at the prevailing world interest rate than borrowers in countries that
have lower debt service ratios.4 We also add time dummies to our base speci…cation to
control for year-speci…c events (such as international business cycle and contagion e¤ects)
that might a¤ect all countries in the sample.
3 See Thomas (2002) for a summary of recent research on investment expenditures and partial adjustment mechanisms.
4 We have in mind here a quantity rationing e¤ect that acts on investment over and above the interest rate (cost of borrowing)
e¤ect. In our robustness checks we also include the real interest rate as a conditioning variable.
Equation 1 reports the results of the …xed e¤ects speci…cation. The lagged dependent
variable appears with a highly signi…cant and relatively large coe¢ cient of 0.63. Lagged
growth is also positive and signi…cant, as are FDI and trade openness. Debt service and
in‡ation, on the other hand, have signi…cant negative coe¢ cients.
However, the …xed-e¤ects estimator is not consistent in the presence of a lagged endoge-
nous variable; moreover, there is possible endogeneity among the regressors. In order to
address these concerns, in the subsequent estimations, we employ the Generalized Method
of Moments estimator developed by Arellano and Bond (1991). In this method, the equation
to be estimated is …rst-di¤erenced, and second and higher lagged values of the dependent
variable and the predetermined variables in levels are used as instruments for the lagged
dependent variable and any endogenous variables.
The equation that appears in Column 2 uses the same variables as the previous estimation;
in‡ation, trade openness, FDI and total debt service are speci…ed as endogenous variables.
The lagged dependent variable appears with a highly signi…cant and relatively unchanged
coe¢ cient of 0.63. Lagged growth, trade openness and FDI all have positive and signi…cant
e¤ects. In‡ation and debt service have negative impacts on investment, signi…cant at the 5%
and 1% levels respectively.
The reported test statistics include the Sargan test, which is a test of the hypothesis that
the instrumental variables are uncorrelated with the residuals, and therefore are valid instru-
ments. The hypothesis can not be rejected for this equation. The tests for serial correlation
indicate the presence of …rst-order but not higher-order correlation of the residuals, which is
consistent with our expectations.
In Equation 3 we introduce the sudden stop variable, initially as an exogenous variable.
The coe¢ cient on sudden stops is signi…cant at the 5% level and indicates that a sudden stop
lowers the investment/GDP ratio by 1.24 percentage points. Since this is a partial adjustment
model, the coe¢ cient is indicative only of the short run impact. The long-run cumulative
e¤ect of a sudden stop can be calculated from the coe¢ cients for lagged investment and the
short-run impact estimate. The long-run decrease in investment spending as a share of GDP
based on this parameter is 3.35 (=1.24/[1-0.63]) percentage points.
In Equation 4 we add the banking crisis variable and treat it initially as exogenous. The
absolute value of the coe¢ cient on sudden stops drops, but continues to be signi…cant at the
5% level. The coe¢ cient on bank crises is signi…cant at the 1% level. Whereas a sudden stop
lowers the investment/GDP ratio by 1.14 percentage points, a bank crisis lowers the ratio by
1.01 percentage points in the short run. The long run impact of a sudden stop is a decline
in the investment/GDP ratio of 3.00 percentage points and for a bank crisis the long run
impact is 2.66 percentage points.5 Moreover, these crises can continue over several years,
particularly the banking crises, and the long-run impacts of each year would be additive in
In Equation 5, we respecify the equation so that the two crisis variables are treated as
endogenous. While sudden stops are sometimes considered to be exogenous to the economies
where they take place, there can be domestic factors that make an economy vulnerable to
capital out‡ows. For example, a collapse in investment and capital out‡ows can both be
driven by a common underlying negative shock to expected returns to investment in the
domestic economy. The point estimates for the sudden stop and banking crisis variables
are very similar: -1.14 and -1.01 in Equation 4 versus -1.14 and -1.00 in Equation 5. The
sudden stop variable continues to be signi…cant at the 5% level while the bank crisis variable
continues to be signi…cant at the 1% level. The long run impact of a sudden stop is identical
to that in Equation 4 - a decline in the investment/GDP ratio of 3.00 percentage points,
while the long run impact of a bank crisis on the investment share of GDP is a decline in
this ratio of 2.63 percentage points.
The results in Table 6 establish that the events identi…ed as sudden stops and bank crises
in our data set have negative e¤ects on investment, as predicted by theory. The coe¢ cient
estimates do not, however, provide an indication of the impact of one crisis in the absence of
5 Note that some of the other variables, such as GDP growth, can also slow investment during a sudden stop or bank crisis,
so the cumulative e¤ect may be higher.
the other. For instance, the marginal e¤ect of a sudden stop on investment is averaged out
over instances in which bank crises also occur simultaneously and periods in which sudden
stops occur in isolation. Before proceeding to separate the e¤ects of sudden stops from those
of bank crises, we subject the basic speci…cation to tests of robustness.
We next test for the robustness of the results to rule out the possibility that they are an
artifact of the way the crisis variables are de…ned or that the event dummies are proxying
for the in‡uence of other incentives to invest in the domestic economy. In Equation 6 of
Table 7, we change the criteria for a sudden stop to include a decline in output per capita
either in the year of the reversal or the following year.6 There are 26 observations of these
sudden stops in our data, 7 less than the number using the previous de…nition. We repeat
the speci…cation of Equation 5 in Table 6, and the results are similar. The coe¢ cient on the
sudden stop variable is negative, signi…cant, and larger in absolute value than in Equation
5, -1.48 versus -1.14. Since these sudden stops by de…nition include a decline in output, it
is not surprising that the impact on investment is larger. The coe¢ cient on banking crises
continues to be signi…cant at 1% and is slightly smaller in absolute value, -0.97 versus -1.00.
In Equation 7 we revert to our original de…nition of sudden stops and introduce the real
interest rate, the lending rate adjusted for in‡ation. The inclusion of this variable does not
change the signi…cance of the coe¢ cients on either of the crisis variables. The coe¢ cient on
the sudden stop variable is identical in absolute value compared to Equation 5 in Table 6.
The coe¢ cient on the banking crisis continues to be signi…cant at the 1% level and is now
larger in absolute value than in Equation 5, -1.39 versus -1.00. The real interest rate itself
has a positive but insigni…cant coe¢ cient. This is consistent with the view that interest rates
in emerging markets are often not driven by market fundamentals, but rather by government
regulation, and consequently banks ration credit among borrowers at prevailing interest rates.
6 This corresponds to Frankel and Cavallo’ (2004) de…nition SS1.
Mody and Murshid (2005), for example, also found that the real interest rate did not have
a signi…cant impact on investment spending.
In the following equation we include the change in the terms of trade, which may in‡uence
the relationship between the crises variables and investment by a¤ecting the relative prices
of imported capital goods. The impact of both crises on investment is robust to the inclusion
of changes in the terms of trade with the absolute values of the coe¢ cients on both crises
variables rising relative to the values in Equation 5. The coe¢ cient on bank crises continues
to be signi…cant at the 1% level, while the coe¢ cient on sudden stops remains signi…cant
at the 5% level. The coe¢ cient on the change in the terms of trade is not signi…cant. This
…nding is in line with previous research. Mody and Murshid (2005) reported that the terms
of trade did have a signi…cant impact on investment in the 1980s but not in the 1990s. Ghura
and Goodwin (2000) did not …nd evidence of a signi…cant e¤ect in their study.
We next investigated whether the type of political system a¤ects the impact of a crisis on
investment. Pastor and Sung (1995) report evidence that democracy has a positive in‡uence
on investment expenditures. In Equation 9, we use the Polity IV measure, which rates a
country’ political system on a scale of -10 (high autocracy) to 10 (high democracy). The two
crisis variables continue to be signi…cant. The governance variable, however, is not signi…-
cant. This can re‡ the in‡
ect uence of o¤-setting e¤ects: on the one hand, democracy might
in‡uence investment positively if it is associated with stronger property rights; on the other
hand, democracy might in‡uence investment negatively due to greater uncertainties inherent
in disputes and negotiations (which would not be present in less democratic countries) over
the direction of economic policy.
We also studied whether the presence of IMF-supported non-concessionary lending pro-
grams a¤ect the impact of sudden stops and banking crises on investment expenditures.
Studies of the e¤ects of IMF lending, such as that of Butkiewicz and Yanikkaya (2005),
have reported that these programs have a negative e¤ect on private and public investment
expenditures. We checked the robustness of the relationship between the two crisis variables
and investment expenditures to the presence of an IMF program by introducing an IMF
The results of this estimation are reported in Equation 10. The inclusion of the IMF
program dummy does not alter the signi…cance of the coe¢ cients on the sudden stop and
banking crises variables. The crises variables therefore continue to have a signi…cant impact
after we control for the presence of IMF-supported programs. Note further that the coe¢ -
cient on the current program variable is negative and signi…cant at the 10% level, which is
consistent with the previously reported results.
4.3 Openness and the impact of crises
In Table 8 we examine whether the impact of sudden stops and banking crises on investment
expenditures was a¤ected by the capital account regime. In Equation 11 we include a measure
of capital account openness developed by Chinn and Ito (2005a, 2005b). They used the data
reported in the IMF’ Annual Report on Exchange Arrangements and Exchange Restrictions
on the existence of multiple exchange rates, restrictions on the current and capital accounts
and requirements to surrender export proceeds, in order to capture the intensity of controls
on capital account transactions. Their index of openness is the …rst standardized principal
component of the four variables above, and ranges from -2.5 in the case of full control to 2.5
in the case of complete liberalization.
In Equation 11, the coe¢ cient on sudden stops drops in signi…cance, whereas the coef-
…cient on the banking crisis variable continues to be signi…cant at the 1% level. Capital
account openness does not have a signi…cant impact on investment. This result is consistent
with that reported by Rodrik (1998), who found no evidence directly linking capital controls
and investment expenditures.
In order to verify whether the impact of sudden stops on investment is a¤ected by the
variation in capital openness, in the next estimation (Equation 12) we interact the sudden
stop variable with the capital account openness variable. The sudden stop variable is signif-
icant only at the 10% level, but the statistical signi…cance of the impact of banking crises on
investment remains robust to the inclusion of this interaction term. Note that neither the
coe¢ cient on capital account openness nor the interaction term is signi…cant in our …ndings.
In the third estimation in Table 8 (Equation 13) we interact the bank crisis variable with
the capital account openness variable. The sudden stop variable is no longer signi…cant, but
the bank crisis variable continues to be signi…cant at the 1% level. The coe¢ cient on the
interaction term is negative and signi…cant, indicating that banking crises have an even more
negative impact on investment in economies that are relatively more open to capital ‡ows.
We interpret this …nding as a re‡ection of the impact of the reversal of short duration ‡ows
interacting with an ongoing bank crisis.
We believe that the capital openness measure picks up the in‡uence of short-duration
portfolio ‡ows (mediated through the banking sector) on investment. Montiel and Reinhart
(1999) have found that in economies that are more open to capital ‡ows, short-duration
‡ows as a proportion of the total capital in‡ows tend to be higher than in economies with
stricter capital controls. Similarly, De Gregorio, Edwards and Valdes (2000) provide evidence
that capital controls in‡uence the composition of capital in‡ows. In their analysis of the
e¤ectiveness of capital controls in Chile, they …nd that the controls have a signi…cant e¤ect
in altering the composition of in‡ows towards longer durations.
In light of this previous work, we believe our results indicate that in economies with
more open capital regimes (and therefore economies that are more exposed to short duration
‡ows), the impact of a bank crisis on investment tends to be greater because the reversal
of short duration ‡ows has additional detrimental e¤ects on the fragile domestic banking
sector. The ability of the banking sector to intermediate between savers and investors is
further impeded when it is more exposed to the withdrawal of deposits by foreign lenders.
The insigni…cant coe¢ cient on the sudden stop dummy indicates that there is no additional
direct impact of a signi…cant decline in the …nancial account on investment.
The evidence suggests that the important component of capital ‡ight is the reversal of
short duration ‡ows. Investment is a¤ected negatively when this reversal interacts with
weakness in the banking sector. Since the e¤ect of this interaction is averaged out over
instances when a sudden stop occurs and periods when there is no sudden stop, the evidence
suggests an indirect impact of one component of sudden stops – reversal of short duration
‡ows –on investment. We explore this aspect of sudden stops more closely in the analysis
4.4 Separating the e¤ects of sudden stops from those of banking crises
In order to investigate the relationship between sudden stops, banking crises, and investment
further, we evaluate the impact of sudden stops in the absence of a bank crisis and vice versa.
We do this as follows by adding to our basic speci…cation an interaction term that captures
the joint occurrence of sudden stops and bank crises:
gcyit = i + t + j xijt + 3 SSit + 4 BAN KCRIit
+ 5 (SSit BAN KCRIit ) + it
In this regression, the coe¢ cient on the level terms for each individual dummy gives us
the impact on average investment when only that crisis occurs and not the other. The
coe¢ cient on the interaction term gives us the additional impact on average investment of
a joint occurrence of both crises.
We establish that the impact disappears altogether for sudden stops, but not for bank
crises. The coe¢ cient on the sudden stop dummy is insigni…cant in Equation 14 (Table
9). This indicates that in the absence of a bank crisis, the sudden stop does not have an
independent impact on investment. The coe¢ cient on the interaction term is also insignif-
icant, indicating that a joint occurrence of a sudden stop and a bank crisis does not have
any additional negative impact on investment either. Bank crises, on the other hand, have
a signi…cant negative e¤ect on investment regardless of whether or not there is an accompa-
nying sudden stop. This is indicated by the signi…cant coe¢ cient on the bank crisis dummy
in Equation 14. A bank crisis that occurs in the absence of a sudden stop reduces the in-
vestment / GDP ratio by 1.02 percentage points in the short run. The cumulative e¤ect on
investment over time is a decline of -2.62 percentage points.7
In Equation 15, we control for the degree of capital account openness using the Chinn-Ito
measure introduced previously. The sample size for this estimation is much smaller than
that used for the previous estimation because the Chinn-Ito variable is not available for all
countries. While the coe¢ cient on the sudden stop dummy continues to be insigni…cant and
the coe¢ cient on the bank crisis dummy remains signi…cant, the coe¢ cient on the interaction
term now appears as negative and signi…cant at the 5% level. This suggests that the e¤ect
of a bank crisis on investment is even more severe when there is an accompanying sudden
stop of net capital in‡ows. In the absence of a sudden stop, the short run impact of a
bank crisis lowers the investment/GDP ratio by 0.98 percentage points in the short run and
2.28 percentage points in the long run. When there is an accompanying sudden stop, the
e¤ect of the bank crisis on investment is worse. It lowers the investment/GDP ratio by 3.88
percentage points in the short run and 9.02 percentage points in the long run.
The evidence is indicative of an indirect impact of sudden stops on investment, act-
ing in combination with the e¤ects of a banking crisis. The coe¢ cient on the interactive
dummy (SS BAN KCRI), however, does not provide information speci…cally on the im-
pact of short duration ‡ows. We therefore include an additional interaction term, bank
crises interacted with the Chinn-Ito openness measure, in Equation 16. The coe¢ cient on
the (SS BAN KCRI) dummy is now no longer signi…cant, but the BAN KCRI Capital
Openness interaction term has a negative and signi…cant e¤ect on investment. Building on
the Montiel-Reinhart (1999) …nding referred to previously, these results indicate the impor-
tance of one particular aspect of a decline in the …nancial account - the reversal of short
duration capital ‡ows mediated through domestic banks. If these withdrawals exacerbate
the fragility of the banking system, any bank crisis that occurs will have an even more severe
7 We also replaced the contemporaneous sudden stop with its value lagged by one period and generated a new interactive
variable of the lagged sudden stop and current bank crisis variable. When we reestimated the equation, the lagged sudden stop
was not signi…cant, the coe¢ cient and standard error for the bank crisis was virtually identical to that reported in the results
for equation 14, and the interactive variable was negative but only signi…cant at the 10% level. The results are available from
impact on investment than a bank crisis that occurs in a relatively more closed economy.
Furthermore, the results in Equation 16 con…rm that a sudden stop crisis that occurs in
isolation does not have a signi…cant impact on investment. In other words, as long as the
banking sector does not also simultaneously experience a crisis, capital ‡ight and a decline
in the …nancial account by itself will not a¤ect the investment / GDP ratio.
In combination with the coe¢ cients estimated in Equation 13 (Table 8), these results
single out the interaction between the reversal of short duration ‡ows and underlying banking
fragility as the critical component of …nancial crises in emerging markets. Our analysis
underscores the importance of prudential borrowing and lending regulations, as well as timely
monitoring of the banking sector to prevent the build-up of mismatches both in the currency
denominations as well as the durations of its assets and liabilities. The result from Equation
13 indicate that bank crises tend to have a more severe impact on investment in more open
economies, but that sudden stops do not have any additional direct impact on investment.
When we examine the relationship between sudden stops, bank crises and investment more
closely, we are able to con…rm that sudden stops that occur in isolation from bank crises do
not have a signi…cant impact on investment. Bank crises, however, have a signi…cant impact
on investment even in the absence of a sudden stops. We are further able to con…rm that in
economies that are more open to capital ‡ows (and thus more vulnerable to the reversal of
short duration ‡ows), the impact of a bank crisis on investment is signi…cantly worse. This
suggests that any e¤ect of a decline in the …nancial account on investment is indirect and
acts through the channel of capital ‡ight exacerbating the underlying fragility in the banking
4.5 The impact of externally-induced bank crises on investment
The preceding analysis has established the importance of capital ‡ight of the variety that
either induces a bank crisis or adds to the adverse impact of an ongoing bank crisis. The
evidence suggests that a sudden stop event - which would typically also involve the reversal
of short duration ‡ows - does not have an impact on investment as long as the reversal is not
associated with a bank crisis.8 We con…rm this in Table 10 by using a variable that captures
the occurrence of bank crises precipitated by withdrawal of funds by external depositors.
Beim (2001) classi…es the bank crises tabulated by Caprio and Klingebiel (1999) into four
di¤erent categories based on the major precipitating factor that causes each crisis. Beim’
four categories are: crises caused by domestic private depositors’withdrawal of funds; crises
caused by the domestic government’ withdrawal of support for the banking sector; crises
caused by external private depositors withdrawing their funds; crises caused by interna-
tional …nancial institutions’ withdrawal of their support. We combine the two external
precipitating factors to create a category of bank crises caused by withdrawal of funds by
external depositors. In Table 10, the dummy variable Bank Crisis (External Factors)
BAN KCREXF AC captures the occurrence of these events.
We repeat the key regressions of the preceding analysis using this new dummy variable
for bank crises. We …rst establish in Equation 17 that the events ‡agged as bank crises
due to international factors do have a signi…cant impact on investment. The negative and
signi…cant coe¢ cient on the bank crisis dummy variable averages out the e¤ects of such
crises on investment across instances in which there is an accompanying sudden stop as well
as cases where there is no sudden stop. The corresponding coe¢ cient on the sudden stop
dummy (averaging out over instances in which there is an accompanying bank crisis due to
international factors and instances in which this is not the case) is insigni…cant. In contrast
with a similar speci…cation in Equation 5 (where the coe¢ cient on the sudden stop dummy
was signi…cant at the 5% level), when we speci…cally distinguish between bank crises based
on the major precipitating factor, the signi…cance of the impact of sudden stops drops.
In order to verify whether the severity of bank crises is a¤ected by the degree of openness
to capital ‡ows, we include the Chinn-Ito measure in Equation 18. Bank crises continue to
have a negative impact on investment, signi…cant at the 1% level. As the coe¢ cient on the
8 Levchenko and Mauro (2006) report in a broad study of advanced, emerging and developing countries that portfolio debt
and bank lending ‡ows are the two components of …nancial ‡ows which experience relatively large reversals during sudden stop
events. Furthermore, they …nd that bank lending ‡ows fail to recover for several years following a sudden stop crisis.
interaction term indicates, the severity of the crises (measured by their impact on investment)
is worse in more open economies. This e¤ect is however signi…cant only at the 10% level.
Sudden stop events do not have an impact on investment. The speci…cation employed here
is similar to the one used in Equation 13. In that regression the coe¢ cient on the interaction
term BAN KCRI Capital Openness was found to be signi…cant at the 1% level. Here,
the coe¢ cient on the analogous interaction term using the bank crises induced by external
factors drops in signi…cance to the 10% level. This could re‡ the fact that in Equation
13, the interaction term was proxying for the e¤ects of the reversal of short duration ‡ows
acting together with underlying weaknesses in the banking sector to curb investment. In
contrast, in Equation 18, we have in BAN KCREXF AC a dummy variable that directly
captures the in‡uence of capital ‡ight harmful to the banking sector. The coe¢ cient on the
interaction term BAN KCREXF AC Capital Openness in Equation 18 therefore drops
The results of the next regression (Equation 19) con…rm the previous …ndings of a similar
speci…cation (Equation 14). In the absence of a bank crisis induced by external factors,
a sudden stop event does not have a signi…cant e¤ect on investment. Furthermore, the
joint occurrence of the two types of crises does not have any additional negative e¤ects on
investment either. The evidence indicates that a signi…cant decline in the …nancial account,
which does not also cause a bank crisis, fails to have an impact on investment. In other words,
if the banking sector is able to withstand the pressure of capital out‡ and continue to
provide …nancial services, investment will not decline on average. The results of this equation
con…rm that the critical component of capital ‡ight is the variety of ‡ reversals that are
harmful to the domestic banking sector. These reversals may take place during sudden stops,
but they need not. As the coe¢ cient on the bank crisis dummy variable indicates, even in
the absence of a sudden stop event (i.e. the …nancial account does not decline signi…cantly)
a bank crisis caused by the withdrawal of funds by external depositors has a negative and
signi…cant (at the 1% level) impact on investment. As Equation 20 indicates, the statistical
signi…cance of this pattern of coe¢ cients is robust to the inclusion of the Chinn-Ito measure
In the …nal regression of Table 10 (Equation 21) we employ a speci…cation similar to
Equation 16, which had suggested the crucial role of short duration ‡ reversals in …nancial
crises.The coe¢ cient on the bank crisis dummy variable in Equation 21 is negative and
signi…cant at the 1% level, as was the case with the composite bank crisis dummy in Equation
16. Similarly, in a repeat of the results found in Equation 16, in the current case too the
sudden stop events do not have a signi…cant impact either in the absence of a bank crisis or in
combination with a bank crisis. The major di¤erence between the results of Equation 16 and
21 is that when the dummy variable coding for bank crises due to external factors replaces the
composite bank crisis dummy, the interaction term BAN KCREXF AC Capital Openness
is no longer signi…cant. In Equation 16, the analogous interaction term with the composite
bank crisis dummy, BAN KCRI Capital Openness, was proxying for the e¤ects of short
duration ‡ reversals of the kind that either induce a bank crisis or add to the adverse
impact of an ongoing bank crisis. In Equation 21, once we replace the composite bank crisis
dummy variable with a dummy variable that codes for the speci…c occurrence of bank crisis-
inducing capital ‡ight, the interaction term is no longer signi…cant because we now have a
variable that directly captures the in‡uence of harmful capital reversals.
We see in the pattern of coe¢ cients reported in Table 10 repeated con…rmation of what
was previously indicated in Tables 8 and 9: the critical component of capital ‡ight is the re-
versal of short duration ‡ows that induce bank crises. First, the coe¢ cient on the externally-
induced bank crises dummy is negative and signi…cant in each of the speci…cations employed
in Table 10. In particular, the impact is signi…cant even in the absence of sudden stop
events. Second, sudden stops do not have a signi…cant impact on investment in the absence
of externally-induced bank crises. Third, the variables that were previously proxying for
harmful capital ‡ight (i.e. capital ‡ight of the variety that either induces a bank crisis or
adds to the adverse impact of an ongoing bank crisis) no longer display the same signi…-
cance once we include the externally-induced bank crisis dummy, a variable that indicates
the occurrence of the type of capital ‡ight detrimental to the banking sector.
Investment collapses in emerging markets have become a source of concern in policy circles.
Not only does the collapse in investment create worries for long run growth in emerging mar-
ket countries, but it is also thought to contribute signi…cantly to the build-up of eventually
unsustainable "global imbalances" (at the time of writing, this term refers mainly to the
US current account de…cit which is being …nanced largely by capital ‡ows from emerging
markets). Some commentators have linked investment collapses to sudden stops of in‡ows
and capital ‡ight from emerging markets, and have used this to argue that openness to
global capital ‡ows in‡icts serious costs on the domestic economy because of the heightened
vulnerability to capital reversals. Others contend that these crises are the short run costs of
…nancial liberalization, which in the long run does bene…t these economies.9
Previous research has established that emerging market countries are more vulnerable to
external crises than either advanced industrial or less developed countries. They are also
more likely to experience another type of crisis which can have a bearing on investment –
banking crises. Our analysis indicates that how open an economy is to capital ‡ows a¤ects
the relationships between these crises variables and investment in important ways. Once we
control for the degree of openness to capital ‡ows, we …nd that only banking crises have a
signi…cant impact on investment. This impact appears even when a slowdown in growth,
or any disruption in trade that could accompany them, are accounted for. Since there is
persistence in investment expenditures, the impact continues over time. We con…rm that in
the absence of a bank crisis, a sudden stop by itself would not cause investment to decline.
Interestingly, we …nd that the more open an economy is to capital ‡ows, the more severe
is the impact of banking crises on investment. This suggests that the critical component
9 Ranciere, Tornell and Westermann (2006).
of the capital ‡ight associated with a sudden stop is the reversal of short duration ‡ows,
intermediated through the banking sector. Any impact of a sudden stop (or, more generally,
a decline in the …nancial account of the balance of payments) therefore appears to act through
the bank crisis channel. Provided the banking sector does not experience a crisis, investment
remains una¤ected by changes in the balance of payments position.
Our results speak directly to an ongoing crucial policy debate on the merits of …nancial
globalization. One of the arguments against …nancial globalization heard in policy circles is
that openness leaves economies vulnerable to adverse e¤ects of sudden stops on investment
and output. Our …ndings indicate that provided the banking sector does not collapse when
faced with the withdrawal of funds by external depositors, sudden stop events fail to have
a signi…cant impact on investment. The results provide statistical support for the policy
conclusion that a strong banking sector that can withstand the negative fallout of capital
‡ight is essential for countries embarking on a path of …nancial liberalization. An ancillary
conclusion is that an appropriate sequencing of …nancial reforms is imperative –policy makers
in emerging market countries need to …x the strength of their banking sector …rst before they
contemplate opening up their capital markets to international …nancial ‡ows. Our results also
highlight the importance of further research on the conditions under which the withdrawal of
deposits by foreign lenders impacts on the ability of domestic banks to intermediate between
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Malaysia 1997 Thailand 1997
t-5 t-4 t-3 t-2 t-1 t t+1 t+2 t+3 t+4 t+5 t-5 t-4 t-3 t-2 t-1 t t+1 t+2 t+3 t+4 t+5
Figure 1: Investment as a share of GDP in the years surrounding the 1997 financial crisis in Malaysia and
Thailand. “t” represents the initial year of crisis. See Tables 2 & 3 for data sources.
Author(s) Type of Crisis Outcome
Milesi-Ferretti and Razin (1998) Current Account Reversals Output Growth
Milesi-Ferretti and Razin (2000) Current Account Reversals Output Growth, Exports
Cerra and Saxena (2003) Currency Crises Output Growth
Gupta, Mishra and Sahay (2003) Currency Crises Output Growth
Hutchison (2003) Currency Crises Output Growth
Edwards (2004) Current Account Reversals Output Growth
Frankel and Cavallo (2004) Sudden Stops Output Growth
Frankel and Wei (2005) Currency Crises Output Growth
Hutchison and Noy (2005) Currency Crises Output Growth
Becker and Mauro (2006) Different Types of Crises Output Growth
Hutchison and Noy (2006) Currency Crises Output Growth
Capital Flow Reversals
Kaminsky (2006) Different Types of Crises Access to Capital Markets
List of Countries and Crises
Country Sudden Stops Bank Crises Bank Crises
Argentina 2001 1980-1983, 1989-1990, 1980-1982,1989-
1995, 2001-2002 1990,1995
Brazil 2002 1990, 1994-1999 1990
Chile 1982-1983, 1988 1976, 1981-1983 1976,1981-1983
China - 1990-1999 -
Colombia 1998-1999 1982-1987 -
Czech Republic - 1989-1991 -
Egypt 1990 1980-1983 1980-1983
Hungary 1996 1991-1995 -
India - - -
Indonesia 1997 1997-2002 1997-1999
Jordan 1992-1993, 2001 - -
Malaysia 1997 1997-2002 1997-1999
Mexico 1982,1994-1995 1981-1991, 1994-2000 1981-1991,1994-1997
Morocco 1995 1980-1983 -
Pakistan 1998 - -
Peru 1998 1983-1990 -
Philippines 1997-1998 1981-1987, 1998-2002 1998-2002
Poland 1994, 2001 1992-1995 -
Russia - 1995, 1998-1999 1995,1998-1999
Slovak Republic - 1991-2002
South Africa 2000 -
Sri Lanka 2001 1989-1993 1989-1993
Thailand 1997 1983-1987, 1997-2002 1983-1987,1997-1999
Turkey 1991, 1994, 1998, 1982-1985, 2000-2002 -
Venezuela 1994 1994-1995 -
Zimbabwe 1983 - -
Sources: Data on Sudden Stops are from Frankel and Cavallo (2004); Bank Crises are
from Caprio, Klingebiel, Laeven and Noguera (2005); Bank Crises (External Factors) are
from Beim (2001),
Data Definitions and Sources
Name Definition Source
BANKCRI Indicator of Systemic Banking Crisis Caprio, Klingebiel, Laeven,
and Noguera (2005)
BANKCREXFAC Indicator of Systemic Banking Crisis Beim (2001)
Precipitated by External Factors
CAPL Capital Account Liberalization Chinn-Ito (2005a,b)
CPIGR CPI Growth (annual % growth) WDI
DTOT Change in Terms of Trade WDI
GCY Gross Capital Formation (% of GDP) WDI
IMF IMF Program Indicator IMF Annual Reports
POLITY General Openness/Closeness of Political Polity IV Project
REALR Real Interest Rate (Lending rate – Inflation) WDI
SS, SSO Sudden Stop Indicators Frankel and Cavallo (2004)
TDSY Total Debt Service (% of GDP) WDI
TRADY Trade (Exports + Imports) (% of GDP) WDI
YGR GDP Growth (annual % growth) WDI
Note: WDI is the on-line edition of the World Bank’s World Development Indicators.
Distribution of Sudden Stops and Banking Crises
Yes No Total
Yes 13 20 33
(2%) (4%) (6%)
No 124 399 523
(22%) (72%) (94%)
Total 137 419 556
Note: The unit of observation is a country-year.
Variable Mean Standard Deviation
Debt Service/GDP (%) 6.8723 3.8977
Foreign Direct Investment/GDP (%) 1.7481 2.1862
Real GDP Growth (%∆) 4.0137 4.8142
Gross Capital Formation/GDP (%) 23.6238 6.5271
Inflation (%∆ CPI) 77.1198 430.7938
Polity 2.0140 6.6388
Real Interest Rate (%) 7.1698 13.5892
∆ Terms of Trade -0.0085 0.1154
Trade Openness: (EX+IM)/GDP (%) 57.9649 36.6185
Investment, Sudden Stops and Bank Crises
(1) (2) (3) (4) (5)
Lagged Investment 0.631 0.626 0.632 0.617 0.617
(0.031)*** (0.030)*** (0.031)*** (0.031)*** (0.031)***
Lagged Growth 0.159 0.164 0.170 0.159 0.159
(0.033)*** (0.032)*** (0.033)*** (0.032)*** (0.032)***
Inflation -0.001 -0.001 -0.001 -0.001 -0.001
(0.000)** (0.000)** (0.000)** (0.000)** (0.000)**
Trade Openness 0.035 0.034 0.032 0.038 0.038
(0.010)*** (0.010)*** (0.010)*** (0.010)*** (0.010)***
FDI/GDP 0.220 0.222 0.212 0.188 0.189
(0.084)*** (0.080)*** (0.089)** (0.089)** (0.089)**
Debt Service/GDP -0.163 -0.162 -0.159 -0.151 -0.152
(0.054)*** (0.052)*** (0.053)*** (0.053)*** (0.053)***
Sudden Stop - - -1.236 -1.140 -1.140
(0.534)** (0.530)** (0.530)**
Bank Crisis - - - -1.005 -1.004
Sargan Test - 0.9640 0.9915 0.9904 1.0000
1st order serial - 0.0000 0.0000 0.0000 0.0000
2nd order serial - 0.2795 0.4169 0.4133 0.4132
Observations 522 493 482 482 482
Note: Dependent variable is the investment share of GDP (GCY). Equation 1 estimated with fixed-
effects estimator, all other equations with GMM estimator. Standard errors in parentheses.
*,**,***significant at 10%, 5%; 1%