Openness and Growth Volatility

Macroeconomic volatility is the outcome of countries’ exposure to shocks (the magnitude and frequency of shocks that hit their economies) and their vulnerability (the ability to respond to these shocks). This paper conjectures that countries with higher degrees of trade and financial integration are better prepared to withstand shocks to output growth. Theoretically, the impact of trade and financial openness is ambiguous. Hence, our problem becomes an empirical one. Using a sample of 82 countries for the period 1975-2005, we find that the response of growth volatility to rising trade and financial openness depends upon some country characteristics. We find that: (a) trade openness stabilizes output fluctuations in countries with well-diversified economic structures, (b) financial openness mitigates growth volatility in countries with low debt-equity ratios, (c) domestic financial depth helps smoothing out the destabilizing effect of financial openness on growth volatility, (d) countries with higher trade openness are less prone to output drops, and (e) countries with higher financial openness are more likely to experience sharp drops in real output only if their external liabilities are more biased towards debt than equity.