Carnegie-Rochester conference, NYU and MIT for their suggestions. Countries that have pursued distortionary macroeconomic policies, including high inflation, large budget deficits and misaligned exchange rates, appear to have suffered more macroeconomic volatility and also grown more slowly during the postwar period. Does this reflect the causal effect of these macroeconomic policies on economic outcomes? One reason to suspect that the answer may be no is that countries pursuing poor macroeconomic policies also have weak “institutions, ” including political institutions that do not constrain politicians and political elites, ineffective enforcement of property rights for investors, widespread corruption, and a high degree of political instability. This paper documents that countries that inherited more “extractive ” institutions from their colonial past were more likely to experience high volatility and economic crises during the postwar period. More specifically, societies where European colonists faced high mortality rates more than 100 years ago are much more volatile and prone to crises. Based on our previous work, we interpret this relationship as due to the causal

External shocks, such as commodity price fluctuations, natural disasters, and the role of the international economy, are often blamed for the poor economic performance of low-income countries. This paper quantifies the impact of these different external shocks using a panel vector auto-regression approach and compares their relative contributions to output volatility in low-income countries vis-a-vis internal factors. We find that external shocks can only explain a small fraction of the output variance of a typical low-income country. Internal factors are the main source of fluctuations. From a quantitative perspective, the output effect of external shocks is typically small in absolute terms, but significant relative to the historic performance of these countries.

Comments are Welcome. We study the collapse of international trade flows during the global financial crisis using detailed data on monthly US imports during this period. We show that adverse credit conditions were an important channel through which the crisis affected trade volumes. We identify the effects of credit tightening by exploiting the variation in the cost of capital across countries and over time, as well as the variation in financial dependence across sectors. We find that countries with higher interbank rates and thus tighter credit markets export less to the US. These effects are especially pronounced in sectors that require extensive external financing, have few collateralizable assets, and can access limited trade credit. Exports of financially vulnerable industries are thus more sensitive to the cost of external capital than exports of less dependent industries, and this sensitivity rose during the financial crisis. Our estimates imply that the crisis would have reduced trade flows by 26 % more if governments had not acted to lower lending rates, and by 30 % less if policy interventions had had a more immediate effect on the cost of capital. These results provide new evidence on the effect of credit conditions on trade, while highlighting the large real effects of financial crises and the potential gains from policy

Abstract. This paper provides firm-level evidence that credit constraints restrict international trade flows and affect the pattern of foreign direct investment. Using detailed data from China, we show that foreign-owned firms and joint ventures have better export performance than private domestic firms, and this advantage is systematically greater in sectors at higher levels of financial vulnerability measured in a variety of ways. This confirms that financial frictions restrict international trade and is consistent with foreign affiliates being less credit constrained because they can tap internal funding from their parent company. Our results imply that FDI can compensate for domestic financial market imperfections and alleviate their impact on aggregate growth, trade and private sector development. Credit constraints and host-country financial institutions thus offer a new explanation for the sectoral and spatial composition of MNC activity.

Authorized for distribution by Stijn Claessens

This paper analyzes the effects of financial liberalization on growth and volatility at the industry level in a large sample of countries. We estimate the impact of liberal-ization on production, employment, firm entry, capital accumulation, and productivity, using both de facto and de jure measures of liberalization. In order to overcome omitted variables concerns, we employ a number of alternative difference-in-differences estima-tion strategies. We implement a propensity score matching algorithm to find a control group for each liberalizing country. In addition, we exploit variation in industry char-acteristics to obtain an alternative set of difference-in-differences estimates. Financial liberalization is found to have a positive effect on both growth and volatility of produc-tion across industries. The positive growth effect comes from increased entry of firms, higher capital accumulation, and an expansion in total employment. By contrast, we do not detect any effect of financial liberalization on measured productivity. Finally, the growth effects of liberalization appear temporary rather than permanent.

We collect new data to assess the importance of supply-side credit market frictions by studying the impact of financial sector recapitalization packages on the growth performance of firms in a large cross-section of 50 countries during the recent crisis. We develop an identification strategy that uses the financial crisis as a shock to credit supply and exploits exogenous variation in the degree to which firms depend on external financing for investment needs, and focus on policy interventions aimed at alleviating the bank capital crunch. We find that the growth of firms dependent on external financing is disproportionately positively affected by bank recapitalization policies, and that this effect is quantitatively important and robust to controlling for other financial sector support policies. We also find that fiscal policy disproportionately boosted growth of firms more dependent on external financing. These results provide new evidence of a quantitatively important role of credit market frictions in influencing real economic activity.

We would like to thank the participants in the NBER Global Financial Crisis preconference and conference and especially Charles Engel, Kristin Forbes, Jeffrey Frankel, and Linda Tesar for very useful comments and suggestions, and Mohsan Bilal for excellent research assistance. The views expressed in this paper are those of the authors and do not necessarily represent those of the National Bureau of Economic Research, the IMF, or IMF policy. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

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 analy-sis 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, par-ticularly 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 finan-cial depth has a more nuanced role in stabilizing the economy. Analysis of interactions across structural determinants reveals complementarities among macroeconomic con-ditions (trade and financial openness and depth) and, separately, among microeco-nomic conditions (flexibility of labor markets and ease of firm-entry). Variables across these groups tend to behave as substitutes for each other. JEL codes: F36, F41, F43. Macroeconomic volatility is not only a source of business cycle uncertainty but also a major cause of low economic growth. Ramey and Ramey (1995) were the first to document this finding for a cross-section of countries. Fatás (2002) and Hnatkovska and Loayza (2005) show that macroeconomic volatility is particu-larly harmful for developing countries, where volatility is higher and its impact more pronounced. Among the causes of macroeconomic volatility, fluctuations in the terms of trade are important sources of external shocks. Across countries about 10 Norman V. Loayza (corresponding author) is a lead economist at the World Bank; his email address is nloayza@worldbank.org. Claudio Raddatz is an economist at the World Bank; his email address is

In theory, better access to bank credit can reduce or increase output volatility depending on whether firms are more financially constrained during contractions or expansions. This paper finds that the volatility of industrial output is lower in coun-tries with more bank credit. Most of the reduction in volatility is idiosyncratic, which follows from the ability of banks to pool and diversify shocks. Systematic volatility is reduced less strongly. Volatility dampening is achieved via countercyclical borrowing: At the firm level, short-term borrowing is less (or more negatively) correlated with sales and inventories in countries with high levels of bank credit. THERE IS A DEBATE ABOUT THE EFFECT OF FINANCIAL INTERMEDIARIES—or financial development more generally—on the volatility of output. In theory, the effect on volatility of having more financial intermediation is ambiguous, depending on the stage of the country’s development (Aghion, Bacchetta, and Banerjee (2004)) or the type of shocks that affect the economy (e.g., real vs. monetary shocks as in Bacchetta and Caminal (2000), or credit demand versus credit supply shocks as in Morgan, Rime, and Strahan (2004)). The existing empirical evidence is also inconclusive. For instance, while Acemoglu et al. (2003) show that macroeconomic aggregates are less volatile in more developed countries, Beck, Lundberg, and Majnoni (2004) find no robust relation between financial intermediation and output volatility when considering different types of macro shocks. Understanding output volatility is important because volatility has a negative effect on growth (Ramey and Ramey (1995), Aghion et al. (2005)), in other words, because stability breeds growth. This paper revisits the debate on finance and volatility using industry-level and firm-level data. From the perspective of a financially constrained firm,