The structural determinants of external vulnerability

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 i