Do Improvements in Government Quality Necessarily Reduce the Incidence of Sudden Stops?

Sudden stops, or large reversals in capital inflows, have been linked to a number of financial crises in emerging market countries. Given their potentially devastating consequences, academics and policymakers have placed great emphasis on analyzing the causes of financial vulnerability. This task has become even more important with increasing financial globalization. A large literature has developed emphasizing the importance of institutions and governance in promoting growth and reducing economic volatility. This paper finds, however, that the effect of government quality on the incidence of costly sudden stops is in fact non-linear. Initial improvements in governance actually increase the incidence of costly sudden stops. A possible explanation is that improved governance encourages capital inflows that can overwhelm banking systems in countries with weak institutions. Eventually, however, improving institutions does reduce the frequency of sudden stops, allowing countries to enjoy the benefits of financial globalization without all the risks. JEL Classification: F32, F36, F41. Keyword(s): Sudden stops, capital flows, institutions. _____________ * Correspondence: Adam Honig, Department of Economics, Campus Box 2201, Amherst College. Amherst, MA 01002-5000. Email, [email protected]. Phone: (413) 542-5032. Fax: (413) 542-2090.