Weathering the financial storm: The importance of fundamentals and flexibility

Abstract

The recent global financial tsunami has had economic consequences that have not been witnessed since the Great Depression. But while some countries suffered a particularly large contraction in economic activity on top of a system-wide banking and currency collapse, others came off relatively lightly. In this paper, we attempt to explain this cross-country variation in post-crisis experience, using a wide variety of pre-crisis explanatory variables in a sample of 46 medium-to-high income countries. We find that domestic macroeconomic imbalances and vulnerabilities were crucial for determining the incidence and severity of the crisis. In particular, we find that the pre-crisis rate of inflation captures factors which are important in explaining the post-crisis experience. Our results also suggest an important role for financial factors. In particular, we find that large banking systems tended to be associated with a deeper and more protracted consumption contraction and a higher risk of a systemic banking or currency crisis. Our results suggest that greater exchange rate flexibility coincided with a smaller and shorter contraction, but at the same time increased the risk of a banking and currency crisis. Countries with exchange rate pegs outside EMU were hit particularly hard, while inflation targeting seemed to mitigate the crisis. Finally, we find some evidence suggesting a role for international real linkages and institutional factors. Our key results are robust to various alterations in the empirical setup and we are able to explain a significant share of the cross-country variation in the depth and duration of the crisis and provide quite sharp predictions of the incidence of banking and currency crises. This suggests that country-specific initial conditions played an important role in determining the economic impact of the crisis and, in particular, that countries with sound fundamentals and flexible economic frameworks were better able to weather the financial storm.