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

Sudden stops have been linked to a number of financial crises in emerging market countries. While a large literature has developed emphasizing the importance of institutions and governance in reducing economic volatility, this paper finds that the effect of government quality on the incidence of sudden stops is 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. What is striking is that this result holds for a large number of countries including those with average levels of institutional quality that already receive considerable inflows. Eventually, however, improving institutions does reduce the frequency of sudden stops, allowing countries to enjoy the benefits of financial globalization with fewer risks. JEL Classification: F32, F36, F41. Keyword(s): Sudden stops, capital flows, institutions. _____________ * Correspondence: Adam Honig, Department of Economics, 315 Converse Hall, Amherst College. Amherst, MA 01002-5000. Email, [email protected]. Phone: (413) 542-5032. Fax: (413) 542-2090. I have greatly benefited from comments from two anonymous referees. I also wish to thank Beth Yarbrough, Geoffrey Woglom, Sami Alpanda and seminar participants at the 2 Annual Workshop in Macroeconomic Research at Liberal Arts Colleges.