A Panel Vector Autoregression Analysis of Sudden Stops and Banking Crises

Abstract

Recent empirical literature on sudden stops and banking crises suggests the interaction of these crises is particularly harmful to the real economy. Despite this, very little empirical research has been undertaken to decipher the interplay between these crises. This paper contributes to this literature by applying a panel vector autoregression to examine how these crises interact via domestic credit, capital flows, and output growth. This research finds evidence supporting the view that sudden stops occurring with banking crises are more harmful than sudden stops occurring by themselves. It also finds that during the joint occurrences of these crises domestic credit increases during the onset of a sudden stop, but this expansion in credit results in an adverse impact on output growth. This result is consistent with the hypothesis that the financial intermediaries are unable to allocate credit efficiently hence why the interaction of sudden stops and banking crises is above and beyond their individual effects.