Macroeconomic volatility in LICs reflects a high frequency of exogenous shocks. Real external shocks and natural disasters are more frequent in LICs compared with advanced and emerging market countries. An analysis of various shocks shows that their frequency differs considerably across country subgroups. Drawing upon the taxonomy in Becker and others (2007), the shocks analyzed here include the following events for the period 1970–2007:
financial and macroeconomic—currency crises, banking crises, debt crises, and reversals in financial flows;
country-specific external—terms-of-trade shocks and natural disasters; and
socio-political—wars and political turbulence.
As seen in Table 2.1, shock frequency increases sharply and monotonically as the income level of the country group falls. In particular, large terms-of-trade shocks occur almost six times as often in LICs as compared with advanced economies. Similarly, large natural disasters and political shocks are unequally distributed, occurring more often in LICs compared with other countries.
Frequency of Shocks Across Country Groups (1970–2007)
Frequency of Shocks Across Country Groups (1970–2007)
| Frequency of Shocks | ||||||
|---|---|---|---|---|---|---|
| Advanced economies | Emerging markets | Low-income countries | ||||
| Total number | Probability (In percent of country years) |
Total number | Probability (In percent of country years) |
Total number | Probability (In percent of country years) |
|
| Financial and macroeconomic shocks | ||||||
| Banking crisis | 13 | 1.1 | 53 | 3.2 | 51 | 1.9 |
| Currency crisis | 13 | 1.1 | 69 | 4.1 | 99 | 3.8 |
| Debt crisis | 0 | 0.0 | 28 | 1.7 | 28 | 1.1 |
| Reversal of capital flows | 46 | 3.9 | 141 | 8.5 | 405 | 15.4 |
| Country-specific external shocks | ||||||
| Terms-of-trade shocks | 45 | 3.8 | 160 | 9.6 | 453 | 17.2 |
| Natural disaster | 17 | 1.4 | 35 | 2.1 | 72 | 2.7 |
| Socio-political shocks | ||||||
| War | 20 | 1.7 | 51 | 3.1 | 77 | 2.9 |
| Political shocks | 5 | 0.4 | 32 | 1.9 | 84 | 3.2 |
Frequency of Shocks Across Country Groups (1970–2007)
| Frequency of Shocks | ||||||
|---|---|---|---|---|---|---|
| Advanced economies | Emerging markets | Low-income countries | ||||
| Total number | Probability (In percent of country years) |
Total number | Probability (In percent of country years) |
Total number | Probability (In percent of country years) |
|
| Financial and macroeconomic shocks | ||||||
| Banking crisis | 13 | 1.1 | 53 | 3.2 | 51 | 1.9 |
| Currency crisis | 13 | 1.1 | 69 | 4.1 | 99 | 3.8 |
| Debt crisis | 0 | 0.0 | 28 | 1.7 | 28 | 1.1 |
| Reversal of capital flows | 46 | 3.9 | 141 | 8.5 | 405 | 15.4 |
| Country-specific external shocks | ||||||
| Terms-of-trade shocks | 45 | 3.8 | 160 | 9.6 | 453 | 17.2 |
| Natural disaster | 17 | 1.4 | 35 | 2.1 | 72 | 2.7 |
| Socio-political shocks | ||||||
| War | 20 | 1.7 | 51 | 3.1 | 77 | 2.9 |
| Political shocks | 5 | 0.4 | 32 | 1.9 | 84 | 3.2 |
The high frequency of external shocks in LICs is related to the intrinsic instability of the development process, including the structure of production and the nature of specialization in these countries. High exposure and frequency of external shocks reflects these countries’ dependence on primary commodities, whose prices experience substantial short-term variability relative to the price of other tradable and industrial goods, less diversified exports, reliance on climate-dependent sectors such as agriculture and tourism for generating output and employment, and concentration of external financing flows, such as aid, tourism receipts, and remittances, from specific advanced and emerging market countries. Figure 2.1 shows that LICs, as a group, present a median terms-of-trade volatility nearly twice as high as that found in the rest of the world (panel d). Moreover, as evidenced by the current crisis, LICs are increasingly exposed to volatility and shocks originating from trading partners.
Distribution of Country Characteristics among Low-Income Countries and the Rest of the World
Sources: IMF Direction of Trade Statistics; IMF, World Economic Outlook; UN Comtrade; World Bank, World Development Indicators; and IMF staff calculations.Note: For each country group, the figure plots the minimum, maximum, and median of the relevant variable. The shaded boxes show the interquartile range.Distribution of Country Characteristics among Low-Income Countries and the Rest of the World
Sources: IMF Direction of Trade Statistics; IMF, World Economic Outlook; UN Comtrade; World Bank, World Development Indicators; and IMF staff calculations.Note: For each country group, the figure plots the minimum, maximum, and median of the relevant variable. The shaded boxes show the interquartile range.Distribution of Country Characteristics among Low-Income Countries and the Rest of the World
Sources: IMF Direction of Trade Statistics; IMF, World Economic Outlook; UN Comtrade; World Bank, World Development Indicators; and IMF staff calculations.Note: For each country group, the figure plots the minimum, maximum, and median of the relevant variable. The shaded boxes show the interquartile range.Home-grown vulnerabilities, both idiosyncratic and policy induced, have historically been an important source of macroeconomic volatility in LICs. Research suggests that idiosyncratic shocks in LICs—related to social conflict, economic mismanagement, and political instability—have historically accounted for the bulk of overall macroeconomic volatility (Raddatz, 2007).
LICs as a group are characterized by greater fiscal volatility than other countries, owing to more narrow and concentrated tax bases, as well as pressures for increased government expenditures during positive shocks that often result in difficult adjustments in the long term. Moreover, macroeconomic vulnerabilities—such as large fiscal and external balances, high and variable inflation, and unsustainable debt ratios—serve to amplify the impact of exogenous shocks (Collier, Goderis, and Hoeffler, 2006).
The importance of external shocks as a source of macroeconomic volatility in LICs has increased over the past two decades. There has been a marked shift in the sources of instability as macroeconomic policies have improved across a range of LICs and as policymakers have upgraded institutions. This, in conjunction with LICs’ growing integration into the global economy (Figure 2.2), has resulted in external shocks becoming an increasingly important source of macroeconomic volatility. For instance, Raddatz (2008) finds that the relative importance of external shocks as sources of output instability in LICs, including in sub-Saharan Africa, was 2.5 times greater in the past 15 years than in the previous 15 year period.
Consequences for Growth and Welfare
Macroeconomic volatility induced by external shocks imposes large welfare costs through its negative impact on output growth (Figure 2.3). A large body of evidence finds that adverse external shocks have a significant impact on growth. In particular, research also suggests that the negative impact of external shocks on growth is especially pronounced in LICs relative to other countries (Collier, Goderis, and Hoeffler, 2006; Collier and Goderis, 2009a; Burnside and Tabova, 2009; Berg and others, 2011). Research suggests that the growth impact of volatility reflects the harmful effect of sharp negative fluctuations rather than the impact of repeated but small cyclical movements observed in advanced economies. In the short term, growth is reduced through the effect on aggregate demand, external balances, and the government’s fiscal position. Moreover, these effects are asymmetric: Although negative shocks impede growth, positive shocks do not necessarily contribute to growth (Collier and Goderis, 2009b).
Macroeconomic Volatility in Low-Income Countries, 1980–2009
Source: IMF, World Economic Outlook; and IMF staff calculations.Note: Emerging market economies include those covered in the Vulnerability Exercise for Emerging Market Economies. LIC: low-income country.Macroeconomic Volatility in Low-Income Countries, 1980–2009
Source: IMF, World Economic Outlook; and IMF staff calculations.Note: Emerging market economies include those covered in the Vulnerability Exercise for Emerging Market Economies. LIC: low-income country.Macroeconomic Volatility in Low-Income Countries, 1980–2009
Source: IMF, World Economic Outlook; and IMF staff calculations.Note: Emerging market economies include those covered in the Vulnerability Exercise for Emerging Market Economies. LIC: low-income country.In the medium term, shock-induced macroeconomic volatility is associated with severe output losses. Although the persistence of the shock’s impact depends on the nature of the shock, the transmission mechanism, country-specific characteristics, and policy responses, research suggests that large external shocks in LICs on average translate into substantial output losses over the medium term (Berg and others, 2010). Also, growth down-breaks, broadly defined as extended periods of markedly slow growth, are associated with external shocks and macroeconomic volatility in LICs (Hausman, Pritchett, and Rodrik, 2006; Berg, Ostrey, and Zettelmeyer, 2008).
Volatility affects long-term growth through reductions in investment, worsening economic policy, and, in extreme cases, increased risk of conflict. Volatility has a negative growth effect through its links with various forms of uncertainty (economic, political, and policy-related) and with the tightening of binding investment constraints. In particular, higher volatility tends to depress investment in both physical and human capital, particularly in countries that are credit constrained (Aghion and others, 2005). Evidence also points to a higher risk of civil war and internal conflict, as well as protracted growth downturns, because of greater economic volatility, which is exacerbated by the structure of income in LICs (Brückner and Ciccone, 2010).
The impact of shocks on macroeconomic volatility is amplified by weaker policy and institutional buffers relative to other countries. In many LICs, notwithstanding the countercyclical response during the current global financial crisis, stabilization policies to counter shocks are less effective, social safety nets are underdeveloped, and automatic stabilizers are weaker than in other countries. A combination of shallow financial markets and weak links to global capital markets makes it difficult for these countries to diversify risk and access financial resources in times of distress. Despite the potential of aid to cushion against shocks, aid volatility itself can be a source of instability in LICs. Also, limited exchange market flexibility in many LICs hampers adjustment by restricting the economy’s ability to reallocate resources in response to shocks (Broda, 2004). The impact of structural impediments—related to trade, financial depth, and labor and firm flexibility—in reducing resilience to shocks is also well documented in the literature (Loayza and Raddatz, 2007; Collier and Goderis, 2009a). These factors translate into large welfare losses, with attendant implications for poverty. It is well documented that macroeconomic volatility, as proxied by output, price, or fiscal volatility, is reflected disproportionately in consumption volatility for LICs (Figure 2.3). Declines in consumption are more precipitous in LICs than in other countries because of low personal savings, liquidity constraints, limited risk-diversification opportunities, and greater dependence of the poor on public services, which exposes them to fiscal cuts in real terms, including through inflation.
International reserves constitute an important form of self-insurance against external shocks, partly because of the speed and ease with which they can be used to prevent import compression and to smooth consumption. At the same time, piling up reserves is costly because the marginal cost of holding reserves is associated with the opportunity cost of the forgone consumption and investment. In LICs, these costs are likely to be higher than in other countries, as the marginal utility of consumption is high and needs for investment in physical infrastructure are more pressing.
