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Sectoral impacts of financial growth and contraction cycles in the open economy

Joshua Aizenman
Brian Pinto
Vladyslav Sushko
UCSC and the NBER
The World Bank

Project Background:

The risks associated with premature liberalization and external integration of the financial sector in emerging markets have been known at least since the documentation of the Southern Cone experience by Diaz-Alejandro (1985). However, the subprime mortgage crisis which began to rear its head in 2006 in the US and eventually morphed into the Great Recession of 2008-09 shows that financial systems even in the advanced economies are vulnerable. Not only that, but evidence in Philippon (2008) shows that the crisis in the US was preceded by a massive and unprecedented expansion of the financial sector.

What is interesting is to view the financial sector in the context of its impact on the growth of the nonfinancial sector, which is where the social costs and benefits ultimately reside. Understanding this growth link is therefore of prime importance for any reform of the financial sector. The starting point of such an endeavor must be an analysis of the links between the financial sector and growth in the nonfinancial sector.

This project undertakes such an analysis looking at 9 nonfinancial sectors in 28 countries over 1960-2005. The study examines how financial growth and contraction cycles affect the broader economy through their impact on various economic sectors. Particular attention is paid to sharp financial sector contractions and expansions, and the factors mitigating or magnifying their sectoral impacts.

Main Findings:

The effect of sharp fluctuations in the financial sector is highly asymmetric, with the majority of other economic sectors greatly affected by financial contractions but not by expansions, with construction sector exhibiting the greatest degree of sensitivity. We also find that all of the adverse effects of financial contractions on the real economy work through the financial openness channel. Foreign exchange reserves serve to mitigate the adverse effect of financial contractions. Both effects are magnified during particularly large financial contraction episodes. Finally, we find that abrupt financial contractions are more likely to take place following period of accelerated growth, indicative of "up by the stairs, down by the elevator dynamics."

Working Paper:

Aizenman, J., B. Pinto, and V. Sushko (2011) "Sectoral impacts of financial growth and contraction cycles in the open economy: mitigation and amplification factors" World Bank Policy Research Working Paper No. 5860

Data Series:

10 Sector Real Value Added Growth Rates and Employment STATA EXCEL
(Source: Groningen Growth and Development Centre (GGDC) 10-Industry Database,, Timmer and de Vries (2009).)

Real Sector Relative Response to 1 Pct. Fin. Shock STATA EXCEL
(Methodology: Share of each significant sector in total non government real value added multiplied by panel regression coefficient (Working Paper Table 6))

SHARP Financial Sector Expansion and Contraction Indicators STATA EXCEL
(Methodology: Clemente, Montanesand and Reyes (1998) and authors' calcuations.)


Clemente, J., A. Montanesand and M. Reyes (1998) "Testing for a unit root in variables with a double change in the mean, "Economics Letters, Vol. 59(2), pp. 175-182

Diaz-Alejandro, Carlos F., (1985) "Goodbye Financial Repression, Hello Financial Crash," Journal of Development Economics, Vol. 19, pp. 1-24

T. Philippon (2008), "The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence," NYU Stern Working Paper

Timmer, M. P. and G. J. de Vries (2009), "Structural Change and Growth Accelerations in Asia and Latin America: A New Sectoral Data Set" Cliometrica, Vol. 3(2), pp. 165-190


Joshua Aizenman and Vladyslav Sushko are grateful to Jean-Jacques Dethier and the Research Support Budget of the Development Economics Vice-Presidency of the World Bank for funding. This paper is part of a broader investigation at the Poverty Reduction and Economic Management Anchor of the World Bank on financial integration and economic growth in developing countries. The views herein are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent, or the NBER.

© 2011 by Joshua Aizenman, Brian Pinto, and Vladyslav Sushko. All rights reserved. Please reference our paper when you use the indicators.