in capital flows falls at least two standard deviations below the (rolling) sample mean, and where the drop is also associated with a contemporaneous fall in output.

Countries vary largely with respect to their likelihood to experience sudden stop crises. Within the sample of 602 country year observations, we identify 31 sudden stop periods leading overall to a 5 percent probability of such an event. However, emerging market economies are more prone to experience a sudden stop than industrialized countries. The sudden stop probability in emerging market economies in the sample amounts to almost 8 percent, compared to less than 2 percent in industrialized countries.<sup>2</sup> Of all the countries in the sample, Argentina and Turkey have experienced the most sudden stops, with both economies having undergone 4 such episodes during the 14 year period under examination. In contrast, 21 countries in the sample have not experienced any sudden stop.

We expect the probability of a sudden stop of capital flows to be primarily driven by external vulnerability and by liability dollarization. Hence, these variables are essential to the present study.

Following Calvo et al. (2004), we define external vulnerability as the degree to which absorption of tradable goods is financed abroad. The higher the measure of external vulnerability the more a country relies on foreign financing of its absorption. When we understand a sudden stop as the sudden closure of a current account deficit back to zero, a higher degree of external vulnerability means that a country is more susceptible to changes in relative prices of tradable versus non‐tradable goods, i.e. a depreciation of the real exchange rate, when a sudden stop happens. This is measured as the ratio of the current account deficit to domestic absorption of tradable goods. We construct domestic absorption by summing agricultural and industrial output as a measure of the supply of tradable goods, and then subtract exports and add imports to obtain the desired measure of absorption of tradable goods.

With respect to external vulnerability the sample displays a large variance over time and across countries (see Appendix 2). Additionally, there are two regional patterns worth emphasizing. While large inflows of capital into transition economies of Eastern Europe have contributed to rapid per capita income growth (leading to a notable income convergence toward European Union levels), large external imbalances (manifested in current account deficits) accompanied by rapid credit growth and currency mismatches have exposed the region to elevated external financial risks and a considerable buildup of vulnerabilities. In contrast, the majority of the countries in Latin America have moved from more externally vulnerable situation in the beginning of the period (mid‐1990) to less dependence on external financing of domestic absorption in more recent years.

Liability dollarization is proxied by a measure of what is known in the literature as the original sin, using data by Eichengreen et al. (2002). The idea of original sin refers to many

> 2 Calvo et al. (1998) explains this tendency as a result of greater financial market imperfections, such as liability dollarization, and limited access to longer‐term capital and equity finance in emerging market economies.

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