Table 7 reports estimates from an econometric model that includes an interaction term between terms of trade volatility and the GDP share of domestic credit to the private sector. Following the finance literature (La Porta et al., 1998), we use variation in the GDP share of domestic credit to the private sector that is predicted by British legal origin. As an additional variable we use distance to the equator in order to generate variation in the GDP share of domestic credit that is exogenous to economic growth.<sup>6</sup> From columns (1) and (2) of Table 7 we see that the negative effect of terms of trade volatility is mediated by cross-country differences in financial development. The coefficient on terms trade volatility is around -0.7 and significant at the 1 percent level; the interaction term between terms of trade volatility and the GDP share of domestic credit to the private sector is around 1.6 and significant at the 5 percent level. These values imply that at median levels of financial development (GDP share of domestic credit to the private sector equal to 35 percent), terms of trade volatility has a significant negative effect on economic growth; however at higher values of financial development the effect is insignificant.<sup>7</sup> Financial development has a positive effect on economic growth on average. This can be seen from the coefficient on the GDP share of domestic credit to the private sector. The relevant coefficient is around 0.2 and is significantly different from zero at the 1 percent level, see columns (1) and (2). This is in accordance with the finance literature where it is found that a greater GDP share of domestic credit to the private sector is on average growth enhancing. Sahay et al. (2015) present evidence that the growth effect of financial development may be non-linear. Indeed, we see from columns (1) and (2) of Appendix Table 1 that the relationship between GDP p.c. growth and the GDP share of domestic credit to the private sector is an inverted U-shaped. The average marginal effect of financial development on economic growth remains, however, positive and significant. Further, we have explored using the index of financial development developed in Sahay et al. (2015); this yields results similar to those presented in Table 7, see Appendix Table 2.<sup>8</sup> The statistical significance of the mediating role of financial development with regard to the effect of terms of trade volatility on economic growth vanishes once country fixed effects are included in the econometric model. This is shown in columns (3)-(5) of Table 7. Although the coefficient on the interaction term remains positive, it is quantitatively smaller than in columns (1) and (2). The interaction term is, in columns (3)-(5), not significantly different from zero at the conventional significance levels. An F-test shows that the coefficients on the interaction term and on terms of trade volatility are jointly not significantly different from zero (p-value above 0.1). Hence, the role of financial development as a mediating factor vanishes when focus is on the within-country relationship between terms of trade volatility and economic growth.

Terms of trade volatility has a particularly large negative effect on economic growth in countries where fiscal policy is procyclical. This is shown in Tables 8 and 9. Table 8 reports estimates from an econometric model that includes an interaction term between the standard deviation of the terms of trade growth rate and the country-specific coefficients that measure the

> fully take into account the average growth of OECS countries.

> 6  Both British legal origin and distance to the equator have a highly significant positive effect on the GDP share of domestic credit to the private sector. The F-statistic on the joint test that British legal origin and distance to the equator have no significant effect on the GDP share of domestic credit to the private sector is 34.77; British legal origin and distance to the equator explain about onequarter of the variation in the sample of countries' average GDP shares of domestic credit to the private sector.

> 7  The interquartile range of the GDP share of domestic credit to the private sector predicted by British legal origin and distance to the equator is [0.25, 0.46]

> 8  The index of financial development developed in Sahay et al. (2015) measures depth (size and liquidity of markets), access (ability of individuals to access financial services), and efficiency of  financial markets and institutions (ability of institutions to provide financial services at low cost and with sustainable revenues, and the level of activity of capital markets).

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