East Asia has experienced a dramatic decrease in output growth volatility over the past 20 years. This is good news, as output growth volatility affects poor households because of coping strategies that have longterm, harmful consequences, and the overall economy through its negative impact on economic growth.

This paper investigates the factors behind this long decline in volatility, and derives lessons about ways to mitigate renewed upward pressure in face of the financial crisis.

The authors show that if, on the one hand, high trade openness has sustained economic growth in the past several decades, on the other hand, it has made countries more vulnerable to external fluctuations. Although less frequent terms of trade shocks and more stable growth rates of trading partners have helped to reduce volatility in the past, the same external factors are now putting renewed pressure on volatility.

The way forward seems therefore to be to counterbalance the external upward pressure on volatility by improving domestic factors.

Elements under domestic control that can help countries deal with high volatility include more accountable institutions, better regulated financial markets, and more stable fiscal and monetary policies.

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Eduardo Olaberria
Jamele Rigolini
The World Bank
East Asia and Pacific Region
Social Protection Unit
July 2009

This paper—a product of the Social Protection unit, East Asia and Pacific Region —is part of a larger effort in the unit to study main sources of vulnerability. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org.

INTRODUCTION AND EXECUTIVE SUMMARY
Before the current financial crisis hit progressively high, middle, and low-income countries, the world economy was experiencing a remarkable decrease in macroeconomic volatility. Since the 1970s output growth volatility had steadily declined in almost every region of the world (Figure 1). In its 2007 World Economic Outlook the IMF reported that volatility had fallen progressively since its 1970s peak, from 3.8 to 2.7 percent of GDP.

Furthermore, the frequency of major recessions had also diminished: crisis volatility, which captures the frequency and magnitude of major recessions, declined from an average of more than 4 percent of total volatility at the end of the 1970s, to less than 1 percent at the beginning of the new century.

The decrease in macroeconomic volatility was even more significant for non-OECD East Asian countries, were volatility dropped from an average of 7.85 percent in the beginning of the 1970s, to an average of 2.35 percent in 2006. This process began at a very strong pace in the 1970s, slowed down in the 1980s and 1990s (a spike can be even observed during the 1997/98 financial crisis), but gained momentum again at the beginning of the new century driving volatility below pre-crisis levels. ...

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