WORKING PAPER SERIES BUSINESS CYCLE SYNCHRONISATION DISENTANGLING TRADE AND FINANCIAL LINKAGES NO 1322 / APRIL by Stéphane Dées and Nico Zorell - PDF

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WORKING PAPER SERIES NO 1322 / APRIL 2011 BUSINESS CYCLE SYNCHRONISATION DISENTANGLING TRADE AND FINANCIAL LINKAGES by Stéphane Dées and Nico Zorell WORKING PAPER SERIES NO 1322 / APRIL 2011 BUSINESS CYCLE

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WORKING PAPER SERIES NO 1322 / APRIL 2011 BUSINESS CYCLE SYNCHRONISATION DISENTANGLING TRADE AND FINANCIAL LINKAGES by Stéphane Dées and Nico Zorell WORKING PAPER SERIES NO 1322 / APRIL 2011 BUSINESS CYCLE SYNCHRONISATION DISENTANGLING TRADE AND 1 FINANCIAL LINKAGES by Stéphane Dées and Nico Zorell 2 3 In 2011 all publications feature a motif taken from the 100 banknote. NOTE: This Working Paper should not be reported as representing the views of the European Central Bank (). The views expressed are those of the authors and do not necessarily reflect those of the. This paper can be downloaded without charge from or from the Social Science Research Network electronic library at 1 We are grateful to Claudia Buch, Jean Imbs, Filippo di Mauro, War wick McKibbin and an anonymous referee for helpful comments and to Martin Schindler for making his database available to us. All remaining errors are the sole responsibility of the authors. 2 Corresponding author: European Central Bank. Kaiserstrasse 29, D Frankfurt am Main, Germany; phone: (+49) ; fax: (+49) ; 3 University of Tübingen. European Central Bank, 2011 Address Kaiserstrasse Frankfurt am Main, Germany Postal address Postfach Frankfurt am Main, Germany Telephone Internet Fax All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the or the authors. Information on all of the papers published in the Working Paper Series can be found on the s website, ecb.europa.eu/pub/scientific/wps/date/ html/index.en.html ISSN (online) CONTENTS Abstract 4 Non technical summary 5 1 Introduction 2 Literature review 3 Methodolgy 3.1 Framework 3.2 Data 4 Empirical results 4.1 Simple data analysis 4.2 Estimation results 4.3 Disentangling the importance of the different channels 4.4 Sensitivity to the financial integration instruments 5 Concluding remarks References Tables and Figures 32 Appendices Abstract Drawing on a large sample of countries, this paper explores whether closer economic ties between countries foster business cycle synchronisation and disentangles the role of the various channels, including trade and nancial linkages as well as the similarity in sectoral specialisation. Overall, our results con rm that trade integration fosters business cycle synchronisation. Similar patterns of sectoral specialisation also lead to closer business cycle co-movement. By contrast, it remains di cult to nd a direct relationship between bilateral nancial linkages and output correlation. However, our results suggest that nancial integration a ects business cycle synchronisation indirectly by raising the similarity in sectoral specialisation. Through this indirect link, nancial integration tends to raise business cycle comovement between countries. Keywords: International transmission of shocks, Financial integration, International business cycle. JEL Classi cation: E32, F41, E44. 4 NON-TECHNICAL SUMMARY The nancial crisis led to a deep and synchronised global downturn, accompanied by a severe contraction in international trade. It is widely held that the unprecedented synchronisation of the downturn across countries is related to the economic globalisation witnessed over the decades leading up to the crisis. Globalisation has tied the countries more closely together in various ways. To start with, globalisation has led to closer trade linkages across the globe. Trade of goods and services as a share of world GDP increased from around 15% in the early 1980s to around 25% before the start of the crisis in In parallel, nancial integration has increased even more. Foreign direct investment (FDI) in particular has grown at rates far larger than those of trade or output. From the early 1980s to 2007, the stock of FDI rose almost vefold to reach around 30% of world GDP. Furthermore, trade openness and international nancial openness have been highly correlated across both industrial and developing countries. Countries that are more open to trade also tend to be more integrated into global nancial markets. While globalisation forces have made countries more interconnected, structural di erences of the various economies might have also generated di erences in business cycles. This calls for taking into account the degree of similarity in the structure of production across countries when studying the factors underlying cross-country output correlations. Against this backdrop, this paper explores whether closer economic ties between countries indeed foster business cycle synchronisation. Drawing on the work by Imbs (2004 and 2006), we also seek to disentangle the role of the various channels. More speci cally, we allow for a complex interplay between trade integration, nancial integration and business cycle synchronisation. Cross-country di erences in production structure and their indirect connections with international linkages are also taken into account. 5 Our paper adds to the existing literature in several ways. First, the analysis rests on a relatively large sample of countries, including various emerging economies, particularly in Central and Eastern Europe. Second, we use several measures of nancial integration, with one of the measures capturing bilateral FDI linkages. This is a novelty in this branch of the literature and allows us to assess whether the various types of nancial integration have di erent e ects on business cycle synchronisation. Third, to account for endogeneity problems, we use various sets of instruments, particularly for nancial integration. We nd that some results turn out to be quite sensitive to the nancial instruments used. Finally, we assess how much the results depend on the country coverage by repeating our empirical exercise for two di erent sub-samples consisting of the OECD countries and the EU Member States, respectively. Overall, our empirical analysis shows that business cycle synchronisation is mostly explained by the similarity in production structure and by trade linkages. Financial linkages contribute to closer output correlations rather indirectly, by making countries more similar. It seems worth noting that we de ne nancial linkages in a very narrow sense, i.e. in terms of bilateral asset holdings. Therefore, we are unlikely to fully capture the nancial transmission of global shocks or shocks spreading through contagion e ects via third countries. These phenomena are likely to have played an important role in the remarkable synchronicity of the downturn across countries that followed the nancial crisis, in addition to the channels described in this paper. 6 1 Introduction The nancial crisis led to a deep and synchronised global downturn, accompanied by a severe contraction in international trade. It is widely held that the unprecedented synchronisation of the downturn across countries is related to the economic globalisation witnessed over the decades leading up to the crisis. Globalisation has tied the countries more closely together in various ways. To start with, globalisation has led to closer trade linkages across the globe. Trade of goods and services as a share of world GDP increased from around 15% in the early 1980s to around 25% before the start of the crisis in In parallel, nancial integration has increased even more. Foreign direct investment (FDI) in particular has grown at rates far larger than those of trade or output. From the early 1980s to 2007, the stock of FDI rose almost vefold to around 30% of world GDP. 1 These developments partly re ect the increasing role of o shoring. Amador and Cabral (2009), for instance, nd that vertical specialisation activities as a share of world manufacturing imports have risen signi cantly over the past decades, with some acceleration over time. Furthermore, trade openness and international nancial openness have been highly correlated across both industrial and developing countries. Countries that are more open to trade also tend to be more integrated into global nancial markets (IMF 2002). While globalisation forces have made countries more interconnected, structural di erences of the various economies might have also generated di erences in business cycles. This calls for taking into account the degree of similarity in the structure of production across countries when studying the factors underlying cross-country output correlations. Against this backdrop, based on a sample of 56 countries, this paper explores 1 These shares have been computed by the authors using di erent sources. Values for world trade of goods and services are from the WTO International Trade Statistics (2008). Values for the world stock of FDI is from the UNCTAD World Investment Report (2008). Values for world GDP are from the IMF World Economic Outlook (2009). 7 whether closer economic ties between countries indeed foster business cycle synchronisation. Drawing on the work by Imbs (2004 and 2006), we also seek to disentangle the role of the various channels. 2 More speci cally, we allow for a complex interplay between trade integration, nancial integration and business cycle synchronisation. Cross-country di erences in production structure and their indirect connections with international linkages are also taken into account. Overall, our results con rm that economic integration fosters business cycle synchronisation. Above all, the GDPs of economies with more intensive bilateral trade move more closely together. Apart from this, similarity in production structure leads to closer business cycle comovements. By contrast, it remains di cult to nd a direct relationship between bilateral nancial linkages and output correlation. Our results suggest that nancial integration a ects business cycle synchronisation not directly, but acts more indirectly by raising the similarity in production structure. Through this indirect link, nancial integration tends to raise business cycle comovement between countries. Our paper adds to the existing literature in several ways. First, the analysis rests on a relatively large sample of countries, including various emerging economies, particularly in Central and Eastern Europe. This might be especially relevant when considering the e ects of vertical integration on business cycle correlation. Second, we use several measures of nancial integration, with one of the measures capturing bilateral FDI linkages. This is a novelty in this branch of the literature and allows us to assess whether the various types of nancial integration have di erent e ects on business cycle synchronisation. Third, to account for endogeneity problems, we use various sets of instruments, 2 In addition to Imbs (2004, 2006), Abbott et al. (2008) also follow the same approach to study the e ects of trade, specialisation and nancial integration for business cycle synchronisation in 15 OECD countries. Similarly, Garcia-Herrero and Ruiz (2008) apply the same methodology to business cycle synchronisation between Spain and a large set of economies. 8 particularly for nancial integration. We nd that some results turn out to be quite sensitive to the nancial instruments used, a point that deserves special attention in future research. Finally, we assess how much the results depend on the country coverage by repeating our empirical exercise for two di erent sub-samples consisting of the OECD countries and the EU Member States, respectively. While we still have di culties to nd signi cant direct e ects between nancial linkages and output correlations for the OECD sample, these e ects become positive and signi cant for the EU sample. Overall, our empirical analysis shows that business cycle synchronisation is mostly explained by similarity in production structure and trade linkages. Financial linkages contribute to closer output correlations rather indirectly, by making countries more similar. The remainder is structured as follows. The next section brie y reviews the related theoretical and empirical literature. Our empirical methodology is described in Section 3. In Section 4 we discuss the results, before concluding in Section 5. 2 Literature review Trade and nancial linkages play a signi cant role in the international transmission of shocks and in business cycle sychronisation. However, empirical studies and theoretical models have so far often produced con icting results. While empirical research has generally found that pairs of countries with relatively strong trade and nancial linkages tend to have highly correlated business cycles, the theoretical models cannot deliver results that are quantitatively consistent with such empirical ndings. Existing theoretical models studying business cycle synchronisation are mostly based on the standard international real business cycle model. In a two-country 9 open economy model with complete nancial markets, Backus et al. (1992) show that, in a world of fully integrated asset markets, high trade intensity is associated with lower business cycle correlations. Extending this model to account for vertical specialisation, Kose and Yi (2001) suggest that higher trade integration might lead to more or less synchronisation, depending on the nature of trade and the type of shocks hitting the economies. If higher trade linkages foster specialisation, then the presence of industry-speci c shocks will result in more idiosyncratic business cycles. By contrast, if higher trade linkages increase intra-industry trade (also in parts and components), then stronger trade ties might lead to higher business cycle synchronisation. Other theoretical models also show that intense bilateral trade tends to be associated with highly correlated business cycles (Canova and Dellas, 1992). While theoretical models support, to some extent, a positive relationship between trade linkages and business cycle synchronisation, the impacts of - nancial integration on output correlations have remained unclear. On the one hand, the ability to borrow and lend internationally facilitates the transfer of resources between economies and can decrease output correlations. Backus et al. (1992) show that, in a complete markets model, a positive technology shock in one economy attracts capital ows from the rest of the world, resulting in negatively correlated output uctuations. On the other hand, a model in which individuals have incomplete access to international risk sharing instruments can lead to opposite predictions, as Baxter and Crucini (1995) show. Another explanation for business cycle comovement is the similarity in production structure. In theory, similar production patterns should a ect synchronisation positively, since two economies producing the same types of goods will then be subject to similar shocks. Thus, countries with similar production patterns tend to have synchronised economic cycles. 10 Empirically, higher trade integration increases cross-country output correlations (Frankel and Rose, 1998; Clark and van Wincoop, 2001). Also, most empirical studies show a positive relationship between nancial integration and business cycle synchronisation (see for instance Imbs, 2004 and 2006). However, Kalemli-Ozcan et al. (2009) argue that the positive assocation between nancial integration and business cycle synchronisation is mainly due to not accounting for the e ects of country-pair factors and global shocks. Using a rich panel data set on banks international bilateral exposures over 30 years and 20 developed countries, they are able to account for these factors and nd a negative relationship between nancial integration and business cycle synchronisation. Finally, concerning the similarity in production structure, Kalemli-Ozcan et al. (2001) and Imbs (2004 and 2006) all nd that country pairs with similar production structure exhibit closer output correlation. Furthermore, interactions between integration and production structure have to be taken into account. For instance, Kalemli-Ozcan et al. (2003) show that nancially integrated economies tend to specialise in di erent sectors, in line with their comparative advantages. However, nancial integration between two economies could also increase the similarity of their production structures, as foreign investment could be concentrated on similar activities, for instance those dependent on external funds (Imbs, 2006). FDI ows could also be concentrated on sectors where the home country has a comparative advantage, thus replicating in the host country a similar productive structure (Garcia-Herrero and Ruiz, 2008). The production structure might in turn in uence the way trade and - nancial integration a ect output correlations. It is therefore important to consider all these linkages together. The methodology generally used in the literature to test for the relevance of trade and - nancial channels is the estimation of a single equation. The fact that there may 11 be indirect e ects going in opposite directions might account for the generally small impact found in studies using single equation regressions. For instance, Kose et al. (2003), using a single-equation regression, nd a positive e ect of trade on business cycle synchronisation, but a non-signi cant e ect of nancial links on output correlations. To address the possibility of con icting indirect e ects, Imbs (2004 and 2006) estimates a system of simultaneous equations to take into account direct and indirect e ects on the synchronisation of output. He nds that similarity in production structure has a sizable e ect on business cycles. Most of this e ect directly re ects di erences in GDP per capita. Also, economic regions with strong nancial links are found to be signi cantly more synchronised, even though they also tend to be more specialised. 3 Methodology We follow Imbs (2004 and 2006) and estimate a system of equations relating bilateral output correlations with measures of trade and nancial integration as well as the similarity in production structures. We present rst the system of equations that will be used in our empirical analysis. We then give details about the data used and the various measures computed. Finally, we present the estimation strategy. 3.1 Framework Similarly to Imbs (2004 and 2006), we estimate the following system of four equations simultaneously. Each observation corresponds to a country pair (i; j): i;j = T i;j + 2 F i;j + 3 S i;j + 4 I 1;i;j + 1;i;j (1) T i;j = F i;j + 2 S i;j + 3 I 2;i;j + 2;i;j (2) 12 S i;j = T i;j + 2 F i;j + 3 I 3;i;j + 4;i;j (3) F i;j = I 4;i;j + 3;i;j (4) Here, the four endogenous variables are the bilateral output correlation, the bilateral trade intensity T, an index S capturing the similarity between country i and j;and the intensity of nancial links between these two countries denoted F. I 1 ; I 2 ; I 3 and I 4 denote exogenous variables. As shown by Imbs (2004), the identi cation of the system requires di erences between at least I 2 and I 3, as well as instruments for F. Equation (1) is rather standard in the literature studying the empirical determinants of cross-country GDP in the vein of Frankel and Rose (1998) and relates bilateral output correlations to measures of trade and nancial integration as well as the similarity in production patterns. Equations (2) to (4) capture the interaction of the endogenous explanatory variables, allowing us to disentangle direct from indirect channels. The speci cations chosen are those used in Imbs (2004 and 2006) Data As in Imbs (2006), the dependent variable is the pairwise correlation of HP- ltered GDP, computed here over Regarding goods market integration, we also follow Imbs (2006) and 3 Imbs (2004) estimates a similar system with 1 = 0 and Imbs (2006) imposes 2 = 1 = 0 and includes T as dependent variable in Eq. (4). 4 Other ltering techniques have also been used, including the asymmetric Christiano- Fitzgerald lter, the Baxter-King bandpass
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