The channels of international business cycle co-movements have been debated in the literature, with this debate focusing on how such co-movements have been propagated and transmitted from one country to another. There are several possible channels, the most prominent channel being trade. Frankel and Rose (1998) state that countries with closer trade links tend to have more tightly correlated business cycles. Baxter and Kouparitsas (2005) also arrives at similar conclusions whereby intense bilateral trade tends to result in a high degree of synchronization among business cycles. By contrast, Gruben et al. (2002) and Inklaar et al. (2008) find that the trade effect is smaller than previously reported. Crosby (2003) even states that trade does not explain the correlation.
Another transmission channel is dissimilarity in industrial structures. Imbs (2004) points out that dissimilarity (or specialization) patterns have sizable effects on business cycle co-movements. However, Otto et al. (2001) and Baxter and Kouparitsas (2005) do not confirm this result. More recently, the role of financial integration on business cycle synchronization has been stressed by Imbs (2004, 2006). He finds that economic regions with strong financial linkages are more synchronized, an argument that is however not supported by Inklaar et al. (2008). Other possible channels can be summarized as follows: (i) monetary integration (Schiavo (2008)); (ii) economic integration (Kalemli-Ozcan et al. (2001)); (iii) similarity of fiscal policies (Clark and van Wincoop (2001)); (iv) exchange rate volatility (Inklaar et al. (2008)); and others (see de Haan et al. (2008) for a recent survey).
In this paper we focus on the role of foreign direct investment (FDI) in technology diffusion and financial investment and argue that FDI might be another important channel for international transmission of disturbances. FDI is a category of cross-border investment made by a resident in one economy (source economy) to acquire a lasting interest in an enterprise operating in another economy (host economy). FDI has increased dramatically since the 1980s. Figure 1 shows the FDI inflows and outflows as a share of GDP among the G7 countries (Canada, France, Germany, Italy, Japan, the U.K. and the U.S.) and the world in different years.
For the world, we find that inward FDI as a share of GDP increased from 0.50% in 1980 to 4.39% in 2000. The share of GDP accounted for by outward FDI for the world increased from 0.51% in 1980 to 3.53% in 2000. For the G7 countries, both inward and outward of FDI have grown more than five times over these two decades. Although Japan’s inward and outward FDI were very low in 2000, being only 0.17% and 0.67%, respectively, its FDI is in a rising trend and could play an important role in cross-border business cycle co-movements. In contrast to FDI, exports and imports as a share of GDP are more stable, but trade (imports+exports) still accounts for a large share of GDP. This is shown in Figure 2.
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Foreign Direct Investment and Business Cycle Co-movements: The Panel Data Evidence
