Ebook How Much do Trade and Financial Linkages Matter for Business Cycle Synchronization?
The last few years have witnessed increasing economic globalization stemming from very rapid growth in trade and financial linkages, among other factors. At least at first sight, one would be tempted to think that tighter trade and financial linkages contribute to the synchronization of business cycles. However, theoretical models do not have a clear prediction regarding the relationship between these variables. In fact, the theoretical literature is able to propose both positive and negative effects on the synchronization of cycles, which may counteract each other. The question is therefore an empirical one, but the empirical literature also reflects these unclear theoretical predictions, as there are a number of diverging results when testing for the influence of trade and financial integration on business cycle comovements, especially because of poor data on financial flows. This paper tries to measure the effect of trade and financial links on business cycle synchronization for a small, open economy, taking Spain as a benchmark. We ask whether these two variables exert a positive or negative influence over the synchronization of output and whether the influence is not only statistically but also economically significant.
The issue is relevant for several reasons. First, more synchronized business cycles would presumably mean a stronger and faster transmission of shocks across countries, which could provide an important reason in favor of international policy coordination. Second, business-cycle synchronization has profound implications for the design and functioning of common currency areas. Third, business cycles in a country are mostly driven by external factors, such as trade and financial linkages, domestic policy aimed at economic stabilization or even policy coordination itself is bound to have a smaller impact. In the same vein, if trade linkages lead to business cycle synchronization, external demand will not manage to dampen economic fluctuations, but quite the opposite. This implies that exchange rate policy will be unlikely to play an important role in boosting demand at times of low economic activity.
This paper contributes to the empirical literature mainly in two ways. First, most of the existing studies analyze the issue estimating a reduced-form equation. However, there are a number of interrelations between trade linkages, financial integration and business cycle synchronization, which need to be taken into account so that the results are meaningful. Although in principle these endogeneity problems can be tackled using instrumental variable estimation, the possibility of conflicting indirect effects between these variables might lead to low net effects, even when partial effects are strong. We, therefore, use a system of equations to disentangle direct and indirect effects on business cycle synchronization.
Second, many studies suffer from the lack of bilateral data to measure financial linkages and use aggregate financial stocks or flows. This, which measures financial integration with the rest of the world, can hardly explain business cycle co-movements between two countries. Studies that use bilateral data generally take the US or a group of big economies as a benchmark to measure business cycle synchronization. Such a large economy, or area, influences other countries through many channels other than trade and financial linkages, which is bound to bias the estimated coefficients. To minimize this problem, we use a small open economy (Spain), as a benchmark an
take advantage of a newly available dataset on bilateral financial flows by geographical origin and destiny, from the Spanish Balance of Payments.
From our empirical exercise, we obtain several conclusions: First, trade or financial linkages only influence the synchronization of business cycles through their effect on the similarity of economic structure. Second, the synchronization of output increases as economic structures become more similar suggesting the prevalence of sectoral shocks in the last 15 years—, and as macroeconomic policies become more synchronized. Third, more trade integration reduces the similarity of productive structures (which might point to trade fostering specialization), and thus would lead to lower business cycle synchronization. However, this is only one of the effects, as we also find that higher trade integration fosters financial integration, which in turn promotes more similar productive structures. The net effect of trade integration on the similarity of productive structures turns out to be positive, but economically small. Fourth, the net effect of financial linkages on output synchronization is also indirect, positive, and very small: its fostering of trade linkages is outweighed by its positive direct effect on the similarity of productive structures, and thus on the correlation of cycles.
Perhaps the more important conclusion of the exercise, however, is our finding that, even though these indirect effects of trade and financial integration over business cycle synchronization are statistically significant, they are not very relevant economically. Specifically, we find that an increase in trade or financial integration by one standard deviation from its mean would increase the correlation of output with Spain from 0.710 to 0717 and 0.727, respectively. The effect of a similar productive structure or synchronized macro policies seem economically more relevant in influencing the synchronization of cycles.
The rest of the paper is organized as follows: the next section reviews recent literature on the relationship between trade and financial integration and business cycle synchronization; section 3 outlines the main theoretical predictions and the estimation strategy; section 4 presents the empirical results and section 5 concludes.
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