The accelerated pace of globalisation in the past fifteen years has led to a high degree of economic integration of Asian economies with the rest of the world, particularly through trade of goods and services. At the centre of the globalisation process in East Asia is a rapid development of vertical trade integration in the region, with China becoming a trading hub of manufactured goods after its accession to the WTO in 2001. The East Asian supply chain is particularly dominant in electronic products, as illustrated by Koopman, Wang, and Wei (2008).
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.
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