Business cycle

Business cycle behavior has been relatively synchronized since the mid-nineties. In 2001, the dispersion of economic growth rates across the industrialized economies even fell to its lowest level in over 30 years, as the global economy experienced a downturn that was unusually wide-spread across countries. Broadly speaking, the observed degree of output comovement reflects both the nature of the shocks that have occurred and the degree of economic interdependence. Output developments will be more correlated if common shocks happen to be predominant, while they will be more asymmetric if idiosyncratic shocks are most important. Because of economic relations among economies, countryspecific shocks may get transmitted to other countries, enhancing output comovement indirectly. The higher degree of output comovement in recent years has partly been driven by common shocks, such as large changes in crude oil prices, the rise and fall of the information technology boom and restrictive monetary policies (Peersman 2002). However, it is widely felt that common shocks are not the whole story, raising the question to what extent deeper economic linkages, and what kind of linkages, may have contributed to the more synchronized nature of economic fluctuations. The rise in international economic interdependence has occurred along three dimensions. The first is international trade in goods and services, which is the ‘traditional’ channel through which economies may affect each other. Although imports and exports as a share of GDP have in general increased, there has been no marked across-the board acceleration of this trend recently. It is therefore unlikely that deeper trade interdependencies have contributed significantly to the recent rise in output correlations. The second type of link is provided by international trade in financial assets, such as equity and bonds, and cross-border credit relations. Cross-border holdings of portfolio assets have mushroomed in recent years. For example, foreign holdings of US long-term securities amounted to 42% of US GDP in March 2000, having tripled in less than 2½ years (Griever, Lee and Warnock 2001). Correlations between stock markets of the major countries have greatly increased over the last twenty years, with the exception of Japan (Goetzmann, Li and Rouwenhorst 2001, Berben and Jansen 2002). Financial markets have thus gained importance as a channel for the international transmission of shocks. The third dimension of interdependence is the internationalization of production through foreign direct investment (FDI). Foreign direct investment has grown at rates far beyond those of international trade or output since the late 1980s. Especially in the second half of the 1990s, firms were exceptionally active in cross-border mergers and acquisitions (M&A). The outstanding global stock of FDI more than doubled in ten years time from 8.3% of world GDP in 1990 to 17.5% in 2000 (UNCTAD 2002). At present, about 11% of world output is produced by foreign affiliates (UNCTA 2002). It is conceivable that the larger presence of FDI is partly responsible for the observed increase in cross-country business cycle comovement. The empirical literature on the effects of FDI is often based on firm-level data and mainly deals with supply-side effects on host economies in the longer run, focusing on the transfer of technology, management techniques and business models. This paper focuses on another aspect of FDI, namely the possible role FDI may play in the transmisssion of economic shocks across borders. Using aggregate data, we examine to what extent the rapid expansion of FDI and the internationalization of production can be related to the phenomenon of more synchronized business cycles. Our basic empirical question is: Do countries that have comparatively intensive FDI ties tend to have more synchronous business cycles? To our knowledge we are the first to investigate this issue. To preview  the results, we find that before 1995 there is no strong evidence in favor of an independent role of FDI (next to foreign trade) in explaining cross-country business cycle correlation patterns. But after 1995, FDI linkages are much better able to explain the pattern of international business cycle linkages than foreign trade relations. Moreover, FDI is associated with the vulnerability to foreign output spillovers that occur with a lag, but international trade is not. This result holds for the complete sample as well as the more recent years.