Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 3 Monetary Policy In An Open Economy

Globalisation and Monetary Policy - Annexure - Business Cycle Synchronisation

Forces of globalisation have led to substantial increases in international trade as well as financial flows during the 1990s. Private capital flows (net) to the EMEs during the 1990s were eight times of that during the 1980s while growth in trade has outpaced growth in output. An issue in this context is whether increased integration has led to a larger degree of synchronisation of business cycles across countries. A global shock - say, an increase in global oil prices - will affect all countries simultaneously. As regards country-specific shocks, a number of forces are at work - some tend to increase co-movement while others reduce co-movement. For countries quite open to external trade, economic developments in their partner countries can get transmitted through exports and imports and this is expected to increase the co-movement of output across countries. Enhanced financial integration, on the other hand, allows countries to smoothen their consumption through borrowing and lending in international markets. This can weaken the output co-movement. Financial integration can, however, lead to an increase in output co-movement through demand-side effects. Illustratively, if investors from different countries have a significant fraction of their investments in a particular stock market, then large movements in that stock market can induce wealth effects across countries and hence output co-movement. Furthermore, due to herd behaviour, capital flows move in similar patterns across countries which can also increase co-movement. Finally, trade as well as financial integration allows countries to specialise in industries in which they have a comparative advantage. This can result in more vulnerability to industry- or country-specific shocks but reduce cross-country output movements. A diversified structure of export destinations tends to weaken the co-movement of business cycles. In view of various offsetting factors at work, the net impact of trade and financial integration on business cycles synchronisation remains uncertain in theory and, therefore, it becomes an empirical issue to gauge the net effect.

Baxter and Kouparitsas (2004) find that variables such as bilateral trade between countries, total trade in each country, sectoral structure, similarity in export and import baskets are significant determinants of business cycle co-movement when considered in isolation. Amongst these variables, however, only bilateral trade is a "robust"¹ determinant of co-movement. Greater similarity in industrial structure is not found to be "robust".

As regards temporal trends in co-movement of output, most studies find evidence that synchronisation has increased in the case of advanced economies, reflecting faster cross-border transmission of shocks. Some studies, however, suggest that synchronisation during the 1980s and the 1990s was broadly unchanged from that in the 1960s and the 1970s, mainly due to common international shocks themselves being smaller.

As regards emerging economies, evidence does not suggest any increase in output co-movements - rather, there appears to be a decline in output correlations. Cross-country consumption correlations also showed no increase during the 1990s. The empirical evidence, therefore, suggests that developing countries were unable to gain from the benefits of international risk sharing. Business cycles synchronisation in the Asia-Pacific region is more by way of similar structural features such as technological know-how and manufacturing structure than by way of trading linkages.

According to IMF (2001), although transmission channels have intensified due to globalisation, there is no global cycle. Country-specific shocks such as German unification and the bursting of the Japanese asset price bubble have interrupted integration trends. Lack of bilateral data complicates the analysis of transmission channels over time. Therefore, it is difficult to decide whether increased correlations were the result of tighter transmission channels or of more frequent common shocks. Cultural similarity and institutional factors such as accounting standards, legal systems, common language and receptiveness to new technologies have a relatively significant impact on growth correlations rather than the traditional transmission channels such as similarity of monetary policy, integration of long-term bond markets and common industry structure.

To conclude, the empirical evidence suggests that the co-movement between business cycles has increased in recent years. Thus, economic developments abroad now have a larger degree of influence on the domestic economy. Monetary authorities, consequently, need to devote more attention to global economic developments in framing their forecasts of inflation and output. Furthermore, the financial stability objective assumes greater importance due to threats of contagion and herding.been observed to cause overshooting of exchange rates as market participants act in concert while pricing information.

¹The authors define a variable to be "robust" if it has a significant coefficient in a regression when all other potential explanatory variables are also included