Macroeconomic Trade Links and Business Cycle Synchronicity

Classic trade theories such as the Heckscher-Ohlin model and Ricardian principles of comparative advantage suggest that with trade countries can benefit when they specialize in industries that are to their comparative advantage. Higher interindustry specialization would cause the industrial structures of trading countries to diverge, potentially weakening global linkages. However, international trade may cause demand or supply spillovers across countries. When demand shocks drive consumption or investment booms in one country, the effects may spill over into its trading partners through increased demand for imports, which in turn boosts other economies.

Furthermore, as noted by Shin and Wang (2004), international trade may affect macroeconomic policies (e.g., exchange rate, fiscal, and monetary policies) of some countries. More specifically, trade may lead to either policy coordination or beggar-thyneighbor policies among countries, which, in turn, affect global economic links. For instance, to gain international market share for exported goods, countries that export similar products may compete with each other by depreciating their currencies. For their mutual benefit, trading partners or countries in production chains may need to coordinate with each other in setting policies relevant to trade.

While many economists agree that trade can play a crucial role in linking economies and transmitting disturbances, the impact of trade linkages on the degree of business cycle synchronization is ambiguous (Kose, Prasad, and Terrones 2003; Shin and Wang 2004; Baxter and Kouparitsas 2005; Rana 2007a, 2007b). On the one hand, specialization in the style of Ricardian or Heckscher-Ohlin principles may mitigate comovements between economies. When countries are more specialized in industries in which they have a comparative advantage, higher trade openness may lead to decreased business cycle correlation if shocks are sector-specific. On the other hand, trade may act as a conduit for the transmission of shocks that affect all industries, which, in turn, reinforces the links among economies and correlations among business cycles (Baxter and Kouparitsas 2005). Furthermore, intraindustry trade (vertical specialization) as a result of production sharing or outsourcing may increase international business cycle comovements (Shin and Wang 2004; Burstein, Kurz, and Tesar 2008). Finally, trade spillovers across countries and resulting policy coordination or competition can cause business cycles across countries to move more closely.

1. Recent Trends of Aggregate Trade and Openness

Figure 1 [ PDF 17KB | 1 page ] shows the actual growth rates of trade in different regions during the past two decades. On average, world trade grew 9.8% annually, over three times the average annual growth (around 3%) of real gross domestic product (GDP). Of the regions listed in the figure, developing Asia achieved the highest average annual growth rate (around 13.6%), while Japan had the lowest, around 7%. During 1987–1993, the growth rate of world trade decreased, but then jumped to nearly 20% in 1995. The 1997 Asian financial crisis strongly affected trade in Asian countries. Both Japan and developing Asia had negative growth rates of trade in 1998, around -12% and -11%, respectively. During 1996–1999, the average growth rates of trade were -1.3% and 1.4% for Japan and developing Asia, respectively, while the average growth rate of world trade was 3.5%. The burst of the information technology bubble in 2001 reduced trade in every region and, on average, world trade decreased by around 5.2%. However, the impact varied across different regions: Japan had the largest decrease, over 12.2%, while the European Union (EU) had the smallest drop (around 0.1%).

As shown in Figure 1, trade in different regions has moved to a large extent in the same manner, especially since 2002. To further illustrate this trend, Table 1 [ PDF 12.5KB | 1 page ] lists the correlation coefficients between trade changes in each region and the world average, and with changes in United States (US) trade, respectively. During 1987–2007, the correlations between changes in trade in the EU and North American Free Trade Agreement (NAFTA) and the world average were above 0.7. When examining each subperiod, a noteworthy fact is that the correlation between each region and the world average has become very high (around 0.95) since 2002 (except for the EU whose coefficient was 0.87). As for the correlations with changes in US trade, the EU had the highest correlation coefficient (0.49) during 1987–2007. The table also suggests that the recent correlations between changes in US trade with other regions have increased sharply since 2002.

Kose and Yi (2001, 2006) showed that in a standard model of international business cycles, trade has a very small effect on overall cross-country GDP correlations given the small shares of trade in GDP for most countries. But as a result of rapid growth in trade and mild growth of GDP during the past two decades, trade openness has increased globally, especially in developing Asia and the EU. This has led to expanded global economic interdependence and the possibility of increasingly synchronized business cycles across and within regions. As shown in Figure 2 [ PDF 85.9KB | 1 page ], for developing Asia, the total trade volume rose from around 46% of GDP in 1986 to 88% in 2006. Trade openness in developing Asia grew rapidly during 1986–1990 (7.7% per year on average), followed by slow growth during the following decade (only 1.7% per year on average). During 2001–2006, trade openness grew on average of around 3.7% per year. The growth of trade openness reflects increasing regional integration and expanding People's Republic of China (PRC) trade, in particular. The EU recorded the highest trade volume and its openness (of around 76% of the GDP) ranked second. Trade openness in the US (or NAFTA, in general) and Japan has been relatively stable.

The rapid growth of trade volume and rising openness have increased the possibility of trade playing a significant role in transmitting economic shocks. Indeed, many empirical studies (e.g., Frankel and Rose 1998; Gruben, Koo, and Millis 2002; Shin and Wang 2004; Rana 2007a) documented that the more countries traded with each other, the more highly correlated their business cycles were, although, in principle, increased trade could lead to either tighter or looser business cycle correlations between trading partners.

The Asian Development Bank (ADB 2007) found that Asian business cycles seemed to have experienced a decoupling from those of G3 during the pre-crisis period of rapid growth in the 1990s, but cyclical comovements between Asia and the G3 have visibly strengthened since the crisis, while business cycle synchronicity among Asian economies has weakened. However, there is also clear evidence pointing to increasing business cycle synchronization between the PRC and the rest of Asia. Statistical test results suggest that, in the post-crisis period, movements in the G3 cycle “Granger-cause” movements in the Asian business cycle at 2- and 3-year lags (but not the other way round). The results also show dramatic increases in the explanatory power and statistical significance for the direction of cyclical influence from the G3 to Asia when the pre- and post-crisis periods are compared. This suggests that Asian business cycles have become more responsive to the cyclicality of the G3 in the post-crisis period. Moneta and Ruffer (2006) also found evidence of increased synchronization within East Asia (except for the PRC and Japan), with the synchronization reflecting primarily export synchronization and common disturbances, including oil prices and the yen-US dollar exchange rate.

2. Trade Balance

The trade balance of each region during 1986–2006 is shown in Figure 3 [ PDF 84.7KB | 1 page ]. The most striking phenomenon is that the US experienced a trade deficit for the whole period. During 1986– 1991, the US trade deficit (2.6% of the GDP on average) was shrinking before expanding rapidly after 1991. The deficit reached US$881 billion (or approximately 6.7% of the GDP) in 2006, about 85% higher than in 2000 and over nine times greater than in 1991.

Given the weight strength of the US in world trade and the global economy, an important feature of past U.S. recessions has been that import growth turned sharply negative during every recession. US imports are strongly procyclical, reflecting the relatively high import share of cyclically sensitive components of domestic final demand, such as consumer durables and investment goods. Not surprisingly, countries with the greatest export exposure to the US suffer the largest declines in output gaps (International Monetary Fund [IMF] 2007).

Regarding the magnitude of the US current account deficit and the patterns of global imbalance, Eichengreen (2006) reviewed four competing views: the deficient US savings view, the new economy view, the global savings glut perception, and the Sino-American codependency view. The deficient US savings view holds that the global imbalance stems primarily from twin deficits in the US, while the new economy view emphasizes the attractiveness of the US for investment. The global savings glut perception argues that high savings rates in the rest of the world are mainly responsible for low interest rates in and capital flows to the US, and therefore, for the global imbalance. The Sino-American codependency view attributes the global imbalance to macroeconomic policies and low investments in risk-averse Asian countries.

No matter which cause actually accounts for the trade imbalance, it generally affects global linkages and business cycles through three channels. First, trade imbalances (or net exports) are a component of aggregate demand for domestically produced goods and therefore directly contribute to GDP growth. In this regard, the fluctuations in trade imbalances clearly link economies. Second, trade imbalances can affect capital flows through trade transactions and the expectation of exchange rate movements. A large trade imbalance (surplus or deficit) in a country may trigger the market to reassess that country's currency and form certain expectations of exchange rate movements (appreciation or depreciation). This, in turn, causes short-term international capital flows. Finally, trade imbalances can transmit macroeconomic policies from some countries—especially those growth engines—to other countries. Given these linkages, when trade occurs in a more balanced manner, economic growth is more subject to a country's domestic shocks. However, if trade occurs in a highly imbalanced manner, disturbances could arise both domestically and internationally.

For instance, during the 1980s, Japan had a large surplus in its bilateral trade with the US (Figure 3) and the market expected that the Japanese yen would appreciate strongly against the US dollar. However, the Japanese government resisted the appreciation and resorted to a forced expansionary monetary policy for an extended period. The government attempted to liberalize imports of goods and services; however, these measures were not sufficient to eliminate the upward pressure on the yen in the foreign exchange market. Finally, after the 1985 “Plaza Agreement,” the Japanese yen appreciated by 70% in three years. To avert declining exports, the Japanese government further implemented expansionary monetary and fiscal policies during this period. The expansionary monetary policy led in part to an asset bubble in Japan during the late 1980s (Kuroda 2004).

Currently, the large global trade imbalance can be directly or indirectly related to surging commodity prices, global inflation, and a potential global recession. Several countries that have huge surpluses in trade with the US (e.g., the PRC) experience pressures to strengthen currencies; however, most of them have resisted steep appreciation with expansionary monetary policy. As a result, inflationary pressures and asset bubbles have formed. Surging commodity prices, in addition to the financial turbulence, have made inflation a threat to the world economy (Figure 4 [ PDF 88.6KB | 2 pages ]).

3. Trade Intensity and Interdependence

Figure 5 [ PDF 128.4KB | 3 pages ] shows changes in trade structures for each region during the four periods. A common trend is that intraregional trade has been increasing and has become the most important part of the total trade of each region. Among all the regions, the share of intraregional trade in the EU has been the largest, above 70% of its total trade. In terms of export size, Figure 6 shows that the intraregional exports of the EU have also been the largest. From a dynamic point of view, intraregional trade in Asia is the most dynamic and has increased greatly. As shown in Figure 6 [ PDF 95.8KB | 1 page ], East Asia has been the fastest growing region in intraregional trade since 1988 and, as a result, the share of East Asian intraregional trade in world trade has increased by 5.6 percentage points. %. Table 2 [ PDF 19.9KB | 1 page ] also shows a similar trade pattern.

where x_ibt denotes total nominal exports (US$ value) from country i to bloc b (b=US, EU, and East Asia) during period t; m_ibt denotes total nominal imports (US$ value) from bloc b to country i during period t; and X_it and M_it denote total global exports and imports of country during period t. The result is similar for both European and East Asian countries and the results for East Asia are shown in Table 3 [ PDF 16.9KB | 1 page ]. The export intensity index also suggests that intraregional trade occupied the highest share of the trade of all the East Asian countries shown. The intraregional trade share was around 60% for Hong Kong, China; Indonesia; Malaysia; Singapore; and Taipei,China; and near 50% for the PRC, Japan, and the Republic of Korea (hereafter Korea) in Period 3. The simple and weighted average export shares in Period 3 of the East Asia bloc were 53.7% and 49.7%, respectively.

To a large extent, the increased intraregional trade is due to fragmented regional production chains, especially in East Asia. Table 4 [ PDF 14.1KB | 1 page ] shows the trade structure in machinery and transport equipment and suggests that trade in parts and components (either exports or imports) occupies almost half of the total trade in many regions. In terms of trade dynamism, developing East Asia and the ASEAN Free Trade Area (AFTA) achieved fast growth in the share of parts and components in total trade during the period from 1989–1990 to 2005– 2006. The share of export in parts and components in total export increased by around 5 percentage points in developing East Asia and around 12 percentage points in AFTA. In terms of imports, developing East Asia, especially the PRC, has dramatically increased its share of parts and components, as shown in Table 4.

Regional trade integration may not necessarily take place at the cost of extraregional trade. In contrast, most emerging countries still depend largely on industrial countries, especially the US, for the final demand market. For example, ADB (2007) found that 61% of total Asian exports are eventually consumed in the US, Japan, and the EU and that intraregional trade dynamics are tightly associated with the US non-oil import cycle. The IMF (2007) found that, if a country's total trade with the US rises by 10 percentage points of its GDP, then the impact of a 1 percentage point increase in US growth was about a 0.1 percentage point rise in the domestic growth of the country. There is also some evidence that the magnitude of spillovers from US growth is significantly larger in those countries that are more financially integrated with the US. Spillovers have become larger over time with increased trade and financial integration. Developing Asia is affected significantly by US growth, but not by growth in Japan.

Compared with the euro area and Japan, the US has seen a larger increase in trade with emerging market and other developing countries in general, not just with countries in the Western hemisphere. Export exposure to the US—the share of exports to the US as a percentage of GDP—has generally continued to increase, even for countries where the US' share of total exports has declined, as trade openness has increased everywhere. Export exposure to the US also tends to be larger than that to the euro area and Japan, except in neighboring regions (IMF 2007).

Shin (2008) also showed that the two largest economies in East Asia (Japan and the PRC) depend heavily on the US market, 23.3% and 22.7%, respectively. Overall, Asia's reliance on external demand remains strong. Asia's export-to-GDP ratio has continued to trend upward, reaching nearly 55% of GDP in 2005 compared with the world average of 28.5%, and the incremental export-to-GDP ratio has also been on an upward trend. Although the share of G3 markets in Asia's total exports is on a decline, the relationship in growth rates rather than levels has strengthened over time. Thus, the dependence of Asian production on overseas markets strengthened rather than weakened. Decadal correlations between growth rates of US non-oil imports and Asian exports confirm that this link has been even closer in the first years of the current century (ADB 2007).

The ADB (2007) correlation analysis of the components of business cycles showed that the correlations of Asian cycles increased markedly both with each other and with the G3 cycle, between the pre- and post-crisis periods. The trend for international business cycle comovements also revealed generally high synchronicity between the Asian business cycle and the G3 cycle in the post-crisis period, after having been negative prior to the crisis.

These macroeconomic studies suggested that East Asia depends on the US and European markets through the PRC as an assembling factory base for intermediate goods from the rest of East Asia. In short, regionalization of economic activities has gained strong momentum through progress in sharing production processes across the region. Increased vertical specialization and the rise in intra-industry trade have led to strong ties among many regional economies, but this regional integration remains structurally linked to final demand from major industrial countries.

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