FEDERAL RESERVE BANK OF SAN FRANCISCO WORKING PAPER SERIES This paper was presented at the conferen ce on "Emerging Markets and Macroeconomic Volatility: Lessons from a Decade of Financial Debacles" cosponsored by the Center for Pacific Basin Studies of the Federal Reserve Bank of San Francisco and the Center for International Economics at the University of Maryland and held at the FRBSF on June 4-5 2004. The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Fede ral Reserve Bank of San Francisco or the Board of Governors of the Federal Reserve System How do Trade and Financial Integration Affect the Relationship between Growth and Volatility M. Ayhan Kose International Monetary Fund Eswar S. Prasad International Monetary Fund and Marco E. Terrones International Monetary Fund May 2004 Working Paper 2004-29 http://www.frbsf.org/publicati ons/economics/p apers/2004/wp04-29bk.pdf Preliminary How Do Trade and Financial Integration Affect the Relationship between Growth and Volatility? M. Ayhan Kose, Eswar S. Prasad and Marco E. Terrones 1 May 31, 2004 Abstract The influential work of Ramey and Ramey (1995) highlighted an empirical relationship that has now come to be regarded as conventional wisdom—that output volatility and growth are negatively correlated. We reexamine this relationship in the context of globalization—a term typically used to describe the phenomenon of growing international trade and financial integration that has intensified since the mid-1980s. We employ various econometric techniques and a comprehensive new dataset to analyze the link between growth and volatility. Our findings suggest that, while the basic negative associ ation between growth and volatility has been preserved during the 1990s, both trade and financial integration attenuate this negative relationship. Specifically, countries that are more open to trade appear to face a less severe tradeoff between growth and volatility. We find a similar, although slightly less robust, result for the interaction of financial integration with volatility. We also investigate some of the channels, including investment and credit, through which different aspects of global integration could affect the growth-volatility relationship. 1 International Monetary Fund, 700 19th Street, N.W., Washington D.C. 20431 [email protected]; [email protected]; [email protected] We thank Olivier Jeanne, Andy Rose, Carlos Vegh, and Kamil Yilmaz for their useful suggestions. We thank Smita Wagh for excellent research assistance. The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF. - 2 - I. Introduction The influential work of Ramey and Ramey (1995) highlighted an empirical relationship that has now come to be regarded as conv entional wisdom—that volatility and growth are negatively correlated. This is an important result since it implies that policies and exogenous shocks that affect volatility can also influence growth. Thus, even if volatility is considered intrinsically a second-order issue, its relationship with growth suggests that volatility could indirectly have first-order welfare implications. How do trade and financial in tegration affect the relationship between growth and volatility? In this paper, we attempt to answer this question, which has taken on increasing importance in view of the significant increases in the volumes of international trade and financial flows over the last four decades. While cross-country trade linkages have been rising steadily over the last four decades, there has been a s ubstantial increase in cross-border capital flows among industrial economies and across industrial and developing economies since the mid- 1980s. However, while the spread of trade linkages has been more broad-based, only a relatively small group of developing economies, often referred to as “emerging markets,” have undergone significant financial integration, as measured by gross capital flows across their borders. 2 Many of these economies have experienced high growth but have also been subject to high volatility, most prominently in the form of severe financial crises that befell many of them during the last decade and a half. These developments naturally lead to the question of whether, in a more integrated global economy, the relationship between growth and volatility has changed. More specifically, do the high growth rates in emerging markets that are presumably partly fueled by financial flows come at the cost of higher volatility associated in pa rt with the vagaries of international trade and financial flows? The change over time in the relative vulnerability of industrial and developing economies to external crises also raises questions about whether the growth-volatility relationship is influenced by the “growing pains” seemingly associated with rising trade and financial integration. In other words, are the level of a country’s development and the extent of its integration into internationa l markets important in determining the conditi onal validity of this 2 For an extensive documentation of changes in the volume of international financial flows, Lane and Milesi-Ferretti (2001, 2003), and Kose, Prasad, and Terrones (2004). - 3 - relationship? In this context, while there appears to be a general consensus that openness to trade flows stimulates domestic growth, it also appears to be the case that such openness increases vulnerability to external shocks, including highly volatile terms of trade shocks. The effects of financial integration are less obvious. Clearly, a more detailed analysis of this question is therefore warranted. In addressing the question stated in the title , our paper has two main objectives. First, we explore how this relationship has been influenced by different aspects of globalization. The Ramey and Ramey results, which have become the benchmark in this literature, are based on a dataset that ends in 1985, just when the pace of globalization began to pick up and enveloped a number of developing countries as well. Some recent papers show that the negative relationship between growth and volatility has persisted into the 1990s. 3 However none of these papers provide a rigorous analysis of the role of rising tr ade and financial linkages in influencing this relationship. Financial globalization, in particular, is likely to have been an important factor influencing this relationship during the past twenty years, especially as increased international financial flows appear to have precipitated sudden episodes of high volatility in many developing economies. A central contribution of this paper is a comprehensive analysis of the roles of both trade and financial integr ation in driving the grow th-volatility relationship. Understanding the channels through which vol atility could potentially influence growth is also of considerable interest. A related issue is whether there are common f actors that affect both growth and volatility and how these common factors interact with the forces of globalization in accounting for the empirical link between volatility and growth. Thus, the second objective of this paper is to provide a comprehensive analysis of such determinants, including investment, credit growth, development of domestic financia l sector, and the quality of institutions. The impact of these common factors on influencing th e individual dynamics of growth and volatility has been examined in some recent papers, which are discussed in the next section. However, our understanding of these factors along with the role played by increased international economic linkages in explaining the relationship be tween growth and vola tility is quite limited. 3 Fatas (2003) and Loayza and Hnatkovska (2003) update the regressions in Ramey and Ramey (1995) using recent data and find that the negative relationship between growth and volatility is preserved. - 4 - In section II, we present a review of recent studies analyzing how globalization affects growth and also how it affects volatility. In addition, we provide a summary of several theoretical and empirical studies focusing on the relationship between growth and volatility. This survey suggests that neither theoretical studies nor empirical ones have rigorously examined the effects of increased trade and financial linkages on the growth-volatility relationship. In section III, we describe the dataset used in the analysis. The main features of the dataset are that is has a broad coverage, comprising 85 countries, both industrial and developing, and annual data over the period 1960–2000. Another important feature of this dataset is that it includes a comprehensive set of measures of trade and financial integration for these countries. In section IV, considering the important implicati ons of the timing of the intensification of trade and financial linkages across national economies for our main question, we document some empirical evidence about the impressive growth of these linkages over the past four decades. In section V, we provide a variety of stylized facts about the changes in the dynamics of growth and volatility over time and across countries. We detect a number of interesting patterns in the relationship between grow th and volatility, which has been changing over time and across different country groups. We also use an event study approach to examine how growth and volatility change before and after trade and financial liberalizations. Both types of liberalizations are typically associated with increases in output and investment growth, but the changes in the volatility of output and consumption growth afte r such liberalization programs do not follow a clear pattern. This sets the stage for the more formal empi rical analysis in section VI, where we use various regression models to analyze the determinants of the growth-volatility relationship. We first examine the empirical validity of the main Ramey-Ramey result when data for the post- 1985 period, which was a turbulent period for many developing economies, are included in the analysis. We find that the basic empirical result of a negative cross-sectional association between volatility and growth holds up even in the 1990s. More importantly, however, we find that the result is sensitive to the choice of country groups. For example, the results indicate that, while there is a significant positive relationship among industrial countries, the relationship is significantly negative among developing countries. Moreover, the association between growth and volatility in developing countries depends on the extent of financial integration. In more