Business Cycle Synchronization and Vertical Trade Integration: A Case Study of the Eurozone and East Asia

Abstract

Business cycle synchronization is an important condition for a currency union to be successful. Frankel and Rose (1998) showed empirically that increased trade would have a positive impact on business cycle correlation while acknowledging the theoretical ambiguity on the relationship. Based on their finding, they claimed that the Eurozone’s optimal currency criteria (OCA) can be satisfied ex-post. In this paper, we first investigate whether the Eurozone exhibits more synchronized business cycles since the adoption of the euro. Then, we attempt to link the business cycle synchronization with trade integration. Our new contribution is that we examine the role intra-industry trade (IIT), and vertical IIT (V-IIT), in business cycle synchronization using the data of two sets of countries, Eurozone and East Asia that have been going through distinctively different kinds of economic integration. Our main findings are as follows. First, our empirical results suggest that the business cycle correlation increased over time, in both the Eurozone and East Asia, but synchronization has been progressing much faster in East Asia. Also, with respect to trade, intra-regional trade intensity in various measures has risen in East Asia but fallen in the Eurozone in recent years, perhaps due to the rise of China as an important trade partner for Europe. Second, unlike Frankel and Rose (1998), we find that the impact of increased trade intensity on business cycle correlation is ambiguous. This could be due to the fact that trade among countries with different factor endowment – e.g. countries within East Asia, among the Eurozone’s old and new member states – may dampen the business cycle correlation via increased specialization in different industries that receive different shocks. Instead, IIT, in particular V-IIT, unambiguously increased business cycle correlation in both regions. Vertical IIT increased substantially over the last few decades in East Asia but not in the Eurozone, which is consistent with the rapid increase in business cycle correlation in East Asia.