International Interdependence and Business Cycle Transmission between Turkey and the European Union

Abstract

1. Introduction Because of globalization and the Asian financial crisis, interest in the international linkages and economic comovements between different regions of the world has recently heightened. One economic relationship of particular interest is the relationship between Turkey and its European neighbors. This relationship is important because of Turkey's European orientation and because of Turkey's long-held ambition of joining the European Union (EU). In view of this situation, we examine the linkages and comovements of outputs, prices, interest rates, and money supplies between Turkey and Europe. The main question we address here is, Do the Turkish and European economies move together through time? That is, are their business cycles synchronized? Three related questions are, How or why does this synchronization or comovement take place? Is there any evidence of business cycle transmission between the European economies and Turkey? Have these comovement relationships changed over time? To address these questions, we gathered statistics on macroeconomic variables, trade linkages, capital flows, and historical economic events. For most of the analysis, Germany, Turkey's largest trading partner, is used as a proxy for the EU nations. Because of the limited period of availability of the quarterly data, we examine the relationship using both annual and quarterly data. Using annual data for 1956-1998 and quarterly data for a shorter period, from the first quarter of 1981 through the fourth quarter of 1998, we calculate correlations between macroeconomic variables for Turkey and Germany and perform principal-components analysis, tests of cointegration and Granger causality, and a structured vector autoregression (SVAR)-impulse response analysis using the method of Bernanke (1986) and Sims (1986). The synchronization issue is investigated through the use of the graphs, correlations, and principal-components analysis. The transmission issue is investigated through the use of the Granger causality tests and SVAR-impulse response analysis. Our results show that the business cycle patterns of Turkey and Europe are quite different; indeed, in some cases they appear to be almost 180 out of phase. In many cases the correlations between the real growth rate of Turkey and those of the EU countries are statistically insignificant. Principal-components analysis reveals a large difference between fluctuations in Turkey and those in the EU countries. Associated regressions also show a surprisingly insignificant relationship between the real GDP growth rates for Turkey and the EU and between those for Turkey and Germany. However, the SVAR-impulse response analysis reveals a modest positive transmission from Germany to Turkey. Our conclusion is that although Turkey and Europe will obviously both benefit from participation in a free trade relationship with each other (see Harrison, Rutherford, and Tarr 1997), because of the absence of synchronization between Turkey and the EU, it appears that Turkey would incur serious stabilization costs if it were to participate in the European Monetary Union. In addition to the transaction benefits of participating in an optimal currency area, there are economic stability losses incurred by a country joining an optimal currency area. Economic costs arise because a country joining an optimal currency area loses its ability to implement an independent exchange rate and monetary policy for income and unemployment stabilization (see Krugman and Obstfeld 2000). Hence, countries out of sync with the rest of the countries in the group will be continuously affected by inappropriate monetary policy. Turkish business cycle fluctuations do not display the similarity with European business fluctuations that would make it beneficial for Turkey to be a part of the European Monetary Union at this time.1 On the other hand, dissimilarity in business cycles might make it profitable for European investors to invest in Turkey for purposes of diversification. …