The state of decoupling before and during the Great Recession

Abstract

This thesis examines the decoupling debate, which gained special prominence during the Great Recession years. Since the credit crunch that started in 2007 seemed initially to be contained within advanced economies, it was speculated that emerging market business cycles had decoupled from those in advanced economies. A theoretical review on business cycle comovement highlights the fact that there are many possible transmission mechanisms through which the Great Recession could have been transmitted to emerging markets. These include international trade and finance. Though the high levels of globalisation which characterised the world economy at the onset of the Great Recession meant that many of these transmission mechanisms were well established, the theory predicts unclear outcomes. For instance, while international finance could have been a channel through which the crisis was transmitted, it could also have allowed emerging markets to diversify and thereby shield themselves from the crisis. As the theory on business cycle comovement reaches no clear conclusion, so too the literature review of prior empirical studies is inconclusive. While some studies find evidence of decoupling, others find evidence of increased business cycle comovement worldwide. Using dynamic factor analysis and rolling regressions to analyse data spanning the period between 1979Q3 and 2011Q2, it is investigated whether emerging market economies did indeed decouple or not. The period covered allows for a long-run view of business cycle comovement development between emerging market and advanced economies. The analysis is carried out for 15 emerging market and 17 advanced economies, and for China as a standalone economy. Sub-Saharan African economies are also analysed. Results show that, broadly speaking, emerging market economies display increased comovement with advanced economies during the Great Recession years. This becomes evident from the decade-by-decade analysis which breaks the overall sample of 1979Q3 to 2011Q2 down into three smaller samples, each spanning roughly a decade, or forty quarters. The coupling, or greater levels of comovement, between emerging market and advanced economies, is further corroborated by rolling regressions. There are certain exceptions though, such as India and Indonesia which displayed low levels of comovement throughout the Great Recession. Australia, New Zealand and Norway are advanced economies that also displayed low levels of comovement during this time. Dynamic factor analysis and rolling regressions for China and 17 advanced economies show that the Chinese economy has also gradually coupled to advanced economies on a decade-by-decade basis, with comovement increasing toward the Great Recession years. For emerging markets as a group and for China as a standalone economy, various factors emerge as explanatory factors for the comovement seen in each sub-period. It is noteworthy however that international trade consistently stands out as an important factor. This ties in to theory on business cycle transmission which identifies trade as an important channel through which business cycle comovement is transmitted between economies. Sub-Saharan Africa is also analysed using dynamic factor analysis, though data restrictions necessitate the use of lower frequency data which cover the period between 1980 and 2011. African economies are divided into groups based on income. These groups display different patterns when it comes to comovement with the G7, as a proxy for advanced economies. For example, middle-income African countries display higher levels of comovement than other groups, indicating that they are more integrated with the global economy. Oil-exporting African countries interestingly display low levels of comovement. Low-income African countries also display lower levels of comovement than that of middle-income counterparts. Fragile African states do not appear to comove with advanced economies, but rather with other African groups. This suggests the possible existence of an „Africa factor‟ for these countries. Overall, this thesis finds that the global economy has become much more integrated since 1980. Trade has played an especially important role in fostering business cycle comovement between advanced economies and emerging markets, and between advanced economies and African economies. It is this interconnectedness which meant that decoupling was not possible during the Great Recession, barring a few exceptions.