Sources of emerging market business cycles: an open-economy factor-augmented VAR approach

ABSTRACT

This paper constructs an open-economy factor-augmented VAR model to assess the dynamic effects of global shocks on emerging market economies and to quantify their relative importance in explaining macroeconomic fluctuations in emerging countries. An unexpected favourable shock to global demand and supply has a strong and positive effect on emerging markets, whereas an unanticipated rise in global interest rates and commodity prices leads to a significant decline in aggregate activity. Variance decomposition analysis implies that more than 80% of the variation in emerging market output growth can be attributed to the global shocks. In particular, the global demand shock is the most critical, explaining roughly 30% of the fluctuation in output growth. The global supply shock is closely associated with the medium-to-long-term variation in output growth, explaining about 17%, whereas the monetary policy and commodity price shocks are relatively relevant for the short-term variation, explaining about 20% respectively.

KEYWORDS:

• Emerging market economies
• global shocks
• factor-augmented VAR

JEL CLASSIFICATION:

• C11
• C32
• F41
• F44

Disclosure statement

The views expressed in this paper do not necessarily reflect those of the National Pension Service or the National Pension Research Institute.

Notes

¹ The classification of the developed and emerging countries is based on the IMF and Morgan Stanley, broadly consistent with Mandalinci and Mumtaz (2019) and Bhattarai, Chatterjee, and Park (2020). China is excluded in emerging markets due to its significant role for the world economy.

² The real GDP and industrial production are seasonally adjusted and expressed by yearly percentage changes.

³ The main source of real GDP data for emerging countries is the OECD database, complemented with the data from the national statistics agency and the central bank for each country.

⁴ Akaike information criterion suggests the lag length to be $\mathit{p}=5$, but the results are largely robust to different lag-length choices.

⁵ To examine the question of potential heterogeneity in the effects of global shocks on emerging markets, we conduct subgroup analysis as follows. Motivated by Kose, Otrok, and Whiteman (2003) and Bhattarai, Chatterjee, and Park (2020), we first divide emerging countries into two groups based on the structural characteristics of economies, such as per capita GDP, commodity dependence in export, manufacturing’s share of output, and current account balance, respectively. We then extract common component for each group, estimate the FAVAR model using the same identification as in the baseline, and compare impulse response functions between the subgroups. We find that although the results quantitatively differ slightly, they are qualitatively similar and there is no statistically significant difference.

⁶ Following the suggestion by Sims and Zha (1999), we use the 68% credible intervals corresponding to one-standard-error bands, which is common practice in reporting VAR estimates of structural impulse responses. For robustness checks, we additionally calculate the 90% credible intervals and find that the overall results still remain valid.

⁷ This finding is consistent with the recent study of Feldkircher and Huber (2016) showing the substantial spillover effects of US aggregate demand and supply shocks on international output.

⁸ Canova (2005) and Maćkowiak (2007) also find that US monetary policy shocks have strong and negative effects on emerging market economies through the interest rate and exchange rate channels. In a recent year, Dedola, Rivolta, and Stracca (2017) show that an increase in US interest rates depreciates a local currency in most countries and declines industrial production and real GDP, driving them into recession.

⁹ Fernández, Schmitt-Grohé, and Uribe (2017), Drechsel and Tenreyro (2018), and Fernández, González, and Rodríguez (2018) similarly emphasize the importance of commodity price shocks for emerging market business cycles, but their commodity price shocks differ from ours in that they do not separate specific shocks driving world commodity prices such as supply or demand shocks.