Business cycle synchronization within the Euro area: disentangling the effects of FDI

ABSTRACT

In this paper, we contribute to the business cycle synchronization literature by investigating a disaggregated level of foreign direct investment (FDI) that has been systematically overlooked by previous empirical studies. We disentangle FDI into two layers – extensive and intensive FDI margins – and examine their effects on the synchronization of the European Union member states with the euro area (EA) in the period 2000–2019. Our analysis, performed using the simultaneous equations methodology, confirms the over-aggregation bias, as more intense existing FDI (the intensive FDI margin) boosts synchronization, whereas new FDI (the extensive FDI margin) seems to compete with the creation of an optimum currency area within the EA. Furthermore, our results suggest that new investment promotes specialization, whereas more intense FDI reduces it, because the deepening of already existing FDI occurs in countries with similar business cycles and industrial structures.

KEYWORDS:

• Business cycles
• synchronization
• monetary union
• FDI margin
• simultaneous equations model

JEL CLASSIFICATION:

• E32
• F15
• F36

Disclosure statement

No potential conflict of interest was reported by the author(s).

Supplementary material

Supplemental data for this article can be accessed here.

Notes

¹ Due to the unavailability of bilateral margin data, we examine synchronization using the EA reference business cycle, which represents a generally accepted approach.

² We apply a five-year rolling window transformation to eliminate redundant fluctuations and noise in the time series (such as the Great Recession in 2008–2009), potentially biasing our results. We also estimate the SEM for the full sample 2000–2019, including the crisis in 2008–2009 and the model for the sample excluding this crisis. The results provided in Table A7 in the online appendix as part of a robustness check are qualitatively similar to both samples and thus robust.

³ To allow for heterogeneity among the considered countries, we also provide the estimation results for two sub-groups – EU members that use the common currency (‘euro sample’) and EU members that have not adopted the common currency (‘non-euro sample’) – as part of the robustness check in the online appendix (see Table A7). The negative effect of total FDI and the extensive FDI margin on the one hand and the positive effect of the intensive FDI margin on synchronization on the other remain qualitatively similar and thus robust.

Additional information

Funding

This work was supported by the Scientific Grant Agency VEGA under Grant No. 1/0394/21.