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Is Asia's business cycle gaining independence?

This section sets out to identify some stylized facts about Asian business cycles and examine their co-movements both within the region and with G3 business cycles. An interesting question is whether, and to what extent, the region's strong growth and tightening trade linkages have affected the dynamics of Asia's business cycles in relation to each other and to the rest of the world.

Traditionally, business cycles are characterized as periodic phases of expansion and contraction in economic activity (Burns and Mitchell 1946). In the traditional approach, the business cycle is defined over movements or changes in the level of an important economic variable, such as GDP or employment. Although recessions (defined as two consecutive quarters of contraction in GDP) have become less frequent, the business cycle approach may be used to examine changes in growth rates to understand turning points of an economy. Business cycles can be also defined as "movements about the trend" in output accompanied by "co-movements" of the deviations from the trend among different economic variables (Lucas 1977). Following modern business cycle theory, the cyclical components in economic activity can be extracted for the business cycles, using the appropriate statistical filtering techniques (Box 1.5.1).

Changing patterns of Asian business cycles

Figures 1.5.12 and 1.5.13 illustrate the movements of real GDP of Asian and G3 economies in terms of, respectively, growth rates and cyclical components. Both figures show that Asian business cycles are generally the more volatile, but also that their amplitude has narrowed visibly over time.

Judging from the patterns of growth fluctuations, Asian business cycles tend to have longer expansionary periods followed by relatively shorter but much sharper contractions than those of G3. These patterns are much more pronounced in most of the 1990s, when Asia experienced an extended period of rapid growth prior to the crisis. Strong growth, accompanied by generally positive macroeconomic indicators, also made Asia a magnet for foreign capital during this period. With more open capital markets since the early 1990s, capital inflows to the region have risen sharply, further boosting economic activity.

Interestingly, this period appears to present a case for Asia's uncoupling, since Asian business cycles seem fairly detached from those of G3 through most of the 1990s. Movements in the cyclical components paint broadly similar pictures. The relatively long of expansion followed by a sharp contraction in the 1990s is even more visible in the cyclical component. It is also clear that the upturn phase was relatively unaffected by the G3 cycle.

These patterns of Asia's business cycles have changed quite significantly in the postcrisis period. Although exhibiting still higher volatility than those in G3, Asia's business cycles have become much more stable. Even more interestingly, they resemble those of G3 in that they become more periodic in terms of upturns and downturns. A notable exception to this new pattern is the PRC: it appears to beat the business cycle by continuing robust growth regardless of ups and downs of both regional and international economies.

The visibly reduced amplitude of Asian business cycles in the postcrisis period may be attributed to the resumption of strong growth and development reinforced by a strengthened institutional framework and reforms to establish efficient financial markets in the crisis-afflicted countries. Although reforms have yet to be completed in some areas, significant progress has been made in banking supervision and regulation. Countries have made efforts to introduce more market discipline in the overall financial system, through enhanced governance and market transparency.

Better economic policies in the crisis countries may have also contributed to macroeconomic stabilization, while underpinning strong growth. Four of the five economies have adopted inflation targeting since the crisis. The first mover in this direction was the Republic of Korea in 1998, followed by Indonesia in 1999, Thailand in 2000, and the Philippines in 2001 (see Cavoli and Rajan 2006). Inflation targeting has increased the degree of freedom in foreign exchange policies to mitigate the impact of external shocks, while enhancing the effectiveness of monetary policy responding to cyclical fluctuations.

Improved fiscal positions with more effective public debt management since the crisis have also allowed room for appropriate fiscal policies. To this end, fiscal reforms are under way in many countries, especially the strengthening of institutional frameworks for public debt management and taxation, which will further enhance the functioning of automatic stabilizers.

Regional and international business cycle synchronization

Tables 1.5.2 and 1.5.3 report the correlation coefficients of the Asian business cycles with each other and with G3 for the precrisis (1983-1996) and postcrisis (1999-2006) periods. The crisis period is omitted intentionally. The previous analysis on business cycles suggests significant differences in co-movements both within Asia, and between Asia and G3, before and after the crisis. The Asian crisis is also perhaps the most significant common shock for Asia, leading to positive correlations for the crisis period. But the same event is also likely to damp the correlation between the Asian and G3 business cycles. In order to see clearly the synchronicity of Asian business cycles without the crisis effect, the correlations for the pre- and postcrisis periods are reported separately.

The correlation analysis of the cyclical components shows that the correlations of Asian business cycles increased markedly, both with each other and with the G3 cycle, between the pre- and postcrisis periods. Table 1.5.2 presents the average of the bilateral correlations between all the pairs of nine Asian economies in the sample over the two periods. If the Asian business cycles co-move, the average of the bilateral correlations would be high. A similar approach is taken to calculate the average correlations for the Asian economies excluding the PRC.

For both Asia and Asia excluding the PRC, the average correlations rose significantly. This may reflect greater intraregional integration. In both periods, the average correlation for Asia excluding the PRC is higher than that for Asia, reflecting the PRC's independent cyclical behavior from the rest of the region. Interestingly, however, the average correlation grew much faster among the Asian economies including the PRC than excluding the PRC. This clearly indicates that the PRC business cycle is increasingly moving in tandem with the rest of Asia.

Similarly, Table 1.5.3 reports the correlations between Asia and G3. Asian business cycles are much more synchronized with those of G3 in the postcrisis period. Again, the correlation between Asia excluding the PRC and G3 is higher than that between Asia and G3, and may be attributed to a generally independent business cycle of the PRC relative to G3.

In view of the PRC's generally independent dynamics, its business cycle correlations with the rest of Asia and G3 are shown in Table 1.5.4. As expected, the correlations of the PRC cycle with both regional and international economies are low, although both correlations have become positive in the postcrisis period, pointing to an increasing synchronization with those economies. This reflects the fact that the PRC's rapid growth has been driven so far largely by domestic factors: the major force has been intensive capital accumulation combined with the release of massive amounts of labor from the agriculture sector (see Woo 1998). Nevertheless, the results also suggest that the PRC is rapidly integrating with the region, while using its regional economic ties as a platform for global integration.

Figure 1.5.14 illustrates the evolution of the average correlation coefficients for Asia and for Asia excluding the PRC, using 5-year rolling windows. For example, the correlation average in 2006 is calculated as the average of the bilateral correlations for each pair of all the Asian economies over a 5-year period ending in 2006. The average correlation among the Asian economies rose sharply from nearly zero in 1991 (for the period 1987-1991) to over 0.5 in 1996 (for the period 1992-1996). The latter period largely coincides with the expansion phase of the Asian economy in the 1990s, prior to the crisis. It is noteworthy that this phase was also accompanied by strong growth in intraregional trade (Figure 1.5.8 above), reflecting rapid regional economic integration.

The correlation trend for international business cycle co-movements also confirms generally high synchronicity between the Asian business cycle and the G3 cycle in the postcrisis period (Figure 1.5.15). What is interesting here is that the correlations between Asian and G3 cycles were negative between 1993 (for the period 1989-1993) and 1995 (1991-1995). The latter period again largely coincides with the strong expansion phase in Asia. As suggested in the previous section, Asian business cycles seemed to have experienced an "uncoupling" from those of G3 during the precrisis period of rapid growth in the 1990s. Robust economic expansion and strengthening regional ties may have contributed to the region's resilience through ups and downs of the G3 business cycles.

Is this "uncoupling" in the 1990s repeating itself in the recent period? It is unclear if the same pattern is emerging on the basis of these figures. There are similarities in general economic conditions. Although registering slightly slower growth compared to the fast precrisis expansion phase in the 1990s, most Asian economies have resumed relatively strong growth since then. More importantly, it has become much more stable (as seen in the previous section). There have also been renewed increases in intra-Asian trade and regional integration. However, cyclical co-movements between Asia and G3 have visibly strengthened since the crisis, while business cycle synchronicity among Asian economies has weakened.

A simple causality test 5 between G3 and Asian business cycles shows that G3 cyclical movements precede Asia's. Table 1.5.5 reports the results of a Granger causality test between G3 and Asian business cycles for the precrisis (1983-1996) and postcrisis (1999-2006) periods. The test has been performed for both directions between G3 and Asian business cycles using quarterly data with different lags from 4 quarters (or 1 year) to 12 quarters (or 3 years). Test results are often sensitive to the number of lags used. Here the reported results are for the tests using at least a 1-year lag, because domestic factors tend to dominate business cycles in periods shorter than 1 year. Thus the transmission effect of external shocks may be offset by spurious common domestic factors.

The test results suggest that, in the postcrisis period, movements in the G3 cycle "Granger-cause" movements in the Asian business cycle at 2- and 3-year lags (but not the other way round). The results also show dramatic increases in the explanatory power and statistical significance for the direction of cyclical influence from G3 to Asia when the pre- and postcrisis periods are compared. This suggests that Asian business cycles have become more responsive to the cyclicality of G3 in the postcrisis period.

A significant departure from the 1990s' pattern may be explained by Asia's renewed export-led growth since the crisis. Despite some notable efforts to strengthen domestic demand in the postcrisis period, evidence suggests that Asia's reliance on exports for growth remains significant. Figure 1.5.16 illustrates the contribution of exports and net exports to GDP growth since the 1980s. ADB (2005) also finds that Asia's export-oriented growth strategy is sustained, if not further strengthened, in the postcrisis period, based on demand-side growth accounting. As intraregional trade is to serve external demand, not regional demand, Asia's export-led growth should result in greater interdependence between Asia and its G3 trading partners.

The dynamics of regional economic and trade integration are also evolving. To the extent that the PRC functions as an assembly and production center for the rest of Asia, the trade linkages would be more direct and stronger between the PRC and each member of the rest of Asia than the cross-relationships among the rest of Asia. Indeed, for the 5-year period 2002-2006, the average correlation for Asia including the PRC is higher than that for Asia excluding the PRC (Figure 1.5.14 above). This reflects the PRC's integration into the regional economy, facilitated by vertical specialization in the rest of Asia. With rapid technological advances, production processes can be further divided and taken up by different countries based on their comparative advantages. While vertical specialization and scale economies will continue to help raise the region's productivity, this may also leave the individual countries exposed to different subsector shocks, as well as to economic shocks originating within the region, particularly the PRC.

The correlation analysis presents positive evidence for greater synchronization among Asian business cycles. There is also clear evidence pointing to increasing business cycle synchronization between the PRC and the rest of Asia. However, a marked feature of Asia's regional integration is its global nature. In many respects, Asia's regionalization is a force behind its globalization, just as its successful integration with the global economy has been a key driver of regional integration through stimulating the region's trade and financial flows.

Recent years have thrown up no evidence pointing to Asia's uncoupling from G3 cycles. In the postcrisis period, strengthening regional ties appear to reinforce business cycle co-movements between Asia and G3. Underlying this interdependence is the structure of rising intra-Asian trade, which is centered on the PRC as a production base. The tighter intra-industry trade linkages between the PRC and each of the other Asian economies might have contributed to the higher business cycle synchronization between the PRC and the rest of Asia. But the cyclicality of the Asian economy remains sensitive to movements in G3.