VOL. 4, NO. 5, December 2015 ISSN International Journal of Economics, Finance and Management All rights reserved.

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1 Inernaional Journal of Economics, Finance and Managemen All righs reserved. hp:// Exernal Cyclicaliy in he Face of Aggregae Demand Shocks: Pros and Cons across Developed and Developing Counries Magda Kandil Cenral Bank of he Unied Arab Emiraes (CBUAE), Abu Dhabi, Unied Arab Emiraes ABSTRACT Using daa for a sample of advanced and developing counries, he paper sudies variaion in he effecs of aggregae demand shocks on he exernal secor and underlying componens and disinguishes beween he effecs of expansionary and conracionary shocks. The aim is o sudy he deerminans and implicaions of cyclicaliy across represenaive counries in each group. The composie evidence poins o high degree of cyclicaliy in many counries. Based on imeseries correlaions, here is a sronger cyclical co-movemen beween he rade and curren accoun balances across advanced counries, compared o developing counries. Furher, flucuaions in he financial balance are dependen on developmens in expors in many developing counries. The deerminans of exernal vulnerabiliy vary wih macroeconomic indicaors. The evidence poins o higher vulnerabiliy of he exernal balance wih respec o higher rend inflaion across developing counries. In addiion, consrains on capaciy in developing counries could risk exernal sabiliy as rend growh increases across counries. Governmen spending is an imporan deerminan of exernal sabiliy in developing counries, reflecing he adverse implicaions of higher governmen spending and a widening fiscal defici on deb susainabiliy and exernal financial flows. Furher, privae consumpion is a key driver of aggregae uncerainy and cyclical flucuaions in he exernal balances across developing counries. Keywords: Cyclicaliy, demand shocks, financing, crowding ou, supply consrains, developing and advanced counries. 1. INTRODUCTION Cyclical downurns could have adverse effecs on he rade and financial balances of he balance of paymens. Exernal balances are deermined by expors and impors, which primarily deermine he rade and curren accoun balances. Furher, he financial exernal balance is primarily deermined by FDI and porfolio flows. I is expeced ha rade and exernal balances vary wih he business cycle. During booms, expors and impors may increase. The ne effec on he rade and curren accoun balances will depend on he relaive elasiciy of expors and impors o he business cycle. Furher, i is likely ha financial inflows increase in response o improved economic condiions. Demand elasiciies or consrains on he supply side may differeniae he expansionary and conracionary effecs of shocks o aggregae demand. Furher, macroeconomic policies could exacerbae (pro-cyclical) or miigae (couner-cyclical) he effecs of aggregae demand shocks on he macro economy. The aim of his research is o sudy variaion in he effecs of aggregae demand shocks on he exernal balances and major underlying componens and disinguish beween he effecs of expansionary and conracionary shocks. Higher inflaion is likely o undermine compeiiveness and he prospec of improved exernal balances during an economic boom. In conras, spending on invesmen conribues o capaciy building and eases consrains on he supply side. Hence, invesmen spending simulaes real oupu wih lile inflaionary effecs. Through his channel, he exernal balances are likely o improve during economic booms. Macroeconomic policies could furher help exernal compeiiveness if argeing higher growh and less inflaion. The daa under invesigaion are for a sample of 29 advanced counries and 19 developing counries beween 1963 and Esimaion coefficiens will measure he effecs of flucuaions in aggregae demand on expor growh, impor growh, he rade balance, he curren accoun balance, FDI flows, porfolio flows and he financial balance. The evidence will inform policy makers on how o capialize on exernal openness o simulae he economy and ensure he bes resuls for economic performance and exernal sabiliy, wihou unduly exacerbaing macroeconomic imbalances and subsequen adverse effecs on he economy. The composie evidence poins o high degree of cyclicaliy in he underlying componens of exernal balances in many counries. The correlaion beween he rade and curren accoun balances is sronger across advanced counries, compared o developing counries. In addiion o he rade balance, oher componens of he curren accoun balance are equally imporan o exernal sabiliy in many developing counries. Flucuaions in he financial balance are dependen on developmens in expors in many developing counries, signifying he need for exernal financing. The deerminans of cyclicaliy in exernal sabiliy also provide sharp conrass across he wo counry groups. The evidence poins o higher vulnerabiliy of he exernal balance wih respec o higher rend inflaion across developing counries. In addiion, consrains on capaciy in developing counries could risk exernal sabiliy as rend growh increases across counries. Governmen spending is an imporan deerminan of exernal sabiliy in developing counries, reflecing he adverse implicaions of higher governmen spending and a widening fiscal defici on deb 171

2 Inernaional Journal of Economics, Finance and Managemen All righs reserved. susainabiliy and exernal financial flows. Furher, privae consumpion is a key driver of aggregae uncerainy and cyclical flucuaions in he exernal balances across developing counries. hp:// 2.1 Demand-Side Asymmery The size of he aggregae demand shif may be differen wih respec o he specific underlying expansionary and conracionary shocks. The remainder of he paper is organized as follows. Secion II provides heoreical background. Secion III describes he empirical mehodology. Secion IV discusses he implicaions of he ime-series evidence. Secion V analyzes co-movemens in he cyclical responses of macro variables o aggregae demand shocks across he groups of developing and advanced counries. Secion VI analyzes deerminans of cyclicaliy in he exernal balances and underlying componens across he wo counry groups. Secion VII offers a summary and conclusion 2. THE ASYMMETRIC EFFECTS OF AGGREGATE DEMAND SHOCKS The empirical invesigaion will separae shocks o aggregae demand ino posiive and negaive componens o sudy possible asymmeric effecs on he macro-economy over he business cycle. This secion oulines he heoreical argumens regarding he deerminans of asymmery in he face of variaion in aggregae demand. Asymmeric cyclical flucuaions may be a funcion of condiions on he demand and/or supply-side of he economy (Kandil, 1995, 1996, 1998, and 1999; Karras, 1996a, b; Apergis e al., 2005). To illusrae, consider he following reduced-form equaion: D(.) is he firs-difference operaor. The log of expors is denoed by x where denoes he log value of impors. Aggregae demand shocks comprise disribued lags of posiive and negaive shocks, posd j negd j. The difference beween d pvj (1) and and d measures asymmery in each variable s response o nvj he specific shocks underlying aggregae demand. The β parameers vary in response o wo facors: a. The size of aggregae demand shifs in he face of he specific underlying shock; and/or b. Condiions on he supply side ha deermine capaciy consrains and price flexibiliy in he face of aggregae demand shifs. Two facors deermine he size of aggregae demand shifs wih respec o he underlying shocks. Firs, binding liquidiy consrains may differeniae he effecs of demand shocks on financial markes. Access o credi is necessary o finance higher spending. Given he limied supply of available loanable funds above maximum capaciy, an increase in spending raises he ineres rae. An increase in he cos of borrowing couners demand expansion in he face of a simulus policy. 1 Consrains on capaciy in he labor and produc markes increase crowding ou and he probabiliy of asymmery in demand shifs in he face of equal underlying expansionary and conracionary shocks. 2.2 Supply-Side Asymmery Condiions on he supply side in he labor and/or produc markes may differeniae he slope of he aggregae supply curve in he face of expansionary and conracionary demand shifs. New Keynesian heoreical models have focused on marke imperfecions owards an explanaion of a kinked-supply curve. The source of asymmery has varied beween sicky-wage and sickyprice explanaions of business cycles. Sicky-wage models have raced sources of cyclical flucuaions o condiions in he labor marke (see, e.g., Gray (1978)). Implici or explici labor conracs may offer an explanaion of sicky wages. Given nominal wage rigidiy, an unanicipaed increase in price, in response o a posiive demand shock decreases he real wage and increases he oupu supplied in he shor-run. Condiions in he labor marke may differeniae, however, upward and downward nominal wage flexibiliy in he face of expansionary and conracionary demand 1 The unfolding deb crisis in Europe provides a clear illusraion of how he increase in governmen spending financed by higher cos of borrowing resuls in a ballooning defici ha demands ever increasing risk premium. The end resul is unsusainable public finances ha undermine he effeciveness of governmen spending o simulae growh and crowd ou privae aciviy. As governmen deb builds up wih fiscal expansions, Miller e. al. (1990) argues ha he moneary risk of defaul or increasing inflaion risk will reinforce crowding ou effecs hrough ineres raes. This explanaion was advocaed in view of he evidence of expansionary fiscal conracions, see, e.g., Giavazzi and Pagano (1990), and Alesina and Peroi (1995). In his environmen, he risk on exernal sabiliy is higher in ligh of higher defici, higher cos of borrowing and higher inflaion. 172

3 Inernaional Journal of Economics, Finance and Managemen All righs reserved. shocks. 2 Implici or explici conracual wage agreemens may esablish ha nominal wage flexibiliy is asymmeric. Asymmeric nominal wage flexibiliy may be he resul of insiuional seings which differeniae wage and salary negoiaions in he upward and downward direcions. 3 Alernaively, he asymmeric flexibiliy of nominal wages maybe an endogenous response o aggregae uncerainy. 4 More upward flexibiliy of he nominal wage o posiive demand shocks promps insananeous increase of wages. The upward flexibiliy of he nominal wage moderaes he increase in oupu growh in he face of expansionary demand shocks. Consequenly, higher demand will be refleced in a higher cos of he oupu produced and, in urn, higher prices. In conras, if nominal wages are more downwardly rigid, relaive o prices, he real wage increases. Higher real wage increases he cos of he oupu produced, exacerbaing oupu conracion and moderaing price deflaion. Accordingly, asymmeric nominal wage adjusmen implies a seeper supply curve in he face of expansionary demand shifs, compared o conracionary shifs. Sicky-price explanaions have isolaed oupu flucuaions in he shor-run from condiions in he labor marke. 5 Menu coss limi he frequency of adjusing prices over ime. These are he coss involved in implemening and announcing a price change. Given price rigidiy, firms resor o adjusing oupu in he shor-run in response o unanicipaed demand shifs. Condiions in he produc marke may esablish, however, ha prices adjus asymmerically in he face of demand shocks. 6 hp:// Posiive rend inflaion plays a key role in inroducing asymmeries. Inflaion causes firms relaive prices o decline auomaically beween adjusmens. This requires greaer adjusmen of firms desired price in he face of posiive shocks, compared o negaive shocks. When a firm wans a lower relaive price in he face of negaive demand shocks, inflaion does much of he work, decreasing he need o pay he menu coss o adjus prices. By conras, a posiive demand shock means ha he desired relaive price increases while acual price is falling on accoun of high rend inflaion, creaing a large gap beween desired and acual prices. As a resul, posiive shocks are more likely o induce a larger price adjusmen, compared o negaive shocks. Asymmeric price adjusmen implies ha shifs in aggregae demand have asymmeric effecs on oupu. Since prices are sicky downward, a fall in aggregae demand is absorbed in oupu conracion. Higher upward flexibiliy of prices moderaes he oupu increase in response o expansionary demand shocks. Accordingly, asymmeric price adjusmen implies a seeper supply curve in he face of expansionary demand shifs, compared o conracionary shifs. 3. EMPIRICAL FRAMEWORK The empirical model comprises reduced-form equaions explaining expor growh and impor growh as well as he change in financial flows, FDI and porfolio flows. The rend componen of he series is he domain of real growh facors ha vary wih labor, capial and echnology. The resuls indicae ha his componen is non-saionary. 7 To accoun for non-saionariy, empirical models are esimaed in firs-differenced form. 2 See, e.g., Kandil (2002a, b). 3 During boom periods, cos of living adjusmens may be specified o guaranee workers an upward adjusmen of wages o keep up wih inflaion. In conras, firms may be relucan o ake aggressive measures owards adjusing nominal wages in he downward direcion during recessionary periods. This is because he search and raining cos of hiring new workers o accommodae a fuure rise in demand may acually exceed he perceived loss of reaining workers a wages ha exceed he marginal physical produc of labor during recessionary periods. 4 Models of he variey of Gray (1978) have emphasized he dependency of he degree of indexaion on he variabiliy of sochasic disurbances. In a siuaion where posiive and negaive shocks are no equally variable, agens incenives for he opimal degree of indexaion would be asymmeric. 5 See, e.g., Ball e al. (1988). 6 See, e.g., Ball and Mankiw (1994). Flucuaions in he esimaed dependen variables are aribued o a variey of shocks impinging on he economic sysem. Assume aggregae demand shocks are disribued symmerically around an anicipaed seady-sae average of growh over ime. This rend is consisen wih capaciy uilizaion in he economy and varies wih agens forecass of he deerminans of aggregae demand in equilibrium. Shocks o aggregae demand develop randomly around he forecased rend and deermine cyclicaliy in oupu growh and price inflaion. 7 The es follows he suggesions of Nelson and Plosser (1982). Based on abulaion provided by Dickey and Fuller (1981), he dependen variables in he empirical model are non-saionary in level and saionary in firsdifference. Noneheless, here is no evidence of join coinegraion beween he non-saionary dependen variable and explanaory variables. Hence, he empirical model does no accoun for an error correcion erm on he righ hand side of he equaion. 173

4 Inernaional Journal of Economics, Finance and Managemen All righs reserved. Aggregae demand varies wih he major deerminans of public and privae spending: governmen spending on consumpion, privae consumpion, and invesmen. To accoun for ineracion wih he res of he world, he model specificaion also includes he exchange rae. Accordingly, he empirical model is specified as follows: Dx Di E 0 y 3yp 0 p 3 pp 1y posd E 1p posd 1 1 Dd E 3yn Dd 3 pn negd negd 2 y 2 p 1 E 1 Dh 4 yp Dh 4 pp posh posh 4 yn 4 pn hp:// negh negh D(.) is he firs-difference operaor. Real expor growh is denoed by Dx while Di denoes impor growh. E(.) is he expeced value of a given variable a ime, based on informaion available o agens a ime EDd denoes anicipaed growh of aggregae demand. Anicipaed demand growh and currency movemen deermines planned demand for expors and impors and, herefore, producion and consumpion plans. Expansionary and conracionary shocks o aggregae demand are approximaed by posd and negd. Random shocks may have asymmeric effecs as producers and consumers may behave differenly wih respec o unforeseen developmens, boh domesically and exernally. i x (2) (3) Expansionary aggregae demand shocks increase demand and income. The resuling increase in money demand raises he ineres rae wih crowding ou effecs on aggregae demand. If he ne resul is posiive, expansionary demand shocks increase price inflaion and oupu growh. Through he income channel, economic expansions are likely o have a posiive effec on consumpion and, herefore, impor growh. The effecs on invesmen spending will depend on he relaive effecs of demand expansion on income and he ineres rae. If he income channel dominaes invesmen demand increases during economic expansion. Higher invesmen is likely o induce higher increase in expors and impors. Srucural parameers deermine he ne effecs of currency flucuaions on oupu and price. 9 Several channels are involved ha affec expor compeiiveness and he cos of inermediae impors for producion. The relaive srenghs of hese channels deermine he ne effecs on he exernal balance. To measure flucuaions in exernal balances in response o aggregae macroeconomic flucuaions, he empirical models in (2) and (3) are replicaed o esimae he change in he rade balance, Dbal, he change in he curren accoun balance, DCA, he change in porfolio financial flows, DPOR, he change in FDI flows, DFDI, and he change in he financial balance, DFBAL. Deails of he esimaion procedure and he approach followed o consruc empirical proxies for explanaory variables are available in Appendix A. 10 Counry-specific aggregae demand shocks provide a composie measure of a variey of shocks impinging on he economic sysem. However, o capure specific channels of openness o rade and financial flows, he empirical model accouns for a specific measure of exernal compeiiveness. The exchange rae measures he real price of he domesic currency relaive o a weighed average of currencies for major rading parners. An increase indicaes anicipaed currency appreciaion, EDh. Posiive shocks o he exchange rae, posh, are unexpeced appreciaion of he domesic currency. Similarly, negh approximaes unexpeced depreciaion of he domesic currency. The erms, and p are random unexplained residuals wih zero mean and consan variance. 8 By consrucion, anicipaed changes of variables on he righ hand-side of he empirical models are funcion of lagged variables in he economic sysem, which capure persisence in adjusmens over ime. Having accouned for his persisence, only conemporaneous shocks appear in he model. y 4. TIME-SERIES RESULTS Tables A1 and A2 of he appendix summarize he resuls of esimaing he empirical models in (1) and (2). 11 The models are esimaed using individual counry ime-series daa o provide evidence of cyclicaliy or lack hereof which will inform furher analysis of variaion across counries. 12 The models are esimaed for expor growh, and impor growh. In addiion, he resuls from replicaing he 9 For a deailed heoreical illusraion, see Kandil and Mirzaie (2002). 10 The empirical models are esimaed using annual daa. The effecs of aggregae demand shocks on he economy usually involve longer ransmission lag ha is beer capured using annual daa. Quarerly daa are no adequaely available o esimae he model using disribued lags. 11 The evidence summarizes variables responses o aggregae demand shocks. Oher deailed esimaes are available upon reques. 12 Pooling he ime-series daa disguises counry-specific evidence which conradics he objecives of he empirical invesigaion. 174

5 Inernaional Journal of Economics, Finance and Managemen All righs reserved. empirical models for he rade balance, he curren accoun balance, porfolio flows, FDI flows and he financial balance are also repored. The evidence disinguishes beween cyclical responses during booms and recessions which will se he sage for furher analysis of asymmery in he cross-secion regressions regarding co-movemens in cyclicaliy across economic variables and he major deerminans of his cyclicaliy. 4.1 Time-Series Evidence: Developing Counries, Table A1 of he appendix presens he evidence of cyclicaliy in he exernal balance and underlying componens. Counries are able o capialize on developmens in he business cycle o mobilize expors. During an economic boom, an increase in aggregae demand simulaes expor growh in 11 counries. During a cyclical downurn a decrease in aggregae demand riggers a reducion in expor growh in 9 counries. Impor growh also varies closely wih cyclicaliy in aggregae demand. Expansionary aggregae demand shocks simulae impor growh in 6 counries. During cyclical downurn, conracionary demand shocks decrease impor growh in 6 counries. The rade balance could be flucuaing wih aggregae demand condiions, reflecing cyclicaliy in expors and impors. An expansionary shock o aggregae demand improves he rade balance in 1 counry. The reducion in aggregae demand worsens he rade balance in 1 counry. The limied pervasive suppor o flucuaions in he rade balance wih cyclicaliy in aggregae demand indicaes offseing channels on impors and expors in many counries. hp:// capial flows or he financial balance wih cyclicaliy in aggregae demand. 4.2 Across Advanced Counries Table A2 of he appendix presens he evidence of cyclicaliy in exernal balances and underlying componens. The impac of demand flucuaions on expor growh appears o be more pervasive across advanced counries, compared o developing counries. Expor growh increases wih aggregae demand shocks during economic booms in 13 counries. Similarly, expor growh slows down wih conracionary shocks o aggregae demand in 14 counries. Impors also vary wih he business cycle in many advanced counries. Expansionary demand shocks simulae impor growh in nine counries. Conracionary demand shocks slowdown impor growh in 19 counries. The evidence aess o he imporance of demand flucuaions o cyclicaliy in impor growh, which appears more responsive during a cyclical downurn. The limied significance and mixed direcions aes o offseing channels of aggregae demand flucuaions on he rade balance in many advanced counries. The rade balance improves significanly during periods of economic expansion in six counries. Similarly, deerioraion in he rade balance during cyclical downurns is limied o hree counries. Offseing channels also render he effecs of cyclical flucuaions on he curren accoun balance mosly insignifican. The curren accoun balance improves significanly in hree counries during economic expansions and decreases significanly in one counry during cyclical downurns. Flucuaions in he curren accoun balance may also vary wih aggregae demand condiions, alhough wih limied saisical significance. An increase in aggregae demand improves he curren accoun balance in 1 counry. A slowdown in aggregae demand worsens he curren accoun balance in 2 counries. FDI flows could also vary wih cyclicaliy in aggregae demand, alhough wih limied saisical significance. An increase in aggregae demand may improve he oulook for invesmen reurn, inducing more FDI inflows. In suppor of his hypohesis is he increase in FDI flows in one counry, where a booming economy aracs FDI flows ino he energy secor. Similarly, a slowdown in aggregae demand decreases FDI flows in four counries. Porfolio capial flows may also be dependen on domesic economic condiions. An increase in aggregae demand simulaes demand for credi and increases he cos of borrowing, aracing capial inflows in one counry. The limied saisically significan evidence does no provide srong suppor o flucuaions in porfolio There is no significan evidence of cyclicaliy in FDI flows during economic booms. Demand conracion slows down FDI in one counry only. The limied significan evidence isolaes FDI flows from cyclicaliy in economic condiions, aesing o robus srucural reurn on FDI ha appears o be guiding flows over ime. The significan evidence is also limied regarding flucuaions in porfolio flows wih he business cycle. No significan increase in porfolio flows is eviden during economic booms. The reducion in porfolio flows is significan during recessions in hree counries. The evidence furher confirms robus srucural reurn on porfolio flows in advanced counries. The financial balance improves significanly during cyclical booms in hree counries. Deerioraion in he financial balance is significan during cyclical downurns in five counries. The limied significan evidence is consisen wih he pervasive a-cyclical responses of FDI and porfolio flows in he majoriy of counries under invesigaion. 175

6 Inernaional Journal of Economics, Finance and Managemen All righs reserved. 5. CO-MOVEMENT BETWEEN TIME- SERIES RESPONSES Having reviewed cyclicaliy wih respec o aggregae demand shocks, he analysis urns o an evaluaion of co-movemen in he cyclical responses across variables based on significan correlaion coefficiens. Correlaions will esablish he ransmission channels of cyclicaliy across he macro economy and possible asymmery in hese channels over he business cycle. Tables 1A and 1B presen co-movemens in cyclicaliy during booms and recessions across developing counries where Tables 2A and 2B presen he evidence across advanced counries. 5.1 Across Developing Counries During a boom, he correlaion beween he cyclical responses of FDI flows and porfolio flows are negaive and significan. Counries ha arac more FDI flows are usually less aracive for ho porfolio inflows. FDI flows are araced o an environmen ha is conducive o privae aciviy. In conras, porfolio inflows may be araced o sovereign lending where fiscal dominance crowds ou privae incenives. Hence, hese flows appear o be compeing, raher han complemenary. During a boom, a wider curren accoun defici is financed by inflows in he financial accoun, as eviden by he negaive and significan correlaion coefficien. More inflows help improve he financial balance and complemen a wider defici in he curren accoun. Counries ha are able o susain high curren accoun defici do capialize on heir abiliy o arac capial inflows and provide financing in he financial balance. During a downurn, expors and impors move ogeher, reflecing he high impor conen of expors. The reducion in impors improves he curren accoun balance, as eviden by he negaive correlaion coefficien. Variaion in FDI appears o be independen of flucuaions in expors and impors, as eviden by he negaive and saisically significan correlaion coefficiens. 5.2 Across Advanced Counries During a boom, counries ha arac higher FDI flows arac less porfolio inflows, as eviden by he negaive and saisically significan correlaion coefficien. This evidence reinforces he previous finding across developing counries. Counries ha boos privae incenives are in a beer posiion o arac FDI flows. In conras, counries ha have higher fiscal defici are ypically arges for higher porfolio inflows. During a boom, he rade balance improves in response o higher expor growh, as eviden by he posiive and significan correlaion coefficien. Higher porfolio inflows help finance a wider rade defici, as hp:// eviden by he negaive and saisically significan correlaion coefficien. Improvemen in he rade balance helps solidify improvemen in he curren accoun balance, as eviden by he posiive and significan correlaion coefficien. As financial inflows are financing a wider rade defici, hey vary negaively wih expor shocks. Similarly, boh he rade and curren accoun balances vary negaively and significanly wih he financial accoun balance. During a downurn, a slowdown in aggregae demand correlaes wih simulaneous reducion in FDI and porfolio capial flows, as eviden by he posiive and significan correlaion. The reducion in expors during downurns necessiaes higher porfolio capial inflows o finance a higher curren accoun defici, as eviden by he negaive and significan correlaion coefficien. The evidence is furher reinforced by he negaive correlaions beween he financial balance and deerioraion in he rade and curren accoun balances during cyclical downurns. A wider rade and curren accoun deficis are financed via higher inflows ha susain improvemen in he financial balance. 6. CROSS-COUNTRY ANALYSIS Having analyzed cyclical responses and comovemens across variables during business cycles, he analysis urns o deerminans of cyclicaliy across advanced and developing counries. The evidence will esablish how indicaors of he macro economy may deermine he cyclical responses and possible asymmery in he relaionship during booms and recessions. 6.1 The Impac of Trend and Variabiliy of Price Inflaion on Cyclicaliy Table 3A summarizes he impacs of higher rend or variabiliy of inflaion on he cyclical responses o aggregae demand shocks during booms and recessions across developing counries. Table 3B summarizes he evidence across advanced counries Across Developing Counries During economic booms, higher rend inflaion reduces he size of he cyclical response of FDI flows and he financial balance o expansionary demand shocks. High rend inflaion is no conducive o financial inflows as i increases uncerainy and erodes he real value of financial reurns. The evidence remains robus in he face of high inflaion variabiliy. During downurns, high rend inflaion increases he cyclical response (reducion) of impors. High rend inflaion simulaes, in general, higher impors in search for a cheaper alernaive o high domesic prices. Consisenly, impors respond more elasically o a cyclical downurn as rend inflaion increases across counries. Furher, higher inflaion variabiliy resuls in an improved curren accoun balance, reflecing significan reducion of impors during cyclical downurns. 176

7 Inernaional Journal of Economics, Finance and Managemen All righs reserved Across Advanced Counries During economic booms, high rend inflaion increases he cyclical response of he rade balance and he curren accoun balance o expansionary aggregae demand shocks. High rend inflaion could be an indicaion of a surge in economic aciviy and expors, improving exernal balances. During downurns, higher variabiliy of inflaion renders expors more resilien (increasing). Variabiliy of inflaion signals high probabiliy of a quick reversal in he business cycle. Producers may prefer hoarding larger invenory in anicipaion of a quick pickup in demand for expors. 6.2 The Impac of Trend and Variabiliy of Real Growh on Cyclicaliy Table 4A presens he evidence of he effecs of he rend and variabiliy of real growh on he cyclical response o aggregae demand shocks across developing counries. Table 4B presens he evidence across advanced counries Across Developing Counries Higher rend growh has a negaive significan effec on he response of FDI and he financial balance o expansionary demand shocks. The implicaion is high rend growh signals near capaciy limiaion which reduces incenives o expand FDI and arac financial inflows during economic expansions. The evidence remains robus wih respec o higher variabiliy of growh. Furher, higher variabiliy of growh has a posiive significan effec on he cyclical response of he curren accoun balance o demand shocks. Higher variabiliy of growh is consisen wih improvemen in he curren accoun balance during expansions. During downurns, higher rend growh increases he resilience of he curren accoun balance. Higher rend and variabiliy of growh increase he probabiliy of a quick reversal in he cycle, which block decisions o slow producion ha could lead o a wider curren accoun defici during cyclical downurns Across Advanced Counries Trend growh does no have a significan effec on he response of economic variables o aggregae demand shocks during a boom. During a downurn, higher rend and variabiliy of growh have a negaive significan effec on he response of impors o cyclical downurns. Growh simulaes higher demand for impors. Accordingly, counries ha experience higher growh over ime are more relucan o slowdown he demand for impors during recessions in anicipaion of a quick reversal of he cycle. 6.3 The Impac of Trend and Variabiliy of Governmen Spending on Cyclicaliy Table 5A presens he evidence of he effecs of he rend and variabiliy of governmen spending on he cyclical responses of componens of he exernal balances hp:// o aggregae demand shocks across developing counries. Table 5B presens he evidence across advanced counries Across Developing Counries During economic booms, higher rend growh of governmen spending has a posiive significan effec on he response of he curren accoun balance o expansionary demand shocks. The implicaion is higher rend growh of governmen spending helps susain higher expors, increasing he probabiliy of improved curren accoun balance during cyclical upurns. Noneheless, higher rend and variabiliy of governmen spending have a negaive significan effec on he cyclical response of FDI flows o expansionary demand shocks. The implicaion is higher governmen spending signals concerns abou he cos of financing a wider fiscal defici which appears o be slowing FDI flows during a boom. During a downurn, higher rend and variabiliy of governmen spending have a negaive significan effec on he cyclical response of he curren accoun balance o conracionary demand shocks. Higher governmen spending helps susain economic aciviy, avering deerioraion in he curren accoun balance during cyclical downurns Across Advanced Counries There is no evidence of significan effec of higher growh and variabiliy of governmen spending on flucuaions of he exernal balances of advanced counries during booms and recessions. 6.4 The Impac of Trend and Variabiliy of Privae Consumpion Growh on Cyclicaliy Table 6A presens he evidence of he effecs of he rends and variabiliy of privae consumpion growh on he cyclical responses of exernal balances o aggregae demand shocks across developing counries. Table 6B presens he evidence across advanced counries Across Developing Counries Higher rend and variabiliy of privae consumpion have a posiive significan effec on he cyclical response of he curren accoun balance o expansionary demand shocks. Privae consumpion helps suppor economic aciviy wih a posiive effec on he curren accoun posiion during cyclical booms. Noneheless, higher rend and variabiliy of consumpion growh have a negaive significan effec (reducion) on he response of FDI flows o expansionary demand shocks. Higher consumpion growh increases inflaionary expecaions wih a negaive effec on he counries abiliy o arac more FDI flows during economic booms. The evidence remains robus regarding he impac of he variabiliy of consumpion growh on cyclicaliy of he curren and financial flows. During a downurn, higher rend consumpion growh has a negaive significan effec on he curren accoun balance. The implicaion is rend consumpion 177

8 Inernaional Journal of Economics, Finance and Managemen All righs reserved. growh helps susain economic aciviy, increasing he resilience of he exernal balance during cyclical downurns. During a downurn, agens expec a quick reversal of economic condiions in ligh of robus rends, increasing he resilience of he curren accoun balance. The evidence is robus wih respec o higher variabiliy of consumpion growh. In conras, higher variabiliy of consumpion increases he cyclicaliy of FDI flows (reducion) during cyclical downurns. The implicaion is FDI is more responsive o cyclical slowdown where consumpion growh is highly variable, as he laer increases concerns abou rising inflaion and risks o susainabiliy Across Advanced Counries During economic booms, high variabiliy of consumpion has a negaive significan effec on he response of porfolio flows o expansionary demand shocks. The implicaion is higher variabiliy of consumpion increases uncerainy wih adverse effec on porfolio flows o advanced counries. During a downurn, higher variabiliy of consumpion increases he resilience of impors, FDI and porfolio flows o a slowdown in demand condiions. The implicaion is higher variabiliy of consumpion increases he probabiliy of a quick reversal in he cycle and, herefore, resilience of key componens of he exernal balance o cyclical downurns. 6.5 The Impac of Trend and Variabiliy of Privae Invesmen Growh on Cyclical Flucuaions Table 7A presens he evidence regarding he impac of rend and variabiliy of privae invesmen growh across developing counries. Table 7B presens he evidence across advanced counries Across Developing Counries During economic booms, higher rend growh of privae invesmen has a negaive significan effec on impor growh during economic expansion. The implicaion is rend invesmen growh does no suppor higher growh of impors across counries. During cyclical downurns, rend growh of privae invesmen acceleraes he reducion in impors wih respec o a slowdown in demand. Asymmery indicaes a risk-averse sraegy. High rend invesmen indicaes less commimen o higher impors during booms and a fas reversal of commimens during downurns Across Advanced Counries During economic booms, higher rend invesmen growh acceleraes improvemen in he curren accoun balance wih respec o expansionary demand shocks. The implicaion is higher invesmen helps boos he exernal posiion, improving he curren accoun balance during an economic boom. However, he financial posiion of he exernal balance deerioraes where rend invesmen is high. As reurns on invesmen decrease wih higher rends, financial inflows are slowing during hp:// economic booms. The evidence is robus wih respec o high invesmen variabiliy, furher reinforcing he decline in reurns on more variable invesmen growh. During downurns, higher rend invesmen growh has a negaive significan effec on he response of he curren accoun balance o a slowdown in aggregae demand. The implicaions are high rend invesmen growh helps increase he resilience of he curren accoun balance during cyclical downurns. The evidence reinforces he posiive role of rend invesmen in simulaing economic aciviy and improving exernal sabiliy. Hence, higher invesmen growh renders he curren accoun balance more resilien during cyclical downurns. 7. CONCLUSION The paper has focused on analyzing he imeseries cyclical responses of key componens of exernal balances wih a goal o idenify he degree of cyclicaliy in he face of aggregae demand shocks. In addiion, he analysis sudies co-movemens among he cyclical responses in he balance of paymens and he deerminans and implicaions of cyclicaliy. The objecive is o draw conras beween binding consrains and he implicaions of exernal cyclicaliy across samples of developing and advanced counries wih a view owards drawing policy implicaions o maximize he reurns on openness o rade and financial flows and ease capaciy consrains. A summary of he ime-series evidence indicaes ha developing counries, in general, are able o capialize on developmens in he business cycle o mobilize expors. Impor growh also varies closely wih cyclicaliy in aggregae demand. The limied pervasive suppor o flucuaions in he rade balance wih cyclicaliy in aggregae demand indicaes offseing channels on impors and expors in many developing counries. Flucuaions in he curren accoun balance may also vary wih aggregae demand condiions, alhough wih limied saisical significance. FDI flows could also vary wih cyclicaliy in aggregae demand, alhough wih limied saisical significance. Furher, he limied saisically significan evidence does no provide srong suppor o flucuaions in porfolio capial flows or he financial balance wih cyclicaliy in aggregae demand in many developing counries. The impac of demand flucuaions on expor growh appears o be more pervasive across advanced counries, compared o developing counries. Impors also vary wih he business cycle in many advanced counries. The limied significance and mixed direcions aes o offseing channels of aggregae demand flucuaions on he rade balance in many advanced counries. Offseing channels also render he effecs of cyclical flucuaions on he curren accoun balance mosly insignifican. The limied significan evidence isolaes FDI flows from cyclicaliy in economic 178

9 Inernaional Journal of Economics, Finance and Managemen All righs reserved. condiions, aesing o robus srucural reurn on FDI ha appears o be guiding flows o advanced counries over ime. The significan evidence is also limied regarding flucuaions in porfolio flows wih he business cycle. The limied cyclical evidence is consisen wih pervasive a-cyclical responses of FDI and porfolio flows in he majoriy of advanced counries under invesigaion. Across developing and advanced counry groups, he evidence is robus regarding he negaive correlaions beween FDI and porfolio flows, ruling ou heir complemenariies. Across boh counry groups, he evidence suppors he noion ha a wider curren accoun defici is financed via higher financial inflows. Higher expor growh appears o be a major driver of improvemen in he rade balance during economic booms across advanced counries. In conras, porfolio inflows are a major complemen of financing a wider curren accoun defici across developing counries. Underlying he difference in he evidence beween he wo counry groups is he degree of posiive correlaion beween he rade and curren accoun balances across developing and advanced counries. While he correlaion coefficien is posiive across he wo counry groups, i is only significan across advanced counries. The implicaion is oher componens of he curren accoun balance (e.g., remiances and he services balance) play a bigger role in differeniaing he curren accoun balance from he rade balance in developing counries. In conras, hese componens appear o be less pronounced across advanced counries, esablishing a closer associaion beween he rade and curren accoun balances. The correlaion beween expor growh and he financial balance is negaive across developing and advanced counry groups bu significan only across he laer group. The evidence furher aess o he imporance of expors o drive he exernal posiion across advanced counries. Higher expors are consisen wih less financial inflows and, herefore, deerioraion in he financial balance across advanced counries. Across developing counries, rend inflaion is a signal of higher uncerainy ha discourages financial flows, while inducing higher impors. Hence, rend inflaion poses serious hrea o exernal sabiliy in developing counries. In conras, rend inflaion is a signal of higher growh ha reflecs posiively on exernal sabiliy in advanced counries. The difference in he evidence poins o higher vulnerabiliy of he exernal balance wih respec o a higher rend inflaion in developing counries. Across developing counries, higher growh helps susain improvemen in he curren accoun balance during booms and recessions. However, high rend growh could pose he risk of reaching capaciy limiaion, slowing down financial flows in he face of decreasing hp:// reurns o scale. In conras, high rend growh is mosly affecing he resilience of impor growh in advanced counries. The difference poins o larger consrains on capaciy in developing counries ha could risk exernal sabiliy as rend growh increases across counries. Governmen spending is an imporan deerminan of exernal sabiliy in developing counries as i deermines he cyclical responses of exernal flows during booms and recessions. In conras, governmen spending is no an imporan deerminan of exernal sabiliy in advanced counries, signaling less concern abou fiscal susainabiliy aribued o higher spending on he widening defici and higher public deb. Trend and variabiliy of consumpion play a bigger role in deermining cyclical flucuaions of exernal balances across developing counries. Privae consumpion is a key driver of aggregae uncerainy and cyclical flucuaions in developing counries. In general, higher rend and variabiliy of consumpion increase uncerainy wih adverse effecs on financial flows o developing counries. Higher variabiliy of consumpion spending increases resilience during cyclical downurns, which is eviden in developing and advanced counries. The evidence signifies he imporance of consumpion o susain demand growh and mainain exernal sabiliy. Impors are he main channel hrough which invesmen growh deermines exernal sabiliy in developing counries. While he evidence aess o he high impor conen of invesmen in developing counries, he cyclicaliy of invesmen may rigger asymmeric responses of impors o avoid risk. Specifically, impors may no go up significanly during a boom and prove o be resilien during a downurn he higher rend invesmen growh across counries. Across advanced counries, invesmen growh reinforces he posiive effecs on he curren accoun balance and is resilience during cyclical downurns. The evidence aess o a broader channel hrough which invesmen impacs exernal sabiliy in advanced counries. However, binding capaciy consrains decrease reurn on invesmen, limiing scope o arac more financial inflows he higher is rend invesmen across counries. For policy implicaions, developing counries should esablish prioriies o conain cyclical flucuaions ha weigh in adversely on exernal sabiliy. Equally imporan is o address srucural bolenecks ha hamper he inflows of financial invesmens over ime. Reform of public finances is crucial o improve confidence and conain vulnerabiliy. Robus consumpion and invesmen spending help susain viable economic condiions. 179

10 Inernaional Journal of Economics, Finance and Managemen All righs reserved. However, prioriies should be focused on addressing capaciy consrains ha accelerae inflaionary pressures wih adverse effecs on exernal sabiliy. Exernal sabiliy in advanced counries appears less vulnerable o cyclicaliy of aggregae demand. However, capaciy consrains appear o pose a binding consrain ha limis reurns on invesmen and slows down financial flows. Prioriies should be focused on addressing srucural bolenecks o address capaciy limiaions and ensure robus financial flows for exernal sabiliy. Across he samples of developing and advanced counries, he evidence aess o he imporance of hp:// managing domesic cyclicaliy o hedge agains exernal vulnerabiliy and ensures susainable exernal balances, aided by robus financial inflows. Table 1A. Co-movemens beween Cyclical Flucuaions in Exernal Balances and Underlying Componens across Developing Counries during Booms Correlaion DEXPpos DIMPpos DFDIpos DPORpos DTBALpos DCApos DFBALpos beween DIMPpos 0.15 (0.54) DFDIpos (0.87) (0.76) DPORpos * (0.78) (0.58) (0.071) DTBALpos (0.72) (0.72) (0.15) (0.72) DCApos * 0.12 (0.94) (0.14) (0.68) (0.018) (0.66) DFBALpos * * (0.53) (0.25) (0.25) (0.024) (0.97) (0.0001) Table 1B. Co-movemens beween Cyclical Flucuaions in Exernal Balances and Underlying Componens across Developing Counries during Recessions Correlaion DEXPneg DIMPneg DFDIneg DPORneg DTBALneg DCAneg DFBALneg beween DIMPneg 0.62* (0.0065) DFDIneg -0.45** -0.66* (0.06) (0.0028) DPORneg (0.35) (0.50) (0.49) DTBALneg (0.84) (0.50) (0.98) (0.81) DCAneg * (0.32) (0.039) (0.19) (0.19) (0.95) DFBALneg (0.92) (0.41) (0.84) (0.39) (0.36) (0.74) Table 2A. Co-movemens beween Cyclical Flucuaions in Exernal Balances and Underlying Componens across Advanced Counries during Booms Correlaion DEXPpos DIMPpos DFDIpos DPORpos DTBALpos DCApos DFBALpos beween DIMPpos (0.58) DFDIpos (0.23) (0.87) DPORpos * (0.21) (0.77) (0.0001) DTBALpos 0.38** * (0.078) (0.37) (0.34) (0.0001) DCApos * (0.23) (0.37) (0.74) (0.32) (0.0001) DFBALpos -0.56* * -0.82* (0.0073) (0.64) (0.97) (0.40) (0.0001) (0.0001) Table 2B. Co-movemens beween Cyclical Flucuaions in Exernal Balances and Underlying Componens across Advanced Counries during Booms Correlaion DEXPneg DIMPneg DFDIneg DPORneg DTBALneg DCAneg DFBALneg beween DIMPneg (0.69) DFDIneg (0.34) (0.71) DPORneg * (0.52) (0.70) (0.0001) DTBALneg (0.46) (0.61) (0.95) (0.63) DCAneg (0.43) (0.65) (0.71) (0.90) (0.23) DFBALneg -0.39* * -0.43* (0.55) (0.78) (0.79) (0.51) (0.0004) (0.035) Noes: Correlaions are beween posiive shocks o DIMP, impor growh; DFDI, growh of FDI; DPOR, growh of porfolio flows; DTBAL, change in rade balance, DCA, change in curren accoun, DFBAL, change in financial balance. Correlaions range beween -1 and 1 where zero indicaes no correlaion. Probabiliy of zero correlaion is in parenheses where * and ** denoe significance a he five and en percen levels of saisical error. 180

11 Inernaional Journal of Economics, Finance and Managemen All righs reserved. hp:// Table 3A: Significan Impacs of Trend or Variabiliy of Inflaion on Cyclical Responses of Key Macro Variables across Developing Counries Dependen Variables During Booms Dependen Variables During Recessions Trend Inflaion or Inflaion Variabiliy Trend Inflaion or Inflaion Variabiliy DEXP n/s n/s DEXP n/s n/s DIMP n/s n/s DIMP 4.55** n/s DTBAL n/s n/s DTBAL n/s n/s (1.90) DCA n/s n/s DCA n/s -23.4* (-2.30) DFDI ** * DFDI n/s n/s (-1.91) (-2.01) DPOR n/s n/s DPOR n/s n/s DFBAL -55.5* * DFBAL n/s n/s (-2.89) (-11.70) Table 3B: Significan Impacs of Trend or Variabiliy of Inflaion on Cyclical Responses of Key Macro Variables across Advanced Counries Dependen Variables During Booms Dependen Variables During Recessions Trend Inflaion or Inflaion Variabiliy Trend Inflaion or Inflaion Variabiliy DEXP n/s n/s DEXP n/s -3.61* (-2.39) DIMP n/s n/s DIMP n/s n/s DTBAL 776.9* n/s DTBAL n/s n/s (2.27) DCA 522.3** n/s DCA n/s n/s (1.92) DFDI n/s n/s DFDI n/s n/s DPOR n/s n/s DPOR n/s n/s DFBAL n/s n/s DFBAL n/s n/s Noes: DEXP, expor growh; DIMP, impor growh; DTBAL, change in rade balance; DCA, change in curren accoun, DFDI, change in foreign invesmen, DPOR, change in porfolio flows and DFBAL, change in financial balance. n/s: no saisically significan. Repored significan coefficiens are from cross-counry regressions ha regress he dependen variable on rend inflaion or inflaion variabiliy. Trend is ime-series average and variabiliy is he sandard deviaion of inflaion. -saisics are in parenheses and * and ** denoe significance a he five and en percen levels of saisical error. Table 4A: Significan Impacs of Trend or Variabiliy of Real Oupu Growh on Cyclical Responses of Key Macro Variables across Developing Counries Dependen Variables During Booms Dependen Variables During Recessions Trend Growh or Growh Variabiliy Trend Growh or Growh Variabiliy DEXP n/s n/s DEXP n/s n/s DIMP n/s n/s DIMP n/s n/s DTBAL n/s n/s DTBAL n/s n/s DCA n/s 8.69** DCA -49.7* * (1.81) (-2.24) (-2.51) DFDI -29.3* ** DFDI n/s n/s (-2.03) (-1.90) DPOR n/s n/s DPOR n/s n/s DFBAL -34.1* * DFBAL n/s n/s (-9.34) (-15.26) Table 4B: Significan Impacs of Trend or Variabiliy of Real Oupu Growh on Cyclical Responses of Key Macro Variables across Advanced Counries Dependen Variables During Booms Dependen Variables During Recessions Trend Growh or Growh Variabiliy Trend Growh or Growh Variabiliy DEXP n/s n/s DEXP n/s n/s DIMP n/s n/s DIMP * * (-2.37) (-4.70) DTBAL n/s n/s DTBAL n/s n/s DCA n/s n/s DCA n/s n/s DFDI n/s n/s DFDI n/s n/s DPOR n/s n/s DPOR n/s n/s DFBAL n/s n/s DFBAL n/s n/s Noes: DEXP, expor growh; DIMP, impor growh; DTBAL, change in rade balance; DCA, change in curren accoun, DFDI, change in foreign invesmen, DPOR, change in porfolio flows and DFBAL, change in financial balance. n/s: no saisically significan. Repored significan coefficiens are from cross-counry regressions ha regress he dependen variable on rend growh or growh variabiliy. Trend is ime-series average and variabiliy is he sandard deviaion of growh. -saisics are in parenheses and * and ** denoe significance a he five and en percen levels of saisical error. 181