Does Foreign Direct Investment Synchronise Business Cycles? Results from a Panel Approach. WWWforEurope Working Paper No. 23

A considerable degree of business cycle synchronisation is a key to a successful operating currency union. The European Monetary Union as well as many other countries strives to attract foreign direct investment (FDI) because of its reputation as being highly beneficial for the host economy. But stronger FDI linkages may also have a significant impact on business cycles and co-movement of these cycles between countries and therefore create a potential confl ict between policies that promote FDI and the conduct of the common monetary policy. In this paper we empirically analyse the FDI channel in more detail revisiting the main determinants of synchronisation. Previous studies were mainly interested in the long-run impact employing cross-sectional variation for identification. Their typical identification strategy, however, neglects the strongly time variant nature in the process of globalisation in general and of FDI in specific. We extend the literature on the determinants of business cycle synchronisation by estimating the impact of the determinants with true panel data and a suitable panel estimator. Results indicate that the trade channel is not as important as cross-section models suggest but that FDI may have the potential to increase co-movement of business cycles.