DP7292 Financial Integration and Business Cycle Synchronization

Author(s): Sebnem Kalemli-Ozcan , Elias Papaioannou , José Luis Peydró-Alcalde

Publication Date: May 2009

Keyword(s): Banks , Business Cycles , Co-movement , Financial Integration , Financial Regulation

JEL(s): E32 , F15 , F36 , G21 , O16

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP7292.asp.asp

Standard theory predicts that financial integration leads to a lower degree of business cycle synchronization. Surprisingly, cross-country studies find the opposite. Our contribution is to document the theoretically predicted negative effect of financial integration on business cycle synchronization as a robust regularity. We use a confidential dataset on banks' international bilateral exposure over the past three decades in a panel of twenty developed countries. The rich panel structure allows us to control for time-invariant country-pair factors and global trends that affect both financial integration and business cycle patterns. In contrast to previous empirical work we find that a higher degree of financial integration is associated with less synchronized output cycles. We also employ two distinct instrumental variable approaches to identify the one-way effect of integration on synchronization. These specifications reveal that the component of banking integration predicted by legislative-regulatory harmonization policies and the nature of the bilateral exchange rate regime has a negative effect on output synchronization.