Economic theory suggests that globalization should have a positive impact on growth but does not indicate the impact of globalization on volatility in economic growth. Until mid-1980s, the impact of volatility on economic growth was found to be minor at best. However, since then, as a growing number of developing countries began to integrate into the global economy through trade and financial liberalization, greater openness coincided with greater volatility as evidenced by the financial crises of the 1980s and 1990s, primarily in the emerging markets. For example, work by Hausmann, Garey and Ramey indicated earlier on that macroeconomic volatility due to shocks and policies may actually reduce long-term growth. While output volatility has increased, relatively open economies also recorded higher than average growth rates. Does this mean that in a period of rising globalization, the negative relationship between growth and volatility has changed?
Analysis of data from 85 countries, of which 21 are industrial countries and 64 developing countries, indicates that during 1985 and 2000, the countries that liberalized their trade regimes increased from 30 percent of the sample countries in 1985 to almost 85 percent by 2000. The share of countries with open financial accounts rose from 20 percent to about 55 percent over this period. So trade and financial liberalization seems to go hand in glove and these liberalizations were a contributing factor in almost doubling the volume of international trade during 1985-2000, and private capital flows from industrialized to developing economies have also increased dramatically since the mid-1980s, with the bulk of these flows going to 23 emerging market economies in the sampled countries.
There is a negative relationship between growth and volatility as measured by standard deviation of per capita output growth during the period 1960–2000. However, when the countries are disaggregated by stages of development, the relationship in fact appears positive for industrial economies, indicating that, for economies at an advanced stage of development, volatility is not necessarily associated with lower growth. For emerging markets, the relationship looks positive while it is negative for other developing economies that have not participated as much in the process of globalization.
For the emerging markets, the relationship between growth and volatility is negative before trade liberalization and positive after. In other words, there is suggestive evidence from these economies that trade integration changes the sign of this relationship. One is that the level of development appears to matter, as the sign of the relationship varies across different groups of countries. The second is that trade and financial integration affect the nature of this relationship.
In addition, there could be other factors that affect growth and volatility independently as well as the relationship between these two variables —such as a country’s initial income level, the national investment rate, population growth, the fraction of the population that has at least a primary-level education, and trade and financial integration. When these potential determinants of growth are included, on average volatility is still negatively associated with growth; while that trade integration clearly has a positive effect on growth, the effect of financial integration is less obvious.
When the interaction between trade and financial integration are included, the interaction terms generally have a positive relationship with growth, implying that although the basic relationship between volatility and growth is negative, higher levels of trade and financial integration make this relationship much weaker. The implication of these findings is that economies that are more open have the ability to withstand higher levels of volatility without adverse effects on growth.
Despite experiencing a similar level of volatility, the greater degree of trade openness of emerging markets still allowed them to post higher growth rates. We find a similar result for financial integration, which also explains close to half of the observed differences in growth rates between these two groups of countries.
Source: Kose, Prasad, and Terrones, 2004.