China's Emergence in the World Economy and Business Cycles in Latin America
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China's Emergence in the World Economy and Business Cycles in Latin America

As vividly illustrated by the impact of the recent global crisis on Latin America, the international business cycle is very important for the region's economic performance.1 The world economy, however, has undergone profound structural changes over the past two to three decades because of globalization and the emergence of China, India, and other large developing economies (including Mexico and Brazil in Latin America) as global economic players. As a result, the transmission mechanisms of the international business cycle to Latin America may have changed.

This paper focuses on the emergence of China as a global force in the world economy and investigates how changes in trade patterns between China and the rest of the world may have affected the transmission of the international business cycle to Latin America. Specifically, we investigate empirically how shocks to gross domestic product (GDP) in China and the United States are transmitted to Latin America, conditional on alternative configurations of cross-country linkages in the world economy. We focus on China because its trade linkages with Latin America and the rest of the world have undergone the most dramatic shift over the period we consider. We focus on the United States because this country remains the largest trading partner of the Latin [End Page 1] American region as a whole and, historically, has been the major source of external shocks for Latin America. To complement this analysis, we also consider a GDP shock to the Latin American region itself and to emerging Asia (excluding China and India) because the analysis of these shocks helps shed light on the ongoing debate about the decoupling of emerging markets' business cycle from that of advanced economies.

To conduct the empirical analysis, we use a variant of the global vector autoregressive (GVAR) model originally proposed by Pesaran, Schuermann, and Weiner and further developed by Dees and others.2 This is a relatively novel approach to global macroeconomic modeling that combines time series, panel data, and factor analysis techniques, which can be used to address a wide set of issues.3 In the first step of the methodology, each country is modeled individually as a small open economy by estimating country-specific vector error correction models in which domestic variables are related to both country-specific foreign variables and global variables that are common across all countries (such as the international price of oil). In the second step, a global model is constructed combining all the estimated country-specific models and linking them with a matrix of predetermined (that is, not estimated) cross-country linkages. Consistent with the existing GVAR literature and the main purpose of the application in this paper, we use trade shares to quantify the linkages among all the economies included in the GVAR model.4

The shocks that we investigate are not structural. However, given that our focus is on the transmission of GDP shocks across countries, the issue of identifying the sources of the shocks (whether they are due to demand, supply, productivity, or monetary policy) is not central to our analysis. The GVAR model that we use identifies the country-specific shocks by conditioning each variable on contemporaneous values of foreign-specific variables, which [End Page 2] renders the cross-country dependence of the shocks weak and of second-order importance.

A novel, methodological contribution of this paper is to set up and estimate a GVAR model in which the country-specific foreign variables are constructed with time-varying trade weights, while the GVAR is solved with time-specific counterfactual trade weights. This allows us to study and compare the impact of GDP shocks with alternative configurations of cross-country linkages and to investigate how the transmission of shocks has changed since the emergence of China in the world economy. Specifically, we simulate GDP shocks in the GVAR model using trade weights at different points in time, thus capturing the fundamental aspect of China's rapidly changing role in the world economy: namely, its new pattern of trade linkages with Latin America and the...