School of Economics

Industry volatility and international trade

6 June 2017

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by Adina Ardelean, Miguel León-Ledesma and Laura Puzzello, discussion paper KDPE 1709, June 2017.

Non-technical summary

In modern theories of economic fluctuations, shocks that drive macroeconomic uncertainty are transformed into business cycles through a propagation mechanism. One such propagation mechanism can be inter-industry linkages: volatility at the industry level can translate into aggregate macroeconomic volatility. For this reason, understanding the sources of risk at the industry level is important. This is even more important in open economies, where industries are exposed to shocks arising in industries located in other countries.

In this paper, we ask the question what are the key sources of industry-level volatility in open economies? To do so, we separately identify how producer-country, industry, and demand shocks affect output volatility at the industry level as well as at the aggregate level. That is, we identify shocks that arise primarily at the level of the country where the industry is located, at the level of the industry regardless of location, and shocks arising at the destination markets for the industry's products (which we loosely label demand shocks). Importantly, we explore the role played by international trade in two ways. First, our methodology separately accounts for demand shocks originating in the home and foreign markets. Second, we estimate the effect of trade openness on industrial volatility and its components allowing us to identify the main channels through which international trade affects industrial output volatility.

We exploit a multi-country, multi-industry dataset that is combined with bi-lateral trade statistics such that our unit of analysis is the amount sold in any destination market by an industry located in a particular country at a point in time. We use data for 34 countries, 19 manufacturing sectors, and 85 destination markets from 1980 to 2000. Methodologically, we develop a decomposition of this data structure that allows us to isolate the above mentioned sources of volatility.

Our results suggest that countries that are volatile in one industry tend to be volatile in other industries as well. Put simply, industrial output volatility does not depend substantially on industry-specific factors. It depends mostly on country-specific factors, such as exposure to aggregate shocks, sale diversification patterns, or both. Our decompositions show that demand risks account for most of the volatility of industrial output, with the contribution of trade-related demand risks depending on the composition of export destinations. We find that global demand risks and idiosyncratic risk to industries are very important drivers of volatility. Interestingly, at the aggregate level, idiosyncratic demand shocks appear to reduce volatility. This is because these shocks covary strongly negatively between industries, which we term "diversification through covariance".

Finally, we find evidence that exports and intra-industry imports have opposite effects on industrial output volatility. In particular, exports reduce industrial volatility as they are targeted to countries with lower global demand volatility than the home market's (a diversification effect). Intra-industry imports drive the positive relationship between industrial output volatility and trade at the industry level by increasing uncertainty in both domestic demand and production (competition and supply-chain effects).

You can download the complete paper here.

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