Business cycles and FDI: evidence from German sectoral data

Business cycles and FDI:
evidence from German sectoral data
Claudia M. Buch
(University of Tuebingen)
Alexander Lipponer
(Deutsche Bundesbank)
Discussion Paper
Series 1: Economic Studies
No 09/2005
Discussion Papers represent the authors’ personal opinions and do not necessarily reflect the views of the
Deutsche Bundesbank or its staff.

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Abstract:
Globalization has affected business cycle developments in OECD countries and has
increased activities of firms across national borders. This paper analyzes whether these
two developments are linked. We use a new firm-level dataset on the foreign activities
of German firms to test whether foreign activities are affected by business cycle
developments. We aggregate the data by the sector of the reporting firm, the sector of
the foreign affiliate, and the host country. Data are annual and cover the period 1989-
2002. We find that German outward FDI increases in response to positive cyclical
developments abroad and in response to a real depreciation of the domestic currency.

Keywords:
business cycles, multinational activity, FDI
JEL-Classification: E3, F23

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Non-Technical Summary
So far, theoretical and empirical literature on multinational firms has focused on the
reasons for becoming a multinational, on the reasons for going into a particular country,
and on the host and home country effects of multinational activity. In this paper, we add
another dimension to the discussion by analyzing the influence of short-term business
cycle movements on multinational activity.
The starting point of our analysis is the idea that firms’ activities might be linked to the
business cycle either because of a financial accelerator mechanism or because of the
presence of fixed costs of market entry. Since financial frictions and fixed costs of entry
can be expected to vary across firms from different sectors, we construct a dataset
which contains information on foreign activities of German firms at a sectoral level. Our
data are annual and cover a time period of 14 years (1989-2002).
Our study has four main findings:
First, foreign activities of German firms increase in response to positive cyclical
developments abroad. This effect was particularly strong in the first and second half of
the 1990s. Adjustment to the cycle mainly takes place through changes in volumes
rather than entry.
Second, a real depreciation of the euro stimulates foreign activities as well. This effect
was particularly strong in the first half of the 1990s. In the second half of the 1990s, the
real exchange rate effect was weaker, possibly because of the impact of the large
valuation changes on global stock markets.
Third, business cycle and real exchange rate effects are especially important for
activities of German firms outside Europe.
Fourth, business cycles have a stronger impact on FDI projects where the sector of the
domestic firm and the foreign affiliate differ than they do in those cases where the
sectors coincide. Sector-by-sector regressions provide relatively weak evidence that
systematic differences with regard to information frictions are driving the results.
Rather, the impact of real exchange rates and of the foreign cycle in the full sample
seems to be driven to some extent by differences between the sectors.

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Nicht technische Zusammenfassung
Bislang konzentrierte sich die theoretische und empirische Literatur über multinationale
Unternehmen auf die Gründe, weshalb diese international tätig werden, die Ursachen,
sich in einem bestimmten Land niederzulassen sowie auf Gast- und Heimatlandeffekte
multinationaler Aktivitäten. In diesem Beitrag dehnen wir die Diskussion auf einen
weiteren Aspekt aus und analysieren den Einfluss kurzfristiger konjunktureller
Schwankungen auf multinationale Aktivitäten.
Ausgangspunkt unserer Analyse ist die Idee, dass die Geschäftstätigkeit eines
Unternehmens entweder aufgrund des finanziellen Akzeleratoreffekts oder der
Fixkosten bei Markteintritt mit dem Konjunkturzyklus in Zusammenhang stehen
könnte. Da finanzielle Friktionen und Fixkosten bei Markteintritt erwartungsgemäß bei
Unternehmen aus verschiedenen Sektoren variieren können, erstellen wir einen
Datensatz, der Informationen über die Auslandsaktivitäten deutscher Unternehmen nach
Sektoren gegliedert enthält. Es handelt sich dabei um Jahresdaten, die einen Zeitraum
von 14 Jahren (1989 bis 2002) abdecken.
In unserer Studie kommen wir zu vier wesentlichen Ergebnissen:
Erstens nimmt das Engagement deutscher Firmen im Ausland als Reaktion auf eine
positive Konjunkturentwicklung im Ausland zu. Dieser Effekt war in der ersten und
zweiten Hälfte der Neunzigerjahre besonders ausgeprägt. Anpassungen an den
Konjunkturzyklus erfolgen hauptsächlich in Form von Anpassungen der Volumen und
nicht beim Markteintritt.
Zweitens stimuliert eine reale Abwertung des Euro die Geschäftstätigkeit im Ausland.
Dieser Effekt war in der ersten Hälfte der Neunzigerjahre besonders stark. In der
zweiten Hälfte der Neunzigerjahre wirkte sich der reale Wechselkurs – vermutlich
aufgrund der großen Bewertungsänderungen an den weltweiten Aktienmärkten –
geringer aus.
Drittens sind die aus dem Konjunkturzyklus und dem realen Wechselkurs resultierenden
Effekte für die Geschäftstätigkeit deutscher Firmen außerhalb Europas von besonderer
Bedeutung.

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Viertens wirkt sich der Konjunkturzyklus stärker auf jene Direktinvestitionen aus, bei
denen sich der Sektor der gebietsansässigen Mutter und des ausländischen
Tochterunternehmens unterscheiden, als auf jene Fälle, bei denen die Sektoren
übereinstimmen. Sektorale Regressionen liefern relativ geringe Belege dafür, dass
systematische Differenzen im Hinblick auf Informationsfriktionen die Ergebnisse
beeinflussen. Die Auswirkungen der realen Wechselkurse und des ausländischen
Konjunkturzyklus in der gesamten Stichprobe scheinen eher bis zu einem gewissen
Grad durch Unterschiede zwischen den Sektoren getrieben zu werden.

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Contents
1 Introduction
1
2 Theoretical Background
4
3 Data and Descriptive Statistics
6
3.1 The
Data
6

3.1.1 Foreign Activities of German Firms
6

3.1.2 Measuring Business Cycle Developments
8

3.1.3 Exchange Rate Issues
8
3.2 Descriptive
Statistics
9
4 New Empirical Evidence
11
4.1 The Empirical Model
12
4.2 Baseline Regression Results
13
4.3 Sectoral
Effects
15
4.4 Robustness
Tests
17
5 Concluding Remarks
18
References
18

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Lists of Tables and Figures
Table 1
Unit Root Tests
27
Table 2
Regression Results FDI and Affiliate Sales
28
Table 3
Sectoral Regressions
29
Table 4
Regional Effects (FDI)
30
Table 5
Loan versus Equity Components of FDI
31

Figure 1
Changes in FDI Stocks and Business Cycles
23
Figure 2
Volatility of Multinational Activity
24
Figure 3
Average Annual Growth Rates of FDI and Affiliate Sales
25-26

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Business Cycles and FDI:
Evidence from German Sectoral Data*
1 Introduction
Two observations characterize the recent globalization period. First, business
cycles in OECD countries have tended to become more synchronized, and they share
key characteristics such as a recently observed decline in output volatility. (See, for
example, Artis (2004), Bordo and Helbling (2004), or Prasad et al. (2003).) Second,
firms have increasingly moved production across borders. This internationalization of
production has, to a large extent, been market-driven, as evidenced by the dominance of
foreign direct investment (FDI) among OECD countries. Recently, FDI that aims at
lowering production costs has increased in importance as well (Barba-Navaretti and
Venables et al. 2004).
The similarity of business cycle developments among OECD countries and the
growing importance of multinational production raise the question of whether these two
observations might be linked. Hanson and Slaughter (2003) have recently pointed out
that the internationalization of production and international business cycle
developments might be jointly determined.
Theoretical work studying business cycles and multinational activity
simultaneously is a fairly underdeveloped area in international economics. To date,
there are rather two separate lines of research.
A first branch of the literature has studied the determinants and effects of the
activities of multinational firms, stressing long-term fundamentals (see, for example,
Markusen (2002)). These long-term fundamentals are the absolute and relative factor
endowments of countries, the distance between markets as well as trade and investment
costs. Models are typically tested using aggregated data although, more recently, firm-

* This paper represents the authors’ personal opinions and does not necessarily reflect the views of the
Deutsche Bundesbank. The authors would like to thank Jörg Breitung, Jörg Döpke, Ralph Heinrich,
Heinz Herrmann, Vasso Ioannidou, Marc-Andreas Mündler, Harald Stahl, Harald Uhlig, seminar
participants at the WEA Annual Meeting 2004 (Vancouver), at the University of Oslo, at Tilburg
University, and at the Conference on “Multinationals and International Integration”, held at the Kiel
Institute for World Economics in October 2004 (organized by the Deutsche Bundesbank) for their
comments and helpful discussions. All errors and inaccuracies are our own.

1

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level data have been employed as well. The impact of shorter-term business cycle
fluctuations is typically not analyzed. In their review of the literature on multinationals,
Barba-Navaretti and Venables et al. (2004) establish a number of facts on multinationals
but they do not refer to business cycle developments. One of the questions that this
literature tries to answer is why firms become multinationals and why multinationals go
to specific countries. Taking into account business cycle developments is unlikely to
change the basic answers to these questions. Rather, our research can be expected to add
to the literature on multinationals by studying the short-term determinants of FDI.
A second branch of the literature has dealt with the impact of aggregated flows of
FDI on business cycle developments and on the transmission of shocks across countries.
These papers take a macroeconomic perspective, and capital flows are analyzed on what
tends to be a more aggregated level. Recently, open economy macro models have paid
greater attention to the impact of firm heterogeneity. (See Ghironi and Melitz (2004) or
Niles Russ (2003) for two recent contributions.) In these models, the number of firms
active at home and abroad is endogenous due to fixed costs of market entry and the fact
that firms differ in their productivity levels. In contrast to models stressing the long-run
determinants of multinational activity, these models assign an explicit role to
macroeconomic fluctuations. Fixed costs and firm heterogeneity can be one reason why
foreign activities of firms react to the cycle. An additional reason could be financial
market frictions. As in a closed-economy setting (see Bernanke, Gertler and Gilchrist
(2000)), financial market frictions may impinge on the foreign investment behaviour of
firms through a net worth effect.
The purpose of this paper is to combine these two strands of research. While we
analyze multinational activity on a fairly disaggregated level, the focus of our analysis is
on the impact of business cycle developments on multinational activity. We use a new
firm-level dataset on foreign activities of German firms. These data allow the study of
heterogeneity across sectors, and they are available for a relatively long time span that
covers several business cycle episodes. Our analysis proceeds in two steps.
As a first step, we isolate the cyclical and the trend component of GDP
developments in Germany and in OECD countries, using a band-pass filter. We restrict
our analysis to OECD countries because of the better availability of data. Since the bulk
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