The Role of Productivity and Financial Frictions in the Business Cycles of a Small Open Economy: Hong Kong 1984–2011

• Date: 01 May 2015
• Author: Paulina Etxeberria‐Garaigorta,Amaia Iza
• DOI: http://doi.org/10.1111/rode.12150
• Published date: 01 May 2015

The Role of Productivity and Financial Frictions in

the Business Cycles of a Small Open Economy:

Hong Kong 1984–2011

Paulina Etxeberria-Garaigorta and Amaia Iza*

Abstract

This paper analyzes the business cycle properties of the Hong Kong economy during the 1984–2011 period,

which includes the financial crisis experienced in 1997/98 and the economic crisis of 2008–2010. We show

that the volatility respectively, of output, of the growth rate of output and of real interest rates in Hong

Kong are higher than the corresponding average volatility among developed economies. Furthermore,

interest rates are countercyclical. We build a stochastic neoclassical small open-economy model estimated

with a Bayesian likelihood approach that seeks to replicate the main business cycle characteristics of Hong

Kong, and through which we try to quantify the role played by exogenous total factor productivity (TFP)

shocks (transitory and permanent), real interest rate shocks and financial frictions. The main finding is that

financial frictions, jointly with the assumption that the country spread is endogenous, seem important in

explaining the countercyclicality of the real interest rates.

1. Introduction

This paper analyzes the business cycle properties of the Hong Kong economy during

the 1984Q1–2011Q3 period, which includes the financial crisis experienced in Hong

Kong in 1997/98 and the economic crisis of 2008–2010. We compare the cyclical com-

ponent of Hong Kong with those of other small open economies. In particular, we

find that the volatilities of output and of the growth of output in Hong Kong are much

higher than the average volatilities of the above two indicators among developed

economies (2.1 and 1.9 times higher, respectively). We also concentrate on the rela-

tionship between output and real interest rates, and find a negative correlation as

observed in emerging economies. Therefore, we try to explain these features through

a dynamic stochastic general equilibrium (DSGE) model for the Hong Kong

economy estimated with a Bayesian approach. Particularly, we build a stochastic neo-

classical small open-economy model to try to replicate the main business cycle charac-

teristics of Hong Kong, and through which we try to quantify the role played by

financial frictions, exogenous total factor productivity (TFP) shocks, both permanent

and transitory, real international interest rate shocks, and country spread shocks. We

include financial frictions in the form of a working capital requirement. The main

focus of this paper is to assess the quantitative impact of these shocks on the charac-

teristics of the Hong Kong business cycles, and to understand the channels through

* Iza, University of the Basque Country UPV/EHU, Avda. Lehendakari Aguirre 83, 48015 Bilbao, Spain.

Tel: +34-94-6013785; Fax: +34-94-6017123; E-mail: amaia.iza@ehu.es. Etxeberria-Garaigorta: University of

the Basque Country UPV/EHU, 48015 Bilbao, Spain. The authors thank Cruz Ángel Echevarra and

Stefano Siviero for useful comments. Financial support from the Basque Government (DEUI, IT-793-13),

and Ministerio de Economa y Competitividad, MEC, through ECO2012-35820 is gratefully acknowledged.

Iza also thanks financial support from UPV/EHU (UFI 11/46 BETS). Any remaining errors are the

authors’ responsibility.

Review of Development Economics, 19(2), 400–414, 2015

DOI:10.1111/rode.12150

© 2015 John Wiley & Sons Ltd