Asymmetric adjustment between oil prices and exchange rates: Empirical evidence from major oil producers and consumers

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Highlights

  • We investigate a long-run asymmetric adjustment of the oil prices and the exchange rates of twelve major oil producers and consumers.

  • We use the TAR and M-TAR models to investigate cointegration with asymmetric adjustments between these series.

  • The results reveal the existence of cointegration in six of the twelve countries studied and co-integration and asymmetric adjustment in four countries.

  • Brazil, Nigeria and UK show higher adjustment after a positive shock than after a negative shock while the Eurozone shows the opposite behaviour.

Abstract

This paper investigates the long-run relationship and asymmetric adjustment between the real oil prices and the real bilateral exchange rates of twelve major oil producers and consumers in the world. It uses threshold autoregressive, TAR, and momentum threshold autoregressive, M-TAR models. The data-set used is monthly series that covers 1970:01–2012:01. The results reveal the existence of cointegration in six of the twelve countries studied and cointegration and asymmetric adjustment in four countries of which Brazil, Nigeria and the UK show higher adjustment after a positive shock than after a negative shock while the Eurozone shows the opposite behaviour.

Introduction

Oil is one of the most important commodities traded in the world. Its many uses include a source of energy, a raw material in various industries and financial markets where many financial derivatives are based on it. Its price is primarily determined by market forces and hence variability of its price is very common. This will have an important effect on both the imports and exports of its major consumers and producers with a consequent impact on their exchange rates. This provokes interest in investigating the relationship between oil prices and exchange rates. Theoretical analysis of this relationship started with the work of Krugman (1980) where he showed that the initial effects of an increase in oil prices on real exchange rates differ from their long-run effects. In the former it is an appreciation and in the latter it is depreciation. Further work by Krugman (1983) proposes three models to explain the effects of oil shocks on exchange rates. The models suggest that oil shocks affect all countries, but their effects on the exchange rate depend on the asymmetries between the economies. Golub (1983) on the other hand, developed a stock/flow model that looked into the effects of oil shocks on exchange rates and concluded that the effects depend on the resultant direction countries take in reallocating their wealth. But the empirical literature is more dominant in this area.

Most of the literature in this area focuses on either single or several oil producing economies. The work of Corden (1984), Amano and Norden (1998) and Issa et al. (2008) are on individual countries where as those of Arteta et al. (2011), Amano and Norden (1998) and Mundaca (2013) involve several oil producing countries. Corden (1984) studied the effects of discovery and subsequent production of oil in the North Sea on the rest of the Ducth economy in which the famous ‘Dutch disease’ was discovered. The Arteta et al. (2011) paper focuses on Mexico. Issa et al. (2008) studied the relationship between energy prices and the Canadian Dollar. Amano and Norden (1998) investigated and found evidence of a long-run relationship between oil prices and the US Dollar exchange rates with respect to several major currencies. Mundaca (2013) analysed the effects of oil price shocks on the exchange rate volatility of Arab Monetary Fund countries with relatively high capital mobility. These papers have largely overlooked the effects that changes in oil prices could have in large developed economies that are dependent on oil imports or countries that are currently both large oil producers and consumers.

Further to the suggestions by the theoretical models that adjustment between these series could be asymmetric, it was also found that foreign exchange interventions as well as other monetary policies have been used by countries in order to influence the behaviour of their exchange rates.1 This will generate asymmetries, which could be better modelled using non-linear techniques. However, most of the empirical literature uses linear models that include the Johansen cointegration and the Engle–Granger approach. Such linear models ignore the implications of monetary authorities’ aversion to large changes in exchange rates as found by the sub-literature on exchange rate regime verification. Notable exceptions are Mohammadi and Jahan-Parvar (2012) who used threshold cointegration to investigate dynamics between the oil prices and exchange rates of Mexico, Norway and Bolivia, and Akram (2004) who studied the possibility of non-linear cointegration between oil prices and exchange rate for Norway.

This paper extends this literature in the following ways. First, it investigates the relationship between exchange rates and oil prices in both large oil producers and consumers in the world. Unlike in the previous literature, this would allow us to analyse the effects of oil prices on exchange rates not only in small resource-based oil exporting economies, but also on large industrial economies where most of them depend on oil imports. Eleven countries and the Euro area, which consists of seventeen European countries, are chosen for this analysis. These countries are among the fifteen largest oil producers and consumers in the world. Secondly, unlike most of the literature in this area, the paper uses a non-linear methodology of cointegration based on threshold autoregressive (TAR) and momentum threshold autoregressive (M-TAR) models developed by Enders and Siklos (2001). Thirdly, using the estimated results, we explore the policy implication of the findings to these economies.

The paper finds evidence for the existence of cointegration in six of the countries covered while signs of asymmetric adjustments were detected in Brazil, the Eurozone contries, Nigeria and the UK. The results indicate that Brazil, Nigeria and the UK recorded higher adjustment after a positive shock than after a negative shock. Thus, real exchange rate appreciation following a rise in the real oil prices is eliminated faster than a depreciation following a fall in the real oil prices. However, the result for the Eurozone shows the opposite. That is adjustment is faster after a negative shock than after a positive shock. In addition, results for Brazil and the UK indicate Granger causality with respect to the real oil prices.

The rest of the paper is structured as follows. Section 2 discusses the econometric model used in this study where the techniques of TAR and M-TAR are explained and Section 3 presents the data used and discusses the estimated results. Section 4 provides conclusions as well as examines some policy implications of the findings.

Section snippets

Methodology

Most of the countries covered in the study are on de jure floating exchange rate regimes. However, a de facto regime may differ with a de jure, which means the regime might not be floating, as monetary authorities often try to influence the behaviour of exchange rates.2

Data

The data consists of monthly observations covering the period 1970:01–2012:01. These are the real oil prices and the real exchange rates of the domestic currencies of the countries considered with respect to the US dollar.4 There are many oil benchmarks in the oil industry which are used as reference, but the

Conclusion and policy implications

This study looked into the existence of long run relationship with asymmetric adjustment between real oil prices and real exchange rates of twelve major world oil exporting and consuming countries, using the non-linear models; TAR and its variant M-TAR. The results show evidence of cointegration in six of these countries. These are Brazil, Eurozone, South Korea, Mexico, Nigeria and UK. Results from the M-TAR model for four of these countries (Brazil, the Eurozone, Nigeria and the UK) show signs

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    They show that 58% of the variation in the U.S. real exchange rate is driven by shocks that are exogenous to the global oil market. Other studies also examine the relationship between oil price and exchange rates for developed countries (see Ahmad & Hernandez, 2013; Amano & Van Norden, 1998; Atems, Kapper, & Lam, 2015; Backus & Crucini, 2000; Basher, Haug, & Sadorsky, 2016; Beckmann & Czudaj, 2013; Benhmad, 2012; Brahmasrene, Huang, & Sissoko, 2014; Buetzer et al., 2016; Chen & Chen, 2007; Coudert & Mignon, 2016; Huang & Feng, 2007; Korhonen & Juurikkala, 2009; Lizardo & Mollick, 2010; Mendez-Carbajo, 2011; Pershin, Molero, & de Gracia, 2016; Rasasi, 2017; Tiwari, Dar, & Bhanja, 2013; Volkov & Yuhn, 2016; Wen, Xiao, Huang, & Xia, 2018). Also, a number of studies investigate the relationship between the oil market and exchange rates for Asian countries.

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We are grateful for the useful and constructive comments we received from the anonymous referee. We also acknowledge the useful comments received from Bruce Morley.

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