effect of Oil Prices on Economy

8/10/2019 effect of Oil Prices on Economy

1/10Electronic copy available at: http://ssrn.com/abstract=2147341

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Impact of Oil Prices onCountry s Economy: a case study South Asian

Countries

Muhammad Ahmad

Lahore Business School,University of Lahore, [email protected]

Syed Atif Ali

Lahore Business School,University of Lahore, Pakistan

[email protected]

Abstract:

The study is based on the four large South Asian oil importing countries namely India, Pakistan,

Sri Lanka and Bangladesh. The impact of fluctuating oil prices is studiedover the economyparticularly on Inflation, GDP, FDI and exchange ratesusing regression analysis. The results of

the study indicated that the increasing oil prices resultantly increase the inflation and puts

pressure on local currency exchange rate against US$. On the other hand, the GDP and FDI are

seen to be increasing with increasing oil prices primarily due to the rapid industrialization and

promising returns on investment in the region.

Key Words: Oil Prices, GDP, FDI, Inflation, Exchange Rate, South Asia.

Introduction:

Oil is the major source of energy. It accounts for about 40% of the global energy production. It

not only drives our cars but is also a major raw material for the purpose of heating and

generating electricity. The availability of low-priced fuel has gone because of swift increase in

population, which eventually increases the demand for energy domestically and overall

worldwide. Oil prices have direct impact on the existing lifestyle of the world as it has become

one of the most important indicators of the economic activity all over the world.

The main economic indicators are inflation, foreign direct investment (FDI), gross domestic

product (GDP) and exchange rates. Inflation means that the prices of the products and services

are generally increased over a time period. It means that to buy same good or services one has


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to pay more than previously. Higher inflation means that the worth of the local currency has

decreased. Foreign direct investment (FDI) is the measure of foreign ownership of assets for

instance factories, lands and mines etc. For developing economies it is the major source of

financing, it also create jobs and help the country s economy to grow. The gross domestic

product (GDP) is one of the strongest indicators that tell about the health of the country s

economy. This is basically the measure of country s total output, everything produced by all the

people and the companies over the year. Exchange rate is the price for which the currency of a

country can be exchanged for another country s currency. Factors that usually affects exchange

rate generally include interest rate, inflation rate, trade balance and political stability etc.

Changing oil price have different impacts on the economy of oil exporting and oil importing

countries. The economies of oil producing companies get boost with the increasing oil price. For

example, Iranian economy heavily relies on oil export which comprise of about 80% of their

total exports. Any shock in the global oil prices has huge impact on Iranian economy. On

contrary, changes in oil prices affects negatively to the oil import ing countries. Any increase in

the oil price results in the increase in the prices of consumer products, puts pressure on the

exchange rates and increase in import bills. The oil prices are also related to the demand. The

recent industrialization of Asian countries specially China and Indian have also created a huge

demand of oil and have pushed oil prices up.

Literature Review

Crude oil was trading between $18 and $23 a barrel in the 1990s; it crossed the $40 mark in

2004; and then rapidly increased to almost $60 from 2005. During 2007, the price of one barrel

of crude oil soared to $70 and touched the highest $147 mark in July 2008. (Mussa, 2008) states

a historical fact that the oil prices are still lower than in the late 1970s and early 1980s in real

terms (inflation adjusted), the recent increase can have striking consequences on oil-importing

countries.

(ADB, 2009) In a study by ADB it is reported that for many developing countries, the increase in

oil prices over the last few years has made structural improvement of the local petroleum


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pricing system which is a decisive factor of their macroeconomic policies. In some countries oil

price increase may have been partly balanced by exchange rate movements (the weakening of

the U.S. dollar against the euro), it has also had major socioeconomic impacts. Many

governments have been reluctant to pass on to consumers a rise in international oil prices

because of the possibly to avoid social resistance by the poor. Looking at the recent scenario

(Kiani, 2010) denies this and says that recent rise in world oil price has shifted the burden to the

consumers as government is already running severe losses and equally shifted this burden to

households. Also consumption of kerosene oil, diesel oil and petroleum products at household

level have also increased.

(Bauch, 2011) finds out that in G7 countries, all of which except Canada are net oil importers,

any oil price increase is usually followed by a knock to real GDP in the second year after the

shock. He also noted a spike in inflation peaking three to four quarters after the oil price shock.

(Hamilton, 2009) further notes that out of ten nine recessions in United States, after the world

war 2, have occurred after increases in oil prices.

This has been identified by (Agarwal, 2008) that the fuel and food prices are very volatile, the

sometimes policymakers choose to aim core inflation and excludes fuel and food prices. But

this also puts policymakers in an unrealistic bubble as core inflation will not show the rise in the

food and fuel prices and if it continues to be long term then the actual inflation of the economy

will be much higher than expected value.

The list of impacts of high oil prices goes on. (Rasmussen & Roitman, 2012) states that import

bills go up when oil prices increase. It is more surprising that GDP often goes up too. A positive

correlation indicates that when oil prices go up, GDP goes up, and when oil prices go down,

GDP goes down. In more than 80% of the countries, the correlation between oil prices and GDP

is positive

(Ghalayini, 2011) Currencies would adjust to changes in trade balances. Since oil contracts are

settled in US dollar and oil exporters invest part of their windfall earnings in US dollar

dominated assets, higher oil prices would lead to raise the value of US dollar by increasing the


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transactions demand for it. A stronger dollar would raise the cost of servicing the external debt

of oil-importing developing countries, as that debt is usually denominated in dollars.

(Malik, 2009) The country having low foreign exchange reserves, high oil price is dealt by a

reduction in total demand for all imported goods, so as to restore balance of payments

equilibrium. Higher oil prices leads to inflation, increased input costs, reduced non-oil demand

and lower investment in net oil importing countries. Various authors including (Lumsdaine,

2009) have noted that while high oil prices have at times been associated with episodes of high

inflation.

(Chittedi, 2012) suggests that in the long run, the influence of oil price on stock prices also

exists, because oil price effect macroeconomic indicators that influence liquidity of stock

markets.

Data and Research Methodology

To study the impact of oil prices on economy, four South Asian countries are selected namely,

India, Pakistan, Sri Lanka and Bangladesh. For the research, the secondary data is used.

Historical data for the economic variables and oil prices is collected from The World Bank

database

1

. The data is from year 1985 to year 2010. To make the analysis convenient all valuesof the dependent and independent variables are taken in US dollars.

The impact of the oil prices on economic variables is studied using regression analysis. Total five

variables have been used in the study. The only independent variable is the oil prices, remaining

dependent variables are gross domestic product (GDP), foreign direct investment (FDI),

inflation and exchange rate. Statistical Package for the Social Sciences (SPSS) is used to run the

regression analysis over the data of four countries individually.

1The World Bank database: data.worldbank.org/


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Results and Findings

Inflation:

Country Beta R square Adjusted R square SignificancePakistan 0.525 0.276 0.245 0.06

India -0.33 0.01 -0.54 0.89

Sri Lanka 0.234 0.55 0.15 0.251

Bangladesh 0.343 0.118 0.078 0.101

The impact of fluctuating oil prices is studied on Inflation of the countries. The regression

analysis adjusted R2 values of Pakistan, Sri Lanka and Bangladesh show that 24.5%, 15% and

7.8% respectively, of the variations in inflations are explained by the variations in the oil prices.

The remaining variations are due to other macroeconomic factors that vary country to country.

The regression model beta values shows that one unit change in the oil price would change

0.525, 0.234 and 0.343 units in the inflation index of Pakistan, Sri Lanka and Bangladesh

respectively. This is very significant finding as the higher oil prices directly raise consumer

prices. With an increasing oil price there is an increase in the cost of energy which as a results

increase in the cost of production and cost of distribution of the consumer goods.

The case of India appears relatively different with beta of -0.33 indicating that the one unit

increase in the oil price would cause the 0.33 units decrease in the inflation. These results may

be rejected as the regression model significance is very high (0.89) and does not meet our

criterion of 0.25 in this case. In actual the inflation percentages in India are very volatile which

resulted in poor fit of the regression model line. In 2008, when the oil prices were highest the

inflation also hit the last 10 year highest of 8.3%


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The estimated curve lines of the countries under discussion are shown below for further

clarification.

Pakistan India

Sri Lanka Bangladesh

Figure 1: Estimated Curves of the Regression Model (Impact of Oil price on Inflation)


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Foreign Direct Investment:

Country Beta R square Adjusted R square Significance

Pakistan 0.890 0.793 0.784 0.00

India 0.838 0.702 0.686 0.00

Sri Lanka 0.846 0.715 0.703 0.00

Bangladesh 0.947 0.896 0.891 0.00

The results show t hat t he bet a values are very close. All the r esults can be accepted as the

significance values are less than 0.01. Analyzing the adjusted R2 values shows that more than

78%, 68%, 70% and 89% of the variation in the foreign direct investments, in Pakistan, India, Sri

Lanka and Bangladesh respectively, can be explained by variation in the oil prices. The beta

values in each case show the common trend in all the countries under discussion. With the

increasing oil prices the foreign direct investments also increased. With one unit change in the

oil price 0.890, 0.838, 0.846, 0.947 units of FDI in Pakistan, India, Sri Lanka and Bangladesh

respectively will change. This also supports the fact that Asian economies are growing and are

offering promising returns on investments. Therefore as the price of oil increase foreign

investors are putting more money for higher returns in South Asian region.

Gross Dom estic P roduct:


Pakistan 0.92 0.846 0.840 0.00

India 0.902 0.813 0.803 0.00

Sri Lanka 0.893 0.797 0.789 0.00

Bangladesh 0.864 0.746 0.735 0.00

The results of the impact of the oil prices on the GDP show they are related. The adjusted R2

values indicate that more than 84%, 80%, 78% and 73% of the variations in GDP of Pakistan,

India, Sri Lanka and Bangladesh respectively, can be explained by the variations in oil prices. All


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the results have significance lesser than 0.01 and meeting the research criterion. From the beta

values of the regression model it is indicated that as the one unit of oil price change 0.92 , 0.902,

0.893 and 0.864 units of GDP of Pakistan, India, Sri Lanka and Bangladesh respectively, changes.

As the oil prices increased, the economies of the South Asian countries have shown increase in

GDP, though the growth rate may have squeezed yet an overall increase is observed.

Currency Exchange Rate to US$


Pakistan 0.731 0.534 0.514 0.00

India 0.455 0.207 0.163 0.044

Sri Lanka 0.762 0.581 0.563 0.00

Bangladesh 0.842 0.679 0.665 0.00

The regression analysis results shows greater than 51%, 16%, 56% and 66% of the variat ions in

the currency exchange rate with US dollar, Pakistan, India, Sri Lanka and Bangladesh

respectively, is related to the changes in the oil price. The remaining variations are due to other

extraneous factors. The beta values of the regression model tells us that one unit change in the

oil price changes 0.731, 0.455, 0.762 and 0.842 units in the local currency exchange rate against

US dollar in case of Pak istan, India, Sri Lanka and Bangladesh respectively.

This gives an evident picture that the local currency of the oil importing countries gets under

pressure due to increase in oil prices because of the major reason that their import bills gets

increased and consequently their balance of payments gets disturbed.

Conclusion:

The belief that oil prices can have a macroeconomic impact is well accepted. Our statistical

estimates suggest changing oil price directly impact the economies of South Asian countries. It

slows down the rate of growth and results in an increase in the price level and potentially an

increase in the inflation rate.


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Bibliography

ADB. (2009). Impact of High Oil Prices. Chennai: African Development Bank.

Agarwal, A. (2008). Understanding the inflation trends in India. IDBI Gilts Econom ic Research, 1 -7.

Bank, T. W. (n.d.). The World Bank.

Bauch, J. H. (2011). The Impact of Oil Prices on the U .S. Economy. CMC Senior Theses, 146.

Chittedi, K. R. (2012). Do Oil Prices Matters for Indian Stock Markets? An Empirical Analysis.

Journal of Applied Econom ics and Business Research, 1 -10.

Fezzani, B., & Nartova, D. (2011). Oil Prices Fluctuation Impact on Iraq s Economy. European

Journal of Social Sciences, 626-633.

Ghalayini, L. (2011). The Interaction between Oil Price and Economic Growth. Middle Eastern

Finance and Economics, 127-140.

Hamilton, J. (2009). Causes and Consequences of the Oil of 2007 -8. Brookings Papers on

Economic Activity, Spring 2009: , 215-261.

Kiani, A. (2010). Impact of High Oil Prices on Pakistan s Economic Growth. International Journal

of Business and S ocial Science, 209-216.

Lumsdaine, R. L. (2009). The R elationship between Oil Prices and Breakeven Inflation Rates.

Social Science Research Network (SSRN) , 1-19.

Malik, A. (2009). How Pakistan is Coping with the Challenge of High. Pakistan Institute of

Development Economics.

Mussa, M. (2008). Global Economic Prospects: Surviving a Mild Case of Stagflation. Global

Economic Prospects. Peterson Institute for International Econom ics.

Rasmussen, T., & Roitman, A. (2012). How Closely are Oil Prices Tied to Economic Activity?The

Oil Drum.


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