ABSTRACT
In this paper, an empirical analysis is used to compare the effects of oil price shock and exchange rate volatility on the economic growth of Nigeria and Kenya. Firstly, a LA- VAR model is applied to investigate whether the oil price shock and exchange rate volatility have the Granger Causality to economic growth of both Nigeria and Kenya. Secondly, we apply a VAR model with co-integration technique to examine how GDP Growth of Nigeria and Kenya are affected by changes in oil prices and the exchange rate in the long-run. Thirdly, a vector error correction model (VECM) is employed to analyze the short-run dynamics of the real GDP Growth for the two countries. Finally, we employed a SURE model in this study to compare the result of oil price shock on international market to GDP Growth of both countries. Our main findings indicate that the oil price shock have effect on GDP Growth of both Nigeria and Kenya. The exchange rate of both countries also has effect on the GDP output of the countries
CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
One factor in the global economy that has continued to pose a big challenge to policy makers across countries is the increasing spate of fluctuations in the price of oil and exchange rate. The world price of crude oil, which was stable between $2.50 and $3 since 1948, quadrupled from $3 per barrel in 1972 to $12 per barrel by the end of 1974, and from $14 per barrel in 1978 to $35 per barrel in 1981. The price of oil, however plummeted below $10 per barrel in 1986, but surged again to between US$18 and $23 in 1990s. It crossed the US$40 mark in 2004; and rose to about US$60 from 2005. During the summer of 2007, the price of one barrel of crude oil jumped above US$70 and even crossed the US$145 mark in July
2008. The price staggered to US$80.50 in October 2009 and remained at an average of US$75 till August 201,NYMEX (2010).
CRUDE OIL PRICE HISTORY FROM 1970 TO 2010
| 1970- $2.10 | 1979 – $14.80 | 1987- $17.13 | 1995 – $16.15 | 2004 – $31.16 |
| 1971- $2.65 | 1980- $29.97 | 1988 – $19.92 | 1996 – $19.70 | 2005 – $29.97 |
| 1972 – $2.80 | 1981 – $40.00 | 1989- $15.05 | 1997 – $24.65 | 2006- $38.21 |
| 1973- $3.10 | 1982 – $36.50 | 1990 – $21.20 | 1998 – $16.50 | 2007 – $56.97 |
| 1974 – $12.60 | 1983 – $35.50 | 1991 – $27.8 | 1999 – $10.60 | 2008 – $63.28 |
| 1975 – $11.80 | 1984 – $30.00 | 1992 – $18.20 | 2000 – $25.55 | 2009- $98.52 |
| 1976- $12.84 | 1985- 28.00 | 1993 – $18.50 | 2001- $22.00 | 2010 – $39.85 |
| 1977 – $14.33 | 1986- $28.65 | 1994- $13.50 | 2003 – $19.88 | 2011 – $77.69 |
| 1978- $14.33 |
Source: The New York Mercantil Exchange
10
A GRAPH OF CRUDE OIL PRICE HISTORY ANALYSIS
Crude Oil Prices
2008 Dollars
$100 ———————-–~–_–_–_–_–_–_–_––—-.
FD»S 1rk reg iw Ai Gr th
] 4kid.Al4
$0 T=
70 72 74
71 T3 T6
o4 06 s2 s 02 04 0% ¢
| ‘s |
d $$ $7 $9 91 93 6 97 99 1 0 0$ 07 09
1970 – August, 200
WTRG Economic +1%8-200
LIS 1st Purchase Frice [ Welhsd] “Ward Frix“
– Avg U.$. $j2.% =hyp World $5.59= Median Warid $30.04
(479} 291–41
An oil price increase, all things being equal, should be considered good news in oil exporting countries and bad news in oil importing countries, while the reverse should be expected when the oil price decreases. The challenge, however, of the combined effect of volatility of oil prices and exchange rate on economic growth for oil producing country like Nigeria and oil importing country like Kenya is really enormous. Huge inflow of oil revenues in Nigeria are more often associated with expansion in the level of government spending while periods of dwindling oil revenues are usually accompanied by budget deficits. There is no gain saying that Nigeria relies so much on revenue from oil exports. At the same time, the country massively imports refined petroleum and other related products. Evidence,
11
for instance, shows that government spending, which before 1999 remained well below N0.5 trillion, hit Nl .02 trillion marks in 2001 and Nl .5 trillion in 2004. The figures for 2006 and 2007 stood at N2.04 and N2.45 trillion respectively,(Aliyu 2009)
Although the Naira exchange rate has witnessed some period of relative calm since the implementation of the structural adjustment programme (SAP) in July, 1986, its continued depreciation, however, may have implications for the level of real sector activities in the country. The Naira which traded at N0.935 = US$1.00 in 1985 depreciated to N2.413 to
$1.00 and further to N7.901 against the US dollar in 1990. To stem the
trend, the policy of guided deregulation pegged the naira at N21.886 against the dollar in 1994. Further deregulation of the foreign exchange market in
1999, however, pushed the exchange rate to N86.322 to US$1.00. With huge inflow of oil revenue due to hike in the oil price, the end-period rate stood at Nl 17 .97 in December, 2007. This remained stable until towards the end of
2008 when the global financial crisis took its toll and the naira exchange rate depreciated from Nl 16.20 in November, 2008 to Nl31.5 in December, 2008 or a decline in value by 12.95% and further to Nl42.00 or a decline by
7.98% in February 2009,(Aliyu 2009)
In spite of these developments, the national income accounts of
Nigeria revealed an impressive performance. During the oil price shock of
1970-78 (oil boom), GDP grew positively by 6.2 percent annually, however, in the 1980s, GDP had negative growth rates. In the period 1988-1997 which constitutes the period of Structural Adjustment Programme (SAP), which entails economic liberalization, the GDP responded to economic adjustment policies and grew at a positive rate of 4.0 percent. Agriculture, industry and manufacturing, oil and gas sectors had greater dominance in the composition
12
of the Nigeria’s GDP. The year 1989 – 1998 was the most turbulent period in the history of the country’s growth pattern, real GDP grew only by an average of 3.6 percent, against the population growth rate of 2.8% during the same period. Inflation, poverty, exchange rate were all at alarming rates. Foreign direct investment, which is a necessary engine of growth, was stifled because of unconducive enabling environment. Between 1999 and 2008, the country’s growth performance improved significantly. GDP growth rate averaged 7 .8% during the decade solely due to the growth of non-oil sector which grew by 9.5 percent. In this regard, however, oil sector constitutes both a drag on growth and a source of instability on GDP growth pattern. According to Obadan (2009), of the 3 large sectors of Nigerian economy, production, wholesale and retail and oil and gas, only the latter exerts a negative influence by up to 4.49 percent of GDP, in spite of its great potentials in relation to manufacturing and its large share of GDP at 23.2 percent.
Kenya is an oil importing developing country. High oil prices as well as exchange rate volatility may have adverse impact on business, consumers, government budget and the economy generally. Kenya has experienced deteriorating terms of trade which jeopardized balance of payment position of the country leading to lower economic growth in the past decade. Unlike developed oil importing countries, which have high taxes on fuels where price shock could be mitigated by reducing the taxes as fuel cost rises, Kenya’s economy bears the full weight of oil price rise, which often results in the government cutting down on social spending. The government is often reluctant to pass on to consumers a rise in international oil price because of the potential for social resistance to a policy that could hurt the poor masses. Government sometimes subsidize oil price with the dwindling income.
13
The story of Kenya is one of Africa’s worst performing economies, notwithstanding a pick-up of economic growth starting in 2004. Kenya operates a “market based” economy with some state owned infrastructure enterprises, and maintains a liberalized external trade system. According to IMF (2010) the value of the Kenyan shilling (KSh), Kenya unit of currency, maintained an impressive performance after independence in 1963, with a constant exchange rate of KSh7.14 to US$1 from 1967 to 1972 and further appreciated to KSh7.02 to US$1 in 1973. The value of the exchange rate of the Kenyan Shilling remained relatively calm till 1985 when it depreciated to KSh16.43 and further to KSh22.91 to US$1 in 1990. The last term of President Moi (1997-2002), which was characterised by corruption and poor governance soared the exchange rate from about KSh60 per US$1 in 1998 to KSh78.75 per US$1 in 2002 and further to KSh79.17 to US$1 in 2005. The exchange rate of the Kenya shilling, however appreciated during the global financial crisis of 2008 to about KSh69 to US$1 due to tourism which has exhibited steady growth in most years, as a principal source of foreign exchange since independence.
Kenya experienced a continuous GDP growth reversal from a peak of about 6.5 percent per year between 1963 and 1973, after independence, to less than 4 percent per year between 1973 and 1983. The country achieved only about 1.5 percent GDP growth per year during the 1990s. The low economic growth, occasioned by world oil price shocks, translated over time into reduced income per head, increased poverty and worsened unemployment. Kenya currently imports its entire crude oil requirement, which accounts for about 20 to 25 percent of the nations total import bills. The economic performance of the country is also hampered by other numerous interacting factors including over dependence on a few
14
agricultural exports that are vulnerable to world pnce fluctuations, population growth that outstripped economic growth, prolonged drought that hamper electricity generation, deteriorating infrastructure, poor governance and corruption.
1.2 Statement of the Problem
The impact of oil price shocks on net oil-exporting and oil-importing developing countries has not been sufficiently covered in the literature. Specifically, studies are rare, to the best of our knowledge, on Nigeria and Kenya that have taken explicit account of potential non-linearity in the oil price-macro economy relationship. Furthermore, most of the studies that look at real output movements typically have a cross-sectional orientation.
There is also dearth of empirical studies that have looked at effects of oil price volatility on the macroeconomic environment of oil exporting and oil importing Sub-Saharan African countries. Such comparative analysis would have important policy implications. First, it may help to evaluate current macroeconomic policies in both countries especially if oil price shocks have differential effects on these economies. Second, such analysis may help to evaluate exchange rate policies and how effective they may be depending on country macroeconomic circumstances. One may assume that uniform exchange rate policies may not work in both oil exporting and oil importing countries. However, if an exporting economy imports massive refined oil products, as in the case of Nigeria, this assumption may not hold.
Hence, the present study further attempts to determine the impact of such effects in an oil exporting economy such as Nigeria and oil importing economy such as Kenya using a time series analysis. Against this background, therefore, this study seeks to provide answers to the following
15
research questions; (i) what is the impact of oil price shocks and exchange rate volatility on output growth in the Nigerian and Kenyan economy? (ii) To what extent do oil price and exchange rate fluctuations drive real output volatility in both countries? (iii) How does oil price volatility impact on exchange rate volatility in the two economies?
1.3 OBJECTIVE OF STUDY
The specific objectives of this study are:
• To ascertain the impact of oil price shocks and exchange rate volatility on output growth in the Nigerian and Kenyan economy.
• To ascertain the extent to which oil price fluctuations drive real output fluctuations.
• To ascertain how exchange rate responds to shocks to oil prices
1.4 STATEMENT OF RESEARCH HYPOTHESIS
The following are the research hypothesis for the study.
Hol: Oil price shocks and exchange rate volatility have no effect on output growth in the Nigerian and Kenyan economy.
Ho2: Output volatility in Nigeria and Kenya is not affected by oil price volatility.
Ho3: Oil price volatility has no impact on exchange rate volatility on the economy of these two nations.
1.5 SCOPE OF STUDY
The study covers the period between 1970 — 2008. The choice of this period is based on the availability of data that will permit a comparative analysis of these two economies. Our data may be annual or quarterly for the periods in which such frequency of data can be found in the two countries.
16
1.6 SIGNIFICANCE OF STUDY
A comparative analysis of the impact of oil price shock and exchange rate volatility on Sub-Saharan African oil exporting and oil importing nations would help policy makers develop economic policies that will capture the specific macroeconomic needs of these developing economies. The mechanism through which shocks are transmitted would become channels through which the economy will be rescued. Again, any international institution that would be involved in making policies for these nations will not assume uniform application, for example, one – size fit – all policy may not applicable in country specific cases. The recent global financial crisis has caused policy makers around the world to be very cautious with macroeconomic instability. This study would add to knowledge of the sources of shocks by looking country specific characteristics and appropriate policy interventions for specific cases.
INTRODUCTION
1.1 Background to the Study
One factor in the global economy that has continued to pose a big challenge to policy makers across countries is the increasing spate of fluctuations in the price of oil and exchange rate. The world price of crude oil, which was stable between $2.50 and $3 since 1948, quadrupled from $3 per barrel in 1972 to $12 per barrel by the end of 1974, and from $14 per barrel in 1978 to $35 per barrel in 1981. The price of oil, however plummeted below $10 per barrel in 1986, but surged again to between US$18 and $23 in 1990s. It crossed the US$40 mark in 2004; and rose to about US$60 from 2005. During the summer of 2007, the price of one barrel of crude oil jumped above US$70 and even crossed the US$145 mark in July
2008. The price staggered to US$80.50 in October 2009 and remained at an average of US$75 till August 201,NYMEX (2010).
CRUDE OIL PRICE HISTORY FROM 1970 TO 2010
| 1970- $2.10 | 1979 – $14.80 | 1987- $17.13 | 1995 – $16.15 | 2004 – $31.16 |
| 1971- $2.65 | 1980- $29.97 | 1988 – $19.92 | 1996 – $19.70 | 2005 – $29.97 |
| 1972 – $2.80 | 1981 – $40.00 | 1989- $15.05 | 1997 – $24.65 | 2006- $38.21 |
| 1973- $3.10 | 1982 – $36.50 | 1990 – $21.20 | 1998 – $16.50 | 2007 – $56.97 |
| 1974 – $12.60 | 1983 – $35.50 | 1991 – $27.8 | 1999 – $10.60 | 2008 – $63.28 |
| 1975 – $11.80 | 1984 – $30.00 | 1992 – $18.20 | 2000 – $25.55 | 2009- $98.52 |
| 1976- $12.84 | 1985- 28.00 | 1993 – $18.50 | 2001- $22.00 | 2010 – $39.85 |
| 1977 – $14.33 | 1986- $28.65 | 1994- $13.50 | 2003 – $19.88 | 2011 – $77.69 |
| 1978- $14.33 |
Source: The New York Mercantil Exchange
10
A GRAPH OF CRUDE OIL PRICE HISTORY ANALYSIS
Crude Oil Prices
2008 Dollars
$100 ———————-–~–_–_–_–_–_–_–_––—-.
FD»S 1rk reg iw Ai Gr th
] 4kid.Al4
$0 T=
70 72 74
71 T3 T6
o4 06 s2 s 02 04 0% ¢
| ‘s |
d $$ $7 $9 91 93 6 97 99 1 0 0$ 07 09
1970 – August, 200
WTRG Economic +1%8-200
LIS 1st Purchase Frice [ Welhsd] “Ward Frix“
– Avg U.$. $j2.% =hyp World $5.59= Median Warid $30.04
(479} 291–41
An oil price increase, all things being equal, should be considered good news in oil exporting countries and bad news in oil importing countries, while the reverse should be expected when the oil price decreases. The challenge, however, of the combined effect of volatility of oil prices and exchange rate on economic growth for oil producing country like Nigeria and oil importing country like Kenya is really enormous. Huge inflow of oil revenues in Nigeria are more often associated with expansion in the level of government spending while periods of dwindling oil revenues are usually accompanied by budget deficits. There is no gain saying that Nigeria relies so much on revenue from oil exports. At the same time, the country massively imports refined petroleum and other related products. Evidence,
11
for instance, shows that government spending, which before 1999 remained well below N0.5 trillion, hit Nl .02 trillion marks in 2001 and Nl .5 trillion in 2004. The figures for 2006 and 2007 stood at N2.04 and N2.45 trillion respectively,(Aliyu 2009)
Although the Naira exchange rate has witnessed some period of relative calm since the implementation of the structural adjustment programme (SAP) in July, 1986, its continued depreciation, however, may have implications for the level of real sector activities in the country. The Naira which traded at N0.935 = US$1.00 in 1985 depreciated to N2.413 to
$1.00 and further to N7.901 against the US dollar in 1990. To stem the
trend, the policy of guided deregulation pegged the naira at N21.886 against the dollar in 1994. Further deregulation of the foreign exchange market in
1999, however, pushed the exchange rate to N86.322 to US$1.00. With huge inflow of oil revenue due to hike in the oil price, the end-period rate stood at Nl 17 .97 in December, 2007. This remained stable until towards the end of
2008 when the global financial crisis took its toll and the naira exchange rate depreciated from Nl 16.20 in November, 2008 to Nl31.5 in December, 2008 or a decline in value by 12.95% and further to Nl42.00 or a decline by
7.98% in February 2009,(Aliyu 2009)
In spite of these developments, the national income accounts of
Nigeria revealed an impressive performance. During the oil price shock of
1970-78 (oil boom), GDP grew positively by 6.2 percent annually, however, in the 1980s, GDP had negative growth rates. In the period 1988-1997 which constitutes the period of Structural Adjustment Programme (SAP), which entails economic liberalization, the GDP responded to economic adjustment policies and grew at a positive rate of 4.0 percent. Agriculture, industry and manufacturing, oil and gas sectors had greater dominance in the composition
12
of the Nigeria’s GDP. The year 1989 – 1998 was the most turbulent period in the history of the country’s growth pattern, real GDP grew only by an average of 3.6 percent, against the population growth rate of 2.8% during the same period. Inflation, poverty, exchange rate were all at alarming rates. Foreign direct investment, which is a necessary engine of growth, was stifled because of unconducive enabling environment. Between 1999 and 2008, the country’s growth performance improved significantly. GDP growth rate averaged 7 .8% during the decade solely due to the growth of non-oil sector which grew by 9.5 percent. In this regard, however, oil sector constitutes both a drag on growth and a source of instability on GDP growth pattern. According to Obadan (2009), of the 3 large sectors of Nigerian economy, production, wholesale and retail and oil and gas, only the latter exerts a negative influence by up to 4.49 percent of GDP, in spite of its great potentials in relation to manufacturing and its large share of GDP at 23.2 percent.
Kenya is an oil importing developing country. High oil prices as well as exchange rate volatility may have adverse impact on business, consumers, government budget and the economy generally. Kenya has experienced deteriorating terms of trade which jeopardized balance of payment position of the country leading to lower economic growth in the past decade. Unlike developed oil importing countries, which have high taxes on fuels where price shock could be mitigated by reducing the taxes as fuel cost rises, Kenya’s economy bears the full weight of oil price rise, which often results in the government cutting down on social spending. The government is often reluctant to pass on to consumers a rise in international oil price because of the potential for social resistance to a policy that could hurt the poor masses. Government sometimes subsidize oil price with the dwindling income.
13
The story of Kenya is one of Africa’s worst performing economies, notwithstanding a pick-up of economic growth starting in 2004. Kenya operates a “market based” economy with some state owned infrastructure enterprises, and maintains a liberalized external trade system. According to IMF (2010) the value of the Kenyan shilling (KSh), Kenya unit of currency, maintained an impressive performance after independence in 1963, with a constant exchange rate of KSh7.14 to US$1 from 1967 to 1972 and further appreciated to KSh7.02 to US$1 in 1973. The value of the exchange rate of the Kenyan Shilling remained relatively calm till 1985 when it depreciated to KSh16.43 and further to KSh22.91 to US$1 in 1990. The last term of President Moi (1997-2002), which was characterised by corruption and poor governance soared the exchange rate from about KSh60 per US$1 in 1998 to KSh78.75 per US$1 in 2002 and further to KSh79.17 to US$1 in 2005. The exchange rate of the Kenya shilling, however appreciated during the global financial crisis of 2008 to about KSh69 to US$1 due to tourism which has exhibited steady growth in most years, as a principal source of foreign exchange since independence.
Kenya experienced a continuous GDP growth reversal from a peak of about 6.5 percent per year between 1963 and 1973, after independence, to less than 4 percent per year between 1973 and 1983. The country achieved only about 1.5 percent GDP growth per year during the 1990s. The low economic growth, occasioned by world oil price shocks, translated over time into reduced income per head, increased poverty and worsened unemployment. Kenya currently imports its entire crude oil requirement, which accounts for about 20 to 25 percent of the nations total import bills. The economic performance of the country is also hampered by other numerous interacting factors including over dependence on a few
14
agricultural exports that are vulnerable to world pnce fluctuations, population growth that outstripped economic growth, prolonged drought that hamper electricity generation, deteriorating infrastructure, poor governance and corruption.
1.2 Statement of the Problem
The impact of oil price shocks on net oil-exporting and oil-importing developing countries has not been sufficiently covered in the literature. Specifically, studies are rare, to the best of our knowledge, on Nigeria and Kenya that have taken explicit account of potential non-linearity in the oil price-macro economy relationship. Furthermore, most of the studies that look at real output movements typically have a cross-sectional orientation.
There is also dearth of empirical studies that have looked at effects of oil price volatility on the macroeconomic environment of oil exporting and oil importing Sub-Saharan African countries. Such comparative analysis would have important policy implications. First, it may help to evaluate current macroeconomic policies in both countries especially if oil price shocks have differential effects on these economies. Second, such analysis may help to evaluate exchange rate policies and how effective they may be depending on country macroeconomic circumstances. One may assume that uniform exchange rate policies may not work in both oil exporting and oil importing countries. However, if an exporting economy imports massive refined oil products, as in the case of Nigeria, this assumption may not hold.
Hence, the present study further attempts to determine the impact of such effects in an oil exporting economy such as Nigeria and oil importing economy such as Kenya using a time series analysis. Against this background, therefore, this study seeks to provide answers to the following
15
research questions; (i) what is the impact of oil price shocks and exchange rate volatility on output growth in the Nigerian and Kenyan economy? (ii) To what extent do oil price and exchange rate fluctuations drive real output volatility in both countries? (iii) How does oil price volatility impact on exchange rate volatility in the two economies?
1.3 OBJECTIVE OF STUDY
The specific objectives of this study are:
• To ascertain the impact of oil price shocks and exchange rate volatility on output growth in the Nigerian and Kenyan economy.
• To ascertain the extent to which oil price fluctuations drive real output fluctuations.
• To ascertain how exchange rate responds to shocks to oil prices
1.4 STATEMENT OF RESEARCH HYPOTHESIS
The following are the research hypothesis for the study.
Hol: Oil price shocks and exchange rate volatility have no effect on output growth in the Nigerian and Kenyan economy.
Ho2: Output volatility in Nigeria and Kenya is not affected by oil price volatility.
Ho3: Oil price volatility has no impact on exchange rate volatility on the economy of these two nations.
1.5 SCOPE OF STUDY
The study covers the period between 1970 — 2008. The choice of this period is based on the availability of data that will permit a comparative analysis of these two economies. Our data may be annual or quarterly for the periods in which such frequency of data can be found in the two countries.
16
1.6 SIGNIFICANCE OF STUDY
A comparative analysis of the impact of oil price shock and exchange rate volatility on Sub-Saharan African oil exporting and oil importing nations would help policy makers develop economic policies that will capture the specific macroeconomic needs of these developing economies. The mechanism through which shocks are transmitted would become channels through which the economy will be rescued. Again, any international institution that would be involved in making policies for these nations will not assume uniform application, for example, one – size fit – all policy may not applicable in country specific cases. The recent global financial crisis has caused policy makers around the world to be very cautious with macroeconomic instability. This study would add to knowledge of the sources of shocks by looking country specific characteristics and appropriate policy interventions for specific cases.
This material content is developed to serve as a GUIDE for students to conduct academic research
THE IMPACT OF OIL PRICE SHOCK AND EXCHANGE RATE VOLATILITY ON ECONOMIC GROWTH: A COMPARATIVE ANALYSIS OF NIGERIA AND KENYA
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