NORWEGIAN SCHOOL OF ECONOMICS essay

Thesis 41

NORWEGIANSCHOOL OF ECONOMICS

BERGEN,SEMESTER AND YEAR OF SUBMISSION

FOUNDATIONCOURSE

SUPERVISOR:

TITLE:THE RELATIONSHIP BETWEEN EXCHANGE RATES AND OIL PRICES

AUTHOR’S

&quotThisthesis was written as a part of the master programme at NHH. Theinstitution, the supervisor, or the examiners are not – through theapproval of this thesis – responsible for the theories and methodsused, or results and conclusions drawn in this work.&quot

Abstract

Fora long time, studies have sought to discover the connection betweenthe effect of the exchange rates upon the exported and importedservices and goods (Harri, et at., 2009). The results of theseinvestigations have revealed that rates of exchange possess animportant impact on the prices of the commodities that are traded ina country. However, energy also impacts the production of goods andservices significantly. The use of products such as petroleum andchemicals has been adopted extensively in agriculture over the pastyears. Changes in these inputs, therefore, triggers changes insupply, and, by extension, the prices of the commodities that usethese inputs (2009).

Thisthesis discusses the connection between oil prices and the exchangerates in 10 net oil importing and exporting nations. The quantitativeresearch methodology will be used to determine the link amid oilprices and the rates of foreign exchange of net oil importing andexporting nations. More specifically, the study will analyse thelong run relation, determine short-term dynamic adjustment to shortterm deviation and impulse response, and make forecast as per theequations developed. The study will begin by investigating thevariables being studied by using the Error Correction Model method,stability test, co-integration test, Granger causality test and thestationarity test. These tests will be utilised to find out whether alink between the oil prices and the rates of exchange exists withinthe net oil importer and exporter nations.

Afterthe preliminary investigation, the co-integration relationshipbetween the prices of oil and the rates of exchange shall bedetermined. If the relationship (co-integration) is revealed, theactuality of a long-run relationship amid the two variables will bestudied. Thus, the Error Correction Model will be utilised to gaugethe short-term properties pertaining to the co-integrated series. TheImpulse Response Function (IRF) will also be used. Also, the IRFexplains the response to shock amongst variables to reveal how randomshock in one variable affects another, for both long-term andshort-term effects. Eventually, the IRF will make forecastingpossible, revealing causality or interactive relationship betweenexchange rates and oil price.

Acknowledgements

Chapter1

1.0Introduction

TheUS dollar is the primary medium of exchange when it comes to sellingand trading oil internationally (U.S. Energy InformationAdministration, 2015: 25). Thus, if the worth of the dollardepreciates, oil price, and, by extension, demand, goes up andvice-versa. The first round of prices hikes, where oil pricesescalated to $10 per barrel, was experienced in late 1973(VERLEGER,2008: 46).The depreciating dollar and inflation was blamed for thebefore-mentioned phenomenon. The second major round of oil priceincreases (1978) was again attributed to the weakening value of thedollar, by oil exporting countries. Eight years later (1986), thedollar value appreciated. Consequently, the oil prices declined. Inrecent times, the dollar exchange rate and the prices of oil havebeen connected (VERLEGER,2008).This paper discusses the link amid the exchange rates and prices ofoil in the net oil importing and exporting nations.

Hypothetically,it has been recognised that an oil-exporting nation might have anincrease in the rate of exchange when the prices of oil increase anda reduction when they plummet. For instance, the robust increase ofthe Norwegian krone in the 1996/1997 and the devaluation in 1998/1999are normally credited to the increase and decrease of oil prices inthose times. Similarly, the 1986 great reduction of the krone hasbeen frequently clarified with orientation to the low oil prices inthe previous year. Experiential studies have, nonetheless, proffereddiverse backing for the presumed covariance amid the price of oil andthe exchanges rates (De Grauwe, 1996). In specific, investigations ofthe Norwegian exchange rates discovered a numerically unimportant ora mathematically frail connection between the oil price and the worthof the krone. The prevailing empirical results can be demonstratedand they indicate a cross relationship between the krone/Dollarexchange rate. Divergent from the model, the cross plot did notdesignate any palpable connection between the oil price and the rateof foreign exchange of a state. The recession line designates theminor progressive covariance and not an undesirable one as projected.Such experiential results tend to be mystifying within the light ofthe hypothetical works and the mutual awareness that the price of oilis an essential element with regards to the key monetary variations.Nevertheless, the perplexing effects of the current research workscould have risen from the utility of linear prototypes to approximatethe connection between the prices of oil and the exchange rate.Consequently, they (indirectly) adopt symmetric influences of anupsurge and a reduction in the oil price on exchange rates.Similarly, oil price effects are sovereign of the value of oilprices. Such norms might, nonetheless, be over basic and result inthe underestimation of oil price effects in linear exchange ratesimulations. The examination of concern is whether the price of oilpossess non-linear influences upon the monetary exchange rates, thekind of the conceivably non-linear connection, and mostly whetherallowance for non-linear effects permits the elucidation of the keyvariations in such exchange rates. Nonetheless, official tests oflinearity are frequently premeditated to have influence againstspecific non-linear practises. Considering that the system of aconceivably non-linear relationship is not clear, an analysis ofdaily annotations of oil prices and the rate of foreign exchangeusing basic evocative procedures is started out with. The resultsfrom this examination are subsequently solemnised and seasoned in thestructure of multivariate prototypes of the minimal operative ratesof exchange.

Inexpectation of certain key outcomes, a precise non-linear relationbetween the prices of oiland the rates of foreign exchange areexposed and they seem interpretable in the light of latest researchon money crunches. These results are promising against the contextualextensive cynicism in the prose concerning the likelihood ofdeveloping those exchange rate prototypes.

1.1The Structure of the Paper

Thepaper is organised as follows: section 1.0 is the introduction. Itgives the general information about the thesis, and the reason it isuseful and interesting. It forms the backbone of the paper. Section1.2 describes the oil shocks, and brief historical perspective intothe same

Chapter2 examines the literature review by studying the relationship betweenthe oil prices and a theoretical framework for the same.

Thesucceeding section examines the aims of the paper, the problemstatement, the objectives and its significance.

Chapter4 gives an analysis of the relationships between oil prices andexchange rates, and the factors which affect such relationships. Asubsection in the chapter investigates the factors which affect theforeign exchange rates in a given country. Section 4.3 scrutinisesthe monetary policy conditions like the interest rate parity (IRP)and the interest rate differentials (IRD). Subsequently, the assetpricing channel theory is examined. Section 4.5 studies thepurchasing power canal such as the purchasing power parity, supplyand demand with respect to the relationship with exchange rates. Thechapter also explores the co-relationships between the dollar and theexchange rates in net oil exporting and importing nations.

Chapter5 gives the information on data and methodology, the ECM model, thebeta estimation, the stability and co-integration tests, includingboth long-term and short-term relationships of the same.

Chapter6 examines the analysis of data and the results obtained. Theanalysis proceeds country-by-country.

Thelast chapter gives the conclusion and recommendations of the paper.

1.2Oil Shocks: A Brief Historical Perspective

Inthe period between 1940s and 1970s, oil prices were considerablysteady: oil price upsurges were slow (Sill 2007). Nevertheless, theperiod between 1970s and 1980s experienced an intense oil pricesurge. The order of phases resulting in the melodramatic upsurges inoil prices can be related to the formation of OPEC and uneven oilsupply from the Middle East oil-producing nations. In essence, the1973 (October) Yom Kippur War resulted in OPEC recognising the effectit had over regulating the price of oil. Afterwards, when theEuropean nations and the U.S. braced Israel in the war, the OPECplaced a restriction on the supply of oil to western states. Thismove resulted in the decrease of oil production by 5 million barrelsper day. As a result, the cut-back resulted in a 400% increase in oilprices within a six month period (2007). Nevertheless, the durationbetween 1974 and 1978 experienced a comparatively constant oil priceera (Sill 2007). The 1979 and 1980 Iraq-Iranian war hastened thesubsequent round of oil price shocks. A noteworthy deterioration inworld oil production was recognised: world production decayed by 10%,resulting in the surge of the price of oil from $15 to $36. Thevariations in oil prices stimulated OPEC nations to discover ananswer to the uneven oil prices. OPEC republics recognised productionproportions nonetheless, the global depression, preservationlabours, and duplicitousness on production by associate nations ledto a momentous weakening in oil prices by 1986.Later, between 1990and 1991, the Gulf War obstructed the supply and prices of oil(Izzard, 2010). Despite the comparatively low prices in 1990s, theOPEC member countries made no determination to raise oil prices,keeping oil prices low for a protracted period. Nevertheless, afterthe Asian monetary catastrophe in 1998, crude oil prices fell to $10per barrel. This incidence compelled OPEC to establish a sequence ofproduction slices, which was initiated in late 1999. Subsequently,OPEC reclaimed control over the oil market, resulting in an upsurgein the prices of oil (2010). Because of the broad fluctuations in theoil prices and the foreign exchange rates, the relationship betweenoil prices and exchange rates has induced substantial attention fromscholars. Throughout the year 2002, crude oil prices was averaging$20 per barrel. In the future, markets designate financiers to expectthe oil prices to continue over $70 per barrel. The U.S. economy thedata shows a clear penchant for spikes in oil prices. The result isan economic depression.

Chapter2

2.0Literature Review

Exchangerates are critical factors when it comes to determining the level oftrade of a country, which is crucial to most free market economiesworldwide (Asari et al., 2011). Therefore, most people and investorswatch exchange rates with close interest to understand how well orpoorly a particular economy is doing. Governments also manipulatethese economic measures – by placing regulatory limits on thetransfers of exchange rates – in an attempt to keep in check localcurrency fluctuations (2011). However, such government actions can attimes be dangerous or even pointless when investors decide to attacka particular currency. In most cases, volatile exchange rates hindereconomic growth, prevent capital outflows, and even hurt the economysometimes (2011).

Theabove considered, many researchers and economists have accepted thatoil price shocks contributed to most of the economic recessions thathit the world (Aziz, 2009). For example, in 1973-74, unexpected oilprice hikes precipitated the appreciation of the US dollar. However,in 1979, the dollar experienced depreciation after oil prices rose.In the 1980s, the same pattern was, again, realised. More recentlyoil prices remained relatively low until 2007 when they hiked, andthe value of the dollar depreciated once again (2009). The questionhere remains: does any rational explanation exist for the performanceof the foreign exchange market, or is it simply a reaction to whatother traders think? A simple answer to this question may be hard todevelop however, one can develop insight into this issue throughanalytically examining the link between oil price vicissitudes andthe corresponding rates of foreign exchange.

Sinceprice indices that comprise various commodities with differentweights are used to compute actual exchange rate, actual exchangerates can be perceived as relative prices (Aziz, 2009). In addition,considering the degree to which countries regard oil an output thatis included in the product value index, variations in non-stationaryoil prices are mirrored in dynamic actual exchange rate variations(2009). People who have studied the contribution of oil price changesto the non- stationary performance of real exchange rates through thepost-Bretton Woods era acquiesced over the findings obtained.Evidence gathered over this period established the fact that oilprice changes and real exchange rates are co-integrated. In addition,the findings also reveal that oil price changes may be attributed tothe non-stationary activities of the US Dollar real exchange rate andpersistent shocks over the post-Bretton Woods era (2009).

Intheory, oil exporting countries experience exchange rate appreciation– a decrease in the value of exchange rates – when oil pricesincrease and exchange rate depreciation – increase in the value ofthe local currency – when oil prices decrease. Studies haveestablished a negative relationship between oil prices and exchangerates in countries that export oil. In other words, oil pricesincreases cause an appreciation of the local currency in oilexporting countries (Aziz 2009).

Benassy-Quereet al. (2007), discovered that if other factors remained constant, a10 percent increase in the price of oil led to a 4.4 percentincrement in the value of the dollar. Additionally, Amano and vanNorden (1998) similarly established a link between the real USeffective exchange rate and oil price shocks in the long-term. Thefindings of these researchers indicate that oil price changes havetriggered persistent shocks, over the past years, on the exchangerate.

Theabove considered, this paper uses a two-pronged approach. Instead ofexamining the effect of oil price changes on import oil countries orexport oil producing countries in solitude, it combines bothapproaches to offer in-depth insight on the effect of oil prices onboth types of economies. Secondly, the oil price change and exchangerate link will be analysed using various co-integration methods,which enhance the capacity of tests.

Asample of 10 nations, comprising five oil producing nations and fivenet oil importing nations using monthly panel data will be used. Netoil exporters include Russia, Venezuela, Norway, Saudi Arabia, andMexico. Net oil importers include India, South Africa, China, Brazil,and Japan.

2.1Earlier Studies on the Relationship between Oil Prices and ExchangeRates

Thedollaris characteristically utilised as the invoice prevalence in worldwidecrude oil trade.Consequently, the price of crude oil is thoughtto be subjective to variations in the worth of the dollar. Since2002, the price of oil tends to increase at the similar time when thedollar is depreciating, in conditions of actual effectual exchangerate, also called the US Dollar Exchange Rate. This brings about thelikelihood that co-activities between the US dollar exchange rate andthe price of oil subsist in the long run, and a reduction of the USdollar is linked to the increase in the dollar price of oil. Declineof dollar makes oil comparatively less expensive in nations withincreasing monetary capabilities like the yen and euro (Alhajji,2004). If the US dollar exchange rate determines the price of oil, itis then suitable to correctly choose the currency for oil pricing. Asa result, it is exciting and significant to examine the connectionbetween the US dollar exchange rate and the dollar oil price. With along and updated data, it is impossible to find a long-termconnection between the US dollar exchange rate and the price of oil.Nonetheless, this paper shows that the long-term connectionappreciably exists with the concern of certain breakpoints. The firstwas in 2002 when the oil invoicing scheme transformed from the plantedge netback to formula netback invoicing. The second was in 2005when the global oil demand amplified, predominantly originating fromthe budding economies.

Manystudies have examined the long-term link between the US dollarexchange rate and the price of oil, and majority of them have foundcausality moving from the exchange rate to the price of oil, and notvice versa. The opposite is not reliable with the examination talkedof above. Several studies have examined the hypothesis causal to therelationships between the US dollar exchange rate and the price ofoil. For the outcome of the oil price on the dollar exchange rate,Krugman (1983) and Golub (1983) describe those outcomes via thebalance of overheads. They dispute that an increase in the oil pricewould catapult a transfer of wealth from oil-importing nations to theoil-exporting ones, and its effect on the exchange rate woulddetermine collection choices of the oil-exporting ones in the shortterm. However, the same would be dependent on their import choices inthe long term. They discover that oil-exporting nations, in generalOPEC nations, prefer the US dollar-priced resources. When the oilprice increases, it correspondingly raises the revenue of theoil-exporting nations. Subsequently, such nations use their highincome to procure for more US dollar-priced resources, leading to theappreciation of the dollar. In the long term, high revenue will leadto high expenditure. For instance, if those nations utilise theirhigh proceeds to buy European assets, then they would have toexchange the dollars for Euros, which would ultimately lead to adowngrading of the dollar.

Consideringdemand, the moment the dollar slumps, the oil in other nations getsless expensive in domestic currencies. This implies that there is ahigh demand for oil, and therefore a high global demand for the same.Then the oil price increases. Considering the supply side, the oilexporting nations would lose the buying power when the dollar slumps,and to protect against losing the buying power, they may restrict thesupply. Consequently, the oil price would increase.

Econometricmethods have been used to examine the relationship between the USdollar exchange rate and the price of oil. A number of them presentlyfocus on the mutual relationship between them by using errorcorrection models and co-integration examinations to investigate thelong-run link, and the course of causality over time. They found thatthe two runs are co-integrated, and the oil value leads to consequentfluctuations in the dollar exchange rate. Utilising a sheetco-integration examination and sheet forecast recession, they showedthat the actual oil invoice might have been the leading source ofactual exchange rate actions. Olomola and Adejumo (2006) alsoinvestigated the link between the actual oil prices and actualexchange rates by accounting for other significant macroeconomicelements such as the productivity, price increases, and the cashsupply, particularly in Nigeria, in the prototype of a co-integratedVector Autoregressive (VAR). They examined the consequence of oilprice shock on Nigeria’s naira alongside the US dollar exchangeoutput, rate, price increases and the monetary stock. They found thatoil price shocks do have some noteworthy influence on the exchangerate including the long-term monetary supply, but never on theproductivity and price increases in Nigeria. Consequently, Lizardoand Mollick (2010) used the same technique to reconnoitre the oilprice-exchange rate connections. They considered the US dollarexchange rate alongside the currencies of oil-importing nations andoil-exporting states, correspondingly they likewise added the UScomparative monetary supply and virtual manufacturing productivity intheir co-integrated VAR prototype. They also found that surges inactual oil invoices results in a substantial devaluation of the USDalongside the net oil exporter states such as Mexico, Canada andRussia, but an increase against the oil importers like Japan. In thesame vein, Huang and Guo (2007) constructed an operational VARprototype to examine the consequences of the shocks in oil price,demand, supply and currencies on China’s actual exchange rate. Theyfound that actual oil price shocks led to an inconsequential increaseof the long-run actual exchange rate owing to China`s diminishedreliance on trade in oil than its business partners. Similarly,Narayan et al. (2008) used the regular statistics on oil invoices andthe US dollar exchange rate for the duration2001-2007, to examine therelationship between the impulsiveness of oil prices and theunpredictability of the US dollar exchange rate, using the sameprototype. It was found that an increase in the oil price results inan increase of the Fijian dollar with reference to the US dollar.Several of the literature similarly examines the trend of thecausality between the price of oil and the US dollar exchange rate.Altogether, such experiential investigations found an influence ofthe invoice of oil on the exchange rate, but not the reverse, whichis never stable with the investigative compromise.

Again,Novotny (2012) investigated the consequence of insignificant actualexchange rate of the US dollar on the British oil price, bycomprising the US dollar manufacturing productivity, short-run actualinterest rates, oil portfolios and the rate of the utility of the oilfactories in the USA in the prototype. The outcomes provided thesubstantiation of a transposed link between the US dollar exchangerate and the British raw oil price. This is because of thesupplementary abstract demand for oil as a substitute instrument forinvestment. Utilising the error correction models and theco-integration tests, Sadorsky (2000) investigated the links infuture prices of crude oil, unleaded gasoline, heating oil and the USdollar exchange rate. The outcomes demonstrate a long-term stabilitylink between the four variables, and the causality ranges from theexchange rate to the future energy prices.

2.2Theoretical Framework

Therates of foreign exchange possess an important control over the valueof exported and imported goods and services (Harry, et al., 2009). Assuch, the prices of goods and services merchandised in particularcountries, therefore, are impacted significantly by the exchangerate. Similarly, energy impacts the production of commodities incritical ways. In agriculture, for instance, the utility of petroleumproducts has significantly increased over the recent years thus, theprice of petroleum is expected to have an impact on the price andsupply of agricultural products (2009).

Thestudies have also linked the price of petroleum to that of commodityprices. A close connection amid the increasing prices of crude oiland the widening U.S. current account deficit has been establishedover the past years. The result of a widening current account is adepreciating currency, making exports more attractive compared toimports. Since 2004, a significant upsurge in the prices of crude oilhas been realised. Conversely, the worth of the dollar decreased incomparison to other countries’ currencies (both low and highincome).

Nevertheless,the research works on the impact of shocks on the oil price and onthe exchange rate is relatively slim (Harry, 2009). Changes in theprices of these variables are very significant when it comes todeveloping risk management strategies and long-term policy decisions.Using the existing literature, on the relationship between oil pricesand exchange rates, one can develop a linkage between oil prices andexchange rates, as illustrated in Figure 1. Assuming that a productsuch as oil, a dollar-denominated product, is affected by dollarexchange rates is reasonable. Direct empirical literature revealingthis relationship is, however, very scant.

Figure1: Relationships between Oil, Exchange Rates and Commodity Prices

Exchange Rates

Commodity Prices

Chapter3

3.0The Aims of the Study

Thegoal of this paper is to gain an insight into the link between therates of exchange and the prices of oil. As pointed out earlier, theUS dollar is the primary medium of exchange when it comes to sellingand trading oil internationally (U.S. Energy InformationAdministration, 2015: 25). Thus, gaining an in-depth insight on howthe link between the oil prices and the dollar works is critical tounderstanding how oil prices affect exchange rates in general. Inthis regard, two primary causes can be attributed to the dollar’seffect on oil prices: the effect of the dollar on oil’s globaldemand and the influence on the dollar on the price setting behaviourof oil producers (Grisse, 2010). Since the main currency in use inthe international markets, to price oil, is the US Dollar, oilbecomes less expensive when the dollar depreciates. Reason being, thelocal currency in non-Dollar countries becomes stronger. As a result,demand increases, leading to an increase in oil prices (2010).Bearing in mind the fact that oil is priced in dollars, the exportrevenue of oil-producing nations is principally the US Dollar.Nonetheless, US consignments total to a very small fraction ofimports for oil producers (Grisse, 2010). In addition, the majorityof oil producing nations compares their nations’ rate of exchangeto the dollar. Thus, a depreciation of the dollar sparks a downwardtrend in the purchasing muscle of oil revenues: what non-Dollardenominations can purchase (2010). Oil producers, consequently, optto counterbalance the negative effects of the depreciating dollar byincreasing oil prices. The before-mentioned means oil producers, to agreater extent, have the power to increase or decrease oil prices.For example, OPEC can increase the price of oil by limiting theamount of oil that is supplied to the market (2010).

Furthermore,one can also consider the reverse effect that oil prices have onexchange rates (Grisse, 2010). Fluctuations in oil prices may affectthe dollar because of a myriad of factors. The first is the impactthat upsurges in oil prices effect on the global outlook and the USdollar, and secondly, the influence that elevated oil prices inflicton trade flows and the allocation of capital (2010). Specifically,the dollar could increase in value if markets speculate the US willsuffer less from increases in oil prices compared to other economiesdue to factors such as the consumption of less energy (2010). Inessence, increases in oil prices means oil producers make more money(revenue) and oil-importers spend more – they save less (Grisse,2010). Perceived from the viewpoint that oil revenues are utilisedwhen it comes to the purchase of goods and services, in a manner thatis disproportionate from the US, the recycling of petro productscould imply the strengthening of the dollar (2010). Since the currentliterature points to the fact that oil exporters purchase goodsdirectly from the US, it is difficult to speculate where oilproducers invest their revenue. However, a big percentage of theprofits of oil producing countries, in the latest oil boom, pointindirectly to the financing of the US current account deficit (2010).

3.1Problem

Significantliterature points toward the effect of oil prices toward theperformance of economies (Aziz, 2009). For instance, oil price shockswere blamed for the 1970s and 1980s recessions. However, lessattention has been directed toward actual rates of exchange and theoil prices (2009). Several researchers claim that oil pricevariations have an important bearing on monetary activity (Al-Azzee,2011). As much as the relationship between prices of crude oil andthe dollar seems explicitly defined, a convincing theory explainingthe coincident movement between the prices of crude oil and exchangerates in net importing and exporting countries has never beenadvanced (Verleger,2008). Although some researchers have linked shifts in exchange rates tooil shocks, empirical data in this area is somewhat inadequate(Ghalayini, 2011). Comprehensive research into this area could revealsome insightful findings.

3.2Purpose of Study

Theprimary drive of this paper is to examine the link between the pricesof oil and exchange rates in net oil importing and exportingcountries. It is organised into five sections: Introduction,Literature Review, Methodology, Results, and Conclusion. Throughoutthese sections, a close analysis of the effects of real oil prices onthe real exchange rate will be done. Since the dollar is the primarymedium of exchange in the market, the relationship between oil pricesand the rate of exchange of the dollar will also be examined. Therelationship between oil prices and the exchange rates of net oilimporting and exporting countries, using the Vector Error CorrectionModel, will also be done. Several studies focus on the influences ofoil prices on net oil importing countries, this study goes muchfurther by seeking the answer to the power of oil prices on both oilimporting and exporting nations. Particularly, the followingquestions will be addressed:

• How has history depicted the link between exchange rates and oil prices?

• What is the link between oil prices and the dollar?

• What is the link between oil prices and foreign exchange rates in net importing and exporting countries?

• What future trends can be anticipated after studying the link between the foreignexchange rates and oil prices?

3.3Significance of the Study

Anumber of reasons make this study critical. First, the gap thatexists between the connections between oil and exchange rates issignificant – in terms of empirical data. Many researchers havebeen able to point out instances where oil price shocks triggeredfinancial crises, while others have pointed out the impact oil priceincreases have had on the performance of the currencies of countries.However, not many researchers have been able to provide a clearrelationship between oil prices and exchange rates. This study seeksto develop insightful findings around the before-mentioned: oilprices and exchange rates. Additionally, dollar exchange influencesthe performance of oil prices, and vice-versa, however, the reasonbehind this phenomenon is somewhat unclear (U.S. Energy InformationAdministration, 2015). Finding the answers to such questions wouldoffer insightful findings into the gaps surrounding the gaps in theacademic field.

Sincethe prices of oil and the currency exchange rate have such a greatbearing on each other, this study has been conducted to providefurther insight into this field. The findings of this study advancedthe existing body of knowledge by testing the theoretical knowledgeadvanced by the various researchers and analysts to develop acomprehensive body of knowledge encompassing the relationship betweenoil price changes and the exchange rates.

Aziz(2009), for instance, pointed out that oil price shocks were blamedfor the 1970s and 1980s recessions. Meaning, increases or decreasesprices of oil have a profound influence on the performance ofeconomies. However, economists such as Ghalayini (2011) state that inspite of the wide literature linking oil price increases or decreasesto the performance of exchange rates, little empirical literatureexists to show the explicit link between the performance of oilprices and the ratio of currency exchange. This study goes back inhistory, reveals the links between oil price fluctuations and theexchange rates, and then seeks to find the clear link between theexchange rates and the variations of oil prices. The study employsthe quantitative research methodology to bring the link between oilprice and the exchange rate of net oil importing and exportingnations. More specifically, it analyses the long run relation,determine short-term dynamic adjustment to short term deviation andimpulse response, and make forecast as per the equations developed.

Chapter4

4.0Theory of Relationships between Oil and Exchange Rates

Theexchange rate is perhaps the greatest challenging macroeconomicelement to empirically model. Several research works have formerlyrecommended that the prices of oil can have a significant effect onthe rates of exchange. The proposition, nonetheless, that the pricesof oil may be adequate to elucidate all long-term actions in actualexchange rates seems to be innovative. Operational time-sequenceeffort on the elements of actual exchange rate variations point outthat actual perpetual or shocks modules play a key and substantialresponsibility in elucidating the actual exchange rate instabilities.

Diverseorigins of actual shocks have been examined by Zhou (1995). Amongstthe numerous sources of actual instabilities, such as monetarypolicy, oil prices, and production shocks, it has been demonstratedthat oil price variations possess a key duty in elucidating theactual exchange rate fluctuations. Furthermore, Chaudhuri and Daniel(1998) explored the 16 OPEC nations and established that the dynamicperformance of US dollar factual exchange rate is because of thedynamic performance of the actual oil prices.

Paralleloutcomes have also been attained by utilising the data on the actualoperative rates of exchange for Japan, Germany and the US.Consequently, and it has been realised that the actual prices of oilis the most significant variable used to determine the actual ratesof exchange in the long term. Camarero and Tamarit (2002) similarlyutilised panel co-integration methods to examine the link between theactual prices of oil prices and the Spain’s peseta’s actualexchange rate. In this regard, an innovative experiential techniqueto the price of crude oil formation has been implemented for thedetermination of comprehending the price responses of member statesof OPEC to fluctuations in the rates of exchange of the US dollaragainst other key currencies and billings of other contributors. Theoutcomes are widely regular considering the assessment of thenon-appearance of an integrated OPEC-regulated prices within theglobal crude market. Moreover, the consequences also highlighted aninter-regional aspect of the crude oil marketplace.

4.1Factors that Affect Crude Oil Prices

Verymany factors influence the price of oil around the globe. They areenumerated as under:

1. OPEC (Organisation of Petroleum Exporting Countries)

OPECrefers to a conglomerate of 13 countries: Angola, Indonesia,Venezuela, Iran, Ecuador, Iraq, Libya, Nigeria, Kuwait, Saudi Arabia,Algeria, Qatar, and the United Arab Emirates. It forms the leadingbody influencing the supply of the world’s oil. It is in control ofover 40% of the world’s oil yield, and draws strategies for memberstates to satisfy the global oil consumption.

2. Demand and Supply

Worldwideoil stores should balance demand and supply. If output surpasses thedemand, then the surplus supplies can be put in storage. Once theconsumption surpasses demand, the stored one can be used to satisfythe increased demand. The link between the oil prices and oil storagepermits for improvements in either way. Non-OPEC countries have anoutput of 60 percent of the world’s oil requirement, and thoughthey are 50 percent bigger than OPEC, they still do not possessadequate reserves to make them regulate oil prices. As a result, theycan only react to market instabilities.

3. Restraining Statutes

Becausethe bulk of the world’s oil production and reserves are regulatedby government agencies and corporations, the international oilmarketplace is seriously politicized thereby making its operations tobe far from a viable one. Energy rules and the heavy taxations inoil-endowed nations also influence the prices of oil. Suppose acountry vetoes oil survey in a location with confirmed reserves, forinstance the Gulf of Mexico, then product bazaars regard it to be a‘loss’ in the supply of crude oil. As a result, gas prices mustescalate. Other variables that influence the prices of oil includedomestic retail rivalry, closeness to oil providers, and theenvironmental guidelines that need expressly manufactured oil.

4. Political Turbulence

Ifan oil-endowed country develops political instability, the suppliercountries could respond by levying high oil prices so that thesupplies are still obtainable by the highest auction-goer. In thiscase, only the insight of a scarcity in the supply can raise oilprices, even when the production rates remains stable.

5. Production

Thesite of oil reserves, the characteristics of oil found, the quantity,the chemical components in which the oil is found, and the expensesof mining are all dependent on physical variables. Since oil isnon-renewable and in natural supply, the physical variablesconsiderably determine the price of delivering oil from a certainreserve. Furthermore, considerable venture is mandatory to constantlyexplore and develop new reservoirs.

6. Monetary Markets

Oilstock brokers compete sellers and buyers of crude oil, and tradeagreements for forthcoming supply of oil, known as the ‘futures’.Customers’ acquisition of futures privet against oil pricesincrease that might unfavourably influence profitability. Therefore,oil producers retail their oil futures deals to lock in prices for adefinite duration of time and oil agents buy the oil futures toguarantee the forthcoming supply of oil at a specific cost.

7. Weather conditions

Likemost commodities, seasonal changes in weather affects the demand foroil. In the winter, more heating oil is consumed, and in the summer,people drive more and use more gasoline. Even though markets knowwhen to expect these increased demand periods, the price of oil risesand levels out with the season every year. Extreme weather conditions(hurricanes, tornadoes, thunderstorms) can physically affectproduction facilities and infrastructure disrupting the supply of oiland induce pricing spikes.

8. Hypothetical Buying

Hypotheticalpurchasing generates variable prices for oil-based products asentrepreneurs purchase and retail stocks deals on the free bazaar.Speculation on oil also results in entrepreneurs purchasing moredeals when undesirable stiffness come into the oil market. Forinstance, in 2008, it was speculated that entrepreneurs were raisingoil prices to create an untenable price level of $40 per barrel.However, by late 2009, oil prices had fallen to $30 per barrel sincethe demand became and could not support the hiked prices.

4.2Factors that Affect the Foreign Exchange Rate of a Country

Zhou(1995), studied how various factors may come into play to explainvarying exchange rate movements: productivity shocks, oil prices,fiscal policies, among others. Afterwards, he showed how significantoil price changes were to actual exchange rate fluctuations. Theensuing discussion reveals some critical factors that lead tofluctuations and variations in currency exchange rates, and pointsout the main reason behind each factor.

1. Inflation Rates

Changesexperienced in market inflation extend to changes in currencyexchange rates. Countries that have lower inflation rates compared toother countries experience increases in the value of theircurrencies. By extension, the value of goods and services increase atrates that are generally lower, in countries with lower inflationrates. Thus, nations with low rates of inflation experience incrementin the worth of their countries while those with higher rates ofinflation experience a decrement in the worth of their currencies.The same is usually proceeded by increased interest rates (Patel,Patel and Patel, 2014).

2. Interest Rates

Thechanges realised in interest rates have a consequential bearing onthe dollar exchange rate and currency value. Inflation, foreignexchange rates and interest rates are all related. Thus, increasesin interest rates lead to appreciation in the currencies of countriessince higher interest rates lead to increased rates to lenders. As aresult, more foreign capital is accrued, in terms of foreign capital,causing a rise in the rate of exchange (Patel,Patel and Patel, 2014).

3. The Current Account or the Balance of Payment of a Country

Thecurrent account of a country is indicative of its foreign investmentearnings and steadiness of business. In this regard, the currentaccount encompasses the total transactions, in addition to exports,debts, imports, etc. Depreciation is, therefore, realised when adeficit in the current account develops as a result of spending moremoney on imports as opposed to exports. Balance of payment the localcurrency’s exchange rate (Patel,Patel and Patel, 2014).

4. Government Debt

Governmentdebt is perceivable as public debt that the central government isresponsible for handling. Countries that have dues are less probableto accrue foreign money thus, resulting in increases in inflation.Foreign entrepreneurs usually prefer to vend their bonds in the openmarket when the market forecasts government dues in a given nation.Consequently, the value of the country’s exchange rate will alsodecline (Patel,Patel and Patel, 2014).

5. Terms of Trade

Termsof trade can be viewed as a country’s export and import pricesratio. The terms of trade of a country go up when that country’sexport prices go up at a rate that super cedes the import of goods orimport prices. Higher revenues are realised as a result thus,leading to hiked demand for that nation’s currency, and, byextension, an increment in the worth of that country’s currency(Patel,Patel and Patel, 2014).

6. Political performance and Stability

Thestate of a country’s economic performance and political state isindicative of its currency’s strength. Countries that suffer frompolitical turmoil are less attractive investors, which leads tosignificant decreases in that country’s rate of exchange.Conversely, a country that depicts less risk of political turmoil ismore attractive to foreign investment thus, pulling investors awayfrom countries that are more stable economically and politically. Asa consequence, the country’s exchange rate appreciatessignificantly (Patel,Patel and Patel, 2014).

7. Recession

Recessionsaffect the interest rates of countries fail. This leads to decreasedchances when it comes to acquiring foreign capital. As a consequence,the country’s currency falters in comparison to other countries,leading to a decline in the exchange rate (Patel,Patel and Patel, 2014).

8. Speculation

Whenthe currency of a country, due to market forces, is expected to goup, investors will seek more of that currency so as to turn a profitin the near future. As a result, since that country’s currency isin high demand, its value goes up, and, by extension, an increase inexchange rate (Patel,Patel and Patel, 2014).

Theabove considered, this paper uses a two-pronged approach. Instead ofexamining the effects of oil price changes on oil exporting andimporting countries in solitude, it combines both approaches to offerin-depth insight on the effect of oil prices on both types ofeconomies. Secondly, the oil price change and exchange rate link willbe analysed using various co-integration methods, which enhance thecapacity of tests.

Asample of ten nations, comprising five oil producing countries andfive oil importing countries using monthly sheet data. Net oilexporters include Russia, Venezuela, Norway, Saudi Arabia, andMexico. Net oil importers include India, South Africa, China, Brazil,and Japan.

4.3Monetary Policy Conditions

Theuncovered interest parity (UIP) situation holds that the dollarincome on a dollar asset must be similar to the dollar income orreturn on a euro asset or investment. For instance, if the interestrate of the dollar is five percent, the rate of interest of the eurois three percent, the dynamic exchange rate of the dollar/euro is 1.2dollars/euro, and the anticipated dynamic exchange rate in a periodof 12 months would be 1.25 dollars/euro.

Uncoveredinterest parity means that it should not exist expectation gains byinvesting in one currency relative to another (Bodie, Kane andMarcus, 2009). Higher interest rates domestically in foreigncountries must be matched by a decline in the exchange rate as great.That currency becomes worth less shall correspond to the increasedinterest in theory (Foxton and Jansen, 2006).

Adepreciating dollar will involve expansionary monetary policy(interest rate reduction) especially in countries with fixed rate ofexchange against the USD. Low interest rates in those fixed exchangerate nations will arouse commercial activities, which in turn willresult in a higher demand for supplies such as oil. Thus, countrieswith fixed exchange rate against the US dollar (or currency closelylinked to the USD) will be very important in this context. Frankel(2006) found three particular reasons why higher interest rates couldreduce the demand (or increase supply) for commodities that can bestored. The first argument claimed Frankel was through increasing theincentive to sell out of commodities today rather than tomorrow, dueto more lucrative positions as a result of an interest rate hike. Thesecond argument was that higher interest rates lowered people’sdesire to own commodities that can be stored, such as oil. At ahigher rate would borrow the cost of keeping raw materials willincrease, which will lessen the supply for such oil. The demand forcrude oil would however increase, due to higher costs by sitting withoil in stock. This will lead to a reduction in oil prices. The thirdargument was providing incentives for speculators to sell out ofcommodity contracts and rather buy government bonds. Frankel arguedthat all three of these mechanisms worked to reduce the market priceof raw materials at an increased rate, and pointed in particular onthe period in the early 80s century when this was the case. Lowered(low) rates of interest have the opposite influence, namely byreducing the cost of keeping ingredients and thus increase the pricesof those. Through these three factors would thus be said to exist anundesirable relationship between the oil prices and the dollar.

Anexceeding exchange rate combined with a relaxed regulation of pricelevels produces a modification in the actual rate of exchange. Thehypothesis proposes that a currency can only have a momentary effectinstead of long-run effect on the actual rate of foreign exchange.When the oil prices rise after the shock happens, the actual rate ofexchange will return to the initial situation. Therefore, the paperdefines real or actual interest rate differential (DRR) and theactual rate of exchange (Q)as a function of the actual or real oil price (ROIL). That is,

Q= F(ROIL, DRR)

4.4Asset Pricing Channel

Theassetprice channelrefers to the financial transfer channel which is accountable for thedelivery or supply of the influences brought by fiscal regulationsresolutions designed by the central bank of a nation which upset thecosts of investment. These influences on the costs of investmentwould thereafter influence the economic well-being of the country.

Ifthe US dollar depreciates against other currencies, this means thatthe return on financial assets priced in USD reduced. The theory isthat the investors (non-USD currency) pulls out of financial assetspriced in USD and into alternative investment sources, such asphysical commodities priced in USD (Sari et al., 2009). A weaker USdollar also bring higher inflation expectations, which makescommodities such as oil are used as a hedge against inflation.Expectations of inflation are not the same as that high inflation ispresent. Speculation about increased inflation fears some years backcreated a number of new instruments for trading in the oil market(Romstad 2008). Less complicated trade of crude oil will make iteasier for an investor to hedge (secure) against inflation. It istherefore expected in line with the theory a negative effect on oilprices through a weaker US dollar as a result of this channel.

Threeclassifications of investment exist for oil prices in addition tothose on debit instruments that are regarded to provide significantconduits via which the financial regulations influences the economy:real estate prices, stock market prices and exchange rates.

Variationsof the stock market are swayed by fiscal regulations, havesignificant influences on the cumulative economy. Transfer networkscomprising the stock market are of four kinds: firm balance-sheeteffects, stock market effects on investment, household wealtheffects, and household liquidity effects.

4.5Purchasing Power Canal

4.5.1Supply Side: Purchasing Power Parity

Purchasingpower parity (PPP) refers to a hypothesis which defines the exchangerates between various currencies to be in symmetry when theirpurchasing power is the similar in both nations. It implies that therate of exchange between the two nations ought to be of the same theratio of the nations` prices level. This is for a stable market ofoil prices. If a nation`s local oil price levels is rising (acondition of inflation), then that nation`s rate of exchange mustdepreciate to return to PPP.

ComparativePPP denotes the rate of variations of oil price levels, that is, therate of inflation. This suggestion holds that the extent of theincrement of a currency is equivalent to the variance in the rates ofinflation between the home and the foreign nation. For instance, ifVenezuela has an inflation rate of 1 percent and the US has a rate ofinflation of 3 percent, the US Dollar will attenuate against theVenezuelan Dollar by 2 percent per annum. This suggestion foots wellexperientially particularly when the differences in inflation arebig.

PurchasingPower Parity (PPP) is a change in the rate of exchange and it leadsto an actual variation in the prices of foreign merchandises.Everything else equal, an appreciation of a country`s currencyincrease the relative price of exports and lowering the relativeprices of imports, the opposite happens when a depreciation (Krugmanand Obstfeld 2007). The merchandises are mainly invoiced in USdollars, including WTI oil. A variation in the rate of exchange willnaturally change price relationship between buyer and seller of crudeoil. Particularly in oil-exporting countries, where income in USD islarge, a change in the price of the US dollar going strong outwardtrade balance. Many oil producing countries keep a stable exchangerate against the dollar, implying that an attenuation of the dollarleads to a decrease in buying power (in non-dollar-priced goods) foroil revenues. These countries therefore have an incentive, throughpurchasing power parity, raising the prices of crude oil so that theymaintain the balance of trade.

4.5.2Demand

Exportersof oil Demand for crude oil in oil-importing countries with floatingexchange rates naturally depend on the domestic price for crude oil.Crude oil prices in local currency changes when the dollar fluctuates(Coudert et al., 2005). A wakening of the dollar reduces the cost ofoil for countries or regions with floating exchange rates, the eurozone being an example. The demand for crude oil thus increasesbecause an attenuation of the dollar results in an increase in realincome in the country with local currency, ceteris paribus. Thedollar attenuation has a very positive effect on oil demand andshould therefore help in increasing the price of oil (Coudert et al.,2005). For countries with fixed exchange rate regime against the USD,the effect of a dollar depreciating however zero.

4.6Linking oil prices to the US dollar exchange rate

Aspointed out earlier, the US dollar is the primary medium of exchangewhen it comes to selling and trading oil internationally (U.S. EnergyInformation Administration, 2015: 25). Thus, gaining an in-depthinsight on how the link between the dollar and oil prices works iscritical to understanding how oil prices affect exchange rates ingeneral. In this regard, two primary causes can be attributed to thedollar’s effect on oil prices: the influence of the dollar on oil’sglobal supply and the effect on the dollar on the price settingbehaviour of oil producers (Grisse, 2010). Since the primary currencyused in international markets, to price oil, is the US Dollar, oilbecomes less expensive when the dollar depreciates. Reason being, thelocal currency in non-Dollar countries becomes stronger. As a result,demand increases, leading to an increase in oil prices (2010).

Bearingin mind the fact that oil is invoiced in dollars, the export returnof oil-producing nations is primarily in the US Dollar. Nonetheless,US consignments are responsible for a very small portion of importsfor oil producing countries (Grisse, 2010). In addition, the majorityof oil producing nations compares their countries’ exchange ratesto the Dollar. Thus, a depreciation of the dollar sparks a downwardtrend in the purchasing muscle of oil revenues: what non-Dollardenominations can purchase (2010). Oil producers consequently opt tocounterbalance the negative effects of the depreciating dollar byincreasing oil prices. The before-mentioned means oil producers, to agreater extent, have the power to increase or decrease oil prices.For example, OPEC can increase the prices of oil by limiting theamount of the oil supplied to the market (2010).

Furthermore,one can also consider the reverse effect that oil price has on theexchange rates (Grisse, 2010). Fluctuations in the prices of oil mayaffect the dollar because of a myriad of factors. The initial effectis that increases in oil prices have on the global outlook and the USdollar, and secondly, the shock that elevated oil prices inflict ontrade flows and the allocation of capital (2010). Specifically, thedollar could increase in value if markets speculate the US willsuffer less from increases in oil prices compared to other economiesdue to factors such as the consumption of less energy (2010).

Inessence, increases in oil prices means oil producers make more money(revenue) and oil-importers spend more – they save less (Grisse,2010). Perceived from the viewpoint that oil revenues are utilisedwhen it comes to the purchase of goods and services, in a manner thatis disproportionate from the US, the recycling of petro productscould imply the strengthening of the dollar (2010). Since the currentliterature points to the fact that oil exporters purchase goodsdirectly from the US, it is difficult to speculate where oilproducers invest their revenue. However, a big percentage of theprofits of oil producing countries, in the recent oil boom, pointdirectly or indirectly to the financing of the US recent accountcrunch (2010).

4.7Linking Oil Prices to Net Importing and Exporting Countries

Theoretically,studies have established that the rate of foreign exchange incrementin oil exporting nations is experienced when oil prices go up, andexchange rate depreciation when oil prices fall (Aziz, 2009). Thus,countries that have oil reserves could experience an increase in thevalue of their currencies in relation to the countries that have nooil when oil prices go up. In other words, OPEC countries usuallyexperience a negative effect in exchange rates. For example, in 1998,Russia, an oil exporting country, experienced a financial crisis thatled the nominal value of the ruble plummeting to over 70% incomparison to the US Dollar. It hadbeen forecast that the Russian oil production would increase inreaction to the weak ruble then, and that its oil producers needed totake lead in the situation. Nonetheless, it took two for the Russianoil production to increase. Russia is not only experiencing themacroeconomic gusts from 20 years ago, but it is also experiencingtrade embargos from the EU and the U.S. The weak ruble, the newlyenforced trade embargos, historical precedents and weak productprices hint to the decline of the Russian oil production in 2016(Rautava,2004). However, the country’s economy recovered swiftly after thecrisis since the weak ruble paved way for improved pricecompetitiveness of the domestic firms (2004). Thus, eventually, anexport boom that was triggered by a decline in oil prices boostedRussia’s economy.

Conversely,in an oil importing country such as South Africa, oil pricesinfluence the country’s exchange rate through a two-way process:through demand and supply canals (Kin and Courage, 2014). Withregards to supply, increases in oil prices results in increase inproduction costs, which by extension, leads to increases in the costsof manufacture of non-tradable commodities. Consequently, there is anappreciation of the exchange rate due to an increase in the costs ofnon-tradable commodities (2014). Perceived from the demandperspective, the exchange rate is indirectly influenced through itsinteraction with disposable income. Thus, an increase in the pricesof oil decreases the power of customers to spend. As a result,non-tradable products will be demanded less, leading to a decline inconsumer spending power. Ultimately, the decline in demand fornon-tradable items will lead to a fall in their costs and finally adepreciation in the worth of the country’s currency (2014).

Thus,the consequences of oil price increases are felt differently in oilproducing and oil importing nations. Although oil price increments inoil producing countries can be perceived as good news, it is,however, perceived as bad news in oil importing nations, and thereverse is also true (Al-Ezzee, 2011).

Theabove considered, this paper seeks to find the connection betweenexchange rates and oil prices in the net importing and exportingnations.

4.8The Prices of Oil in the Period

Thenominal oil prices data are as shown in Table 1 below:

4.8.1Oil Importers and Exporters

Table2 below shows key oil importer and exporter countries.

4.9The impact of the oil price change on the exchange rates of net oilimporting countries

Oilimports denote an important part in the balance of trade in energydependent countries (Kim and Courage, 2014). Various authors havelinked oil prices to shifts in exchange rate Aziz (2009).Manyresearchers have asserted that fluctuations in oil prices possessconsequential influences on the relative values of currencies ofsmall open economies. Literature concerning the effects of oil priceson exchange rates usually concentrates focus on oil exportingcountries. The following discussion takes a different approach: itdiscusses the impact oil prices on the exchange rates of oilimporting nations.

4.9.1South Africa

SouthAfrica is a small open economy that is energy dependent and has afloating exchange rate. The Energy Information Authority (2013)asserts that the current consumption of oil in South Africa isapproximately over 20% of the total amount of energy used. SinceSouth Africa lacks commercial oil deposits, it is dependent on oilreserves from oil producing countries to fuel its energy needs (Kimand Courage, 2014). Statistics (EIA, 2013) reveal that South Africais highly dependent on the imports of oil, and out of the country’soverall imports, oil totals to6 percent.

Additionally,South Africa also imports more 90% of its crude oil thus, exposingit to external shocks that either disrupt routine business activitiesor lead to escalation of oil prices. In the end, the before-mentionedresults in disrupted economic growth or development (Kim and Courage,2014). Another cause of alarm is that South Africa’s main segments,agriculture and transport, depend highly on oil products as aresult, any shift in the oil prices can have a profound effect onSouth Africa’s economy (2014).

4.9.2India

Indiais ranked 7^thin terms of land mass, and second, in terms of population – morethan 1.2 billion people. India’s population amounts to17.2 percentof the entire world’s population and must produce approximately 1.2trillion in value of GDP for catering for the needs of the largepopulation (2014). As a consequence, the country requires a minimumof 2.5 million barrels a day to produce the trillion dollar work ofoutput it needs. India’s oil needs represent 4.4% of the world’sdemand for oil (2014). The growth rate of oil demand is approximately7 percent. Thus, the continued demand for oil exerts profoundpressure on the country’s inflation and growth levels.International oil prices are likely to have consequential effects onIndia’s domestic prices (2014).

InIndia’s case, however, oil shocks have not had a very profoundeffect on domestic prices. Reason being, India had an administratedprice mechanism that shields it from the negative impacts of oilshocks. The Indian government has seized control over the regulatedpricing technique mechanism in the oil sector and opted to link localoil prices to international one. Nevertheless, crude oil pricesremain a peripheral factor to India’s economy as a result,affecting the Indian currency (Rupee) since the US Dollar is themedium of exchange in the International market (2014). Public sectoroil companies have thus resorted to sharing the load of oil priceincreases in the form of inflation. The Indian government supportspublic sector companies through the budget. For instance, the Indiangovernment recently deregulated all petroleum items apart fromKerosene and the LPG cylinder (2014).

SinceIndia is primarily an oil importer and energy the key driver ofeconomic growth, oil importation consumes a substantial portion ofthe country’s foreign exchange revenue (Hidhayathulla1 andMahammad, 2014). India’s oil import expenses account for about 30percent of the entire imports. Within the first five months of 2013,India’s import costs went up by 9.5%. India is dependent on importsto meet 80% of her needs (2014).

4.9.3China

Shiftsin the real exchange rate in China involve an intricate structuresince the country is seemingly moving toward higher economicintegration with the rest of the world (HUANGand GUO, 2007).In fact, between 1996 and 2005, it consumed a third of the entireworld’s supplementary oil demands. In addition, China’s net oilimports is projected to rise by three-fold over the subsequent20-year period (2007). The before-mentioned considered, large oilprice shocks could play an important duty in causing shifts in theexchange rate.

Nevertheless,China’s decision to depegg the renminbi (RMB) from the US Dollarhas made understanding of the impact of oil price fluctuations on thecountry’s rate of exchange somewhat perplexing (HUANGand GUO, 2007).China shifted to a currency that gave leeway to a system that allowedthe country’s currency to drift in a significantly constricted bandalongside a diversity of currencies from the nation’s chief tradingpartners.

4.10The impact of the oil price change on the exchange rates of net oilexporting countries

4.10.1Russia

Russiais highly dependent on oil exports. However, it is the second leadingexporter of oil in the world, after Saudi Arabia (Gedek 2013).Thecountry mainly exports oil and natural gas. In 2009, oil accountedfor 50% of Russia’s exports, and contributed to 30% of all ForeignDirect Investments. Thus, the country’s economy is highlysusceptive of changes in oil prices. In 1998, for example, thecountry suffered a major crisis after the Russian ruble depreciateddue to a substantial drop in oil prices. However, the rubbleappreciated by over 80% between 1999 and 2008 after oil pricesincreased. Russia’s economy flourished during this period becauseof the boom in price-exports, which eased liquidity constraints inthe economy.

4.10.2Norway

Norwayis one of the giants in the oil exporting industry (Akram, 2004).However, unlike most countries, The Norwegian rate of exchangereveals an undesirable link with oil prices. Studies conducted on thebehaviour of the Norwegian currency (krone) reveal that it remainsreasonably resilient despite the depreciation of oil prices: $14andbelow. For instance, the Norwegian krone experienced an appreciationbetween 1996 and 1997 (when oil prices decreased), and thendepreciated in the period between 1998 and 1999 (when oil pricessurged) (2004). Also, the devaluation of the krone in 1986isattributable to the decline in oil prices in the period between 1986and 1987

4.10.3Venezuela

Inthe period between December 2002 and February 2003, Venezuelaexperienced an oil strike that crippled its economy significantly.The country lost over 29% of her GDP. However, between the 2003 and2008 period, Venezuela’s economy grew rapidly: the country’s GDPalmost doubled. However, in the first quarter of the year 2009, thecountry experienced another recession (Weisbrot and Johnston, 2012).

Studies(Rodrik,2009) reveal that there is a close connection between an increment inthe value of a nation’s exchange rate and economic growth. Thus,deducing from the above discussion, one can conclude that oil pricescontributed the strengthening and depreciation of Venezuela’sexchange rate. Between December 2002 and February 2003, Venezuelaexperienced an energy crisis after the oil strike, which led to thecollapse of her economy. However, between 2003 and 2008, researchreveals that oil prices had surged thus, leading to a significantimprovement in Venezuela’s economy, and, by extension, thestrengthening of the country’s exchange rate. In 2008, oil pricesdeclined, leading to another recession in 2009 (Weisbrotand Johnston, 2012).

4.10.4Mexico

Mexicois a net oil exporter meaning higher oil prices are usuallypreferred over lower prices (Lajous 2014). Lower prices, however,also offer opportunities that Mexico can seize, for instance,eliminating price subsidies. Compared to most oil exportingeconomies, Mexico is more diversified: oil contributed around 6% ofthe country’s GDP. In 2014, oil export revenues accounted for 12%of the total exports (2014).

Oilplays a critical role in catering for Mexico’s public finance,considering Mexico’s low tax burden (Lajous 2014). Oil-relatedrevenues account for about 33% of the Mexican government’sreceipts, which means lower revenues result in reduced foreignreserve accumulation. The USD/MXN, therefore, have a negativecorrelation. Oil prices, in most cases, lead to an increase in thevalue of the USD.MXN, meaning the peso depreciates against the dollar(Cassilas and Paredes, 2014).

4.10.5Canada

Oilrepresented 22 percent of Canada’s exports between 1972 and 2008(Ferraro, Rogoff, and Rossi 2011). Canada’s economy is a small openeconomy that utilises a market-based fluctuating rates of exchange,with a relatively small scope in the global market. For this reason,changes in the prices of crude oil can both be observed and revealterms-of-trade shock within the Canadian economy (2011).

Studies(Aguilar 2013) have revealed the relationship between an increase indemand of exports in a country and a rise in the worth of thatcountry’s currency. The Canadian dollar is not an exception to thisrule. The value of the Canadian dollar goes up when the global demandfor the dollar increases (2013). If net oil importers, for instanceOPEC countries, restrict oil supply, Canada’s oil will alsoexperience an increase in demand, and, by extension, escalate thevalue of the Canadian dollar (2013).

Chapter5

5.0Methodology

5.1.0Data Collection Method and Sources

Thisstudy begins by investigating the variables under study by using thestationarity test, Error Correction Model method, stability test,co-integration test, and the Granger causality test. These tests weresubsequently utilised to determine if a link exists between exchangerates and oil prices in the net oil importing and exportingcountries. After the preliminary investigation, co-integrationbetween oil prices and exchange rates will be determined. If therelationship (co-integration) will be revealed, the existence of along-run relationship between the two elements will be studied. Thus,the Error Correction Model will be used to find out whether theshort-term properties of the co-integrated series. The data used inthe analysis will be gathered from peer reviewed sources and studieson the effect of oil shocks on the exchange rate. The ImpulseResponse Function (IRF) will also be used. The IRF explains theresponse to shock amongst variables to reveal how random shock in onevariable affects another, both in the long and short term.Eventually, the IRF will make forecasting possible, revealingcausality or interactive connection between exchange rates and oilprices, in addition to using oil prices to forecast exchange rates,or both ways based on the VECM model.

5.1.1Sample

Thisstudy is designed to collect data from 10 countries: five netimporters and five net exporters of oil. Previous studies and trendson the impacts of oil on the exchange rates will also be used toestablish whether a relationship exists between these two variables.After getting these statistics, the data is then subjected tomultiple tests to establish whether a real connection exists betweenoil prices and exchange rate. The tests used are the ECM, thestationarity test, Granger causality test, the co-integrationtest, and the stability test. This sample analysis is designed toexplore one country, Venezuela, in a bid to understand the connectionbetween crude oil prices and exchange rate in any oil-exportingcountry. In particular, the following issues will be addressed:

• How has history depicted the link between exchange rates and oil prices?

• What is the connection between oil prices and the dollar?

• What is the connection between exchange rates and oil prices in net importing and exporting countries?

• What future trends can be anticipated after studying the link between oil price and the exchange rates?

5.1.2Details on the Sources of Data

Thedata used in the research has been derived from ten differentcountries: 5 net oil-importing states and 5 net oil-exportingnations exporters: Russian Federation, Norway, Venezuela, Mexico,Canada importers: China, Japan, South Africa, India and Brazil.Table1 below represents the data with variables of net-oil importing,net-oil exporting countries and crude oil prices. The data was takenfrom https://research.stlouisfed.org, the Economic Research, FederalReserve Bank of St Louis, which was uploaded 2016-02-01at 3:41 PM CST&nbspfor all exchange rates and for crude oil priceswas uploaded 2016-01-13 at 1:41 PM CST. All data is not seasonallyadjusted&nbspand it is with monthly frequency. For RussianFederation the data for 2015 has been taken from X-Rates page(http://www.x-rates.com). Table 3

5.1.3Procedure and Choice of the Period

Thedata used in this particular research was archival data, whichdisplayed the trends in the effect of exchange rates since 1971 to2015. For purposes of uniformity in comparison and statisticalanalysis, the research period will be from 1995-01-01 to 2015-12-01,so it means that there were considered 20 years in data analysis withmonthly frequency. In view of the fact that the statistics presentedin the archival data represents the figures for each month for aspecific year. The average units for all the 12 months was used indrawing the graph that represented the trend of prices of oil withregard to the exchange rate for the 10 countries that were consideredfor the study both the exporters and importers. Exporters: Russia,Norway, Venezuela, Mexico, Canada importers: China, Japan, SouthAfrica, India and Brazil.ExchangeRates for Venezuela: Table 4

5.2 Explanation of Variablesand how they were builtThispaper uses monthly figures of prices of oil, exchange rates andinterest rates for Venezuela from 1980 to 2008. Statistics are gottenfrom the International Financial Statistics (IFS), issued by theInternational Monetary Fund (IMF). Actual exchange rate is built byutilising the domestic oil price levels and the price levels in aforeign nation. Theactual exchange rate is equivalent to the Nominal Exchange Rate *(Foreign Price Level / Domestic Price Level). Theactual oil prices are delineated as the cost of crude oil in USdollars, emptied by the local consumer cost indices. They are denotedin natural logarithmic form. The real interest rate differentials(DRR) is computed as follows:DRR_it=r_it–r_t*,Where:r_itisthe real or actual interest rate of a particular state i,andr_t*arethe actual foreign interest rates. UnitedStates is selected to be the numeraire nation. The prototype used forapproximation is as follows:q_it=α_i+ β_1iDRR_it+ β_2iROIL_twherethe rate of exchange (q_it)is depicted as the price of an entity of foreign currency in terms ofthe local currency, DRR_itisthe actual interest rate differential and ROIL_tisthe actual price of crude oil. The hypothetical model gives arise inthe real interest rate differential which would subsequently increasethe currency. The sign conforming to the actual prices of oil is bepositive for all oil-importing nations, and negative for all theoil-exporting nations. For instance, a rise in the actual price ofoil would decrease the oil-importing billings comparative tooil-exporters. Therefore, in this situation, β_1i&lt0 and β_2i&gt0 for all oil-importing nations and β_1i&lt0 and β_2i&lt0 for all oil-exporting nations.5.3Long-Term Relationships5.3.1Stationarity Test / Test for Unit RootsAstationary test is identified as a stochastic process in which jointprobability distributions do not change when exposed to shifts intime (Asari,2011).With regards to this, it is realized that parameters such as varianceand mean, if present tend not to change with time and also do notfollow a particular trend. All in all there are various advantages oftesting non-stationarity. One of them being that the stationarity ofa particular series influences the series behaviour and properties.The other main reason of testing for stationarity is to identifymatters related to spurious regression. This basically means that iftwo variables tend to trend over time, the existence of regression ofone of them could have the possibility of having a high R²even if both are not correlated (2011). Thereare usually two specific models used to test for dynamism, that is,the deterministic trend process and the random walk model with drift:Y_t=μ+yt-1 +u_t(random model)Y_t= α + β_t+ u_t (deterministicprocess)5.3.2Co-integration TestTheco-integration test identifies the equilibrium relationship betweentime series that tend to be individually not in equilibrium (Asari,2011).It comes in handy when allowing a researcher to incorporate both thelong-run expectations and the short-run non-stationaries. Whentesting for co-integration, once the variables have been categorisedas combined in a specific order to make it easy to set up a specificmodel that allows the researcher to bring forth the stationaryrelationship between elements, and also where it is feasible toacquire standard influence. With regards to this, the necessarycriteria or method of stationarity among non-stationary variables iswhat is referred to as co-integration. This, therefore, means thatco-integration is a necessary tool in checking whether a chosenmodelling criteria brings forth meaningful relationships (2011). 5.3.3Error Correction Model (ECM) Model

Thisis a comprehensive outline used to reveal the non-stationaryrelationship that exists between stationary elements (Hauser2010).Thus, the initial stage in time sequence examination is to establishwhether data levels are fixed. If the time sequence is dynamic, thenVAR framework is usually modified to allow for a more consistentapproximation of relationship among sequences. The Error CorrectionModel is a modified approach of the VAR for elements that are fixedin their variances. The ECM also considers the co-integratingconnections among elements (2010).

Thefollowing vector error correction model (ECM) equations have beendeveloped in this regard.

ΔlnEXPt= ө2 + ΣbΦ2(i)ΔlnEXCt-i + Σb Ω2(i)ΔlnIMPt-i + Σbg2(i)ΔlnEXPt-i + ψ2Et-1 + e2t (1)

ΔlnIMPt= ө3 + ΣcΦ3(i)ΔlnEXCt-i + Σc Ω3(i)ΔlnEXPt-i + Σcg3(i)ΔlnIMPt-i + ψ3Et-1 + e3t (2)

ΔlnCOPt= ө1 + ΣaΦ1(i)ΔlnEXPt-i + Σa Ω1(i)ΔlnIMPt-i + Σag1(i)ΔlnCOPt-i + ψ1Et-1 + e1t

(3)

Where:

Δ= First-differenceoperator

E= Errorcorrection term

ө,Φ, Ω, g, ψ = Parametersto be estimated

a,b, c = Laglengths

Et-1= Speed of adjustments of ΔlnEXCt, ΔlnEXPt, and ΔlnIMPt towardslong-run equilibrium levels. The error correction terms can thus bedeemed as providing long run causal relationships in the equations.

5.4Short-Term Relationships

5.4.1Beta Estimation

Beforeany approximations, the paper seeks to find out the order ofintegration of all the sequences in any exchange unit. Anincorporated unit demands to be distinguished to attain astationarity state. Therefore, panel series beta, β_t,which needs no differentiation to attain stationarity. This isdesignated as β_t∼I(0).Accordingly, an incorporated sequence like β_t∼I(1)is considered to grow at a constant rate whereas β_t∼I(0)sequence appears to be without any discernible trend. Therefore, iftwo sequences of diverse order are combined, such as β_t∼I(0)and Y_it∼I(1)correspondingly, then they need to be moving apart with time. Thisresults in an instinctive understanding of a co-integratedclassification to be one that characterises long-term constantcondition of balance. 5.4.2Granger-causality TestThistest is used in statistical hypothesis computations (Asari,2011).It is used to determine whether a particular time sequence issuitable for use in predicting another time sequence. The testusually stipulates that if a particular signal y1 “granger causes’signal y2, in this case the past value of the unit y1 should be ableto help in predicting signal y2, this is with regards with the pastvalues of y2 alone (2011). 5.5Impulse Response Function (IRF)Thisis a tool used to track the impact that any variable has on othervariables in a system (Lin 2006). The IRF reveals the empiricalcausal analysis and policy effective analysis of variables. Theabove can be perceived as follows, where Y_tisthe multi-dimensional vector sequence which can be derived asfollows:Yt= A₁Y_t−1+· · · · · · · + A_pY_t−p+U_tI= (I − A₁B− A₂B− · · · · · · · − A_pB^p)Φ(B)Assumingthat cov(Ut) = Σ, Φi is the coefficient of MA that are used tomeasure impulse response, then Φjk,i is symbolic of the response thevariable jhas on a unit impulse in the multi-dimensional element that occurs atthe i^thperiod.IRF can be used to evaluate how effective a policy change is, forexample, the effects of oil prices on the exchange rate of a givencountry. Chapter 66.1 Analyses of the Theoryabout Relationship between Oil and Exchange RateWhereasthe link between exchange rate and oil prices is broadly explored inthe press and amongst market experts, the research works on thissubject are quite rare. One aspect of the works examines thelong-term connection between the dollar actual exchange rate and theactual prices of crude oil. By utilising the periodical statistics oneither the US dollar trade-balanced rates of exchange, or the mutualexchange rate of the dollar against the developed economies, thispaper typically reveals that the actual exchange rate and the actualprices of oil are essentially co-integrated and show a positivelong-term stability correlation. In other words, high oil prices arecorrelated with the appreciated US dollar. In addition, the paperreveals that oil prices Granger-cause the exchange rates, but notconversely. It has been demonstrated that both the actual oil pricesand the dollar effectual rate of exchange are co-integrated with theUS overall overseas investment position. In fact, it has been claimedthat the effects of oil price on exchange rate cuts across theinfluence of oil prices on US overall overseas investments.Anestimation of the non-stationary error correction model (ECM) usingstatistics from the product prices, the US dollar real exchangerates, global manufacturing production, the commodity inventory andthe Federal funds rates have been found to be correlated (Cheng,2008). The depreciation of the dollar is linked with high oil prices,and the effect of the same can be felt after approximately sevenyears. In this regard, Akram (2009) estimated the structural VARusing statistics from the OPEC manufacturing production, actual USshort-run interest rate, the actual trade-balanced dollar exchangerates, and a consortium of actual prices of commodities such as crudeoil. He found that the rate of dollar depreciation is linked with thehigh prices of commodities, and the same conforms to the negativerelationship between products and the dollar exchange rate. Theoutcomes demonstrate that a rise in the oil prices is linked with anattenuation of the dollarin the short term and over longperiods. Similarly, dollar attenuation results in high oil priceswithin any given period. Over a protracted period, the instabilitiesin the interest rateselucidate most of the fluctuations inexchange rates and oil prices. The discovery that oil pricesinfluence the dollar in the long term conforms to previous researchworks, though several of such works focus on nominal elements,utilises monthly data, and examines the previous decade period.Consequently, this thesis permits two-course concurrent responsebetween exchange rate and oil prices in an entirely recognisedstructural model. The outcome then permits for the recognition of theshort-term influences of fluctuations of the dollar on oil prices.Firstly,variations in the dollar exchange rates might have an influence oncrude oil prices due to its huge demand globally, and same would alsoinfluence the behaviour of the oil producer’s price setting.Particularly, since oil is valued in dollar on global fiscal markets,when the dollar attenuates, oil becomes inexpensive in terms ofdomestic currency for consumers in non-dollar nations. This is likelyto inflate their demand for oil, resulting in inflated oil prices.This canal offers an instinctive description for the negative linkbetween the dollar and oil prices as witnessed in the recent years.However, there exists little experiential indication that theinternational demand for oil is actually reactive to the variationsin the dollar. An associated claim is that dollar attenuation mightbe linked with financial facilitation in nations that pin theirexchange rates to the dollar. Low rates of interest in such nationsmight in turn arouse economic movement and result in a high demandfor oil-based products.Next,noting that the inverse influence of oil prices on exchange rateexposes the influences that the dollar has on the oil prices from aglobal perspective, trade exhibitions and allocation of capital isgreatly impacted. High oil prices suggest high incomes for the oilproducers and low investments in oil-importing nations. To the degreethat oil proceeds are utilised in buying or investing commoditiesexcessively from the US, the reprocessing of petrodollars can belinked with a stronger Dollar. In this light, Higgins, Klitgaard andLerman (2006) note that just a little proportion of revenues from theUS to the oil-exporters has been utilised in purchasing commoditiesfrom the US. Nonetheless, they claim that though inadequatestatistical accessibility makes it naturally hard to trail where oilexporters’ monies are spent, most of their proceeds during theprevious oil prices boom indirectly or directly resulted in fundingthe US current foreign account debits.6.1.1Monetary Policy RelationshipsMonetarypolicy is performed by the financial authorities through financialtools and also by regulating the fiscal groups. A typical prototypefor examining financial policy includes three equalities (McCallumand Nelson, 2000): an aggregate supply (AS) curve, an IS curve and aninterest rate response strategy equation.Thecollective demand reacts adversely to the actual interest rates, butvery complimentary to the anticipated production. A decline in theex-ante actual interest rates would be anticipated to arouse theaggregate demand for oil. This is because aggregate demand and thedemand for oil are closely correlated. The AS equality designates thevariation in the collective price level as a function of theanticipated future price increase and the eccentricity of productionfrom its normal degree that would be obtained under completelyelastic costs. Hence, high aggregate demand results in arousedinflation.6.1.2Asset Pricing ChannelTheasset pricing model which naturally gets the most consideration in asfar as financial policies are concerned are the exchange rates. Inthis perspective, central banks are concerned about the worth of thelocal currency for numerous causes. Variations in the exchange ratescan cause a great effect on price boom, especially in small,vulnerable economies. For instance, decline in currency leads toinflation because of the pass-through from high import costs and highdemand for exports. Moreover, the citizenry and the politicalfraternity give specific consideration to the exchange rates and thisexerts stress upon the central banks to change financial policies. Anincrease of the local currency can cause local commerce to beuncompetitive, whereas a decrease in the same is frequently viewed asa delinquency of the central banks. Developing market states, fairlyacceptably, have a great concern about exchange rates variations. Notonly can an actual increase create a condition of lesscompetitiveness within the local industries, but it can also resultin huge current account insufficiencies that could cause the nationto be more susceptible to currency crunch if cash influxes change toexpenditures. Devaluations in developing market nations areespecially hazardous since they could be contractionary, and canactivate a monetary disaster of great proportions. Considerations onexchange rate instabilities can make nations to select to hangertheir exchange rate to another nation. Nevertheless, if a nationchooses to make its own sovereign financial policies, then,considering the open monetary markets, it must permit the exchangerates to vary. Considering that exchange rate variations are a keycause of alarm in several nations, it rears the risk that financialpolicies might focus too much on controlling the variations ofexchange rates. The next difficulty focusing on controlling theexchange rate vacillations is that it could encourage an incorrectpolicy reaction when a nation is confronted with actual financialshock such as the terms and conditions of commerce.6.1.3 Purchasing PowerRelationshipsSupply– Importers of OilTheshort-term supply of crude oil inclines to be cost unyielding. Infact, it appears to react adversely to price variations, suggestingthat manufacturers do not increase productivity in the light of costincrement. This is because of short-term volume restrictions, fixedquotas, and substantial price upsurges. Likewise, producers do notcut productivity in the light of huge drops in costs. In certainconditions of depreciated oil prices, several oil manufacturers leantowards supplying more quotas to make the seriously wanted budgetaryincomes, especially for those oil manufacturers whose budgets dependprofoundly on oil proceeds. This outcome regarding the price supplyelasticity is particularly significant to understand the operationand the volatilities of the crude oil markets and oil prices. Inother words, supply is price-inelastic and cannot increase because ofadditional demand or huge price booms. Short-term oil supply issubstantially effected by the production of natural gas. Natural gasand crude oil are theoretically, technically and commerciallysymbiotic. Therefore, an upsurge in the production of natural gasgoes together with an inflation in the production of crude oil. Demand– Exporters of OilBothmonthly and yearly statistics support the theory of low short-termcost-demand pliability because the fluctuations in oil prices have aslight fractional influence on the demand for crude oil. This isparticularly vital and it is embedded at the centre of the crude oilmarket, and it elucidates the instability of the oil markets andtheir defencelessness to minor fluctuations. The same implies thatthe consumption of energy is influenced in the short-term bystationary equipment and the dominant expertise, and proffersrestricted range for significant changes with respect to pricevariations. The statistics also corroborates the theory of animportant upshot of economic bustle on the supply and demand forcrude oil. Short-term revenue pliability is important statistically.In fact, it is mainly significant because it proves plainly that thedemand for oil is receptive to the variations within the economicbustle. High economic activities would involve a rise in the demandfor oil. Hence, this discovery concerning the elasticity of revenueis also vital in explaining the impetus which upset the crude oilmarkets.Adecrease or increase of the exchange rate of the U.S. dollar tends tocause crude oil to be more costly and thereby reducing or increasingits demand depending on the prevailing market conditions. Concerningthe part played by the interest rates, the latter is very likely toact adversely on crude oil demand. Nonetheless, the interest rate’ssemi-elasticity is mathematically important with regards to theyearly data. An inflation in the interest rates tends to lessen thedemand for crude oil. The opposite is also true. The monthly interestrates semi-elasticity is negative, though it is not computationallysubstantial. Variations in the interest rate is not transferredinstantly to costs and the economic activities instead, theireffects are recognised to delay. Consequently, it is evident that oilmarkets are considerably affected in the short-term by the financialpolicies. 6.2Country-by-Country AnalysisVenezuelaECMmodel: ΔREERt = α1 + Σα11(i)ΔREERt-i + Σα12 (i)ΔDRRt-i + Σα13(i)ΔROILPt-i + εREERt.Taking ROILP as exogenous variable inthe model.When it comes to the Granger – causality test, ΔREERt= α1 + Σα11(i)ΔREERt-i + Σα12 (i)ΔDRRt-i + εREERt, is firsttested and then added to ROILP to get the model ΔREERt = α1 +Σα11(i)ΔREERt-i + Σα12 (i)ΔDRRt-i + Σα13 (i)ΔROILPt-i +εREERt. The model tests the strongest of the causality.i)Granger Causality Test

Tofind the trend of influence among the study elements, that is, theexchangerate in the net exporting and importing nations and their respectivecrude oil prices, the study performed a Granger causality test.Findings are as presented in table 1.4 below. Four null hypotheseswere set to this effect:

H₀₁:Exchange rates in net exporting countries does not Granger causecrude oil prices.

H1_:Exchange rates in net exporting countries does Granger cause crudeoil prices.

H₀₂:Exchange rates in net importing countries does not Granger causecrude oil prices.

H2:Exchange rates in net importing countries does Granger cause crudeoil prices.

H₀₃:Crude oil prices does not Granger cause exchange rates in the netoil-exporting nations.

H₃:Crude oil prices does Granger cause exchange rates in the netoil-exporting nations.

H₀₄:Crude oil prices does not Granger cause exchange rates in the netoil-importing nations.

H₄:Crude oil prices does Granger cause exchange rates in the netoil-importing nations.

TheVenezuelan Granger Causality Test are as tabulated in Table 4 below:

Findingsestablished in table 4 above reveal P values greater than 5 percent.In this regard, the study does not reject any of the four proposednull hypotheses. It follows then that rates of exchange in bothoil-exporting and importing nations have no Granger-causality effecton crude oil prices. Crude oil prices have no influence on theGranger-causality exchange rate in both net exporting and importingcountries. These findings further support results from the modelstability test in which case the variables were found to beindependent of each other.

ii)Co-integration Test

Toanalyse the co-integration test, the study adopted theJohansen-Juselius (1990) testing procedure. Two co-integrationtesting procedures are provided for in the Johansen-Juselius test, toidentify the sum of the co-integrating vectors. Such vectors arereferred to as traceandmaximumEigen-value teststatistics. Results for the tracetest statistics are as presented in Table 5 below.

Intrace statistics, the null hypothesis holds that there exists at mostrnumberof co-integrating vectors to be adopted. To this end, the equation,λtrace= T Σj=r+1,nln(1-λj),was adopted, where:

T= Numberof observations

λjs= Approximated value of the characteristic roots. It is assumed thatthe variables are I(1).Findings as presented in Table 5 above indicate that at 1 percent, 5percent and 10 percent critical level, the null hypothesis that thereare at most 2, 1 and 0 number of co-integrating vectors cannot berejected both in Traceand Eigenstatistics.

iii)Stability Test

Totest for model stability, the study employed Pearson`s Chi-squaredtestof independence, proceeding with the hypothesis that exchange ratesare independent of fluctuations in crude oil prices for both netexporting and net importing countries. Findings are as presented inTable 6 below.

Fromthe results presented above, taking the standard 0.05 level ofstatistical significance, the study did not discard the nullhypothesis, having established a p-value of 0.2358. It follows thenthat exchange rates are independent of fluctuations in crude oilprices for both net exporting and net importing countries.

TheGranger Causality Relationship tests were obtained by using thefollowing techniques:

a)H0:Ω1=0 and H0:Φ1=0 forall (i) shows short term or an insignificant Granger-causalitycorrelation.

b)H0:ψ1=0 showsthe existence of long-term Granger-causality between the variables.That is, if ψ1=0,thenCOP does not react to the abnormalities from the long-term stabilityin the preceding period.

c)H0:Ω1=ψ1=0 andH0:Φ1=ψ1=0forall (i) indicates a strong Granger-causality correlation between theelements.

Theresults of the Error Correction Model are as tabulated below:

Norway

TheNorwegian Granger Causality Test are as tabulated in Table 7 below:

Co-integrationTestTable8

StationarityTestTable9

Mexico

TheMexican Granger Causality Test are as tabulated in Table 10 below:

Co-integrationTestTable11

StationarityTestTable12

Russia

TheRussian Granger Causality Test are as tabulated in Table 13 below:

Co-integrationTestTable14

StationarityTestTable15

Canada

TheCanadian Granger Causality Test are as tabulated in Table 16 below:

Co-integrationTestTable17

StationarityTest

China

TheChinese Granger Causality Test are as tabulated in Table 18 below:

Co-integrationTestTable19

StationarityTestTable20

Japan

TheJapanese Granger Causality Test are as tabulated in Table 21 below:

Co-integrationTestTable22

StationarityTestTable23

India

TheIndian Granger Causality Test are as tabulated Table 24 below:

Co-integrationTestTable25

StationarityTestTable26

SouthAfrica

TheSouth African Granger Causality Test are as tabulated in Table 27below:

Co-integrationTestTable28

StationarityTestTable29

Brazil

TheBrazilian Granger Causality Test are as tabulated in Table 30 below:

Co-integrationTestTable31

StationarityTestTable32

Thestudy firstconducted unit root tests to determine whether the sequences arestationary.Whereas there exists many unit root tests used to determinestationarity, the analysis used the Augmented Dickey-Fuller (ADF)technique to investigate the stationarity of the series. The criticalvalues are bench-marked against Dickey et al. (1981) values, as inTable 33 below (see appendix).

6.3 Impulse Response FunctionTheGranger-causality test could not give all the details on therelationships between the elements of a structure or system. It isfrequently of concern to determine the reaction of one element to ashock in another element in a structure or system which encompassesseveral other elements also.Itis also possible to analyse the impulse reaction link between twoelements in an advanced multi-dimensional system. In other words, ifthere is a response of one elements to an impulse in another element,the second variable can be referred to as the causal for the firstvariable.Theimpacts of oil shocks are momentary at all times and for all exchangerates. The shocks do not seem to have a perpetual effect on anyexchange rate. In fact, the complete impulse reaction analysissupports the Granger-causality outcomes. This is because theincreased significance of oil prices in elucidating the exchangerates fluctuations is witnessed.Towitness the non-stationary reaction of each of the exchange rates toa standardised impulse in the prices of oil, the generalised shockreaction graphs may be utilised. In contrast with the impulsereaction functions for structural models, the generalised impulsemodels do not need the identification of any structural shocks.Accordingly, the generalised impulses provide the tool for describingthe dynamics in a time-series model by mapping out the reaction inthe exchange rates in a unit standard eccentricity impulse againstthe residual crude oil prices. The generalised responses are thentraced out of every exchange rate to a unit standard eccentricityimpulse in the oil prices for all the systems.6.4 Forecast

Thestudy made a 10 year forecast into the future with a view toestablish any causality or interactive connection between oil pricesand exchange rates and crude oil prices using the ECM model. Thefindings are as presented in the Figure 2 below.

Fromthe figure above, it can be established that over the next 20 years,there will be slight decline in exchange rates among net exportingcountries, while net importing countries will experience a steadydecline in their exchange rates. Crude oil prices will on thecontrary experience a sharp incline over the next 20 years. As such,it can be deduced that whereas exchange rates in net exporting andimporting countries will be moving quite closely together downwardsin over the next 20 years, crude oil prices will be independently onthe incline. Findings are as conducted at 95% confidence interval.

Chapter 7

7.2Finding and interpretations

Theoutcomes from the error correction model which were used were wellfitting in the error regression specification revealed that themerely approximated error correction term in the initial case wasimportant in the study because it gave the positive sign telling thatthe merging to the stability condition cannot be attained in thelong-term. The error estimation that resulted from all the case usedin this method is very important statistically. It shows that theerror correction term coefficient in the entire cases tells that anonconformity from the long-term stability worth in one duration innot rectified in the next duration using the amount that is estimatedby the coefficient used.

Thefuture of the interactive relationship between the exchange rate aswell as the prices of the oil, and the price of the crude oil can beforecast using the VECM model. The results from the graphs arediscussed below. From the forecasting graph for export using the VECMmodel discussed in chapter four, it can be noticed that the exchangerate for the export will have a positive gradient, this means thatthe will be an increase in the rate of the for the exporters in thefuture. From the graph of the forecast imports, it can be revealedthat in the coming years the importing will have a negative gradient,this implies that the net rate of exchange of the importing nationswill go through a sharp decrease in their rate of exchange. But forthe crude oil, the net rate of exchange will go through a steadyincrease in the future, the next twenty years, this graph shows asharp positive gradient that exhibits the explained results. It canbe deduced from the graphs that the rate of exchange in both the netimporting as well as the exporting countries will be having a closerrelationship that entails a gradual decline in the future, the nexttwenty years in this study. These findings that were carried out atninety-five percent confidence interval revealed that the exchange,contrary to the oil prices of the net importing as well as exporting,of prices of the crude oil will independently be on the increase inthe coming years. The VECM is an effective method because it hasrevealed that the future exchange rates of net importing as well asexporting countries can be forecasted.

7.2Conclusion

Thegeneral aim of this paper was to determine the overall connectionbetween exchanges rates and oil prices. To accomplish this, it becamenecessary to conduct research in ten countries which are activelyinvolved in oil importation and exportation. With regards to the linkbetween oil price and rates of foreign exchange, it is realized thatthe dollar has always been the primary medium of exchange when itcomes to selling and trading oil internationally. In this, it isnoted that if the value of dollar depreciates, the overall price ofoil, and by extension, demand tends to go up and vice versa. It,therefore, became necessary to conduct a 20 years data study thatwill enable the study to come up with the required statistics thatwill facilitate the comprehension of the connection between oilprices and exchange rate. To provide an extensive and concreteresult, this study was able to utilize studio data analysis as afundamental tool for establishing the required information so thatthere could be the proper understanding of the topic under study.This chapter, therefore, reports on the recommendations andconclusion that resulted from this study.

Basedon the study conducted there are some critical factors that have beenable to lead to the variations and fluctuations in monetary exchangerates. These elements are rates of inflation, interest rates, thebalance of payments, government debts, the terms of the commerce,political performance and stability, and economic recessions andspeculations. Considering the fact that oil is usually pricedregarding dollars, the general export revenue of oil-producingcountries tends to predominantly the US dollar. With regards to this,the depreciation of the dollar tends to spark up a downward trend inthe purchasing power of the oil revenues. In this case, Oil producersopt to counterbalance the negative effects of the depreciating dollarby increasing oil prices. Fluctuation in oil prices tends to affectthe US dollar’s value and also trade flows with regards toallocation of capital related to the trade.All in all, it isrealized that increases in oil prices mean that oil producers tend tomake more money and, as a result, importers tend to spend more thanthey save.

Fromtime to time, exchange rates are often noted to play an immense dutyin matters about the level of trade that a country can participate(both imports and exports) which is a crucial factor in freest marketeconomies worldwide (Asari et al., 2011). It is for this reason thatmost investors and governments tend to watch exchange rates withclose interest to understand how poor or how well a particulareconomy is doing. Some governments, therefore, have been able tomanipulate the economic factors that influence their economies tohave a strong currency against the dollar. In most cases, volatileexchange rates tend to have the ability to hinder economic growth,prevent capital outflows, and even hurt the economy. Researchers andeconomists have been able to concur to the fact that oil price shocktends to contribute to most of the economic recessions that often hitthe world (Aziz, 2009). The unexpected oil prices hike in 1973-1974an example of the factors that were able to result in theappreciation of the US dollar. (Aziz, 2009). This, therefore, raiseda question on whether there is a cogent explanation for theperformance in the currency exchange market or it is based accordingto what traders think? With this, the examination of the link betweenoil price and exchange rates became a crucial element in answeringthe question.

Froma theoretical perspective, it was realized that oil-exportingcountries tend to experience exchange rate appreciation when oilprices increase. On the contrary, they tend to experience exchangerate depreciation when there is an increase in the value of theirlocal currency and a decrease in oil price. Studies have establisheda negative link between oil prices and exchange rates withincountries that export oil. Somehow, oil prices rise to cause anincrease of the local currency in oil exporting nations (Aziz 2009).

Tocome up with the answer to the raised issues related to exchangerates and oil prices, this study was able to investigate thevariables from the data collected using various approaches. Theseapproaches include the Error Correction Model technique, stationaritytest, stability test, co-integration test, and the Granger causalitytest. The test conducted was able to determine the relationshipbetween the prices of oil and the exchange rates in net oil importingand exporting nations. With this, the co-integration between oilprices and the exchange rates was determined. The data used foranalysis was gathered from peer-reviewed sources and studiesconducted on the effect of oil shocks on the rate of exchange. Thedata used covered a 20-year period, 1995 to 2014, which was obtainedfrom the Federal Reserve System (US) and the Organization forEconomic Co-operation and Development (OECD) database (Adiguzel, etal., 2013).

7.3Recommendations

Furtherstudy should be carried to show a deep link between the prices of thedollar and crude oil to give a clearly described as well asconvincing theory. The theory should elaborate the coincidingmovement that exists between the exchange as well as the prices ofcrude oil in the nations’ net importing as well as exporting. Sincethe empirical data in the research is not enough, the study shouldhave concentrated on the data despite linking the rate of exchange tothe shocks from the oil. If a compressive and deep study in this areais done effective, it could have revealed more understandable as wellas insightful results.

Thestudy should also bring out numerical data as well as supportivematerials such as the charts and graphs to give insightful details ofthe relation it seeks to elaborate. This numerical figures, as wellas pictorial presentation, will bring out the explicit connectionbetween the price of oil and the dollar.

Theresults revealed by the ECM model in this study can be used in theprediction of the future exchange rate of the net importing andexporting nations. Both the importing and exporting nations shouldutilise the forecasted information to put the necessary measure inplace to cope up this the changes that may arise due to thefluctuation of the oil prices. The positive results forecasted forthe rate of exchange for the crude oil will be helpful to theimporting countries. The importing countries should use the positivecrude oil prices rather than invest of the price of the refined oilthat keeps on varying over the time.

Thetheoretical information discussed in this paper can be very helpfulto the country. The country should use the theoretical information ofthe factors affecting its exchange rate to make sure that this rateis favourable. The government should avoid government rate topreventing increase the revenues that might lead to increased demand.The interest rates of countries should be regulated to prevent anincreased exchange rates. It should be recommended that a countryshould regulate its rate of inflation to control the value of itscurrency.

Thetheoretical impact of the exchange rate in countries should be takenwith a lot of seriousness to help the countries control the price ofthe oils. The information on the relationship between exchange ratesand the oil prices should be analysed to help the affected nationcome up with the policy of ensuring there is a balance between thetwo.

Theresults obtained from the study on the appreciation of rate exchangeas well as depreciation exchange can be used by the countriesproducing oil to prevent negative effects which may rise because ofthese fluctuations. This can help the oil producing countries not todepend fully on the revenue obtained from the oil by investing inother areas to prevent any form of financial crisis that may affectthe country due to the decline of the rates of exchange because ofthe increments in the oil prices.

Theoil producing countries that go through the turmoil of politicalinstability should avoid such political unrest. This is because oilsuppliers respond by increasing their bid on the cost of the oilproduct. Therefore, the highest buyer takes to control the oil supplybusiness in that republic. Price upsurges in oil due to the insightthat there is a decline in oil supply, even if the cost of oilproduction may remain constant. The peace stability as well politicalstability in this countries can help in the in the regulation of theprices of the oil, that will go hand in hand with control of theexchange, this can cause the country to have a stable exchange rate.This will prevent the country from facing the challenges ofdepreciation.

Thispaper also recommends that various government should avoid by allmeans nay form of the debt. The more a government has foreign debt,the more the exchange rate of that country is influenced. Thisbecause the oil price has a direct impact on the dollar currency thataffects the currencies of countries importing oil as well as thecountries exporting the oil product. Avoidance of these debts willbring a country a stable rate of exchange because the governmentswill accrue the foreign capital causing these countries to experiencethe high rate of inflation.

Theresearch in this study can be very help to the scholars pursuing thelink between the oil prices and the rates of exchange. This will helpthem to understand the main factors that affect the rate of exchangeof a certain country. It provides both theoretical as well asempirical information that will help the students to relate theconnection which exists between the rates of exchange and the oilprices. When used by the students, it provides good methods ortechniques for analysis data in this area.

Fromthe study, it can be revealed that the dollar currency is the oiltrading currency hence, any fluctuation in the currency affects theprices of the crude oil. There are strong relationships that existbetween the dollar currency and the prices of the energy. From theabove research, it is revealed that the since 2002, increments of theprices of oil has brought decline in currency value of the dollar.Over the past years, the study revealed that the trend of the oilprices has precipitated fluctuations in the rate of exchange trendsboth in the economies of exporting as well as importing oil.

Fromthe collected data, it was revealed that exchange rates have a hugeessential effect on the value of commodities that are exported andimported. The prices of the imports and export of a particularcountry have a significant consequence of the rate of exchange.Likewise, the energy affects the production of goods in manyimportant ways. Due to the rise in the prices of crude oil productsin 2009, the supplies from the field of agriculture haveoverwhelmingly increased as the result of the increase in the pricesof energy. It can be said from the above result, the price ofcommodities obtained from production is directly proportional to theprices of the energy related product, especially the products fromthe oil. The variations in the prices of the oil variables have thesubstantial effects on the establishment of the risk management plansas well as developing of the decision based on the long-termobjectives of a given company.

Fromthe finding of non-stationarity in the series, it can be concludedthat at the level form, the statistics were larger than the givencrucial values of all of the equations. This indicated there was notrend that had a constant only as well as no constant or trend thatshowed both the trend as well as the constant of the results. Fromthe result of the stationary test, it revealed that the unit rootexisted in all the tools at the level form of each model. It was alsonoted that the conversion of the variables to their first differenceforms showed all the variable became stationary as well as can beperceived as integrated into the form of one order.

Thisstudy also examined the factors that influence the foreign exchangerate of a given country. It was found that the inflation rates that acountry experience in the market price increase influences theexchange rates of the currency. It is concluded that the countrieswith low rate of inflation as compared to others, witness increasesin the value of their currency. Another factor revealed to beinfluencing the exchange rate of a nation is the interest rates, itwas concluding that the variations in the rates of interest have aneffect on the dollar exchange rates as well as the value of currencyfor a particular country. Another factor found to be affecting theexchange rate is the government debt, it was found that from thetheoretical framework the nations accrue foreign capital as a resultof the government debt causing the value of the nation’s exchangerate decrease. Terms of trade were found to be influencing theexchange rate of a particular country, high terms of trade cause theincrease in the country’s revenues that have an increased impact onthe demand for then currency.

Fromthe theoretical framework of the study, it has been confirmed that anincrement in the prices of the oil has a proportional effect on theproduction cost for the firms of a country. This kind of increase cancause an upsurge in the production cost of the non-tradable products.This confirmed that the above effect is an appreciation of the rateof exchange caused by the increment in the prices of the commodities.According to the perception of demand, the study showed the rate orexchange is inversely proportional the relationship it has with thedisposable income. From the research, an upsurge in the prices of oildecreases the consumer’s power of spending. Therefore, the demandfor the non-tradable goods will be low causing a decrease in thespending power of the consumers, as well as a decline in the cost ofproducts that will cause a decrease in the value of country’scurrency.

Finally,the study has concluded that the appreciation of exchange rate in thecountries exporting oil occurs when the prices of oil increases, aswell as a decrease of the rate of exchange, is because of thedecrease in the oil prices. Therefore, in countries with oilreserves, the value of the currency increases about the states thatdo not possess the oil reserves once there is a rise in the oilprices. From the study, this was indicated to happen in Asia afterthe prices of the oil decreased causing a financial crisis in theAsian countries, such as Russia.

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Tables and Appendices

Table34: Results of Unit Root Tests

Table35: Lag Order Selection

Table36: VAR Residual Normality Tests

Table37: VAR Residual Heteroskedasticity Tests

Table38: VAR Residual Serial Correlation LM Tests

Table39: Co-integration Tests

Table40: Co-integration Equations Specifications and Residuals Tests

Table41: Short-run estimation output

Table42: Residuals Autocorrelation Test of Short-run Model

Table43: Residuals Normality Test of Short-run Model

Table44: Residuals Serial Correlation Test of Short-run Model

Table45: Residuals ARCH Heteroskedasticity Test of Short-run Model

Table46: Residuals White Heteroskedasticity Test of Short-run Model

Table47: Ramsey Reset Test of Short-run Model

Figure3: Parameters Stability Tests of Short-run Model