Question

(Econometrics)

Oil prices are notoriously difficult to predict. People studying commodity prices often refer to random oil shocks as the most important determinant of current oil price.

How would you build this model?

Be thorough in your reasoning and explicit in model specification.

Answer 1

The Short-Run
In this section, I explore the choice of appropriate exchange rate regimes in fossil fuel
exporters. I then discuss the polar views of the (independent) monetary policy response
to a drop in oil prices. I also touch upon the issue of the transmission of monetary policy.
Choice of Exchange Rate Regime
Adopting a flexible exchange rate regime is appropriate in countries where inflation
expectations are well anchored. That flexible arrangement allows for an instantaneous
adjustment of the nominal exchange rate following a terms-of-trade shock resulting from,
say, fluctuations in the prices of fossil fuels
In practice, we observe however that many commodity exporters are pegging to the
currency of their main trading partners (dollar or euro) or have adopted managed float . There are two main reasons for this. First, a fixed exchange rate regime maintains
the parity between the domestic currency and a foreign currency, thus limiting fluctuations
in the price of imported goods and inflation—also pertinent given that domestic prices are
often sticky. A fixed exchange regime may also contribute to building credibility for monetary
policy by anchoring inflation expectations. Second, the lack of exchange rate flexibility has
to do with the so-called fear of floating . Indeed, currency mismatch can
be fatal and lead to crisis. Hence, countries are often afraid of allowing their currencies
to float. That said there are important risks associated with adopting a fixed exchange rate
regime if the countriesrun pervasive external deficitsthat often stemfrominternal deficits—so
called twin deficits.

Besides pegs, many countries operate ‘managed floats’. This arrangement allows them
to choose how much of the adjustment to a terms-of-trade (hereinafter ToT) shock should
come from exchange rate adjustment vs domestic price adjustment. A ToT shock amounts
to a negative wealth shock suggesting the real exchange rate has to adjust towards a new
equilibrium level. A resource windfall is also typically associated with the so-called Dutch
‘Disease’. In other words, a positive oil price shock leads to a relative price change between
non-oil tradables and non-tradables.
In the case of a pure float, a ToT shock leads to immediate adjustment of the real ex-
change rate through the nominal exchange rate when goods’ prices and wages are rigid.
Empirical evidence suggests that flexible exchange rate regimes allow for a smoother
real adjustment—that is, lower output volatility.
In the case of a managed float, it might not be desirable to force such a speedy adjust-
ment through the nominal exchange rate, so managed float allows countries to combine a
nominal exchange rate movement with a gradual adjustment in the domestic price level.
This however could come at a cost to the credibility of policies. Fiscal policy could help
counteract the effect of a ToT shock and hence limit/spread domestic price adjustment over
time. There are also important issues associated with the ‘asymmetrical’ nature of the Dutch
Disease stemming from downward nominal stickiness. It these
circumstances it may make sense to resist nominal appreciation and let inflation increase
above target to facilitate this relative price change.
There are also issues associated with capital account openness and the conduct of
monetary policy. Brazil is a good example of a country that has struggled with the conse-
quences of a rapid exchange rate appreciation resulting from the surge in capital inflows
during the boom in commodity prices.

The Two Polar Views of Independent Monetary Policy
A dilemma for fossil fuel exporters is that an oil price drop may lead to two polar views in
terms of what the appropriate response of independent monetary policy should be. On the
one hand, a central bank pursuing a (strict) inflation mandate would tighten monetary policy in
the face of a drop in oil prices. Indeed, a drop in oil prices would lead to a depreciation of the
exchange rate, hence leading to a rise in inflation justifying a tightening of monetary policy.
On the other hand, a central bank focused on stabilising output would loosen monetary policy
in the face of drop in oil prices. Indeed, an oil price drop would reduce demand from the oil
sector to the non-oil sector. That would in turn generate a rising negative output gap for the
non-oil economy, hence justifying a loosening of monetary policy. That would in turn make
the output gap of the non-oil economy rise, hence justifying a loosening of monetary policy.
The channels include large backward and forward linkages between oil and non-oil sector
(e.g. Norway, Russia) and changes in government spending/taxes and the credit channel.
In theory, the new Keynesian framework with wages or goods price rigidity offers guid-
ance on the correspondence between targeting inflation and targeting output. In a ‘closed
economy’, the so-called divine coincidence—the equivalence between targeting inflation
and output stabilisation—holds under the assumption of limited frictions . In the context of so-called commodity openness (both consumption and production
openness), there appears to be no divine coincidence under standard assumptions. Flexible
inflation targeting is (constrained) efficient. Core inflation targeting is more appropriate in the presence of credit constraints and a
large share of food in the consumption basket . Some authors have
argued for setting the exchange rate to stabilize the domestic currency price of commodity
exports . While that rule would smooth government oil revenue in terms of
local currency, it has no clear welfare rationale.
In practice, most countries loosen monetary policy in the face of a drop in oil prices
suggesting that output stabilisation is more important than strictly targeting inflation.
Other Issues
Monetary policy in fossil fuel exporters should also be mindful of issues related to the
effective transmission of monetary policy for a discussion with regard
to developing countries). In fossil fuel exporters, excess liquidity indeed incapacitates the
transmission of monetary policy. Structurally, the financial system in fossil fuel exporters is
subject to a ‘financial curse’ in that its reach is limited. Banks do not rely on
refinancing from the central bank as they instead earn relatively high risk-free returns on
securities issued for sterilisation purposes. That situation hence incapacitates the traditional
monetary policy tools (no base rate to speak of).
All in all, a peg allows fossil fuel countries to stabilise (imported) inflation and build credi-
bility if the country maintains fiscal discipline (by avoiding pervasive current account deficits).

The Medium-Run
In this section, I examine the role monetary authorities should play beyond the business
cycle horizon. I first explore the issue of the complementarity between fiscal and monetary
policy in fossil fuel exporters. Then, I discuss the need for macroprudential policies. I then
draw lessons from the recent collapse in oil prices and the associated policy responses.

Complementary between Fiscal and Monetary Policies.
Commodity exporting countries in general—and fossil fuel exporters are no exception—
tend to overspend in good times, leading to excessive indebtedness and crisis in bad times
. The effectiveness of CBs’ contribution to stabilisation thus
rests on the existence of a credible/sustainable fiscal anchor. The cost of borrowing rises
with falling commodity export prices

Chile provides an example of a commodity exporter that has set up a fiscal rule and
graduated from pro-cyclicality. The set-up is that an independent council of experts deter-
mines the ‘volume’ of spending while members of parliament decide on the ‘composition’ of
spending—by picking from projects that have been pre-screened by a fiscal authority. The
presence of a fiscal rule in Chile has arguably supported the implementation of monetary
policy and specifically inflation targeting .
Short of building the needed constituency to set up and implement a fiscal rule, Mexico
settles for a large-scale hedging programme against oil price volatility .
The difficulty with hedging programmes, of course, is the tension that may arise over the
perceived excessive cost of the programme during boom times. To allay that concern, the
Mexican programme has been designed to capture the uptick from high oil prices using Asian
options. It should be noted however that both tools (fiscal rules and hedging programmes)
are often politically difficult to put in place and implement.
Macroprudential Policies
Credit and asset prices in commodity exporters tend to amplify macroeconomic fluctu-
ations . The concentration of wealth in one sector makes the concerns
over systemic risk much more prevalent in commodity exporters. Macroprudential tools are
thus all the more important in these economies to help limit the amplitude of boom and
bust cycles in credit and asset prices (e.g. stocks, real estate prices) hence reducing the
risk of financial instability.
The IMF (2016) recommends that the use of these tools—which are to a large extent
commonly used separately—be coherent in order to limit perverse and countervailing
effects. The most common prudential tools include capital buffers, risk-based supervi-
sion, time-varying loan-to-deposit and loan-to-value ratios. Sector specific tools aim to
limit sectoral exposure, particularly for real estate and personal loans. Other efforts to
limit systemic risk include liquidity management, the development of domestic interbank
money and debt markets. The modernisation of insolvency regimes and the strengthening
of crisis management and resolution systems are also area where progress is needed in
many fossil fuel exporters.

Lessons from the 2014–16 Oil Price Collapse
The policy response to the spectacular oil price collapse has been quite different across
countries . Conceptually, one needs to
distinguish between countries that have buffers and those who have none. Those with
buffers should use them to adjust gradually to the medium anchor. Those with no buffers
have no choice and need to let the exchange rate depreciate. In practice, the differences
in responses reflect different countries’ circumstances, including the presence of buffers
but also the share of imported goods in total domestic demand (e.g. 11 per cent for Russia
compared to 40 per cent for the Cooperation Council for the Arab States of the Gulf (GCC)).Russia and Azerbaijan have either devalued or let their currency depreciate early on
(with some risks of currency mismatch). Inflation from imported goods in turn pushed
the central banks in these GCC countries to raise rates. GCC countries have kept their
pegs unchanged reflecting their very large share of consumption concentrated around
imported goods and their open capital account. On the fiscal front, many GCC countries
have however embarked on an ambitious reform programmes (subsidy cuts) to reduce
spending and also diversify their economy (e.g. the Saudi 2030 plan). Nigeria had initially
opposed devaluing its currency and hence losing most of its reserves and leading to an
explosion of the black market premium. The authorities recently opted for devaluation
and a managed float.Another issue to consider when responding to a commodity price shock is the nature
of the shock, especially the permanent vs transitory aspects. This is, of course, hard to
know a priori. Typically one can distinguish between demand and supply. While monetary
policy needs to respond swiftly, erring on the side of caution by assuming that part of
the shock is temporary and part is permanent is appropriate. Oil prices are notoriously
hard to forecast . The market seems to learn only gradually as the evolution of
futures curves suggests . The uncertainty surrounding the nature of the shock
calls for precautionary saving in the form of (fiscal and ‘financial’) buffers. Hedging re-
duces the need for precautionary saving . It is often forgotten
that uncertainty about oil price also has an independent effect that affects investment
and consumption decisions.

The Long-Run
The historical COP21 agreement to keep global warming below 2 degrees Celsius and
ensuing technological innovations (declining cost of renewables; electric cars) have further
boosted the energy transition away from fossil fuels (IMF, 2016). This means that gigatons
of reserves will have to stay underground unexploited. While this risk of stranded assets for
fossil fuel exporters appears to be remote, it does pose an existential threat that monetary
authorities cannot afford to ignore . It is not easy to define the contours
of how monetary authorities should engage on these issues. They appear structural in
nature, but as they pose a systemic risk it is urgent that monetary authorities take up the
challenge of rethinking their role in light of these new risks.
To keep the mean global surface temperature rise below 2 degrees Celsius, only 300
to 400 gigatons of carbon can still be burnt, but the reserves of private oil and gas majors
alone are at least three times as high. To abide by international commitments to limiting
global warming a third of oil, half of gas, and 80 per cent of coal reserves should be kept inthe ground forever . This would mean keeping unburned
one-third of oil reserves in Canada and the Arctic, 50 per cent of gas and 80 per cent of coal
(mainly China, Russia and the US). In the Middle East, reserves are three times larger than
their ‘carbon budget’. In other words, 260 billion barrels of oil from the Middle East cannot
be burnt. In addition to stranded reserves, the structures and capital used in the extraction
and exploitation of fossil fuels can become stranded.
Recent discoveries of giant oil and gas reserves (Israel, Egypt, Lebanon, Mozambique
and Senegal) are expanding the list of countries that are faced with the risk of stranded
assets and capital . It is hard to reconcile this trend with the objective
of keeping planetary warming below 2 degrees Celsius. Nonetheless, the large number
of countries that are increasingly exposed to stranded assets makes it a priority for mon-
etary authorities in concert with fiscal authorities to communicate and help adapt to and
mitigate these risks.

PERMANENT AND TEMPORARY
OIL PRICE SHOCKS, MACROECONOMIC
POLICY:

In the last two years, the oil market experienced a series of negative price developments.
Brent crude oil prices had declined from the peak of USD 111.6 in June 2014 to the trough of USD
30.7 in January 2016. The fall in oil prices observed this time around fundamentally differs from
the drop that occurred during the most recent financial crisis. The latter decline resulted from
market anxiety surrounding liquidity problems provoked by the insolvency of Lehman Brothers,
while the former fall was rather engendered by structural changes in demand and supply.
In the former Soviet Union, there are three major oil exporting countries: Azerbaijan, Kazakh-
stan and Russia. These countries are characterised by a high dependence on oil in trade and
fiscal accounts. When the negative oil price shock hit the oil market, the inflow of petrodollars
slowed down, which in turn put pressure on national currencies. To prevent foreign exchange
reserves from falling to critical levels, the central banks in these countries had to devalue thecurrencies and change exchange rate regimes. Additionally, the governments of these countries
started optimising their spending and suspending low priority projects.
Numerous studies have examined the relationship between changes in oil prices and
macroeconomic variables in oil exporting countries. One strand of the literature assumes
that economies respond symmetrically to negative and positive shock. Another strand instead argues that economies respond differently to negative and
positive oil price shocks and therefore distinguishes these two kinds of shocks . A third strand, along with estimating the impact of either symmetric or
asymmetric oil price shocks aims to determine the nature of the shocks using structural
vector autoregression (SVAR) models .
Despite the diversity of approaches, there exists a consensus about the existence of a
significant positive relationship in oil exporting countries between oil prices on the one side
and output and fiscal spending on the other.
following the permanent income hypothesis (PIH) ,
which proposes that consumption responds to permanent changes in income rather than
temporary changes, I argue that fiscal spending in oil exporting countries responds only
to permanent oil price changes. To test the proposition, I estimate a five-variable vector
autoregression model with two exogenous variables (VARX)—permanent and temporary oil
price shocks—for Azerbaijan, Kazakhstan and Russia using quarterly data over the period
2003–15. The results for Azerbaijan and Kazakhstan support the PIH, while the result for
Russia, that real budget expenditure responds to a temporary oil price shock, contradicts
the PIH. Such a counter-intuitive reaction of fiscal spending in Russia can be explained by
the rule used to manage oil revenues. As regards the presence of the symptoms of the Dutch
Disease, the results indicate only one symptom—appreciation of the national currency.

Methodology

In this paper, to investigate the impact of permanent and temporary oil price shocks on
the real economy, I use a quarterly VARX with five endogenous and two exogenous variables.
The endogenous variables considered in this model are the following: real short-term interest
rate, real effective exchange rate, real budget expenditure, real imports and real tradable
non-oil GDP. The set of exogenous variables includes a nominal permanent oil price shock and
a nominal temporary oil price shock. Here I use the assumption that the oil price is an exoge-
nous factor for these economies. For the analysis of the reactions of the economic variables
to permanent and temporary oil price shocks, I estimate impulse responses functions (IRFs).
The composition of the endogenous variables is motivated by both the propagation
mechanism of the oil price shocks and the interest of the paper in examining the impact of
the oil price shocks on macroeconomic policy and the tradable non-oil sector. Changes in
oil prices affect budget revenues and therefore the spending capacity of the government.
Expenditures in turn have a significant effect on demand, which can be met through
either higher imports or domestic production. Fluctuations in the inflow of petrodollars alsoaffect the supply of the foreign currency into the country and therefore affect the value
of the national currency. Changes in the value of the national currency, in turn, affect its
purchasing power and can influence country imports. Additionally, the variable set includes
a real short-term interest rate to capture the reaction of the monetary sector to inflationary
pressures coming from increased demand.
The vector auto regression (VAR) model contains real permanent and temporary oil
price shocks to test the PIH, which states that only changes in permanent income have an
influence on consumption. Following the logic of this hypothesis, one can suggest that the
fiscal spending in oil exporting countries has to react only to permanent oil price shocks
because only permanent changes in oil prices will cause permanent changes in oil revenues.
Besides, the analysis of the VAR model will allow us to test whether these countries have
the symptoms of the Dutch Disease. The Dutch Disease theory predicts that a large inflow
of petrodollars into the economy has to lead to the appreciation of the domestic currencies,
a decline in manufacturing, an increase in wages, and fast growth of the non-tradable
sector . In this VAR specification, it will
be possible only to test the impact of oil price shocks only on the real exchange rate and
tradable non-oil sector.

Data The sample period is almost the same for all countries; it runs from 2003Q1 to 2015Q4 for Azerbaijan and Kazakhstan and from 2003Q4to 2015Q4 for Russia. The oil price is defined as the spot price of the Brent brand of crude oil in USD. The real short-term interest rate is the nominal short-term lending rate adjusted for inflation. For Azerbaijan and Kazakhstan, the short-term lending rate is an average rate on credits up to one month charged from individuals and firms; for Russia, it is an average rate on credits up to one year charged from f irms. The real budget expenditure represents the expenditure of the consolidated budget in the national currency deflated by the CPI. The real non-oil tradable GDP stands for the total real value of production in agriculture and manufacturing expressed in the national currency. All variables except real interest rates are expressed in logs. As the purpose of the analysis is to determine the impact of permanent and temporary oil price shocks, one should extract permanent and temporary components from the oil price series. To decompose the oil price series into permanent and temporary components, I use the Kalman filter. A permanent oil price shock series is defined as a growth rate of the permanent component of the oil price series, and a temporary oil price shock series is defined as a growth rate of the temporary component of the oil price series. The time series properties of the variables were assessed by the augmented Dickey Fuller and Kwiatkowski–Phillips–Schmidt–Shin tests. For Azerbaijan, all variables are found to be f irst-difference stationary series. For Kazakhstan and Russia, the real short-term interest rate is determined to be a stationary process and the other series are determined to be first-difference stationary processes.

Policy Implications :

The finding that a temporary oil price shock stimulates growth in the budget expenditure of Russia is the consequence of a fiscal rule that does not adjust the amount of the oil transfer to the budget for temporary fluctuations in oil prices. In Azerbaijan and Kazakhstan, there is no specific rule, but it seems that when the respective governments and parliaments decide on the transfer from the wealth funds to the budget they take into consideration the nature of changes in oil prices. In practice, the failure to distinguish between permanent and temporary changes can lead to undesirable consequences. If there is a temporary positive oil price shock and the government decides to increase social spending, which is irreversible, then after the positive temporary shock quickly decays the government can find it problematic to f ind the resources with which to fulfil increased social obligations. Therefore, the authorities need to design fiscal rules that account for the nature of oil price shocks. The IRFs show that these countries have only one symptom of the Dutch Disease—real exchange rate appreciation. No evidence was found that an increase in oil prices leads to a decline in the tradable non-oil sector. Such a counterintuitive outcome is the result of the efforts of the governments of these countries to develop their non-oil sectors in order to avoid the Dutch Disease. Now, when oil prices experience a negative shock, the scale of the financial support of the government to the non-oil sector and domestic demand for the goods of the non-oil sector will drop, and this in turn will lead to a downturn in the tradable non-oil sectors. To minimise the negative effect of a fall in oil prices on the tradable non-oil sector, the authorities should assist firms in finding new markets to compensate for the decline in domestic demand.