THE IMPACT OF OIL PRICE SHOCK AND EXCHANGE RATE VOLATILITY ON ECONOMIC GROWTH: A COMPARATIVE ANALYSIS OF NIGERIA AND KENYA

ABSTRACT

In this paper,  an empirical analysis is used to compare the effects of oil price  shock  and  exchange  rate  volatility  on  the  economic  growth  of Nigeria  and  Kenya.   Firstly,   a  LA- VAR  model  is  applied  to  investigate whether the oil price  shock and exchange rate volatility have the Granger Causality  to economic  growth  of both Nigeria  and Kenya.  Secondly,  we apply  a  VAR  model  with  co-integration  technique  to examine  how  GDP Growth of Nigeria and Kenya are affected by changes in oil prices and the exchange  rate  in the  long-run.  Thirdly,  a  vector  error  correction  model (VECM)  is employed  to analyze  the short-run  dynamics  of the real GDP Growth for the two countries.  Finally,  we employed  a SURE model in this study  to compare  the result of oil price  shock on international market  to GDP Growth of both countries.  Our main findings indicate that the oil price shock have effect on GDP Growth of both Nigeria and Kenya.  The exchange rate of both countries also has effect on the GDP output of the countries

CHAPTER ONE

INTRODUCTION

1.1     Background to the Study

One factor in the global economy that has continued to pose a big challenge to policy makers across countries is the increasing spate of fluctuations in the price of oil and exchange rate.  The world price of crude oil, which was stable between $2.50 and $3 since 1948, quadrupled from $3 per barrel in 1972  to $12 per barrel by the end of 1974,  and from $14 per barrel  in  1978  to  $35  per  barrel  in  1981.  The  price  of  oil,  however plummeted  below  $10 per  barrel  in  1986,  but  surged  again to between US$18 and $23 in 1990s.  It crossed the US$40 mark in 2004;  and rose to about US$60 from 2005. During the summer of 2007, the price of one barrel of crude oil jumped above US$70 and even crossed the US$145 mark in July

2008. The price staggered to US$80.50 in October 2009 and remained at an average of US$75 till August 201,NYMEX (2010).

CRUDE OIL PRICE HISTORY FROM 1970 TO 2010

1970-  $2.10	1979  – $14.80	1987-  $17.13	1995  – $16.15	2004 – $31.16
1971-  $2.65	1980-  $29.97	1988  – $19.92	1996  – $19.70	2005 – $29.97
1972  – $2.80	1981  – $40.00	1989-  $15.05	1997  – $24.65	2006-  $38.21
1973-  $3.10	1982  – $36.50	1990  – $21.20	1998  – $16.50	2007 – $56.97
1974 – $12.60	1983  – $35.50	1991  – $27.8	1999  – $10.60	2008 – $63.28
1975  – $11.80	1984 – $30.00	1992  – $18.20	2000 – $25.55	2009-  $98.52
1976-  $12.84	1985-  28.00	1993  – $18.50	2001-  $22.00	2010  – $39.85
1977 – $14.33	1986-  $28.65	1994-  $13.50	2003 – $19.88	2011  –  $77.69
1978-  $14.33

Source: The New York Mercantil Exchange

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A GRAPH OF CRUDE OIL PRICE HISTORY ANALYSIS

Crude Oil Prices

2008 Dollars

$100 ———————-–~–_–_–_–_–_–_–_––—-.

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70    72   74

71    T3   T6

o4   06                  s2   s            02   04   0%    ¢

‘s

d $$    $7    $9    91   93    6 97   99   1 0 0$   07   09

1970 – August,  200

WTRG Economic  +1%8-200

LIS  1st Purchase  Frice  [ Welhsd]               “Ward  Frix“

– Avg U.$.  $j2.% =hyp World $5.59= Median Warid   $30.04

www.wtrg.em

(479} 291–41

An oil price  increase,  all things being equal,  should be considered good  news  in  oil  exporting  countries  and  bad  news  in  oil  importing countries, while the reverse should be expected when the oil price decreases. The challenge, however, of the combined effect of volatility of oil prices and exchange rate on economic  growth for oil producing  country like Nigeria and oil importing country like Kenya is really enormous. Huge inflow of oil revenues in Nigeria are more often associated with expansion in the level of government  spending while periods  of dwindling oil revenues  are usually accompanied by budget deficits.  There is no gain saying that Nigeria relies so  much  on  revenue  from  oil  exports.  At  the  same  time,  the  country massively imports refined petroleum and other related products.  Evidence,

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for instance, shows that government spending, which before  1999 remained well below N0.5 trillion, hit Nl .02 trillion marks in 2001  and Nl .5  trillion in 2004. The figures for 2006 and 2007 stood at N2.04 and N2.45 trillion respectively,(Aliyu  2009)

Although  the  Naira  exchange  rate  has  witnessed  some  period  of relative   calm   since   the   implementation    of   the   structural   adjustment programme  (SAP) in July,  1986, its continued  depreciation, however, may have implications  for the level of real sector activities  in the country.  The Naira which traded at N0.935  = US$1.00 in 1985  depreciated to N2.413 to

$1.00 and further to N7.901  against the US dollar in  1990.  To stem the

trend, the policy of guided deregulation pegged the naira at N21.886 against the dollar in 1994.  Further deregulation of the foreign exchange market in

1999, however, pushed the exchange rate to N86.322 to US$1.00. With huge inflow of oil revenue due to hike in the oil price, the end-period rate stood at Nl 17 .97  in December,  2007.  This remained stable until towards the end of

2008 when the global financial crisis took its toll and the naira exchange rate depreciated from Nl 16.20 in November, 2008 to Nl31.5 in December, 2008 or a decline in value by  12.95%  and further  to Nl42.00  or a decline by

7.98% in February 2009,(Aliyu 2009)

In  spite  of  these  developments,  the  national  income  accounts  of

Nigeria revealed an impressive performance.  During the oil price shock of

1970-78 (oil boom), GDP grew positively by 6.2 percent annually, however, in the 1980s, GDP had negative growth rates. In the period 1988-1997 which constitutes  the period  of Structural Adjustment  Programme  (SAP),  which entails economic liberalization, the GDP responded to economic adjustment policies and grew at a positive rate of 4.0 percent. Agriculture, industry and manufacturing, oil and gas sectors had greater dominance in the composition

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of the Nigeria’s  GDP.  The year 1989  – 1998  was the most turbulent period in the history  of the country’s  growth pattern,  real GDP  grew  only by  an average of 3.6 percent, against the population growth rate of 2.8% during the same period.  Inflation,  poverty,  exchange  rate  were  all  at alarming  rates. Foreign direct investment, which is a necessary engine of growth, was stifled because of unconducive enabling environment. Between  1999 and 2008, the country’s growth performance improved significantly. GDP growth rate averaged 7 .8%  during the decade solely due to the growth of non-oil sector which  grew  by 9.5 percent.  In this regard,  however,  oil sector constitutes both  a drag on growth  and a source of instability  on GDP growth pattern. According  to Obadan  (2009),  of the 3  large  sectors  of Nigerian  economy, production,  wholesale  and  retail  and  oil  and  gas,  only  the  latter  exerts  a negative  influence  by  up  to  4.49  percent  of  GDP,  in  spite  of  its  great potentials  in relation  to manufacturing  and its large  share  of GDP  at 23.2 percent.

Kenya is an oil importing developing country.  High oil prices as well as exchange rate volatility may have adverse impact on business, consumers, government budget and the economy generally. Kenya has experienced deteriorating  terms  of trade which jeopardized  balance of payment position of the country leading to lower economic growth in the past decade. Unlike developed  oil importing  countries,  which  have  high  taxes  on  fuels  where price  shock  could  be  mitigated  by  reducing  the  taxes  as  fuel  cost  rises, Kenya’s  economy bears the full weight of oil price rise,  which often results in the government cutting down on social spending. The government is often reluctant to pass on to consumers a rise in international oil price because of the potential for social resistance to a policy that could hurt the poor masses. Government sometimes subsidize oil price with the dwindling income.

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The  story of Kenya is one of Africa’s  worst performing  economies, notwithstanding   a  pick-up  of  economic  growth  starting  in  2004.  Kenya operates  a “market  based”  economy  with  some  state owned  infrastructure enterprises, and maintains  a liberalized  external trade system. According  to IMF (2010) the value of the Kenyan shilling (KSh), Kenya unit of currency, maintained  an   impressive  performance  after independence  in  1963, with a constant exchange rate of KSh7.14 to US$1  from  1967 to 1972 and further appreciated to KSh7.02 to US$1  in 1973.  The value of the exchange rate of the Kenyan Shilling remained relatively  calm till  1985  when it depreciated to  KSh16.43  and  further  to  KSh22.91  to US$1  in  1990.  The  last  term  of President Moi (1997-2002), which was characterised by corruption and poor governance soared the exchange rate from about KSh60 per US$1 in 1998 to KSh78.75 per US$1 in 2002 and further to KSh79.17 to US$1  in 2005. The exchange rate of the Kenya shilling, however appreciated during the global financial crisis of 2008 to about KSh69 to US$1  due to tourism  which has exhibited  steady  growth  in  most  years,  as  a  principal  source  of  foreign exchange since independence.

Kenya experienced  a continuous GDP growth reversal from a peak of about 6.5 percent per year between  1963  and  1973,  after independence,  to less than 4 percent per year between  1973  and  1983.  The country achieved only  about  1.5  percent  GDP  growth  per  year  during  the  1990s.  The  low economic growth, occasioned by world oil price shocks, translated over time into  reduced  income  per  head,  increased  poverty  and  worsened unemployment.  Kenya  currently  imports  its  entire  crude  oil  requirement, which accounts for about 20 to 25 percent of the nations total import bills. The  economic  performance   of  the  country  is  also  hampered     by  other numerous    interacting    factors   including    over   dependence    on   a   few

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agricultural   exports   that   are   vulnerable   to   world   pnce   fluctuations, population growth that outstripped economic growth, prolonged drought that hamper  electricity  generation, deteriorating  infrastructure, poor governance and corruption.

1.2     Statement of the Problem

The impact of oil price shocks on net oil-exporting and oil-importing developing countries has not been sufficiently covered in the literature. Specifically, studies are rare, to the best of our knowledge, on Nigeria and Kenya that have taken explicit account of potential non-linearity in the oil price-macro  economy  relationship.  Furthermore,  most  of the  studies  that look at real output movements typically have a cross-sectional orientation.

There is also dearth of empirical studies that have looked at effects of oil price volatility on the macroeconomic environment of oil exporting and oil  importing  Sub-Saharan  African  countries.  Such  comparative  analysis would have  important  policy  implications.  First,  it may help  to evaluate current  macroeconomic  policies  in  both  countries  especially  if  oil  price shocks have differential effects on these economies.  Second,  such analysis may help to evaluate exchange rate policies and how effective they may be depending on country macroeconomic circumstances. One may assume that uniform exchange rate policies may not work in both oil exporting and oil importing  countries.  However,  if an exporting  economy  imports  massive refined oil products, as in the case of Nigeria, this assumption may not hold.

Hence,  the present study further attempts to determine the impact of such effects in an oil exporting economy such as Nigeria and oil importing economy   such   as  Kenya  using   a  time   series   analysis.   Against   this background,  therefore,  this study seeks to provide answers  to the following

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research  questions;  (i) what is the impact of oil price  shocks  and exchange rate volatility  on output growth in the Nigerian  and Kenyan economy?  (ii) To what extent do oil price and exchange rate fluctuations drive real output volatility  in  both  countries?  (iii)  How  does  oil price  volatility  impact  on exchange rate volatility in the two economies?

1.3   OBJECTIVE OF STUDY

The specific objectives of this study are:

•    To  ascertain  the  impact  of  oil  price  shocks  and  exchange  rate volatility on output growth in the Nigerian and Kenyan economy.

•    To ascertain the extent to which oil price fluctuations drive real output fluctuations.

•   To ascertain how exchange rate responds to shocks to oil prices

1.4     STATEMENT OF RESEARCH HYPOTHESIS

The following are the research hypothesis for the study.

Hol:  Oil price shocks and exchange rate volatility have no effect on output growth in the Nigerian and Kenyan economy.

Ho2:  Output volatility  in Nigeria  and Kenya is not affected  by oil price volatility.

Ho3:  Oil price volatility has no impact on exchange rate volatility on the economy of these two nations.

1.5     SCOPE OF STUDY

The study covers the period between 1970 — 2008. The choice of this period is based on the availability  of data that will permit  a comparative analysis of these two economies. Our data may be annual or quarterly for the periods in which such frequency of data can be found in the two countries.

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1.6     SIGNIFICANCE OF STUDY

A comparative analysis of the impact of oil price shock and exchange rate  volatility  on  Sub-Saharan  African  oil  exporting  and  oil  importing nations  would  help  policy  makers  develop  economic  policies  that  will capture the specific  macroeconomic  needs of these developing economies. The  mechanism  through  which  shocks  are  transmitted   would  become channels   through   which   the   economy   will   be   rescued.   Again,   any international institution that would be involved in making policies for these nations will not assume uniform application, for example, one – size fit – all policy  may  not  applicable  in  country  specific  cases.  The  recent  global financial  crisis  has  caused  policy  makers  around  the  world  to  be  very cautious   with   macroeconomic   instability.   This   study   would   add   to knowledge   of   the   sources   of   shocks   by   looking   country   specific characteristics and appropriate policy interventions for specific cases.

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