ABSTRACT
This study evaluates the impact of Crude Oil Price (COP) on the Exchange Rate (EXCHR), External Reserves (EXRS), Gross Domestic Product (GDP), Inflation Rate (INFL), International Trade (INTR) and Money Supply (MSUP) in Nigeria with quarterly data from 1995 to 2014 using GARCH and VAR models. From the analysis, all the variables were stationary at first difference with p-value less than 0.05. The presence of heteroscedasticity was found in exchange rate with some of its coefficient models being significant at 5% level; and the forecasting model for exchange rate is GARCH (2, 1). The findings further showed that negative crude oil shocks did not pose an inflationary threat on Nigerian economy, but rather it improved output growth in terms of GDP and enhanced the flow of MSUP. On the other hand, negative crude oil price shocks did affect external reserves and international trade due to the recent fall in the price of crude oil which calls for a diversification of economy in Nigeria.
TABLE OF CONTENTS
COVER PAGE ………………………………………………………………………………………………………i FLY LEAF ……………………………………………………………………………………………………………ii
TITLE PAGE ……………………………………………………………………………………………………….iii
DECLARATION ……………………………………………………………………………………………………………… v
CERTIFICATION ……………………………………………………………………………………………………………. vi
DEDICATION ……………………………………………………………………………………………………………….. vii
ACKNOWLEDGEMENT ……………………………………………………………………………………………… viii
ABSTRACT ……………………………………………………………………………………………………………………. ix
TABLE OF CONTENTS …………………………………………………………………………………………………… x
LIST OF TABLES …………………………………………………………………………………………………………. xiii
LIST OF FIGURES ………………………………………………………………………………………………………… xiv
LIST OF APPENDICES ………………………………………………………………………………………………….. xv
LIST OF ACRONYMS …………………………………………………………………………………………………… xvi
DEFINITION OF TERMS ………………………………………………………………………………………………. xiv
CHAPTER ONE ……………………………………………………………………………………………………………… 1
INTRODUCTION …………………………………………………………………………………………………………… 1
1.1 Background of Study …………………………………………………………………………………………… 1
1.2 Statement of Problem ………………………………………………………………………………………….. 5
1.3 Aim and Objectives of Study ……………………………………………………………………………….. 6
1.3.1 Aim ………………………………………………………………………………………………………………….. 6
1.3.2 Objectives …………………………………………………………………………………………………………. 6
1.4 Significance of Study ………………………………………………………………………………………….. 6
1.5 Scope and Limitations of Study ……………………………………………………………………………. 7
1.5.1 Scope of study ……………………………………………………………………………………………………. 7
1.5.2 Limitation of Study …………………………………………………………………………………………….. 7
CHAPTER TWO…………………………………………………………………………………………………………….. 8
LITERATURE REVIEW ………………………………………………………………………………………………… 8
2.1 Introduction ……………………………………………………………………………………………………….. 8
2.2 Nigeria Crude Oil Price Shocks ……………………………………………………………………………. 8
2.2.1 Transmission channels of oil price shocks ……………………………………………………………… 9
2.3 Oil Price-Inflation Relationship ………………………………………………………………………….. 11
2.3.1 Types of Inflation ……………………………………………………………………………………………… 11
2.4 Oil Price- Exchange Rate Relationship ………………………………………………………………… 13
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2.5 Oil Price- GDP Relationship ………………………………………………………………………………. 14
2.6 Conceptual Review …………………………………………………………………………………………… 16
2.6.1 Crude Oil Shock ……………………………………………………………………………………………….. 16
2.6.2 Literature and Theoretical Issues on GARCH ………………………………………………………. 17
2.6.3 Literature and Theoretical Issues on VAR ……………………………………………………………. 18
2.7 Gaps Identified in Literature ………………………………………………………………………………. 22
CHAPTER THREE ………………………………………………………………………………………………………. 23
METHODOLOGY ………………………………………………………………………………………………………… 23
3.1 Introduction ……………………………………………………………………………………………………… 23
3.2 Data for the study ……………………………………………………………………………………………… 23
3.3 Stages Incorporated in Estimating Volatility Models …………………………………………….. 23
3.4 Number of Lag Length ………………………………………………………………………………………. 24
3.5 Normality Test (Using Jarque-Bera Test) …………………………………………………………….. 24
3.6 The Stationary Test (Augmented Dickey Fuller Test) ……………………………………………. 26
3.7 Model Selection ………………………………………………………………………………………………… 27
3.7.1 Akaike Information Criterion (AIC) ……………………………………………………………………. 27
3.8 Test for ARCH Effects (Heteroscedasticity) …………………………………………………………. 27
3.9 Generalize Autoregressive Conditional Heteroscedasticity Model …………………………… 28
3.10 Diagnostic Check of the Residuals ………………………………………………………………………. 30
3.11 Forecasting Evaluation ………………………………………………………………………………………. 30
3.12 Variance Autoregressive (p)-Models With More Than Two Variables …………………….. 31
3.13 Assumption of Variance Autoregressive Models …………………………………………………… 32
3.14 Impulse Response Function (IRF) ……………………………………………………………………….. 32
3.15 Variance Decomposition (VD) ……………………………………………………………………………. 33
CHAPTER FOUR …………………………………………………………………………………………………………. 35
ANALYSIS, RESULTS AND DISCUSSION ………………………………………………………………….. 35
4.1 Introduction ……………………………………………………………………………………………………… 35
4.2 Descriptive Statistics …………………………………………………………………………………………. 35
4.3 Graphical Representation …………………………………………………………………………………… 36
4.4 Test for Stationarity (Unit Root) …………………………………………………………………………. 36
4.5 Specifying the Mean Equation ……………………………………………………………………………. 37
4.6 Testing for ARCH Effects (Heteroscedasticity) …………………………………………………….. 38
4.7 Estimation of GARCH ………………………………………………………………………………………. 39
4.7.1 Diagnostic Checking …………………………………………………………………………………………. 40
4.8 Forecasting Volatility Models …………………………………………………………………………….. 40
4.9 Parameter Estimates of Vector Autoregressive (VAR) Model ………………………………… 41
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4.10 Estimate of Impulse Response Function ………………………………………………………………. 43
4.11 Estimation of Variance Decomposition ……………………………………………………………….. 44
4.11.1 External Reserves ……………………………………………………………………………………………… 45
4.11.2 Gross Domestic Product ……………………………………………………………………………………. 46
4.11.3 Inflation Rate …………………………………………………………………………………………………… 46
4.11.4 International Trade ……………………………………………………………………………………………. 46
4.11.5 Money Supply ………………………………………………………………………………………………….. 46
CHAPTER FIVE …………………………………………………………………………………………………………… 48
SUMMARY, CONCLUSIONS AND RECOMMENDATIONS ……………………………………….. 48
5.1 Introduction ……………………………………………………………………………………………………… 48
5.2 Summary …………………………………………………………………………………………………………. 48
5.2.1 GARCH Results ……………………………………………………………………………………………….. 48
5.2.2 VAR Estimated Results …………………………………………………………………………………….. 48
5.3 Conclusions ……………………………………………………………………………………………………… 49
5.4 Recommendations …………………………………………………………………………………………….. 50
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CHAPTER ONE
INTRODUCTION
1.1 Background of Study
Crude oil plays a central role in bringing wealth and power to the world as Mehrara and Mohaghegh (2011) underscored. Several countries around the globe have experienced existing financial crises in the last two decades, namely: the Mexican crisis (1994), the Asian crisis (1997), the Russian crisis (1998), the Brazilian crisis (1999), the Argentina crisis (2002), the Iraq crises (2004), the US subprime crisis (2008) and the Greek crisis (2010) which diverted macroeconomic variables to extreme volatility and to disorder noted by Gaye and Sercan (2013). Hamilton (1983) documented that sharp rises in oil prices caused worldwide recessions and stock market collapses. Gaye and Sercan (2013) stated that the fluctuations in oil prices are the results of the global demand shocks, the demand growth in China and India and the recession in the US and European economies due to the sub-prime mortgage crises; or the supply shocks mainly stemming from the US invasion of Iraq and the output decisions of OPEC countries. According to Mulyadi (2012), the movements of oil price affected movement of macroeconomic variables and varies from net oil export countries to net oil import countries. For instance, oil boom during the 1970s paid a big share on output (Gross Domestic Product) in Indonesia, leading to higher inflation rate and immense increase in foreign exchange rate.
Regionally, Lauren (2013) indicated that Africa‟s oil history stretches over a period of several decades along with its changes in oil. For example, between 1973 and 1983 Ghana experienced an average decline in per-capita GDP of more than 3% a year due to crude oil price shocks; (Fosu and Aryeetey, 2008). This is because the period of poor economic performance in Ghana was associated with political instability, high levels of
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corruption and economic mismanagement. With crude oil prices averaging $28.3 per barrel in 2000, domestic prices of crude oil products rose by more than 20%; budget deficit also increased by 87.7% and economic growth fell from 4.4% in 1999 to 3.7% in 2000 with inflation rising to 40.8%. The nominal exchange rate between Ghana Cedi and the US dollar depreciated from GH¢0. 35 per dollar in January 2000 to GH¢0.63 per dollar in December 2000 (World Bank, 2012). Angola faced a period of decline in global oil prices from 2009 to mid-2011 resulting in the fall of oil revenue, inflation, output, GDP growth and a slowdown in domestic oil production that fell to an average of less than 1.6 million barrels per day (mbpd) in the first half of 2011 (Monday, 2010). As the backbone of Nigeria‟s economy, Crude oil plays a substantial role in influencing the economic and political destiny of the country; yet as the 6th largest producer of crude oil in the world, Nigeria is vulnerable to fluctuations in the international oil market which presents its macro economy as fragile in nature due to heavy dependence on crude oil (Akpan, 2009). Describing crude oil shocks, Ogundipe and Ogundipe (2012) refered to it as a sudden, unexpected change in oil price or production. Similarly, Akpan (2009) defined oil price shock as price fluctuations resulting from changes in either the demand or supply side of the international oil market (Hamilton, 1983; and Wakeford, 2006). These changes have been traditionally traced to supply-side disruptions such as OPEC supply quotas, political upheavals in the oil-rich Middle East and activities of militant groups in the Niger Delta region of Nigeria (Akpan, 2009).
Although, Nigeria’s oil industry was founded at the start of the century, it was not until the end of Nigeria civil war (1967-1970) that the oil industry began to play a prominent role in the economic life of the country. Odularu (2008) and Agbede (2013) noted that between 1960 and 1966, agriculture contributed about 58 percent to the
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country’s Gross Domestic Product (GDP) and employed over 60 percent of her work force. But in the 1970s, Agriculture lost its pre-eminent position to Mining and mostly to Petroleum due to occurrence of oil boom in the period. In Nigeria, oil accounts for more than 90 percent of its exports, 25 percent of its Gross Domestic Product (GDP), and 80 percent of its government total revenues (Gunu and Kilishi, 2010). Thus, a small oil price change can have a large impact on the economy. For instance, a US$1 increase in the oil price in the early 1990s increased Nigeria’s foreign exchange earnings by about US$650 million (2 percent of GDP) and its public revenues by US$320 million a year (Agbede, 2013). Philip and Akintoye (2006) vividly stated that persistent oil price shocks could have severe macroeconomic implications that induced challenges for policy making either fiscal or monetary in both the oil exporting and oil importing countries over the past three decades. The studies of Hamilton (1996) and Cashin et al. (2000) suggested that rising oil prices reduced output and increased inflation in the 1970s to early 1980s and in contrast, falling oil prices boosted output and lowered inflation, particularly in the U.S mid-to late 1980s. Akpan (2009) stated that the shocks could be positive (a rise) or negative (a fall) in the macroeconomic variables and that two issues can be identified regarding these shocks. Firstly, is the magnitude of the price increase which can be quantified in absolute terms or as percentage changes; secondly, the timing of the shock, that is, the speed and persistence of the price increase.
Furthermore, the trend of demand and supply of Crude oil in the global economy along with OPEC‟s activities consistently affects the crude oil price; and the current global economy melt down in which suddenly offset the increasing oil price observed to reduce GDP growth, boost real interest rate and inflation. At the start of the crisis, Gunu and Kilishi (2010) and Agbede (2013) noted that oil price crashed below $40/b in the world
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market which had severe consequences on Nigeria fiscal budget and led to the downward review of the budget. Recently, crude oil price is fluctuating between $60/b and $75/b, which has become of great concern to everyone including academia and policy makers; therefore, a study of this kind as contained herein is worth considering. Naturally, the bigger the crude oil price increases and the longer higher prices are sustained, the bigger the macroeconomic impact (Akpan, 2009). Despite these perceived benefits of oil price change, Nigeria macro economy was undesirable during the booms. For instance, inflation was mostly double digit in the 1970s; money supply grew steeply and huge fiscal deficits resulted (Akpan, 2009). This had implications for the economies of oil exporting countries, particularly oil dependent countries like Nigeria. This study examines the impact of these fluctuations on the macroeconomic variables of Nigeria.
This study takes on quarterly data on crude oil prices by using the Bonny light crude oil (with 0.4% sulphur that credits it light and sweet crude) obtained from the Central Bank of Nigeria (CBN) online statistics database for its analysis, since the Bonny light crude accounts for more than 55 per cent of the Nigerian crude oil export over the years as against the UK Brent crude oil price and the Nigerian- Forcados crude oil price employed by other authors (Olomola and Adejumo, 2006; Akpan, 2009; Aliyu, 2009; Chuku, 2012; Akinleye and Ekpo, 2013). Therefore, this guarantees that the effect of shocks to crude oil price on key macroeconomic variables- such as, Exchange Rate, External Reserves, Gross Domestic Product, Inflation, International Trade and Money Supply- in Nigeria is captured using more reliable crude oil price data. This study also estimates oil price shocks and its impact on the Nigerian economy and as well forecasts the volatility of crude oil price shocks and the macroeconomic variables using General Autoregressive Conditional Heteroscedasticity (GARCH) and Vector Autoregressive (VAR) models. The aforementioned macroeconomic variables are used because they are internal variables that
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affect standardized policy in the country as earlier suggested by Akinleye and Ekpo, (2013).
1.2 Statement of Problem
Fluctuations in crude oil prices lead to fluctuations in macroeconomic variables since Nigeria is a mono-cultural economy (Ogundipe and Ogundipe, 2012). Likewise Obioma (2006) and Akpan (2009) maintained that the bigger the oil price increase and the longer higher prices of oil are sustained, the bigger the macroeconomic impact. Nigeria became more exposed to oil price fluctuations the moment she started importing refined petroleum products due to the collapse of local refineries in the late 1980s. Recently, Bernard (2014) in „The Guardian Newspaper‟- a daily publication in Nigeria- pointed out that crude oil prices collapsed from US$104 per barrel to about US$82 per barrel and dropped further to $50.28 in 2014, which is less than 90% of Nigeria‟s foreign exchange earnings resulting to a deficit of 0.5 per cent of GDP. From the foregoing, it is clear that crude oil price variations play a significant role in macroeconomic fluctuations in both oil importing and exporting countries (Akpan, 2009; Mehrara and Mohaghegh, 2011). For fiscal and monetary policy makers to know what effort to make in order to stabilize Nigeria‟s economy, the extent to which macroeconomic variables are affected by the recent fall of crude oil price shocks should be known. This is what this study considers herein so as to evaluate how much is the effect of these oil price shocks, and to predict how subsequent shocks in the future can be controlled and/or minimized by some control measures in order to reduce its effect on the economy of Nigeria.
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1.3 Aim and Objectives of Study
1.3.1 Aim
The aim of this study is to evaluate the impact of crude oil price shocks on some selected macroeconomic variables (exchange rate, external reserves, gross domestic product, inflation, international trade and money supply) in relation to the overall economic advancement in Nigeria.
1.3.2 Objectives
In order to achieve the aim stated above, the following objectives are used to:
1) evaluate crude oil shocks and the macroeconomic variables in terms of heteroscedasticity test in order to forecast the volatility of macroeconomic variables using GARCH model.
2) investigate the response of macroeconomic variables due to crude oil price shocks using Vector Autoregressive model.
3) estimate oil price shocks and its impact in the economy using Vector Autoregressive model.
1.4 Significance of Study
Examining the impact of crude oil price shocks on macroeconomic variables is vital because it can assist the fiscal and monetary authorities to know the extent to which oil price shocks affect macroeconomic variables so that adequate policies can be put in place in order to absorb the shocks, caution the effects, stabilize, improve the economy and predict measures that may be applied to future oil price shocks occurrences.
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1.5 Scope and Limitations of Study
1.5.1 Scope of study
The scope of this study is limited to crude oil prices only- Freight on Board (dollars per barrel) – obtained from CBN Statistical database (2014).
1.5.2 Limitation of Study
This study is limited to six macroeconomic variables which were collected within the period of twenty years by CBN. The model that is used in achieving the objectives is limited to VAR and GARCH models which by extension adopt models like ARCH, Impulse Response Function, and Variance Decomposition. These are well-known techniques in statistics.
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