Oil prices and exchange rates in oil-exporting countries: evidence from TAR and M-TAR models

“Dutch disease,” refers broadly to the harmful consequences of exogenous increases in a country’s income and wealth due to discovery of natural resources, inflow of foreign currency due to a surge in natural resource prices, foreign assistance, and foreign direct investment. These developments, although positive, may appreciate the country’s real exchange rate, and as a result crowd out the traditional exporting sector. For example, a rise in oil prices increases the flow of foreign exchange in the oil exporting country, and raises its income. If the foreign exchange is spent entirely on imports, it would have no direct impact on supply of money or demand for domestically produced goods. However, it if is converted into domestic currency and spent on non-traded goods, it will result in real exchange rate appreciation irrespective of the choice of exchange rate regime. With flexible exchange rates, the appreciation occurs through a rise in nominal value of domestic currency while with fixed exchange rates it occurs through a rise in domestic prices. The appreciation of real exchange rates weakens the competitiveness of the country’s exports, crowds out the traditional export sector, and reallocates resources from the exports sector to the non-tradable sector (Ebrahim-zadeh 2003).

The effect of oil prices on real exchange rates may be considered as a part of a broader literature on exchange rate determination and tests of purchasing power parity. According to this literature, the real exchange rate may be interpreted as a measure of deviations from purchasing power parity (PPP). In such framework, a stationary real exchange rate is consistent with the PPP theory. Some recent contributions to this literature include Taylor et al. (2001), Taylor and Sarno (2004), Taylor and Taylor (2004), and Lopez (2008).

A number of other studies have examined the effect of other commodity prices on equilibrium exchange rates of commodity-exporting countries. In particular, Cashin et al. (2004) find strong relationship between real commodity prices and real exchange rates in about a third of 58 commodity-exporting countries in their sample. Chen and Rogoff (2003) report a strong relationship between US dollar prices for commodity exports and exchange rates in three major commodity exporting OECD members—Australia, Canada and New Zealand.

Recent applications of this method are Enders and Granger (1998), Enders and Dibooglu (2001), Bajo-Rubio et al. (2004), and Payne and Mohammadi (2006).

Estimation of Eq. 1 requires assumptions regarding the stochastic properties of real oil prices. Given the global nature of oil markets and potential stickiness in domestic prices, it is reasonable to assume that real oil prices are exogenous with respect to real exchange rates.

According to Taylor et al. (2001), the real exchange rate may be interpreted as a measure of the deviation from purchasing power parity. As such, Eq. 1 explains such deviations in terms of real oil prices.

More specifically, let P, P* and E represent domestic price, foreign price, and the nominal exchange rate (price of a unit of foreign currency in terms of domestic currency), respectively. Then the real exchange rate is P/E×P*.

As a check of robustness, we also experimented with two alternative oil prices, the North Sea Brent and the Dubai Fateh spot prices. The results are robust to this choice.

Bahrain was included in the original sample. However, due to data limitations, it was excluded in these analyses.

We thank two referees for pointing out the possibility of currency crisis, the existence of endogenous breaks in the real exchange rates, and thus tests of unit roots with endogenous breaks.