How does a falling oil price affect exchange rates?

Oil prices have plummeted in recent months. The decline in the price of West Texas Intermediate – from more than $100 per barrel in the past summer to less than $50 in January – has been large in both relative and absolute terms, comparable to the ‘oil counter-shock’ in the mid-1980s.1 In principle, this should be an important factor to be incorporated in foreign exchange markets, and a superficial reading of the evidence, such as the large depreciation of the Russian rouble or the recent abandoning of the US dollar peg in Azerbaijan, seems to confirm this view. But is it true more generally that large movements in oil prices are accompanied by shifts in global exchange rate configurations?

The theory

From a theoretical point of view, an oil price shock may be transmitted to the exchange rate through two main channels (see Bodenstein et al. 2012):

• The terms of trade: A negative terms of trade shock (say, a fall in oil prices for an oil exporter) drives down the price of non-traded goods in the domestic economy and thereby the real exchange rate, which is defined as the relative price of a basket of traded and non-traded goods between the domestic and the foreign economy. As prices of non-traded goods may be sticky, the adjustment of the real exchange rate could require nominal exchange rate depreciation too;
• Wealth effects: A negative oil price shock transfers wealth from oil exporters to oil importers, leading to large shifts in current account balances and portfolio reallocation (see Kilian 2007). In order to restore the external net financial sustainability of oil importers (exporters), the real exchange rate has to depreciate (appreciate) following a negative shock to the oil price, in order to improve the non-oil trade balance.

These fundamental channels derived from textbook inter-temporal models tend to suggest that a fall in oil prices should be accompanied by a real depreciation of oil exporters. However, things may be somewhat different in practice.

The real world

While theory suggests that oil exporters’ currencies should depreciate in the wake of negative oil price shocks (and vice versa for positive shocks), in practice there may be counter-balancing forces. First, monetary authorities may dislike large swings in the nominal exchange rate, countering exchange rate pressures through the accumulation or reduction of foreign exchange reserves. Second, the international risk-sharing channel may provide an automatic stabiliser through currency exposure. Given that oil exporters have accumulated a large pool of foreign exchange reserves and tend to be ‘net long’ in foreign currency, a decline in the oil price accompanied by a depreciation produces a positive valuation effect – a net gain for them relative to domestic GDP – therefore playing a stabilising role. In other words, the exchange rate does not need to depreciate quite as much to ensure external sustainability.

The evidence

In Buetzer et al. (2012) and later versions, we conduct a careful empirical analysis of the link between oil shocks and exchange rate configurations for the currencies of oil importers and exporters. We use a large database comprising 43 advanced and emerging countries over a sample period spanning from 1986 to 2013. Following the seminal studies by Kilian (2009) and Peersman and Van Robays (2009), we apply sign restrictions in a VAR model to identify three different types of oil price shocks that can be attributed to (i) global demand, (ii) oil-specific demand, and (iii) oil supply. In a second stage, we analyse the impact of these shocks on nominal and real exchange rates, reserve accumulation, and an index of exchange market pressure in a panel regression.

We uncover three stylised facts:

1. For the full sample of countries, we find no systematic evidence of a clear link between the oil or the commodity trade balance and real exchange rate movements following oil price shocks.
2. However, oil exporters (but not oil importers) tend to lean against depreciation pressures by running down foreign exchange reserves, notably after oil demand shocks, but also global demand shocks (which also decrease oil prices).
3. The exchange rate regime does matter. Oil exporters with floating currencies not only reduce foreign reserves in the face of negative oil demand shocks, but also experience a nominal depreciation. For these countries, therefore, oil demand shocks are a relevant factor for their exchange rates.

All in all, we find that oil shocks, in particular oil demand shocks, do determine exchange market pressures for oil exporters, which are more visible for floating currencies and which are countered by these countries by increasing or decreasing foreign reserve holdings. More generally, however, we find that the link between oil price movements and exchange rates is a loose one, which is perhaps another manifestation of the exchange rate disconnect.

The fall in oil prices between June 2014 and January 2015 represents an interesting ‘quasi-natural experiment’, given its sheer size and unexpected nature. While we do not cover this episode in our paper, it is natural to ask what happened to exchange rates. As can be seen in Figure 1, the whole group of oil exporters did depreciate against the US dollar, but so did most other currencies due to the dollar’s strength in the same period. Especially if we exclude Russia, which was influenced by largely idiosyncratic factors, we observe no clear sign of an additional depreciation of oil exporters’ currencies.

Figure 1. Floating oil currencies depreciating against the US dollar, roughly in line with other currencies

Exchange rate vs. USD of oil exporters and trade weighted value of the USD (index Jan-2014=100)

Source: Haver and authors’ calculations.
Notes: Hard pegs: Oman, Qatar, Saudi Arabia, UAE, and Venezuela. Floats: Azerbaijan, Kazakhastan, Mexico, Nigeria, Norway, Kuwait, and Russia. The USD index is the nominal broad trade-weighted index of the Federal Reserve Board. WTI is the spot price of oil, USD per barrel, from the Energy Information Administration.

What oil exporters did was to run down their foreign exchange reserves in order to support their exchange rates, in line with our predictions (see Figure 2). Moreover, and interestingly, both hard pegs and supposedly floating currencies did that.

Figure 2. Oil exporters running down international reserves to counter the negative oil shock

International reserves of major oil exporters (index Jan-2014=100)

Source: National authorities/Haver and authors’ calculations.\
Notes: Hard pegs: Oman, Qatar, Saudi Arabia, UAE, and Venezuela. Floats: Azerbaijan, Kazakhastan, Mexico, Nigeria, Norway, Kuwait, and Russia.

This article is published in collaboration with VoxEU. Publication does not imply endorsement of views by the World Economic Forum.

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Author: Sascha Bützer is an Economist in the International Monetary Affairs Division, Deutsche Bundesbank and a PhD candidate in Economics, University of Munich. Maurizio Michael Habib is a Senior Economist, European Central Bank. Livio Stracca is the Head of the International Policy Analysis Division, Directorate General International and European Relations, ECB.

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