Exchange Rates and Stock Prices in the MENA Countries: What Role for Oil?

• DOI: http://doi.org/10.1111/j.1467-9361.2011.00641.x
• Author: Mohamed Abdelaziz Eissa,Georgios Chortareas,Andrea Cipollini
• Date: 01 November 2011
• Published date: 01 November 2011

Exchange Rates and Stock Prices in the MENA

Countries: What Role for Oil?rode_641758..774

Georgios Chortareas, Andrea Cipollini,

and Mohamed Abdelaziz Eissa*

Abstract

This paper considers the linkage between stock prices and exchange rates in four MENA (Middle East and

North Africa) emerging markets. In contrast to the existing evidence that uses a global market index to

uncover such a relationship it is found that for the sample countries oil prices emerge as the dominant factor

in the above relationship. The paper considers the presence of regime shifts and evidence is found of

cointegration only for the period following the 1999 oil price shock. Readjustment towards equilibrium in

each stock market occurs via oil price changes. Finally, a number of robustness checks are performed and

persistence profiles produced.

1. Introduction

We examine the long-run relationship between stock prices, and exchange rates in four

Middle East countries: Egypt, Oman,Saudi Arabia, and Kuwait. A number of reasons

motivate our focus on this relationship. First, foreign currency denominated assets are

increasingly being included in investment fund portfolios. Knowledge about the link

between currency rates and other asset prices in a portfolio is vital for the performance

of a fund in the context of the standard mean-variance approach to portfolio analysis.

Second, the link between those two markets may be used to predict the path of the

exchange rate. This can have implications for the ability of multinational corporations

to manage their exposure to the risk that exchange rate fluctuations generate. Estim-

ates of the correlation between stock prices and exchange rates allow us to obtain more

accurate estimates of the variability of globally diversified portfolios.Third, the under-

standing of the stock price–exchange rate relationship may prove helpful in foreseeing

a crisis. Khalid and Kawai (2003) as well as Ito andYuko (2004) among others, claimed

that the link between the stock and currency markets contributed in the propagation of

the 1997 Asian financial crisis as the sharp depreciation of the Thai baht triggered the

depreciation of other currencies in the region, which led to the collapse of the corre-

sponding stock markets. Thus, awareness about such a relationship between the two

markets could facilitate preventive measures before the spread of a crisis.

The literature shows that a two-variable framework is typically inadequate for

uncovering a relationship between exchange rates and stock prices.While we consider

the possible role of a global market indicator, as is typical in the literature we also

include oil prices into the system, given that the countries under investigation are oil

* Chortareas (corresponding author): Department of Economics,University of Athens,8 Pesmazoglou Street,

Athens 10559, Greece. Tel: +30-210-3689805; E-mail: gchortar@econ.uoa.gr. Cipollini: Faculty of Economics,

University of Modena and Reggio, 41121 Modena, Italy. Emilia: E-mail: andrea.cipollini@unimore.it. Eissa:

College of Business and Economics,Qatar University,P.O.Box: 2713, Doha,Qatar. E-mail:m.eissa@qu.edu.qa.

Tel:+974-44035079.

Review of Development Economics, 15(4), 758–774, 2011

DOI:10.1111/j.1467-9361.2011.00641.x

© 2011 Blackwell Publishing Ltd

exporters. The impact of rising oil prices on stock market and exchange rates differs

according to whether a country is an oil importer or exporter. In fuel importing

countries, the rise in world oil prices worsens the trade balance, leading to a higher

current account deficit and a deteriorating net foreign asset position. At the same time,

higher oil prices tend to decrease private disposable income and corporate profitability,

reducing domestic demand and stock prices; along with a depreciation of the exchange

rate, this acts to bring the current account back into equilibrium over time. The speed

and output cost of adjustment depends on factors such as the degree of trade openness,

structural flexibility, and central bank credibility, as well as the shock’s expected per-

sistence and the speed with which it is allowed to feed through into domestic fuel prices.

Among other things, these determine the extent to which rising oil prices raise infla-

tionary pressures. In fuel exporting countries (such as the Organization of Petroleum

Exporting Countries (OPEC)), the process works broadly in reverse: trade surpluses

are offset by stronger growth and, over time, real exchange rate appreciation and

increases in stock prices.1

We focus on the oil shock following the March 1999 OPEC meeting.2In the wake of

the Asian financial crisis and a pick-up of Iraqi oil sales under the United Nations

oil-for-food program,oil prices plummeted to US$10 per barrel in late 1998. Then,after

the 1999 OPEC meeting, oil prices began to head sharply higher.In this paper we treat

oil prices as an endogenous variable. According to Barsky and Kilian (2004), for

example, an endogenous response in oil price to structural imbalances in the economy

might be due to producers trading off the immediate gains from abandoning the cartel

against the present value of the future cartel rents foregone.

Our focus is on the existence of a long-run equilibrium relationship between stock

prices and the real exchange rate in a number of Middle East oil producing countries,

and our work contributes to the literature in the following ways. First, in line with

earlier studies (e.g. Phylaktis and Ravazzolo, 2005), we consider the possibility that the

failure to establish a relationship between the stock and foreign exchange markets

might be due to the omission of an important variable from the system. Contrary to the

findings of those studies,however, we find that the variable establishing a causal link (in

the long run) between stock price and real exchange rate in the countries we consider

is not the US stock prices, but the oil price. Second, given the nonnormality and

heteroscedasticity in the residuals of the full system of equations described through a

vector error correction model (VECM) we use not only the reduced rank regression

technique, advocated by Johansen (1988), but also a quasi maximum likelihood estim-

ation method. Finally, we use the persistence profile technique (Pesaran and Shin,

1996) to examine the speed through which the stock market returns to its long-run

equilibrium state, once it is shocked away. The organization of the paper is as follows:

section 2 introduces the literature review, section 3 describes the data and the meth-

odology, section 4 discusses the empirical results, and section 5 provides the summary

and conclusions.

2. Literature Review

Traditional models of the open economy suggest that a relationship between the stock

market performance and the exchange rate behavior may exist. For instance, goods

market approaches (Dornbusch and Fischer, 1980) suggest that changes in exchange

rates affect the competitiveness of firms as fluctuations in exchange rate affect the value

of the earnings as well as the cost of its funds (as many companies borrow in foreign

currencies to fund their operations and hence its stock price). A depreciation of the

EXCHANGE RATES AND STOCK PRICES IN MENA 759

© 2011 Blackwell Publishing Ltd