Nonlinear Granger causality between oil price and stock returns in India

• Published date: 01 February 2021
• Author: Debi Prasad Bal,Devi Prasad Dash
• Date: 01 February 2021
• DOI: http://doi.org/10.1002/pa.2137

ACADEMIC PAPER

Nonlinear Granger causality between oil price and stock

returns in India

Debi Prasad Bal

1

|Devi Prasad Dash

2

1

Department of Economics, Birla School of

Social Sciences & Humanities, Birla Global

University, Bhubaneswar, India

2

Department of Economics and Public Policy,

Indian Institute of Management, Rohtak, India

Correspondence

Debi Prasad Bal, Department of Economics,

Birla School of Social Sciences & Humanities,

Birla Global University, Bhubaneswar, India.

Email: debiprasad.bal@gmail.com

The nonlinear causal dimension in oil price and stock returns aspect is less explored

in literature. This study provides such evidence by applying Hiemstra and

Jones (1994) nonlinear Granger causality test to the VAR residuals in case of India.

Our result indicates that there exists bi-directional nonlinear causality between oil

price and stock returns. It implies that the lagged information of oil price and stock

returns can be able to predict each other efficiently.

1|INTRODUCTION

Oil is an important source of energy and its shock affects extensively

to the economies in the post-Gulf war period across the globe. Theo-

retically, it has been asserted that a sudden volatility in oil price

impacts the economic activity and stock market movement signifi-

cantly in case of oil dependent economies. Reflecting the recognition

of such importance in recent period, it has been found that there has

been plethora of research, which shows the nonlinear relationship

between oil price and stock returns (Lee & Zeng, 2011; Naifar & Al

Dohaiman, 2013; Narayan & Gupta, 2015; Narayan & Sharma, 2011;

Rafailidis & Katrakilidis, 2014; Reboredo, 2010; Sotoudeh &

Worthington, 2015). But, these studies show the unidirectional rela-

tion between oil price and stock returns. However, it has been

observed that both variables are linearly correlated to each other

(Blanchard & Galí, 2010; Bodenstein, Guerrieri, & Kilian, 2012;

Kilian, 2010). Therefore, in order to show whether they are

nonlinearly related to each other or not in both direction, this study

examines the nonlinear Granger causality between them in the Indian

context. Hence, Hiemstra and Jones (1994) nonlinear causality test

has been used. This test has the high power of detecting nonlinear

Granger causality and also helps to examine the extent to which

nonlinear predictive power of oil price is responsive to the Indian

stock returns and vice-versa.

In 2018, the central bank of the country, Reserve Bank of India

(RBI) has stated 8 key risks to the Indian economy where oil price vol-

atility is considered as the major ones. RBI's prediction has stated that

any sort of international oil price fluctuation has possessed two types

of risks mainly upside and downside risks to the economy. Geo-

political tensions and supply disruptions constitute mostly the upside

risks, by negating the economic growth and decline in stock returns

indirectly. International oil prices have gone up by 12% from April to

Dec, 2018, thus widening up more current account deficit. In 2019,

stand-off between United States and Iran deal, supply cuts by nine

major oil producing economies amidst the price hike and disruptions

in World's highest oil processing facility in Saudi Arabia have impacted

the oil import of India significantly along with its consequent impacts

on the economic growth and asset price returns.

Our analysis contributes mainly three aspects to the literature.

First, we examine the nonlinear relationship between oil price and

stock returns. It is because, the Indian stock returns has been fre-

quently crumpled by the oil price fluctuations over the years, notably

after 1990s. These fluctuations in the Indian stock prices have been

triggered by Gulf War of 1990s, Asian, Russian crises in late 1990s,

energy crisis of 2000s and global financial crisis of 2007. Historically,

the Indian stock returns were also affected by the 1970s oil crisis of

Middle East because of heavy reliance on the Arabian economies. Lib-

eralization of 1990s along with the Kuwait war has made the econ-

omy more susceptible to oil price fluctuation. The recent plummeting

oil price of late 2015 to early 2016 has put aviation, transport and

other related sectors in advantage. Therefore, it is indispensable to

justify the existence of nonlinearity between them. The second contri-

bution is that, we apply the Bayer and Hanck (2013) cointegration test

(B-H) to analyze the long run cointegrating relation. The advantage of

this test over other traditional test is that it combines four

cointegration tests in order to give a more reliable finding and main-

tains high power through a Meta test across the nuisance parameters.

Further, B-H test also shows the existence of long run relationship

Received: 8 October 2019Revised: 26 November 2019Accepted: 8 March 2020

DOI: 10.1002/pa.2137

J Public Affairs. 2021;21:e2137.wileyonlinelibrary.com/journal/pa© 2020 John Wiley & Sons, Ltd1of5

https://doi.org/10.1002/pa.2137