The oil price shock effects on macroeconomic fundamentals of the GCC countries.

• Author: Fayyad, Abdallah
• Position: Gulf Cooperation Council

1. INTRODUCTION

   Recent changes in oil prices in the global economy have been rapid and unprecedented. Oil prices have traditionally been both highly volatile, and subject to exogenous supply shocks from natural disasters, political events, financial crises, etc. Furthermore, the demand for oil products is expected to increase for the predictable future, driven by the increased demand for oil by China and India. Over the past three decades China's economy has grown fifteen-fold to become the world's second-largest economy after the United States. By 2050, India is expected to be the world's third-largest economy. Today, Asia accounts for 50% of GCC trade, a big change from 30 years ago when some 80% of GCC trade was with the developed economies of Europe and the US, IISS (2012). The Global Financial Crisis beginning in September 2008 was followed by a year of less acute financial turmoil, which substantially reinforced the cyclical downturn in oil prices. At the beginning of 2008 the basket prices of oil was less US$100/b, by the middle of the year it was approximately US$140/b and by the year end the price was below US$40/b. Figure 1 shows the trend price of Brent daily spot price for the 24 years 1987-2011 versus the GDP in the selected GCC countries, it is noticeable the correlated trend between them except the period which witnessed the incursion of Kuwait by Iraq on 1990, the consequence of this action was catastrophic for Kuwait.

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   This paper will focus on three major oil exporting countries among the GCC countries: Kuwait, UAE & Saudi Arabia (SA). The GCC was established in 1981 it includes six countries, Bahrain, Oman, Kuwait, Qatar, Saudi Arabia and the United Arab Emirates (UAE).

   The GCC markets are important as in 2007; the GCC countries produced about 20% of the world's crude oil, controlled 36% of the world's oil exports and held 47% of the world's oil verified oil reserves. Table 1 shows the GCC countries market capitalization of listed companies and the corresponding contribution of Oil as a percentage of GDP for each country. Oil is responsible for between 22% of Bahrain's total output to 44% for the Kingdom of Saudi Arabia.

   GCC markets differ from those of developed and other major emerging market economies in that they are predominately-segmented markets, largely isolated from the international markets and are overly sensitive to regional political events Arouri and Rault (2010).

2. BACKGROUNDS

   The relationships among real economic variables and financial asset values have long been topics of economic research. Since the U.S. triggered financial crisis in 2008, stemming from the Lehman Brothers filing for bankruptcy, the sharp fluctuation of oil prices and volatile swings in the major stock market have caused great concern regarding economic growth in both developed and developing countries. The aim of this paper is to investigate the impact of oil prices shock on stock price and on real economic activity in three economies of oil exporting countries: Kuwait, UAE & Saudi Arabia (SA).

   Numerous researchers suggest that oil price fluctuations have considerable consequences for real economic activity. First, transmission mechanisms through which oil price impacts real economic activity include both supply and demand channels. The supply-side effects are related to the fact that crude oil is a basic input of production, and an increase (decrease) in oil price leads to a rise (fall) in production cost, which induces firms' to lower (higher) output. Oil price changes also entail demand-side effects on consumption and investment. Consumption is affected indirectly through its positive relation with disposable income. The rise (fall) of oil price reduces (increases) consumer spending power. Moreover, a rise (fall) in oil price is generally considered to have a negative (positive) impact on investment by increasing (decreasing) firms' costs. On the other hand, economic theory suggests that stock prices reflect expectations about future firms' earnings. Firms' profits are an important part of the gross domestic product (GDP) and also are likely to be correlated with its components, including consumption and investment. The fundamental value of a firm's stock equals the present value of expected future dividend. The future dividend must ultimately reflect the real economic activity. The forward-looking nature of stock prices would imply that stock prices should be valuable as leading indicators of economic activity Wang, X. (2010).

   A brief review of related empirical investigations is provided below. First, the interrelation between oil price change and real economic activity is a significant issue that has been studied for most industrialized countries (Hamilton (1983); Gisser & Goodwin (1986); Mork (1989); Lee et al. (1995); Ferderer (1996); Hooker (2002); Hamilton (2003); Jimenez-Rodriguez and Sanchez (2005). The existence of a negative relationship between oil price increases and economic activity has become widely accepted since Hamilton's pioneering 1983 work. Later, other researchers extended Hamilton's basic findings using alternative data and estimation procedures.

   Many researchers have studied the relationship between oil prices and stock markets In addition; most of these studies have concentrated on developed oil importers with less focus on emerging markets or oil exporting countries. In this paper, we will focus on oil--exporting countries. Jones and Kaul's (1996) initial study focused on testing the reaction of advanced stock markets (Canada, UK, Japan, and US) to oil price shocks on the basis of the standard cash flow dividend valuation model. They found that for the US and Canada the reaction can be determined by the impact of the oil shocks on cash flows while the outcome for Japan and the UK were indecisive. Huang et al. (1996) applied unrestricted vector autoregressive (VAR) which confirmed a significant relationship between some US oil company stock returns and oil price changes. Conversely, they found no evidence of a relationship between oil prices and market indices such as the S&P500. In contrast, Sadorsky (1999) applied an unrestricted VAR with GARCH effects to US monthly data and found a significant relationship between oil price changes and aggregate stock returns. In recent times Abu Zarour (2006) applied a VAR model to investigate the relation between oil prices and five stock markets in Gulf Countries during the period between May 2001 and May 2005. They found the response of these markets to shocks in oil prices increased and became faster during episodes of oil price increases. Malik and Hammodeh (2007), examined the spillover effects of volatility in oil prices on equity markets for the US, Saudi Arabia, Kuwait and Bahrain by applying MGARCH models. The findings confirm that in all cases the three Gulf equity markets were affected by the volatility experienced in oil markets. Rao (2008) found that, the emerging markets in GCC gain more of their volatility persistence from the domestic market. So that, international investors could increase diversification in the GCC markets and utilize opportunities for high returns due to higher risk-return trade off.

   Figure 2 shows how the stock market in the GCC countries and oil prices are interrelated; it appears that they have a common trend. Miller & Ratti (2009) analyzed the long-run relationship between the world price of crude oil and international stock markets over the period from January 1971 to March 2008. They found obvious positive statistically significant co-integrating long-run relationship between real stock prices for six OECD countries and world real oil price from January 1971 until May 1980 and again from February 1988 and September 1998.

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   Arouri & Rault (2010) used the panel-data approach of Konya (2006) which is based on seemingly unrelated regression (SUR) systems and Wald tests with Granger-cause to study the sensitivity of stock markets to oil prices in GCC (Gulf Corporation Council) countries for the period from 7 June 2005 to 21October 2008, and from January 1996 to December 2007. The results showed strong statistical evidence that the causal relationship is consistently bi-directional for Saudi Arabia. In the other GCC countries, stock market price changes do not Granger-cause oil price changes, whereas oil price shocks Granger-cause stock price changes.

   This study suggested that, investors and policy makers in the GCC stock markets should be aware on changes in oil prices because these changes drastically affect GDP and stock market returns. Also, GCC policy makers should diversify their GDP income and depend less on oil as a core GDP income also stock markets are potential areas for international portfolio diversification hence studying the influence of oil price shocks on GCC stock market returns can help investors make necessary investment decisions.

   The present paper extends the existing empirical literature in two directions by analyzing the effects of an oil price shock on oil exporting of Kuwait, UAE & Saudi Arabia (SA) through the assessment of the dynamic relationship among stock price, real economic activity and oil price shocks simultaneously by using the most recent time series data. In this paper, a multivariate generalized autoregressive conditional heteroskedasticity (MGARCH-BEKK) and an unrestricted vector auto-regression (VAR) model is employed to investigate the long-run relationships among real economic activity, stock price and oil price in Kuwait, UAE & Saudi Arabia (SA). The remainder of this paper is organized as follows. Section 3 presents the data and empirical descriptive...