1. The Effects of Oil Price Volatility on the Kenyan Economy Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis Presented at the 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya NOT AN OFFICIAL UNCTAD RECORD

2. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 2 Presentation Outline The Issue The Policy Questions Stylised Facts Methodology Findings Conclusions

3. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 3 The Issue Global dependence on oil to grow economies and improve human welfare will continue for the foreseeable future Kenya is a net importer of oil and its derivative products In light of Kenya’s ambition of sustaining an average economic growth rate of 10% annually to the year 2030, it is important to understand how oil prices and their volatility affects the Kenyan economy

4. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 4 The Policy Questions What is the nature of macro and microeconomic impacts of oil prices and their volatility? What are the methodological approaches for investigating this relationships? What should Kenya’s policy stance be in facilitating implementation of effective mitigation measures to control and ameliorate the negative consequences of oil price volatility on the economy?

5. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 5 Stylised Facts Oil prices affect the economy through the effects of changes in oil price levels and oil price volatility Both rising oil prices and oil price volatility serve to stifle economic activity Evidence from literature seems to suggest that small oil price increases result in sizeable economic losses AuthorsPeriod Studied% GDP Growth Decrease Quarters after initial price shock Hooker1948-19720.63-4 Hamilton (2000)1948-19801.44 Rotemberg and Woodford 1948-19802.55-7

6. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 6 Stylised Facts In a long period of stability, oil price shocks have a greater impact than in a volatile environment Ferderer (1996) explaining the asymmetry in effects in the US between 1970 – 1990 found that Volatility has a negative and significant impact on output growth immediately and again eleven months later. Oil price changes have a significant impact on output growth after about one year. Anna Herrera (nd) looking at the US economy found that there is a substantial time lag between the increase of crude oil and the slowdown in real GDP growth. Typically, a decline in economic activity does not show up until four quarters after the shock Jones, Kaul (1996) looking at four countries found that oil price hikes had a “significant, and (on average) detrimental effect on the stock market of each country”. Papapetrou (2001) looking at the Greek economy between 1989-1999 determined that In a mid- and long-term relationship, oil price shocks account for up to 22% of change in industrial production.

7. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 7 Stylised Facts most thorough research to date has found that post-shock recessionary movements of GDP are largely attributable to the oil price shocks, not to monetary policy two nonlinear and asymmetric specifications of oil price shocks have been found that yield stable oil price-GDP relationships over the entire post-World War II period detailed empirical research has shown that considerable reallocation of labour occurs after oil price shocks, amounting to as much as 11 percent of the labour force in manufacturing, and similar extents outside manufacturing. Much of this movement is within industry classifications that are sufficiently closely related the best current, empirical estimates (as opposed to simulation constructions) of the oil price-GDP elasticity are around -0.055. This is the cumulative effect on GDP over a 2-year period of a shock in one period only, regardless whether the price increase is sustained. findings from studies of the effects of oil prices on the stock market parallel the findings from more direct examination of current activity in the form of GDP.

8. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 8 Methodological Approaches Input and output models which involve use of dynamic price modelling to measure impact of price volatility on the economic performance Jing He (nd) applies this model on the Chinese economy and concludes that the economies of oil importing developing countries would suffer most from higher oil prices because they are more dependent on imported oil. In addition, energy intensive manufacturing generally accounts for a larger share of their GDP and energy is used less efficiently. The economic stimulus provided by higher price would be outweighed by the depressive effects of higher prices on economic activity.

9. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 9 Methodological Approaches The Granger causality method which analyses the direction of relationships among variables. Erdal Atukeren (2003) analysed how an oil price shock might affect an economy in general and the Swiss economy in particular. They determined that large increases in oil prices lead to a decline in Swiss GDP. provided some evidence of an asymmetric relationship between oil price shocks and economic performance in Switzerland, i.e., positive oil price shocks have real effects while decreases in oil prices do not lead to a boost. oil price increases do not affect ‘core inflation’ to any significant degree and the adverse effects of a large oil price shock may be felt with a time lag due to differences in sectoral responses, or because investments and consumer spending are sensitive to an uncertain environment Oil price shocks may affect a small open industrial economy without oil resources through their adverse effects on the country’s export markets. We find this true for Switzerland, but imports also shrink and lessen the overall impact on real GDP growth.

10. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 10 Methodological Approaches Input and output models which involve use of dynamic price modelling to measure impact of price volatility on the economic performance The Computable General Equilibrium (CGE) which has been used to analyse how price affects various sectors of the economy Panel estimations have been used in cross country time series studies and involve estimations of systems of equations across countries for the same variables and time period. The Ordinary Least Squares (OLS) approach provides a linear specification in the model has also been used to establish the impact of price shocks on macroeconomic variables such as the GDP. Parametric statistical techniques specify and tests hypothesis about flexible non linear regression specifications The Granger causality method which analyses the direction of relationships among variables. The Vector Autoregressive (VAR) Model has been used to establish presence of cointegration and relationships among macroeconomic variables in many studies on oil price volatility

11. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 11 Methodological Approaches Input and output models which involve use of dynamic price modelling to measure impact of price volatility on the economic performance The Computable General Equilibrium (CGE) which has been used to analyse how price affects various sectors of the economy Panel estimations have been used in cross country time series studies and involve estimations of systems of equations across countries for the same variables and time period. The Ordinary Least Squares (OLS) approach provides a linear specification in the model has also been used to establish the impact of price shocks on macroeconomic variables such as the GDP. Parametric statistical techniques specify and tests hypothesis about flexible non linear regression specifications The Granger causality method which analyses the direction of relationships among variables. The Vector Autoregressive (VAR) Model has been used to establish presence of cointegration and relationships among macroeconomic variables in many studies on oil price volatility

12. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 12 Model Variables Crude petroleum prices Gross domestic Product US$) Money supply (US$) Exchange Rate Interest Rate Inflation Nairobi Stock Exchange Index

13. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 13 Findings Literature shows that there is an asymmetric relationship between oil price levels and volatility of oil prices The duration of an oil price increase has more adverse effects. However, the impact of these depends on the nature and speed of responses within the economy

14. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 14 Findings Preliminary trend analysis was undertaken for the following variables: Crude petroleum prices; Gross domestic Product US$) Money supply (US$); Exchange Rate Interest Rate; Inflation Nairobi Stock Exchange Index It suggests that: When the economy is declining or growing slowly, the negative effects of oil price increases are higher as in the 1990s When it is growing robustly, the negative effects of oil price increases are subdued as in the 60s and 70s Results on effects between 2000 – 2006 are indeterminate but point to the fact that recent oil price increases have not had a deleterious effect on the macro economy

15. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 15 Variance Decomposition of GDP PeriodS.E.DLACRUDEPDLEXCHRTDLM2US$LINFLATIONDRINTRDLNSEINDEXDLGDP 1.0000.1090.95692.6152.4460.0190.0110.0093.943 2.0000.1313.60567.0594.9310.70818.5671.5903.540 3.0000.1426.99356.9309.8080.81521.0061.3403.107 4.0000.1448.48855.6419.5770.81820.7631.3333.380 5.0000.14810.43952.9519.1290.79919.7603.0413.881 6.0000.14810.39852.8369.1760.86019.7113.1323.888 7.0000.14910.88052.7489.0330.99619.4153.0843.843 8.0000.15011.13552.3689.0200.99919.3213.2833.875 9.0000.15011.15452.1958.9901.09019.3263.2763.969 10.0000.15011.10052.1859.1541.08719.2243.2983.952

16. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 16 Response of GDP GDP will respond positively to a shock from crude oil price increases from 0.96% in the first period to 10.43% in the fifth period. From economic theory, we expect, GDP to be negatively affected by increased crude oil prices but this is not the case from our data. In the short run the government responses to shocks from both endogenous and exogenous shocks through a number of fiscal and monetary policies to cushion the economy from any adverse effects. The GDP will decline by 52.9% in the fifth period from a shock on the exchange rate. GDP has a positive shock of 9.1%, 20% in the case of money supply and interest rates respectively.

17. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 17 Conclusions There is need to maintain a consistent database to be able to have a more robust estimation of the relationship between oil price volatility and Kenyan economy and therefore be in a position to design effective policy responses Because of the nature of the available data, these findings are preliminary because we would wish to look at these results using monthly or quarterly data A volatile environment weakens the effect of price level changes since it reduces the “surprise”. Volatility creates market uncertainties that induce companies to postpone investments. It affects labour markets by disturbing the reallocative process amongst sectors

18. 11th African Oil and Gas, Trade and Finance Conference & Exhibition 23-25 May 2007 Kenyatta International Conference Centre Nairobi, Kenya Eric Aligula, Wilson Wasike, and John Mutua Infrastructure & Economic Services Division Kenya Institute for Public Policy Research and Analysis 18 Conclusions In the interim policy measures should aim at achieving the following in respect of the Kenyan economy: REDUCING THE DEPENDENCE OF THE ECONOMY ON FOSSIL BASED OIL ENHANCING THE ABILITY AND CAPABILITY OF PLAYERS IN THE ECONOMY TO SHIFT BETWEEN FACTORS OF PRODUCTION