In policy discussions, it is generally taken for granted that oil price shocks have large and harmful effects on external accounts – forcing countries to borrow abroad to offset the adverse terms-of-trade shock. While this foreign indebtedness is implicitly viewed as harmful by many, foreign borrowing allows countries to smooth their growth paths when oil prices fluctuate unexpectedly. Hence, a standard economist’s view is that there is not enough international risk-sharing; the real problem is that the ensuing imbalances are not big enough. But good or bad, how do oil price shocks affect nations’ current accounts in the real world?
Recent developments in the crude oil market and the emergence of large global external imbalances have reignited the long-standing policy discussion about the role of oil prices in determining external balances.1 It is widely recognised that the impact depends heavily on how increased oil-export revenues are recycled through international trade in goods and assets. Dearer oil certainly raises the cost of oil-importers’ imports, but does the adjustment come in the form of trade deficits at constant real exchange rates, big devaluations and no trade-balance effect, or some combination of the two effects? Moreover, the exchange rate change in turn may affect the valuation of foreign assets holdings.
Until recently, this policy discussion was little-informed by research. There is, of course, a large literature on the macroeconomic impact of oil-price shocks, focusing in particular on the response of real economic growth and consumer price inflation in oil-importing countries.2 Very little formal analysis, however, had been undertaken of the impact of oil price shocks on the external balances of oil-importing and oil-exporting countries.3
Recent work that Alessandro Rebucci, Nikola Spatafora and I have undertaken sheds light on this question. Our study provides a comprehensive analysis of the effects of oil price shocks on external balances covering a wide range of countries.4
Critically, our analysis recognises that oil price changes do not take place in isolation; they are driven by demand and supply shocks, each of which have different effects on the price of oil, the world economy and countries’ external accounts. It is useful to differentiate between three distinct demand and supply shocks in the global market for crude oil:5
- Shocks to the production of crude oil (“oil supply shocks”);
- Shocks to global demand for all industrial commodities including crude oil (“aggregate demand shocks”); and
- Oil-market-specific demand shocks such as shocks to the precautionary demand for crude oil driven by shifting expectations about future oil supply shortfalls (“precautionary demand shocks”).
The evolution of oil prices can be understood as the cumulative effect of all three shocks. Of particular importance for understanding fluctuations in the price of crude oil are demand shocks.
Aggregate demand shocks, for example, reflect the global business cycle. They also reflect structural shifts caused by the emergence of newly industrialised economies, such as China or India. Such shocks will raise the price of oil persistently, but much of that increase, while large, only occurs with a delay. Precautionary demand shocks in response to expectation shifts, in contrast, may have immediate and large effects on the price of oil. Finally, oil supply disruptions tend to cause only a comparatively small temporary increase in the price of oil. The same distinction between different types of demand and supply shocks in the global crude oil market is crucial when studying the effects of higher oil prices on external accounts, because each of these three shocks has qualitatively and quantitatively different effects on the macroeconomic aggregates of oil-importing and oil-exporting economies.
Key economic insights
The findings in our paper suggest a number of key insights:
- The non-oil trade balance matters.
Although oil trade deficits are the most obvious effect of an unexpected oil price increase, the overall effect of oil shocks on the trade balance, which depending on the source of the shock may be large, depends critically on the response of the non-oil trade balance.
- Valuation effects are important.
International financial integration affects the transmission of shocks in the crude oil market by giving rise to valuation effects. Valuation effects manifest themselves in capital gains or capital losses on asset holdings abroad that may offset or amplify trade imbalances. While in some cases large and systematic, the valuation effects for oil-importing countries are difficult to interpret without a fully articulated economic model, since they depend on the cross-ownership of assets among oil-importing economies and on the relative responses of oil-importing countries’ currencies and asset prices. They are also imprecisely estimated as a rule.
- A nation’s degree of international financial integration matters.
The estimated magnitude of capital gains and losses, in particular in response to oil demand shocks, makes it necessary to consider the degree of financial integration of a country in assessing the effect of these shocks. The data suggest that increased international financial integration will tend to cushion the effect of oil shocks on net-foreign-asset positions for major oil exporters and for the US, but may amplify it for other oil importers.
- The US is different.
Whereas the US response differs systematically from that of other oil-importing countries, the responses of middle-income oil-importing economies do not differ systematically from those of the euro area or Japan.
- The source of the shock matters greatly for its effects.
The nature of the transmission of oil price increases is highly dependent on the underlying cause of the oil price increase. Thus, policy-makers need to consider the origins of oil price increases before they can assess their likely consequences. In discussing how different components of countries’ external accounts respond to demand and supply shocks in the crude oil market, it is useful to differentiate between oil-importing economies and oil-exporting economies.
Typical responses of an oil-importing economy
A typical oil-importing country will show the following responses. First, while any shock in the crude oil market that raises the price of crude oil will push a typical oil importer's oil trade balance into deficit, the timing and the magnitude of the response of the oil trade balance depends on the source of the shock. A positive aggregate demand shock, for example, tends to generate an oil trade deficit with some delay. In contrast, unanticipated increases in the precautionary demand for oil, and unanticipated oil supply disruptions, tend to cause an immediate oil trade deficit, the former being more sustained and larger than the latter.
Second, these same shocks also tend to be associated with a non-oil trade surplus that partially offsets the oil trade deficit, giving rise to an overall trade deficit (with some delay in the case of aggregate demand shocks, and immediately upon impact for positive precautionary oil demand and negative oil supply shocks).
Third, the extent to which the resulting trade and current account deficits translate into a deterioration of the net-foreign-asset position depends on the response of capital gains. Oil demand shocks may cause large and systematic (if not always statistically significant) valuation effects. Increased international financial integration thus may help cushion the impact of future disturbances in global crude oil markets for oil importers whose assets are widely held abroad (as in the case of the US), while potentially amplifying it in other cases.
Typical responses of an oil exporter
The overall response of the typical oil exporter is the mirror image of the typical oil importer. Positive precautionary oil demand shocks and negative oil supply shocks produce an immediate oil trade surplus, whereas positive aggregate demand shocks cause an oil trade surplus with some delay. The surplus in the oil-trade balance is associated with a non-oil trade deficit. On balance, the trade and current account balances of oil exporters improve. The net-foreign-asset increase in response to positive aggregate demand or precautionary demand shocks is dampened to the extent that oil exporters experience capital losses. In response to oil supply disruptions, in particular, capital losses tend to render the positive response of net-foreign-asset changes insignificant.
To summarise, international financial integration plays two distinct roles in the transmission of oil shocks. First, it allows risk-sharing between oil exporters and oil importers. Ownership of oil assets by residents of oil-importing countries provides some insurance against oil price increases and helps diversify the risks associated with shocks in the global crude oil market. In turn, ownership of foreign assets by oil producers provides some insurance against falling oil prices for oil-exporting economies. Second, international financial integration affects how the burden of adjustment is distributed across oil-importing economies. Not all countries benefit from increased international financial integration. The US in particular is in a unique and privileged position in that its net-foreign-asset position tends to improve in response to positive demand shocks in the global crude oil market, when other oil-importing economies may experience net-foreign-asset losses in response to the same shocks. Third, the widening imbalance in the US current account (as a share of real GDP) can be explained to a large extent by the cumulative effect of demand and supply shocks in the crude oil market. In particular, the data suggest that global aggregate demand shocks have played a significant role in recent years in the emergence of these imbalances.
1 See, e.g., Rebucci, A., and N. Spatafora (2006), “Oil Prices & Global Imbalances,” in: IMF World Economic Outlook April 2006: Globalization and Inflation, chapter II, International Monetary Fund: Washington, DC, 71-96.
2 Recent reviews of this literature include Barsky and Kilian (2004), “Oil and the Macroeconomy since the 1970s”, Journal of Economic Perspectives, 18, 115-134; Kilian, L. (2007), “The Economic Effects of Energy Price Shocks”, in preparation for the Journal of Economic Literature; and Hamilton, J.D. (2008), “Oil and the Macroeconomy,” forthcoming: New Palgrave Dictionary of Economics).
3 See, e.g., Bruno, M., and J. Sachs (1982), “Energy and Resource Allocation: A Dynamic Model of the Dutch Disease,” Review of Economic Studies, 49, 845–859; Bodenstein, M., Erceg, C.J., and L. Guerrieri (2007), “Oil Shocks and US External Adjustment,” mimeo, Federal Reserve Board.
4 Kilian, L., A. Rebucci, and N. Spatafora (2007), “Oil Shocks and External Balances,” mimeo, Department of Economics, University of Michigan; also see CEPR DP 6303.
5 This decomposition was originally proposed in Kilian, L. (2006), “Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market,” mimeo, Department of Economics, University of Michigan.