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A vector autoregressive model of the Saudi Arabian economy
I~R'ITI- ~
A Vector Autoregressive Model of the Saudi Arabian Economy J. Barkley Rosser, Jr. and Richard G. Sheehan
This paper examines the institutions and then estimates a VAR model of the Saudi economy. The results indicate that the Saudi economy was influenced by world inflation and by Saudi oil policy. These results suggest that a small open economy with fixed exchange rates dependent on a single export commodity will have difficulty conducting independent monetary policy. Monetary policy may be endogenous to export-generated revenues. These results need not generalize to other small open economies. However, they suggest that small economies likely have different causal flows than large economies, and analysis of their institutional details is a preprequisite for understanding internal economic relationships.
I. Introduction Between 1973 and 1985, the world economy experienced substantially higher oil prices in real terms than seen before or since. In the eyes of most observers, these high oil prices existed largely because of the active behavior of the OPEC cartel led by its most powerful member, the Kingdom of Saudi Arabia. 1 Oil price shocks, in particular in 1973 and 1979, in turn appear to have had a severe stagflationary impact on oil-importing economies. 2 During this period, the Saudi economy was characterized by its openness with essentially fixed exchange rates and its very substantial oil export revenues. In this paper, we seek to investigate two related hypotheses regarding the Saudi Arabian economy and its relationship with the world economy during this period. First, the price of oil responded to the internal conditions of the Saudi economy. The authors are with, respectively, the Department of Economics, James Madison University, Harrisonburg, VA 22807, and the Department of Finance and Business Economics, University of Notre Dame, Notre Dame, IN 46556. Address reprint requests to Richard G. Sheehan, Department of Finance and Business Economics, University of Notre Dame, Notre Dame, IN 46556. t Griffin (1985) confirms cartel behavior by OPEC, although Johany (1984) argues that the high post-1973 oil prices were a reaction to previous overproduction by multinational oil companies anticipating the eventual nationalization of their Middle East holdings. 2 For negative impacts of high oil prices on U.S. and world real GDP, see Tatom (1981), Darby (1982), Hamilton (1983), and Burbidge and Harrison (1984). For their inflationary impacts on the U.S. and global economies, see also Sheehan and Kelly (1984), and Ahmed et al. (1988, 1989).
Journal of Economics and Business 1995; 47:79 90 © 1995 Temple University
0148-6195/95/$09.50 SSDI 0148-6195(94)00025-9
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J.B. Rosser, Jr. and R. G. Sheehan And second, small open economies dependent on a single export commodity may be characterized by different internal macroeconomic relationships than those found in large economies with diverse export bases such as the U.S., Germany, or Japan. 3 We find support for both of these hypotheses. We employ a vector autoregressive (VAR) model for the Saudi Arabian economy that includes five variables: Saudi CPI, Saudi money supply, Saudi crude oil price, Saudi oil exports, and a world price index. We examine the characteristics of this model using both specification tests and variance decompositions. A central issue related to our two hypotheses stated above concerns the nature of Saudi monetary policy in this period. Was it independent and did it determine inflation or was it endogenous to another policy, in particular oil policy, and have little impact on inflation? Our results suggest the latter. Monetary policy was endogenous to oil policy, as well as global inflation, and had little independent influence on Saudi inflation, which in turn was also largely driven by oil policy and global inflation. Several caveats must be noted regarding our results. One is excluded variables, most significantly the global supply and demand for oil. 4 In addition, Saudi oil policy clearly responded to a variety of hard-to-model external factors including the fall of the Shah of Iran, the Iran-Iraq War, and the Persian Gulf War. Despite these external factors, our results suggest that during this period, Saudi oil policy influenced global inflation, which in turn influenced the domestic Saudi macroeconomy. Another concern is the possibility of structural shifts during this period. Saudi oil policy may have shifted, encouraging a price hike in 1973 and moderating one in 1979. However, both policies led to increased export revenues, suggesting a potentially consistent policy focused on maximizing the present discounted value of future oil revenues. Quandt and Chow tests suggest a structural break around 1985-1986. Thus, we end our reported estimation period in 1985. 5 In 1986, the Saudis substantially increased oil production, leading to a sharp decline in prices. The apparent reason was to punish the " O P E C cheaters," warring Iran and Iraq. Since then, oil prices have remained lower and Saudi Arabia has experienced budget deficits, thereby apparently leading to the observed internal structural shifts. The potential structural shifts include allowing larger changes in value of the Saudi currency (the riyal) in foreign exchange markets. Thus, it is plausible to assume that Saudi Arabia recently has had a more independent monetary policy, despite continuing Islamic restrictions on the charging of interest. Hence, our results are strictly limited to the 1973-1985 time period. Section II reviews important institutional details of the Saudi economy. Section III discusses the hypothesized structural model and the methodology employed to test it. Section IV presents the estimated equations, alternate specifications, and model simulations. Section V contains conclusions.
3 See Sheehan (1992) for VAR studies of large, advancedeconomies. 4 Saudi GDP was excludedbecause of data unavailability.Exchangerates and fiscalpolicyvariables were excludedafter initial tests in our VAR modelsfound them to have no connectionswith any other variables. 5Our estimation initially ran through 1988, with this ending date based on the Saudi Arabian Monetary Agency(SAMA)not publishingan Annual Report since 1988.
A VAR Model of the Saudi Arabian Economy
81
II. Saudi Arabian E c o n o m i c Institutions Prior V A R studies generally focus on four variables: inflation, money growth, real output, and interest rates. However, the structure of the Saudi economy dictates a different approach. Output and interest rates are excluded, while oil prices, oil export revenues, and a global price level are included. Real output is excluded based primarily on data availability. We seek to build a quarterly model, and quarterly output data for Saudi Arabia are simply unavaila b l e ) This may limit the relevance of our model. However,many small countries lack reliable short-run output data. In addition, if there is a stable relationship between inflation and output, relatively little may be lost by excluding output. Furthermore, during our sample period, Saudi Arabia operated under severe supply constraints. Thus, output determination is unlikely to be cyclically sensitive in a manner similar to the U.S., Germany, or Japan, for example. Most available evidence (Cl~ron, 1978) suggests that the Saudi leadership was obsessed with inflation during this period. Output fluctuations were a secondary issue, at least until the emergence of budgetary shortfalls in 1986. Until that time, government spending was directed at removing supply bottlenecks in infrastructure, resource development, and human resources. 7 Saudi institutional arrangements suggest that monetary and fiscal policies were endogenous to oil policy during our sample period. For example, Johany et at. (1986) describe the major source of monetary expansion as check writing by government agencies on accounts with the Saudi Arabian Monetary Agency (SAMA) whose funds are derived from oil revenues. Export revenues flow directly to the Ministry of Finance and Economy which oversees and contains SAMA, the chief monetary policy entity) Thus, oil policy predicates monetary policy. Given the fabled secretiveness of Saudi policy makers, it is difficult to know what determines oil policy. Alternative h y p o t h e s e s - - n o t necessarily mutually exc l u s i v e - i n c l u d e maximizing the present discounted value of oil revenues (setting prices to maintain long-term market share (Johany, 1984)), concern for the stability of O P E C (Griffin, 1985), and an overriding emphasis on political and military security (Moran, 1982). To this list we suggest adding a recognition by the decision makers of the link with the domestic macroeconomy. While most V A R models include interest rates as a concomitant to monetary policy, we exclude them because of Saudi restrictions on interest, in adherence to the Hanbali Sunni Shari'a law code. 9 The forbidding of interest is not absolute. A
6 One might argue that the annual output series should be employed to generate a quarterly series. However, estimation results could be highly sensitive to the method used to create the quarterly series. 7 Rosser (1983) and Looney (1988) find evidence for the anti-inflationary effects of such government investments, especially during the 1970s. SAn anonymous referee suggests, based on private discussions with SAMA authorities, that oil revenues are maintained in an investment portfolio separate from monetary policy. While this may be true, especially since 1986, it is not discussed in any published SAMA report. No report has been published since 1988, and Saudi decision makers have a well-deserved reputation for opaqueness. 9Aghnides (1916) provides a classic discussion of the forbidding of interest in different Islamic Shari'a law codes. Knauerhase (1975), Looney (1982), and Wilson (1991) discuss the Saudi policy. Rosser and Rosser (1994, ch. 5 and 6) compare the Saudi policy with those of other Islamic countries.
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J.B. Rosser, Jr. and R.G. Sheehan three-tiered structure of rates is allowed. Nevertheless, financial markets remain incomplete, with the m o s t important market for the riyal located in Bahrain, outside the K i n g d o m and b e y o n d S A M A ' s control (Gerakis and Roncesvalles, 1983). T h e embryonic financial markets continue to emphasize cash, especially specie, which some believe is e n c o u r a g e d by certain Q u r ' a n i c passagesJ ° Thus, S A M A lacks s o m e traditional m o n e t a r y policy tools, although this has changed since 1986 with the e m e r g e n c e of b u d g e t deficits and the issuance of Treasury D e v e l o p m e n t Bonds. 1~
III. Model and Methodology O u r V A R m o d e l allows us to analyze dynamic responses of m a c r o e c o n o m i c variables within the context of hypothesized Saudi structural relationships. O u r five variables are Saudi C P I (P), Saudi m o n e y supply (M, m e a s u r e d as M1 in riyals), Saudi oil exports ( T R or total revenue in riyals), Saudi crude oil prices ( P O in U.S. dollars), and a world price index (W). Algebraically, the m o d e l can be stated as
PO
=
-all(L)
a12(L)
a13(L)
al4(L)
als(L)
a21(L)
az2(L)
a23(L)
a24(L)
a25(L)
a31(L)
a32(L)
a33(L)
a34(L)
a35(L)
a41(L)
a42(L)
a43(L)
aaa(L)
a45(t)
a51(L)
as2(L)
a53(L)
a54(L)
a54(L)
•
PO
ul]
u3
(1)
u4 u5
where the aijs are the estimated coefficients and L indicates a lag operator. T h e lag o p e r a t o r s can be expressed simply as a i j ( L ) Z i =- a l j Z i , t _ 1 + a 2 j Z i , t _ 2 + ... + a K j Z i , t_ K.
(2)
Given sufficient identifying restrictions, we can view equation (1) as a structural e c o n o m i c model. 12 Given the high level o f Saudi imports with globally set prices, it is reasonable to assume that Saudi inflation is influenced by work inflation as well as by domestic oil policy. Thus, we expect als > 0.
10Johany et al. (1986) present a detailed discussion of Saudi financial institutions~ With respect to the emphasis on specie, they note the widespread and traditional use of Maria Theresa silver dollars and the continued importance of money changers. An even more telling detail is that Saudi paper money contains silver threads. 11 The 1988 SAMA Annual Report (p. 29) hints at the emergence of an independent monetary policy based on open market operations using these bonds. Wilson (1991, ch. 9) notes that Saudi religious authorities strongly oppose the development of this deficit-driven bond market because of the implied increased use of interest rates. x2 The assumption that equation (1) can be viewed as a system of structural equations and that all variables respond with at least a one-period lag are made to avoid the criticisms of VAR analysis raised by Leamer (1985) and Cooley and LeRoy (1985). The structural view of VAR models has been advanced by Bernanke (1986) among others. The assumption that variables respond only with a lag can be tested by examining the cross correlations. Only three contemporaneous correlations are significant, and all three have a natural interpretation. The first is between money growth and inflation where the monetarist assumption is that the money growth causes inflation. The second is between Saudi oil prices and Saudi exports. Saudi Arabia generally has set the price with sales determined by the world demand, and causality runs from oil prices to exports. The third is between Saudi oil prices and the world price index, and also is discussed in more detail below.
A VAR Model of the Saudi Arabian Economy
83
Oil policy can influence inflation indirectly through money growth, leading us to expect a12 > 0. In contrast, a13 and a14 will depend on whether spending out of oil revenues increases aggregate demand or aggregate supply more. If oil policy responds to the domestic economy, then a31 and a41 should be significant, albeit with indeterminant signs a priori. If oil prices respond to global inflation, then a35 > 0. If the components of oil policy effect each other, then a34 and a43 should be significant. We expect no direct impact of money growth on oil policy. Thus, a32 = 0 = a42. However, endogeneity of money to oil policy suggests that a23 > 0 and a24 > 0. Inflation also might impact money growth, leading a~2 to be significant, but its sign depends on the nature of the policy response. During most of the period of analysis, Saudi Arabia pegged its exchange rate, first to the dollar and then to the SDR. Thus, world money growth should drive Saudi money growth, and the former also should drive world inflation, and a15 > 0. We also expect oil prices to affect world prices. Thus, a53 > 0, while as1 = 0 = a52. Our data are from International Financial Statistics, except for Saudi oil exports which are based on information provided by the U.S. Energy Information Administration and by ARAMCO. 13 We used two measures of world inflation, the U.S. CPI as well as an IMF world price index. The results reported below employ the former, except where noted since it avoids an additional layer of index number problems and the results differ little. Our VAR methodology follows that of Hsiao (1981, 1982) as modified by McMillan and Fackler (1984) and Sheehan (1992). Based on the results of augmented Dickey-Fuller tests, we achieved stationarity in all variables by using the first differences of natural logs. Equations initially are estimated for the period 1973:2 to 1988:3 using quarterly data, which probably are subject to a steadily improving degree of accuracy. We first estimate vector autoregressions for each of the variables in the system: Z, = a + ~(L)Z,
+ et
(3)
where Z is a vector of the five variables considered here and L is the lag operator. The maximum lag length must be specified a priori and is set equal to four here. Akaike's final prediction error (FPE) criterion then is used to determine the appropriate lag lengths. The individual equations are collected into a system of equations that is deliberately overfit and underfit using Zellner's SUR procedure. Standard diagnostics such as the F statistics are calculated to ascertain the overall goodness of fit of the estimated model. The final model then is employed in subsequent variance decompositions.
IV. Estimation Results The FPE test described above yields a preliminary estimate of the appropriate model. Alternate specifications are then compared using standard F tests to determine the final equation specifications. The equations initially were estimated ~3Data are available for Saudi CPI from 1971 : 1, but the first observationsare used for differencing and lags. We begin in 1973: 1 to correspond to the floatingexchange rate period.
84
J.B. Rosser, Jr. and R. G. Sheehan over the full sample period, 1973-1988. We then examine the results for structural stability. Without exception, Quandt tests indicated the most likely break in 1985 or 1986, and Chow tests indicated that those breaks were significant. This finding was not unexpected given the above discussion. The shift suggests more recent emphasis on budgetary shortfalls and less emphasis on inflation. Thus, the following analysis focuses on the period through 1985:2.14 The period since then, while clearly of substantial interest, is not considered further because it has insufficient degrees of freedom to allow any precision for estimated equations. Since the Persian Gulf War, however, the Saudis apparently have paid increasing attention to inflation, thus increasing the current relevance of the equations estimaed here. The final equations for the 1973:2 to 1985:2 period are presented in Table 1 and are summarized below in equation (4), the estimaed form of equation (1). The values in parentheses indicate the lag lengths. 0 0
PO
=
0
[a41~4)
a33 (2)
a34(2)
a35(1)
•
PO
(4)
0a43(4)a44(1)a45(2)0 0 0 a55(4)
A summary of some of the overfitting and underfitting tests is presented in Table 2. The specification tests reported there represent only a subset of the specification tests actually undertaken. For example, alternative combinations of the zero restrictions were tested, as well as restrictions on coefficients corresponding to alternative lag lengths on the right-hand-side variables. Nevertheless, the results in Table 2 are consistent with our general conclusion that the specification results are not sensitive to lag length or to the inclusion/exclusion of other variables. 15 We briefly discuss below the estimated equations, the overfitting and underfitting results, the variance decompositions, presented in Table 3, and the highlights of some impulse response functions (which are not presented to conserve space). The ordering of the variables for the variance decomposition is as presented in Table 3.16 The estimation results indicate that Saudi inflation is determined by world inflation and by Saudi oil policy. These results are consistent with both prior studies and our model. The Saudi economy is relatively open. World inflation has a marginally significant effect, at least in the short run, based on the regression
14This endpoint is chosen since the Quandt test identifies the break in the inflation equation there and all Chow tests reject structural stability at this point. 15Potentially the most noteworthy limitation of the results is the large number of estimated coefficients, particularly in the P and M equations, given the sample size. These equations were reestimated using a maximum of two lags. The results basicallywere unaltered from those presented in the tables. 16World inflation is first since, by assumption, it is largely unaffected by domestic Saudi considerations. The policy variables are ordered next, with money growth the last of the three since it is hypothesized to be determined by oil policy. Inflation is last. With one exception noted below, the results generally are not sensitive to the ordering chosen.
A V A R Model of the Saudi Arabian E c o n o m y
85
Table 1. P(t)=
0 . 3 8 1 P ( t - l) (3.59) + 0.137M(t-3) (2.11) + 0.113PO(t-4)+ (5.08)
0 . 3 1 8 P ( t - 2 ) + 0 . 4 0 6 P ( t - 3 ) + 0 . 3 4 5 M ( t - 1) (2.82) (0.41) (6.86) 0 . 2 1 8 M ( t - 4 ) - 0 . 0 0 0 P O ( t - 1)+ 0 . 0 3 8 P O ( t - 2 ) (3.41) (0.03) (1.62) 0 . 4 0 2 W ( t - 1) + 0 . 2 2 6 W ( t - 2 ) + 0 . 0 6 3 W ( t - 3 ) (0.77) (0.38) (0.l 1) R 2 = 0.79 S E = 0.021 Q(21) = 22.66
M(t)=
0 . 1 1 0 M ( t - 1) - 0 . 0 6 1 M ( t - 2 ) + 0 . 4 2 2 M ( t - 3 ) + 0 . 4 5 4 P ( t - 1) - 0 . 3 3 7 P ( t - 2 ) (1.07) (0.46) (3.41) (2.12) (1.68) + 0.879P(t-3) + 0.021TR(t- 1) - 0 . 0 8 8 T R ( t - 2 ) + 0 . 0 6 6 T R ( t - 3 ) - 0 . 0 9 7 T R ( t - 4 ) (5.57) (1.98) (2.09) (2.08) (2.82) + 0.031 P O ( t - 1) + 0.029 P O ( t - 2) - 0.091 P O ( t - 3) + 0.193 P O ( t - 4) (0.93) (0.46) (l.49) (3.50) R 2 = 0.71 S E = 0.043 Q(21) = 15.85
PO(t)
= 0.333 (3.12)
TR(t)=
0.067TR(t- 1) + 0 . 4 l i P ( t - 1) + 0 . 7 2 9 P ( t - 2 ) (1.71) (0.81) (1.46) + 0.446 P O ( t - 1) - 0.444 P O ( t - 2) + 0.254 P O ( t - 3) (3.37) (2.48) ( 1.66) - 5.916 W ( t - 2) (2.05) R 2 = 0.96 S E = 0.169 Q(21)
W(t)=
PO(t
-
1) - 0.419 P O ( t - 2) + 0.071 T R ( t (2.50) (2.15) R 2 = 0.72 S E = 0.128
0.931W(t- 1) - 0 . 5 5 5 W ( t - 2 ) (7.33) (3,70) R 2 = 0.66
-
1) + 0.176 T R ( t (1.94) Q(21) = 4.71
-
0.132M(t-2) (2.18) 0.044PO(t-3) (1.81) 1.157W(t-4) (2.34)
2) + 3.745 U ( t (1.71)
-
1)
1.217P(t-3) + 1.559P(t-4) (2.55) (3.45) 0.401 P O ( t - 4) + 11.782 W ( t - 1) (2.85) (3.50)
= 8.64
+ 0.738W(t-3) 0.314W(t-4) (5.03) (2.55) S E = 0.0051 Q(21) = 27.78
t statistics are presented in parentheses. Seasonal dummies are also included in the world inflation equation.
results. T h e v a r i a n c e d e c o m p o s i t i o n s in T a b l e 3, h o w e v e r , s u g g e s t t h a t t h e i m p o r t a n c e o f this e f f e c t is s m a l l in c o m p a r i s o n to oil policy. 17 A c h a n g e in oil p o l i c y i n f l u e n c e s S a u d i inflation, w i t h a n i n c r e a s e in oil p r i c e s p e r m a n e n t l y i n c r e a s i n g i n f l a t i o n . M o n e y g r o w t h has a significant s h o r t r u n i m p a c t , b u t its l o n g - r u n e f f e c t is s m a l l a n d p o s s i b l y insignificant. T h e r e l a t i v e u n i m p o r t a n c e o f m o n e y g r o w t h in t h e l o n g r u n m a y s e e m surprising. T h i s r e s u l t i n d i c a t e s o n l y t h a t m o n e t a r y p o l i c y h a s h a d n o i m p a c t o n i n f l a t i o n b e y o n d t h e i m p a c t felt d u e to oil policy. G i v e n t h a t m o n e t a r y p o l i c y is d e r i v e d f r o m oil policy, h o w e v e r , t h e e f f e c t s o f e x p e c t e d m o n e t a r y p o l i c y c h a n g e s s h o u l d b e c a p t u r e d by t h e oil policy terms.
17 Runkle (1987) contends that variance decompositions (VDC) may have large confidence intervals. Hafer and Sheehan (1991), in contrast, find that confidence intervals obtained from systems of equations estimated using the same approach employed here may be substantially narrower. Both studies employ models similar to that presented here. Our discussion of the importance of the variance decomposition results is based on Hafer and Sheehan's view of the significance of VDC confidence intervals.
86
J.B. Rosser, Jr. and R. G. Sheehan Table 2. Specification Tests
Coefficient all a12 a13 a14 a15 a21 a22 a23 a24 a25 a31 a32 a33 a34 a35 a41 a42 a43 a44 a,5 a51 a52 a53 a54 a55
Variables Included in Final Form Significance Joint of Coefficient Significancea Sum 0.000 0.000 0.000
0.001 0.085 0.002
0.057 0.000 0.001 0.005 0.001
0.268 0.000 0.001 0.083 0.204
Variables Excluded from Final Form Joint Significanceb
0.168
0.858 0.251 0.825 0.002 0.025 0.093 0.000
0.608 0.014 0.093 0.015
0.001 0.095 0.002
0.543 0.095 0.046
0.911
0.827 0.531 0.421 0.402 0.000
aNumber of included lags are stated in Table 1. bNumber of included lags equals four.
Saudi money growth appears to be largely an outgrowth of oil policy, although it also responds to accommodate Saudi inflation. The magnitude of the latter effect appears small relative to the impact of oil policy. The relative importance of oil policy in influencing Saudi money growth is best demonstrated by the variance decompositions. After 16 quarters, approximately 44% of the variance in money growth is due to innovations in oil policy (including both PO and TR). Thus, it appears that oil policy determines monetary policy. The oil price and export equations imply that Saudi oil policy is influenced by both Saudi and world inflation. Saudi inflation directly alters export revenues, while world inflation directly influences both oil prices and export revenues. In addition, the hypothesized zero restrictions on the money variable cannot be rejected. Higher world inflation prompts higher oil prices as well as higher export revenues (based on the impulse response functions). Given repeated Saudi statements that oil price increases have been prompted in part by world inflation, these last results should not be surprising. The variance decompositions also indicate that world inflation has a substantial impact on both oil prices and exports. In addition, the variance decompositions make clear that oil prices are determined primarily by their own past (and world inflation), and are the closest thing to an exogenous variable in the Saudi economy.
A VAR Model of the Saudi Arabian Economy
87
T a b l e 3. Variance Decomposition
Percent ofvariance in POdue to innovationsin: After qua~ers: 1 4 8 16 Percent ofvariance in TR due to innovationsin: 1 4 8 16 Percent ofvariance in Mdue to innovationsin: 1 4 8 16 Percent ofvariance in P due to innovationsin:
W
PO
TR
M
P
6 16 17 17
94 81 80 80
0 3 3 3
0 0 0 0
0 0 0 0
W
PO
TR
M
P
13 28 26 26
34 35 37 38
52 35 32 31
0 0 2 2
0 1 3 4
W
PO
TR
M
P
0 1 2 3
0 4 20 33
11 16 14 11
89 71 48 36
0 11 17 17
1
W 2
PO 8
TR 0
M 2
4 8 20
7 7 7
11 37 40
4 5 5
22 13 12
P
89 56 39 36
Oil prices and export revenues a p p e a r as significant i n d e p e n d e n t variables in the equations for each other, with oil prices impacting revenues m o r e strongly than the reverse. T h e impulse response functions and variance decompositions confirm that the link f r o m oil prices to exports is stronger than the reverse. (Reversing the order o f P O and T R in the variance decompositions makes the weighting less overwhelming than suggested in Table 3.) This finding should not be unexpected. O P E C policy makers generally c h a n g e d oil prices and allowed o u t p u t and exports to be d e t e r m i n e d by market d e m a n d . T h e relationship between oil prices and oil exporters also is consistent with the a p p a r e n t official thrust o f Saudi oil policy since the initial large price increase of 1973. Saudi oil policy has acted as a countercyclical stabilizer in the global oil market. This policy led t h e m to increase production and exports when oil prices were rising in 1979 and 1980, and to lower p r o d u c t i o n and exports when oil prices were falling or w e a k in 1977 and 1978 and again in 1984 and 1985. (This result may be due to the Saudi's upward sloping marginal cost curve for oil.) Given the small size of the Saudi e c o n o m y relative to the rest of the world, we hypothesize that world inflation should not be influenced by any Saudi variable except oil prices. While the estimated e q u a t i o n and specification tests indicate that the zero restrictions on a21, a24 , and a25 cannot be rejected, they also suggest that oil prices have had no effect. 18 A positive c o n t e m p o r a n e o u s correlation between Saudi oil prices and world inflation, however, indicates a link between the two series. It appears m o r e plausible to argue that oil prices influence world inflation
18We do not claim that the world inflation equation accurately describes the world inflation process from a world perspective. We contend only that from the Saudi perspective, it is a reasonable approximation of their influence on world inflation. In a more realistic equation for world inflation, including world money growth, lagged off prices could have significant coefficients. Evidence for such a result has been found by Ahmed et al. (1988, 1989).
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J.B. Rosser, Jr. and R. G. Sheehan contemporaneously--within one quarter--rather than the reverse. Oil price-setters in one quarter have little information about world inflation in that quarter. It OPEC sets oil prices and those prices are known immediately, the contemporaneous relationship suggests that oil prices influence world inflation. Ordering oil prices before world inflation implies that approximately 15% of the variance in I~ is due to innovations in PO. This finding is consistent with a "global inflationar5 feedback mechanism." Oil price increases have led to worldwide inflation, which iv turn has led to further oil price increases. Money growth is insignificant in all estimated equations. There are at least two possible explanations of this result. First, as discussed above, monetary policy is ar outgrowth of oil policy and may have no independent impact. Any impact ol monetary policy is anticipated at the time oil policy is undertaken. Alternately monetary policy may be insignificant due to the prohibition of interest payment,, and the embryonic nature of Saudi financial markets. We should emphasize thai these results refer to the pre-1986 period. Since then, we have seen a greatel increase in the use of open market operations by the Saudi monetary authorities Thus, there now may be a more independent monetary policy since the oil revenu~ decline of 1986 greatly increased the size of the fiscal budget deficit.
V. Conclusions We have estimated and simulated a VAR model of the Saudi Arabian economy fo the period 1973-1985, the heyday of OPEC dominance of world oil prices and o Sadi Arabia's dominance of OPEC. Our results strongly support our twin hypothe ses that Saudi oil policy, driven by internal factors, influenced world inflation, an~ that in turn the open Saudi economy was significantly influenced by world inflatioJ as well by its own oil policy, these relations changed after the Saudi-induced 198~ oil price decline, when budget deficits appeared and the exchange rate was allowe~ to vary more readily. These results indicate that a small open economy with a fixed exchange rat, dependent on a single export commodity will have difficulty conducting an indepen dent monetary policy. Its monetary policy may be endogenous to the revenue generated by those exports. If it is in the rare position of being able to influenc the price of that export commodity, then internal conditions will influence tha price-setting policy. In the even rarer case where the price of that export commoc ity powerfully impacts the world economy, then a mutual feedback system ma become established between the world economy and the domestic econom~ operating through the nation's export commodity pric~-setting policy. Clearly, the results presented here for Saudi Arabia need not generalize t other small open economies. However, they do carry two simple but stron implications. First, other small open economies likely have different causal flo,~ than large economies. And second, a complete analysis of those economic: institutional details is a prerequisite for understanding, for example, how monc and inflation are related or how policy is conducted. Our thanks to two anonymousreferees for valuable commentson an earlier draft, and to Pat Smith ar Annetta Homer of the U.S. Energy Information Administrationand Taylor Kelsh of ARAMCO fi providingus with data. We alone are responm'blefor any errors.
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89
References Aghnides, N. P. 1916. Mohammedan Theories of Finance. sity.
New York: Columbia Univer-
Ahmed, E., Rosser, J. B. Jr., and Sheehan, R. G. Nov. 1988. A global model of OECD aggregate supply and demand using vector autoregressive techniques, European Economic Review 32:1711-1729. Ahmed, E., Rosser, J. B., Jr., and Sheehan, R. G. 1989. A comparison of national and international aggregate supply and demand VAR models: The United States, Japan and the European economic community, Welwirtschafiliches Archiv 125(2):252-272. Alam, M. S. Jan. 1982. The basic macroeconomics of oil economies, Journal of Development Studies 18:205-216. Bernanke, B. S. Autumn 1986. Alternative explanations of the money-income correlation, In Carnegie-Rochester Conference Series on Public Policy 49-100. Burbidge, J., and Harrison, A. June 1984. Testing for the effects of oil-price rises using vector autoregression, International Economic Review 25:459-484. C16ron, J. P. 1978. Saudia Arabia 2000: A Strategy for Growth.
London: Croom Helm.
Cooley, T. F., and LeRoy, S. F. Nov. 1985. A theoretical macroeconometrics: A critique, Journal of Monetary Economics 16:283-308. Darby, M. R. Sept. 1982. Oil prices and world recession and inflation, American Economic Reciew 72:738-751. Gerakis, A. S., and Roncesvalles, O. Jan. 1983. Bahrain's offshore banking center, Economic Development and Cultural Change 31:271-293. Griffin, J. D. Dec. 1985. OPEC behavior: A test of alternative hypotheses, American Economic Review 75:954-963. Hafer, R. W., and Sheehan, R. G. Jan. 1991. Policy inference using VAR models, Economic Inquiry 29:44-52. Hamilton, J. D. Apr. 1983. Oil and the macroeconomy since World War II, Journal of Political Economy 91:228-248. Hsiao, C. Jan. 1981. Autoregressive modeling and money-income causality detection, Journal of Monetary Economics 7:85-106. Hsiao, C. Aug. 1982. Autoregressive modeling and causal ordering of economic variables, Journal of Economic Dynamics' and Control 4:243-258.
International Financial Statistics. 1969-1982.
Washington: International Monetary Fund.
Johany, A. D. 1984. The Myth of the OPEC Cartel. Chichester: Wiley. Johany, A. D., Berne, M., and Mixon, J. W., Jr. 1986. The Saudi Arabian Economy. Baltimore: Johns Hopkins. Knauerhase, R. 1975. The Saudi Arabian Economy.
New York: Praeger.
Leamer, E. E. Spring 1985. Vector autoregressions for causal inference?, In CarnegieRochester Conference Series on Public Policy 22:255-304. Looney, R. E. June 1982. Saudi Arabia's Islamic growth model, Journal of Economic Issues 16:453-459. Looney, R. E. Autumn 1988. Infrastructure investment and inflation in Saudi Arabia, Journa I of Energy and Development 14:103- 113. McMillin, W. D., and Fackler, J. S. Jan. 1984. Monetary vs. credit aggregates: An evaluation of monetary policy targets, Southern Economic Journal 50:711-723. Moran, T. 1982. Modeling OPEC behavior: Economic and political alternatives, In J. M. Griffin and D. J. Teece (eds.), OPEC Behavior and World Oil Prices. London: Allen and Unwin.
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J.B. Rosser, Jr. and R. G. Sheehan Rosser, J. B., Jr. Summer 1983. Infrastructure investment and inflation in Saudia Arabia, Economic Forum 143-147. Rosser, J. B., Jr., and Vcherashnaya Rosser, M. 1994. Comparative Economics in a Transforming World Economy. Burr Ridge: Irwin. Runkle, D. E. Oct. 1987. Vector autoregressions and reality, Journal of Business and Economic Statistics 5:437-442. Saudi Arabian Monetary Agency, Annual Report, 1988. Sheehan, R. G. Nov. 1992. U.S. influences on foreign monetary policy, Journal of Money, Credit and Banking 24:447-464. Sheehan, R. G. and Kelly, N. Apr. 1983. Oil prices and world inflation, Journal of Economics and Business 35:235-238. Tatom, J. A. Jan. 1981. Energy prices and short-run economic performance, Review Federal Reserve Bank of St. Louis 63:3-17. Wilson, P. W. 1991. A Question of Interest: The Paralysis of Saudi Banking. Boulder: Westview.
A Vector Autoregressive Model of the Saudi Arabian Economy J. Barkley Rosser, Jr. and Richard G. Sheehan
This paper examines the institutions and then estimates a VAR model of the Saudi economy. The results indicate that the Saudi economy was influenced by world inflation and by Saudi oil policy. These results suggest that a small open economy with fixed exchange rates dependent on a single export commodity will have difficulty conducting independent monetary policy. Monetary policy may be endogenous to export-generated revenues. These results need not generalize to other small open economies. However, they suggest that small economies likely have different causal flows than large economies, and analysis of their institutional details is a preprequisite for understanding internal economic relationships.
I. Introduction Between 1973 and 1985, the world economy experienced substantially higher oil prices in real terms than seen before or since. In the eyes of most observers, these high oil prices existed largely because of the active behavior of the OPEC cartel led by its most powerful member, the Kingdom of Saudi Arabia. 1 Oil price shocks, in particular in 1973 and 1979, in turn appear to have had a severe stagflationary impact on oil-importing economies. 2 During this period, the Saudi economy was characterized by its openness with essentially fixed exchange rates and its very substantial oil export revenues. In this paper, we seek to investigate two related hypotheses regarding the Saudi Arabian economy and its relationship with the world economy during this period. First, the price of oil responded to the internal conditions of the Saudi economy. The authors are with, respectively, the Department of Economics, James Madison University, Harrisonburg, VA 22807, and the Department of Finance and Business Economics, University of Notre Dame, Notre Dame, IN 46556. Address reprint requests to Richard G. Sheehan, Department of Finance and Business Economics, University of Notre Dame, Notre Dame, IN 46556. t Griffin (1985) confirms cartel behavior by OPEC, although Johany (1984) argues that the high post-1973 oil prices were a reaction to previous overproduction by multinational oil companies anticipating the eventual nationalization of their Middle East holdings. 2 For negative impacts of high oil prices on U.S. and world real GDP, see Tatom (1981), Darby (1982), Hamilton (1983), and Burbidge and Harrison (1984). For their inflationary impacts on the U.S. and global economies, see also Sheehan and Kelly (1984), and Ahmed et al. (1988, 1989).
Journal of Economics and Business 1995; 47:79 90 © 1995 Temple University
0148-6195/95/$09.50 SSDI 0148-6195(94)00025-9
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J.B. Rosser, Jr. and R. G. Sheehan And second, small open economies dependent on a single export commodity may be characterized by different internal macroeconomic relationships than those found in large economies with diverse export bases such as the U.S., Germany, or Japan. 3 We find support for both of these hypotheses. We employ a vector autoregressive (VAR) model for the Saudi Arabian economy that includes five variables: Saudi CPI, Saudi money supply, Saudi crude oil price, Saudi oil exports, and a world price index. We examine the characteristics of this model using both specification tests and variance decompositions. A central issue related to our two hypotheses stated above concerns the nature of Saudi monetary policy in this period. Was it independent and did it determine inflation or was it endogenous to another policy, in particular oil policy, and have little impact on inflation? Our results suggest the latter. Monetary policy was endogenous to oil policy, as well as global inflation, and had little independent influence on Saudi inflation, which in turn was also largely driven by oil policy and global inflation. Several caveats must be noted regarding our results. One is excluded variables, most significantly the global supply and demand for oil. 4 In addition, Saudi oil policy clearly responded to a variety of hard-to-model external factors including the fall of the Shah of Iran, the Iran-Iraq War, and the Persian Gulf War. Despite these external factors, our results suggest that during this period, Saudi oil policy influenced global inflation, which in turn influenced the domestic Saudi macroeconomy. Another concern is the possibility of structural shifts during this period. Saudi oil policy may have shifted, encouraging a price hike in 1973 and moderating one in 1979. However, both policies led to increased export revenues, suggesting a potentially consistent policy focused on maximizing the present discounted value of future oil revenues. Quandt and Chow tests suggest a structural break around 1985-1986. Thus, we end our reported estimation period in 1985. 5 In 1986, the Saudis substantially increased oil production, leading to a sharp decline in prices. The apparent reason was to punish the " O P E C cheaters," warring Iran and Iraq. Since then, oil prices have remained lower and Saudi Arabia has experienced budget deficits, thereby apparently leading to the observed internal structural shifts. The potential structural shifts include allowing larger changes in value of the Saudi currency (the riyal) in foreign exchange markets. Thus, it is plausible to assume that Saudi Arabia recently has had a more independent monetary policy, despite continuing Islamic restrictions on the charging of interest. Hence, our results are strictly limited to the 1973-1985 time period. Section II reviews important institutional details of the Saudi economy. Section III discusses the hypothesized structural model and the methodology employed to test it. Section IV presents the estimated equations, alternate specifications, and model simulations. Section V contains conclusions.
3 See Sheehan (1992) for VAR studies of large, advancedeconomies. 4 Saudi GDP was excludedbecause of data unavailability.Exchangerates and fiscalpolicyvariables were excludedafter initial tests in our VAR modelsfound them to have no connectionswith any other variables. 5Our estimation initially ran through 1988, with this ending date based on the Saudi Arabian Monetary Agency(SAMA)not publishingan Annual Report since 1988.
A VAR Model of the Saudi Arabian Economy
81
II. Saudi Arabian E c o n o m i c Institutions Prior V A R studies generally focus on four variables: inflation, money growth, real output, and interest rates. However, the structure of the Saudi economy dictates a different approach. Output and interest rates are excluded, while oil prices, oil export revenues, and a global price level are included. Real output is excluded based primarily on data availability. We seek to build a quarterly model, and quarterly output data for Saudi Arabia are simply unavaila b l e ) This may limit the relevance of our model. However,many small countries lack reliable short-run output data. In addition, if there is a stable relationship between inflation and output, relatively little may be lost by excluding output. Furthermore, during our sample period, Saudi Arabia operated under severe supply constraints. Thus, output determination is unlikely to be cyclically sensitive in a manner similar to the U.S., Germany, or Japan, for example. Most available evidence (Cl~ron, 1978) suggests that the Saudi leadership was obsessed with inflation during this period. Output fluctuations were a secondary issue, at least until the emergence of budgetary shortfalls in 1986. Until that time, government spending was directed at removing supply bottlenecks in infrastructure, resource development, and human resources. 7 Saudi institutional arrangements suggest that monetary and fiscal policies were endogenous to oil policy during our sample period. For example, Johany et at. (1986) describe the major source of monetary expansion as check writing by government agencies on accounts with the Saudi Arabian Monetary Agency (SAMA) whose funds are derived from oil revenues. Export revenues flow directly to the Ministry of Finance and Economy which oversees and contains SAMA, the chief monetary policy entity) Thus, oil policy predicates monetary policy. Given the fabled secretiveness of Saudi policy makers, it is difficult to know what determines oil policy. Alternative h y p o t h e s e s - - n o t necessarily mutually exc l u s i v e - i n c l u d e maximizing the present discounted value of oil revenues (setting prices to maintain long-term market share (Johany, 1984)), concern for the stability of O P E C (Griffin, 1985), and an overriding emphasis on political and military security (Moran, 1982). To this list we suggest adding a recognition by the decision makers of the link with the domestic macroeconomy. While most V A R models include interest rates as a concomitant to monetary policy, we exclude them because of Saudi restrictions on interest, in adherence to the Hanbali Sunni Shari'a law code. 9 The forbidding of interest is not absolute. A
6 One might argue that the annual output series should be employed to generate a quarterly series. However, estimation results could be highly sensitive to the method used to create the quarterly series. 7 Rosser (1983) and Looney (1988) find evidence for the anti-inflationary effects of such government investments, especially during the 1970s. SAn anonymous referee suggests, based on private discussions with SAMA authorities, that oil revenues are maintained in an investment portfolio separate from monetary policy. While this may be true, especially since 1986, it is not discussed in any published SAMA report. No report has been published since 1988, and Saudi decision makers have a well-deserved reputation for opaqueness. 9Aghnides (1916) provides a classic discussion of the forbidding of interest in different Islamic Shari'a law codes. Knauerhase (1975), Looney (1982), and Wilson (1991) discuss the Saudi policy. Rosser and Rosser (1994, ch. 5 and 6) compare the Saudi policy with those of other Islamic countries.
82
J.B. Rosser, Jr. and R.G. Sheehan three-tiered structure of rates is allowed. Nevertheless, financial markets remain incomplete, with the m o s t important market for the riyal located in Bahrain, outside the K i n g d o m and b e y o n d S A M A ' s control (Gerakis and Roncesvalles, 1983). T h e embryonic financial markets continue to emphasize cash, especially specie, which some believe is e n c o u r a g e d by certain Q u r ' a n i c passagesJ ° Thus, S A M A lacks s o m e traditional m o n e t a r y policy tools, although this has changed since 1986 with the e m e r g e n c e of b u d g e t deficits and the issuance of Treasury D e v e l o p m e n t Bonds. 1~
III. Model and Methodology O u r V A R m o d e l allows us to analyze dynamic responses of m a c r o e c o n o m i c variables within the context of hypothesized Saudi structural relationships. O u r five variables are Saudi C P I (P), Saudi m o n e y supply (M, m e a s u r e d as M1 in riyals), Saudi oil exports ( T R or total revenue in riyals), Saudi crude oil prices ( P O in U.S. dollars), and a world price index (W). Algebraically, the m o d e l can be stated as
PO
=
-all(L)
a12(L)
a13(L)
al4(L)
als(L)
a21(L)
az2(L)
a23(L)
a24(L)
a25(L)
a31(L)
a32(L)
a33(L)
a34(L)
a35(L)
a41(L)
a42(L)
a43(L)
aaa(L)
a45(t)
a51(L)
as2(L)
a53(L)
a54(L)
a54(L)
•
PO
ul]
u3
(1)
u4 u5
where the aijs are the estimated coefficients and L indicates a lag operator. T h e lag o p e r a t o r s can be expressed simply as a i j ( L ) Z i =- a l j Z i , t _ 1 + a 2 j Z i , t _ 2 + ... + a K j Z i , t_ K.
(2)
Given sufficient identifying restrictions, we can view equation (1) as a structural e c o n o m i c model. 12 Given the high level o f Saudi imports with globally set prices, it is reasonable to assume that Saudi inflation is influenced by work inflation as well as by domestic oil policy. Thus, we expect als > 0.
10Johany et al. (1986) present a detailed discussion of Saudi financial institutions~ With respect to the emphasis on specie, they note the widespread and traditional use of Maria Theresa silver dollars and the continued importance of money changers. An even more telling detail is that Saudi paper money contains silver threads. 11 The 1988 SAMA Annual Report (p. 29) hints at the emergence of an independent monetary policy based on open market operations using these bonds. Wilson (1991, ch. 9) notes that Saudi religious authorities strongly oppose the development of this deficit-driven bond market because of the implied increased use of interest rates. x2 The assumption that equation (1) can be viewed as a system of structural equations and that all variables respond with at least a one-period lag are made to avoid the criticisms of VAR analysis raised by Leamer (1985) and Cooley and LeRoy (1985). The structural view of VAR models has been advanced by Bernanke (1986) among others. The assumption that variables respond only with a lag can be tested by examining the cross correlations. Only three contemporaneous correlations are significant, and all three have a natural interpretation. The first is between money growth and inflation where the monetarist assumption is that the money growth causes inflation. The second is between Saudi oil prices and Saudi exports. Saudi Arabia generally has set the price with sales determined by the world demand, and causality runs from oil prices to exports. The third is between Saudi oil prices and the world price index, and also is discussed in more detail below.
A VAR Model of the Saudi Arabian Economy
83
Oil policy can influence inflation indirectly through money growth, leading us to expect a12 > 0. In contrast, a13 and a14 will depend on whether spending out of oil revenues increases aggregate demand or aggregate supply more. If oil policy responds to the domestic economy, then a31 and a41 should be significant, albeit with indeterminant signs a priori. If oil prices respond to global inflation, then a35 > 0. If the components of oil policy effect each other, then a34 and a43 should be significant. We expect no direct impact of money growth on oil policy. Thus, a32 = 0 = a42. However, endogeneity of money to oil policy suggests that a23 > 0 and a24 > 0. Inflation also might impact money growth, leading a~2 to be significant, but its sign depends on the nature of the policy response. During most of the period of analysis, Saudi Arabia pegged its exchange rate, first to the dollar and then to the SDR. Thus, world money growth should drive Saudi money growth, and the former also should drive world inflation, and a15 > 0. We also expect oil prices to affect world prices. Thus, a53 > 0, while as1 = 0 = a52. Our data are from International Financial Statistics, except for Saudi oil exports which are based on information provided by the U.S. Energy Information Administration and by ARAMCO. 13 We used two measures of world inflation, the U.S. CPI as well as an IMF world price index. The results reported below employ the former, except where noted since it avoids an additional layer of index number problems and the results differ little. Our VAR methodology follows that of Hsiao (1981, 1982) as modified by McMillan and Fackler (1984) and Sheehan (1992). Based on the results of augmented Dickey-Fuller tests, we achieved stationarity in all variables by using the first differences of natural logs. Equations initially are estimated for the period 1973:2 to 1988:3 using quarterly data, which probably are subject to a steadily improving degree of accuracy. We first estimate vector autoregressions for each of the variables in the system: Z, = a + ~(L)Z,
+ et
(3)
where Z is a vector of the five variables considered here and L is the lag operator. The maximum lag length must be specified a priori and is set equal to four here. Akaike's final prediction error (FPE) criterion then is used to determine the appropriate lag lengths. The individual equations are collected into a system of equations that is deliberately overfit and underfit using Zellner's SUR procedure. Standard diagnostics such as the F statistics are calculated to ascertain the overall goodness of fit of the estimated model. The final model then is employed in subsequent variance decompositions.
IV. Estimation Results The FPE test described above yields a preliminary estimate of the appropriate model. Alternate specifications are then compared using standard F tests to determine the final equation specifications. The equations initially were estimated ~3Data are available for Saudi CPI from 1971 : 1, but the first observationsare used for differencing and lags. We begin in 1973: 1 to correspond to the floatingexchange rate period.
84
J.B. Rosser, Jr. and R. G. Sheehan over the full sample period, 1973-1988. We then examine the results for structural stability. Without exception, Quandt tests indicated the most likely break in 1985 or 1986, and Chow tests indicated that those breaks were significant. This finding was not unexpected given the above discussion. The shift suggests more recent emphasis on budgetary shortfalls and less emphasis on inflation. Thus, the following analysis focuses on the period through 1985:2.14 The period since then, while clearly of substantial interest, is not considered further because it has insufficient degrees of freedom to allow any precision for estimated equations. Since the Persian Gulf War, however, the Saudis apparently have paid increasing attention to inflation, thus increasing the current relevance of the equations estimaed here. The final equations for the 1973:2 to 1985:2 period are presented in Table 1 and are summarized below in equation (4), the estimaed form of equation (1). The values in parentheses indicate the lag lengths. 0 0
PO
=
0
[a41~4)
a33 (2)
a34(2)
a35(1)
•
PO
(4)
0a43(4)a44(1)a45(2)0 0 0 a55(4)
A summary of some of the overfitting and underfitting tests is presented in Table 2. The specification tests reported there represent only a subset of the specification tests actually undertaken. For example, alternative combinations of the zero restrictions were tested, as well as restrictions on coefficients corresponding to alternative lag lengths on the right-hand-side variables. Nevertheless, the results in Table 2 are consistent with our general conclusion that the specification results are not sensitive to lag length or to the inclusion/exclusion of other variables. 15 We briefly discuss below the estimated equations, the overfitting and underfitting results, the variance decompositions, presented in Table 3, and the highlights of some impulse response functions (which are not presented to conserve space). The ordering of the variables for the variance decomposition is as presented in Table 3.16 The estimation results indicate that Saudi inflation is determined by world inflation and by Saudi oil policy. These results are consistent with both prior studies and our model. The Saudi economy is relatively open. World inflation has a marginally significant effect, at least in the short run, based on the regression
14This endpoint is chosen since the Quandt test identifies the break in the inflation equation there and all Chow tests reject structural stability at this point. 15Potentially the most noteworthy limitation of the results is the large number of estimated coefficients, particularly in the P and M equations, given the sample size. These equations were reestimated using a maximum of two lags. The results basicallywere unaltered from those presented in the tables. 16World inflation is first since, by assumption, it is largely unaffected by domestic Saudi considerations. The policy variables are ordered next, with money growth the last of the three since it is hypothesized to be determined by oil policy. Inflation is last. With one exception noted below, the results generally are not sensitive to the ordering chosen.
A V A R Model of the Saudi Arabian E c o n o m y
85
Table 1. P(t)=
0 . 3 8 1 P ( t - l) (3.59) + 0.137M(t-3) (2.11) + 0.113PO(t-4)+ (5.08)
0 . 3 1 8 P ( t - 2 ) + 0 . 4 0 6 P ( t - 3 ) + 0 . 3 4 5 M ( t - 1) (2.82) (0.41) (6.86) 0 . 2 1 8 M ( t - 4 ) - 0 . 0 0 0 P O ( t - 1)+ 0 . 0 3 8 P O ( t - 2 ) (3.41) (0.03) (1.62) 0 . 4 0 2 W ( t - 1) + 0 . 2 2 6 W ( t - 2 ) + 0 . 0 6 3 W ( t - 3 ) (0.77) (0.38) (0.l 1) R 2 = 0.79 S E = 0.021 Q(21) = 22.66
M(t)=
0 . 1 1 0 M ( t - 1) - 0 . 0 6 1 M ( t - 2 ) + 0 . 4 2 2 M ( t - 3 ) + 0 . 4 5 4 P ( t - 1) - 0 . 3 3 7 P ( t - 2 ) (1.07) (0.46) (3.41) (2.12) (1.68) + 0.879P(t-3) + 0.021TR(t- 1) - 0 . 0 8 8 T R ( t - 2 ) + 0 . 0 6 6 T R ( t - 3 ) - 0 . 0 9 7 T R ( t - 4 ) (5.57) (1.98) (2.09) (2.08) (2.82) + 0.031 P O ( t - 1) + 0.029 P O ( t - 2) - 0.091 P O ( t - 3) + 0.193 P O ( t - 4) (0.93) (0.46) (l.49) (3.50) R 2 = 0.71 S E = 0.043 Q(21) = 15.85
PO(t)
= 0.333 (3.12)
TR(t)=
0.067TR(t- 1) + 0 . 4 l i P ( t - 1) + 0 . 7 2 9 P ( t - 2 ) (1.71) (0.81) (1.46) + 0.446 P O ( t - 1) - 0.444 P O ( t - 2) + 0.254 P O ( t - 3) (3.37) (2.48) ( 1.66) - 5.916 W ( t - 2) (2.05) R 2 = 0.96 S E = 0.169 Q(21)
W(t)=
PO(t
-
1) - 0.419 P O ( t - 2) + 0.071 T R ( t (2.50) (2.15) R 2 = 0.72 S E = 0.128
0.931W(t- 1) - 0 . 5 5 5 W ( t - 2 ) (7.33) (3,70) R 2 = 0.66
-
1) + 0.176 T R ( t (1.94) Q(21) = 4.71
-
0.132M(t-2) (2.18) 0.044PO(t-3) (1.81) 1.157W(t-4) (2.34)
2) + 3.745 U ( t (1.71)
-
1)
1.217P(t-3) + 1.559P(t-4) (2.55) (3.45) 0.401 P O ( t - 4) + 11.782 W ( t - 1) (2.85) (3.50)
= 8.64
+ 0.738W(t-3) 0.314W(t-4) (5.03) (2.55) S E = 0.0051 Q(21) = 27.78
t statistics are presented in parentheses. Seasonal dummies are also included in the world inflation equation.
results. T h e v a r i a n c e d e c o m p o s i t i o n s in T a b l e 3, h o w e v e r , s u g g e s t t h a t t h e i m p o r t a n c e o f this e f f e c t is s m a l l in c o m p a r i s o n to oil policy. 17 A c h a n g e in oil p o l i c y i n f l u e n c e s S a u d i inflation, w i t h a n i n c r e a s e in oil p r i c e s p e r m a n e n t l y i n c r e a s i n g i n f l a t i o n . M o n e y g r o w t h has a significant s h o r t r u n i m p a c t , b u t its l o n g - r u n e f f e c t is s m a l l a n d p o s s i b l y insignificant. T h e r e l a t i v e u n i m p o r t a n c e o f m o n e y g r o w t h in t h e l o n g r u n m a y s e e m surprising. T h i s r e s u l t i n d i c a t e s o n l y t h a t m o n e t a r y p o l i c y h a s h a d n o i m p a c t o n i n f l a t i o n b e y o n d t h e i m p a c t felt d u e to oil policy. G i v e n t h a t m o n e t a r y p o l i c y is d e r i v e d f r o m oil policy, h o w e v e r , t h e e f f e c t s o f e x p e c t e d m o n e t a r y p o l i c y c h a n g e s s h o u l d b e c a p t u r e d by t h e oil policy terms.
17 Runkle (1987) contends that variance decompositions (VDC) may have large confidence intervals. Hafer and Sheehan (1991), in contrast, find that confidence intervals obtained from systems of equations estimated using the same approach employed here may be substantially narrower. Both studies employ models similar to that presented here. Our discussion of the importance of the variance decomposition results is based on Hafer and Sheehan's view of the significance of VDC confidence intervals.
86
J.B. Rosser, Jr. and R. G. Sheehan Table 2. Specification Tests
Coefficient all a12 a13 a14 a15 a21 a22 a23 a24 a25 a31 a32 a33 a34 a35 a41 a42 a43 a44 a,5 a51 a52 a53 a54 a55
Variables Included in Final Form Significance Joint of Coefficient Significancea Sum 0.000 0.000 0.000
0.001 0.085 0.002
0.057 0.000 0.001 0.005 0.001
0.268 0.000 0.001 0.083 0.204
Variables Excluded from Final Form Joint Significanceb
0.168
0.858 0.251 0.825 0.002 0.025 0.093 0.000
0.608 0.014 0.093 0.015
0.001 0.095 0.002
0.543 0.095 0.046
0.911
0.827 0.531 0.421 0.402 0.000
aNumber of included lags are stated in Table 1. bNumber of included lags equals four.
Saudi money growth appears to be largely an outgrowth of oil policy, although it also responds to accommodate Saudi inflation. The magnitude of the latter effect appears small relative to the impact of oil policy. The relative importance of oil policy in influencing Saudi money growth is best demonstrated by the variance decompositions. After 16 quarters, approximately 44% of the variance in money growth is due to innovations in oil policy (including both PO and TR). Thus, it appears that oil policy determines monetary policy. The oil price and export equations imply that Saudi oil policy is influenced by both Saudi and world inflation. Saudi inflation directly alters export revenues, while world inflation directly influences both oil prices and export revenues. In addition, the hypothesized zero restrictions on the money variable cannot be rejected. Higher world inflation prompts higher oil prices as well as higher export revenues (based on the impulse response functions). Given repeated Saudi statements that oil price increases have been prompted in part by world inflation, these last results should not be surprising. The variance decompositions also indicate that world inflation has a substantial impact on both oil prices and exports. In addition, the variance decompositions make clear that oil prices are determined primarily by their own past (and world inflation), and are the closest thing to an exogenous variable in the Saudi economy.
A VAR Model of the Saudi Arabian Economy
87
T a b l e 3. Variance Decomposition
Percent ofvariance in POdue to innovationsin: After qua~ers: 1 4 8 16 Percent ofvariance in TR due to innovationsin: 1 4 8 16 Percent ofvariance in Mdue to innovationsin: 1 4 8 16 Percent ofvariance in P due to innovationsin:
W
PO
TR
M
P
6 16 17 17
94 81 80 80
0 3 3 3
0 0 0 0
0 0 0 0
W
PO
TR
M
P
13 28 26 26
34 35 37 38
52 35 32 31
0 0 2 2
0 1 3 4
W
PO
TR
M
P
0 1 2 3
0 4 20 33
11 16 14 11
89 71 48 36
0 11 17 17
1
W 2
PO 8
TR 0
M 2
4 8 20
7 7 7
11 37 40
4 5 5
22 13 12
P
89 56 39 36
Oil prices and export revenues a p p e a r as significant i n d e p e n d e n t variables in the equations for each other, with oil prices impacting revenues m o r e strongly than the reverse. T h e impulse response functions and variance decompositions confirm that the link f r o m oil prices to exports is stronger than the reverse. (Reversing the order o f P O and T R in the variance decompositions makes the weighting less overwhelming than suggested in Table 3.) This finding should not be unexpected. O P E C policy makers generally c h a n g e d oil prices and allowed o u t p u t and exports to be d e t e r m i n e d by market d e m a n d . T h e relationship between oil prices and oil exporters also is consistent with the a p p a r e n t official thrust o f Saudi oil policy since the initial large price increase of 1973. Saudi oil policy has acted as a countercyclical stabilizer in the global oil market. This policy led t h e m to increase production and exports when oil prices were rising in 1979 and 1980, and to lower p r o d u c t i o n and exports when oil prices were falling or w e a k in 1977 and 1978 and again in 1984 and 1985. (This result may be due to the Saudi's upward sloping marginal cost curve for oil.) Given the small size of the Saudi e c o n o m y relative to the rest of the world, we hypothesize that world inflation should not be influenced by any Saudi variable except oil prices. While the estimated e q u a t i o n and specification tests indicate that the zero restrictions on a21, a24 , and a25 cannot be rejected, they also suggest that oil prices have had no effect. 18 A positive c o n t e m p o r a n e o u s correlation between Saudi oil prices and world inflation, however, indicates a link between the two series. It appears m o r e plausible to argue that oil prices influence world inflation
18We do not claim that the world inflation equation accurately describes the world inflation process from a world perspective. We contend only that from the Saudi perspective, it is a reasonable approximation of their influence on world inflation. In a more realistic equation for world inflation, including world money growth, lagged off prices could have significant coefficients. Evidence for such a result has been found by Ahmed et al. (1988, 1989).
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J.B. Rosser, Jr. and R. G. Sheehan contemporaneously--within one quarter--rather than the reverse. Oil price-setters in one quarter have little information about world inflation in that quarter. It OPEC sets oil prices and those prices are known immediately, the contemporaneous relationship suggests that oil prices influence world inflation. Ordering oil prices before world inflation implies that approximately 15% of the variance in I~ is due to innovations in PO. This finding is consistent with a "global inflationar5 feedback mechanism." Oil price increases have led to worldwide inflation, which iv turn has led to further oil price increases. Money growth is insignificant in all estimated equations. There are at least two possible explanations of this result. First, as discussed above, monetary policy is ar outgrowth of oil policy and may have no independent impact. Any impact ol monetary policy is anticipated at the time oil policy is undertaken. Alternately monetary policy may be insignificant due to the prohibition of interest payment,, and the embryonic nature of Saudi financial markets. We should emphasize thai these results refer to the pre-1986 period. Since then, we have seen a greatel increase in the use of open market operations by the Saudi monetary authorities Thus, there now may be a more independent monetary policy since the oil revenu~ decline of 1986 greatly increased the size of the fiscal budget deficit.
V. Conclusions We have estimated and simulated a VAR model of the Saudi Arabian economy fo the period 1973-1985, the heyday of OPEC dominance of world oil prices and o Sadi Arabia's dominance of OPEC. Our results strongly support our twin hypothe ses that Saudi oil policy, driven by internal factors, influenced world inflation, an~ that in turn the open Saudi economy was significantly influenced by world inflatioJ as well by its own oil policy, these relations changed after the Saudi-induced 198~ oil price decline, when budget deficits appeared and the exchange rate was allowe~ to vary more readily. These results indicate that a small open economy with a fixed exchange rat, dependent on a single export commodity will have difficulty conducting an indepen dent monetary policy. Its monetary policy may be endogenous to the revenue generated by those exports. If it is in the rare position of being able to influenc the price of that export commodity, then internal conditions will influence tha price-setting policy. In the even rarer case where the price of that export commoc ity powerfully impacts the world economy, then a mutual feedback system ma become established between the world economy and the domestic econom~ operating through the nation's export commodity pric~-setting policy. Clearly, the results presented here for Saudi Arabia need not generalize t other small open economies. However, they do carry two simple but stron implications. First, other small open economies likely have different causal flo,~ than large economies. And second, a complete analysis of those economic: institutional details is a prerequisite for understanding, for example, how monc and inflation are related or how policy is conducted. Our thanks to two anonymousreferees for valuable commentson an earlier draft, and to Pat Smith ar Annetta Homer of the U.S. Energy Information Administrationand Taylor Kelsh of ARAMCO fi providingus with data. We alone are responm'blefor any errors.
A VAR Model of the Saudi Arabian Economy
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