The impact of oil price on inflation the case of vietnam

UNIVERSITY OF ECONOMICS

INSTITUTE OF SOCIAL STUDIES

HO CHI MINH CITY

THE HAGUE

VIETNAM

THE NETHERLANDS

VIETNAM - NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE IMPACT OF OIL PRICE ON INFLATION
THE CASE OF VIET NAM
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

TRUONG NGO TRONG NGHIA

Academic Supervisor:

DR. NGUYEN VAN NGAI

HO CHI MINH CITY, NOVEMBER 2012

Acknowledgement
Over two years not so long but it is one of the most interesting periods of my life
with many impressive memories. I would like to take this opportunity to express my
deep gratitude to the Vietnam-Netherlands Master Program for Economics of
Development for organizing many helpful and exciting curriculums.
For the completion of this thesis, I have indebted to many people who have given
me their continued support, advice and guidance.
First of all, I would like to express my sincere gratitude to my supervisor Dr.
Nguyen Van Ngai who gave me valuable guidelines, comments, suggestions, and
inspiration for the successful completion of this study. Besides, his friendly and
thoughtful instructions have given me a great deal of encouragements to overcome
difficulties in the whole research process.
I am also thankful to Dr. Nguyen Trong Hoai, Dr. Nguyen Hoang Nam, Dr. Tu Van
Binh, MBA Ly Thi Minh Chau, Tutor-Mr. Phung Thanh Binh and all lecturers and
program administrators in the Vietnam – The Netherlands Program for M.A. in
Development Economics. They gave me advanced knowledge and help me kindly
during the course.
I would like to express my heartfelt thank to all my classmates in MDE15, MDE16,
especially Tran Tuyet Hanh, Tran Van Long, Le Trong Binh, Vo Thi Ngoc Trinh,
Le Anh Khang, Nguyen Van Dung, Nguyen Xuan Phap, Nguyen Le Thao Nguyen
and other classmates for their continuous support and encouragement.
Last but not least, I would like to express my deepest thanks to my parents, my
brother, my close friends who have always given the most favorable environment
and kept encouraging me that made me feel more confident during my study.

ii


Certification
“I certify that the content in this thesis has not already been submitted for any

degree and has not submitted for any other degree until now.
I certify that this thesis is done from the best of my knowledge. All the aids that I
received during the time in preparing the thesis as same as all sources used have
been acknowledged in my thesis.”

Signature

Truong Ngo Trong Nghia
Date:

iii

/

/ 2012


Abstract
A steep upward trend in the price of crude oil in recent years, reaching a spike
record in middle of 2008, has led to increasing concern about its impacts on
macroeconomic, both abroad and in Vietnam. In this study, using the vector auto
regression approach (VAR) with monthly dataset from 2001M1 to 2010M10, I
attempt to empirically investigate the dynamic effects of oil price and Vietnam
macroeconomics. Focusing on the reduced-form of causal relationships between
world oil price (expressed in Vietnamese price) and macroeconomic variables, I
have used both linear and non linear form of oil prices to get the results of their
impact on price level and output. In empirical analysis, I find consistent evidence
that oil price shocks have a significant effect on output and price level in short term.
In detail, my research finds a weak and positive statistically significant association
between oil price shocks and price level. The output is more highly sensitive and I

find an empirical evidence about the negative impact of oil price shocks on
economic growth although it’s not straight forward. I also assert the existence of
asymmetric impact of oil price proxies’ changes on economic growth rate.

Key words: inflation, GDP, oil price shock, VAR models, Cointegration, Granger
causality, Phillips curve

iv


TABLE OF CONTENTS
Acknowledgement ......................................................................................................... ii
List of Tables ................................................................................................................. 4
List of Figures ............................................................................................................... 5
List of Acronyms ........................................................................................................... 6
Chapter 1: Introduction ................................................................................................ 7
1.1 Problem statement .................................................................................................. 7
1.2 Research Objectives ............................................................................................... 8
1.3 Research Questions ................................................................................................ 8
1.4 Scope and methodology of the Study .................................................................... 9
1.5 Thesis structure .................................................................................................... 10
Chapter 2: Literature Review .................................................................................... 11
2.1 Review oil shocks in history ................................................................................ 11
2.1.1 Suez Crisis in period 1956-1957 ....................................................................... 14
2.1.2 OPEC Embargo in 1973-1974: ......................................................................... 14
2.1.3 Iranian revolution and oil price fluctuation in 1979 ......................................... 15
2.1.4 Iran-Iraq War in 1980-1981 .............................................................................. 15
2.1.5 The great price collapse in 1981-1986 .............................................................. 15
2.1.6 First Persian Gulf War in 1990-1991 ................................................................ 16
2.1.7 The downtrend of oil price in 2001 ................................................................... 16

2.1.8 Growing demand and stagnant supply ............................................................. 17
2.2 How higher oil prices affect the economy ........................................................... 18
2.2.1. Why oil shock seems to be the big economic headache ................................... 18
1


2.2.2 The scenario of oil price and inflation in Vietnam ............................................ 21
2.3 Review price level and inflation theories ............................................................. 22
2.4 The transmission mechanism of oil price shocks ................................................. 25
2.5 Approaches to estimate oil impact on macro economy variables ........................ 30
2.6 Empirical studies about the oil price-macroeconomic relationship ..................... 32
2.7 Conceptual Framework ......................................................................................... 44
Chapter 3: Model Specification and Data .................................................................. 45
3.1 Analytical Framework .......................................................................................... 45
3.2 Model Specifications ............................................................................................ 46
3.3 Steps of Estimation .............................................................................................. 50
3.3.1 Descriptive statistics.......................................................................................... 50
3.3.2 Unit root testing ................................................................................................. 50
3.3.3 Granger Causality Test ...................................................................................... 51
3.3.4 Impulse response functions ............................................................................... 53
3.3.5 Variance decomposition .................................................................................... 53
3.4 Data Sources ......................................................................................................... 53
Chapter 4: The impact of oil price on inflation-the case of Vietnam ........................ 56
4.1 Descriptive Statistics ............................................................................................ 56
4.2 Unit Root Test ...................................................................................................... 57
4.3 Var Granger Causality Test .................................................................................. 58
4.4 Impulse Responses and Variance Decompositions .............................................. 61
4.5 Asymmetric Impacts ............................................................................................ 65
4.6 Result comparisons .............................................................................................. 70
2

Chapter 5: Conclusion and Policy Implication .......................................................... 73
5.1 Conclusions ........................................................................................................... 73
5.2 Policy Implication ................................................................................................. 75
5.3 Limitation and Further Studies.............................................................................. 78
5.3.1 Limitation ........................................................................................................... 78
5.3.2 Further Studies ................................................................................................... 79
References ................................................................................................................... 81
Appendix ..................................................................................................................... 88

3


List of Tables
Table 2.1: Summary results of empirical studies ........................................................ 40
Table 3.1 The definition of variables in the model ..................................................... 55
Table 4.1: Description statistic of key variables ......................................................... 56
Table 4.2: Augment Dickey-Fuller test ....................................................................... 57
Table 4.3: Philips-Perron test ...................................................................................... 58
Table 4.4: Optimal lag length...................................................................................... 59
Table 4.5: VAR Granger- CausalityTest ..................................................................... 60
Table 4.6: Variance Decompositions for Var Model .................................................. 62
Table 4.7: Granger causality test of proxies of oil price shocks ................................. 65
Table 4.8: Accumulated Response of PC_IP_SA to non-linear oil price shocks ....... 68

4


List of Figures

Figure 2.1: Price of oil in 2009 dollars, 1973:M1-2010:M10. Price of West Texas
Intermediate deflated by CPI (Hamilton, 2011). ......................................................... 12
Figure 2.2: The natural logarithm of the real price of oil, 1861-2009, in 2009 U.S.
dollars .......................................................................................................................... 12
Figure 2.3: When oil prices head up, the US turns grey: the oil market and US
recessions .................................................................................................................... 18
Figure 2.4: Illustration of oil price and macroeconomic variables in level ................ 21
Figure 2.5: Factor contributions of price level ............................................................ 23
Figure 2.6: Cost-push inflation in the AS-AD model ................................................. 24
Figure 2.7: Demand-pull inflation in the AS-AD model ............................................ 25
Figure 2.8: Two round effects of oil price increases ................................................... 26
Figure 2.9: Mix transmission channels of oil price shocks ......................................... 27
Figure 2.10: Conceptual framework ........................................................................... 44
Figure 4.1: The relationships of variables ................................................................... 60
Figure 4.2: The impulse response functions for basic model ..................................... 62
Figure 4.3: The variance decompositions of variables ............................................... 64
Figure 4.4: The impulse response functions of output to negative oil price changes . 66
Figure 4.5: The impulse response functions of price level to net oil price increase ... 69

5


List of Acronyms
AIC: Akaike Information Criterion
AR: Autoregressive
ARCH: Autoregressive Conditional Heteroskedasticity
CPI: Consumer Price Index
GARCH: Generalized Autoregressive Conditional Heteroskedasticity
INF: Inflation
OLS: Ordinary least squares

OPEC: Organization of Petroleum Exporting Countries
PPI: Producer Price Index
SBV: State Bank of Vietnam
SC: Schwartz criterion
UK: the United Kingdom
US: the United States of America
VAR: Vector Auto Regressive
WTI: West Texas Intermediate

6


Chapter 1: Introduction
1.1

Problem statement
Most of nations, oil industry plays critical roles for the development in

economic, industrial, and social activities. In fact, oil price volatility not only brings a
negative effect on the GDP growth for country because of increasing of input costs,
but also influences foreign exchange markets, generates higher interest rate, leads to
monetary and financial instability, and last but not least produces inflation.
In recent years, although Vietnam is to start a crude oil exporter but we still
import a large amount of petrol. The volatile oil prices and oil shocks potentially
cause vulnerability of the economy Vietnam. The story of inflation is going on and
will certainly create bad impacts. Inflation was rather low from 1996 to 2006. But
after 2006, high inflation returned to Vietnam’s economy with two-digit rate. At the
early beginning of the year 2011, Viet Nam has to face with the very high pressure of
inflation. On 24 February, 2011, the Viet Nam’s Government has to issue the 11 The
Resolution of "package solution" to control inflation, stabilize macro-economy,

ensuring social security.
Because of the inflation in Viet Nam is so hot up to now. This study tries to
make the researches on two aspects as follows:
First, most of the empirical studies focused primarily on the relationship
between oil price and macroeconomics in the economy of the developed countries
such as US or OECD countries (e.g. Brown et at, 1995, 1999, 2004; Cunado and
Gracia, 2003; Darrat and Otis, 1996; Hamilton, 1983, 1996, 1999, 2000, 2009, 2011;
Hooker, 1996, 1999; Jimenez and Sanchez, 2004, 2005; Katsuya, 2008; Lee et al,
2002; Mork, 1989, 1994; Mory, 1993; Nagy, 2000; Webber, 2006…). Although some
researches of developing countries in Africa (e.g. Aliyu, 2009; Chhiber & Shafik,
1990; Farrell, 2001; Kiptui, 2009; Nkomo, 2006) could be identified, just few studies
of Asian developing countries with relatively high inflation rates could be found. In

7


the Vietnamese context, very few studies have been done. Therefore, more empirical
researches are needed in the context of Vietnamese economy.
Second, this study is informative and useful for authorities through some
evidences. One important is the Granger causality between macroeconomic variables
and oil prices in the short term. In addition, the evidence of asymmetrical relationship
between the oil price changes–inflation rate and in oil price changes–economic growth
rate will be presented. All these evidences above pass through some results of impulse
response and affective decomposition in Vietnam. They will have reliable economical
basis to propose and implement policies in order to alleviate significantly negative
impact of oil shocks as same as to develop the economy less dependently on
petroleum.

1.2 Research Objectives
With the respect to the period of 2001-2010, this study aims mainly the impact

of oil price on inflation in Vietnam. Following the main objectives for the case of
Vietnam, the study is attempted:
-

To analyze the effect of oil prices on macro economies, especially the
price level and output.

-

To find out the evidence of asymmetries when oil price is in trend of
increasing and in trend of decreasing throughout examining the
relationship between proxies of oil price changes and inflation rates and
proxies of oil price changes and economic growth rate.

-

To suggest policies to stabilize macroeconomic.

1.3 Research Questions
In order to meet these objectives, the thesis will attempt to answer the following
questions:
Main question:
-

What are the impacts of oil price and its proxies on the macro economy
in the context of Vietnam over the period of 2001-2010?
8


Sub-questions:

-

Which are the directions of the causality relationships among oil price,
price level and output?

-

How are the impacts of oil price on the macroeconomics?

-

Are there any different impacts of proxies of oil price on inflation rate
and economic growth rate of Vietnam when oil price is in trend of
increasing and in trend of decreasing?

-

What policies should be implied to mitigate the bad impacts of oil price
and to develop Vietnam macro economy more sustainably?

1.4 Scope and methodology of the sstudy
This study applies both qualitative and quantitative method. The first one will
be concerned later on a little bit in section 2.2.2. The second one will be concerned
mainly in section 2.6 and others next.
The quantitative method will apply the econometric techniques related to
Vector Auto-regression (VAR) model with monthly time series dataset from 2001M1
to 2010M10, with the following macro indicators: world oil price, consumer price
index, industrial production, money supply and exchange rate, taken from IMF’s
International Finance Statistic (IFS), IMF’s Direction of Trade (DOT) and Vietnam
General Statistic Office (GSO).

To carry out above objectives, I will apply the descriptive statistic and the
econometric techniques. In this study, the overview of all variables will be shown out
by the descriptive statistic as the first step. It is the full collection of max-min-mean
values, variation of all original and transformed data. Thus, we have an overview and
an evaluation about the used data quality.
With regarding to the analyzing time series data, the econometric techniques
related to vector auto regression (VAR) model will be employed to answer key
questions. Firstly, unit root test is used to examine for stationary of all variables by the
validation of t-test and F-test. Secondly, optimal lag lengths for VAR model are
chosen by different criteria to have the best model. VAR Granger causality test will
help us answer the first sub question whether the effect of oil price to inflation and
9


output of economy. Then, impulse responses and variance decompositions are two
popular techniques of VAR model to answer next sub questions. Next, asymmetric
testing procedures with some proxies of oil price are used to explore the last sub
question. Collecting from those empirical results, we can conclude the role of oil price
in the context of Vietnam and propose the appropriate policies for Vietnam’s
economy.

1.5 Thesis structure
The thesis is organized in four chapters. Chapter 1 is introduction. Chapter 2
covers literature review and empirical studies. Chapter 3 presents the research
methodology. Chapter 4 reports the findings and discussion. Chapter 5 presents the
conclusion, suggests some practical policy implications, and discusses the limitation
and direction for further studies.

10

Chapter 2: Literature Review
This chapter concerns about the overview of oil shocks in history, the serious impacts
of high oil prices on world economics, the scenario of oil price and inflation in
Vietnam. It also includes the review inflation theories, the transmission mechanism of
oil price shocks, the approaches to estimate oil price impacts and summary results of
empirical studies about the oil price-macroeconomic relationship.

2.1 Review oil shocks in history
Definition of oil shock
One of the clearest definitions of an “oil shock”, Wakeford (2006, p2) stated
that: “Oil shocks are usually defined in terms of price fluctuations, but these may in
turn emanate from changes in either the supply of or the demand for oil. In practice it
is unlikely for demand to grow rapidly enough to cause a price shock unless it is
motivated by fears of supply shortages. Historically, as is indicated in the following
section, the supply side has been primarily responsible for observed oil price shocks,
at least as an initial trigger”.
At least, there are two important attributes of a price shock. The first one is the
amplitude of the price increase which can be measured in absolute values or in
percentage changes. The second is one of timing including the speed and durable spell
of oil price increases. In which, three cases can happen: (1) A sharp and sustaining
price increase that can be called a “break” (e.g. occurring within a few quarters); (2) A
rapid and temporary price increase that is called a “spike”; and (3) a slowly sustaining
rise can be called a “trend”. The speed of an oil shock can harm directly economies
because it affects the ability of economies to adjust by them while able adjustments
are typically restricted in the short run. The durability of oil price increasing impacts
obviously the overall performance of many economies and extent of the
consequences.
According to Nkomo (2006: 10), vulnerable level of a particular oil-importing
country to oil shocks depends on some dimensions of the economy: the dependence

on oil importing activity or the oil consumption imported in percentage of the whole
11


world; the dependence on oil resource or the proportion of oil use over the total
energy use; and the intensity of energy or the spending energy cost in percentage of
the real gross domestic product’s value. Furthermore, the developed countries could
be less vulnerable than the developing countries during the period times of oil price
shock affects; especially industrial mine and production industrialization are
considered as the important sectors being get serious impacts.

Figure 2.1: Price of oil in 2009 dollars, 1973:M1-2010:M10

Price of West Texas Intermediate deflated by CPI (Hamilton, 2011).
Measure price of oil
As the figure 2.1 showed out, many oil shocks had at least a doubling of the oil
price within a year or two. And in history, there were three eras in the determination
of international crude oil prices (Nkomo, 2006). Global oil companies determined
mainly oil prices until the 1970s. Since then the Organization of Petroleum Exporting
Countries (OPEC) set the price via its output decisions based on its influence power
and its oil export capacity. Since the late 1980s, world oil prices were set by a market12


related pricing system which linked oil prices to the ‘market price’ of a particular
reference crude (Farrell et al., 2001: 69). Now, two important reference prices, Brent
and West Texas Intermediate (WTI) are determined on the London and New York
futures exchanges, respectively.
Figure 2.2: The natural logarithm of the real price of oil, 1861-2009, in 2009 U.S.
dollars.

Data source: Statistical Review of World Energy 2010, BP; Jenkins (1985,
Table 18); and Historical Statistics of the United States.

Key oil shocks
According to Hamilton (2011), key post-World-War-II oil shocks reviews
include the Suez Crisis of 1956-57, the OPEC oil embargo of 1973-1974, the Iranian
revolution of 1978-1979, the Iran-Iraq War initiated in 1980, the first Persian Gulf
War in 1990-91, and the oil price spike of 2007-2008. Each of the major postwar oil
shocks since 1973 which is closely connected with political conflict and economic
downturns that followed.

13


2.1.1 Suez Crisis in period 1956-1957
The crisis begun from Egyptian President Nasser nationalized the Suez Canal
in July of 1956. Hoping to regain the power of canal controlling, France and Britain
encouraged Israel to invade Egypt’s Sinai territories on October 29, and in short time
later they succeeded by their own military forces. During the war, 40 ships were sunk
and blocked around the canal. In order to get through, 1-1/2 million barrels of oil were
transported per day. They established the pumping stations for the Iraq Petroleum
Company’s pipeline. Through these stations, an additional half-million barrels moved
per day to Syria arriving to ports in the eastern Mediterranean. They were also
sabotaged. That occupied 10.1% of total world output by that time. It is a bigger
fraction of world production that would be seed of the subsequent oil shocks. That
case would be experienced study in the following decades. .
And overall U.S. exportations of goods and services started to fall after the first
quarter of 1957. That is proven to be an 18% decline over the next year (Hamilton,
2011).

2.1.2 OPEC Embargo in 1973-1974:
An attack on Israel was led by Egypt and Syria beginning on October 6, 1973.
On October 17, some members of the OPEC, the Arab members announced an
embargo on oil exportation. They punished all countries viewed as supporting Israel
that were followed the significant cutbacks in OPEC’s total oil production. In
November the capacity of production from Arab members of OPEC was down 4.4
mb/d compared with what it was in September, a shortfall corresponding to 7.5% of
global supply side. The consequences later, on January 1974 the Persian Gulf
countries doubled the price of oil.
Frech and Lee (1987) estimated that the time was spent for waiting in queues to
buy gasoline added more 12% to the cost of gasoline in December 1973 and 50% in
March 1974 in USA urban. The problem was evaluated to be more severe in rural
areas, with respectively estimated costs of 24% and 84%.

14


2.1.3 Iranian revolution and oil price fluctuation in 1979
The beginning of a turbulent decade in the Middle East was remarked by the
Arab-Israeli War in 1973. In defiance of the Arab states, Iran increased the oil
production bypass the 1973-74 embargoes. At the beginning of 1978, Iran exported
5.4 millions of crude oil barrels per day which were up more than 17 percent of
OPEC. But that met a public resistance in 1978, strikes spread out on the oil sector
through the fall of 1978. It caused the oil production of Iran downed by 4.8 mb/d (or
7% of world production at the time) from October 1978 to January 1979.
Frech and Lee (1987) estimated that the opportunity cost of waste time queuing
added about a third to the cost when Americans bought gasoline on May of 1979.
During 12 months, gasoline queues were again a hot phenomenon and price of oil
barrel increased from $15.85 to $39.5. That was the premise of crisis lasting 30 month
in U.S.A. In 1980, the increasing of oil price hiked the inflation rate to get peak 13.5

percent.

2.1.4 Iran-Iraq War in 1980-1981
In 1979, Iranian production recovered to about half of its pre-revolutionary
levels. But it was reduced again when Iraq launched a war against Iran in September
of 1980. The total lost of production from both countries amounted to about 6% of
world production at that time within a few months.
This shortage in supply side caused the real price of oil was double during the
period 1978-1981. In the contrary, during that period there was a negative reaction in
demand side in which fuel demands decreased 13 percent on some main oil
consumption markets such as U.S.A, Japan, and Europe.

2.1.5 The great price collapse in 1981-1986
The consequences of oil crises in 1973 and in 1979 were the reasons that the
economic growth of the industrial countries, oil demands all over the world slowed
down from 1981 to 1986.

15


This really caused oil price strongly felt from $35 in 1981 to lower than $10 in
1986. While this event was a motivation for development on the demand side of oil
consumers, vice versa this delegated an “oil shock” for the producers.

2.1.6 First Persian Gulf War in 1990-1991
By 1990, Iraqi production recovered its levels of the late 1970s. Due to this
country invaded Kuwait on August 1990, its production collapsed again and it parallel
induced Kuwait’s substantial production down. At that time, both countries accounted
for nearly 9% of world production. Then, the oil exporting embargo with Iraq and
Kuwait was enforced by United Nations Organization. It rejected 5 million barrels per

day out of the market and pushed the oil price increase. Despite oil price did not
exceed the peak of 1979 and 1979-1980 crises, as fever it lasted within nine months.
External expression during 2 months, the price of each barrel doubled from $17 to $36
per barrel.
This crisis may be the reason that led the USA recession to the collapse of
financial market. Other powerful countries also were rolled in recession because they
had to suffer indirect influence such as Japan, Australia, England and Canada.

2.1.7 The downtrend of oil price in 2001
In the summer of 1997, Asian crisis started with Thailand, South Korea, and
other countries. Like a domino effect, it spread out their currency with serious stresses
to the financial system. At the end of 1998, the dollar oil price followed the crisis
falling below $12 a barrel. In 1999, the world petroleum consumption restored to
strong growth. But after 2000, the world economy declined. Especially after the event
of September 11th terrorism, the oil price trended to decrease more. A broader global
economic downturn happened and the tenth postwar U.S. recession began in March of
2001. In 2001, due to the decreasing of consumption rate contributed to oil price fall,
the price was only $20 per barrel.

16


2.1.8 Growing demand and stagnant supply
Global economic growth in 2004 and 2005 was quite impressive, with the IMF
estimating that real gross world product grew at an average annual rate of 4.7%
(Hamilton, 2009b). Over this period, world oil consumption grew up 5 mb/d and 3%
per year on average. Even though there was initially enough excess capacity on supply
side to keep production growing along with demands, these strong demand pressures
were the key to make the oil price increase steadily. In recent years, one of the most
important suppliers has been Saudi Arabia. This nation contributed 13% of global

field production in 2005 and kept an active role as the world’s residual supplier during
the 1980s and 1990s. They could decide to increase their production whenever
needed. But in the event, Saudi production was 850,000 barrels a day lower in 2007
than it had been in 2005. However, oil demands continued to grow, along with world
real GDP increasing an additional 5% per year in 2006 and 2007. That was a faster
rate of economic growth in which oil consumption accompanied the 5 mb/d increasing
during 2003 - 2005. Especially, China increased its own consumption by 840,000
barrels a day from 2005 to 2007.
In the short-run, according to Hamilton (2009a), price elasticity of oil demand
has been quite low and may have been even smaller over the last decade (Hughes,
Knittel, and Sperling, 2008). It means a little bit demand increase needs a
compensation of large price increase. With no more oil being produced, a large shift
of the demand curve in case of the increasing limit on supply side led a raise of oil
price from $55 a barrel in 2005 to $142 a barrel in 2008.
On December of 2007, the USA recession began again that was likewise the
worst in postwar experience, but of course the financial crisis rather than any oilrelated disruptions were the leading contributing factor of that downturn.

17


2.2 How higher oil prices affect the economy
2.2.1. Why oil shock seems to be the big economic headache
Why we should worry
In 2008, oil prices reached USD150 per barrel. Shortly afterwards, the global
economy collapsed. Based on HSBC (2011, February), at that time many problems
occurred such as the imploding US housing market, the beginnings of a securitization
crisis, the collapse of Lehman Brothers. Nevertheless events in three years ago, much
evidence were shown that substantial changing oil prices are so hot news for the
global economy.
Figure 2.3 shows the level of oil prices in real terms (adjusted using the US

consumer price index) tracked against US recessions. Seemingly like a cycle,
increases in oil prices of more than 100% lead to declining GDP.

Figure 2.3: When oil prices head up, the US turns grey: the oil market and
US recessions

Source: Thomson Reuters Datastream
As oil prices approach historical record levels, there are some debates to
discuss how is important the impact of oil price changes on the global economy have
been clarified. Quite recently, according to Rasmussen and Roitman (2012, February)two IMF economists found that generally there has been a relationship between oil
price rises and good times in the global economy. They concluded that causing of the
oil price shocks there were lagged negative effects on the output of OECD economies
18


in which a 25% of oil price increase was related with 0.3% of output decline of oil
importing countries for over two years.
With the same topic research, Li (2012) examined the global economic growth
affects in the situation of the oil price changes. He argued that there have been
significant negative impacts of oil price rises on world economic growth. By the
evidence, the analysis of the data from a time-series of 1971 - 2010 showed that there
was a relationship between an increase in real oil price by 10 dollars and a reduction
of world economic growth rate by between 0.4 and 1% in the following year.
So as oil prices approach historical hikes, that the global economy is seriously
vulnerable. Wherever oil prices eventually end up, it is possible to tease out some of
the more important economic effects. There are immediate winners (net oil producers
and exporters) and losers (consumers and importers) despite any given shift in oil
prices. It is not only a straight-forward redistribution of income but also a big problem
occurs.
HSBC Bank emphasized that for global demand, one of the most important

matters is the marginal propensity to spend of oil producing nations relative to oil
consuming nations. In general, that is higher for oil consuming nations than producers
(for example, comparring the balance of payments position of the US with Saudi
Arabia). Therefore, a big increase in oil prices intends to dampen global demand.
Oil prices as a tax
It’s obvious that for net oil consuming nations, higher oil prices have an effect
similar to an extra in indirect taxes. The target to smooth over the effects of higher oil
prices is either to offset by an tax cut on importing price or to subsidize the
downstream of oil products (subsidizes are simply negative taxes). By these ways,
inflationary pressures can be suppressed and real incomes can be conserved for a
while at least.

The second round effects: demand, supply and inflation
19


The confidence of business and consumer can easily be vanished by higher oil
prices because of both the immediate harming real incomes and the uncertainty
generating of future real income (how long do oil prices stay at the higher level or,
worse, will oil prices go up even further?). In this situation, economic activities are
weak for a while or even slow down further; these are called second round effects.
Besides, in theory, a lower level of demand should be sufficient to prevent any
initial raising inflation. But there are two additional worries as the follows:
 If a country’s capital stock was installed on the foundation that the oil
prices would average, for instance, USD80 per barrel in given year but oil
prices got double that year, at least some of the capital stock would be loss
and even be scrapped. By another way, when demand in an economy was
down because of higher oil price, this affected directly supply potential
economy and led to the uncertainties over the amount of spare capacity.
 What happens if nominal wages are increased when rising price level

simply has been pressing down real wages? HSBC Bank gives an argument
that at the moment, this seems that the emerging countries are suffering
from risky more than the developed world. But in reality, there are a plenty
of Western policymakers who are now increasing nervous. Obviously,
interest rate is considered to rise by three members of the Bank of
England’s Monetary Policy Committee (MPC). That is reflecting the
worries about wage growth and rising inflationary expectations.
In history, there were lots of areas of great uncertainty. Following the big event
in 1991 (Iraq invasion of Kuwait), the Bank of Japan prioritized to protect macro
economy from the near-term inflation threat associated with the higher oil prices and
ignore the affect of deflationary forces that made against an appearance of the whole
Japanese economy. In fact, with high interesting rate, the inflation came down.
Although the policy worked but the consequence as we actually known, the longerterm costs were enormous including stagnation, economic underperformance and
deflation.
Experienced from history, in 2005, the interest rate was cut by the Bank of
England’s decision in the light of a low inflation and a beginning steady increase of
20


oil prices. Over the medium term, the interest rates in the Western world are published
nearly at zero with the confidence of controlling inflation ability. But later on, this
confidence was less after the oil price reached a spike in middle of 2008. Finally, the
reason that fears of inflation are back, the interest rate has been considered to be up.

2.2.2 The scenario of oil price and inflation in Vietnam
As we have concerned before, by qualitative method, the overall picture of the
macro economy will be drawn with some variables including consumer price index,
industrial production, oil price, money supply as the following figure 2.4.

Figure 2.4: Illustration of oil price and macroeconomic variables in level

2,500,000
2,000,000
1,500,000
1,000,000
180

500,000

160

0

140
120
100
80
60
01

02

03

04

05

CPI_SA
VOP

06

07

08

09

10

IP_SA
M2

Note: CPI_SA is seasonal adjustment in regard to consumer price index; IP_SA is
seasonal adjustment in regard to industrial production; VOP is world crude oil price
(transformed to Vietnamese oil price); M2 is money supply
Source: by author
It is clear that crude oil price (VOP) was in uptrend year by year with high
variation from 2001 to 2010. VOP was increasing gradually during the period
2001M1-2007M6. It reached 1.1 million VND/barrel in 2007M7. Then it temporarily
21