The Effect of Oil Price Shocks on the Dynamic Relationship between Current Account and Exchange Rate: Evidence from D-8 Countries

The research aims to assess the dynamic relationship between current account and exchange rate and to analyse the effect of oil price changes on their relationship for D-8 countries. The research is based on the time series analysis and covers the time span from 1981-2010. For achieving the objective of the study, recursive Vector Autoregression technique is used. Impulse response function and variance decomposition analysis is also conducted to forecast the results for next ten years. The results revealed that J-curve phenomenon exists in all oil importing countries of the group. Among oil exporting countries, J-curve phenomenon exists for Egypt and Nigeria while for Iran, Marshal Lerner condition holds both in short and long run. The case of Malaysia is opposite to that of Iran where depreciation could not stimulate current account improvement even in long run. After including oil prices in the model, J-curve phenomenon continues to exist in Bangladesh and Turkey, though, it dampens the long run favourable effect of currency depreciation for current account for both of the countries. For Pakistan, in presence of oil prices exchange rate depreciation not only deteriorates current account in short run, this deterioration exacerbates in long run. Current account balance of Indonesia happens to improve with depreciation of exchange rate after inclusion of oil prices both in short and long run. For all oil exporting countries the role of exchange rate for improving current account balance strengthens in long run after the inclusion of oil prices. Given the results it is recommended that oil exporting countries should diversify their exports to overcome the recourse curse problem and oil importing countries should consider Bangladesh as role model to reduce the vulnerability of current account to oil price shocks.