Does the PPP condition hold for oil‐exporting countries? A quantile cointegration regression approach

• Date: 01 April 2018
• Published date: 01 April 2018
• DOI: http://doi.org/10.1002/ijfe.1603
• Author: Jose Olmo,Matthew Lyon

Received: 8 October 2017 Accepted: 12 December 2017

DOI: 10.1002/ijfe.1603

RESEARCH ARTICLE

Does the PPP condition hold for oil-exporting countries? A

quantile cointegration regression approach

Matthew Lyon Jose Olmo

Department of Economics, University of

Southampton, Highfield Lane,

Southampton SO17 1BH, UK

Correspondence

Jose Olmo, Department of Economics,

University of Southampton, Highfield

Lane, Southampton SO17 1BH, UK.

Email: J.B.Olmo@soton.ac.uk

JEL Classification: C22; F31; G1

Abstract

This paper examines the legitimacy of the Purchasing Power Parity condition

applied to the quantile process for 12 oil-exporting countries: Algeria, Angola,

Canada, Colombia, Indonesia, Iran, Kazakhstan, Kuwait, Mexico, Nigeria,

Norway,and Russia. The application of quantile unit root inference methods to

test the specification of the PPP condition in the quantile process yields limited

support to the equilibrium condition. However,the application of quantile coin-

tegration methods that estimate the equilibrium relationship between national

prices and the nominal exchange rate is much more supportive of a generalized

PPP condition that varies across countries and quantiles. Our empirical findings

suggest that the distribution of the nominal exchange rate reflects a nonlinear

equilibrium relationship between national prices that varies widely between the

central and tail quantiles and is country-specific.

KEYWORDS

oil-exporting countries, purchasing power parity, quantile cointegration, quantile unit root test

1INTRODUCTION

The PPP theory states that in the long run, the exchange

rate between two countries is determined by their rela-

tive price levels. For the majority of oil-exporting coun-

tries, oil makes up a large proportion of their merchan-

dize exports, in some cases, countries become specialized

to the point of only exporting one commodity, oil. For

example, fuel exports account for over 90% of all exports

for four of the countries analysed in our study.1Asa conse -

quence, oil is the main determinant of the economic con-

ditions in these countries; especially the price level and the

exchange rate.

In countries with economic activities so heavily linked

to oil, fluctuations in oil prices impact the exchange rate

through many different channels. For example, changes

in inflation potentially lead to systematic deviations from

PPP in the long run, if countermeasures are not imple-

mented. This link has been well established in the

literature, see inter alios, Amano and Van Norden (1998)

and Coudert, Mignon, and Penot (2008). The main chan-

nel through which the price of oil may influence the

exchange rate of an oil-exporting country being the terms

of trade channel. Backus and Crucini (2000) show that

most of the variation in terms of trade can be attributed

to the variation in oil prices. These impacts are exacer-

bated by the unique volatility historically exhibited by oil

prices. Dehn (2000) finds oil to be twice as volatile as

other traded commodities. Moreover,Agenor, McDermott,

and Prasad (2000) find this volatility impacts oil-exporting

countries more than oil-importing countries. Finally,

Mendoza (1995) highlights that trade shocks have more

impact in countries that only export a few commodities,

such as oil-exporting countries.

As a result, oil-exporting countries exhibit a number of

economic characteristics that may invalidate PPP. First,

large nominal exchange rate volatility is likely to lead

to deviations from PPP. This is empirically supported by

Int J Fin Econ. 2018;23:79–93. wileyonlinelibrary.com/journal/ijfe Copyright © 2018 John Wiley & Sons, Ltd. 79