Reinvestigating the Oil Price–Stock Market Nexus: Evidence from Chinese Industry Stock Returns

• Published date: 01 May 2018
• Author: Xinsheng Lu,Paul G. Egan,Sheng Fang
• DOI: http://doi.org/10.1111/cwe.12242
• Date: 01 May 2018

©2018 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 43–62, Vol. 26, No. 3, 2018 43

*Sheng Fang, PhD candidate, School of Economics and Management, Tongji University, China. Email:

fangsheng007@126.com; Xinsheng Lu (corresponding author), Professor, Business School, University of

Jinan, China. Email: normanxlu@tongji.edu.cn; Paul G. Egan, Associate Lecturer, School of Economics

and Finance, University of St. Andrews, UK. Email: pge4@st-andrews.ac.uk. The authors acknowledge the

nancial support of the National Natural Science Foundation of China (No. 71173088).

Reinvestigating the Oil Price–Stock Market Nexus:

Evidence from Chinese Industry Stock Returns

Sheng Fang, Xinsheng Lu, Paul G. Egan*

Abstract

The present study investigates the influence of international oil prices on China’s

stock market returns across 29 different industries. The paper attempts to account for

any structural breaks and nonlinearity in this relationship. The results reveal that the

effect of changes in the international price of oil on stock returns differs substantially

across industries. The stock returns of the coal, chemical, mining and oil industries are

found to be positively affected by crude oil price movements. Conversely, electronics,

food manufacturing, general equipment, pharmaceuticals, retail, rubber and vehicle

industries are found to be negatively affected by movements in the price of crude oil. The

results of the estimations also suggest that the majority of Chinese industries have been

signicantly affected by oil prices since 2004. The inuence of international oil prices on

Chinese stocks also has a stronger effect in the presence of high volatility but the effect

varies across industries.

Key words: China’s stock market, international oil prices, regime switching, structural

break

JEL codes: C58, G12, Q48

I. Introduction

Oil is an important commodity and an essential component of a modern industrial

economy. This is particularly true for China, the largest developing country in the

world. According to China’s General Administration of Customs (GAC), the crude oil

dependency ratio stood at 65.9 percent in 2016. In the rst half of 2017, China imported

an average of 8.55 million barrels per day, replacing the USA as the world’s largest oil

importing nation. Energy analysts predict that this trend will continue as China’s new

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Sheng Fang et al. / 43–62, Vol. 26, No. 3, 2018

©2018 Institute of World Economics and Politics, Chinese Academy of Social Sciences

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urban construction and the Belt and Road Initiatives advance under a new strategy of

economic stimulus planned by policy-makers. Reforms in China’s oil rening industry,

which began in the second half of 1998, have strengthened the link between domestic

and international oil prices. Therefore, it could be argued that the relationship between

international crude oil prices, the Chinese economy and China’s financial markets

is as strong and as important as ever. With this in mind, studying and understanding

the impact of changes in international oil prices on China’s economy is of the utmost

importance, not only for policy-makers in China, but also for prospective investors

globally.

Stock prices are inuenced by changes in the price of oil through the change in the

operating cost of companies and wealth transfer effects (Gogineni, 2010). In addition,

the contagion between the oil and stock market occurs due to the nancial characteristics

of both oil and stock prices. Given these arguments, theoretically speaking, changes

in the price of international crude oil could bring about signicant changes to Chinese

stock returns. However, the mechanism that oil price shocks impose on listed companies

is not uniform across all industries. Higher oil prices can affect one industry negatively

but another positively. Therefore, the impact on stock returns might vary in direction and

degree from industry to industry. A key consideration is whether crude oil is an essential

input for the industry.

We therefore investigate the oil price–stock market relationship in China from 2002

to 2015 from the perspective of different stock industries. This paper has a number of

novel features. First, the impact of oil price changes on industry stock returns is tested

for uniformity across industries through a seemingly unrelated regression (SUR) model.

Second, any nonlinear relationship between the variation in oil prices and China’s stock

returns is accounted for. The sample period is characterized by certain important events

in the Chinese A-share market, such as the split share structure reform in 2005, the 2008

global financial crisis and the recent boom and crash of stock prices in China. These

events, along with others, may have caused the relationship between the crude oil market

and the Chinese stock market to change over time. By accounting for these changes,

it can be determined whether the effect of oil price variations on industry returns has

switched in any signicant way, based, for example, on the degree of volatility.

II. Effect of Oil Prices on Stock Markets

The channel by which oil price changes affect the stock market is complex and

differs depending on firm performance and the strength of the macroeconomy. There

seems to be a consensus that positive shocks to oil prices have negatively depressed

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