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Oil Prices and Currency Movements
Written by: PaxForex analytics dept - Thursday, 10 January 2019 0 comments
The sharp increase in oil prices and oil price volatility over the past decade has coincided with a closer link between oil prices and asset prices, including exchange rates. There is a growing literature analyzing the link between oil prices and currency movements, showing that currency values of commodity exporters contain information about future commodity price movements, while commodity prices also have predictive power for commodity currencies.
When a country’s principal export is oil or a commodity, its currency exchange rate tends to track the global price of that export. When the price rises, so do the exchange rate. The rising global price tends to attract inward investment and resources to the extractive industry, while other export industries struggle due to the high exchange rate – a phenomenon known as “Dutch disease” in which the economy becomes increasingly dependent on its extractive industries. When the prices of oil and commodities fall, the currency exchange rates of exporting countries fall in tandem.
There are several explanations for the inverse relationship between the oil price and the US dollar exchange rate. One of them involves the growing role of investors in commodity markets related to falling financial asset returns in advanced countries. In this case, oil is a recognized investment asset used as a means of diversifying the risk of inflation, the risk of US dollar depreciation or the risk of a stock market decline. Furthermore, a depreciation of the US dollar
or an easing of monetary policy in the US implies an easing of the monetary conditions in countries whose exchange rate is tied to the dollar.
While theory suggests that oil exporters’ currencies should depreciate in the wake of negative oil price shocks (and vice versa for positive shocks), in practice there may be counter-balancing forces. Monetary authorities may dislike large swings in the nominal exchange rate, countering exchange rate pressures through the accumulation or reduction of foreign exchange reserves and the international risk-sharing channel may provide an automatic stabilizer through currency exposure. Given that oil exporters have accumulated a large pool of foreign exchange reserves and tend to be ‘net long’ in foreign currency.
Falling oil prices can have an adverse impact on countries whose currencies rely on energy exports to fuel economic growth and development. Currencies with the highest correlation between oil prices and the value of the nation's money are traditionally known as petrocurrencies. Additional exporting countries whose currencies have a strong link to oil prices include Saudi Arabia, Iran, Iraq, Nigeria, and Venezuela. Should oil prices rise in the coming months, these currencies would likely appreciate against the dollar and the currencies of nations that are net importers of energy commodities.