UNIVERSITI MALAYSIA SABAH

BORANG PENGESAHAN STATUS TESIS a

JUDUL: DOMESTIC MACROECONOMIC ADJUSTMENT TO OIL PRICE SHOCKS

UNDER DIFFERENT EXCHANGE RATE REGIMES IN MALAYSIA.

DAZAH: SARJANA EKONOMI (EKONOMI KEWANGAN)

SESI PENGAJIAN: 2005-2007

Saya, CHONG HUI ING mengaku membenarkan tesis Sarjana ini disimpan di Perpustakaan Universiti Malaysia Sabah dengan syarat-syarat kegunaan seperti berikut:

1. Tesis adalah hakmilik Universiti Malaysia Sabah. 2. Perpustakaan Universiti Malaysia Sabah dibenarkan membuat salinan untuk

tujuan pengajian saya. 3. Perpustakaan dibenarkan membuat salinan tesis ini sebagai bahan pertukaran

antara institusi pengajian tinggi. 4. TIDAK TERHAD.

(Penulis: CHONG HUI ING)

Alamat: Peti surat 1249, 91037 Tawau, Sabah.

Tarikh: 15 August 2007

Disahkan oleh

(TANDATANGAN PUSTAKAWAN)

(Penyelia: Dr. Fumitaka Furuoka)

Tarikh: -----

Catatan: a Tesis dimaksudkan sebagai tesis Ijazah Doktor Falsafah dan Sarjana secara penyelidikan atau disertassi bagi pengajian secara kerja kursus dan penyelidikan, atau laporan Projek Sarjana Muda (LPSM).

DOMESTIC MACROECONOMIC ADJUSTME.NT TO OIL PRICE SHOCKS UNDER DIFFERENT

EXCHANGE RATE REGIMES . IN MALAYSIA.

CHONG HUI ING

PERPJSTAKAA .. J UNIVERSITI MALA YS1.1\ SI\BAH

A THESIS IS SUBMIlTED IN THE FULFILLMENT OF REQUIREMENT FOR

THE DEGREE OF MASTER OF ECONOMICS

SCHOOL OF BUSINESS AND ECONOMICS UNIVERSITI MALAYSIA SABAH

2007

DECLARATION

The materials in this thesis are original except for quotations, excerpts, summaries and references, which have been duly acknowledged.

(~O~j

CHONG HUI ING PS05-002-073 15 AUGUST 2007

ACKNOWLEDGEMENT

I would like to express my appreciation to my supervisors, Dr. Fumitaka Furuoka and Dr. Wong Hock Tsen, who have made valuable comments and suggestions to improve the thesis substantially. lowe the debt to Madam Sharija Che Shaari for her helps at different stages of the thesis. I would also like to thank the staffs in Perpustakaan Universiti Malaysia Sabah for their helps in collecting information. As always, I am grateful to my family for their support.

ii

ABSTRACT

This thesis examines on the insulation properties of flexible exchange rate regime against fixed exchange rate regime from oil price shocks. A monthly sample 1980-2005 from Malaysia is investigated whether the response of output, exchange rate and price level to oil price shocks are different across exchange rate regimes in the short run by applying Structural Vector Autoregressive model. The oil prices are found to be exogenous to the macroeconomic variables in Malaysia. Results show that the short run output responses to oil price disturbances are smoother under flexible exchange regime than fixed exchange regime. And there is asymmetric response of domestic variables to positive and negative oil price shocks across and within exchange regimes.

iii

ABSTRAK

PENYESUAIAN MAKROEKONOMI DOMESTIK TERHADAP KEJUTAN HARGA MINYAK DI BAWAH SESTEM KADAR PERTUKARAN YANG BERLAINAN

DI MALA YSIA.

Tesis ini mengkaji ciri-ciri penyingkiran sistem kadar pertukaran boleh ubah berbanding dengan sistem kadar pertukaran tetap daripada kejutan harga minyak. Satu sampel bulanan 1980-2005 dari Malaysia dikajikan sama ada tindak balas output, kadar pertukaran dan tingkat harga terhadap kejutan harga minyak adalah berlainan di bawah sistem kadar pertukaran yang berbeza dengan mengaplikasikan model ''Structural Vector Autoregressive'~ Harga minyak didapati eksogen kepada pembolehubah makroekonomi di Malaysia. Keputusan menunjukkan bahawa tindak balas jangka pendek output terhadap kejutan harga minyak adalah lebih licin di bawah sistem pertukaran boleh ubah daripada sistem pertukaran tetap. Ttndak balas asimetri pembolehubah domestik terhadap kejutan harga minyak positif dan negatif wujud antara dan dalam sistem pertukaran.

iv

ADF AIC CFA CFA CPI EIA EMS GARCH GDP GNP IFS IMF Ml M2 NYMEX OECD OLS PPI UNCTAD VAR VARY.. VECM WIT

LIST OF ABBREVIATIONS

Augmented Dickey-Fuller Akaike Information Criteria Cooperation financiere en Afrique centrale (for Central Africa) Communaute financiere d'Afrique (for West Africa) Consumer Price Index Energy Information Administration European Monetary System Generalized Autoregressive Conditional Heteroskedasticity Gross Domestic Product Gross National Product International Financial Statistics International Monetary Fund Monetary Aggregate 1 Monetary Aggregate 2 New York Mercantile Exchange Organization of Economic Co-operation and Development Ordinary Least Square Producer Price Index United Nations Conference on Trade and Development Vector Autoregressive Vector Autoregressive with Exogenous Variables Vector Error Correction Model West Texas Intermediate

v

LIST OF CONTENTS

PAGES

DECLARATION

ACKNOWLEDGEMENT ii

ABSTRACT iii

ABSTRAK iv

LIST OF ABBREVIATIONS v

LIST OF CONTENTS vi

LIST OF FIGURES viii

LIST OF TABLES ix

GLOSSARY x KEYWORDS xi

CHAPTER 1: INTRODUCTION 1 1.1 INTRODUCTION 1 1.2 STATEMENT OF PROBLEM 4 1.3 RESEARCH QUESTIONS 4 1.4 OBJECTIVES OF STUDY 5 1.5 SIGNIFICANCE OF STUDY 5 1.6 SCOPE OF STUDY 6 1.7 ORGANIZATION OF STUDY 7

CHAPTER 2: BACKGROUND OF STUDY 8 2.1 INTRODUCTION 8 2.2 MALAYSIA AS A PRICE TAKER OF CRUDE OIL 8 2.3 IMPACT OF CHANGES OF OIL PRICES ON MALAYSIA 9

2.3.1 CHANGES OF OIL PRICES AND INFLATION RATE 11 2.3.2 CHANGES OF OIL PRICES AND OUTPUT GROWTH 11

2.4 RESPONSES OF ECONOMIC POUCIES TO THE 14 INCREASE OF OIL PRICES

2.5 DEVELOPMENT OF EXCHANGE RATE REGIMES IN 17 MALAYSIA

2.6 SUMMARY 19

CHAPTER 3: LITERATURE REVIEW 20 3.1 INTRODUC110N 20 3.2 THE FRIEDMAN'S (1953) HYPOTHESIS 20 3.3 RESULTS OF RELATED PAST STUDIES 21

3.3.1 THE OIL PRICES AND MACROECONOMIC 21 VARIABLES

3.3.2 THE ROLE OF EXCHANGE RATES IN INSULATING 28 THE EXTERNAL SHOCKS

3.3.3 PAST STUDIES IN THE CASE OF MALAYSIA 36 3.4 SUMMARY 39

CHAPTER 4: METHODOLOGY 40 4.1 INTRODUCTION 40

vi

4.2 UNIT ROOT TEST 4.3 JOHANSEN COINTEGRATION TEST 4.4 THE EXOGENEIlY OF OIL PRICES 4.5 VAR MODEL

4.5.1 STRUCTURAL VAR MODEL 4.5.2 THE IDENTIFICATION ISSUE 4.5.3 IDENTIFICATION OF STRUCTURAL VAR MODEL 4.5.4 ESTIMATING STRUCTURAL VAR MODEL 4.5.5 ESTIMATING IMPULSE RESPONSE FUNCTION 4.5.6 ESTIMATING VARIANCE DECOMPosmON

4.6 DEFINmONS OF DATA 4.7 SOURCES OF DATA 4.8 SUMMARY

CHAPTER 5: RESULTS 5.1 INTRODUCTION 5.2 UNIT ROOT TESTS 5.3 JOHANSEN COINTEGRATION TESTS 5.4 THE EXOGENEIlY OF OIL PRICES 5.5 IMPULSE RESPONSES TO OIL PRICE SHOCKS 5.6 ASYMMETRIC EFFECTS UNDER DIFFERENT REGIMES 5.7 RELATIVE IMPORTANCE OF OIL PRICE SHOCKS 5.8 ALTERNATIVE EVIDENCE ON OIL PRICE SHOCKS 5.9 SUMMARY

CHAPTER 6: CONCLUSION 6.1 INTRODUCTION 6.2 FINDINGS OF STUDY 6.3 DISCUSSION 6.4 IMPLICATIONS OF STUDY 6.5 LIMITATIONS OF STUDY 6.6 SUGGESTIONS FOR FUTURE STUDY 6.7 CONCLUSION

REFERENCES APPENDIX A: RECOVERING STRUCTURAL VAR MODEL APPENDIX B: IDENTIFICATION BY BLANCHARD AND QUAH (1989) APPENDIX C: DATA USED AND RELATED GRAPHS APPENDIX D: OUTPUT OF EVIEWS

PAGES 40 41 42 43 44 46 48 49 50 50 51 52 53

54 54 54 56 57 57 60 63 66 72

73 73 73 75 77 80 81 82

84 89 91 92

100

vii

LIST OF FIGURES

PAGES

Figure 1.1 Trade and Share of Trade to GDP 2

Rgure 1.2 FDI and Share of FDI to GDP 3

Figure 2.1 Malaysia Production, Consumption, Exports and Imports of 9 Crude Oil

Figure 2.2 Prices of Crude Oil and Petroleum Products 10

Figure 2.3 Malaysia Producer Price Index and Consumer Price Index 10

Figure 2.4 Fluctuations of World Crude Oil Prices and Malaysia Output 13

Figure 2.5 Changes of Malaysia Revenue, Subsidies and Sales Taxes of 15 Oil

Figure 2.6 De Facto Exchange Rate Analysis 18

Figure 5.1 Responses to Oil Price Shocks 58

Figure 5.2 Flexible Period: Responses to Positive and Negative Oil Price 61 Shocks

Figure 5.3 Fixed Period: Responses to Positive and Negative Oil Price 62 Shocks

Rgure 5.4 Responses to Oil Price Shocks 68

Figure 5.5 Flexible Period: Responses to Positive and Negative Oil Pri~e 69 Shocks

Figure 5.6 Fixed Period: Responses to Positive and Negative Oil Price 70 Shocks

Figure C.1 Changes of Real Oil Prices 99

viii

LIST OF TABLES

PAGES

Table 2.1 Malaysia Production and Exports of Crude Oil 9

Table 2.2 Changes of Producer Price Indicator and Consumer Price 12 Indicator

Table 2.3 Overnight Policy Rate 16

Table 2.4 De Jure Exchange Rate Analysis 16

Table 5.1 Unit Root Tests 55

Table 5.2 Johansen Cointegration Tests 56

Table 5.3 F - statistics of Granger Causality Tests 57

Table 5.4 Variance Decompositions of Domestic Variables 64

Table 5.5 Unit Root Tests 66

Table 5.6 Johansen Cointegration Tests 67

Table 5.7 F - statistics of Granger Causality Tests 67

Table 5.8 Variance Decompositions of Domestic Variables 71

Table 6.1 Exports of Crude Oil by Major Countries (Percent) 78

Table 6.2 Imports of Crude Oil by Major Countries (Percent) 79

Table C.l Data from January 1980 to June 2005 92

Table 0.1 Johansen COintegration Test of oil, y, rer, p 100

Table 0.2 Johansen Cointegration Test of oil, y, reer, p 103

Table 0 .3 F - statistics of Granger Causality Test of oil, y, rer, p 106

Table 0.4 F - statistics of Granger Causality Test of oil, y, reer, p 108

Table 0.5 Flexible: Variance Decompositions of oil, y ., rer, p 110

Table 0.6 Fixed: Variance Decompositions of oil, y, rer, p 113

Table 0.7 Flexible: Variance Decompositions of oil, y, reer, p 116

Table 0.8 Fixed: Variance Decompositions of oil, y, reer, p 119

ix

Endogenous

Exogenous

Fixed rate regime

Flexible rate regime

Globalization

Impulse responses

Managed float system

Matrix algebra

GLOSSARY

Variables with values determined inside the model.

Variables with value that is not explained within the model.

A system in which a country maintains a fixed value of its currency in terms of other currencies.

Rates that are completely free to vary; that is, the foreign exchange market is cleared at all times by changes in the exchange rate.

The growing economic interdependence of countries worldwide through increasing volume and variety of cross-border transactions in goods and services, free of international capital flows and more rapid and widespread diffusion of technology.

Trace out the pattern of response of current and future values of each of the variables to one unit increase in the current value of one VAR error terms.

A system with some intervention in foreign exchange market by monetary authorities with exchange rate movements to smooth out short run fluctuations without keeping exchange rates rigidly fixed.

Provides a compact method than scalar algebra in handling regression models.

Moving average Linear combination of white noise error terms.

Oil price shocks An unexpected disturbance or unexplained movements in oil prices, reflecting the influence by exogenous factors.

Price stickiness The tendency of prices to adjust only slowly to changes in the economy.

Structural VAR Combine statistical methodology of basic VARs with a model number of widely accepted long run restrictions derived

from economic theory to recover the underlying economic shocks.

Variance decom position

West Texas Intermediate

Percentage of the variance of the error made in forecasting a variable due to a specific shock in a given horizon.

One of the leading benchmark of high quality crude oil prices which is referred in the United States and the world.

x

KEYWORDS

Exchange rate regimes, Oil price shocks, Macroeconomic variables, Structural VAR model, Malaysia.

xi

CHAPTER 1

INTRODUCTION

1.1 Introduction

The world has started to globalize since the cross border flows of trade has started

around 1870s (World Bank, 2005) and economists have been long aware of this

global economy trade since the Ricardian theory in 1880s. The realization of the

flexible exchange rate regime in insulating the economies against foreign shocks in

the early 1950s by Friedman (1953) encouraged the development of floating

exchange rate system since early of 1970s. 1

Nowadays, markets for merchandise are much more integrated than ever

before. Many developing countries have broken into the world markets for

manufactured goods and services since 1980s (World Bank, 2005). This increasing of

economic interdependence through the cross border flows of trade and financial can

further support through simple proxies as shows in Figure 1.1 and 1.2. Figure 1.1a

and 1.1b indicate the index of the openness for goods and services market has

increased markedly for many countries especially in the case of Malaysia since

1970s.2 Figure 1.2a and 1.2b show a strong growth in the foreign direct investment

(FDI), as proxied by the share of FDI stocks to output.3 This is further supported by

1 The terms "floating" and "flexible" is used interchangeably. 2The common indicator use to measure the degree of an economy's openness is the

percentage of total trade as a share of national income. 3 According to Prasad et al. (2003: 12), stock data is a better indication of capital market

integration since it is accumUlation of capital flows through relevant valuation adjustments.

1

Figure 1.1: Trade and Share of Trade to GDP

Figure 1.la: World 14,000 .-------------------------------~ 250

...... 12,000 c ~ = 10,000 0 III ;:) 8,000 '-" ~ 0 6,000 o Export Lett Scale Q, E • Import ~ .... - Share of Trade to GOP ~ 4,000 0 Right Scale Q, ! ~ 2,000

a JlI.JJI.1.ILl.I.Ja

Year

Figure 1.1b: Malaysia

...... o

200 ~ D. Q ~

150 .B CII ~

100 ~ 'l; !!

50 ~ III

a

600,000 .-------------------------------~ 250 ...... c ~ 500,000 i ~ 400,000 ...., ~ 8,300,000 E .... ~200,000

8-~ 100,000

a lI'I lI'I 01 ....

Source: IMF

o Exports • Imports - Share of Trade to GOP

0 '" 0 lI'I 0 \0 \0 r-. r-. co 01 01 01 01 01 .... .... .... .... .... Year

'" 0 In co g: 01 01 01 .... .... .... 0 0 0 N

...... o

200 ~ D. Q ~

150.B CII ~

100 ~ "0 !!

50 ~ III

o

Prasad et. al. (2003: 15), who indicated that the financial restriction has decreased

as financial openness has increased in both industrial and developing countries since

1970s.

The factual discussed above shows the cross border trade and capital flows

are increasing, which leaves many nations more vulnerable to unexpected

international economic shocks. The monitor of the international economic

development therefore become crucially important since an economy with relatively

2

Figure 1.2: FDI and Share of FDI to GDP

Figure lo2a: World 16,000 100

14,000 ...... ...... 80 c ~

~ 12,000 0 ....., D. iii

Left Scale C * 10,000 60 CJ III

D FDI Inward Stocks ! .2 ;:) 8,000 .....,

• FDI Outward Stocks .... ~ C u 6,000 - Share of FOI to GOP

40 II.

.2 ~ (II

~ .... 4,000 C Right Scale 20 III .c II. ! (II 2,000

0 0 0 N .,. \0 00 0 N ~ \0 00 0 N i!i 00 00 00 00 00 (JI (JI (JI $ 0 0 (JI (JI (JI (JI (JI (JI (JI (JI (JI 0 0 0 ... ... ... ... ... ... ... ... ... ... N N N

Year

Figure lo2b: Malaysia 60 100

...... SO ...... c 80 ~ ~

0 Left Scale

.....,

l D.

iD 40 D FDI Inward Stocks C * 60 CJ III • FOI Outwars Stocks .s ;:)

30 - - Share of FOI to GOP .... ~ c 40 II. U "0 ~ 20 RlghtScale + ~ .... III C

10 20 .c

II. III

0 0 0 N 1li \D 00 0 N ~ \D 00 0 N i!i co co co 00 (JI 0\ (JI (JI 0 0 (JI (JI (JI 0'1 0\ (JI 0\ 0\ (JI (JI 0 0 0 ... ... ... ... ""' ... ""' ... ... ... N N N

Year

Sources: IMF and UNCfAD

high degree of openness likes Malaysia will be affected more by outside world. As an

alternative, the understanding of flexible exchange rates as a tool to mitigate the

foreign shocks can help nations to react better to the international economic

development, as predicted by Friedman's (1953) hypothesis.

3

1.2 Statement of Problem

Malaysia is a small, trade dependent economy with a high degree of foreign presence

in both the real and financial sectors. International economic development thus has a

significant impact on Malaysian economy. Unexpected change originating abroad

from time to time can transmit and affect on the macroeconomic performance, which

can be measure by Malaysian macroeconomic variables. On the international context,

the direction on the oil prices is a major concern. The changes of international oil

prices are uncertainty, for example, there is a slightly declining trend of the oil prices

in the late of 2006 by easing political concerns and no expected hurricane season in

the United States, instead of continuing increase of price of oil in the early 2000s

until a peak in July 2006.

Since oil price shocks have a impact on domestic macroeconomic variables,

the role of exchange rate regimes in mitigating the impact of these oil price shocks

on domestic macroeconomic variables therefore become an interesting issue. This

study will investigate the adjustment process of domestic macroeconomic variables in

order to test the effectiveness of flexible exchange rates in insulating the Malaysia

macroeconomic variables from oil price shocks.

1.3 Research Questions

The research questions for this study are stated as follows:

1. Is the long run relationship existed between oil price shocks and domestic

macroeconomic variables?

2. Is the oil price shock exogenous within a set of domestic macroeconomic

variables?

3. What is the response pattern of each domestic macroeconomic variable to oil

price shocks under alternative exchange rate regimes?

4

4. Is the response pattern of domestic macroeconomic variables the same to the oil

price increases as to the oil price decreases?

5. How importance is the oil price shocks in explaining the overall variance of

domestic macroeconomic variables?

1.4 Objectives of Study

The purposes for this study are stated as follows:

1. To examine the cOintegration and exogeneoty of oil prices with domestic

macroeconomic variables.

2. To analyze the insulating properties of floating exchange rate regime against

fixed exchange rate regime from the oil price shocks. ExpliCitly, the adjustment

process of exchange rates, price level and output in response to the oil price

shocks is compared under different exchange rate regimes.

3. To analyze the asymmetric effect of the positive and negative oil price shocks on

exchange rates, price level and output within and across the exchange rate

regimes.

4. To measure the relative importance of the oil price shocks in explaining the

overall variance of exchange rates, price level and output.

1.S Significance of Study

Different exchange rate regimes have advantages and disadvantages. For example,

fixed rate regime can reduce exchange rate volatility and stimulating trade,

investment and growth. While economic with floating rate regime has greater ability

to adjust to external shocks. This study intends to contribute as a guideline on the

effects of the foreign shocks, or unexpected change originating abroad, on the

domestic economies under different exchange rate regimes through statistical

5

analysis. An understanding of the insulating properties of exchange rate from foreign

disturbances to domestic economies can help the policymakers and investors to

monitor international conditions in order to properly react to these undesirable

foreign disturbances.

Past studies examined on this issue focused on terms of trade shocks, natural

shocks and foreign macroeconomic variables shocks such as output, interest rate,

price level and money supply shocks (Lastrapes and Koray, 1990; Hutchison and

Walsh, 1992; Broda, 2004; Edwards and Levy Yeyati, 2005; and Ramcharan, 2005).

On the other hand, studies examine on the relationship between oil price shocks and

output did not include the role of the exchange rate (Hamilton, 1983; Mork, 1989;

Mork, Olsen and Mysen, 1994, Hooker, 1996; Lee, Ni and Ratti, 1995; Ferderer,

1996; and Guo and Kliesen, 2005). This study fill such a gap in current literature as it

focuses on the adjustment process of domestic macroeconomic variables in

responses to the oil price disturbances under different exchange rate regimes in

Malaysia.

1.6 Scope of Study

Instead of asking whether the economic poliCies such as monetary policy, fiscal policy

or trade policy can help to stabilize the' output, the study examines if fixed or floating

exchange rates can help to achieve this objective. Study is concerned with 'normal

times' but not focuses on speCial economic events since there are many interesting

economic variations besides these events. And the study is conducted from 1980 to

2005 for Malaysia.

6

1.7 Organization of Study

The remainder of the study arrange as follows. Chapter two describes background of

this issue in the case of Malaysia. The following chapter reviews the Friedman's

(1953) theory and some related literature. Chapter four outlines the econometric

framework employs in this study. Chapter five reports the empirical results. And the

final chapter provides a summary and implications of the study's findings besides

discusses some limitations and suggestions for future study.

7

CHAPTER 2

BACKGROUND OF STUDY

2.1 Introduction

Chapter two briefly reviews the important of the international world crude oil prices

in influencing Malaysian economy and the development of exchange rate regimes in

Malaysia.

2.2 Malaysia as a Price Taker of Crude Oil

Malaysia is a crude oil producer and a net exporter country of crude oil. Since the

consumption of the crude oil is less than the production capacity in Malaysia as

shows in Figure 2.1, Malaysia is exporting the crude oil. At the same time, Malaysia

also importing crude oil for consumption as Malaysia can earn more from the higher

quality of produced and exported crude oil, namely Tapis. Figure 2.1 indicates that

the gap for the volume of exports against imports, and the production compare with

consumption of crude oil become smaller over 1990 to 2004. This is further proven

through Table 2.1, which shows the share of crude oil production to gross domestic

product (GDP) and percentage exports of crude oil to total exports in Malaysia

indicates a declining trend. Moreover, the share of the crude oil production in

Malaysia to the world crude oil production is less than 2%. Therefore, Malaysia is a

crude oil price taker from international crude oil market since Malaysia is a small oil

producer country as compare with the world crude oil production.

8

Figure 2.1: Malaysia Production, Consumption, Exports and Imports of Crude Oil 50,000 800

45,000 700 ....... 40,000 >-1/1

Right Scale III GI 600 Q c 35,000 CJExport ... c 0 _Import GI -- .. - 500 a. I- 30,000 - Production ---c - - Consumption ., *"-- - _ .. - Qj ~ " 400 I: 25,000 ,, - III i Left Scale CD ...., 20,000 ! 300 -g GI "0 15,000

200 ~ I!! 10,000 0 l- .e 5,000 100 I-

° 0 0 N (J; \D IX) 0 N g Cl'I Cl'I Cl'I '" 0 0 Cl'I Cl'I '" '" '" 0 0 0 ..... ..... ..... ..... ..... N N N Year

Source: Department of Statistics, Malaysia and EIA

Table 2.1: Malaysia Production and Exports of Crude Oil

Percentage Percentage

Year PG EE PP Year PG EE PP

1991 8.98 10.79 1.07 1998 7.88 2.63 1.08 1992 8.63 8.80 1.09 1999 7.93 2.89 1.05 1993 7.54 6.54 1.06 2000 7.31 3.82 1.01 1994 7.32 4.25 1.06 2001 7.18 3.34 0.97 1995 8.19 3.62 1.09 2002 7.17 3.25 1.04 1996 7.66 3.66 1.09 2003 7.20 3.94 1.07 1997 7.27 3.20 1.07 2004 6.98 4.53 1.05

Sources: Department of Statistics, Malaysia; Ministry of Finance, Malaysia; and EIA Note: PG: Share of Malaysia crude oil production to Malaysia GDP

EE: Share of Malaysia crude oil export to Malaysia total export PP: Share of Malaysia crude oil production to world crude oil production

2.3 Impact of Changes of Oil Prices on Malaysia

Oil is a primary commodity for the world economy - as a raw material in

manufacturing industries and is a source of transport fuel. It therefore has an

inelastic demand in the short term, in which a slightly drop in crude oil supply will

result in large hikes in the international oil prices.

9

Figure 2.2: Prices of Crude Oil and Petroleum Products

Figure 2.2a: World Prices of Crude Oil 80 .------------------------------,

70

60

SO

40

30

20

10

0 0 ~ C7\ C7\ C7\ C7\ ..... .....

N M

"'" ILl

C7\ C7\ CTI C7\ C7\ CTI CTI CTI ..... ..... ..... .....

June 2006_

ID r-- 00 C7\ 0 .... N M g ILl ID C7\ C7\ C7\ C7\ 0 0 00 0 0 C7\ C7\ C7\ C7\ 0 0 00 0 0 0 ..... ..... ........ N N NN N N N

Year

Figure 2.2b: Malaysia Retail Prices of Petroleum Products 2.0 -,--------- --- -------,

- Petrol Premium (RM/litre) June 2006-

- - Petrol Regular (RM/litre)

- - Diesel (RM/litre)

1.5 - LPG (RM/kg)

crT--. 1.0

.r· .-, " -

~ - ----- - ------~----~--0.5

0 ... N M V LrI

2.3.1 Changes of Oil Prices and Inflation Rate

The continuing increase of the world crude oil prices or West Texas Intermediate,

WIT, as shows in Figure 2.2a has increased the retail prices of petroleum products in

Malaysia more frequent in 2000s when compare to 1990s, as shows in Figure 2.2b.

The international crude oil prices has increased about 232%, while the prices of

RON97, RON92, diesel and liquefied petroleum gas in Malaysia have increased about

70%, 77%, 143% and 48% respectively in June 2006 compare with January 1990.

The percentage increase of price of oil is smaller in Malaysia than in the world since

the government has controlled these retail prices through subsidy and sales tax

exemption. In another case, fuel which is one of the major sources in electric

supplying sector had reviewed since 1 June 2006, in which this tariff was last

reviewed in 1997 (Tenaga Nasional Berhad, 2004). An upward revision of electricity

tariffs would affect the inflation.

The rapid increment of the fuel prices cause inflation indirectly, which can be

represented by producer price index (PPI) and consumer price index (CPI). Figure 2.3

shows that the increment of the fuel prices increases the PPI more rapidly against

CPI especially when the PPI can use to predict CPI. These inflation rates in 2000s are

accelerated mostly on account of the rising retail prices for fuel products since oil is

an important material in production and transportation. Table 2.2 shows the rapid

increment of PPI and CPI is mainly cause by changes in the price of crude materials,

mineral fuel, lubricants and related materials and transportation and communication.

2.3.2 Changes of Oil Prices and Output Growth

Table and Figure 2.1 show that the share of crude oil production to GDP has

decreased, consistent with the gap of production and consumption of crude oil has

become smaller over 1991 over 2004. However, the increment of international crude

11

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