Oil price volatility, financial institutions and economic growth

Abstract

Theory attributes finance with the ability to both promote growth and reduce output volatility, and therefore increase energy security. But evidence is mixed, partly due to endogeneity effects. For example, financial institutions themselves might be a source of volatility, as the events of 2008 suggest. We address this endogeneity issue by using periods of extreme oil price volatility as a source of nearly exogenous volatility, to study the effect of finance. To do this, we develop a quasi-natural experiment and study the effect of the dramatic decline of oil prices in 2014, using a synthetic control methodology. Our hypothesis is that the ability of oil-rich countries to mitigate the effects of this decline rested on the quality of their financial institutions. We focus on 11 oil-rich countries between 1980 and 2014 that had “poor” measures of financial development (treatment group) out of 20 such countries and synthetically create counterfactuals from the remaining (control) group with “superior” financial development. We subject both to the oil price shock of 2014 and find evidence that better financial institutions do indeed reduce output volatility and mitigate its negative effect on growth in the year that showed a sustained decline in oil price. To address any remaining potential endogeneity between oil prices and finance, we also use a cross-sectionally augmented autoregressive distributed lag model with data on 30 oil-producing countries over the period 1980-2016, and confirm that the effects of oil volatility on growth is mitigated with better financial institutions. Our results make a strong case for the support of the positive role of financial development in improving energy security and fostering growth.