Impulse response functions

In this section we investigative the relationship between China’s macroeconomic growth and the world oil market by considering the propogation of the identified intertemporal structural shocks. We begin our analysis by examining the effects of oil market shocks on China’s macroeconomic growth. Following Baumeister and Peers- man [2013b], we normalize all structural shocks so that they lead to raise the real oil price by 10 percent on impact at each point in time. The intertemporal generalized impulse response functions for real Chinese GDP growth in response to an oil sup- ply, specific demand and demand shock are shown in Figure 4.3. More specifically, the figure shows the response corresponding to the first quarter of each calendar year to an unanticipated increase in global real oil prices caused by either suddenly changes in supply or demand factors. Two broad conclusions can be drawn. First, the magnitude response of China’s output to the oil price shocks are small. Sec- ond, throughout the sample period, the pattern responses of China’s output to the

66The Relationship between Oil Price Shocks and China’s output: A Time-varying Analysis 1995 2000 2005 2010 2015 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1995 2000 2005 2010 2015 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 1995 2000 2005 2010 2015 0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5 1995 2000 2005 2010 2015 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1

Figure 4.2: Estimated standard deviations of the structural shocks

Note: (From left) Global oil production, real crude oil price, global real economic activity index (Kilian’s Index), Chinese real GDP growth. The shaded areas indicate 68 percent posterior credible sets.

oil price shocks are not persistent. The first finding is consistent with evidence in a recent study by Herwartz and Plödt [2016] who observe that the reaction of Chinese real GDP to different global oil price shocks is relatively flat and insignificant. One potential reason for these small effects could be the structure of Chinese economy. As documented in Hamilton [2009] and further empirically supported by Aastveit et al. [2015], the share of energy purchases in total expenditure is the key parameter in determining the impact of an oil price shock. More precisely, Aastveit et al. [2015] highlight the fact that per capital oil consumption in the US is 10 times lager than that in China and the oil production pricing mechanism in China may prevent the full pass-through of a higher international oil price to domestic users. Moreover de- spite the Chinese economy being the worlds second largest oil importing nation, the energy structure of the Chinese economy is coal-dominated.15 The second finding reflects clearly that the structural effect of the oil price shocks on Chinese economy is changing over time and implies the importance of allowing for time variation in ex- amining the relationship between China’s output and the shocks of world oil prices. Next, we present and briefly discuss the evolution over time of the impulse response to specific oil shocks.

Oil supply shock: The responses to the oil supply shock are presented in the top-left

15_{The share of oil, coal and natural gas in total energy consumption, calculate based on 2013 IEA}

§4.4 Empirical results 67 -0.3 20 -0.2 2015 15 -0.1 Percent 2010 0 10 2005 2000 5 1995 -0.5 20 -0.4 -0.3 2015 15 Percent -0.2 2010 -0.1 10 2005 0 2000 5 1995 -0.2 20 -0.1 0 2015 15 Percent 0.1 2010 10 0.2 2005 2000 5 1995 20 -0.2 -0.1 2015 15 Percent 2010 0 10 2005 0.1 2000 5 1995

Figure 4.3: GIRFs for Chinese GDP growth

Note: (Clockwise from top left panel) Responses to the oil supply, oil specific demand, China’s output and global demand shock.

1995 2000 2005 2010 2015 -0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2 1995 2000 2005 2010 2015 -0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2 1995 2000 2005 2010 2015 -0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.15 0.2

Figure 4.4: Time-varying median impact impulse responses of China’s output

Note: (From left) Responses to the oil supply, specific demand and demand shock. The shaded areas indicate 68 percent posterior credible sets.

68The Relationship between Oil Price Shocks and China’s output: A Time-varying Analysis

graph in Figure 4.3. The results show that output in China slightly falls by unan- ticipated increases in global oil prices driving by the disruption of oil production. But, as is clearly captured by the figure, the impact response changes over time. A few years before and after the Asian crisis in 1997, the global supply shock did not matter for the economy. This dynamic effect, again, is reflected more clearly in the first column in Figure 4.4 which displays the median responses of China’s output to the supply shock after four quarters the shock occurs. We find that the response of output was slightly positive in 1996 and 1999. However, for alternative horizons output responds negatively to the oil supply shock. More specifically, the negative impact was lager during the period from 2002 to 2008 when the global economy ex- perienced the most remarkable surge in the price of oil since 1979.

Oil specific-demand shock: The top-right graph in Figure 4.3 shows the response of

Chinese real GDP growth to the specific-demand shocks. The shock is defined as a surprisingly increase in global oil prices that is not related to changes in oil pro- duction or global economic activity. As can be seen from the graph, the response of output to the shock also changes over time but less volatile than that of the above supply shock. Broadly speaking, the impact of the specific demand shock is largest than that of other shocks in terms of scale. The scale of the response can bee seen in the second column in Figure 4.4. We also observe a deeply negative impact over the period of the great sure of oil price of 2002-2008.

Oil demand shock: The bottom-left graph in Figure 4.3 characterizes the response of

China’s output to the oil demand shock. Throughout the sample period, China’s output responds positively for the quarter in which the oil demand shock occurs. A few negative impacts appear during the Asian financial crisis time (1997) but the magnitude of those changes are negligible. The last column in Figure 4.4 plots the median response and provides clearly the pattern of impact. We find that an increase in global oil prices caused by raising global demand has a positive effect on Chinese real GDP growth in the years after the global financial crisis of 2008. Before 2008, the oil demand shock produces negative impact on Chinese GDP growth, especially in the year that the Asian crisis occurs. Interestingly, looking at the two recent crises, the Asian financial crisis 1997 and the global financial crisis 2008, we observe that the effect of the oil demand shock in the former crisis is deeper than the latter event. Whilst this study is the first to estimate the time-varying effects of different oil shocks to China’s output, it is nonetheless interesting to compare the results with related studies. The most relevant studies can be found in work conducted by Herwartz

§4.4 Empirical results 69

and Plödt [2016] and Zhao et al. [2016]. Both of these studies differentiate between an oil supply and demand shock but they apply different methods; Herwartz and Plödt [2016] utilize a CVAR model whilst Zhao et al. [2016] obtain their results by simulating a dynamic stochastic general equilibrium (DSGE) model. With regards to the supply shock on output, Herwartz and Plödt [2016] find a negligible effect while Zhao et al. [2016] show a more clearly negative impact. The same conclusion can be drawn for the scenario of the specific demand shock. The reaction of Chinese real GDP to the specific demand shock is flat in Herwartz and Plödt [2016] but negatively in Zhao et al. [2016]. Under the demand shock, finally, both of these studies agree that the shock produces a positive impact on output in China. Our results are not only in line with the previous results but also provide richer information. Whilst we agree that both the oil supply and specific demand shock can harm the economy, the results presented here show that such shocks also stimulate GDP growth. This view is supported by Aastveit et al. [2015], who find that an adverse oil supply can produce a positive impact on GDP in Asia, and in China in particular. Similarly, the oil demand shock can bring benefits to the country but not all horizon in our sample period. In closing, we highlight the fact that the response of China’s output to the price of oil is not a simple constant relationship but is in fact evolving over time.