The relationship between oil price shocks and China’s macro-economy: An empirical analysis Limin Du a,n , Yanan He b , Chu Wei c a China Center for Energy Economics Research, Xiamen University, Xiamen 361005, China b The Wang Yanan Institute for Studies in Economics, Xiamen University, Xiamen 361005, China c School of Economics and Management, Zhejiang Sci-Tech University, Hangzhou 310018, China article info Article history: Received 13 January 2010 Accepted 18 March 2010 Available online 13 April 2010 Keywords: Oil price shocks Macro-economy China abstract This paper investigates the relationship between the world oil price and China’s macro-economy based on a monthly time series from 1995:1 to 2008:12, using the method of multivariate vector autoregression (VAR). The results show that the world oil price affects the economic growth and inflation of China significantly, and the impact is non-linear. On the other hand, China’s economic activity fails to affect the world oil price, which means that the world oil price is still exogenous with respect to China’s macro-economy in time series sense, and China has not yet had an oil pricing power in the world oil markets. The structural stability tests demonstrate that there is a structural break in the VAR model because of the reforms of China’s oil pricing mechanism, thus it is more appropriate to break the whole sample into different sub-samples for the estimation of the model. & 2010 Elsevier Ltd. All rights reserved. 1. Introduction A large amount of researches have investigated the relation- ships between oil price shocks and economic activities of the developed countries since the first oil crisis of 1970s, but only a few studies have focused on that of China. The oil consumption in China has increased dramatically since its economic reforms initiated in 1979. As the second largest world oil consumer only after the US, the total amount of oil consumed in China reached 366 million tons in 2007. What’s more, with the progress of industrialization and urbanization, especially the increase of privately owned cars, China’s oil demand will keep increasing for the foreseeable future (IEA, 2006). On the other hand, the domestic oil production of China has slowed down since 1997, and almost half of the oil consumed in China was imported from outside markets in 2007. The correlation between oil price shocks and macro-economy is also significantly affected by a country’s domestic oil pricing mechanism. With the foundation of the People’s Republic of China in 1949, the oil industry was put into the central planning system because of its strategic importance. Before 1980, oil field development and refinery construction were primarily financed by the central government, and both wholesale and retail prices for crude oil and petroleum products were determined by the central and local governments (Wang, 1995). Thus, the impact of the world oil price on China’s macro-economy was negligible for that period. Along with the general market-oriented economic reforms initiated in 1979, the oil industry has also experienced a series of deregulation reforms, and the domestic oil prices of China have been increasingly correlated with that of the world oil markets. In 1981, the State Council of China announced to introduce dual-track pricing system to the oil industry. The Ministry of Petroleum was required to sell their oil at regulated low price for the first 100 million tons, but the extra production more than 100 million tons was allowed to sell at higher market prices. The revenues from the extra production were allowed to be allocated by the Ministry of Petroleum itself. Under the dual-track pricing system, most of the oil prices were still under regulation, thus the correlation between the domestic oil price of China and the world oil price was still very low. In 1998, the central government of China further deregulated its domestic oil pricing mechanism. According to the new pricing mechanism, the dual-track pricing system was abolished, and the monthly price of the crude oil was determined on the basis of the average world oil prices of similar quality of last month. As to the petroleum products, the monopoly oil companies (PetroChina and SinoPec) were still required to follow the guiding prices set by the central government, but the retail prices were allowed to fluctuate within 5% on the basis of the guiding prices. Thus, the crude oil price of China has been highly correlated with that of the world oil markets with lags since then, but for petroleum products, the correlations were still very low. In 2000, the pricing mechanism of the petroleum products of China was further deregulated. Under the new pricing mechan- ism, the monthly prices of the petroleum products were ARTICLE IN PRESS Contents lists available at ScienceDirect journal homepage: www.elsevier.com/locate/enpol Energy Policy 0301-4215/$ - see front matter & 2010 Elsevier Ltd. All rights reserved. doi:10.1016/j.enpol.2010.03.042 n Corresponding author. Tel.: + 86 15980937905. E-mail addresses: dlmsos@hotmail.com, dimsos@126.com (L. Du). Energy Policy 38 (2010) 4142–4151