How volatility in the oil market and uncertainty shocks affect Saudi economy: a frequency approach

The paper investigates how uncertainty from oil market volatility, geopolitical risk, and global uncertainty shapes Saudi Arabia’s financial development and economic growth. Motivated by the country’s oil dependence, recent global crises, and rapid financial market evolution, the study asks whether positive and negative uncertainty shocks differentially affect financial development (market-based and banking access) and real activity over short-, medium-, and long-run horizons. Understanding these mechanisms is crucial for designing policies that stabilize growth and financial systems in an environment of recurrent global shocks.

The literature shows mixed effects of oil price volatility on growth depending on oil exporter/importer status, with long-run impacts often larger in developing economies. Studies link oil price uncertainty to macro-financial instability and heightened corporate risk. Evidence on GPR suggests it depresses investment, trade, tourism, and growth, though direct links to financial development are less explored. Global uncertainty has been tied to declines in industrial output and macro activity, with limited work on its role in financial development. For GCC/MENA, prior studies document that foreign uncertainty (e.g., US EPU) affects regional financial markets. The paper identifies gaps regarding asymmetric and frequency-domain analysis of uncertainty impacts on Saudi financial development and growth.

Data are annual for 1993–2020. Variables: financial development via market capitalization-to-GDP (MCGDP) and Financial Institutions Access Index (FIAIX); economic growth (EG); uncertainty via crude oil volatility (VTOIL), Geopolitical Risk Index (GPR), and World Uncertainty Index (WUI). Brent crude volatility is modeled with a TGARCH(1,1) (Zakoian, 1994) to obtain conditional variance as VTOIL. Stationarity is assessed with Phillips–Perron tests; VAR lag adequacy and residual diagnostics (Portmanteau, LM-ARCH, Jarque–Bera) validate model assumptions. Causality is tested in the frequency domain using Breitung and Candelon (2006) spectral Granger causality derived from a finite-order VAR, decomposing causality across frequencies to map short (<2 years), medium (2–5 years), and long (>5 years) horizons. Asymmetries are analyzed by decomposing uncertainty series into positive and negative shocks. Robustness includes: (1) replacing GDP growth with Industrial Production Index (IPI) and (2) re-estimating with quarterly data (2015Q1–2022Q4) to capture higher-frequency dynamics. Impulse response functions (Cholesky, Monte Carlo CIs) illustrate channels via government expenditure, domestic investment, and FDI flows.

- Oil volatility and financial development (MCGDP): Significant and persistent causality from VTOIL to MCGDP across frequencies; negative oil volatility shocks have strong long-run adverse effects on financial development via capital flight and reduced domestic investment, although government spending partially offsets the impact. - Oil volatility and FIAIX: Positive shocks have no significant effect; negative shocks exhibit long-run causal effects, underscoring banking-sector vulnerability to oil price declines. - Geopolitical risk (GPR): Long-run impact on MCGDP due to uncertainty from regional/global tensions. For FIAIX, effects are mixed; in decomposed analysis, positive GPR shocks significantly affect FIAIX over many frequencies, and negative shocks show significant causality at selected frequencies, indicating sensitivity of banking access to geopolitical tensions. - Global uncertainty (WUI): Limited direct impact on FIAIX; for MCGDP, negative WUI shocks exhibit long-run causality, while positive shocks are insignificant. There is long-run causality from financial development (both MCGDP and FIAIX) to WUI, suggesting domestic financial conditions feed back into perceived global uncertainty. - Economic growth (EG): Positive oil volatility shocks significantly affect EG in short and long runs; negative oil shocks show no significant causality for EG. GPR and WUI shocks show limited or no direct causality to EG; however, IRFs reveal channels via FDI outflows and domestic investment. - Channels (IRFs): Oil volatility reduces domestic and foreign investment, depressing MCGDP and EG; government spending acts as a stabilizer. Under rising GPR, capital flight and weaker domestic investment weigh on financial development and growth despite countercyclical fiscal support. Under higher WUI, financial development becomes volatile, with investment flows crucial for resilience. - Robustness (IPI, quarterly data): IPI is significantly affected by crude oil volatility (both positive and negative shocks) over long horizons; positive oil volatility shocks propagate from short to long term. GPR and WUI exert limited direct effects on IPI; IPI can Granger-cause GPR and WUI in the long run, consistent with feedback from real activity.

The frequency-domain results demonstrate that uncertainty affects Saudi financial development and growth asymmetrically across horizons and by uncertainty source. Oil-market shocks, especially negative ones, exert sustained pressure on market-based financial development and banking access, primarily via investment retrenchment and capital flight. Geopolitical risk imposes long-run headwinds on market capitalization and, in shock decomposition, materially affects banking access, emphasizing vulnerability of financial intermediation to regional tensions. Global uncertainty has muted direct effects on banking access but can erode market-based financial development when negative, while domestic financial conditions feed into perceived global uncertainty. For growth, positive oil volatility shocks matter more than negative ones, whereas GPR and WUI have limited direct spectral causality; nonetheless, impulse responses show real effects through FDI and domestic investment, with fiscal policy cushioning shocks. Collectively, the findings validate the hypothesis that effective monitoring and management of uncertainty—especially oil volatility and geopolitical risks—are pivotal for sustaining financial development and economic performance in Saudi Arabia.

The study shows that negative crude oil volatility shocks significantly undermine financial development (MCGDP) through capital flight and weakened domestic investment, with public spending mitigating some effects. Banking-sector access (FIAIX) is resilient to positive oil shocks but vulnerable to negative shocks over the long run. Geopolitical risk imposes a long-run drag on market capitalization and, in asymmetric analysis, affects banking access at various frequencies. Global uncertainty has limited direct influence on banking access but can impair market-based financial development when negative; financial development itself influences perceived global uncertainty. Economic growth responds more to positive oil volatility than to negative shocks; GPR and WUI show limited direct spectral effects on growth, though investment channels matter. Robustness using IPI confirms long-run sensitivity to oil volatility. Policy implications include: accelerating economic diversification beyond oil; strengthening financial sector resilience (risk management, regulatory oversight, financial inclusion); enhancing investor protection and transparency to curb capital flight; and pursuing sustainable energy strategies to reduce exposure to oil volatility. Future work should incorporate additional uncertainty measures (e.g., global EPU), higher-frequency data, regional comparisons, and advanced interpretable frequency methods.

- Variable scope: Economic policy uncertainty (EPU) not explicitly modeled alongside WUI/GPR; additional uncertainty proxies could refine results. - Data frequency and coverage: Annual data limit degrees of freedom; monthly data may capture richer short-run dynamics. WUI availability constraints drive sample selection. - External validity: Single-country focus (Saudi Arabia); no comparative analysis with other MENA/GCC economies. - Model specification: VAR-based linear framework; while frequency-domain addresses dynamics and asymmetries via sign-decomposition, nonlinearities and structural breaks could be explored with alternative models. - Sectoral granularity: Financial development measured by MCGDP and FIAIX; deeper micro/sectoral banking and market indicators could yield finer insights.