Nonlinear causality between crude oil price and exchange rate: A comparative study of China and India

- We use Hiemstra and Jones non-linear Granger causality test to for checking causality between oil price and exchange rate.
- The persistence in variance of oil price and exchange rate is taken into account using a GARCH(1, 1) model.
- Narayan and Popp (2010) unit root test shows no evidence of rejecting the unit root null hypothesis for oil price and exchange rate.
- Significant bi-directional non-linear Granger causality runs between oil price and exchange rate in China and India.
- Oil price non-linearly causes exchange rate irrespective of exchange rate regimes.

While several studies have examined the linear causal relationship between oil prices and exchange rates, little is known about the nonlinear causality between these two variables. The present paper tries to fill this research gap in the context of India and China. By applying the Hiemstra and Jones (1994) nonlinear Granger causality test to the VAR residuals, the study finds a significant bi-directional nonlinear Granger causality between oil prices and exchange rates in both countries. The findings suggest that the nonlinearity of oil price influences the exchange rate irrespective of the exchange rate regimes. Further, to check robustness, the persistence in the variance of oil price and exchange rate is taken into account using a GARCH (1, 1) model. While the results consistently hold in the case of India, with respect to China, a unidirectional causality runs from exchange rate to oil price. However, the oil price in China does not Granger cause exchange rate.