Exploring the Non-linear Relationship between Oil Price Uncertainty and Manufacturing Production in Pakistan

Abstract

The paper sets out to investigate the impact of oil price uncertainty on the manufacturing sector in Pakistan, recognizing the potential for economic instability stemming from a heavy reliance on oil-intensive manufacturing processes, especially amidst high oil price volatility. Oil price shocks are known to exert adverse effects on economies like Pakistan, impacting both the supply and demand sides of the manufacturing sector. To empirically explore this relationship, the study employs a two-step approach. Firstly, an EGARCH-in-Mean model is utilized to construct and measure an appropriate proxy for oil price uncertainty. This step is crucial in accurately capturing the dynamic nature of oil price fluctuations and their potential implications for the manufacturing sector. In the second step, an autoregressive distributed lag regression model is specified to examine the relationship between manufacturing production and oil price uncertainty, incorporating both linear and non-linear effects. Specifically, the model includes oil price uncertainty and its square term, along with other relevant economic determinants, as explanatory variables. The empirical results of the analysis reveal intriguing insights into the relationship between oil price uncertainty and manufacturing production in Pakistan. Contrary to linear expectations, the findings suggest a non-linear relationship, wherein manufacturing production initially increases with rising oil price uncertainty. However, beyond a certain threshold level, manufacturing production begins to decline in response to further increases in oil price uncertainty. Moreover, the study employs impulse response functions to assess the short-run effects of oil price uncertainty on manufacturing production. The results indicate contractionary effects, suggesting that heightened oil price uncertainty exerts immediate adverse impacts on manufacturing output in Pakistan. These findings underscore the nuanced and complex nature of the relationship between oil price uncertainty and manufacturing sector dynamics, highlighting the importance of considering non-linear effects and threshold levels in empirical analyses. Furthermore, the implications of these findings have significant implications for policymakers and stakeholders tasked with managing economic stability and promoting industrial growth in Pakistan. By recognizing the adverse effects of oil price uncertainty on manufacturing production and adopting proactive measures to mitigate its impact, policymakers can work towards fostering a more resilient and sustainable manufacturing sector. From diversifying energy sources to implementing hedging strategies and promoting technological innovation, there exists a range of policy options through which Pakistan can navigate the challenges posed by oil price volatility and promote long-term economic stability and industrial development.