Transition risk of a petroleum currency

Abstract

The Norwegian krone has been persistently weak since 2017. This is not well explained by data in a standard model where the exchange rate depends on relative interest rates and prices. We extend the standard model by including a risk premium consisting of non-traditional explanatory variables, including the importance of petroleum exports, foreign direct investments and a petroleum related equity index. These variables reflect risks associated with the expected transition of the Norwegian economy which is linked to fading petroleum revenues and the green shift. The model is estimated on quarterly data from 2001, when a monetary policy of inflation targeting was implemented, up to and including 2019. We find that the weak Norwegian krone can be attributed to a higher risk premium. The risk premium is driven by oil prices and improves the model’s explanatory power.