Impact Of High Oil Price On Asia

The impact of high oil prices on Asian emerging markets SUMMARY Consistent high oil prices have threatened the growth outlook for Asia. But how governments in the mainly net oil importing region are reacting is also having a significant impact on economic reform and political stability. Oil prices have risen to nearly $70 a barrel - in real terms the highest since the shocks of the 1970s. Much of emerging Asia subsidises oil; therefore they are facing rocketing subsidy bills. These are threatening fiscal stability, inflation and the balance of trade. But they are also creating problems for political leaders. What should governments do? The Asian Development Bank says it is critical for Asia to phase out subsidies on petroleum products. By doing this, countries may stop their fiscal deficits expanding further and will be able to spend more on essential infrastructure. However the withdrawal of subsidies must be managed, or the region’s recent good growth rates could be threatened. If subsidies remain on kerosene products the impact on the poor may be reduced. Inflation will have to be balanced with rises in interest rates, where necessary. Governments will have to act in order to maintain the confidence of the markets and prevent a deteriorating balance of trade. Recent troubles of the rupiah are a case in point.

Background 1. International oil prices have risen by 111% since beginning of 2004. In real terms they are the highest since the 1970s oil crisis. Conditions in the world economy particularly high oil consumption in emerging Asia, long term under-investment in extraction and refinery operations and continued political instability in oil producing countries - have led analysts to predict oil prices will be high and volatile in the medium term. Goldman Sachs expects US benchmark oil prices to remain above $60 a barrel for the rest of the decade. Real Price (August 2005 prices) 120

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2. There are three main reasons why Asia should be worried;

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• Firstly, Asia is a net oil-importing region. Higher oil prices generate a higher import bill, which has to be paid for with foreign exchange and be balanced by exports. Emerging Asia’s oil imports are projected to nearly double from 43% of total world oil consumption in 2002 to 78% in 20301, and oil demand is predicted to account for 26% of the world total in 2030– more than the US and Canada together. Asia’s suffers from poor energy efficiency. For each unit of output emerging economies use twice as much energy as OECD countries2. • Lastly, many Asian economies subsidise oil prices. Subsidies have, on average, moved in line with international oil prices and subsumed as much as 10% of government spending. However with the growth in oil prices they have become unsustainable in many countries. The President of the Asian Development Bank (ADB) has said it is critical for all countries in the region to phase out subsidies on petroleum products. The challenge for governments is to reduce subsidies without clouding growth prospects or adversely impacting on their poverty strategies. 3. One of the direct economic implications of high oil prices in subsidising countries is the build up of fiscal deficits. These have to be financed with domestic or foreign debt, which threaten the government’s overall debt sustainability. However governments are reluctant to lower subsidies because of the effects on poverty and growth. If the burden of high oil prices is shifted from government to producers and consumers, demand in the economy will drop and the poor may suffer disproportionately. Also, if oil is available at market prices inflation is likely to increase. In response the central banks may raise interest rates – further damaging growth prospects. 4. The follow table shows the current level of fiscal deficits in emerging Asia. Countries with low budget expectations of oil prices, which therefore underestimate the cost of subsidies, are likely will find their deficits worsen. India’s deficit is high however its assumption of oil prices is realistic, whereas Thailand currently has a good fiscal deficit, but it’s low oil price suggests the deficit will grow. Country China India

Fiscal deficit as % of GDP 2003 2.8 4.4 (04-05) 1

Budget assumption for oil prices Not published $603

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WEO 2004, p262 WEO 2004, p63. Figure 2.4. 3 No such assumption made in India's Budget 2005-06. However the unreported/unstated expectation was $60 Pb. The Gol now has stopped playing any guessing games on global crude prices with many unexpected events happening. Currently both the GoI (petroleum Min and Finance Min) and the Reserve Bank of India (RBI) are on the lookout for inflationary pressures resulting from high crude prices. (Attached email would shed some light on the Indian economy's vulnerability to oil price shocks.) Worth noting that the GoI plans to expand India's refinery capacities by 60% in 3 yrs time to tap into the export demand for refined petro-products. This way the GoI hopes to balance its balooning import bill (70% of India's oil needs are met through imports) with the export of refined petro products (current capacity is 2.5 million bpd; to increase to 4 million bpd by end 2008) that contributed $6 billion in FY04-05 (i.e. a quarter of India's crude import bill). 2

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Indonesia Philippines Thailand

1.9 (IMF Article IV) 3.9% fiscal surplus of 0.1% (04/05)3

$605 $444

5. A worsening balance of trade also feeds inflation. Although exports are growing in many countries they are not sufficient to balance imports, causing deteriorating balance of trade and depreciating exchange rates. If the exchange rates fall, the price of imports increases, further stimulating inflation. Much of Asia has substantial foreign exchange reserves, which will protect them from threats to the exchange rate. However these are declining in some countries and governments will then have to depend on other inflows, especially FDI and remittances, to keep the current account in balance. Economic policy implications China 6. The Chinese government has marginally increased diesel and petroleum prices in the past months. However the absence of means that unlike the rest of emerging Asia, there has not been pressure to reduce subsidies. 7. The political implications are only likely to be felt if the economic outlook deteriorates. If inflation seeps into the economy – through escalating property prices, increasing consumer credit and an over-heating economy – the public will feel their wages devalued. India 8. The Indian government increased oil prices in June by 7% and again in September by a further 7%. The government initially delayed hiking prices because of opposition from Communist coalition partners. However, global oil prices had risen 35% since January and without a parallel hike in domestic prices, the stateowned oil firms made considerable losses. Despite the recent rises, JP Morgan estimate that prices are less than half what was needed to bring India’s fuel prices in line with international benchmarks and state oil companies would continue to bear the brunt.4 9. The ruling government needs support from its left-wing partners to make the structural reforms necessary to keep economic growth on track. Without room to manoeuvre – on subsidies, labour market reform and FDI – the economy will suffer. The government is therefore faced with a tough choice on how best to use its political capital. Thailand 10. In June the Thai government slashed subsidies on diesel oil prices. However they have tried to cushion the impact of ending subsidies by pairing it with an expansionary fiscal policy. The government introduced a 5-per-cent increase in salaries for public officials; increases in the minimum daily wages from the current 175 baht; and extra monthly payments to the elderly poor. It is hoped that 4

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these will keep growth buoyant despite forecasts already being revised from 4.55.5% growth to 3.5-4.5%. Analysts are sceptical about the likely success of this policy. Although the minimum wage should boost rural incomes many of the structural problems, such as an unskilled, unproductive workforce, remain unresolved. Until these are dealt with companies will not be able to bear the increased costs from reduced subsidies and will pass them on to consumers, fuelling inflation. 11. These measures will have made the government popular in the short-term. However in the medium term they are likely to exacerbate inflation from high oil prices. Consumers will realise that the extra wages they receive are worth less as inflation and higher interest rates eat into them. Thailand’s growth rates stand to be badly hit by the combination of oil prices and the already detrimental impact of drought and bird-flu. Thailand’s balance of trade will suffer also as, unlike Indonesia, it has no oil exports to soften the blow. Philippines 12. The Philippines does not have fuel subsidies however its fiscal deficit is suffering as a result of government spending on fuel. In 2004 the government introduced a 4-day week for public services in order to reduce fuel consumption. 13. The impeachment allegations surrounding President Gloria Arroyo have taken oil off the political agenda in recent months. However economic stability is important for her credibility and if she can deal with oil prices whilst fighting an impeachment trial, it may boost her ratings. The peace process in precarious in the Philippines and Arroyo may find it easier to re-build her credibility through economic reform at this point, than tackle the peace process. Indonesia 14. The impact of high oil prices in Indonesia has already been felt – economically, fiscally and to a lesser extent, politically. 15. In March the Indonesian government increased fuel prices by 29%, reducing subsidies which last year cost the government around 7 billion dollars. However the price rises were not enough to offset long-standing pressure on the value of the rupiah from high oil prices and inflation. This became particularly intense when global oil prices rose in August, fuelling fears that high prices would translate into higher fuel subsidies and further widen the fiscal deficit. At that time, the exchange rate fell to an all time low against the dollar and the rupiah lost 11% of its value since January5. The central bank unsuccessfully attempted to use foreign exchange reserves to stabilise the currency, to the extent that the central bank now believes it may experience a shortage of $12bn-15bn in foreign exchange this year. 16. On 30th August, the central bank increased interest rates causing the exchange rate to increase against the dollar. However the improvement was short-lived. On 31st August the government announced economic reforms to combat the falling rupaih. 5

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However instead of improving the exchange rate, the rupaih fell further cancelling out the effect of the interest rate rise. 17. Although President Yudhoyono’s reforms on energy supply; fiscal reforms; monetary policy and investment were wide in scope, the package lacked sufficient depth and new initiatives to regain the market’s confidence. Although subsidies were to be reduced, the exact size of the reduction was not explicit, and the timing was uncertain. The government also announced that the Rp 48.3 trillion deficit in the 2005 budget would have to be financed by issuing domestic and foreign bonds. 18. The politico-economic impact is already being felt. The IMF has said the outlook for Indonesia is still largely positive, but economic growth is likely to miss the government's target of 6% this year. More worrying is the lack on confidence in the President’s economic team and, to a lesser extent, the central bank. Previous governments have been ousted over oil price hikes, so this government will be wary of succumbing to the same fate. The last price rise in March triggered public protests in 10 cities, although protests are a common event in Indonesia and none of these fuel protests got out of hand. The Government has now won over Parliament on the need to increase fuel prices. The debate has moved on to “how much and when” rather than “if”. This is a step in the right direction. But in order to keep moving, the government will need to clarify its compensation plans to ensure that funds will reach the poorest members of society.

Implications for the World Economy 19. A slowdown in these key emerging markets would be damaging for the world economic interests. The developed countries t has invested heavily in Asia . . Also any rise in political instability in the region could threaten our broader agenda there, for example on counter-terrorism and migration. 20. Political and economic instability in Asia is likely to be detrimental to the economic reform process. Introducing more flexible market pricing policies, like on subsidies, is a way of assisting fiscal reform. Therefore lobbying the emerging Asian governments to reduce their subsidies in a slow and transparent way would allow a greater role for the market in determining prices. Blanket subsidies could also be cut so that middle classes do not benefit unnecessarily. However maintaining subsidies on kerosene may be needed to reduce the negative impact on poverty reduction. 21. High oil prices may encourage greater energy efficiency. Some countries have already made progress, such as India’s purchase of hydroelectric power from Bhutan. However recent attempts by Asian governments to reduce fuel consumption by introducing 4-day working weeks have often been little more than publicity stunts, which do little to change consumption habits.

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