BURNING RAMIFICATIONS OF MOUNTING OIL PRICES
AROOJ ASGHAR (firstname.lastname@example.org)
Apr 21 - 27, 2008
The rapid and large oil price rise experienced in March & April 2008 has created widespread concern about its impact on country's economy and on poor households. According to the latest State Bank's report, quote "the sustained increase in food commodity prices and the impact of rising costs of oil products led to unexpected rise in inflationary pressures in the economy during the first half of FY08" unquote. The cost of petroleum products and crude oil accounted for over 24% of the import bill in 2006-07 and a sustained rise in prices has already created serious trouble for the fiscal year 2007-08. If energy becomes costlier, the cost of production will go up, adversely impacting both domestic consumers and exporters whose products could be rendered even less competitive than they are at present.
The increase in oil price has a three-fold economic impact on Pakistan's economy. First, oil import bills increase manifold because in the short run the price elasticity of demand for petroleum products is very low. Even when the oil import volumes decline, the bills increase. Financing of costlier oil imports took up a greater proportion of export revenues, which is also not in very stable and good shape and, with certain exceptions, the balance of payment deficits increase. Secondly, the higher international oil prices are passed on domestically with certain subsidies, and this tends to fuel inflation. Thirdly, the rate of economic growth is also affected, either by the direct impact of the crisis, or by the price adjustment policies, or both.
THE IMPACTS OF HIGHER OIL PRICES
THE NET OIL IMPORT BILL
The net oil import bill increases with the increase in oil prices without correspondingly affecting GDP thus disturbs foreign reserves and balance of payments. As per the World Bank reports, a sustained US$10 a barrel price increase would deliver a shock equivalent to a loss of GDP of 0.5% percent. Statistical evidence shows that there is a small but significant negative association between the level of per capita GDP and the ratio of net oil imports to GDP, so that systematically the Pakistan being one of the low income oil importers suffers the most from the direct impact of higher oil prices on the balance of payments. Growth and development therefore tend to reduce.
REDUCTION IN GDP
Following a global oil price rise, Pakistan's GDP falls below where it would otherwise have been, so that there is an additional impact on Pakistan being oil importer. The reduction in Pakistan's GDP is estimated at around 0.5% due to heavy import oil bill. .
DIRECT AND INDIRECT EFFECTS OF OIL PRICE INCREASES ON HOUSEHOLDS
Households, which are consumers of certain petroleum products (kerosene, LGP and gasoline) and who also purchase other goods whose costs are impacted by oil product prices (diesel for transportation) feel the effect of higher oil prices in their household expenditure though the government controls the product prices and does not let them rise by allowing subsidies. According to an estimate and number of surveys low-income deciles are more severely affected than higher income groups and resultantly there emerges an increase in the cost of living of general people. An important component of this total cost of living increase came from impacts on non- fuel expenditures, especially those on transport and food, which are impacted by higher diesel prices. Studies also confirmed the picture that the rural poor suffer the most, primarily because of the importance of kerosene for these households. Small and medium size enterprises are also likely to suffer from higher fuel costs. As said above oil prices in Pakistan are subsidized to benefit masses. This subsidy is used as political weapon as well. As known to all that government didn't increase oil prices for almost 18 months just to benefit previous ruling political party so that they could perform well in the general election. Now the new government has to increase oil prices to cover the gap and to ensure that they could also achieve the revised rate of growth of GDP of 6%. Keeping in mind that continuous subsidies seriously affect government's fiscal position, which results in less government spending than, would otherwise have been possible.
In Pakistan, government passes on less than the full oil price increase. It has to bear the financial burden, and this has macroeconomic consequences in terms of reduced expenditure on other items, which in itself may be anti-poor.
INDIRECT EFFECTS OF OIL PRODUCT PRICE
The indirect effects of oil product price is the most difficult to calculate. It requires the availability of both an input output table and a household expenditure survey, and some method of linking the categories in these two sources of information. For example, in many developing countries, much of the purchase of diesel is by firms (including taxis, buses etc.) rather than households. These companies then sell their services or products to households. Transport costs are themselves an important item in total food costs, and so the rise in the diesel price also makes it felt in the food price index, and hence is felt by households. By knowing the contribution of diesel costs to transport costs and of transport costs to food costs, and then of the share of food costs in the total household budget, a total picture for the impact of oil product price increases via this chain can be quantified. Prices of almost all the items were increased even before the government effectively increased the oil prices in March 2008. The worst part of this story is that prices of daily use items were increased before the actual change in oil prices by OGRA that shouldn't have been happened.
Lower employment prospects and the higher inflation rate are lowering the purchasing power of the poor. The biggest impact comes through the higher price of kerosene, which is used for cooking and lighting. The poor is also affected by higher transportation costs. The transport fuels, where the poorest households certainly do not own their own vehicle, the impact of the fuel price increase is most burdensome in percentage terms. Clearly, higher petroleum costs will increase commuting costs and, especially in the case of agricultural economies, the cost of getting the crops to the markets. However, governments should resist the temptation to provide subsidies to offset the high price of energy. Subsidies constitute a serious drain on public finances, especially if the high price of oil persists. They will have to be financed through higher taxes, or external borrowing which will generate a higher debt burden. Moreover, although kerosene is considered an inferior good, it is not clear that subsidizing it is the best means to protect the poor because it is difficult to prevent non-poor from consuming kerosene. Discretionary fiscal response should be limited since it may be difficult to remove in the future.
COST OF PRODUCTION
The impact on manufacturers and other companies that use oil-based ingredients could be significant, causing a ripple effect throughout the economy. As firms are faced with rising prices and see their margins cut, they may have to cut back on production, reduce their other expenses or maybe shut down. Due to higher cost of production, Pakistan's goods are already expensive than other countries and with the continuous increase in cost of production, it appears that going forward Pakistan's exports will hit unless otherwise government doesn't take serious measure to control expensive energy and switch over to cheap energy. But in an extremely competitive market where orders are awarded on a difference of cents only such continuous increase in cost of production is alarming.
State Bank may be tempted to tighten its monetary policy in reaction to the increase in inflation. Previous oil price shocks have produced significant increases in real interest rates which undermined domestic investment, pushed the country deeper into recession and produced stagflation like situation. Furthermore, a rising fiscal deficit, combined with increasing public expenditures due to petrol consumption by public entities, can prompt the authorities to use monetary creation to finance the additional expenditures. As the increase in the price of oil is akin to a supply shock, an accommodating monetary policy would contribute to inflation. It is advisable to adopt a non-inflationary policy to avoid hyper inflation and to maintain monetary credibility.
Although the duration and magnitude of the increase in world oil prices is not yet clear, there is certainly enough evidence to raise concerns about their impact on the poor. Oil prices in international market have touched US$115.5 a barrel yesterday that is an alarming trend. Even if this recent episode turns out to be short lived, and long term oil prices drop below US$100 a barrel range, it will have a substantial impact and country's economy will take some time to adjust its indicators.
In Pakistan the inflation is high and food inflation is even higher. In order to curtail the downside effects of this issue the government should do not plunge into short-term remedies such as raising prices abnormally to mitigate the upcoming risks. The new government needs to look at the whole issue in its entirety rather than exercising easy options to pass on the burden of oil subsidy to the consumer or accumulate debts to pay oil marketing companies. Raising prices would be the simplest thing to do. The estimated Rs. 160 billion liability on account of subsidy needs to be shed by applying prudent economic principles rather than going for commercial bank borrowing. Moreover, it would be prudent for the new government to present the entire oil pricing picture before the nation honestly including who is earning what, who has deprived the public money etc. A recent report pointed out that over Rs. 50 billion worth of annual anomalous profits to the oil industry due to faulty decision making of the former economic managers. High energy prices should also be viewed as a signal to reduce the heavy reliance on oil and make use of alternate clean energy resources. To this end, a number of technologies can be used at a minimal cost.