Will rising oil price stifle recovery?
By Shahid Javed Burki
Monday, 19 Apr, 2010
OIL prices have begun to rise just as Pakistan seems to be emerging out of a deep economic recession. The increase in oil price was partly responsible for the sharp slow down in the economy in 2008-09. The rate of GDP growth declined to only two per cent that year, one of the lowest in the country’s history.
How badly will the current oil price rise hurt the economy? The answer, given the experience of 2008-09, is that the effect on Pakistan will be considerable. It could – probably would – once again result in increasing the trade deficit which, in turn, will have an impact on the balance of payments.
The most recent rise in oil price comes at a time when the flow of funds from the IMF is stalled because of the lack of progress the country has made in instituting tax reforms. There is lack of satisfaction at Islamabad’s ability to move in instituting the value-added tax (VAT). This is considered vital for increasing tax-to-GDP ratio from less than 10 per cent, the lowest in a major emerging economy.
With the flow of funds from the IMF no longer certain to arrive according to the time schedule, Pakistan had factored in its own calculations, any pressure on the balance of payments will have a very debilitating effect. This will happen if the recent trends in the world oil market continue into the future.
Last week oil climbed to $87 a barrel, the highest level since October 2008. This jump in price occurred after a period of eight months when oil traded between $70--80 a barrel. The oil- producing and exporting countries had expressed satisfaction that oil was being traded within this narrow band. Saudi Arabia, the largest producer and exporter of oil, had indicated that it was comfortable with this price. It satisfied its financial requirement while it was not considered to be disruptive for recovery in the global economy.
The latest surge in oil price appears to be the result of the way the market players are reading the extent and level of recovery from the Great Recession of 2008-09. There is a rising confidence in global economic recovery. The rise in the Dow Jones Index of stock prices in the United States – it crossed the 11,000 mark on April 13, the day the price of oil touched its highest level in recent months – is one of the several indicators of return in confidence. The more optimistic Wall Street players see a further rise in oil prices. According to Barclay Capital oil price will touch $97 a barrel; Morgan Stanley sees the price climbing even higher, to $100 by next year; while Goldman Sachs sees it increasing to $110.
Let us go back for a moment in history in order to understand what may be in store for oil importing countries such as Pakistan. Oil prices first hit $100 in January 2008. They continued on a rising trend, reaching a peak of $147 in July of that year. This meant an increase of 47 per cent in six months. While the shock delivered to the global economy was not as severe as in 1974 and 1979 when price increases resulted from the actions taken by the oil producers and exporters in the Arab world, the effect on the health of the economy in 2008 was severe. This was the case since the global economy was already under great pressure because of the problems in the financial sector.
This time the increase in price is occurring as the global economy is recovering rather than being on the way down. But that notwithstanding, according to Olivier Jakob of Petrometrix, a group that keeps watch over oil prices, “recovery of 2009 was fuelled with crude oil at $62 a barrel, not at $90 a barrel or $100. We fear that the latest run in oil prices will be a kiss of death for the global economy that was trying to avoid a double-dip recession.”
During the earlier period, the United States and other rich countries were able to absorb to some extent price rise since the consumers were able to draw upon home-equity loans and credit cards to finance the increases in petrol and home heating oil. These cushions are no longer available. For most consumers equity in their homes has evaporated because of the decline in house prices and credit card companies are not prepared to offer loans as liberally as they did then. In other words, if the price of oil continues to increase, the effect on them and hence on the economy may be as sharp as was the case two years ago. This was one reason why the prospect of oil-induced recession cannot be altogether ruled out.
In the case of Pakistan the increase in the price of oil will impact in three ways. If there is another global economic downturn, Pakistan will suffer once again by seeing its exports failing to increase at any appreciable rate. This is what happened last time around. Also worrying is a possible increase in the prices of commodities Pakistan must import in order to maintain a reasonable amount of economic activity. But the most severe consequence for the country will be on the price it will have to pay for importing fuel oil, an important source for generating electricity.
It has been two years since Pakistan began to experience shortages of electricity which led to load shedding. This had impacted all sectors of the economy, in particular manufacturing. If anything, the load-shedding duration has increased in most cities and industrial areas. There was an expectation that the government would take some steps to ease the shortage by establishing additional power generation. That has not happened. Some increase in capacity will come through but it will not be sufficient to ease the pressure and the economy will continue to perform poorly.
In spite of the repeated crises Pakistan has been through, the government has still to put together a viable strategy that will take care of the energy needs.. This strategy must address a number of issues. It must settle on what are the most attractive sources of energy. In that context policymakers have to decide how they can use the enormous potential that exists for using hydro resources. Politics has stalled any major effort to tap the waters of the Indus River system for generating electricity.
Several decades ago the UNDP prepared a long-term plan for the realisation of the potential that exists. This assessment needs to be updated. There is also the need to settle on an appropriate institutional structure for managing the generation, transmission and distribution of electricity. Advised by the World Bank, Pakistan spilt these functions and assigned them to separate entities.
In addition a regulatory agency was created for determining the appropriate level of tariffs for consumers. These changes resulted in the break-up of WAPDA. But the logic behind this move was not fully followed through with the consequence that much confusion now prevails. This approach needs to be revisited. There is, in other words, a great deal of policy work that needs to be done to secure Pakistan’s energy future and avoid another recession brought about by an increase in the price of oil.