Oil price shocks and macroeconomic stability in global economies

Exogenous Effects of Oil Price Shocks

The destabilizing effects of Oil price hikes in the trade balance of both developed and developing oil-importing economies is very clear. Even for the OPEC nations, the initial gains in their national revenues would be offset by the depressive effects of inflation in the oil importing countries. Sub-Saharan African countries having the lowest per capita income and highest external debts are the worst prepared to absorb the Oil price shocks. Over the next decade energy diversification would be the key strategic focus for countries that are struggling to manage the ever-increasing demands with the limited sources and striving to reduce their dependence on oil.

Introduction

Global economic performance is clearly dependent on the price of Oil. Oil prices affect the macroeconomic stability of a nation. Geopolitical tensions have created a destabilizing effect on the world economy. The 1973 oil embargo caused immediate repercussions causing the collapse of the stock market in the U.S. This was followed by the 1979 Iranian revolution and then the 1990 Iraqi invasion of Kuwait led to another recession. With seven consecutive years of rising Oil prices last year saw prices reach an unprecedented 147$ per barrel. Early this year the price of oil was 63% lower at $54 a barrel. [Jad Muawad, 2009] However, the supply management polices of OPEC countries intervened to hold off any further fall in the prices and the last few weeks witnessed a dramatic upswing. These fluctuations in Oil price adversely impact the OECD countries, oil importing developing economies, as well as the OPEC in the longer term. Particularly in the OECD and developing nations higher Oil prices contribute to greater unemployment, inflation and national budget deficits. Even for the OPEC countries the immediate profits due to rising oil prices are offset by the reduced exports with their trading countries that are experiencing economic recession. Geopolitical uncertainties, OPEC supply management policies and the ever-increasing demand for energy and its limited sources have made oil the single most important commodity that controls the global economy. Let us have a brief overview of the exogenous effects of oil price shocks on the world economy.

Macro economic Effects of Oil price Hikes

Before we discuss the impact of oil price shocks on the different global; economies it is necessary to have an overview of the transmission mechanisms through which fluctuations in oil price affect the macroeconomic variables. There are six transmission channels that are theoretically known to affect the economy due to changes in oil pricing. The most important of these is the 'supply side shock effect' which simply means the changes in production cost ascribed to the oil price changes. Next is the 'Wealth transfer effect' that relates the marginal consumption rate of 'petro-dollar' to normal trading surplus. Thirdly the inflationary effect which is simply the relationship between regional inflation in context of global oil prices. [Tang et.al, 2009]

Oil Prices and the OPEC Economy

OPEC group represents 12 nations that together have almost four fifths of the world's crude oil reserves and produce almost one third of the world's oil output. The steady growing demand for oil implies that OPEC oil GDP will surge with the hike in the oil prices. The recent swelling of oil prices from 54$ a barrel to almost 80$ is worrying economists as the world is slowly recovering from the recent recession. As per the recent data from the U.S. Energy Information Administration, the Oil export earnings of the OPEC countries for 2010 is supposed to increase to $750 billion as opposed to the earlier projection of $503 billion due to the current hike in oil prices. This is a 30% increase in OPEC oil revenues compared to the current year. The record high prices of 2008 (oil was $147 a barrel) earned the OPEC nations a whooping $966 million in oil revenues. [Tom Doggett, 2009]

In fact, all the OPEC nations enjoyed current account surpluses in 2008 when oil prices went skyrocketing. Together, the OPEC group enjoyed an account surplus of $467 billion, which translates to a 28% increase of current account balance. Saudi Arabia, one of the major members of the OPEC group made $283 billion in oil revenues in 2008 compared to $206 billion in 2007. The increase in oil revenues boosted the country's productivity that can be inferred from the GDP at $482 billion for 2008 up from $381 billion in 2007. In fact, the OPEC group's combined GDP witnessed a distinct increase from $2.27 trillion in 2007 to $2.88 trillion in 2008. [Christopher Johnson] On the flip side, the economic recession of the trading partners would result in lower export levels in the future.

Developing and Transition Economies

The impact of oil price hikes is more pronounced for developing economies. As per the IMF data, the poorest countries suffer up to 1.5% loss in their GDP if oil price is increases by 10$ over a sustained period. For instance India and China are two of the important and fast developing economies of this decade. In India and China a sustained $10 increase in oil price would negatively impact the GDP by 1% and .8% respectively. OECD secretary Angel Gurria mentioned China and India would be two main drivers of economy in this period of global recession. However, since India and China import majority of their oil requirements a sudden surge in oil prices has inflationary consequences.

One of the reasons for such immediate impact is the poor energy efficiency in China and India. Oil importing developing countries are more oil intensive economies. Statistics indicate that oil intensive developing countries spend twice as much energy to produce one unit of economic output compared to developed economies. [IEA] India for instance utilizes two and a half times the energy compared to U.S. per unit of GDP. Similarly the energy consumption of China per U.S. $1,000 GDP is .56 tones of oil. This again is far higher than Germany (.09), U.S. (.17), Japan (.12) etc. Also China's oil imports rose to 52% by the end of 2007. However, between 2000 and 2007 when the oil prices were steadily rising China's economy averaged around 9.78% per year. In general increased oil prices would imply industrial production below maximum capacity and passing over of the burden to the consumer. So production output is directly related to consumer price index (CPI ) and the oil price. However, in China low domestic demand, price regulations and stiff competitions in the export sector have not allowed the direct transmission of the price along the chain to the end consumer. This invariably means reducing the profit margin for the producers, which economists feel has long-term implications. That is the lack of smooth inflationary shock transmission leads not only to reduction in production output but also contributes to reduction in future investments. Thus, inflationary shocks due to oil price hikes are more long lasting in China. [Tang et.al, 2009]

Sub-Saharan Countries

The impact of Oil price explosion is nowhere as pronounced as in sub-Saharan Africa and in particular the oil importing countries. Among the lower economies those that are oil intense such as the sub-Saharan countries are bound to suffer more -- as much as 3% of their GDP. Oil dependence has not change much with only 6% reduction between 1990 and 2005. This is because these countries have a total dependency on oil as their major source of energy compared with other developing countries in Asia. For instance, India and China use coal as their principal source of energy (50% and 70% respectively). Besides few oil exporting countries most other nations in Africa are entirely dependent on oil such that some of these countries lost as much as 3.5% of their GDP for few years during the recent Oil price hike. Seventeen countries in the continent are totally dependent on Oil or biomass for their energy demands. Sub-Saharan African countries are very vulnerable to Oil price fluctuations as most of these countries spend as much as 14% of their GDP for oil imports. Statistics show that compared to the 1990 Oil price hike Africa is adversely affected during 2003. The fact that sub-Saharan African countries have the lowest per capita income and highest external debts makes it difficult for the economy to absorb the Oil price shocks. Also while Asian (Philippines and Thailand increased production) and South American countries such as Brazil (reduced oil imports by 50%) have increased local production there are no similar possibilities for the sub-Saharan African countries (excluding the few oil exporting countries) in the immediate future which makes their situation very bleak and vulnerable to oil price changes. Statistics from 1990 to 2003 show that 10 out of the 37 oil importing countries experienced a GDP per capital fall of around 10% while for five countries it was 20%. Rwanda, Burundi, Central African Republic and Malawi experienced a doubling of the debt ratio during this period. [Robert Bacon, 2005]

Macroeconomic Effects of Oil Price Hikes (A comparison)

Comparing the oil price shocks in the 1970's with the recent years and their respective impact from a global economic standpoint would help us better understand the macroeconomic effects of Oil shocks. Understanding the differences between the periods would help us better prepare for future episodes of stagflation. Firstly the Yom Kippur war in 1973 and the ensuing oil embargo of the OPEC nations and next the 1979 Iranian revolution both resulted in severe recession. Blanchard et.al conducted an extensive comparative study of these varied periods of economic downturns and by using statistical multivariate and bivariate VAR analysis tools using GDP, CPI and other variables such as prices and quantities, arrived at some conclusions. Inferring from the statistical data and graphs it was clear that the impact of Oil price hikes in the context of unemployment, price hikes, wages and overall productivity were milder in the recent years than in the 1970's. One of the reasons ascribed to this is the declining wage rigidities particularly since the 1990's. The absence of wage adjustment or slower wage adjustment in the 1970's could have led to the loss in productivity and increased inflation. Secondly, improvements in monetary policies in the recent years have helped to reduce the inflationary impact of Oil price changes. Today's banks are more committed to maintaining low levels of inflation. Also, the OIL GDP share is significantly reduced today when compared to the early periods. Last but not least, many nations today have built strategic oil reserves to offset any sudden and short-term supply limitations. So overall, the world is better prepared now than it was in the earlier period to tackle the repercussions of oil price fluctuations. [Blanchard (2007)]

Conclusion

Oil price directly influences the economic development of all the countries of the world. The destabilizing effects of Oil price hikes in the trade balance of both developed and developing oil-importing economies is very clear. As discussed above, both for the OECD countries as well as the non-OECD countries oil price hikes tend to slow down the economy. Even for the OPEC nations, the initial gains in their national revenues will be offset by the depressive effects of inflation in the oil importing countries. Oil importing developing nations would bear the brunt of the oil price hike more compared to developed countries as their higher oil intensive economies and higher import costs would stretch their already overstretched resources. Though, on a comparative level, we are much better prepared now than the 1970's, Oil price still remains an important macrovariable that governs the global economy. Today's governments are better prepared to control inflation while maintaining low interest rates. Still the frequent upswing in oil prices is a big problem for most nations, including the OECD nations that have large and growing budget deficits driven by surging oil import bills. In developing economies such as India where government offers subsidies, fiscal imbalances due to Oil subsidies will be further amplified. Sub-Saharan African countries having the lowest per capita income and highest external debts are the worst prepared to absorb the Oil price shocks. Over the next decade energy diversification would be the key strategic focus for countries that are struggling to manage the ever-increasing demands with the limited sources and striving to reduce their dependence on oil.