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p. 20 of 25 BACK | NEXT Foreword, Acronyms and Abbreviations, Definitions I. Developing Asia and the world II. Economic trends and prospects in developing Asia III. The challenge of higher oil prices Adjusting to higher oil prices: The challenge for developing Asia Why are oil prices so high? Why high oil prices matter Policy responses to higher oil prices Long-term responses Conclusions Selected references Statistical appendix

Asian Development Outlook 2005 Update : III. The challenge of higher oil prices

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Why high oil prices matter

As developing Asia consumes more oil than it produces, higher oil prices are likely to eat into its income growth. By how much will depend on the extent to which oil prices rise and how long they remain elevated. For net oil-importing countries, the impact will depend on a range of factors, including their oil and energy intensity and the ease with which needed adjustments take place. For net oil-exporting countries, higher oil prices raise oil sector profits but these benefits are often highly concentrated and can be offset by negative effects elsewhere. To understand possible impacts, it is useful first to look at how developing Asia's economies depend on oil.

Oil and energy dependency in Asia

Table 3.1 profiles developing Asia's reliance on oil in 2003. Dependency is measured in four ways, using five indicators: oil self-sufficiency; intensity of oil use in energy consumption; energy intensity of GDP, both at market and at purchasing power parity exchange rates; and per capita oil consumption. The oil self-sufficiency index measures oil production less consumption in relation to oil consumption. Thus a value of -1 signifies that a country has no oil production and is totally reliant on oil imports; a positive number means that a country is a net exporter. The intensity of oil use in energy consumption index measures the share of oil in an economy's primary energy consumption. If a country relies only on oil to produce energy, the value of the index is 1; if no oil is used in producing its energy, the value is 0.

The third and fourth indicators show a measure of the energy intensity for an entire economy (energy consumption divided by GDP). This measure is standardized on the energy intensity of the G7 countries. For example, a value of 2 would mean that the country in question uses twice the energy as the G7 average per unit of GDP. This measure is presented for both nominal GDP calculated at market exchange rates and for purchasing power parity-adjusted GDP from the World Economic Outlook database of the International Monetary Fund (IMF). The fifth indicator simply divides annual oil consumption in barrels by a country's population.

Developing Asia shows considerable diversity in oil self-sufficiency (Table 3.1, "Oil self-sufficiency" column): several countries are net oil exporters, but many more are totally reliant on oil imports. In addition, its reliance on imported oil has trended up through time: in 2003, 44.7% of oil consumption was imported, compared with just about 10% in the mid-1980s (Figure 3.3).

At the subregional level, South Asia is the most reliant on imports followed by East Asia; Southeast Asia has also become a net importer as Indonesia's production has failed to keep pace with consumption. Central Asia and the Pacific are net oil exporters, though the position of the Pacific masks the complete reliance on imports of all countries but Papua New Guinea (and Timor-Leste, which is not included in the International Energy Annual 2003 figures due to lack of data). In Central Asia, the Kyrgyz Republic and Tajikistan are highly reliant on imports.

Vulnerability to rising oil prices depends not just on oil self-sufficiency but also on the intensity with which oil is used to produce energy. In the mid-1980s, oil met about 30% of developing Asia's energy needs, or much the same as in 2003 (Figure 3.4). However, the oil intensity of energy consumption is much more pronounced in some countries than in others (Table 3.1, "Intensity of oil use in energy consumption" column). A notable feature is that small island economies are highly dependent on oil for their energy needs. Elsewhere, oil intensity is highest in Southeast Asia and lowest in Central Asia and the PRC, due to their use of alternatives, such as natural gas, hydropower, and coal.

The energy intensity of GDP (Table 3.1, "Energy intensity of GDP" columns) is affected by several factors, including a country's climate, size, and stage of development as well as whether it produces and refines oil. Countries that have colder climates consume more energy, other things being equal, while countries with a large oil contribution to GDP are likely to be more energy intensive. The energy intensity of GDP also varies with income levels: across countries, it tends to be low for the poorest but then rises with per capita income, before tapering off at higher income levels. These features of the relationship between energy use and real output (GDP) show up in divergent patterns across developing Asia (Figure 3.5). East Asia has become much less energy intensive over time but the energy inputs into GDP have risen in Southeast Asia while South Asia and the Pacific have been on a flat to slightly declining trend. The economies of Central Asia have also as a whole become less energy intensive, possibly because of changes in economic structure during their transition to being more market oriented.

In comparing developing Asia's energy intensity with other countries, it matters greatly whether GDP is measured in nominal terms at market exchange rates or in purchasing power parity rates. In nominal market terms, developing Asia consumes over three times as much energy as the G7 per unit of output. But in purchasing power terms, developing Asia is less energy intensive than the G7. Only countries that are major oil producers or refiners, or which have very cold winters, are more energy intensive than the G7 average. A "true" picture of energy intensity in developing Asia is likely to lie somewhere between the nominal and purchasing power parity-adjusted GDP measures. But it is highly likely that, for identical activities, for example power production, developing Asia is less energy efficient than industrial countries.

The last column of Table 3.1 shows per capita oil consumption for developing Asia. These numbers show a strong positive association with per capita income, although other factors also matter. A measure of Asia's potential demand for oil is captured by the difference between the average per capita consumption of developing Asia and that of the G7. For developing Asia, these differ by a factor of more than 11 times.

Impact of higher oil prices on import bills and export adjustment

In Table 3.2, the potential impact of higher oil prices on the (net) import fuel bill is shown. For this purpose, oil prices are assumed to rise by 75%, which is approximately the increase in prices between the start of 2005 and end-August. All costs are expressed as a percentage of GDP. In these calculations, higher prices are assumed to last for 1 year. As oil production and consumption are taken as given and there is no allowance for possible adjustments, these are estimates of potential costs rather than those that are likely. This simple, illustrative exercise also gauges the potential squeeze on domestic absorption of traded goods in circumstances where added import costs cannot be met by use of foreign exchange reserves or through external borrowing. To the extent that base-value shares of net oil imports have risen since 2002, which is the base year for the calculations in Table 3.2, potential impacts on oil import bills will be larger.

At the subregional level, this exercise suggests that South Asia is the most vulnerable to higher oil prices that work through rising fuel import bills. South Asia also has the lowest oil self-sufficiency index of all subregions and its GDP, measured at market exchange rates, is comparatively energy intensive. Impacts are also substantial for East Asia and Southeast Asia. A more modest impact for the Pacific is largely attributable to Papua New Guinea and its very heavy weight in the Pacific aggregate--but for individual Pacific island economies (apart from Timor-Leste), the potential impact on import bills of higher oil prices is substantial. As a net oil-exporting region, Central Asia will potentially enjoy larger net export receipts from higher oil prices.

At the country level, Mongolia and Tajikistan seem to be the most exposed to the risk of a sharp rise in import fuel bills. Although potential costs could be exaggerated by the data used here, other sources too suggest large potential impacts: 6.8% of GDP for Tajikistan and 9.8% of GDP for Mongolia (International Trade Centre 2005). Potential impacts are also large for the Maldives, Pacific island economies (except Papua New Guinea and Timor-Leste), Kyrgyz Republic, and Singapore, ranging from 4.5% to 9.0% of GDP. Pakistan, Philippines, Nepal, and Sri Lanka face more measured impacts of about 3.0-4.5% of GDP. For other countries, including the PRC and India, potential costs are smaller but by no means insignificant. For developing Asia as a whole, imported fuel costs could rise by 1.5% of GDP, but this is after subtracting possible gains by oil-exporting countries.

Another way to measure exposure to higher oil prices is to identify by how much exports would need to grow to pay for higher import fuel bills. The data in Table 3.3 show the percentage point growth in exports that would be needed to offset the impact of a 75% rise in the fuel import bill on the trade balance. Again, it should be noted that to the extent that oil import costs have risen relative to exports since 2001-2003, the estimates in Table 3.3 may understate the ratios that would result from use of more recent data. Also, this is, once more, a partial calculation and so impacts should be interpreted as "potential" rather than likely.

The estimates in Table 3.3 bring out several points. For many net oil-importing Asian countries, the growth in exports that would be needed to pay for a 75% rise in the cost of imported oil is potentially large. The most pronounced impacts are in Mongolia and in some South Asian countries. Normally, such adjustments would occur through a depreciation of the domestic currency and a shift of resources from nontraded to traded goods activity. Even if higher prices were not sustained and these estimates were halved, temporary financing needs could still be significant. In some countries, financing needs might be met by a drawdown of foreign exchange reserves. But other countries face more difficult circumstances. Countries with large external debts, meager reserves, and limited borrowing capacity could face financing difficulties.

These estimates of the potential susceptibility of import bills and trade balances to higher oil prices omit many factors that will affect the eventual impacts. Oil product prices tend to move in step with crude prices but the correlation is not exact. To some degree, therefore, susceptibility will depend on the particular product mix of oil consumption. Producers and consumers will also adjust to higher oil product prices, as well as to changes in income, exchange rates, and interest rates. Important indirect effects will also follow from impacts on major trading partners and from policy responses to changing circumstances. Box 3.1 summarizes the different ways in which higher oil prices can affect an economy.

The Impact of higher oil prices on growth

Numerical simulation methods are needed to unravel the kinds of impacts of higher oil prices on growth that are described in Box 3.1. Any estimate of the impact of higher oil prices on growth is necessarily contingent on a large number of assumptions about the nature of the "shock," underlying economic structures and behaviors, and policy responses. In Table 3.4, the results of simulations of the impact of higher oil prices on growth and fiscal balances for selected developing countries in Asia are summarized. These simulations have been conducted using the Oxford Economic Forecasting (OEF) model. In the OEF model, higher oil prices squeeze aggregate demand and supply for net oil importers. Balance-of-payments adjustments occur through the real exchange rate. Indirect impacts are captured through the effect of higher oil prices on trading partners' growth, which affects exports. Cuts in investment may result in a smaller capital stock and permanent output losses, but growth should later return to its original trajectory. The model assumes that public sector savings or deficits adjust passively to the hike in oil prices, and that inflationary pressures are addressed through higher interest rates. The focus here, however, is on possible short-run impact effects and not on more protracted adjustment processes.

In Table 3.4, the results of the "GDP growth, OEF" column show percentage point differences in GDP growth for 2006 resulting from a $17/bbl hike in the price of oil over this Update's $53/bbl baseline assumption, essentially a rise to $70/bbl. The results in the "Budget balance, OEF" column show percentage point changes in government budget deficits measured relative to GDP. It is assumed that higher oil prices start in the third quarter of 2005 and are sustained through the fourth quarter of 2006. All other factors are held constant. In reality of course, many changes occur together, so these calculations are indicative and do not constitute forecasts.

The simulated impacts reported in Table 3.4 are sizable for some countries. The OEF model simulations suggest that Philippines, Singapore, and Thailand are most susceptible to slower growth if higher oil prices endure through 2006. All these countries are large net oil importers, but negative impacts on growth are mitigated by expanded fiscal deficits. In the Philippines and Thailand, fiscal deficits increase by nearly 1 percentage point of GDP compared to the baseline. These fiscal impacts reflect automatic tax and expenditure adjustments as incomes and prices change, and do not take account of specific oil subsidy schemes, such as the substantial expenditures incurred over the last 18 months in a number of countries.

Simulated impacts on output growth in the PRC and India are smaller, but not insignificant. Although oil dependency is low in the PRC, the model traces relatively large negative growth impacts through external trade. Simulated fiscal impacts in the PRC are modest. The impact on India's GDP growth is broadly consistent with its oil dependency. In India, growth is shielded through a large measure of fiscal stabilization, and the public sector deficit expands by 0.9% of GDP in response.

The OEF model suggests that higher oil prices would substantially reduce growth in Indonesia and Malaysia. Indonesia became a net oil importer in 2004, but its dependency on oil imports is still low. As Malaysia is a net oil exporter, it benefits directly from higher prices. The simulations suggest that any benefits accruing to oil producers are significantly outweighed by indirect impacts on exports as growth slows in major trading partners. These calculations assume, though, that additional fiscal revenues accruing from higher oil prices are added to government saving. If, instead, governments target the deficit and recycle oil revenues, a smaller negative impact on output is likely to follow. For Malaysia, the negative impact on growth could be as small as 0.6 percentage point of growth if the entire fiscal windfall is recycled. For Indonesia, the windfall is smaller, but could reduce the potential impact on growth from 1.1 to 0.9 percentage point. Again, these calculations make no allowance for the cost of fuel subsidies.

Measured in terms of its oil self-sufficiency and oil intensity of energy consumption, Korea is highly vulnerable to higher oil prices (Table 3.1 above). Korea's oil dependency and oil intensity of energy profile is very similar to that of the Philippines and therefore it might be expected that similar impacts are likely. However, compared to the Philippines and other oil-dependent countries, the estimated reduction in growth for Korea is small. The reason is that the model predicts substantial import compression, showing Korean imports' greater sensitivity to the real exchange rate following the rise in oil prices. Impacts are also moderated through more expansive fiscal accommodation in Korea.

IMF (2000) has also estimated the possible impact on growth of an oil price shock. These results have been used as a basis for imputing the numbers shown in the "GDP growth, IMF MULTIMOD" column of Table 3.4. For most countries, the OEF and IMF estimates are broadly similar, once allowance is made for the fact that Indonesia is now a net oil importer.

In its April 2005 World Economic Outlook, and drawing on the results of an associated background paper (IMF 2005), IMF revisited the likely impact of higher oil prices on growth. This Update occurred in a context where the impact of higher oil prices on global growth in 2004 had been muted (Box 3.2). IMF considers a temporary rise in the price of oil to $80/bbl from a baseline of $46. In real terms, and measured in terms of annual averages, prices at this level would be close to the historical high of 1979. For developing Asia, IMF reports that output losses could be about 0.8 percentage point of GDP. Adjusted for differences in the scale of the assumed shocks, this estimate is substantially lower than the OEF model impacts and, indeed, those of IMF (2000) and the International Energy Agency (2004). But when IMF assumes that higher prices are sustained over a longer period, as more recent news emanating from the oil markets would seem to suggest, impacts rise to 1.3 percentage points of GDP.

There is clearly uncertainty about the likely impact of higher oil prices. Much depends on assumptions both about the size and duration of the shock, and about how various actors respond. For example, producer behavior in the OEF model implies both a rapid pass-through of higher oil prices to final goods, and consumer adjustment to changes in current income. However, competitive pressures and weaker demand growth may slow or limit the pass-through, and if consumers and producers believe that higher prices will be temporary, they are more likely to spread adjustments out.

Despite this uncertainty, there is a consensus that, for developing Asia, the impact of higher oil prices will be negative. Drawing together the strands of evidence presented here, it seems that oil prices at about $70/bbl through to the end of 2006 could cut growth by over 1 percentage point in a number of countries. Some countries in Southeast Asia and South Asia could see growth trimmed by the most but there are offsetting positive factors that vary from country to country and that will influence actual growth outcomes (see Part 2 of this Update). The point bears repeating that developing Asia is now better positioned to absorb large shocks than it was at the time of the previous oil price shocks (see ADO 2004 Update, Part 3): external payments positions are more secure, monetary policy is more credible, fiscal strength is greater, and economic structures are more flexible and capable of adjusting more quickly than before. Although the region's appetite for oil continues to grow, the oil intensity of output is drifting lower.

In the next section, policy responses to higher oil prices are considered.

Box 3.2 Oil prices, inflation, and GDP growth, 2004-2005 Between 2004 and 2005, GDP growth in developing Asia is expected to slow by about 0.8 percentage point, from 7.4% to 6.6%. Broadly, this is a reversion to trend. Several factors, in addition to higher oil prices, may have contributed to softening (see Part 1): some economies have been affected by a cyclical downturn in the electronics sector; slower growth of global trade has trimmed export growth; and in several countries, fiscal and monetary policies have been less accommodative. It is difficult to be precise about the part that the various factors have played in moderating growth, though there are several reasons to think that the role played by higher oil prices has been muted. First, for much of 2004 and in early 2005, impacts ran largely from global demand (notably, US and PRC demand) to oil prices, not the other way round, thereby limiting the negative effects of higher oil prices on consumer and investor confidence. Second, over this period the escalation in oil prices was gradual, suggesting that impacts, too, may stretch out over time. Third, if consumers and investors had regarded higher oil prices as largely temporary, they would not have significantly adjusted their spending plans. And, fourth, consumers across developing Asia were to a significant extent shielded from the effects of higher prices by discretionary rises in government fuel subsidies and by firms limiting the pass-through to final prices through cutting markups. The box figure indicates that the recent upsurge in oil prices has had little impact in accelerating consumer price inflation. IMF's World Economic Outlook in April 2005 assumed that average oil prices over 2005 would be about 23% higher than in 2004. On this basis, IMF calculated that higher oil prices might cut global growth in 2005 by 0.2-0.5 percentage point in a context where global growth is expected to slow by 0.8 percentage point. As developing Asia is a large net oil importer and the global estimate includes gains for net oil exporters, it might be expected that the effect of higher oil prices on slowing growth in developing Asia might be at the upper end of the IMF range. Indeed, as oil prices have climbed well beyond the IMF projection for 2005, it would be tempting to conjecture that output losses in developing Asia might be larger than the IMF upper bound. If this were in fact the case, little of the slowdown in 2005 could be attributed to other developments, including a dip in the growth of world trade volumes. More likely, the extensive use of fuel subsidies seen in 2004 and so far in 2005, helped by generally strong fiscal and foreign reserves positions, has contained output losses. This, though, raises the question of what is likely to happen as subsidies are scaled down or removed, a process that is now under way in several countries.

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