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p. 21 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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Policy responses to higher oil prices

No "one size fits all" response to higher oil prices exists. Across developing Asia, circumstances vary greatly and countries need to respond in different ways. For net oil importers, the challenges posed by higher oil prices will differ depending on their macroeconomic conditions, available financial resources, degree of access to international capital markets, impact on trading partners, economic structure, and fuel-pricing policies. For net oil exporters, structural factors will also be important, including their oil reserves, the ownership structure of the oil sector, oil taxation, the government's financial position, and the public sector's absorptive capacity. Matters are more complicated still, for all countries, because there is often a considerable measure of uncertainty about how long higher prices are likely to endure. One small benefit of such uncertainty, though, is that it will generally commend a measured response, which can be reversed without incurring large costs. Looking to the long term, policies that influence oil consumption and use must be consistent with broader development objectives.

Oil subsidies and taxation

Many governments across developing Asia directly subsidize oil products, including kerosene, liquefied petroleum gas (LPG), and, generally to a lesser extent, diesel and gasoline. In some countries retail prices are openly subsidized and in others they are regulated or controlled through state-owned distribution channels. Indirect subsidies are also common, and are seen where products that have a high oil content, principally electric power, are provided at prices below their true cost. Even in countries where there are no open or indirect subsidies, taxation is often modest. Excise and customs taxes on oil products are a potentially important source of fiscal revenue that need to be maintained at an appropriate level both for budget revenue and the proper long-term allocation of the country's investment capital. In the recent run-up in oil prices, however, some countries have markedly reduced such taxes in an attempt to protect consumers.

Box 3.3 summarizes the experience of eight countries with fuel subsidies. Subsidies in these countries have so far limited the pass-through from higher crude oil prices to the retail prices of various oil products and therefore to final goods. This has certainly helped contain the inflationary impacts of rising crude prices, but in the absence of detailed study very little is known about exactly who benefits from these subsidies and by what amount.

Beyond concerns about the impact of higher fuel prices on the general population, the rationale for oil subsidies and discretionary increases in subsidies is not particularly clear. Subsidies do not eliminate the negative effects of higher oil prices on potential output. Demand must still adjust to the deterioration in the external payments position. Subsidies also add to the fiscal burden and represent an opportunity cost (in terms of the alternative uses to which scarce fiscal resources could have been put). In Indonesia, for example, the fiscal cost of oil product subsidies in 2005 will be larger than budgetary allocations for education and health combined. Raising subsidies or reducing excise taxes as oil prices rise creates deeper distortions, too. Subsidies underwrite fuel and energy inefficiency, retard the development and diffusion of cleaner technologies, and contribute to harming the environment. The rent created by subsidies also encourages fuel smuggling and other illegal activities.

Rising fiscal deficits, driven in part by growing fuel subsidies, have led some countries to scale down or withdraw subsidies. For example, on 12 July, having incurred fiscal costs of about $2.2 billion over an 18-month period, the Government of Thailand announced that all fuel subsidies would be removed by February 2006, and immediately ended all diesel subsidies. Malaysia's Government, which had earlier suspended excise taxes on gasoline and diesel, has now declared its intention to scrap subsidies on these two products. Malaysia has adopted a graduated approach and has so far lifted gasoline and diesel prices three times in 2005.

In Indonesia, too, diesel subsidies were cut earlier in 2005, but subsequent increases in the price of crude oil mean that expected budgetary costs of all subsidies have swollen and now exceed their 2005 appropriation. Other countries have problems. In Bangladesh, the state-owned oil distributor, Bangladesh Petroleum Corporation, is accumulating very large operating losses while the oil bill is putting pressure on foreign exchange reserves. In India, the federal Government has expressed concern about recently announced losses at major refining and oil marketing companies. Without doubt, similar pressures are being felt in other countries that are heavily reliant on imported fuel while selling it domestically at below imported cost.

Removing fuel subsidies clearly meets with formidable political resistance in some countries. But if subsidies are retained and higher oil prices do not recede, their fiscal costs will mount. One approach might be to remove subsidies first on those fuel types on which the poor do not depend. In most countries in developing Asia, gasoline subsidies are not provided or are relatively small, but, equally, taxation is often relatively modest given the income levels of gasoline consumers. Although diesel subsidies are widespread, and the poor do not directly consume much diesel, the poor indirectly rely on it, particularly for transportation. But many non-poor also benefit from diesel subsidies, and the case for phasing out is strong.

For those fuels that the very poor rely on the situation is more vexed, and a range of factors needs to be carefully considered. In principle, it may make sense to replace fuel subsidies by income subsidies, but income-targeting approaches, e.g., vouchers, may prove difficult and costly to implement. In some situations, the removal of subsidies may not make much economic sense if the alternative is that poor people turn to other fuel sources, particularly biomass, which result in heavier environmental damage and costs to health.

Governments also need to be careful in considering the distributional impact of subsidies. Sometimes, as e.g., with diesel, subsidies are captured by the non-poor. This can happen where there are both monopoly control over distribution and regulatory failure. For example, the relatively large share of kerosene in total oil product consumption (see the appendix table to this part) in countries where kerosene is heavily subsidized is an apparent indication of problems in targeting subsidies. A decision to remove or scale back subsidies may be politically more palatable if some part of the fiscal savings is visibly earmarked for development programs that are fast disbursing and that directly benefit the poor.

As many decisions on energy production and use are taken by the private sector, it is important that oil prices reflect fully their social and environmental opportunity costs. This requires going beyond just removing subsidies on oil products. Oil taxes could provide an important source of budget revenue. Moreover, tax rates need to ensure that oil products are priced to fully reflect the negative externalities that they create in terms of pollution.

The price of oil products will be a major determinant of Asia's future demand, not just for oil but for alternative sources of renewable energy as well (Box 3.4). If oil is not suitably taxed, or is inappropriately subsidized, incentives to develop and adopt more energy-efficient technologies will be blunted and conservation will be hampered. This is a major reason why, in the past, developing Asia has not always adopted energy-efficient technologies, preferring cheap but less energy-efficient alternatives.

Macroeconomic policies

For net oil-importing countries, higher oil prices will require that domestic demand adjusts to a decline in potential output. The role of macroeconomic policies should be to ease needed adjustments to demand and supply and to guard against the possibility of a destabilizing inflationary spiral. Different economies will have varying degrees to maneuver in their policy responses.

In countries where the monetary authority enjoys credibility and where inflationary expectations are well anchored, monetary policy may be able to accommodate some of the direct impact of higher oil costs on final goods prices. But if higher oil prices threaten to percolate through to rising wages in a second round of cost increases, or inflationary expectations become heightened, the monetary authorities should consider tightening. This will help guard against the risk that higher oil prices unleash a cost-price spiral, magnifying output losses over a protracted period. This was the experience across much of Asia during the first and second oil price shocks, though this time around, preemptive tightening of monetary policy, as seen in timely measures taken in the Philippines and Thailand, should help contain inflationary impacts.

Fiscal policy can help buffer the output losses entailed by higher oil prices. Its role should be to assist in smooth adjustments and to provide a measure of temporary relief, but it cannot inoculate an economy against higher oil prices. Normally, fiscal stabilization should occur automatically. Any discretionary response should be limited, especially as it may be difficult later on to remove expenditure programs and subsidies or to restore oil taxation to previous levels if oil prices subsequently fall. Attempts to shield consumers and producers from the impact of higher oil prices through discretionary fiscal subsidies, as is happening in many countries, can have a high opportunity cost both in fiscal terms and in terms of broader efficiency considerations (see above). For countries whose initial fiscal position is weak, even automatic stabilization may prove difficult. If a larger deficit cannot be accommodated, adjustments will need to be more abrupt.

Box 3.4 Retail fuel prices in Asia The box figure gives a snapshot of retail prices of super gasoline and diesel in November 2004 across a sample of 30 Asian developing countries. The data were compiled by German Technical Cooperation (GTZ). It shows three sets of colored vertical lines that define benchmark prices that broadly indicate national pricing policies for transportation fuels. The red lines (27 US cents per liter) indicate the cost per liter of crude oil, which was $43/bbl at that time. The green lines are the US prices (54 US cents per liter for gasoline and 57 US cents per liter for diesel) representing product prices determined in a competitive market with an efficient refining industry; the US prices include about 10 US cents per liter of taxation that was considered a reasonable dedicated tax standard needed for road or general transportation infrastructure. The yellow vertical lines indicate Luxembourg product prices representing the approximate minimum level for the 10 European Union accession countries. Only two economies--Hong Kong, China and Korea--priced around or above this benchmark. For gasoline, the bulk of countries (18) charged the green line benchmark price or more while an additional six charged the green line price excluding taxes of 10 US cents per liter. Whether at the margin the green line prices would represent cost recovery in a country would depend on local circumstances, especially refining industry efficiency and national distribution costs. Only a small fraction of crude costs are covered in Turkmenistan and Myanmar while in November 2004 Indonesia's gasoline prices might just have covered crude costs. Uzbekistan, Malaysia, and Azerbaijan covered crude costs, but gasoline prices at that time appear to have been substantially subsidized. For diesel, five countries charged less than the indicative crude cost--Turkmenistan, Myanmar, Indonesia, Malaysia, and Azerbaijan. As with gasoline, all countries that did not recover crude costs were oil producers. It is notable that another 14 countries did not price to the green line standard, i.e., the bulk of countries provided subsidies for diesel. Since November 2004, crude prices have risen considerably, but many of developing Asia's governments have not fully passed this through to retail prices. They have extensively relied on increases in direct subsidies, cuts in petroleum taxation, and losses by state-owned petroleum companies to avoid full price adjustment. Thus the very mixed picture for November in cost recovery in transportation fuel (including some minimal taxation) has likely been heavily clouded since then. Across Asia, the most heavily subsidized oil products are not transportation fuels but products such as kerosene and LPG used by the poor, mainly for cooking. (However, data on the structure and magnitude of these subsidies are not readily available.) Kerosene, in particular, is heavily subsidized in many countries, since it often accounts for a significant part of poor households' expenditure. For example, in India and Nepal, kerosene absorbs about 2% of total household spending among the poorest urban households (UNDP/ESMAP 2005). If kerosene prices increased significantly, poor households in these countries and elsewhere would be at risk.

Those countries facing external payments difficulties will generally have less scope to smooth out the negative impacts on prices and potential output, and are likely to face more difficult economic adjustments. In the absence of sufficient foreign reserves or external financing opportunities, a deteriorating trade balance must be accommodated by reductions in domestic consumption and investment. In such cases, a depreciating exchange rate will facilitate adjustments of domestic demand and will help move resources from the nontraded to the traded goods sector. However, in poor countries with large external debts, additional external financing assistance on a grant basis or on highly concessionary terms may be needed as a temporary measure to help fill payments gaps.

Higher oil prices also pose challenges to net oil exporters. Much will depend on the distribution of income gains, and whether the non-oil sector faces higher costs. In countries where oil revenues are narrowly concentrated, the overall impact of higher oil prices on aggregate demand may be negative, but where increased oil incomes spill over into the broader economy, private demand may expand and generate inflationary pressures. As a consequence of foreign exchange inflows, an appreciation of the real exchange rate is likely to follow, squeezing activity in the non-oil, traded goods sector--the so-called "Dutch disease."

Sterilized intervention may slow the process and help contain domestic inflation, but cannot stop it. If the increased oil income seems to be temporary, governments need to exercise caution about expanding expenditure programs. Even if the gains look like being more permanent, the authorities need a plan to use them over a medium- to long-term horizon, integrate them within a broader expenditure planning framework, and ensure that spending decisions pass standard tests that guard against waste.

Oil-exporting countries may also consider the benefits of making a precautionary reduction of their debts; of saving in oil stabilization funds held in foreign currency assets (to finance future development expenditures); and of targeting a non-oil fiscal deficit that would limit macroeconomic strain. These are some of the issues that the net oil exporters in Central Asia and Pacific, for example, will continue to grapple with.

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