Seven questions about recent oil price slump
Sri Lanka, Jan. 2 — The effect on core inflation depends both on the direct effect of lower oil prices on headline inflation, and on the pass through of oil prices to wages and other prices.
The strength of the pass through depends on real wage rigidities the way nominal wages respond to CPI inflation and the anchoring of inflation expectations.
In normal times, monetary policy would respond to lower core inflation through a more than one-for-one decrease in the nominal interest rate, and thus a lower real interest rate. However, times are not normal, and the major advanced economies are constrained by interest rates at zero, leaving aside quantitative easing.
While the United States, which is getting closer to exiting this zero lower bound, can respond to a decrease in inflation by delaying the timing of its exit, the euro zone and Japan, which are expected to remain at the zero lower bound for a long time, cannot materially change their conventional monetary policy.
Our simulations reflect, to the best possible extent, these differences in energy intensity, in the proportion of oil produced at home, and in monetary policy constraints. We assume that inflation expectations are similarly anchored in the United States, the euro zone, and Japan, leading to a pass through of about 0.2, so a decrease in core inflation of 0.2 percentage points when headline inflation decreases by 1 percentage point.
The implications for GDP are shown in Chart 8 for the two simulations described earlier.
The effect on China in both scenarios are larger than those for Japan, the United States and euro zone countries. For China, GDP increases 0.4-0.7 percent above the baseline in 2015, and 0.5-0.9 percent in 2016.
For the United States, GDP increases 0.20.5 percent above the baseline in 2015, by 0.3-0.6 percent in 2016. (The simulation assumptions do not take into account the potential offset from some policies that governments may implement following the fall in oil prices. For example, China may decide to tighten monetary or fiscal policy in response to the oil price decline).
Other effects are relevant, which our simulations do not take into account. Among them:
The depreciation of the yen and the euro since June (by 14 percent and 8 percent respectively, for reasons mostly unrelated to the decline in the price of oil), imply that the decrease in the price of oil in terms of yen and euros has been smaller t han i n dollars, namely 36 percent and 40 percent respectively. Those depreciations somewhat mute the impact of the oil price slump for Japan and the euro zone compared to our simulations.
In countries which have large specific as opposed to proportional taxes on energy (that is, they levy a fixed dollar or euro amount per gallon or liter), the same percentage decrease in the world price of oil leads to a smaller percentage decrease in the price paid by consumers and firms.
Countries may also use the opportunity of a decreasing price of oil to reduce energy subsidies a move that has been generally recommended by the IMF leading again to a smaller decline in the price paid by consumers and firms.
Some oil importers depend heavily on what happens to oil exporters, and thus may benefit less from lower oil prices. For example, low-income importers in the Caribbean that benefit from transfers under Venezuela’s Petrocaribe regime could face a marked reduction in transfers as Venezuela itself comes under pressure. Caucasus and central Asia oil importers are likely to experience adverse spillovers from slowing growth in their oil exporting neighbors, particularly Russia, which will reduce non-oil exports and remittances. Mashreq countries and Pakistan might also be adversely affected through a decline in non-oil exports, official transfers and remittances from the member countries of the Gulf Cooperation Council, especially over the medium term. What are likely to be the effects on oil exporters?
As Chart 8 shows, t he effect is, not surprisingly, negative for oil exporters. Here again, however, there are substantial differences across countries.
In all countries, real income goes down, and so do profits in oil production; these are the mirror images of what happens in oil importers. But the degree to which they do, and the effect of the decline in the price of oil on GDP depends very much on their degree of dependence on oil exports, and on what proportion of revenues goes to the state.
Oil exports are much more concentrated across countries than oil imports. Put another way, oil exporters depend much more on oil than oil importers.
To take some examples, energy accounts for 25 percent of Russia’s GDP, 70 percent of its exports, and 50 percent of federal revenues. In the Middle East, the share of oil in federal government revenue is 22.5 percent of GDP and 63.6 percent of exports for the Gulf Cooperation Council countries. In Africa, oil exports accounts for 40-50 percent of GDP for Gabon, Angola and the Republic of Congo, and 80 percent of GDP for Equatorial Guinea. Oil also accounts for 75 percent of government revenues in Angola, Republic of Congo and Equatorial Guinea. In Latin America, oil contributes respectively about 30 percent and 46.6 percent to public sector revenues, and about 55 percent and 94 percent of exports for Ecuador and Venezuela. This shows the dimension of the challenge facing these countries.
In most countries, a mechanical effect of the oil price decline is likely to be a fiscal deficit. One way to illustrate the vulnerabilities of oil exporting countries is to compute the so-called fiscal break-even prices that is, the oil prices at which the governments of oilexporting countries balance their budgets. The breakeven prices vary considerably across countries, but they are often very high. For Middle Eastern and Central Asian countries, the break-even prices range from $54 per barrel for Kuwait to $184 for Libya with a notable $106 for Saudi Arabia (see Chart 9). For countries for which we do not have available data on break-even prices, budgetary oil prices (that is, the oil prices that countries assume in preparing their budget) are another way to gauge countries’ vulnerability to falling oil prices.
For Africa, those budgetary oil prices have been revised down in 2015 in light of the falling prices (See Chart 10). For Latin America, the budgetary oil prices are $79.7 for Ecuador and $60 for Venezuela.
Some countries are better equipped than in previous episodes to manage the adjustment. A few have put in place policy cushions such as fiscal rules and saving funds and have more credible monetary framework, which have helped decouple internal from external balances, such as Norway.
But, in many, the adjustment will imply fiscal tightening, l ower output, and a depreciation (harder to achieve under the fixed exchange rate regimes that characterize many oil exporters). And where expectations of inflation are not well anchored, the depreciation may lead to higher inflation.
What are the financial implications?
Declines i n oil prices have financial implications, directly through the effects of oil prices themselves, and indirectly through the induced adjustment of exchange rates.
Lower oil prices weaken the financial position of firms in t he energy sector, especially those that have borrowed in dollars, and by implication weaken the position of banks and other institutions with substantial claims on the energy sector.
The proportion of energy firms with an interest coverage ratio (the ratio of cash flows to interest payments) below 2 stands at 31 percent in emerging countries, indicating that some of these companies may indeed be at risk. CEMBI spreads, which reflect spreads on high yield emerging market corporates, have increased by 100 basis points since June.
Stress tests carried out in the context of our financial stability assessments over the past few years in a number of oil exporting countries had found only a few countries where some banks did not pass the tests, implying recapitalization needs of a few points of GDP at most. However, those stress tests results may not be very informative since the capital buffers at the time of the tests may have changed, as well as the profitability of banks. Russia is a good example of rapidly evolving conditions in both respects considering the effect of sanctions on its financial sector. Overall the impact of l ower oil prices on banks i n oil-exporting countries will depend critically on how persistent the fall in price is and its impact on economic activity and in turn on prevailing buffers.
Lower oil prices also typically lead to an appreciation of oil importers’ currencies, in particular the dollar, and to a depreciation of oil exporters’ currencies. The drop in oil price has contributed to an abrupt depreciation of currencies in a number of oil exporting countries including Russia and Nigeria. While the decrease in the price of oil is only one of the reasons behind the fall of the rouble, the Russian currency has depreciated by 40 percent so far this year, and 56 percent since September.
While controlled depreciations can help oil exporters adjust, they also exacerbate financial problems for those firms and governments whose debt is denominated in dollars. And, in countries where expectations are not well anchored, uncontrolled depreciations can lead quickly to very high inflation.
If sustained, the oil price slump will thus have a concentrated and material impact on those bondholders and banks with high dollar and energy sector exposures. However, the global banking system’s exposure is likely not to be large enough to cause more than a moderate increase in provisioning requirements and should be partially offset by improving credit quality in oil importing countries and sectors. Some oil importers may nevertheless have financial sector linkages to oil exporters, and may be exposed to economic and financial developments in the latter. For example, Austrian banks have significant exposure to Russia, and some have seen a very sharp decline in their equity price recently.
This relatively optimistic assessment must however come with a clear warning. One of the lessons from the Great Financial Crisis is that large changes in prices and exchange rates, and the implied increased uncertainty about the position of some firms and some countries can lead to increases in global risk aversion, with major implications for repricing of risk, and for shifts in capital flows. This is all the more true when combined with other developments such as what is happening in Russia. One cannot completely dismiss this tail risk. What should be the policy response of oil importers and exporters?
Clearly, the appropriate policy response to falling oil prices will depend on whether the country is an oil importer or exporter. The exception is the shared opportunity provided by low oil prices to reform energy subsidies and energy taxes.
The I MF has long advocated that governments use t he saving from t he removal of energy subsidies toward more targeted transfers. Low prices provide a great opportunity to remove subsidies at less political cost. For example, India was able to decrease diesel subsidies recently, and there were no protests as the price did not rise. And, in a number of advanced countries, this might be an opportunity to increase energy taxes, using the savings to reduce other taxes, such as labor taxes.
Now let’s turn to oil importing countries. In normal times, for a country in good macroeconomic health say, no output gap, inflation is at target and current account is balanced t he advice is well honed, learned from past movements in oil prices: monetary policy should make sure that, in the face of lower headline inflation, inflation expectations remain anchored, and try to maintain stable core inflation. Whether this implies an increase or a decrease in the interest rate is ambiguous. On the one hand, higher demand calls for higher interest rates; on the other hand, keeping core inflation from declining, may call for lowering interest rates. In general, whatever the interest rate does, the improvement in the current account balance is likely to generate an exchange rate appreciation. This appreciation is natural, and desirable.
Times are not normal however. Most large advanced economies suffer from a substantial output gap, inflation below target, and conventional monetary policy constrained by interest rates close to zero. This suggests that any increase in demand is welcome at this stage, and that lower inflation, which cannot be offset by lower interest rates, is more dangerous. Against this backdrop, use of forward guidance to anchor medium run inflation expectations and avoid sustained deflation is crucial.
One might think that the appropriate policy response for oil exporters is the same as that of oil importers, but sign reversed. Importers differ however from exporters in two important ways: first, the size of the shock faced by oil exporters as a proportion of their economy is much larger than for oil importers. Second, the contribution of oil revenues to fiscal revenues is typically much higher. Thus, in all countries, lower fiscal revenues, and the risk that prices remain low for some time, imply the need for some decrease in government spending.
In countries that have accumulated substantial funds from past higher prices, allowing for larger fiscal deficits and drawing on those funds for some time is appropriate. This is even more so for exporters with fixed exchange rates, and where the real depreciation needed for adjustment may take some time to achieve.
For countries without such fiscal space, and where room to increase the fiscal deficit is limited, the adjustment will be tougher. Those countries need a larger real depreciation. And they need a strong monetary framework to avoid that depreciation leads to persistently higher inflation and further depreciation. This will indeed be a challenge for a few oil exporters.