Middle East Economic Survey
VOL. XLVII
No 24
Impact Of High Oil Prices On World Economic Growth: A Mixed Assessment
Oil prices have climbed in recent months to hit 13-year highs of over $42/B for the benchmark WTI crude, and the focus among analysts has now shifted from the causes of the price spike to its potential effects on the world economy’s gathering recovery. The decision by OPEC last week to raise production quotas and put incremental barrels in the market has put a temporary cap on prices (MEES, 7 June). But while real oil prices are not high compared to previous peaks, the effect of higher oil prices is nevertheless to depress output and incomes, and to fuel inflation. Oil exporters are obviously reaping rich rewards, but it is less clear how great is the effect on oil importers. The consensus is that current oil prices are having the expected dampening effect on growth prospects for 2004, but that they are not a cause for undue concern and are not likely to derail the world economic recovery.
Oil-Dependent Developing Countries Suffer The Most, Says IEA
According to analysis by the International Energy Agency (IEA), the effect of a sustained $10/B increase in oil prices from $25/B to $35/B would lower world GDP, other things being equal, by at least 0.5% in the following year (MEES, 10 May). However, the effects on oil importing countries are not uniform. The higher prices would reduce the GDP of OECD member countries by 0.4% in the first and second years, with Eurozone countries losing 0.5% of GDP, says the IEA. But developing countries would be hit particularly hard since on average they use twice as much oil to produce a unit of output as more developed countries. According to IEA estimates, the loss of GDP in Asia from the $10/B increase would be 0.8%, and 1.6% in poor, highly indebted countries. The effect on sub-Saharan Africa could be as high as 3% of GDP, says the IEA. Using the IEA’s analysis as a yardstick, the current level of oil prices is not a devastating blow to the world’s economic recovery, particularly if such levels are not sustained and they return to around the OPEC target band of $22-28/B. It does suggest cause for concern for developing countries, however, and the need for support for those countries from the developed world.
Oil Matters…
Even though developed economies such as that of the US are less reliant on oil than they were at the time of the first serious oil price shock in 1973, oil prices are still a key variable in the economic growth equation. The evidence coming from central bankers, finance ministers and economists, so far, suggests that the findings of the IEA study are largely correct – high oil prices are dampening growth, but not yet throwing it off course. Nevertheless, the importance with which the world’s finance ministers view the issue is evident. Discussions of the impact of high oil prices and the appropriate policy response have invariably been followed by calls to OPEC to lift supply – as they subsequently did – while monetary policy has remained extremely accommodating, particularly in the US. Speaking following a gathering of the Group of Seven (G7) finance ministers on 23 May, US Treasury Secretary, John Snow, said that is was “vital that oil producers provide adequate supplies to ensure that prices are at levels that foster strong global economic growth… Lower prices would contribute to our efforts to achieve strong and sustained growth.”
…But Gauging Its Effects Is Hazardous
But it was Alan Greenspan, Chairman of the US Federal Reserve, who put his finger on the difficulty posed by the oil price spike. Speaking via satellite to a banking conference in London on 8 June, Mr Greenspan said that “the impact by oil prices in modern market-based economies is difficult to infer in a way in which policy is automatically obvious.” The Federal Reserve’s macroeconomic models, he explained, estimate the impact of oil prices on the US and elsewhere. The findings are that despite the fact that most of the recent recessions have been preceded by oil price spikes (MEES, 29 September 2003), the actual pattern of price change that has occurred over the last 30 years does not create recessions in the models. “Which tells us either that those relationships… are spurious or that there is a nonlinearity in the way oil prices impact market economies.”
Meanwhile, US Federal Reserve Board Governor, Donald Kohn, said in a speech to the National Economists Club that inflation in the US had rebounded from an “unexplainably low” level of 1.4% last year, to an annualized 3% for the first four months of 2004. However, he said that this was the result of a combination of increases in commodity, energy and import prices and was not cause for serious concern. Instead, “the challenge we face is to remove the accommodation [of slack monetary policy] in such a way as to foster both the return to full employment and the maintenance of price stability.”
Europe Coordinates Policy Response
In Europe, finance ministers gathered in Luxembourg on 1 June to discuss the impact of high oil prices on Eurozone growth, and their collective response. According to the European Commission, higher oil prices are expected to have a “relatively weak” impact on Eurozone growth this year and “a bit less in 2005,” said French Finance Minister, Nicolas Sarkozy. European Central Bank (ECB) officials also “expressed a relatively optimistic position” on the fallout from oil prices, he added. EU Economic and Monetary Affairs Commissioner Joaquin Almunia, said that if oil prices remained around $40/B, 0.2 percentage points would be shaved from the Commission’s Eurozone growth forecast of 1.7% for 2004 and 0.2 percentage points added to inflation. Nevertheless, German Finance Minister, Hans Eichel warned that “we have to be a little bit worried about the impact on the economy.” The European finance ministers agreed to coordinate their response to high oil prices to avoid the situation which occurred when prices peaked in 2000 and France’s Laurent Fabius took unilateral action by reducing taxes on petrol. The Eurozone’s monetary policy remains relatively relaxed, albeit at slightly tighter levels than in the US, and the recent downturn in oil prices has obviated the need for an immediate Europe-wide policy response.
Analysts See Muted Effect On Asia
The Asian economy has recorded strong growth to date in 2004. Merrill Lynch estimates, using purchasing power parity weightings, that the Asia-Pacific region, excluding Japan, grew at a real rate of 8.4% in the first quarter, and this is expected to be surpassed in the current quarter. However, growth is forecast to fall back in the second half of the year, and oil (along with a decline in China’s growth and a possible rise in US interest rates) is one factor expected to dampen prospects. Japan, South Korea, and increasingly China are heavily dependent on imported oil. Nevertheless, analysts expect the effect of high oil prices on the region to be fairly muted. Jonathon Anderson of Swiss bank UBS says that the net effect even of prices staying at around $40/B would be to knock off some 0.5-0.6 of a percentage point from GDP growth in the near term. Much of the region has very high current account and balance of payments surpluses, he says, meaning that even a significant increase in the import bill would not force further currency depreciation. Some also argue that Asian demand, especially from China, has more effect on the oil price than the oil price has on Asia, and the consensus is that the Asian economy is slowing but not stopping. HSBC forecasts growth for Asia (excluding Japan) of 7.6% this year, declining to 6.1% in 2005.
But What If Prices Rise Further?
The principal risk that could lead to a further jump in oil prices lies in Iraq and Saudi Arabia. The current level of oil prices undoubtedly contains an $8-10/B risk premium due to the ongoing instability in Iraq and the recent spate of attacks against Westerners in Saudi Arabia. But to put the current situation into perspective, oil prices in today’s terms hit nearly $60/B at the time of the first Gulf war in 1991, and topped $80/B in the late 1970s. Current prices remain some way below that, but a serious disruption to Saudi oil could well push prices towards those levels, particularly given the shortage of spare capacity outside the kingdom. In such a scenario, the impact on the world economy could be significant. As Mr Greenspan noted, we may not understand the exact nature of the effect oil prices have on the world economy, but as recent history has shown, when oil prices spike recession is rarely far behind.