Payments imbalance caused by oil import

Impact assessment of balance of payments imbalance caused by crude oil import

Afia Malik (2008) explored the consequences and challenges that Pakistan would face due to rising oil prices, internationally. She mainly used four indexes to check for the dependency of oil to a price shock namely, oil sufficiency index, oil intensity in energy consumption, energy intensity index and net oil import in GDP index.

The Oil sufficiency index which is percentage change in oil production minus consumption had remained persistent at -0.8 since 2000. The Oil intensity index which is intensity to which oil is used by a country had declined due to switching alternatives to oil, most prominent of which was gasoline. The Energy intensity index which is the percentage change in energy consumption to percentage change in Gross Domestic Product was almost constant since 1990, thus pointing that there has been no improvement in efficiency.

To calculate direct impact of high oil prices on Gross Domestic Product is through net oil import to GDP ratio which showed that it had risen to -5.5 in 2005-06, thus, pointing the fact that oil price increase had affected the Gross domestic Product of the country negatively.

Further concerns were raised that there is a need for a tight monetary policy to be applied in order to control inflationary pressures. There is a need for exploration of Pakistan’s own oil and gas reserves and to the use of coal as a switching alternative as vast amount of energy requirements could be met through the use of coal.

The International Energy association paper (2004) examined the effect of oil prices on the macro-economy and the degree of vulnerability of OECD and developing countries to it.

To test the impact on the macro-economy and how vulnerable OECDs and developing countries are to it, the OECD’s macro-economic model was used. Two scenarios were examined. One was OECD’s base scenario in which the price of oil was assumed to be constant at $25 per barrel over a five year period i.e. 2004-2008. The second was OECD’s sustained higher oil price case at which the prices are taken at $35. Exchange rate was held constant in both cases.

Impact on OECD countries:

The higher price model estimated that Gross Domestic Product deteriorates by 0.4% in the short run as terms of trade deteriorate. Inflation rises which is measured by Consumer Price Index that showed 0.5% increase. Unemployment rate rises by 0.1% and OECD’s current and trade account also worsens. The impact across OECD countries vary depending upon the degree to which they are importers of oil, however, oil-exporting OECD countries experience GDP growth in the short run but it declines in the long run due to decline in exports of non-oil goods and services.

Impact on Developing countries:

The impact of oil price increase is graver. According to IMF estimates, the reduction in GDP would account to 1.5% only after one year. Developing Asian countries would experience a deterioration of more than 8 million in their current account balance. Inflation in countries like China would increase by 1%, let alone other Asian developing and under-developed countries. The impact on developing countries would be higher depending on the degree of their dependence upon oil import according to which Africa and Asia would suffer more than Latin America. Oil intensity of OECD countries stands at 100 while China and India stands at 232 and 282, respectively. This shows that developing countries are more dependent and oil intensive than developed countries. Also, the vulnerability of developing countries to higher oil price is high due to their limited ability to switch to alternatives. This tends to drive up inflation and deteriorate trade balance. The impact of high oil price is less on developing countries than that of developed countries if taken as a group, because the improvements of current account balance of oil exporting developing countries offset the deterioration of current account balance of oil importing ones more than developed countries. The impact on both the developed and developing countries from an oil price increase, it is deduced that the net effect would ultimately be negative. There will be a net fall of 0.5% in global GDP.

The paper of Caesar. B (2000) argues whether the impact of an oil price increase can be lessened or not using a general equilibrium model of the Philippine economy. Negative impact is referred in terms of GDP growth, inflation, and government budget and income inequality. Results from the model indicate that import tariff policy is one tool to lessen the effects.

The model used was termed as PCGEM (Phillipines Computable General Equilibrium Model). PCGEM is a medium sized GCE model and is coded in software called General Algebraic Modelling Systems (GAMS). It is a square model with 2272 equations and 2272 variables.

According to the model, increase in oil price results in GDP decline of 2.5% . The government balance improves to become positive from zero. This results due to decline in government expenditure and improvement in its revenue as figured out by the dynamics of the model. Income also decline, but the decline is faster in the income of poor segments than that of rich segments.

Seven different scenarios are discussed and the best choice depends upon six criteria like GDP growth, income inequality, government budget balance, government revenue implications, import growth of oil and composite price of oil products which are measured by GINI coefficient. The two best solutions that are derived are: while viewing economic impact, solution of percentage reduction in indirect tax and import tariff appears to be the best. But it can result in crisis due to lower revenue generated from indirect sources. The other solution offered is a high percentage reduction of tariff imported oil products.

The IMF working paper discusses the impact of the 2003-05 oil shock on Low Income Countries and steps that these countries took to cope with the shock. The low income countries discussed are 55 out of eligible 78 Poverty Reduction and Growth Facility countries.

Econometric Analysis is applied to calculate change in current account, capital account, oil import and export and the overall reserve position of the countries during the 2003-2005 period. Elasticity of oil import to price was also measured during three time periods: 1965-99, 1980-99 and 2000-05. Oil Intensity Index was also calculated. Cross-country differences in borrowing were also taken into account.

Oil Intensity index showed that the oil imported by PRGF countries had fallen only by 7% from 1973-2003. The econometric tests applied showed that current account of these countries fell by 2.3%. Oil imports increased by 1.4% while non-oil imports increased by 3.5%. Exports rose by 1.7%. However, the capital accounts position of most of these countries improved by 3%. Reserve levels also rose by an average of 0.7% of GDP. Overall borrowing of Low Income Countries fell.

It was concluded that most of these PRGF countries were better positioned to meet the adverse affect of these oil shocks than previous shocks due to a favorable environment and more importantly rise in exports and capital account improvement. However, results showed that Pakistan neither improved upon neither its current nor its capital account and their reserve position deteriorated further.

Stefan.F.Schubert (2009) studied the effect of an oil price shock on the current account. The model he used was studied on an open economy with time non-separable preferences included. The non-separable preferences contained some assumptions to the model used in order to come up with a real depiction of the current account.

The results depicted a J-curve of the current account which showed that the current account first deteriorates but steadily improves due to improvement in non-oil trade balance over time as the non-oil trade balance negates he negative effects of an oil price shock. However, the limitations of this model is that oil is viewed as having a small share in GDP and this model is tested for a short-run with permanent increase in oil price.

James.D.Hamilton (2000) studied relationship of linearity between oil price change and GDP. He conducted regression analysis to test a null hypothesis of linearity against alternative non-linear models. The results depicted a non-linear relationship in the sense that an oil price increase affects the economy more than does an oil price decrease. The effect concluded was tested on GDP growth and the results showed that an oil price increase effects the GDP more in a negative manner than does an oil price decrease.

The study of Ahmed, Seyed and Azizi (2009) focused on whether the Keynesian or Monetary approach to Balance of Payments is the correct theory to be applied on an open economy like Iran. The study was focused on finding out whether the Keynesian theory of balance of payments which points out that devaluation of exchange rate and price level will affect the Balance of trade which in the case of Keynesian theory is the most important account in the balance of payments is better option when applying fiscal and monetary policies to counter balance of payments imbalance in an open economy like, Iran. The monetary approach to balance of payments focuses that disequilibrium in money forces like, income level, interest rate, exchange rate imbalances the money forces and causes the imbalance in balance of payments.

The methodology applied was that data on Iran and the rest of the world was collected, the rest of the world being China, Korea Rep and Japan. Comparison between Keynesian approach and monetary approach was done applying sign test using the Polynomial Distributed Lag (PDL) model. Regression test was also applied which led to the conclusion that imbalances in the balance of payments is due to disequilibrium and money supply and demand forces in the case of and open economy like Iran.

James D. Hamilton in his research work compared the causes and effects of the 2007-08 and the previous oil shocks on the economy. His research was aimed at finding the causes that led to the latest oil shock and comparing them to mainly five previous oil shocks that had hit the economy of the world hard. He wanted to look at the position of macro-economic variable like GDP growth had there been no oil shock.

He examined previous study of Blanchard and Gali (2008) to understand the effect oil prices had on the overall economy. Their study was based on a vector auto regression with three oil shocks and two output indicators (real GDP and total hours worked) . The calculate two separate versions using VAR from 1960-83 and 1984-2007. Blanchard re-examined the tests using VAR co-efficient to calculate the average GDP growth over 1974-75 and at the time of other oil shocks, also using CPI, deflator, wages, GDP and hours worked. His conclusion was that, had there been no oil shocks, GDP would have grown in at least some of the scenarios when oil shocks took place.

Blanchard re-estimated many of Edelstein- Kilian regressions for the same sample period they used to see real consumption expenditures response to historical energy price increase. His results show decline in consumption expenditures following increase in energy prices.

He also used econometric tests in order to come up with the causes of 2007-08 oil shocks naming reduced supply, increased demand and the role of speculation in spiking the real prices of oil to all-time high.