Impact of Rising Oil Prices on the Macro Economy

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1 Impat of Rising Oil Pries on the Maro Eonomy Akira YANAGISAWA Energy Demand, Supply and Foreast Group Energy Data and Modelling Center Institute of Energy Eonomis, Japan Summary Despite the deep shadows being ast on the global eonomy by the European debt risis, rude oil pries are soaring against a bakdrop of inreasing tensions around the situation in Iran and further monetary easing. The prie of Brent Crude has gone past $120/bbl, an inrease of $20/bbl from the most reent lows. This jump in the prie of rude oil greatly inreases the energy osts of eah ountry, and has beome of even greater onern as a risk fator in a fragile global eonomy. The impat of rising oil pries on the maro eonomies of various ountries differs depending on the individual eonomies and their energy supply and demand strutures. Those ountries most likely to be adversely affeted an be harateried as having the following: High net imports of oil per GDP Large marginal propensities to onsume and invest; small marginal propensity to import A high ratio of exports as a portion of GDP A low level of exports to oil exporting ountries Typially, non oil produing developing ountries, and the Asia with its signifiant dependene on exports tend to meet these onditions. At the same time, the developed ountries of Europe are thriftier in their use of oil and enjoy a signifiant bakflow of oil money. They are thus well positioned to see an easing of the adverse effets of a rise in oil pries. Impat of a $10/bbl Rise in Oil Pries on Real GDP 0.0% -0.6% -0.8% Korea China India ASEAN Australia & NZ Japan United European States Union Today, a rise in the prie of rude oil may have a negative eonomi impat along paths and to a degree that would not be ause for onern in normal times. A worsening of urrent aounts omprising balane of trade will, by definition, lead to deteriorating treasury budgets and a worsened balane between savings and investment. Moreover, eonomi deeleration will see treasury budgets deteriorate further through redued tax revenues and other fators. The world now faes major hallenges due to the eonomi risis originating from Europe, in whih treasury budgets have shaken the real eonomy through the finanial setor. The expansion of imbalanes aused by the rise in rude oil pries in the midst of these hallenges threatens to push the world eonomy further into risis. Keywords: Crude oil pries, global eonomy, GDP 1

2 Soaring Crude Oil Pries Despite the deep shadows being ast on the global eonomy by the European debt risis, rude oil pries are soaring against a bakdrop of inreasing tensions around the situation in Iran and further monetary easing. The prie of ICE Brent Crude has gone past $120/bbl, rising more than $20/bbl from the most reent low marked in Otober of Further, in January 2012 Saudi Arabia, onsidered a moderate among OPEC member ountries, announed it would favor a prie of $100/bbl, an inrease of $25/bbl over its previous target of $75/bbl. Coinidentally, the urrent prie of $120/bbl is the same level pointed out a year ago by Deutshe Bank, Morgan Stanley, and others as being a threat to the world eonomy. While it is debatable whether breahing the $120/bbl level will bring on rapid reession, soaring rude oil pries inrease nations energy osts. This has beome of even greater onern as a risk fator in a fragile global eonomy. For example, in 2011 Japan marked its first trade defiit in 31 years, as its balane of trade worsened by JPY 9.2 trillion, of whih JPY 2.3 trillion was attributable to rising rude oil pries. The downward pressure this plaed on business ativity exeeded the ontribution of global eonomi deeleration and the Great East Japan Earthquake (JPY 1.9 trillion) to the drop in exports. Fig. 1 Contributions to Changes in Japan s Balane of Trade, Trillion JPY Rise in prie of LNG Rise in LNG imports Rise in prie of rude oil Others Drop in exports 0 Balane of trade Calender Year Soure: Computed from Ministry of Finane Trade Statistis The Eonomi Impat of Rising Oil Pries Impat on the Domesti Eonomy Given oil s strong harateristi as a vital ommodity, demand, partiularly in the short term, is inelasti versus prie. This is why, when oil pries rise, the value of oil imports by importing nations will inrease at about the same rate as the rise in prie. For example, with Japan s net imports of oil at approximately 4.5 Mb/d, a $10/bbl inrease in oil pries will inrease net import value by about $16.0 billion annually (equivalent to approximately 0.3% of GDP). This is the first blow rising oil 2

3 pries strike against the eonomies of oil importing nations. It is also why the ratio of the value of net oil imports to nominal GDP an be an indiator for understanding the impat of oil prie flutuations. Companies and other produers in importing nations faing inreased osts due to rising oil pries find themselves onfronted with (1) having to raise the pries of the goods and servies they produe; (2) redued profits; and (3) restraints on personnel expenses, investments, and other outlays. Seen by other produers, these lead to redued revenue and inreased osts, with a broad impat extending even to industries whose diret oil onsumption levels are low. At the same time, for the onsumer, a rise in the prie of goods and servies and falling wages diminish real purhasing power. This in turn fores onsumers to respond with (1) redued savings; and (2), restraints on the purhase of other goods and servies. A diret drop in profits and wages, or an indiret rise in pries? Whih path omes to the fore will depend on irumstanes at the time. Nevertheless, for oil importing nations as a whole, the fat remains that produers and onsumers must ope with and bear the burden of the inrease in import values, while the wealth generated flows to exporting nations. For importing nations with their diminished purhasing power, the multiplier effet ats as a mehanism for further eonomi deeleration. Fig. 2 Path of Impat of Rising Oil Pries on Eonomies of Importing Nations Rise in Oil Prie Inrease in Value of Produers Prie of Goods and Servies Raised Restraints on Personnel Expenses and Investments Redued Profits Consumers Diminished Real Purhasing Power Redued Savings Restraints on the Purhase of Goods and Servies Impat on Oil Exporting Nations In oil exporting nations, a rise in oil pries has the opposite effet of a rise for importing nations, working to expand the eonomy. In other words, an inrease in the value of exports brings inreased profits and wages. And, beause domesti oil pries in oil exporting nations are typially heavily subsidied, a rise in international pries has only a limited impat. The multiplier effet further invigorates the domesti eonomies of oil exporting nations. Indeed, the eonomies of many oil 3

4 exporting nations expanded rapidly with rising oil pries in 2004 and beyond, with the eonomies of ountries in the Middle East and North Afria, for example, nominally tripling in sie, inreasing by nearly 50% in real terms. In that sense, the eonomi aeleration brought by a $10/bbl rise in pries atually represents a signifiant deterioration ompared to the past. This shift in wealth resulting from flutuations in the value of the oil trade may be a ero sum when seen at a global level. Nevertheless, inreased purhasing power in the few oil exporting nations brings eonomi expansion. Differenes in propensity of onsumption annot, however, ompletely make up for the eonomi shrinkage aused by a loss of purhasing power in the many oil importing nations. Impat on the International Eonomy and Effets on Individual Nations The impat of the shift in wealth from oil importing nations to oil exporting ountries does not stop at the domesti eonomy. Diminishing purhasing power in oil importing nations redues the demand for other imported goods and servies, and restrains global trade. This auses a drop in prodution ativity in ountries exporting those goods and servies for whih demand has fallen, putting even further pressure on eonomi deeleration. At the same time, inreased demand for imported goods and servies among oil exporting nations supports, to a ertain extent, prodution of those goods and servies in ountries that export them (through a bakflow of oil money). Again, however, at a global level the impat of eonomi deeleration remains greater. Nations Partiularly Affeted From the above, we an see that nations on whih the burden of a rise in oil pries has a partiularly signifiant impat would inlude those having: High net imports of oil per GDP Poor energy effiieny, high dependene on oil, low self suffiieny in oil... Large marginal propensity to onsume and invest. Small marginal propensity to import. Results in a larger multiplier effet. A high ratio of exports as a portion of GDP. More suseptible to the effets of redued global trade. A low level of exports to oil exporting nations. Little relief from a bakflow of oil money. Typially, non oil produing nations, and the nations of Asia with their signifiant dependene on exports tend to meet these onditions. At the same time, the developed ountries of Europe are thriftier in their use of oil and enjoy a signifiant bakflow of oil money. They are thus well positioned to see an easing of the adverse effets of a rise in oil pries. 4

5 The Impat of a $10/bbl Rise in Oil Pries By building a general model based on the above mehanism, we estimated the impat of a rise in oil pries on the real GDPs of various nations and regions. The results of a $10/bbl rise in the prie of oil are shown in Fig. 3. Note that, for example, the IMF estimates plae an embargo on Iranian rude in the absene of alternative supplies ould result in a 20% to 30% equivalent to about $20 to $30/bbl inrease in rude oil pries (January 2012). While the U.S. is the world s largest oil onsuming nation, it produes approximately 40% of that oil itself (this self suffiieny ratio has limbed higher in reent years with inreased prodution of rude oil through expansion of shale gas prodution, and with improvements to automobile fuel eonomy). Thus, the impat of an inrease in the value of net oil imports resulting from a rise in oil pries remains small. The low weight exports arry in the U.S. eonomy has also ontributed to holding the impat on real GDP to. Asia, by omparison, has few oil resoures, and relies heavily on imports to meet demand. The impat of an inrease in the value of net oil imports is thus signifiant. The impat of import values is smaller in China and ASEAN, where oil self suffiieny is relatively high, and in Japan, where energy onservation is advaned. Nevertheless, given the eonomi importane of exports, the impat on real GDP is as muh as to. In partiular, given that domesti eonomi growth rates in Japan in the seven years sine rude oil pries began rising have averaged no more than 0.3% annually, the rise in oil pries represents a relatively large burden. Fig. 3 Impat of a $10/bbl Rise in Oil Pries on Real GDP 0.0% 0.0% Impat on Real GDP -0.6% -0.8% Real GDP Value of oil imports Korea China India ASEAN Australia & NZ Japan United States European Union 0.2% 0.4% 0.6% 0.8% Change in Value of Net Oil Imports (vs. Nominal GDP) Note that in Asia, there is a strong tendeny to link natural gas pries to the prie of rude oil. In other words, as oil pries rise, these ountries will suffer the side effet of a onomitant rise in the prie of natural gas imports. This results in an even greater risk of adverse eonomi impat when ompared to North Ameria or Europe. 5

6 In Summary Rising rude oil pries an do more than limit the eonomi options available for urbing inflation. Given the urrent situation, they may also result in adverse eonomi impats along paths and to a degree that would not be a onern in normal times. A worsening of urrent aounts omprising balane of trade will, by definition, lead to deteriorating treasury budgets and a worsened balane between savings and investment. Moreover, eonomi deeleration will see treasury budgets deteriorate further through redued tax revenues and measures for eonomi stimulation. The world today faes major hallenges due to the European eonomi risis, in whih treasury budgets have shaken the real eonomy through the vetor of the finanial setor. Soaring rude oil pries threaten to beome a fator in further worsening the global eonomy. A grave eonomi risis was brought on by the nations of southern Europe, diffiult to explain given the sie of their eonomies. By the same token, the onerns raised by the enormous negative impat on a fragile world eonomy of the expanding imbalane brought on by a rise in rude oil pries annot be brushed off as groundless. 6

7 Appendix: Model Struture An eonometri model was used in estimating the impat of a rise in rude oil pries on the global eonomy. In doing so, to avoid the model beoming a blak box, we took partiular are to ensure good visibility. Beause the model is omprised only of real expenditure omponents, and beause eah behavioral equation is linear, it an be solved algebraially. The atual system is as shown below. Note that eah vetor is ranged by ountry and region. [GDP] y i g x m r [Gross Domesti Inome] y t [Private Consumption] α u [Investment] i β ui [Government Consumption] g [Exports] x m : Import share matrix with ountry of origin on the horiontal and importing ountry on the vertial. [Imports] m γ i g x r um [Statistial Disrepanies] r [Trade Gain/Loss] t Solving for these strutural equations results in: y { I ( I {( I ( I)( I ) ( I)( I ) I ( I ) ( γ )( α u )( )} m )} β 1 g r ( ) t u u ) i Here, I is the identity matrix. The impat on GDP was estimated by applying the shift in wealth resulting from a rise in rude oil pries (the first blow) to the above formulas in the form of trade gains/losses. 7 Contat:

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