Why dearer oil impacts developing economies more.

It wasn’t long ago that $100 for a barrel of oil was the norm but with the advent of the shale market the production increased which depressed prices. It was felt that the flexibility of large scale shale production from the USA could act as a stabiliser to global oil prices.

Oil shocks – supply or demand?

Oil shocks are not all the same. They tend to be associated with supply issues caused by conflict or OPEC reducing daily production targets. In the case of an increase in global growth there is the demand side for oil which increases the price. However this doesn’t have a great effect as in such cases the rising cost of imported oil is offset by the increasing export revenue. However today’s increase has a bit of both:

Demand – global consumption has increased as the advanced economies recover after the GFC especially China
Supply – supply constraints in Venezuela from the economic crisis. Also tighter American sanctions on Iran and OPEC producers are not increasing supply with the higher price.

Higher oil prices do squeeze household budgets and therefore reduce demand. Lower prices are expected to act as a stimulus to consumer spending but it can also have negative effects on the petroleum industries.

Emerging economies the impact of higher oil prices

Oil importing emerging economies are badly impacted by higher oil prices:

  • Terms of trade deteriorate as the price of their imports rise relative to their exports
  • Exports pay for fewer imports = importers’ current-account deficits widen.
  • Normally this leads to a depreciation a a country’s currency which makes exports cheaper and imports more expensive.

However this is not the case today. World trade is slowing and with it manufacturing orders therefore higher oil prices make the current account worse which in turn depreciates the exchange rate. For emerging economies who have borrowed from other countries or organisations a weaker exchange rate intensifies the burden of dollar-denominated debt. Companies in emerging economies have borrowed large amounts of money being spurred on by very low interest rates but they earn income in the domestic currency but owe in dollars – a weaker exchange rate means they have to spend more of their local currency to pay off their debt. Therefore indebted borrowers feel the financial squeeze and may reduce investment and layoff workers.

Another problem for emerging economies, as well as higher oil prices, is that central banks are looking to tighten monetary policy (interest rates) with the chance of higher inflation.

Source: The Economist – Crude Awaking – September 29th 2018

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