Background
At the
recent Monetary Policy Meeting (MPC) that was held on
the 14th of October this year, the South
African Reserve Bank (SARB) did not change the repo
rate. This decision was based on, among other things,
the fact that the strong performance of the rand has
shielded the economy from the international oil price
shock. Hence the short run impact of the rising oil
price has been, to some extent, absorbed. However,
although the SARB could be optimistic, should the oil
crisis be sustained, the CPIX could breach the 6% upper
limit of the inflation target over time. The result
would erode consumer expenditure on goods and services,
and force companies to tighten their hiring strategies,
and occasionally would exert pressure on interest rates.
This oil crisis is looming on the horizon as oil
supplies keep increasingly dwindling on one hand, and
the global oil demand keeps rising on the other.
Therefore, persistently rising oil prices would likely
put a brake on the recovery of the global economy. The
high dependence on fuel renders many economies
vulnerable to any oil price shock. This article provides
a review of recent developments in the international oil
markets as well as traces their possible implications
for Lesotho
Recent Developments in
the Oil Markets
The
global oil prices have risen above 50 US dollars a
barrel recently. According to the International Monetary
Fund (IMF), every 5 US dollar a barrel increase in oil
price may cause a global economic slowdown estimated at
0.3 per cent. This situation could bring dire
consequences on the developing world, especially African
countries whose gains from non-fuel commodities would be
offset by losses from high oil prices.
The
Organisation for Petroleum Exporting Countries (OPEC),
which was formed in 1960, purported that prices of oil
are rising due to non-economic fundamentals such as
political turmoil in the Arab countries, and the mayhem
of terrorism. Conversely, some theorists propounded that
historical evidence points to the fact that oil price
cycles have always responded to changes in demand for
and supply of oil. The extreme sensitivity of prices to
supply shortage have historically reflected an interplay
of market forces which cause wide price swings in times
of a shortage or glut. Thus oil price surge is a
repercussion of market disequilibrium, in case demand
exceeds supply.
When
putting this oil crisis into perspective, the outlook
for the global economy appears to have three stripes. As
a starting point, the severity of the oil crisis depends
on the energy-intensity of the non-fuel sub-sectoral
modes of production. Due to the inter-linkages among
these sectors surging oil prices may spark off a
non-fuel price crisis as well, particularly in the
absence of lack of, or no energy-input substitutes in
production. Also, the continuously rising demand for oil
in countries such as the US, India, and China underpin
the persistence of the oil crisis. Moreover, quantity
supplied manipulation by OPEC indicated either the fact
that the spare capacity is limited among OPEC members,
or that these cartel is exerting pressure in pursuit of
feel good national goals of its members.
On the
non-fuel asset market arena, there is a continuing lack
of volatility in equity and bond markets across the
globe. This scenario has hit negatively on hedge fund’s
profitability, and then prompted many funds to invest in
commodities and oil. This in turn, fuelled higher oil
prices. Countries that export oil enjoy windfall gains
from higher international oil prices. For example it has
boosted economic growth in Arab oil producers resulting
in healthy fiscal and current account positions. These
high prices have gone a long way in supporting the
equity markets in the region because energy stocks tend
to lead the way. This positive outlook for oil exporters
has caused some economists to reason that the net effect
of the crisis on the global economy may be minimised as
some countries have gained while others have lost. It is
therefore imperative to examine how the mountain kingdom
would likely fare during this critical time.
The effects of an
oil crisis on Lesotho
The age of global
industrialisation and its dependence on fuel has caused
high degree of vulnerability to oil shocks for almost
all economies. Lesotho could not be immune to this
problem because of its dependence on transportation,
increased reliance on mechanised agricultural production
methods, and manufacturing. Evidently, soaring fuel
prices threaten the performance of various sectors in
the economy, due to the linkages that exist between
these sectors. Ultimately, both the producer and the
consumer would be adversely affected by an oil price
hike.
The oil price channel can
influence macroeconomic behaviour through several
channels. First, the income would be transferred from
oil-importing, such as Lesotho, to oil-exporting
countries. Second, this income transfer would reduce
global oil demand. Third, the higher prices reduce the
purchasing power of money and worsen public welfare.
Fourth, workers and producers may resist the declines in
their real wages and profit margin, thereby exerting
upward pressure on unit labour costs and the prices of
finished goods, and services. Fifth, should the wage
spiral persist, high fuel prices may gain a greater
potential for a pass-through into core inflation, thus
inducing monetary policy tightening.
Since Lesotho satisfies the
energy needs by importing 100 per cent of oil from
abroad, this underscores the extent to which the impact
of the shock will be on the economy. The oil driven
inflation could eat into people’s disposable income,
pensions, and savings. This would worsen people’s
standard of living, because it would hike transport
costs, and narrow the profits margins of companies that
offer flying services. As a result, air travel could
become expensive and discourage the much needed tourists
from visiting the country. Under this scenario more and
more people would likely lose their jobs and further
exacerbate the poverty problem.
Imports of oil are estimated
to have cost the Lesotho M398.4 million in 2003-an
equivalent of 9.3 percent of GDP. The completion of the
construction activities associated with Phase1B of the
Lesotho Highlands Water Project (LHDA) went a long way
in reducing the level of oil imports. Nonetheless, the
country remains heavily reliant on imports to meet its
oil demands. Assuming that production activities are
currently and will continue to be, undertaken
efficiently, a 10 percent increase in the price of oil
-persistent for a year, would have a negative impact on
GDP, heat up the economy and exacerbate the unemployment
problem. According to table 1 below, an increase to this
tune would hike oil cost to M438.2 million - an
equivalent of 9.9 percent of GDP. Put simply, the
country would have to spend 0.6 percent more of GDP to
import the same quantity of oil. The same hike is likely
to fuel inflation by 0.1 percent using 2003 estimates.
Table
1: Impact Analysis of the Oil Crisis
|
The Impact of a 10% Oil price hike on: |
2004 |
|
GDP |
-0.60% |
|
CPI |
0.09% |
Despite the welfare erosive
impact of the oil crisis, the outlook for Lesotho is not
entirely bleak and hopeless. This is true because the
crisis is compelling many economies to explore
possibilities of oil-import substitutes. For example,
South Africa’s coal based syn-fuel industry could be
increased significantly through the medium of Sasol. The
low-grade coal resources available for this purpose are
large, and technology has greatly improved over the
years. Thus sustained rise in international oil prices
would potentially furnish new opportunities for South
Africa as it faces the challenge of increasing
self-sufficiency in the respect of oil supplies. This
may have positive spill-over effects on the Lesotho
economy because as the coal mining industries increase
production, more miners would have to be employed and
many of these are from Lesotho. This would in turn
increase mine worker remittances and improve the
country’s foreign currency earnings. In view of the
foregoing, how can monetary authorities respond to this
challenge?
A
Monetary policy Response
In order
to face the challenge policy must be timed properly. The
reaction of policy makers to the impending crisis should
be cautious due to the uncertainties involved. The
uncertainty about the extent to which oil prices may
come down in the future, as well as uncertainty about
the effects of higher oil prices on core inflation, put
up a strong case for monetary authorities to either
delay or moderate their response to the run-up in prices
until the macroeconomic effects of the price shock are
more apparent. This is because sometimes the shocks may
be very temporary or the risk of a pass-through into
core inflation may be low.
In
Lesotho, the monetary policy maker- the Central Bank of
Lesotho (CBL) – has a dual mandate, namely; to stabilise
prices and to maximise sustainable employment. This
two-fold mandate implies that CBL’s response to the oil
price increases should focus on these two objectives. It
is recommended that it would be best to accept some
temporary rise in both inflation and unemployment in
tandem with the underlying mandated objectives, such
that a balance could be struck. This balance is
necessary because first, if policy were to try to avoid
any rise in unemployment, the initial oil price shock
might be passed through to continuing inflation and
second, if policy were to try to avoid any rise in
inflation, the movement in unemployment would be
substantial. Hence, a good policy stance should lie
between the two extremes, and should be properly timed
instead of being spontaneous.
Conclusion
The CBL,
among other functions, has been mandated to maintain
price stability in the economy. Hence, the soaring
prices of oil present a great challenge for the Bank,
and it may over the long run over heat the economy.
Anecdotal evidence, points to the detrimental effects
that higher oil prices could cause to the real economy
due to the crucial role played by oil in both the
production and consumption arms of the economy. The
network of linkages between various sectors of the
economy may facilitate a pass-through of the price
increase into the economy’s core inflation. The main
competing objectives of the monetary authorities,
namely, high employment and price level stability pose a
great challenge, and call for a policy balance between
the two ends. This problem is sure to further be
amplified by the oil price shock, thus should not to
taken as a grain of salt.
This
report is benefited by International Energy Agency (IEA)
report on “the analysis of the impact of high oil prices
on the global economy” and www.imf.org
