Weathering the Storm So Far: The Impact of the 2003–05 Oil Shock on Low-Income Countries
Author: Mr. Helaway Tadesse, Mr. Mark W Lewis, Jörg Zeuner, Mr. James A John, Luzmaria Monasi, and Mr. Paolo Dudine

Contributor Notes

Author(s) E-Mail Address: pdudine@imf.org, jjohn@imf.org, mlewis@imf.org, lmonasi@imf.org, htadesse@imf.org, jzeuner@imf.org
Publication Date:
01 Jul 2006
eISBN:
9781451864311
Language:
English
Keywords:
WP; GDP; price; balance of payments; current account
Download PDF (260.7 KB)

This paper examines the impact of the 2003-05 oil price increase on the balance of payments positions and IMF financing needs of low-income country oil importers. It finds that stronger exports reflecting favorable global conditions, a compression of oil import volumes due to the pass-through of world prices to domestic consumers, and a large increase in capital inflows helped low-income countries cope with the oil price shock. Preliminary data suggest that reductions in oil import volumes have not harmed growth. While fiscal balances generally improved, quasi-fiscal liabilities may be building. Lower demand for IMF assistance may reflect broader trends, but further oil price increases could put pressure on additional countries in 2006 and beyond.

Abstract

This paper examines the impact of the 2003-05 oil price increase on the balance of payments positions and IMF financing needs of low-income country oil importers. It finds that stronger exports reflecting favorable global conditions, a compression of oil import volumes due to the pass-through of world prices to domestic consumers, and a large increase in capital inflows helped low-income countries cope with the oil price shock. Preliminary data suggest that reductions in oil import volumes have not harmed growth. While fiscal balances generally improved, quasi-fiscal liabilities may be building. Lower demand for IMF assistance may reflect broader trends, but further oil price increases could put pressure on additional countries in 2006 and beyond.

I. Introduction

A puzzling feature of the large increase in world oil prices since 2002 is the seemingly limited macroeconomic impact on low-income countries (LICs). The balance of payments and fiscal positions in these countries—expressed relative to GDP—have on average improved in 2003–05. And while development needs in LICs remain vast, balance of payments financing needs, as demonstrated by demand for IMF resources, have declined over this period (Figure 1), and there has not yet been a request for support under the newly-created Exogenous Shocks Facility.

Figure 1.
Figure 1.

Oil Prices and PRGF Financing

Citation: IMF Working Papers 2006, 171; 10.5089/9781451864311.001.A001

Sources: World Economic Outlook; IMF Finance Department.

This paper examines the effects of the oil shock on LICs, factors that mitigated its impact, and steps taken by countries to adjust to the shock. The focus of the analysis is on balance of payments and fiscal positions. The paper assesses the impact of the oil shock on the 66 oil importers among the 78 Poverty Reduction and Growth Facility (PRGF)-eligible countries, and compares results for 2005 to 2003.2

The structure of the paper is as follows. The role of global conditions is discussed in Section II. Section III examines the balance of payments impact of the current shock, looking at different components of the current and capital accounts as well as trends in reserves. Econometric evidence on the determinants of two important aspects of country adjustment—changes in oil import volumes and external borrowing—is also presented. Section IV discusses the impact of the oil shock on fiscal balances. Section V considers how further price increases may affect LICs going forward, and Section VI concludes, considering why the demand for Fund resources has not been greater.

II. The Global And Historical Context

The global environment was significantly more favorable in 2003–05 than it had been during previous oil shocks. This helps explain why high prices have had less impact than might have been expected. As shown in Text Table 1 below, global output and trade growth have been much higher, and interest rates much lower, when compared to earlier periods.

Text Table 1.

The 2003–05 Oil Shock in Historical Perspective

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While nominal oil prices reached new highs in 2005, real prices have remained below the 1980 peak and the increase over 2003–05 occurred relatively gradually, allowing countries more time to adjust. The measured pace of annual oil price increases in recent years seems consistent with demand-side pressures from global growth, in contrast to the sharp supply-side shocks of the 1970s (Figure 2).3 Looking at recent prices, it would take the seven-year change between 1998 and 2005 (308 percent) to exceed the one-year increase of (252 percent) in 1974.4

Figure 2.
Figure 2.

Oil Prices and Annual Percentage Changes

Citation: IMF Working Papers 2006, 171; 10.5089/9781451864311.001.A001

Sources: World Economic Outlook; IMF Finance Department.

Although the magnitude of the recent shock relative to country economies appears similar to the shocks of the 1970s and 1980s, countries have been better positioned to deal with adverse conditions. At about 1½ percent of GDP on average for low-income oil importers (measured as the change in the value of oil imports as a share of GDP), this shock is in line with earlier episodes. However, in addition to the more favorable global environment noted above, low-income oil importers entered the most recent period with a higher level of reserves—roughly double the coverage ratios of the late 1970s—providing more of a cushion before adjustment or additional borrowing became necessary.

Two issues—namely oil intensity and exchange rates—did not appear to be factors in the scale of the shock. Oil intensity for PRGF oil importers fell by only 7 percent between 1973 and 2003, and thus offers limited insight into why the most recent price rise has not had a greater impact on low-income countries. In contrast, oil intensity for Organization for Economic Cooperation and Development (OECD) countries fell by 38 percent between 1973 and 2003.5 Likewise, exchange rate movements against the dollar, in which petroleum products are priced, varied but on average did not significantly appreciate or depreciate against the dollar.

III. Balance of Payments Impact

The following section reviews the balance of payments impact of the oil shock from two perspectives. First, the average balance of payments impact is assessed for PRGF importers as a group, identifying the effect on the current account as well as on reserve levels. Comparisons with earlier periods of high oil prices, and with developments in middle income countries, are also examined. Second, this section explores cross-country differences in the impact of the oil shock to assess why the shock was so much larger in some countries than in others and identify the different means by which counries adjusted.

A. Average Impact of the Oil Shock6

The external current account balance of PRGF oil importers declined by 2.3 percent of GDP on average between 2003 and 2005. This reflected the following developments (see Text Table 2, and Tables 1 and 2 attached):

  • Oil imports of the typical PRGF country increased by 1.4 percent of GDP, rising from an average of about 5 to 6½ percent of GDP. On a volume basis, however, oil imports appear to have fallen in a number of countries.7

  • At the same time, exports rose on average by 1.7 percent of GDP, more than sufficient to fully cover the higher oil bill. This improvement was due equally to price and volume effects.

  • Non-oil imports rose by 3½ percent of GDP, which reflected stronger volume rather than price effects. This result indicates that despite the oil shock, there did not appear to be a compression of other imports.

  • Other components of the current account (services, income, and transfers) picked up by 1 percent of GDP. Within this amount, official transfers remained largely unchanged.

Text Table 2.

Oil Shock Impact for PRGFs

Average changes between 2003 and 2005: (In percent of GDP)

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Note: Negative sign represents adverse BOP impact
Table 1.

Impact of Higher Oil Imports for PRGF-Eligible Countries: 2003–05

(In percent of GDP)

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Note: Country desk submissions as recorded by WEO on April 2006. CA=current account; KA=capital account; BOP=balance of payments.
Table 2.

Selected Economic Indicators for PRGF-Eligible Countries: 2003-05

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Note: Country desk submissions as recorded by WEO on April 2006.

The capital account of the typical PRGF oil-importing country registered a strong improvement during 2003–05. Net inflows rose from an average of 7 percent to 10 percent of GDP—an improvement that was sufficient to more than offset the current account deterioration. Higher official borrowing does not explain the capital account improvement. In fact, new official borrowing fell by about 1 percent of GDP during 2003–05 while debt stocks declined from 123 to 100 percent of GDP on average.8

A strong pickup in flows to the private sector, as well as debt relief, appears to account for the large capital account gains. Based on data from IMF staff reports, debt relief is estimated to have risen by 0.6 percent of GDP between 2003–05 reflecting both debt service and debt stock relief provided by the Heavily Indebted Poor Country (HIPC) Initiative. The largest volume of inflows, however, related to private sector transactions. These include Foreign Direct Investment (FDI), which rose by about ½ a percent of GDP for the average oil importing PRGF country, as well as a combination of trade credits, private borrowing, and a drawdown of private foreign assets such as currency and deposits held abroad.9 The latter items taken together rose by an estimated 2½ percent of GDP between 2003 and 2005, and thus played a substantial financing role during this period. A further decomposition of these inflows is unfortunately unavailable as they are reported jointly, and are typically a residual in the balance of payments accounts recorded by WEO. It is possible that these flows in part include unidentified private transfers and remittances that are not captured elsewhere in the balance of payments.

As a result, despite the adverse oil shock, the reserve position of PRGF countries improved on average during 2003–05. Reserve levels, expressed relative to GDP, rose by an average of 0.7 percent of GDP, although coverage ratios fell on average from 4.7 to 4.2 months of coverage during this period, reflecting the spike in imports.

Based on this average PRGF experience, the two key factors mitigating the impact of the oil shock have been the rise in exports and the capital account improvement. Interestingly, according to OECD data, official development assistance (including grants) from bilateral and multilateral donors to oil-importing PRGF countries is estimated to have declined slightly as share of GDP. Overall, despite the fall in grants, debt ratios fell, reflecting in large part greater debt relief.

As outlined in Appendix I, several key issues distinguish balance of payments developments under the current oil shock from the previous episodes of high oil prices in 1973–75 and 1978–80. First, while the magnitudes of the shocks as a share of GDP were broadly similar, shocks in the earlier periods were not offset by higher exports as they were in 2003-05. As a result, overall current account deficits were higher during the earlier periods. Second, the strong capital inflows during the earlier shocks were primarily composed of additional borrowing, and countries’ indebtedness increased markedly. Finally, reserve positions expressed relative to GDP deteriorated during the earlier shocks, but have improved during the current shock.

Comparing balance of payments developments in LIC oil importers and middle income oil-importing countries during 2003–05 suggests a broadly similar experience.10 As a share of GDP, the scale of the shock was similar in the middle income countries (1.7 percent of GDP), but was offset by even higher exports (3.2 percent of GDP), compared to the results for LICs in Text Table 2 above. Developments in other components of the current account were similar between the two groups of countries, although the capital account and reserves improvements were more limited in the middle-income countries.

B. Cross-Country Differences

The aggregate relationships summarized above mask some important variations in country experiences. In particular, we find that the impact of the oil shock and country responses fall into four broad categories (Figure 3 and Text Table 3):

  • For 16 countries—close to 30 percent of PRGF importers—there was a decline in the oil import bill relative to GDP owing to what appears to have been a particularly sharp contraction in the volume of oil imports. The oil price rise did not lead to an adverse impact on the balance of payments for this set of countries, as they saw improvements in both the current and capital accounts during 2003–05 that translated into a strengthening of the reserve position.

  • Another 12 countries faced higher oil imports, expressed in relation to GDP, but benefited from substantial current account offsets in the form of improved exports, services, and/or grant receipts. Together with gains in the capital account, this subgroup also saw a strong overall improvement in the reserve position.

  • For a third category of 12 countries, they faced both higher oil imports and a worsened current account, but a substantial improvement in the capital account allowed for a net improvement in the reserve position.

  • The remaining 22 PRGF importers benefited from neither current account nor capital account improvements sufficient to offset the oil shock and thus saw a deterioration in their overall reserve position. Within this group, however, a majority of cases maintained relatively comfortable reserve coverage levels11 and could thus accommodate the drawdown in reserves. Only in a sub-set of seven countries did reserves fall to very low levels: two of these cases requested a PRGF augmentation (Bangladesh and Madagascar); three cases are in the process of moving towards a PRGF arrangement (Cambodia, Djibouti, and Tajikistan); and the remaining two cases (Kiribati and Zimbabwe) have no PRGF prospects at present.12

Figure 3.
Figure 3.

The 2003–05 Oil Shock and Its Impact on PRGF-Eligible Countries

Citation: IMF Working Papers 2006, 171; 10.5089/9781451864311.001.A001

1/ From the 66 oil importers, four countries are excluded: Liberia and Somalia (due to insufficient data) and Maldives and Timor Leste (which represent extreme outliers).2/ Three of the four PRGF access augmentations during 2003-05 were to countries hit by the oil shock and that faced balance of payment losses; the fourth country (Niger) received an augmentation due to a drought-related balance of payment shock.
Text Table 3.

Summary Data for PRGF Country Groupings

(In percent of GDP)

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Negative sign represents adverse BOP impact.

Annual average percent changes.

The varied cross-country experience described above is noteworthy on two counts. First, the decline in oil imports relative to GDP for such a large number of cases shows that oil volume reductions have likely been a dominant form of adjustment by low income countries, a topic which is further explored below. Second, the degree of offsets provided by other current and capital account items is clearly an important determinant of whether the country experiences overall reserve losses, and thus the variance across countries in the capital account is also explored. Issues related to economic growth are discussed in Box 1.

The 2003–05 Oil Shock and Its Impact on Growth

The 2003–05 oil shock has not been associated with any marked shifts in the average economic growth performance of PRGF importers. Average growth rates rose from 4.2 percent in 2003 to 4.5 percent in 2005, but the country experience was quite varied as the number of cases where growth rates fell roughly matched the number of instances in which growth rates rose. While growth might have been stronger had oil prices not risen so sharply, the extent of higher growth under such a counterfactual scenario is difficult to ascertain.

The continuation of the growth momentum in PRGF countries reflected both external and internal factors. As noted earlier, global growth provided increased support to exports by PRGF economies, as trading partners’ import demand grew by an average of 7 percent in 2005, compared to 5 percent in 2003. Rising investment activity in PRGF countries—reflected in investment ratios climbing from 21 to 23 percent of GDP on average—further boosted economic growth during this period.

With respect to differences in growth rates among low income oil-importers:

  • Despite the oil shock, growth rates have come to show much less variance, reflecting fewer cases of low/negative growth in 2005 than in 2003. The latter outcome appears to reflect the fact that strong global conditions more than offset the impact of the oil shock in those countries where growth was below the norm in 2003.

  • A simple comparison of growth performance across the various country groupings (identified in Figure 3) suggests that growth has not been affected by the degree of adjustment in oil imports. In particular, average growth during 2003–05 in countries with sharp adjustments in oil volume was roughly similar to that in countries that relied on reserves drawdowns; moreover, looking at growth trends over time, countries with sharp adjustments in oil imports showed improving growth rates between 2003 and 2005, in contrast to deteriorating outturns seen for those countries that relied on reserves drawdowns.

  • Econometric tests did not find evidence that growth was affected by adjustments in oil import volumes. These adjustment do not seem to have affected growth even after controlling for other typical determinants (for instance, expenditure in education the previous year, investment as a percentage of GDP, and the change in the terms of trade). For each country, a growth accounting exercise was also carried out covering the period 1975–2002 (or the earliest period after 1975 for which data is available). GDP growth for 2004 and 2005 was then predicted for each country and the discrepancy between the predicted and the actual rate of growth was considered. In the framework of growth accounting, this discrepancy captures the impact of shocks to total factor productivity. No relationship was found between oil volume adjustments and discrepancies between actual and predicted growth rates, even after controlling for changes in the terms of trade.

Regarding the determinants of oil volume adjustment, a cross-country econometric analysis was carried out (see Appendix II) to examine the relationship between changes in oil import volumes between 2003 and 2005, and variables such as real GDP growth, the terms of trade, oil intensity, and the degree of oil price pass-through. Under many specifications, no strong evidence emerged pointing to a unique pattern explaining oil volume adjustments: for example, countries with sharp volume cutbacks did not show systematically lower growth. As a further review, the elasticity of oil import volumes to the oil price, income, and the non-oil terms of trade was estimated for three different time periods: 1965–2000, which is suitable to study long-run elasticity; 1980–99, a period when oil prices oscillated nominally but declined in real terms; and 2000–05, a period of steady nominal and real increases in oil prices. The main finding is that the estimated price elasticity in 2000–05 was almost the same as in the long-run and half the elasticity in 1980–99.

The determinants of cross-country differences in borrowing were also explored. This work looked at the change in borrowing as a percentage of GDP between 2003 and 2005, and regressed it for the group of oil importers over the change in oil volumes (barrels per unit of output), the change in the terms of trade, the change in grants as a percentage of GDP, and the change in the non-oil current account as a percentage of GDP. The results showed that while overall borrowing by LICs as a group has declined, countries that borrowed more were those with larger (non-oil) current account deficits and smaller reductions in oil import volumes (see Table 3 of Appendix II).

Table 3.

Domestic Retail Fuel Prices by Country

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Source: Research Department; and PDR staff estimates.

Defined as: Change in domestic retail fuel price/change in benchmark price.

“Brent”, Europe.

CIS stands for Commonwealth of Independent States and includes Albania, Moldova, and Mongolia.

IV. Fiscal Impact

Higher oil prices can have a fiscal impact through a number of channels, as outlined below. Which costs, if any, materialize will depend on oil pricing and tax regimes and policies; the scale of the costs is a function of the degree of price pass-through and subsidy decisions.13

  • On the expenditure side, there can be fiscal costs when oil-importing countries do not adjust domestic petroleum product prices. These could take the form of quasi-fiscal losses—for example, as distribution margins of national oil companies may be squeezed—or through direct subsidies paid to such companies.

  • Costs may also arise when domestic prices adjust to world oil prices to the extent that governments raise social benefits payments or other transfers to moderate the impact on consumers. As well, the public sector would have to pay more for the petroleum products it consumes.

  • On the revenue side, fuel tax collection is affected by the degree of price pass-through. When domestic demand for petroleum products is price-elastic, fuel tax collection may fall, especially when petroleum products are subject to a specific tax.

  • Lowering fuel taxation to mitigate the impact of higher world market prices for petroleum products may be another source of revenue loss.

The budgetary impact of the oil shock for oil-importing PRGF countries was either low or offset by other fiscal developments. The average overall fiscal balance improved by more than half a percent of GDP per year in 2003–05 (see Figure 4 below). The average primary deficit—which excludes interest payments and thus the impact of debt relief during this period—improved moderately, from an average of 2½ percent of GDP in 2003 to about 2 percent of GDP in 2005.14 The fact that fiscal balances improved on average does not necessarily mean that the fiscal impact of the oil shock was minor in every country. Several countervailing policy actions might have been taken—for example, far reaching tax reforms in the case of Georgia—and not all of them linked to the oil price shock.

Figure 4.
Figure 4.

Oil Impact and Overall Fiscal Balance, 2003-05

(Annual average change, in percent of GDP)

Citation: IMF Working Papers 2006, 171; 10.5089/9781451864311.001.A001

An important factor contributing to the positive fiscal outcome seems to be that most oil-importing PRGF countries are net fuel tax recipients and have passed-through the oil price shock. Most countries rely on petroleum taxation for fiscal revenue, and do not explicitly subsidize domestic retail fuel prices (Box 2).15 As a result, many of these countries have had a strong incentive to pass-through world prices to domestic retail prices to increase petroleum tax revenue. Domestic retail fuel prices (in U.S. dollar terms) have remained above the world market price for crude oil as well as the U.S. retail price for gasoline between end-2002 and mid-2005, and over this period, have increased by more than the U.S. equivalent in more than three-quarters of the PRGF countries in the sample (Figure 5). Pass-through ratios (defined as the change of the domestic retail gasoline price over the change in the U.S. retail gasoline price) are larger than one for these countries (Table 3 attached).16 However, regional differences remain. African countries have had the highest retail fuel prices and pass-through ratios, while CIS countries have had the lowest (Table 4 attached).

Figure 5.
Figure 5.

Retail Fuel Prices by Country

(In U.S. cents/liter)

Citation: IMF Working Papers 2006, 171; 10.5089/9781451864311.001.A001

Sources: www.International-Fuel-Prices.com; gerhard.metschies@gmx.de; and Fund staff estimates.
Table 4.

Fiscal Developments by Country

(Annual average change in 2003-05, in percent of GDP)

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Source: WEO; Research Department; www.internationalfuelprices.com; and PDR staff estimates.

A minus indicates an increase in expenditures.

Fuel tax dependence can be high (++) or normal (+). Fuel price subsidization can be low (-) or high (--).