Sri Lanka: Selected Issues
Author: International Monetary Fund
Publication Date:
21 Dec 2006
eISBN:
9781451823578
Language:
English
Keywords:
ISCR; CR; price; remittance; Rs.; GDP; administered fuel price; clothing price; oil import; South Asian country; world oil price; Fuel prices; Oil prices; Oil; Inflation; Energy subsidies
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This paper attempts to assess the impact of the oil shock on South Asian economies, including Sri Lanka, as well as policy responses to deal with the shock, and the real income loss for low-income households if fuel subsidies were fully removed. The most important impact has been on the balance of payments followed by the results of poverty and social impact analysis (PSIA) conducted for Sri Lanka. Finally, the paper explores to what extent Sri Lanka’s large receipts of worker remittances serve as a hedge against shocks.

Abstract

This paper attempts to assess the impact of the oil shock on South Asian economies, including Sri Lanka, as well as policy responses to deal with the shock, and the real income loss for low-income households if fuel subsidies were fully removed. The most important impact has been on the balance of payments followed by the results of poverty and social impact analysis (PSIA) conducted for Sri Lanka. Finally, the paper explores to what extent Sri Lanka’s large receipts of worker remittances serve as a hedge against shocks.

I. Macroeconomic Challenges of High Oil Prices in the South Asian Region1

A. Background

1. Over the past two and a half years, South Asia has been hit particularly hard by the doubling of world oil prices. Its terms of trade deteriorated by 7 percent during 2004 –05 and it is projected to deteriorate by another 5 percent in 2006, reflecting higher import prices for oil and lower prices for garment exports after the Multifiber Agreement expired. This contrasts with a much smaller decline of about 3½ percent in the terms of trade of Asia as a whole and about 1½ percent for developing countries as a group, with many of them benefiting from higher nonfuel commodity prices. In addition, because of high oil intensity (the ratio of oil imports to total energy consumption), South Asia’s net oil imports rose more sharply than those of other Asian countries as a whole.

Figure I.1.
Figure I.1.

Average Spot Oil Prices

(U.S. dollars per barrel)

Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A001

Sources: IMF, Commodity Price System database; and CEIC Data Company Ltd.1/ Deflated by U.S. CPI.

2. Exports and remittances helped mitigate the impact of higher oil prices on South Asia’s external current account, but non-oil imports were also buoyant. Despite falling textile and clothing prices, non-oil exports rose as a share of GDP in five of the six countries in the South Asia region. In some countries, workers’ remittances increased as well, aided by the outpouring of help after the tsunami (Sri Lanka) and the fact that many of South Asians work in oil producing countries. However, non-oil imports also boomed, contributing to higher current account deficits than could be accounted for by increased net oil imports.

3. Looking forward, the oil prices are expected to remain volatile as the oil market continues to be tight. Supply constraints and strong growth momentum around the world are likely to give rise to upside risks on oil prices. At current level of $60 per barrel, the South Asian countries are expected to continue to face pressures on the balance of payments. Moreover, with economies closer to capacity, oil price increases may create stronger inflationary pressures.

B. Impact of the Oil Shock2

4. The most important impact of higher oil prices on the South Asian region was on the balance of payments.

Figure I.2.
Figure I.2.

Change in the Terms of Trade, 2004–2005 1/

(In percent)

Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A001

Source: IMF, World Economic Outlook database.1/ The change is calculated from end-2003 to end-2005.2/ Unweighted. Excluding Bhutan and Nepal. SAARC = South Asian Association for Regional Cooperation.

  • The terms of trade of South Asian countries (excluding Bhutan and Nepal) declined by about 7 percent on average during 2004–05, compared to 3½ percent for Asia as a whole (Figure I.2). The oil shock came at a time when many South Asian countries also had to cope with the impact of the expiration of the Multifiber Agreement (MFA) in 2004. At the same time, South Asian countries did not benefit from the improved nonfuel commodity prices enjoyed by commodity-exporting countries. In contrast to the deterioration experienced by South Asia, the terms of trade was virtually unaffected during 2004 – 05 for oil importing countries as a group, and deteriorated by only 1½ percent for developing countries as a group.

  • South Asian countries net oil imports rose by 2.5 percent of GDP during 2004–05, compared with 1.2 percent of GDP for Asia as a whole, reflecting its high oil intensity in economic activities.

  • The oil shock amounted to about 25 percent of South Asian countries overall external reserves in 2003. This contrasts with 30 percent for low-income Asian countries and 8 percent for Asia as a whole.

5. The impact of higher oil prices on growth in the South Asia region has been muted, but there was a push on inflation.

Figure I.3.
Figure I.3.

Growth and Inflation

Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A001

  • The oil shock coincided with a pickup in growth across South Asia (except Maldives which experienced major damage from the tsunami) (Figure I.3). Countries responded to the oil shock through a mix of financing and adjustment, and the output effects were also mitigated by monetary and fiscal accommodation in some cases.

  • Domestic price adjustments were limited in many South Asia countries during 2004 – 05, and implicit or explicit subsidies helped contain the impact of the oil shock on inflation. However, as world oil prices continue to rise, some of these economies implemented more aggressive price adjustments since early 2006. This is the case of Sri Lanka, with an average increase of 35 percent in domestic prices. Inflation rates have picked up, reflecting in part the effect of the price pass-through, but they remain manageable (Figure I.4). The weight of petroleum products and related services (including transport and electricity) in the CPI in SAARC is about 10 percent, comparable to other Asian countries.

Figure I.4.
Figure I.4.

Growth and Inflation

(In percent)

Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A001

Sources: CEIC Data Co. Ltd.; IMF, IFS database; and, IMF, APD database.1/ India is using WPI data.

C. Cope With the Oil Shock

6. How has South Asia responded to the oil shock? During 2004–05, most South Asian economies financed their current account deficits through external borrowing—usually by the government, with the exceptions of Bhutan and Maldives, where capital grants played a significant role. India enjoyed a surge in private capital flows during this period, which helped finance the oil shock and build up reserves. The reserve coverage of imports declined in nearly all South Asian countries—with reserves in Bangladesh, Sri Lanka, and the Maldives falling below the equivalent of 3 months of imports (Table I.1).

Table I.1.

Financing of the Oil Price Shock

(In percent of GDP; annual average 2004–2005)

article image

International reserves in next year’s imports of goods and nonfactor services.

The large negative other item is assumed to be capital flight.

Stock of international reserves in the last two columns refer to mid-2003 and end-2005.

Unweighted average.

Excluding net oil exporters.

Low income.

7. Healthy economic growth in 2004–05, however, helped offset increased borrowing. For most countries in South Asia (except for Bhutan and Maldives), external debt fell as a share of GDP. Nevertheless, with external debt above 45 percent of GDP in the majority of countries, indebtedness remains at vulnerable levels and is higher than the Asian average of about 30 percent of GDP (Table I.2).

Table I.2.

External Borrowing, 2004–2005

article image

Unweighted average.

Excluding net oil exporters.

Low income.

8. South Asian countries also responded to the oil shock by raising administered fuel prices. On average, they achieved full price pass-through for gasoline, but lagged by significant margins for diesel and kerosene. Their adjustment is comparable to industrial Asia’s and more ambitious than that of other regions (Figure I.5).3 However, for diesel, the average pass-through has been 80 percent at end-2005 and it is ahead of other regions. For kerosene, the average pass-through has been around 50 percent, which is similar to that for low-income Asia. As the average world oil price (APSP) continued to climb since early 2006 to about $76 per barrel in early August from $62 per barrel in January, South Asian countries have further adjusted domestic fuel prices, but most of them are still lagging behind the amounts required for full pass-through in kerosene. Sri Lanka has achieved full pass-through for diesel and substantially increased domestic price for kerosene by September. To avoid amplifying price shocks, the Sri Lankan authorities also removed the ad valorem tax of 15 percent on diesel and revised the pricing formula for the two oil companies to ensure cost recovery and a profit margin for future price adjustments.

Figure I.5.
Figure I.5.

Domestic Oil Price Developments

Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A001

9. Nevertheless, the incomplete pass-through for diesel and kerosene since 2004 has taken a toll on public finances. Total oil subsidies amount to 0.8 percent of GDP on average during 2004–05 for South Asian economies compared with an average of 0.4 percent of GDP for Asia as a whole (Figure I.6). Moreover, budgeted oil subsidies in South Asia accounted for about 20 percent of the total, implying a substantial amount of quasi-fiscal subsidies. Much of this quasi-fiscal cost was financed by borrowing from the state-owned banks, delayed payments to suppliers, and profit and equity erosion of state-owned enterprises in the energy sector.

Figure I.6.
Figure I.6.

Explicit and Implicit Energy Subsidies, 2004–2005 Average 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A001

1/ Comprises budget oil subsidies and losses of state-owned energy enterprises.2/ No data available for quasi-fiscal losses.3/ Unweighted average.4/ Excluding net oil exporters.5/ Low income.

10. In fiscal and monetary policy, the region has made a limited adjustment to the oil shock. During 2004–05, fiscal policy was eased or remained the same in all but two South Asian countries (India and Nepal), and money growth picked up in four (Bangladesh, Bhutan, India, and Sri Lanka) (Figure I.7). Moreover, with the exception of Bangladesh, real effective exchange rates appreciated in all South Asian countries, contributing to the strong growth of non-oil imports.

Figure I.7.
Figure I.7.

Policy Developments

Citation: IMF Staff Country Reports 2006, 447; 10.5089/9781451823578.002.A001

D. Policy Options

11. A permanent terms of trade shock eventually requires macroeconomic adjustment. But the optimal speed of that adjustment is determined by a country’s access to external financing, its level of international reserves, constraints imposed by external and public debt, and its stage in the business cycle. With oil price likely to remain higher, the full pass-through to domestic consumers is the best policy on both fiscal and efficiency grounds. Subsidization of petroleum products can crowd out productive expenditures, increase public debt, and undermine the financial position of public enterprises. Below cost prices also create distortions (for example, using kerosene to adulterate diesel) and prevent the adjustment in domestic demand that facilitates a return to a sustainable external balance. In the longer term, correct price signals induce countries to adopt alternative energy sources and pursue more energy-efficient technologies, which will serve the countries when they face future oil shocks.

12. Countries with weak external positions, financing constraints, and adverse debt dynamics would need to adjust more rapidly to the oil shock. In these countries, there is likely to be less external financing available to their private or public sectors to help cushion their adjustment, and central bank credibility tends to be lower. This necessitates extra caution in monetary policy. Within the overall fiscal adjustment, some support is likely to be needed to protect vulnerable groups. Real exchange rate depreciation would also facilitate adjustment to the oil shock. Countries with flexible exchange rate regimes could generally allow nominal depreciation, while those with fixed exchange rate regimes (or peg to a major currency or a regional currency) will have to rely more on a reduction of domestic absorption in the short term and on downward adjustment of domestic wages and prices to achieve real depreciation over the longer term.

13. Depending on the availability of external concessional financing, low-income net oil importers may be among those that need to adjust more rapidly. Their limited access to foreign capital markets and frequently low levels of reserves would, in many instances, prevent a significant smoothing of their adjustment to the shock. In these cases, increased financing from official sources would help cushion the impact in the short run. However, especially for countries facing already high debt and debt service burdens, such financing would usually lead to the higher debt service burden as the oil financing is unlikely to be given on long term and concessional terms.

14. Some countries, for social equity reasons, have not passed on the full cost of oil price increases. But subsidies are typically inefficient and regressive, as evidenced by the substantial leakage of existing subsidies to high-income households. A more efficient and effective way to help the poor is to eliminate oil subsidies, use some of the proceeds to compensate them through well-targeted safety nets, and still record budget savings. However, it is recognized that the design of effective compensation schemes are a challenge task.

15. With the recognition of the need for full price pass-through, considerations should be given to the pricing mechanism for oil products. International experience shows that countries with liberalized prices or automatic fuel pricing mechanisms have the highest degree of pass through. In contrast, countries with systems of ad hoc changes take longer to adjust prices upward and the size of the adjustment is smaller.

16. The formulas used to determine price changes should be transparent and based on the international prices of petroleum products. To be transparent, the adjustment formula should be clearly specified and fully documented. International prices are an appropriate benchmark because they provide a measure of the opportunity cost of fuel consumption. To reduce the volatility of prices, a moving average for the reference price could be used. It is generally recommended that prices be adjusted monthly which is preferable to avoid sharp increases.

17. Where excise taxes on petroleum products are on an ad valorem basis, consideration could be given to converting them to specific rates. Ad valorem taxation can increase tax revenues procyclically in oil-importing countries, placing the burden of an additional adjustment on the private sector. Where the level of ad valorem excises prior to the recent oil price increases was already appropriate from the point of view of conservation and fiscal needs, it might be reasonable to make the switch to specific rates on a revenue neutral basis.

18. Some countries are also concerned about the impact of full pass-through on growth. But delaying adjustment unduly is also not without risks since it could induce a larger and more abrupt adjustment later on, with possibly worse effects on growth. In the case of Indonesia, for example, domestic retail prices were raised by 30 percent in March 2005—the first adjustment after a long delay against the doubling increases in international prices since 2002. At the same time, monetary conditions were loose and real interest rates turned negative. In this environment, capital outflows picked up and reserves coverage reached critical levels. In October 2005, the Indonesian authorities embarked on a large adjustment to avert a potential balance of payments crises. Oil prices were raised between 90 percent (gasoline) and 200 percent (kerosene) on a single day and policy rates were jacked up by 425 basis points between August and December, complemented by a program to compensate the poor. As a result, the monthly growth of oil and gas imports decelerated sharply during that period (to 3 percent in November from an average of over 50 percent during January-August). However, real growth slowed—from 6.1 percent in the first quarter of 2005 to 5.3 percent in the third quarter, and an expected 4½ percent in 2006.

E. Conclusion

19. With high oil prices likely to persist over the medium term, South Asian countries need to reconsider the balance between financing and adjustment to the oil shock. Those countries with high debts and low external reserves will need to adjustment more rapidly. As experience has shown, a determined and timely adjustment is preferable to a large and disruptive one and eventually helps to minimize the negative effects often associated with external shocks.

1

Prepared by Erik Lueth and Marta Ruiz-Arranz.

2

Most of the analysis for the South Asian region was limited to the period of 2004–05 for which country-wise data are available.

3

Figure I.5 depicts pass-through as the absolute change in domestic retail prices between end-2003 and end-2005 as percent of the absolute change in world prices over the same period.

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Cover IMF Staff Country Reports
Sri Lanka: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2006: Issue 447
Publisher:
International Monetary Fund
ISBN:
9781451823578
ISSN:
1934-7685
Pages:
42
DOI:
https://doi.org/10.5089/9781451823578.002

Average Spot Oil Prices

(U.S. dollars per barrel)

Change in the Terms of Trade, 2004–2005 1/

(In percent)

Growth and Inflation

Growth and Inflation

(In percent)

Domestic Oil Price Developments

Explicit and Implicit Energy Subsidies, 2004–2005 Average 1/

(In percent of GDP)

Policy Developments