The civil war in Iraq has jolted global oil prices; London Brent has surged by 6 percent (or $6/ barrel) in ten days. Forecasts by global analyst community have increased by $10-15 per barrel. Pakistan’s economic weakness due to pricier oil is nothing new.
Recall, that the 2008-9 crisis stemmed from the failure to pass on the hike in fuel prices to consumers-–fiscal and external imbalances worsened, inflation peaked at 25 percent, exchange rate depreciated by 30 percent, foreign exchange imports cover was thinned to two months of imports and growth was stagnated.
The fiscal year 2013-14 deemed to be the first year of economic recovery after a recessionary period of five years but right at the onset of FY15, the economy is tested by the risks of an oil shock. The picture would surely not be as murky as it was back then. However, cautious and prudent approach is required to withstand that shocks. Slippages in import balance are likely to be balanced by foreign privatization and loan flows. However, inflation outlook ought to be revised upwards.
In order to quantify the impact of change in global oil price on inflation, BR Research recently sought guidance from Dr Hafeez Pasha; and after spending a day in his library, arrived at the following striking conclusion: a 10 percent increase in oil prices would inflate the prices, directly and indirectly, by 1.9 percent (See table), whereas the current account would be increased by $1.5 billion (0.6% of GDP).
Those who might be interested in understanding the math behind this back-of-a-jumbo-envelope calculation are encouraged to read further.
The quantification of inflationary impact of oil price rise is not an easy job. First, there is a direct impact on consumption. Then the ensuing hike in transportation prices-–i.e. higher freight—seeps into the prices of goods transported from production or import centers to consumers. The cost push also has an impact on industries and then the second round of inflation through exchange rate depreciation also plays a role. On top of all this, inflationary expectations can also exacerbate the scenario.
In computing the impact, first the build-up of POL prices that consumers pay is analyzed where by assuming full petroleum levy, a 10 percent increase in oil would result in 8.96 percent increase in high speed diesel prices.
According to National Accounts (2005-6), the component of fuel cost was 37 percent of transportation costs. Hence, transportation prices would increase by 3.3 percent due to 10 percent increase in international oil prices.
The value of transport as a percentage of total market value of supply of goods was 27.4 percent in 2005-6. Assuming the same ratios today, it would result in 0.9 percent increase in the price of goods. And with 66 percent share of goods in the CPI basket, inflation would be up by 0.6 percent due to 10 percent increase in oil prices. This relationship is linear, i.e. 15 percent oil price increase would increase CPI by one percent.
The second element was to find the cost-push factor. For this purpose, the impact of increase in oil prices on power generation cost is computed. According to NEPRA State of Industry report, the share of furnace oil in total power generation was at 78 percent. Assuming the same share, a 10 percent oil price hike and 75 percent recovery of bills, the rise in power tariffs will be 10.4 percent.
The impact of higher tariffs on industries was then calculated by using Census of Manufacturing Industries (2005-6)-–where fuel and electricity was three percent of total value of production. And by applying the same ratio, the cost-push impact came at 0.33 percent. Given that manufacturing goods have a weight of 30 percent in CPI, a 10 percent oil price hike would push cost of production by 0.1 percent.
The direct impact of oil shock on consumption is simple. First, you look at the CPI weights of electricity (4.4% weight in CPI), kerosene (.0057%) and motor fuel (3.03%) and then you take a weighted sum of the impact of 10 percent rise in international oil prices. The number comes down to 0.73 percent.
The second round of inflation is based on the assumption of 2.5 percent depreciation in nominal exchange rate by current account slippage of $1.5 billion. That’s a conservative estimate given Finance Minister Ishaq Dar’s love for sticky currency. In 2013-14, the imports ($45bn) share in GDP ($250bn) was coming at 18 percent and by 2.5 percent depreciation in nominal exchange rate the CPI would rise by 0.45 percent.
Adding all these components, the CPI will increase by 1.87 percent upon 10 percent upward revision in oil prices. The relationship is almost linear which implies by doubling the oil price increase, the hike in CPI would double as well, and vice versa.
An interesting scenario could be that the government does not pass the increase of oil prices to consumers. If that’s the case, then the increase in inflation would be marginally low but at the cost of high fiscal deficit.
Eventually the economy has to pay the cost and that has a spillover on all the macro fundamentals-–reminiscent of what happened in 2008-9 when the country paid the prices of not passing on the prices in 2007-8.
The model predicts that for 10 percent oil hike, keeping the petroleum levy at half would increase inflation by 1.5 percent-–instead of 1.87 percent in the base case scenario—and fiscal deficit would soar by Rs62 billion or 0.21 percent of GDP. By totally eliminating the petroleum levy, the deficit would swell by Rs123 billion or 0.42 percent of GDP and prices increase by 1.05 percent.
The optimal, but politically tough, choice for PM Nawaz Sharif would be to pass on impact of higher oil prices back to the consumers, which also means that to change expectations of interest rates-–given that inflation outlook might be revised up from eight percent target to nearly double digits—there is a case for the hawks to come back at the SBP.
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IMPACT OF 10% HIKE IN GLOBAL OIL ON PAKISTAN CPI
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Rise in transport cost 0.60 %
Cost push inflation in manufacturing 0.10 %
Impact directly on consumption 0.73 %
Exchange rate depreciation impact 0.45 %
Impact on overall CPI 1.87 %
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Source: BR Research calculations based on PBS, NEPRA, SBP, OGRA.
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