Pakistan and the fall in oil prices

Far reaching effects

Battle hardened Pakistan finally gets some measure of reprieve. The fall in crude oil prices comes at a particularly sensitive time in Pakistan’s history. Energy is closely intertwined with the fortunes of countries. Among other things, one of the main driving forces of the industrial revolution was easy access to cheap energy, coal at that time. Same was true for oil for a long while, with the west having access to cheap oil until OPEC decided to flex its muscles in the 1973 oil crisis, leaving the west insecure and vulnerable as only shortage of energy can.

Oil held its ground till the mid ’80s, providing oil exporting countries with a windfall in revenues and allowing large amounts of capital to be ploughed back into the industry. From then on, supply concerns pushed down the price of oil with the commodity falling to new lows. This fall in prices provided an impetus to world economic growth. Cheap oil was back and was warmly greeted by the world.

With the rise of developing Asia and an increase in political tension in the Middle East, oil began its depressing price rally; depressing contingent on whether a country is an oil importer or exporter. At the height of the global economic boom there was a general understanding that oil’s spectacular rise would sustain with talks of the commodity eventually breaching the $200 per barrel mark. As with most predictions concerning commodities, this one too found its way into the rubbish heap. Six years after the recession of 2008, oil demand has slackened and given way to a largely unanticipated price fall.

Pakistan’s central bank will have an easier time with its foreign reserves. Oil and oil commodities make up nearly a third of Pakistan’s imports, and any fall in oil prices is bound to reduce pressures on the rupee

Circa 2007, Pakistan’s economy suffered an intense period of economic depression. To compound that problem, the rise in world oil prices left very little space for policy makers. With the rupee under pressure and the circular debt growing, both on account of oil prices, Pakistani policy makers were left with unenviable choices.

With the fall in prices, however, some of that will change. For one, Pakistan’s central bank will have an easier time with its foreign reserves. Oil and oil commodities make up nearly a third of Pakistan’s imports, and any fall in oil prices is bound to reduce pressures on the rupee. As a commodity, demand for oil is extremely price inelastic, meaning that for a change in oil prices, quantities demanded do not change by much.

That is true at least in the short run. People cannot immediately change their consumption patterns; through buying more fuel-efficient cars, for example, or through changing behaviours that influence consumption. The recent surge in hybrid imports is an example of consumers changing their preferences to cater to higher petrol prices. With little change in demand expected, Pakistan can see its import bill shrink considerably.

Lower oil prices also eventually translate into higher spending by consumers. Pakistanis are not the biggest of savers; years of high inflation have eroded incentives to save. An inflation rate that has remained over and above the savings rate on incomes deposited in banks has meant a loss of purchasing power for people intending to put money in savings accounts over extended periods of time. The economy has remained stunted, offering few entrepreneurial or investment opportunities for Pakistanis to channel their savings into. As an exercise in comparison, as per the IMF’s figures, Pakistan has a gross national savings rate of 14.1 percent of GDP. In contrast, India’s saving rate is 32.4 percent, Bangladesh at 26.8 percent while the world average stands at 20.0 percent of GDP and median at 18.9 percent of GDP.

In this case, lower oil prices could serve as an adrenalin shot to the Pakistani economy in the form of increased demand for consumer goods, since Pakistanis would spend rather than save.

More important is the dampened effect on inflationary expectations. While there has been a general sentiment of lower inflation, lower oil prices will further cement the prevailing sentiment of lower future inflation. So while prices will rise, they will rise at a slower rate than before.

While costs are imported, they become hostage to local politics once in the grid, leaving policy makers with only so much wiggle room. This gives rise to a situation where the cost of producing each unit of electricity has risen dramatically

For the government, the lowering of oil prices might turn out to be a double edged sword. Lower oil prices will take away some of the steam from Pakistan’s growing circular debt while on the other hand the government stands to lose taxes from the import and sale of oil and oil products.

Pakistan’s dependence on crude oil to produce electricity leaves it especially vulnerable to the vagaries of the oil market. The political economy surrounding electricity and its pricing has dictated, over the years, that prices could be raised only up to a point even as the price of oil reached historic highs. So while costs are imported, they become hostage to local politics once in the grid, leaving policy makers with only so much wiggle room. This gives rise to a situation where the cost of producing each unit of electricity has risen dramatically while the government is unable to pass on the full brunt of the rise in oil prices on to consumers. This gap has led to Pakistan’s burgeoning circular debt, where the government has had to subsidise each unit of electricity produced. With lower oil prices, expect a narrowing of the required subsidy and for circular debt to grow at a slower rate than before.

There is a flipside to this, however, in the form of lower taxes for the government. Taxes from oil are chiefly dependent on the price of oil, since consumption is not expected to change by much in the short term. Hence lower prices lead to lower taxes. But some of those losses will be recouped through the added spending in the economy. With higher disposable incomes on account of lower oil prices it is expected that most of it will find its way into the economy. Where that money is spent will have a bearing on the government’s fiscal position. Incomes spent in the documented economy will be taxable, allowing the government to recover some of the tax losses accruing from the fall in prices. Whereas incomes directed towards the undocumented sector, which comprises around half of Pakistan’s economy, will result in a loss of taxation for the government.

The fall in oil prices provides Pakistan’s economy with some measure of breathing space. For both consumers and the government, lower oil prices will have far reaching effects, on the condition that the recent oil price drop sustains and is not a temporary phenomenon.