World braces for the ripple effect

From the Sydney Morning Sun Herald:
World braces for the ripple effect
September 3, 2005

Katrina may start a perfect storm in the world economy, write John Garnaut and Los Angeles Times reporter Evelyn Iritani.

It’s easy to think the full impact of the oil crisis is half a world away, where American motorists are paying double what they were three years ago for petrol, after the Gulf Coast was ravaged by Hurricane Katrina.


But the implications are far more global, and more complicated, than that. The most acute economic impact is being felt closer to home.

It is being felt by people such as Indonesia’s President Susilo Bambang Yudhoyono, for example, whose year-old government faces a choice between ending fuel subsidies and risking serious political instability, on the one hand, and fiscal bankruptcy and a return to financial crisis on the other.

In Thailand, fuel costs are choking the economy and growth forecasts have been slashed by half. And high oil prices are forcing China’s state-owned companies to start shopping for foreign oilfields, sparking new Sino-US rivalries.

Analysts are wondering how the world will be changed by the transfer of an extra $US100 billion ($130 billion) in oil payments from the West, Asia, eastern Europe and Africa to the Middle East and Central Asia.

And this week’s record New York oil price of $US70.85 a barrel has probably arrested the global hike of higher interest rates as the US and China, the world’s two great growth engines, face their most serious economic tests in years.

In Australia, where record petrol prices have thus far been greeted by an eerie calm, financial markets are flirting with the thought that this oil crisis will lead to a crunch for commodity prices, after an initial surge – as has happened with oil shocks that have gone before.

“One reason the [Australian] dollar dropped below US75c was markets were worried that high oil prices would hurt economic growth, and therefore demand for Australian commodities,” says Peter Jolly, head of research at National Australia Bank.

Until now, however, the country’s top policy makers have cautiously distinguished this oil crisis from its 1970s predecessors – which were mainly caused by the oil cartel simply turning off its taps.

In his latest public appearance, Reserve Bank governor Ian Macfarlane said the oil price rise was happening because “the world economy is just growing so fast”.

He argued the impact on consumers had been muted by the exchange rate, saying Australia would benefit on the whole, because it is a net energy exporter.

“There is enough similarity between oil prices and the prices of other hydrocarbons like coal and gas that when the dust settles, we gain more in income than we pay out in extra expenditure because of the higher price of oil,” Macfarlane told a Parliamentary Committee on August 12. “For the country as a whole, the oil price shock is not directly harmful.

“It is only harmful in so much as it might cause the rest of the world to slow down; but it is not harmful to our industries. If you add up all of the industries, the ones that benefit, benefit more than the ones that lose.”

High oil costs played no small part in this year’s enormous coal price rises for BHP Billiton and Rio Tinto, as Chinese industry shifts away from small diesel power generators to massive new coal-fired plants.

Oil prices are also linked to huge gas and uranium price rises, and even the Government’s opening the way for new uranium mining and exports to China.

The oil price surge is part of the wider commodity boom – which is more of a boon to Australian miners than a tax on consumers. “Most of the same reasons that oil is flirting with $US70 a barrel are the same reasons that coking coal is $120 a tonne – Australia is taking a lot with one hand and handing [some] back with the other,” says Chris Richardson, a director of Access Economics.

But, as Macfarlane also warned in last month’s parliamentary appearance, there will be a point where even Australia’s energy-exporting economy will begin to hurt.

“At some point, it clearly does become important, and then the interesting issue is the policy response,” he said.

That point seems to have arrived this week, in the form of a hurricane.

“It’s clear that the short-run effect is now unambiguously negative,” a senior policy official told the Herald on Friday.

“It’s getting a bit scarier now.”

One remarkable thing about oil prices now, compared to previous surges, is that markets expect prices to stay this high for most of this decade.

And for the next six months the oil futures market is in an unusual state of “contango”, with prices rising for deliveries for each month until March.

Regina Schleiger, an economist with well-connected interest rate analysts Medley Global Advisers, says it is wrong to talk about an oil price shock, or spike, because those terms connote a temporary phenomenon.

Global demand is so strong, and supply so limited, that oil prices will have to rise far enough to choke its own demand, in a brutal self-correcting cycle, Schleiger says.

“That means ‘demand destruction’ – a polite way of saying a sharp economic slowdown in the world’s key growth engine economies – becomes the only means to bring prices down,” she says in a recent client report.

And that was before Hurricane Katrina.

Beyond the enormous human cost and dislocation, Katrina has pushed oil rigs across the Gulf of Mexico and smashed eight Gulf Coast refineries out of production. That stretch of coast produces one-third of US oil.

Average petrol prices have jumped US55c towards $US3 a gallon (a gallon is about 3.8 litres) in a week – unprecedented in the US experience.

Ben Bernanke, who recently left the Federal Reserve to advise the US President, George Bush, told Bloomberg that American consumers should expect to pay $US3 a gallon or more for at least “the next six to eight weeks”.

He noted oil futures markets project petrol prices will average $US3.25 a gallon this month and a similar price for October.

Global markets have spent little time pondering the appropriate policy response to this type of demand shock.

Unlike in the 1970s, when central banks raised interest rates to curb oil’s inflationary effects, investors are confident Federal Reserve chairman Alan Greenspan will halt his “measured” march towards higher rates – immediately.

“There’s no way in the world the Fed’s going to hike rates again in the near term,” says Rory Robertson, debt market analyst at Macquarie Bank.

“The one thing we know is [oil] is negative to growth. What we don’t know is whether the damage is modest or massive.”

Markets across the world judge that inflation and wages are compliant, leaving central bankers to deal with oil’s dampening effect on demand and growth.

“In the space of two days we have seen one of the biggest reassessments of Fed policy I’ve ever seen,” says Jolly, at NAB. “They have taken out 1½ rate hikes in the past 24 hours.”

Yields on two-year US government bonds tumbled this week to 3.7 per cent, suggesting that the official 3.5 per cent rate will remain broadly where it is for the foreseeable future.

Australian bond yields have tumbled even faster, responding to diminishing growth prospects across the Asian region.

The export-led growth prospects for the Asia-Pacific region, including Australia, depend on how the oil crisis plays out in Indonesia, Thailand, Japan and, above all, China.

The Asian region demands more oil but produces less than other economic centres. Countries such as Japan and Korea import 100 per cent of what they consume.

“The Asian region consumes three times more oil than it produces,” says Richard Grace, an analyst at Commonwealth Bank.

“They’re under a little bit of pressure now.”

Economic growth in the Asian region is far more oil intensive than the global average, largely because of China’s early stage of industrialisation.

The global economy has typically grown three times faster than oil consumption, but the dominance of Chinese growth last year dropped that ratio to 1:1.

Skyrocketing oil prices are “a heavy tax on most Asian economies”, says William Overholt, director of Rand Corp’s Center for Asia-Pacific Policy.

Asian governments are taking steps to cushion the economic effect of energy costs.

Some have imposed emergency energy restrictions in hopes of avoiding more draconian, and unpopular, price hikes. Filipino workers have been ordered to take three-day weekends. Japanese salarymen are wearing short-sleeved shirts and abandoning their ties so they can turn off their air-conditioners.

Ifzal Ali, chief economist at the Asian Development Bank in Manila, says those steps have simply delayed the pain for countries such as Thailand and Indonesia, which will experience much slower growth in 2006.

“Countries have been in denial, and now it is gradually sinking in that this is here to stay for the foreseeable future,” he says.

As oil prices have risen, many Asian governments have spent billions of dollars to avoid raising prices for kerosene and other fuel.

But those expensive subsidies are eating away at governments’ reserves and forcing them into debt to maintain them, says William Belchere, chief Asia economist at Macquarie Securities in Hong Kong. “At some point, that will begin to grind into their economies,” he says.

That has already happened in Thailand, which was forced to abandon price controls on diesel fuel this summer after spending $US2.5 billion in subsidies, says Eugene Davis, managing director of Finansa, a Bangkok investor group. He says the government’s mishandling of the energy situation has contributed to a loss of investor confidence and put pressure on the currency.

Davis says Thailand’s growth could slow to 2 per cent this year, less than half its projected level.

Elsewhere, high oil prices are extracting a political price.

In Indonesia, there were nationwide protests this spring when the government raised fuel prices to cover soaring energy costs. Indonesia’s kerosene and petrol price ceiling means the government directly pays the bill above that point.

The subsidy policy was difficult to fund eight years ago, when Indonesia was a net exporter and oil prices were a third of what they are now. The International Monetary Fund even used the issue to help shoe-horn president Suharto off his 30-year pinnacle.

But the Indonesian government recently warned that fuel subsidies could double this year to $US15.3 billion if prices hold at current levels – an astonishing 5 per cent of GDP.

“The subsidy is now worth six times the combined central government expenditure on health and education,” says Professor Hal Hill, economist and Indonesia expert at Australian National University.

“[President Yudhoyono’s] first term administration will be judged by how he handles this,” he says.

President Yudhoyono this week postponed outlining reforms until next month, as the rupiah resumed a deep fall.

In India, where state-owned energy companies are running huge losses, the government will soon be forced to raise fuel prices, says Amitabh Dubey, an analyst at Eurasia Group in New York.

He predicts energy will be a hot issue in next year’s elections in the communist-controlled states of Kerala and West Bengal. “There will be political instability,” he warns.

Energy prices also have become a problem in China, where fuel prices are heavily subsidised, says Jason Kindopp, a China specialist at Eurasia Group. Last week, the government dispatched extra police to Guangzhou after service stations ran short of petrol and motorists were forced to endure lengthy waits and rationing.

Kindopp says the shortages occurred because some of the state-owned refineries have trimmed production or exported their petrol because they were tired of operating at a loss under the government’s strict price controls. Since the start of the year, retail petrol prices in China have risen by 15 per cent, while global oil prices have risen by 50 per cent, he says.

To avoid future shortages, the Chinese government may have to raise retail prices, which not only will be politically unpopular but also will stoke inflation and put a brake on the economy.

“It’ll certainly have a dampening effect,” Kindopp says, “because so much of what is driving China’s economic growth relies on low-cost inputs.”

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