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Here Comes Inflation!
Adios Cheap Oil!
When your neighbour losses his job, it is called
hyperinflation. When you lose your job it is
described as a recession. But when an economist
losses his job, it is labelled a depression.
This old joke probably contains an iota of truth about the
way economists perceive harsh economic
realities. Indeed, neither depression nor
recession is affecting the world economy at this
particular juncture. But, a sharp rise in energy
prices, particularly the price of oil, is
sparking concerns and even taking a serious toll
in many oil importing countries stretching from
Timbuktu to Taipei.
Currently, the price of a barrel of oil stands at around 60
dollars. If the price is to be maintained at
current levels, or even climb higher (which
appears to be a strong possibility), it will,
undoubtedly, not only shrink corporate profits
and trim global growth, it will also push
economies down in the dumps, and squeeze
household incomes.
There are many fundamental reasons for the hike in the
price of oil. The Chinese economy, which is now
growing at breathtaking speed, is partly
responsible for higher oil prices. International
trade data shows,
China’s oil import recently jumped by 40pc.
Countries such as India have also shown an
increased appetite for energy and raw materials.
On top of this, the turbulence and political strife in oil
producing countries, such as
Nigeria and Iraq, and the lack of investment in
new oil fields are factors considered to be
contributing to the upward pressure on crude
prices.
Although the cyclical component of growth is always larger
than the structural, official statistics
indicate that
Ethiopia’s gross domestic product (GDP) has now
sprinted to reach seven per cent. This is also
fuelled by an export sector that has registered
a remarkable growth of 33pc, to reach to 700
million dollars. This news has encouraged
optimistic souls to predict better times to
come. Hopefully, they will be proved right.
Nonetheless, past experience suggests that when things look
so rosy, it is better always to ask, “what might
go wrong”. Accordingly, a closer look at other
statistical indicators reveals that the
Ethiopian economy is actually facing a double
whammy as a result of a spiking oil import bill
and rising inflation.
A bumper harvest usually refreshes the entire economy,
keeping inflationary pressures in check and
putting some money in the pockets of farmers to
spend on consumer goods, stimulating some of the
industries.
In spite of the bumper harvest during the last two years,
the food price index jumped from three per cent
in December 2004 to 13.7pc this year, while core
inflation (excluding food) has almost doubled
from 3.9pc to 7.2pc. As a result, the general
price index has shot up from its last year level
of 3.2pc to 11.7pc this year.
What is puzzling is that, in spite of a 15pc rise in
agricultural productivity, the food price index,
which usually declines during the second quarter
of the year, has sky rocketed. The hope remains
that a flow of food aid in the coming months
will help dump the price of food items in the
domestic market.
Without exaggeration, if inflation keeps rising or remain
at its current level, it will knock-off the
spurt in GDP growth, whose forecast varies from
5.1pc (the IMF) and eight per cent, reported by
the government.
Government blames the work of speculators and “blood
sucking vampires” for the current price
escalation, whom it alleges are trying to thrive
by hoarding goods and employing cheap market
rigging tactics.
Indeed, there are some who argue that inflation is not a
worrying factor in
Ethiopia due to the fact that core inflation
stands at 7.2pc. True: core inflation usually
indicates how and to what extent the money
supply in an economy is affecting price levels.
However, it is ridiculous in the Ethiopian case
to ignore the food price index as irrelevant as
60pc of household consumption consists of food.
Sticking to core inflation alone does not make
much sense, indeed it can be misleading.
It is also plausible to argue that inflation in
Ethiopia, by and large, is not a monetary
phenomenon. It is the amount of rainfall that
often determines the level of price.
Generally speaking, inflation is eroding the purchasing
power of many people in many ways in spite of
the debate that it is caused by food prices or a
non-food one, and whichever is moderate. Just
wander the market places, you can see how fast
prices are moving upwards.
It is not only inflation that tops everyone’s list. It is
also the country’s oil imports bill that has
surged up dramatically at the very time the
government is struggling to ease inflationary
pressures and do away with the uncertain climate
in the aftermath of the May national elections
saga.
Available data from the Ethiopian Petroleum Enterprise
indicate that,
Ethiopia
imported over 1.4 million tonnes of oil, valued
at 5.2 billion Br, during the year 2004/05. This
represents 25.2pc of the total import of
Ethiopia in the same year valued at 21 billion
Br (2.38 billion dollars). This is nearly a 62pc
rise on the previous year oil import bill.
Out of the total export earnings, over 84pc is spent on the
import of oil alone. As a result of soaring oil
prices, the country’s trade deficit has widened
to 1.7 billion dollars. Apparently, the
government is spending over one billion Birr
annually to subsidize local fuel consumption.
There is no doubt that this is slowly becoming a
menace on the budget, with a deficit assuming
four per cent of the GDP, according to the IMF.
A recent estimate indicated that a five dollars
rise per barrel of oil would erode 0.9pc of
Ethiopia’s
Real Gross Domestic Product (RGDP).
The government is indeed struggling to keep inflation in
check and to continue to subsidize local fuel
consumption. In fact, any measure that increases
the price of oil at the fuel stations would
certainly amplify the current economic
difficulties. Without any doubt, a rise in fuel
prices will have a knock-on effect on the
purchasing power of the population.
Nevertheless, continuing to subsidize fuel
consumption will put pressure on the already
strained government finances and become a drag
on the economy.
In fact, the standard IMF fiscal discipline criterion
requires developing countries to keep their
fiscal deficit at around seven per cent of their
GDP. In the face of mounting oil subsidy, the
government has little chance but to head towards
this threshold.
There is little doubt whether the government can subsidize
oil without shelving some of its development
activities. Imagine how many schools, clinics,
mosquito nets that the one billion Birr subsidy
could build and buy in just a year? Continuing
the oil subsidy will severely affect next year’s
government spending on infrastructure, education
and health.
Furthermore, most of the oil subsidies do not benefit the
majority of the people in whose name the subsidy
is paid. Cheap petrol largely benefits the
gas-guzzling nouveau riche who drive fuel
consuming posh Mercedes and Sport utility
vehicles, a.k.a. SUVs, on the streets of Addis.
In fact, the nouveaux riche these days are
changing their spending habits as often as their
underwear. There is hardly any justification why
the state should foots their bill with
taxpayers’ money.
While the general mechanism by which oil prices affect
economic performance is well understood, the
precise dynamics and the magnitudes of these
effects on the Ethiopian economy needs in-depth
analysis.
The impact of the rise in fuel import prices could become
more pronounced if such prices continue to rise
in the global oil market at the current rate.
More immediately, the higher the price of oil
imports, the larger the nation’s merchandize
trade deficit and the greater the
disproportionate impact they have, particularly
on the manufacturing sector that largely depends
on imported raw materials.
Seen from the political perspective, the continuation of
subsidy might be correct. However, if is hardly
possible for the government to shoulder the bill
indefinitely. Although there is little sign of
an inevitable crisis, the government – should it
chooses to continue to subsidise - will gain
nothing except to push the economy to the edge
of the cliff. The postponement of adjustment is
not the best way to circumvent economic
difficulties that are hovering around. Nor is a
sudden and abrupt adjustment advisable.
For instance, a sudden and abrupt increase in fuel price
has more dire consequences than a gradual
increase. The higher the oil-price in the world
market and the longer subsides are sustained at
local markets, the worst the cumulative
macroeconomic impact will be. Sky rocketing oil
prices lead to a deterioration of the balance of
payments (IMF estimates the gap to be 570
million dollars in December 2005), putting
downward pressure on the stability of the
exchange rates.
Fiscal imbalances would worsen, creating pressure to raise
taxes that could turn the current cyclical
economic upturn upside down. An abrupt increase
in fuel prices could lead to significant shifts
in levels and patterns of investment, savings
and spending. A sudden rise in fuel prices also
exacerbates inflation, and reduces aggregate
demand, pushing the economy further into
deflation.
Deflation is much more damaging to economic stability than
inflation. It deepens recession because it
increases the real burden of debt and encourages
people to postpone consumption in the hope that
prices will fall further.
In that scenario tax revenue falls and the budget deficit
increases, due to rising government expenditure,
which normally pushes the interest rate up.
Because of the real decline in wages, a sudden
increase in prices typically leads to upward
pressure on nominal wages.
Wage pressures, together with reduced demand, tend to lead
to higher unemployment. The combination of a
high level of inflation, alarmingly increasing
unemployment, lower exchange rates and lower
real output could finally push the economy into
the doldrums.
Ethiopia’s economy has little financial leeway
to indefinitely subsidize fuel at the pumps.
While protecting the very poor should be a
priority, it however has to gradually pass some
of the costs to them. To cushion the effects of
fuel price rise, the government has to take a
host of supply side measures to boost economic
activities. If growth is to be held, it requires
the incumbent to do more than encouraging the
export sector.
More aggressive restructuring of the public sector,
expansion of public works, such as the
construction of dams, roads, through better
budget management and further exploration of
minerals and mines would help boost the economy
and reduce the prevalent rampant unemployment.
Further, the government has to support the
expansion of private businesses by introducing
corporate laws that remove barriers to the entry
and expansion of new firms.
Ensuring property rights, introduction of bankruptcy laws
and improving the commercial code will enhance
the creation of a pulsating economy. The moot
point here is that the government has to
exigently revamp the real sector and put the
country on a fast growth trajectory which is
certainly the best way to withstand cyclical
exogenous shocks.
Key to all these is the need for the central bank to
liberalize the bank deposit rate, currently at
the three per cent level. This would help
enhance consumer spending, thereby further
helping to revamp productive activity. In fact,
the functioning minimum deposit rate has
achieved nothing except allow banks to sit on a
mountain of excess liquidity, which is estimated
to be 25pc of the GDP.
It is very difficult to comprehend the rationale behind
fixing the same interest rate for all categories
of deposits. It would be much better to allow
banks to decide their deposit rates rather than
maintain the minimum deposit rate indefinitely.
Moreover, the central bank has to be cautious
that contractionary monetary policy to contain
inflationary pressures at this point in time
could exacerbate unemployment and lead to a
further fall in income.
Belt tightening measures are dangerous in an environment
where there are no more belts to tight.
The upshot is that if public deficit continues as a result
of the fuel subsidy, it could lead to higher
inflation because the government will be forced
to seek more money from the domestic finance
sources that stands now at 985 million Br,
according to a World Bank report. This will
certainly push up the interest rate, crowd out
private investment and weaken the financial
system.
To avoid a full-size macroeconomic shock, the government
has to make a careful adjustment of the local
price of fuel, while trying to protect the very
poor within the limits of its budget. After all,
there is not much alternative left, except to
embrace price inflation and live with an
expensive fuel price. Indeed, as the old Chinese
proverb has it, what you cannot avoid, welcome.
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