The Oil Price Shock

| by Arujuna Sivananthan

Income Inequality

( February 26, London, Sri Lanka Guardian) With recent hikes in the price of distillates and resultant protests, a pertinent question to ask is who is affected most by them. Athula Naranpanawa and Jayathileka S Bandara of the University of Griffith in Australia, in a recently published discussion paper, suggest that low income households followed by low income rural households are most affected. And, those energy intensive sectors such as manufacturing also suffer.

Sri Lanka’s distillates subsidies accounted for 2.1 percent of GDP. And, while most developing countries progressively eased them, Sri Lanka’s policymakers had steadfastly refused to do so. It was non-compliance with the terms of the International Monetary Fund’s (IMF) standby facility and the urgent need for foreign exchange (forex) which finally forced their hand into raising prices to market levels. In effect, they have sought to trade off the ability of loss making state owned utilities to partially withstand external shocks for political capital and a narrowing of their electoral base. Of particular relevance is the impact on Sri Lanka’s one million working poor, that is those living just above the poverty line.

The authors’ conclusions are startling; when increases in global oil prices are passed on to consumers in full, employment and household consumption fall by 7.96 and 5.55 percent respectively, and, the poverty line rises by 1.12 percent from the base case scenario. Also, there is an increase in the rate of inflation and a drop in purchasing power. Real income inequality widens with blue collar workers in the manufacturing sector worst affected. A failure ameliorate this burden on vulnerable social groups may suggest that we have not seen the end of the civil disobedience campaigns we saw last week.
Sri Lanka’s policy makers have indeed taken their first step towards reforming underperforming state utilities. Now they need to counter its resultant political and social consequences.

Remittances
There is a widespread belief that migrant worker remittances, Sri Lanka’s biggest source of forex, are altruistic in nature and help cushion Sri Lanka from oil price shocks. As such they should be negatively correlated with real incomes in Sri Lanka and positively with host countries, particularly Gulf States, and, thus act as a hedge against rising oil prices. On the other hand, remittances may be driven by macroeconomic variables and the level of the exchange rate. Erik Lueth and Marta Ruiz-Arranz study this and their results are published in a paper in the Asia-Pacific Development Journal Vol. 14, No. 1, June 2007.
Their analysis provides an insight into the balance of payments crisis confronting Sri Lanka. While remittances are positively correlated with high oil prices, they decline with exchange rate weakness. They also increase when economic activity accelerates and drop when conditions deteriorate, suggestive of investment considerations and also perceptions of the political situation being positive. The paper clearly dispels the myth that remittances are altruistic, and, on the contrary is positively correlated with Sri Lanka’s economic cycle, diminishing its usefulness as a shock absorber. The authors conclude by saying that “while it is important to continue facilitating remittance inflows with policies directed at reducing transaction costs, promoting financial sector development and improving the business climate, remittances should not be seen as a substitute for government policy and structural reform”.
These studies provide some context on why Sri Lanka’s policy makers response to growing economic imbalances were characterised by inertia. Undertaking structural reform necessitates a trade-off between expending economic and political capital. And, if policy makers avoid it, in the end, as we have witnessed, markets will force that choice on them.
In the case of the former it has manifested itself in the form of mass public demonstrations.
With remittances, it is not yet clear. However, with the so-called ‘free float’ of the rupee and ‘moral suasion’ used by Sri Lanka’s Central Bank (CB) to floor its value, at which level it will settle remains unresolved. With the rupee still trading at 15 percent above where the IMF believes to be its equilibrium level, it is difficult to see how migrant workers will rush to remit their hard earned money back home. And, in all likelihood it was the increased probability of this that made the CB so reluctant to relent on its soft-peg.
Unfortunately, this is not the end of the Sri Lanka’s oil price shock. It imports twelve tankers of crude oil on average per year, of which eleven are from Iran. Its policymakers have entered into bilateral negotiations with both Oman and Saudi Arabia to replace Iranian imports. These remain yet to be resolved favourably. And, if they are not, the impulse which drove prices higher may further increase in intensity.

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Author: Sri Lanka Guardian

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