Reliable availability of cheap energy is, as the Gulf war highlights, essential to modern economies and societies. Shocks divide the world into the oil haves and oil have-nots. Alongside higher energy prices, the shortage of chemicals derived from petrochemicals will affect agriculture, mining, plastics, textiles, semiconductors and construction. Given that it would take months or years to restore normalcy even if the conflict ends with a lasting agreement, the effects are likely to be severe.
Among those substantially affected are Europe, already burdened by their decision to cut off Russian gas supplies, and Japan. But the most major consequences will be felt across oil-poor South and East Asia. The extent of the damage depends on pre-existing vulnerabilities like insufficient currency reserves, poor public finances, trade imbalances, high debt levels (especially those denominated in foreign currencies), reliance on overseas capital, narrow industrial bases and poor contingency plans.
For energy importers, supply disruptions work through several pathways. Its most immediate manifestation is a widening current account deficit. Given the pervasive impact of transport costs, prices increase across the board. Rising input expenses for businesses affect profitability and, ultimately, viability. As essentials cost more, the fall in surplus income decreases consumption, slowing the economy and pushing up unemployment. Tax revenues fall and welfare spending kicks in, worsening government budgets. This is frequently aggravated by vote-buying subsidies, frequently to alleviate cost-of-living pressures.
The current crisis is a textbook case of how oil shocks work through economies. Financially, the most obvious signs are weakening currencies and falling asset prices. Foreign investment inflows slow. Portfolio investors exit as asset values translated into their base currency decrease. Direct investment fall reflects the poorer prospects. Banks face higher non-performing loans from the weaker economy as well as lower loan demand. The availability of funding is affected. Inflation places pressure on interest rates, which further exacerbates the stress.
What is to be done? Like the Irish farmer’s direction to a traveller: “I wouldn’t start from here!”
The classic policy prescription is to let the currency devalue and force the necessary adjustments. An alternative is to intervene in the currency markets and simultaneously use higher short-term interest rates to support the exchange rate. The most extreme measure is to increase government intervention restricting capital movement and, as an option, implement prices and income controls. Each path has advantages and disadvantages.
Depreciation of the currency should, in theory, have the effect of reducing imports by choking off purchases assuming the application of the normal laws of supply and demand. It should simultaneously boost exports. It forces the necessary adjustment of living standards, often brutally.
In practice, its effectiveness depends on several factors, particularly the elasticity of demand for a country’s imports and exports. If the import is vital and not replaceable, or the cost can be passed on, foreign purchases may not decrease. Improvements in export volumes depend on the type of product and the demand sensitivity to price. It also depends on competition and substitutes. If competitors have superior products or are willing to match the prices, then volumes may not respond. This is particularly problematic when the whole emerging market complex is affected and all countries want to devalue at the same time, reducing the ability of a single country to cheapen its currency.
Devaluation also feeds inflation through higher import costs, unless it destroys demand. A weaker currency may accelerate capital flight as investors fear losses. It creates unhelpful behaviours with importers accelerating purchases and exporters delaying conversion of foreign currency inflows. Foreign currency borrowers without any equivalent matching revenues providing a natural hedge face rising indebtedness. Emerging market businesses frequently take advantage of lower interest rates, relative to domestic funding, running the currency risk.
Intervention in money markets rarely works. It risks using up currency reserves needed to cover commercial imports or short-term debt. Historically, success requires co-operation between major central banks, as in the 1985 Plaza Accord that devalued the dollar. Emerging-market central banks have a poor track record on this. In the 1997 Asian crisis, Thailand, Indonesia and Malaysia severely depleted their foreign exchange reserves in failed attempts to defend their currencies, which were fixed against the dollar. In general, where foreign currency debts and investments exceed reserves, such interventions rarely succeed.
Capital controls would require managing the exchange rate and restricting foreign currency flows. They can manage a crisis to maintain sovereignty over exchange rates, interest rates, inflation and the banking system. In the longer term, capital controls will deter foreign investment. It often leads to a currency black market and other workarounds.
In a market-based system, it is difficult to insulate an economy from external events, especially of the magnitude of the Gulf war. Poorly-developed domestic capital markets, which limit local supply of capital and risk management tools, impair the ability to absorb shocks.
Many emerging market economies are also woefully unprepared. Assuming no disruption in supply chains, they have pitifully low buffer stocks or reserves. Their economies remain narrowly structured with little diversification of their industrial base. Despite a history of energy dependence and previous disturbances, efforts to increase energy independence have been limited. Investment in renewables such as solar, wind, hydro and biofuels remains inadequate. Even emergency plans for rapidly scaling up alternative fossil fuels, like coal, are largely absent.
The exception is China, which displays significant forward planning. The country built substantial strategic oil reserves and renewable supplies, which now account for up to 40 percent of its total electricity generation and over half its installed capacity.
Governments have encouraged magical thinking among citizens, encouraging them to believe that policymakers can shield them from these events. Subsidies, transfers and price control are electorally popular, but they do not address the core problems.
Like Aesop’s grasshopper, energy-deficient countries that have wasted summers of abundant supplies now face a difficult winter.
Satyajit Das | Former banker and author of A Banquet of Consequences
(Views are personal)