EM economies and monetary policy, however, could see a much more nuanced story playing out, given how different economic conditions are both within the EM world and relative to the DM economies. In fact, DM and EM economies differ widely across five metrics we consider in a bottom-up analysis: oil balance (how much of their oil consumption is met by domestic production), oil reliance (how much of their energy needs are met by oil), oil efficiency, the growth of oil consumption and the impact of oil prices on inflation.
In today's note, we assess the impact of a moderate, supply-driven change in oil prices (a further 15-20%) on DM and EM economies, given the stagflationary concerns surrounding such changes. A demand-driven change in oil prices is much more benign - in fact, oil prices then act like automatic stabilisers - and so we focus on the more worrisome path.
The Top-Down View
Why the seemingly tepid DM policy response to oil prices? Take the impact on growth to start with. In last week's note, Spyros Andreopoulos and Sung Kang argued that it is the change rather than level of oil prices that matters over the time horizon of a business cycle (see Global Economics: Barrel Bill (2012 Edition), March 14, 2012). The current run-up in oil prices, they argue, is likely to be drag on global growth but is unlikely to derail the global expansion. A simple rule of thumb our US team uses is that a US$10 supply-driven increase in oil prices leads to a quarter of a percentage point decline in GDP and a third of a percentage point increase in headline CPI. Our euro area team similarly sees a moderate increase in oil prices as a modest drag on growth, but not much more.
Next, consider the impact on inflation: Headline inflation should feel the pinch. However, it is not just the level of inflation but also the type of inflation being generated that matters for policy-makers. A Bank of England study shows that most of the inflation in the UK is likely to have come from abroad, implying that domestic pricing power remains weak - a story that is likely to find echoes in the US and euro area. In a nutshell, this suggests that oil price increases can be passed onto consumers, but domestic producers do not yet have the pricing power to raise prices more than pipeline pressures would suggest, i.e., the dreaded ‘second-round effects' are less likely to assert themselves.
Finally, consider the policy response: While the ECB worries about the impact of oil prices on inflation, the risks of tightening policy are all too apparent from the 2011 episode in which the ECB raised its policy rate. In an era of fiscal dominance, a tightening of policy in response to oil prices might set into motion a negative feedback loop of higher costs of servicing debt and a less sustainable growth profile (see The Global Monetary Analyst: Is Modern Central Banking Ancient History? October 19, 2011). However, the risk remains that central banks take a less sanguine view of the risks to inflation from higher oil prices. This is particularly true in the EM world.
For EM economies, the arguments above are less clear-cut. Growth is weaker there than it was a year ago, but still strong enough for second-round effects to materialise. Real interest rates are higher today than they were a year ago but are not unreasonably high, and certainly not high when compared with the level of growth. Finally, EM central banks are constrained by weaker growth, but not nearly as much as their DM counterparts.
So, how will oil prices affect EM economies? Using the early 2011 oil price jump as a blueprint might be tempting, but the situation has changed markedly since then. Then, overheating risks were on the rise thanks to surging EM exports and strong domestic growth on the back of still easy monetary policy. Now, data in the US and the euro area have alleviated concerns about a recession. This has put a floor under EM exports but has not pushed them through the roof. The tightening of monetary policy in 2011 and the damage from the EM sell-off in 2H11 mean that domestic conditions in EM economies remain tender (with the exception of Russia and some select LatAm economies that are growing rapidly). Finally, unlike in 2011, inflation has trended lower recently and is now at relatively benign levels in most EM economies.
In such a scenario, a further increase in the oil price related to supply could produce greater concerns about growth even as inflation risks start to worry central banks. Inflation risks will almost certainly be tilted to the upside, which would mean that many EM central banks will be less likely to deliver the easing that we expect from them in 2012. The tough choice about whether to worry more about growth or inflation today stands in stark contrast to early 2011 when rising growth and rising inflation both pointed to a tightening of monetary policy regardless of the impact of oil prices. As always, painting all EM economies with the same brush is a difficult proposition. We therefore turn to a more nuanced, bottom-up view of the impact of oil prices on EM (and select DM) economies.
The Bottom-Up View
Building on the approach used by our regional economics teams (see Asia Insight: Higher Oil Prices: What Does it Mean for AXJ? February 26, 2012, "CEEMEA: Revisiting Oil Sensitivities", CEEMEA Macro Monitor, February 24, 2012, and "Oil Risk to Abundance", This Week in Latin America, March 12, 2012), we use five metrics to assess the impact of oil across DM and EM economies:
(i) Oil balance: how much of their oil consumption is met by domestic production;
(ii) Oil reliance: how much of their energy needs are met by oil;
(iii) Oil efficiency: how efficiently they use oil in the production process;
(iv) The growth of oil consumption, and
(v) The impact of oil prices on inflation.
The ‘oil balance' (oil consumption minus production) determines if a country is a net exporter or importer of oil and hence its reliance on the world oil supply and prices. The second metric, a country's reliance on oil as source of energy, examines to what extent an alternative source of energy is available to shield the economy from changes in the oil price. Efficient oil usage (measured by barrels of oil used to produce US$1 million of output) means that less oil is needed to produce the same amount of GDP, implying a lower per unit pass-through of higher oil prices. Oil consumption growth shows whether all of these dynamics have worsened or improved over time. Finally, using estimates produced by our teams, we look at which economies face the greatest inflationary impact of a rise in oil prices.
In interpreting the information on our first three metrics - oil balance, oil reliance, oil efficiency - we make a distinction between exposure and vulnerability. Nearly all EM economies (with the exception of the major oil producer-exporters) are exposed to varying degrees to the possibility of a sudden surge in oil prices. However, vulnerability is less obvious. LatAm and AXJ economies rely more on oil for its energy use than DM economies do. Most EM economies are less efficient than DM economies in how efficiently they use oil, and thus face a greater per-unit pass-through of higher oil prices to the final product.
LatAm benefits from a moderate jump in oil prices, but more reliant on oil: LatAm economies are net oil exporters, but they do suffer on two counts. First, they have a fairly large (above EM average) reliance on oil for their energy needs, suggesting a larger pass-through of higher oil prices onto the domestic economy. Second, even though an increase in oil prices benefits LatAm economies, it exacerbates the terms of trade effect that creates risks of abundance and the ensuing ‘growth mismatch' that our LatAm team has flagged. Chile is the exception to the LatAm rule, with a large exposure to an oil price change since it is a net importer. Colombia, on the other hand, emerges as a clear winner, being a large net exporter of oil and an efficient user as well.
AXJ the mirror image of Latin America; net importers but less vulnerable: AXJ economies are net oil importers (except for Malaysia), with an above-average dependence on oil. In addition, the region is quite inefficient in the use of oil. To boot, oil consumption growth is the strongest in AXJ, hence oil reliance is not getting any smaller. Even here, though, the vulnerability of the AXJ region can be kept under control thanks to oil subsidies and the considerable fiscal room in AXJ to increase subsidies should oil prices continue to rise. The exception to limits on vulnerability is India, thanks to the severe limits on its fiscal balance sheet. While LatAm would see currency appreciation thanks to its net exporter status, AXJ currencies would likely depreciate, supporting exports but aggravating inflation further.
CEEMEA is a mixed bag: With the obvious exception of Russia and Kazakhstan, the CEEMEA region is a net importer of oil, and hence remains exposed. The vulnerability, however, is limited thanks to a relatively low reliance on oil for their energy needs. At the same time, oil efficiency is lower than the EM average for nearly the entire region. Fiscal legroom in the exposed part of the region is limited to absent across the board, so the kind of help that policy can provide in AXJ simply isn't on hand in CEEMEA.
Impact on inflation: Finally, we take a rather direct approach to looking at the impact of oil prices on inflation by using estimates generated by our country teams. Faced with a US$10 increase in oil prices, these estimates suggest that Korea, India and Turkey faced the greatest increase in inflation. All three economies are constrained in terms of policy, Korea the least so in more than one way. Both India and Turkey are constrained in terms of monetary and fiscal policy. There are downside risks to growth from non-oil factors in both countries and the current account deficits in both countries are at risk of widening further if oil prices surge. Korea faces growth concerns too, thanks to its debt-laden consumers. Raising interest rates to fight oil-driven inflation would exacerbate household woes. However, a current account surplus and a good fiscal position mean that Korea is in a more comfortable position than India and Turkey.
In summary, DM and EM economies differ widely in terms of their exposure and vulnerability to a supply-driven increase in oil prices. From a bottom-up perspective, LatAm economies are net beneficiaries of a moderate increase in oil prices but are more vulnerable than their (lack of) exposure suggests. AXJ economies, however, are the opposite. They are net importers and hence exposed, but their fiscal legroom (India aside) means that they retain the ability to cap their vulnerability.
From a top-down perspective, DM growth is likely to see oil prices create a drag on growth but it is unlikely that these negative effects will be large even if we see a moderate, supply-induced increase in oil prices. The Fed and the ECB, constrained by a regime of fiscal dominance, are unlikely to act to ward off the impact of oil prices on inflation. In the EM world, growth has moderated, as has inflation. However, growth is still strong enough that higher oil prices could generate second-round effects on core inflation. In 2011, rising growth and inflation pointed to a tightening of monetary policy regardless of the impact of oil prices. Today, however, EM central banks will have to worry about downside risks to growth as well as the upside risks to inflation if oil prices rise. Compared to 2011, we believe that EM central banks will find it easier to ease or not hike.
Summary and Conclusions
The Budget and the OBR's March 2012 Economic & Fiscal Outlook contained no major surprises, with the key details already well covered by the media in recent days. The Budget was fiscally neutral, and Chancellor Osborne remains on course to achieve his fiscal mandate and supplementary target according to the OBR. The public finance projections were flattered by the planned transfer of Royal Mail pension assets. But, underlying all that, nothing much changed. The government finances are looking only slightly better than they did last November (i.e., moving in the right direction, but still rather unhealthy).
OBR's Main Economic Assumptions Were Little Changed
As widely expected, there were no major changes to the OBR's economic or ‘underlying' PSNB forecasts. The OBR expects the UK to avoid a technical recession and nudged up its forecast for 2012 GDP by one-tenth to 0.8%, but it reduced its estimate for 2013 by a similar magnitude. The medium-term profile for 2014-16 was left unchanged. It continues to see the main risks to its forecasts coming from the situation in the euro area and a further surge in oil prices. In terms of inflation, for 2012 it revised its forecast higher by one-tenth to 2.8%, although this was more than offset by downward revisions to 2013 and 2014.
The Deficit ‘Ex-Royal Mail' Broadly as Expected
In terms of borrowing forecasts, the underlying profile (excluding the impact of the transfer of the Royal Mail's pension deficit and a share of its assets to the public sector) was little changed. PSNB was reduced by £1 billion to £126 billion in the current fiscal year (the ‘starting point' for the projections), less than many had previously expected based on the monthly public finance data until the end of January. The modest downward revision was driven by significant spending restraint, as revenue growth has been weaker than expected in November. There were also small downward revisions to future borrowing numbers.
Royal Mail Transfer Flatters the Figures...
Looking at the impact of bringing Royal Mail pensions into the public accounts (we had assumed that the OBR would not yet include these), this provided a one-off reduction in the PSNB of £28 billion to £92 billion in 2012-13. Hence, the PSNB (deficit) projections were more than £20 billion better than we'd expected in 2012-13 (though broadly as expected for later years) and a cumulative £39 billion better than the OBR's November projections.
...Including Gilt Issuance and Public Sector Net Debt
This also feeds through into less gilt issuance than expected. The £4.5 billion of cash received and assumed asset sales of an identical amount were the driving factors behind the reduction in the Gross Financing Requirement for 2012-13 to £166.4 billion from the £178.3 billion we had previously forecast. Further pension asset sales of £4.5 billion are also assumed for 2013-14.
But We Caution Against Reading Too Much into These Figures, Given the One-Off Impact from Royal Mail
We see little change to the big picture for UK public finances:
1) The fiscal finances still look rather unhealthy. The OBR still forecasts a deficit of 6% of GDP in 2013/14 for example. Government debt as percentage of GDP still doesn't start falling until 2015-16 (reaching 92.7% on the more internationally comparable general government gross debt measure).
2) The Royal Mail pension fund is running a deficit and the government takes on both its assets and liabilities. However, as is normal with public sector pensions, the liabilities are not included in headline debt measures (since the ultimate scale of these liabilities is so uncertain). The ongoing impact on government expenditure and receipts looks set to be relatively neutral; the long-term effect is negative according to the OBR.
3) Austerity is still the main theme driving public finances over the next several years, and partly as a result, we continue to find it hard to get too excited about the UK's near-term growth prospects.
Policy Changes: Lots of Them, but Fiscally Neutral
There were plenty of policy changes in the Budget, most of them well trailed by the UK media. Together, the measures imply a little near-term stimulus and a little more tightening thereafter. However, stimulus measures are largely balanced by revenue-raising measures or spending cuts. We list below the main policy changes (those with a >£0.5 billion impact on the public finances).
Lowering revenue/incurring a cost:
• The personal income tax allowance will be raised to £9,205 from April 2013, up from the £8,100 level which it is due to reach next month. This is the single most expensive measure in the Budget, costing around £3.5 billion a year.
• The rate of corporation tax will fall by an extra percentage point to 24% in April 2012 and will reach 22% by 2014. The levy on bank assets will be increased, however, to offset any gain the sector would receive from lower tax rates.
• Child benefit cuts are now only to impact those earning >50K. The benefit received will begin to fall when one member of a household earns in excess of £50k (£40k had previously been planned). It will be gradually phased out with a 1% decline for every £100 earned in excess of £50k.
Raising revenue/cutting expenditure:
• Freezing age-related allowances: Age-related tax allowances are currently higher than personal income tax allowances. They will now be frozen until the personal allowances catch up. The Treasury estimates that this will save about £1 billion a year.
• Cuts to the ‘Special Reserve': This reflects the end of combat operations in Afghanistan by end-2014 (the net additional costs of military operations in Afghanistan are currently met from the Treasury Special Reserve in addition to the main defence budget). This saves £2.4 billion cumulatively.
• Closing tax loopholes/crackdown on avoidance: As widely flagged, the government is significantly stepping up its efforts against tax avoidance, particularly in relation to the purchase of homes in excess of £2 million. In addition, from midnight there will be a 7% stamp duty on all properties sold for more than £2 million. Taken together, these measures are expected to raise around £0.6 billion a year.
Several other changes featuring in the Budget speech have a much smaller impact on the public finances, although the political importance (and even wider economic importance) may of course prove to be greater. This includes the cut in the top rate of income tax, from April 2013, from 50% to 45% (analysis by HMRC suggested higher tax rates on top earners have raised much less than originally forecast). This is set to cost around £100 million a year.
The Next Spending Review: Yet More Austerity Ahead
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