The Impact of Higher Oil Prices on the Global Economy

I. Introduction

Over the past two years, oil prices have increased very sharply, with the Fund's reference price rising from a 25 year low of $11 per barrel in February 1999 to a peak of close to $35 per barrel in the first week of September 2000.² After easing somewhat in early October, oil prices increased again in late October and November to an average of about $32 per barrel. At the same time, futures markets indicated that average oil prices in 2001 would be about $5 per barrel higher than projected in the most recent World Economic Outlook (WEO) published in late September.³

The recent World Economic Outlook contained an extensive discussion of the potential impact of higher prices.⁴ The purpose of this paper is to expand on that discussion in the light of developments since then. The paper is divided into three sections. Section I reviews the causes underlying the recent oil price increase and the outlook for 2001. Section II discusses the potential impact of a sustained $5 per barrel increase in the price of oil on the global economy, focusing on the key channels through which it operates, and the effects of differing policy responses. Section III provides a summary and includes a discussion of main policy implications for developed and developing countries. An Appendix reviews lessons from earlier oil price increases.

Since late November, oil prices have fallen back significantly, reflecting both the slowing of global economic activity-which to some degree, of course, itself reflects higher oil prices-and the impact of recent OPEC production increases, resulting in a rising level of stocks. As of December 20th, the Fund's reference price had fallen back to just over $22 per barrel, while futures markets suggest that the average price of oil in 2001 will be just under $24, only $1 higher than in the original WEO baseline. While oil prices remain highly volatile, if this decline is sustained the recent spike in oil prices would be shorter lived than assumed in the discussion below, and the resulting impact on growth and inflation would be correspondingly less severe.

II. Recent Developments and Outlook in Oil Markets

In October and November, 2000 the world oil price averaged over three times higher than its February 1999 low, and, excluding the Gulf war period, reached a 15 year high in both real and nominal terms. In the mid-1990s, as the pace of economic expansion picked up so did world demand in general for energy and for oil in particular. The effect on oil prices was muted as oil production largely kept pace with the increase in oil consumption.⁵ With the onset of the Asian crisis in 1997, as well as subdued activity in Japan and Europe, global consumption of oil fell significantly short of production and the Fund's indicator price for oil fell progressively from about $20 a barrel in early 1997 to below $11 in February 1999 (Figure 1).

In an effort to arrest the decline in the price of oil, the Organization of Petroleum Exporting Countries (OPEC) met on several occasions in 1998 and concluded agreements to restrain production.⁶ The upward trend in production was reversed, but compliance with the agreements was not sufficient to prevent price declines.⁷ In early 1999, however, OPEC's production restraints were reinforced by parallel agreements with some other oil exporting countries (most notably Mexico and Norway) which enabled oil production to be reduced more effectively from the second quarter of 1999 onwards. Prices progressively increased, more than doubling by the end of the year and oil production fell below oil consumption even in the summer period when stocks usually accumulate. Early this year, in an effort to moderate the price increase, OPEC policy reverted to one of periodic increases in production targets. In March, OPEC increased targeted production by 1.7 million barrels per day-equivalent to about 2 percent of world production. Following this increase, and partly in response to concerns by some OPEC members on the long term effect of high prices, including loss of market share to non-OPEC producers, OPEC informally defined a target price band of $22 to $28 a barrel and prescribed increases or decreases of one half million barrels per day, should the OPEC reference price remain outside this range for more than 20 consecutive market days.⁸ Subsequently, OPEC increased its production targets by amounts in excess of one half million barrels on June 21 and September 10, and by one half million barrels on October 30.

The recent price rise is the fourth episode of sharp upward movement in the price of petroleum in the past thirty years. So far it is much smaller in terms of magnitude of the terms of trade impact than the first two episodes, but it has outpaced the third (see Annex). In terms of the magnitude of the price change, the first and second oil price shocks, in the mid and late-1970s, respectively, each entailed a more than tripling of the price of oil; and both lasted for about 5 years. By contrast, the price spike in 1990-91 lasted only about six months and even at its highest point was less than double the price in the preceding period.

A. Current Market Conditions and Near Term Outlook

The current market conditions and the near term outlook for oil reflect the interplay of production, stocks and consumption. Over the past two years global economic growth has greatly strengthened-from a rate of 2.6 percent in 1998 to 3.4 percent in 1999 and to an estimated 4.7 percent in 2000. As a result, the growth in global oil consumption increased from 0.6 percent in 1998 to 1.6 percent in 1999, before moderating somewhat this year due to the sharp oil price increase.

There are noticeable seasonal patterns in production and in primary consumption cycles of oil. Peaks for both cycles occur in the fourth quarter of the year, and troughs in the second quarter. Measured stocks of crude oil and products are usually run down near the end of the calendar year when consumers in the northern hemisphere build up their supplies (invisible stocks) of heating oil for the winter season and visible stocks are rebuilt around the middle of the following year. In 1999 the seasonal accumulation of stocks did not occur because of producers' attempts to curb production at a time when the rate of demand growth was increasing, and it contributed to the doubling of the oil price during the year. Latest data on production and consumption suggest some replenishment of stocks of oil products in the middle months of this year. However, a strong seasonal demand for gasoline led refineries to bias the mix of their output towards gasoline at the expense of heating oil. In addition, it appears that stocks of heating oil held by final consumers in recent weeks have been higher than usual because of concerns about higher prices and/or shortages during the height of the heating season, as well as worries about a cold winter. (The volume of heating oil sold in the United States to final consumers has been 10 to 20 percent higher than in recent years). As a result, visible stocks of heating oil appear to be low and many market analysts have questioned the extent to which these stocks would cover seasonal demand, especially should the weather in the northern hemisphere be colder than average (Figure 2). For this reason the price of oil this year has been unusually sensitive to weather information and this situation is likely to persist throughout much of the winter.

With stocks so low, the market has become highly sensitive to news relating to short term supply changes and much attention is given to the actions and intentions of OPEC. On October 30, after the price of oil in the OPEC basket had stayed above its agreed price range of $22 to $28 for twenty consecutive working days, OPEC announced a half million barrel per day increase in the aggregate production target for its members. As in the three previous increases in production targets this year, the new target failed to bring down the price to the upper level of the target range. Recently, however, the concern of many OPEC members has turned to the possibility of "overproduction" should the current tight market conditions ease early next year. At its regular meeting held on November 12, OPEC decided that production targets should not be increased until the group's meeting in mid-January when they would be reconsidered.⁹ Saudi Arabia, however, has stated that it remains ready to provide extra deliveries should prices surge again.

In addition, many short-term political developments and problems along the production-consumption chain, which in periods of ample stocks would receive little attention, are adding to price uncertainty. Recently these have included such diverse matters as Iraq's request for payment in euros rather than dollars; escalation of conflict between Israel and the Palestinians and the threat that this may spill over into actions affecting oil deliveries; blockades of oil terminals by commercial truckers aiming to pressure governments in Europe to cut petroleum taxes; and localized gasoline price spikes in the United States.¹⁰ Added to these are changes in oil-specific government policy such as the use of strategic reserves, notably in instances of persistently low stocks. The main such event was the announcement on September 22 of a release of 30 million barrels by the United States from its Strategic Petroleum Reserves to oil companies, in exchange for an equivalent future delivery between August and November 2001.

Key factors that will influence the supply-demand situation over the next six to nine months include the severity of the winter, the pace of global economic activity, and whether any oil production increases will be sustained. An important consideration is the fact that nearly all OPEC countries, with the exception of Saudi Arabia, are close to or producing at full capacity which may make it difficult to agree to production increases which will lower oil prices and hence revenues for most OPEC members. (There is also very little spare capacity in non-OPEC countries). As noted above, oil prices have fallen back significantly in December; however, uncertainty regarding future prices remains high and it is not difficult to envisage situations which could lead to prices at least $5 higher, or $5 lower.

B. Energy Intensity of Consumption and Production

The medium to longer term prospects for oil prices reflect the changing structure of energy use and of the energy intensity of production. The International Energy Agency (IEA) publishes country energy balance sheets which measure energy production and consumption in terms of the heat content of oil. These data indicate that world energy use at the primary level (refineries, heat plants, electricity plants, etc.) increased by about 50 percent over the 25-year period from 1973 to 1998 (Figure 3). Over this period, there has also been a shift away from oil towards natural gas, a less expensive and less polluting source of energy (see Box 1). The increase in global consumption of oil was only 25 percent while that for natural gas was over 50 percent. The share of coal has remained roughly constant at about 25 percent of overall fuel consumption.

In the early 1980's, after the first and second oil price shocks, there was little growth in total global energy consumption, and world oil consumption fell. They both resumed their upward trend in the late 1980's. In OECD countries, the ratio of energy consumption to real GDP has fallen steadily and that of petroleum consumption to real GDP has fallen at a greater rate (Figure 4). In Russia and other countries of the former Soviet Union, total energy consumption has fallen progressively in the 1990s in line with the decline in real GDP, but energy intensity remains largely unchanged. In these countries, natural gas replaced petroleum as the leading source of energy in the 1980s and this trend has been accentuated in the 1990s. In developing countries energy consumption has increased steadily. This increase is largely in line with the growth in real GDP although there appears to be some decline in the ratio of energy use to GDP in the 1990s, at least in Asia. In these countries, more so than elsewhere, the growth in the consumption of natural gas has outpaced the growth in consumption of oil and the share of natural gas in total energy use has doubled.

In 2000, the price of oil has been at its highest level since the mid-1980s, excluding the brief price spike at the end of 1990. The current price hike, if maintained for any significant length of time, is likely to accentuate the trend towards energy conservation and the shift from oil to other sources of energy, especially in sectors other than transport. Consumption of oil is likely to continue to grow in the medium term but, as in the past three decades, at a considerably slower rate than other energy sources, particularly those which have a cost advantage. The longer the oil price hike lasts, the more this process will be accentuated.

The price increase for petroleum has spilled over into the market for natural gas-the source of energy most closely competitive with petroleum, but not yet into the market for coal, the other leading source of energy (Figure 5). Because of the incorporation of oil prices into formulas for the pricing of future deliveries of natural gas, the price increase for natural gas has lagged behind that of petroleum by about six months. The effect of the higher oil prices was incorporated for the most part in the second and third quarters of this year. However, international transfers resulting from changes in prices of natural gas are of less consequence to the global economy than those of petroleum. The price of natural gas per unit of energy is considerably lower than that of petroleum and a much smaller proportion of natural gas production enters international trade (as discussed in Box 1).

III. The Impact on the Global Economy

The latest World Economic Outlook projections were based on an assumed path of oil prices that is about $5/barrel lower in 2001 and 2002 than suggested by futures markets during October and November 2000. Higher oil prices affect the global economy through a variety of channels:

• There will be a transfer of income from oil consumers to oil producers. As the propensity to spend of those who lose income (energy consumers) is generally larger than the propensity to spend of those who gain income (energy producers), there will be some fall in demand. On an international level, the transfer is from oil importing countries to oil exporters (Table 1), and oil exporters tend to expand demand only gradually (in the past, they have spent about 1/3 of their additional revenues after one year, rising to 75 percent after 3 years).¹¹ In addition, a reduction in demand can also occur within producing countries that allow higher oil prices to feed through to consumers, as energy producers tend to have a lower propensity to consume than energy consumers.

• There will be a rise in the cost of production of goods and services in the economy, given the increase in the relative price of energy inputs, putting pressure on profit margins. As the oil intensity of production in advanced countries has fallen over the past three decades, the supply side impact for a given increase in oil prices can be expected to be less than in past episodes. In developing countries, however, where the oil intensity of production has declined less, the impact may be closer to that in the earlier period.
  
  
• There will be an impact on the price level and on inflation. Its magnitude will depend on the degree of monetary tightening and the extent to which consumers seek to offset the decline in their real incomes through higher wage increases, and producers seek to restore profit margins. These responses can create a wage/price spiral, as was the case, for example, during the oil shocks in the 1970s-see Annex.
  
  
• There will be both direct and indirect impact on financial markets. Actual as well as anticipated changes in economic activity, corporate earnings, inflation, and monetary policy following the oil price increases will affect equity and bond valuations, and currency exchange rates.
  
  
• Finally, depending on expected duration of price increases, the change in relative prices creates incentives for suppliers of energy to increase production (to the extent that there is scope for doing so) and investment, and for oil consumers to economize.

To undertake an analysis of these five channels, several simulations of a sustained $5 per barrel (20 percent) increase in the price of oil were run using MULTIMOD, focusing on the implications for real GDP, inflation, and monetary policy.¹² In these simulations, it is assumed that the monetary authorities in advanced countries target expected core inflation, while fiscal policy is passive, allowing automatic stabilizers to operate. The results, reported in Table 2, indicate that a $5 per barrel increase in the price of oil would reduce the level of global output by around ¼ percentage point over the first 4 years, after which the output losses slowly fade away. The impact is somewhat larger for industrial countries than for developing countries as a group, particularly as regards domestic demand, largely due to terms-of-trade effects (as many developing countries are net oil exporters). However, as discussed below, the significant diversity across developing countries, in particular the mixture of oil exporters and importers, means that the impact on individual developing countries is often large.

Table 1. Impact of an Oil Price Increase of - $5 per barrel on Oil Exporting and Oil Importing Countries (for 2000)

Source: WEO and staff calculations.

1/ An oil-dependent exporter is defined as a country for which at least 10% of export earning are derived from the (net) exports of oil.

Some of the limitations of this exercise should be recognized. First, these results underestimate the global impact in that they do not incorporate the impact of higher prices of other energy products, such as gas, which is a particularly important source of energy in the transition countries. Second, the impact of the rise in oil prices may be amplified if they exacerbate existing macroeconomic imbalances or lead to inappropriate policy responses, particularly in oil importing countries. Third, the simulations take little account of relative demand effects within countries.

A. The Impact on Industrial Countries

For the industrial countries as a group, real GDP falls 0.3 percentage points below the baseline in 2001 and 2002 before recovering subsequently, while real domestic demand follows a similar profile but with a somewhat greater short-term loss of 0.4 percentage points because of negative terms-of-trade effects. The impact on activity and demand in the United States and euro area are somewhat larger than the industrial country average, while the impact on the group "other industrial countries" is smaller than the average because the largest two members of this group-the United Kingdom and Canada-are net oil exporters. Headline CPI inflation rises in all countries in the short run, with particularly large impact in the United States and euro area, resulting in an increase in real and nominal short-term interest rates as monetary policy responds to counter second round wage and price increases (as noted earlier, the monetary authorities are assumed to target core inflation). The financial impact of the increase in oil prices is quite muted. Exchange rates remain relatively stable, with the dollar appreciating slightly relative to the yen and euro because the United States faces a smaller terms-of-trade shock. Lower expected future profits result in a fall of 1-2 percent in equity prices in the advanced economies. If adverse confidence effects were to magnify these effects, the corresponding effect on the real economy would also be larger. Financial market considerations are discussed in more detail below.

These differences in response reflect the net effect of the differing importance of the four most important channels through which the oil price hike is transmitted to activity in the short-term-a temporary impact on supply potential proportional to the energy intensity of production (as the change in relative prices of intermediate goods temporarily disrupts existing production arrangements¹³), the fuel tax wedge, the increase in expected core inflation, and the terms-of-trade impact on real incomes. The supply-side impact is largest in the United States, as it has a higher energy intensity of production than most other industrial countries. The higher the fuel tax wedge, the smaller the proportional impact on retail prices of a given rise in oil prices. The United States has the smallest wedge and hence the biggest impact. The inflationary consequences and monetary policy response are most significant in the United States and euro area, reflecting a combination of relatively high energy consumption (which increases the inflationary impact in the United States), inertia in the inflation process (which is particularly important in the euro area, with its labor market rigidities), and differences in resistance to real income losses (which is low in Japan). The negative terms-of-trade impact, on the other hand, is smaller in the United States than the euro area and Japan, as the United States has significant domestic oil production, and is positive for the other industrial countries as a group.

Table 2. Permanent $5 per Barrel Increase in the Price of Oil: Baseline Scenario
(Percent deviation from baseline unless otherwise specified)

¹Includes countries not in other groups.

Table 3 provides summary comparisons of this simulation result with estimated impact on industrial economies from two other global macroeconomic models: the OECD's INTERLINK and McKibbin-Sachs Global 2 (MSG2).¹⁴ The results show some interesting differences which highlight the uncertainties surrounding the estimated impact of an oil price increase.

• The inflationary impact of the oil price shock, and the associated monetary response, are smaller in the other models. These estimated effects may be too small, as the baseline MULTIMOD results appear consistent with the weight of oil prices in CPIs.
  
  
• Despite a more limited monetary tightening, the real GDP effects using MSG2 are similar to those in the baseline scenario. The smaller impact reported by the OECD probably largely reflects both the more muted monetary policy response and the temporary nature of the assumed oil price shock.

Table 3. Comparison of the Baseline Scenario with Outside Simulations

Source: The OECD simulations are reported in ECSS(2000)5, "Oil: Impact and Policy Implications of the Current Situation," October 24, 2000. The MSG2 simulations were generated by Warrick McKibbon of the Brookings Institution at the staff's request.
¹ Corresponds to OECD countries in the OECD and MSG2 simulations.
² Baseline scenario.
³ The OECD simulations consider a shock in which the oil price averages about 13 percent above baseline in the first year (2000), is 22.5 percent above baseline throughout the second year, and declines to 10 percent above baseline by the end of the third year.

The results described above are based on price equations which incorporate historical estimates of the degree of resistance to declines in real income in advanced economies. It is possible, however, that the extent of inflation pass through from terms-of-trade disturbances has declined in recent years as labor markets and profit margins have become more flexible.¹⁵ In the current episode, the pass through from the oil price hike into core inflation in advanced economies appears to have been relatively limited, implying that the second round inflationary effects might be smaller than assumed above. It is also possible that the wage response is being delayed as relatively few labor contracts have come up for renegotiation, as the most recent hike in oil prices occurred since mid-August.¹⁶

Nevertheless, to explore the effects of limited second round effects further, Table 4 reports a second MULTIMOD simulation which assumes that there is no pass through of the impact effects of higher oil prices into core inflation. As core inflation remains unchanged, the assumed monetary policy rule calls for essentially no change in short-term interest rates. As a result, the fall in real GDP and real domestic demand is only around one half of the impact reported in the baseline.

Other MULTIMOD results indicate that delaying the monetary response can significantly increase the loss in output if it erodes confidence in the central bank's commitment to control inflation, reinforcing one of the lessons from past oil shocks that the monetary response should be prompt (see Annex). Finally, some additional simulation results also suggest that monetary policy errors can significantly increase the loss in output if they erode confidence in the central bank's commitment or ability to control inflation. The conclusion one can draw from these results is that monetary authorities need to make a broad based assessment and make use of a wide range of analytic tools in estimating the extent to which the oil price increase is likely to pass through into core inflation and have an impact on potential output in the short run.

B. The Impact on Developing and Transition Economies

The impact on individual developing countries would likely be at least as large as for many of the industrial countries. On the one hand, oil exporting countries—which suffered seriously from the decline in oil prices in 1997-98—benefit substantially (this includes a number of countries that have recently experienced financial crises, such as Ecuador, Indonesia, Russia, and Venezuela). On the other hand, there is a significant adverse impact on oil importing countries, especially as dependency on oil has not fallen to the same extent as in industrial countries. Figure 6 illustrates how the impact of a $5 per barrel oil price hike will affect developing countries differently. For example, in the top right quadrant the square marked United Arab Emirates shows that country has a large current account surplus and that the oil price increase is expected to further increase that surplus by more than 5 percent of GDP. By contrast, many of the oil-importing HIPC and transition economies are expected to be adversely affected. For example, Belarus was expected to be running a current account deficit of over 7 percent of GDP. The oil price hike would add to the current account deficit by about 1.6 percent of GDP. Mali, shown in the lower left quadrant, is an example of a HIPC country that is running a current account deficit of almost 15 percent of GDP. The oil price increase would add to its current account deficit by 1¼ percent. A number of countries also face additional pressures from weak non-oil commodity prices, and have limited access to capital markets, which will further increase the adverse impact on domestic absorption.

Table 4. Permanent $5 per Barrel Increase in the Price of Oil: Alternative Scenario
(Percent deviation from baseline unless otherwise specified)

Major Emerging Market Economies

Table 5 summarizes the impact of a $5/barrel increase in the price of oil, estimated by IMF country desks for 16 major emerging market countries,¹⁷ separating out the direct effect of higher oil prices, and the second round effects stemming from the decline in global growth and higher interest rates in advanced economies. The results vary widely by region, depending in large part on the relative size of oil importing to exporting countries. Asia experiences the largest negative impact on growth. Latin America, emerging Europe and Africa are less adversely affected by the oil shock owing the larger influence of net oil exporters in aggregate activity. There is an even wider variation within and across regions as to the impact of the oil price rise on inflation, depending on the pass through to domestic prices and whether countries allow the oil price increase to feed through into administered energy prices. Asia is expected to experience the largest increases in inflation, owing in part to the rapid pass through of oil price increases to domestic prices.

Figure 6. Impact of a $5 per Barrel Oil Price Increase on Current Account Blances

Table 5. Emerging Markets-Estimated Effects After 1 Year of a $5 Oil Price Hike

Source: Staff estimates.
¹The external shock is calculated by the Research Department and is the sum of two second round effects on the current account: a decline in exports due to a fall in global demand of 0.3 percent (assuming an export elasticity of two), and an increase in short-term debt payments, owing to the increase of world interest rates of 80 basis points, except for Asia where it is a scaled version of a similar exercise computed by APD.

The first round effects on the current account are, on the whole, similar to those for growth. For all countries the external effects of the reduction in export demand and an increase in interest rates leads to a deterioration in the external accounts, although these effects tend to be much smaller than the first round effects, particularly for oil importers. Among the oil importing countries, the largest impact on GDP growth and the balance of payments is expected to be felt in India, Korea, Pakistan, Philippines, Thailand, and Turkey. Both Pakistan and Turkey were already expected to run sizable current account deficits, and given the oil price increase their current account deficits are expected to worsen by a further ½ percent of GDP.

The oil price hike generally benefits the six oil exporters in the sample, and the external current account position universally improves substantially. The impact on activity, however, is more ambiguous. Domestic demand and output can fall even in oil exporting countries, as the propensity to consume of oil producers within each economy is lower than the propensity to consume of oil consumers, and second round effects due to lower demand for exports and higher U.S. interest rates also slow activity. Overall, growth is projected to rise in Russia and Indonesia but to fall in Argentina, China, Mexico, and Malaysia.

How do the above results compare with estimates by other analysts? Most of the work that has been published by other analysts has focused on measuring the direct effect of the oil price hike, and are generally consistent with Table 5.¹⁸ There are relatively few estimates of the impact on growth and inflation in developing economies. Recent work on the impact of the oil price rise in Asia by Deutsche Bank and Merrill Lynch, like the staff estimates, suggest relatively moderate effects.

Oil Importing HIPC and CIS Countries

While the Heavily Indebted Poor Countries (HIPC countries) and transition economies account for only a small share of global GDP, many of them are among the most seriously affected by higher oil prices. Indeed, 30 of the 40 HIPC countries, and a majority of the Commonwealth of Independent States (CIS) countries, are net oil importers. Most of these countries have very low per capita incomes, high level of oil imports relative to GDP, large current account deficits, high external debt, and very limited access to global capital markets.¹⁹ As Figure 6 shows, many HIPC countries, and to a lesser extent the transition countries, are clustered in the lower quadrant, indicating these countries are already running large current account deficits and will encounter a significant deterioration in that balance. In the absence of international assistance, the lack of access to private capital markets will likely make the impact of higher oil prices on output relatively large, as it will have to be met primarily through a reduction in domestic demand.

The direct impact of higher oil prices on the HIPC and transition countries are set out in Table 6. To put the impact of the oil shock in perspective, note that the largest negative first round impact on the current account for the emerging market economies was 0.5 percent (the Philippines), while the average impact for the oil-importing HIPC and CIS economies is expected to be 0.8 percent and 1.7 percent, respectively. All of the CIS and several HIPC countries will be seriously affected, with trade balance deteriorating by more than 1 percent of GDP. With essentially no access to international capital markets, this could well lead to a sharp contraction in domestic demand.²⁰ The first round impact on the current accounts of the HIPC and transition economies is about $0.7 billion for both groups. In terms of quotas, this is around one eighth of quota for the average oil-importing HIPC and one quarter of quota for an average oil-importing CIS country.

OPEC Countries

A $5 per barrel oil price hike is expected to raise the net trade balance of the OPEC countries by approximately $64 billion (7 percent of GDP); after allowing for the impact of lower global growth, the net trade balance would improve by 6.5 percent of GDP. All of these countries are expected to experience improvement of their current account balances of between 4 and 9 percent of GDP, with Iraq as the largest beneficiary (Table 7). Amongst the other countries, Venezuela stands to gain the least and Nigeria the most, reflecting the relative importance of oil in the economy.

The impact of higher oil prices on growth and activity in oil producing countries will depend on a variety of factors, most importantly how these windfall oil revenues are spent.²¹ In many oil exporting countries, a significant proportion of higher oil revenues will accrue to the government (Table 8). The reaction of the government, in turn, is likely to depend on the underlying financial situation of the country. Saudi Arabia, which has traditionally been a net creditor, may choose to replenish reserves. The authorities may also decide to use some of the additional revenue to ease spending restraints adopted as oil prices declined. For other oil exporters that have in the past been net debtors, such as Mexico and Venezuela, a rise in oil prices would not only increase export earnings but could also lower external borrowing costs, assuming the higher oil prices would reduce the risk premia charged these countries as their future export earnings rose.

Table 7. OPEC - Preliminary Estimates of First Round Effects of an Oil
Price Increase and Global Slowdown Effect
(current account as a percent of GDP)

¹Computation is based on an increase of oil prices of $5 per barrel.
²Computation is based on a decline in exports due to a fall in global demand of 0.3 percent (from Multimod) assuming an export elasticity of 2.

Both the baseline simulation reported above and the OECD simulations assume that oil-exporters would spend around 75 percent of their additional export revenues on imports after three years, in line with historical averages. However, this estimate could be on the high side and hence the increase in imports by major oil exporters could be underestimated. In the GCC countries, the completion of major infrastructure projects, greater government expenditure controls, and rising privatization receipts may well reduce the short run propensity to spend the additional revenues. More generally, the oil price rise is viewed by many as temporary, which may increase the desire to save the proceeds. Finally, countries that run down reserves in response to the oil price falls in 1997 and 1998 may use current revenue to rebuild external reserves and strengthen their fiscal positions, and there appears to be a determined effort by most oil exporters to avoid the boom-bust cycle of the past.

C. Financial Markets

An increase in the oil price, by affecting economic activity, corporate earnings, inflation and monetary policy has implications for asset prices and financial markets.

Table 8. Selected Oil-Exporting Developing and Transition Countries: First-Year Impact of a 20 Percent Increase in Oil Prices on Public Sector Revenues¹