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IMFSurvey Magazine: Policy

Managing Surging Oil Prices in the Developing World

Countries responded to world oil price increases in 2007 by raising both explicit and implicit fuel subsidies (photo: Richard Levine/Newscom)

ENERGY MARKET OPERATION

Managing Surging Oil Prices in the Developing World

By Amine Mati
IMF Fiscal Affairs Department

March 20, 2008

  • Developing and emerging countries have been hit hard by surging oil prices
  • Most countries do not fully pass on higher costs to consumers
  • Well-targeted transfers can mitigate pass-through impact on poor

Less than half of a sample of 42 developing and emerging market countries fully passed through sharply higher world oil prices to retail customers in 2007.

According to research by the IMF, this is much lower than in 2006, when three-quarters of the countries allowed domestic retail prices to rise.

Pass-through was considerably less for net oil exporters than oil importers. This is attributable mainly to controls on domestic fuel prices and lower fuel taxes.

Countries responded to world oil price increases to above $100 per barrel in 2007 by raising both explicit fuel subsidies (to 1½ percent of GDP) and implicit subsidies (to 4 percent of GDP). These findings are based on the results of a survey of IMF economists assigned to work on developing and emerging market countries.

At the same time, developing countries have had to deal with fast-rising food prices. The added cost of measures to cushion the impact of these increases on domestic prices has been limited to date but could rise substantially if food prices continue climbing.

Countries that don't let the market operate by passing on to consumers the full cost of oil price hikes risk incurring large fiscal costs (through higher generalized subsidies and forgone petroleum revenues). But well-targeted safety nets can mitigate the impact of higher petroleum prices on the poor, while ensuring a sustainable fiscal position.

Extent of the problem

The limited pass-through of higher prices in 2007—defined as the ratio of absolute changes since December 2003 in the retail price of fuel and the local currency price of the relevant fuel import product—was evident for all types of fuel:

Gasoline. Only 18 of the 42 sample countries fully or more than fully passed through the increase in import prices by end-2007, with a median pass-through ratio of 0.9. By comparison, three-quarters of the countries fully passed through the rise in international oil prices by the end of 2006. In 2007, the pass-through averaged 0.4. An analysis of the data shows that:

    • The median pass-through was higher for net oil-importing countries (1.15 in 2007) than for net oil-exporting countries (0.58 in 2007).

    • Asia-Pacific economies recorded some of the highest pass-throughs in 2005-06, as countries that had prolonged price freezes, such as Indonesia, substantially raised retail prices to limit the growth in fuel subsidies. Prices have remained unchanged in Indonesia since then, leading to an average pass-through ratio of just 0.7 for 2007.

    • The pass-through was highest in Turkey, a country with a liberalized price regime where higher excise taxes amplified the pass-through.

    • The average pass-through by the end of 2007 (0.7) was sharply lower than the average for the Group of Seven industrial countries (1.23).

Diesel. Of 37 countries for which data are available, 17 fully passed through the rise in diesel prices in 2007. Pass-through was sizable in a few countries that liberalized their markets for selected fuel products (such as Indonesia). The lowest pass-through occurred in such oil-producing countries as Bolivia, Egypt, and Mexico.

Kerosene. Although the median pass-through for retail prices of kerosene was 0.85 for the 42 countries, only 11 had fully passed through costs by November 2007. The limited price pass-through may reflect kerosene's relative importance in the consumption basket of poor households. India, for example, has kept kerosene prices frozen since 2003 while it has raised other fuel prices.

Cross-country differences in retail fuel prices have widened since 2003, reflecting variation in pass-through across countries (see table). In late 2007, retail gas prices ranged from $2.25 a liter in Turkey to just $0.23 in Egypt. Consistent with the pass-through results, retail prices are lower in oil-exporting than in oil-importing countries.

Fuel pricing mechanisms

More than half of the 42 sample countries have price controls and adjust prices on an ad-hoc basis, which partly explains the less-than-full pass-through in these countries. Retail prices are currently 25 percent higher in countries with liberalized pricing regimes than in countries adjusting prices on an ad-hoc basis.

Lower pass-through has been associated with higher explicit or implicit price subsidies for domestic fuels. Explicit subsidies mainly reflect compensation to national energy or refining companies for the difference between the wholesale domestic price and the world price of fuels.

Data on countries providing such subsidies in 2007 are available for only 14 countries; they range from 0.1 percent of GDP (Lebanon) to 9.3 percent of GDP (Yemen), with an average of 1.5 percent of GDP. Not surprisingly, explicit subsidies were larger in countries where the price pass-through was smaller.

Implicit subsidies reflect domestic sales of fuels at below export prices, with no explicit compensation in the budget. Data in 2007 were available for only five countries, and subsidies ranged from 0.14 percent of GDP (Peru) to 13.4 percent (Azerbaijan). Implicit subsidies currently average 4.2 percent of GDP.

Oil pricing regimes largely determine the degree of pass-through. Liberalized and automatic fuel pricing mechanisms were associated with the highest retail fuel prices and price pass-through.

In 2007, average retail fuel prices in countries with liberalized mechanisms were about 25 percent higher than in countries that adjusted prices on an ad- hoc basis. Oil importers are more likely to have liberalized pricing regimes than oil exporters, which typically provide petroleum products to their population at low prices.

Fuel tax regimes

Petroleum tax revenues represent an important source of revenue for many countries. In response to higher world prices, countries—especially oil importers—have made major changes in taxation.

While overall revenue for oil-importing countries declined to 1.8 percent of GDP in 2007, from about 2 percent in 2003, responses to increases in world prices have been wide ranging. Some countries have boosted customs duties or excise rates to mitigate fiscal pressures or to fund increased social spending; others have tried to limit the rise in domestic prices by reducing excise rates and adjusting import duties.

Average tax collection as a share of retail prices fell to 31 percent in 2007 from 37 percent in 2003. This mainly reflected attempts to limit the advance in domestic prices by cutting excise taxes (Lebanon, Mexico, and Peru) and lowering import duties (the Philippines and Ukraine).

World food prices have also surged

Since late 2006, petroleum price increases have been accompanied by sharply rising world prices for food. Average food prices have climbed about 20 percent since the end of September 2006.

Increases have been especially large for maize, palm oil, and wheat. And, unlike past episodes, these increases are not the result of supply constraints but of a sustained rise in demand from China and India and of the use of biofuels as renewable energy sources (especially maize, to produce ethanol).

What to do?

Countries should pass through increases in world petroleum prices, both to preserve economic efficiency and avoid excessive fiscal costs. This requires overcoming political constraints, but is critical since oil importers are facing greater financing requirements as a result of the negative terms-of-trade shock they are suffering. Greater pass-through also implies the need for expanded safety nets, particularly in the light of higher food prices.

Comments on this article should be sent to imfsurvey@imf.org


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