The price of a barrel of oil was $115 in June this year. It has now dropped by 25% to $85. The fall in the price of oil is said to be due to both increased supply and falling demand. Economic recoveries are currently stalled in places like Japan and Europe. This means their demand for oil is less. On the other hand, thanks to new sources of oil such as shale oil in America, world supply of oil has been increasing by 1 to 2 million barrels a day since early 2013. These combined forces of demand and supply have led to current falling oil prices.
This situation implies a shift of incomes from the rich oil producing countries to consumers in importer countries. According to IMF economic models, a price fall of 25% has the potential to push up global GDP by 0.5%. But this is not happening. The IMF itself recently scaled back its previous forecast global GDP growth for both 2014 and 2015.
However, within that overall forecast of drop of global GDP, there is a good probability that some of the more enterprising countries of the world will use this windfall gain to consolidate themselves, become more competitive and move forward. This will not apply immediately to countries like Burkina Faso at this moment, embroiled in a power struggle even as its past-27 year president finally decided, in the face of popular revolt, to quit instead of seeking to extend his further stay in power. Progressive countries will be like India which has decided that it will make lighter the government budget by doing away altogether with huge oil subsidies and hand-outs the government has been giving to placate consumers all these years.
Removal of unsustainable subsidies should eliminate distortions that come in their wake and make lighter the fiscal burden, without for that matter denying the benefit of lower international prices to economic operators such as farmers and fertilizer producers using oil as input. Countries which mean business will take the opportunity of falling oil prices to set right their external balance of payments, making an effort to get out of structural deficits in their trade accounts. They should also be expected to take advantage of a falling rate of domestic inflation to try to boost up exports.
This good news for importer countries in particular is not playing out fully at the global level. Why? Because while some of the countries are continuing to register reasonable economic growth rates (China: +7.3%; Malaysia:+6.4%; India: +5.7%; Indonesia:+5.1%; Britain:+3.2%; US: +2.6%), others are falling behind (Euro area: +0.8%; Japan: -0.1%; Brazil:-0.9%; South Africa: +1.0%). This picture of mixed performance among countries is introducing an element of pessimism in terms of future growth performance at the global level.
The reason for this pessimism stems from headwinds of a phenomenon called ‘deflation’ unfurling in certain countries on the global economic stage for some past quarters.
What is ‘deflation’? It happens when demand for goods and services keeps falling behind the economy’s capacity to supply them, creating a persistent output gap. There is no incentive in the circumstances for firms to undertake additional investment. When this happens, firms cut prices and wages, hoping to attract more demand and be able to sell their output. Successive rounds of falling wages/firms’ incomes due to the slackening demand — and the growing inability of borrowers to repay their debts – bring down economic growth rates further, causing demand for both local and imported goods and services to fall sharply. Deflation may prove more difficult to deal with than inflation.
Japan was hit by it in 1997 and it is only in 2013 that it showed signs of being able to pull out of it after battling against it for all these years. The Euro area, one of the principal markets for our exports appears to be getting into deflation right now in the face of contradictory signals (austerity v/s fiscal easing) being given by its policy makers. In the face of this contradiction, the Euro zone appears to be headed for the same sort of breakdown that Mario Draghi, the European Central Bank’s president, parried two years ago by using a decisive language.
Deflation appears to be stretching its wings further out. In China, inflation is down to 2% against a central bank target of 4%. Domestic inflation is below zero in Italy, Spain and Greece. Low or negative rates of domestic inflation are being experienced in many places: Euro area: +0.3%; Hungary: -0.5%; Poland: -0.3%; Switzerland: – 0.1%; Belgium: -0.1%; the US: +1.7%; S Korea: +1.1%; Britain: +1.2%; Singapore: +0.9%. Since most major central banks have already reduced the interest rate to close to zero in their zeal to combat inflation these past years since 2001 and particularly so since 2007, there is little armoury left in their hands – by way of bringing the interest rate further down to induce more spending in the economies – to deal with deflation if it actually became more generalized and crystallized in the markets which matter the most to us.
The decision taken by the Monetary Policy Committee (MPC) of the Bank of Mauritius (BoM) on October 27th to keep the Bank’s Key Repo Rate steady at 4.65% should be looked at against this background of a potential significant slowdown of demand from our external markets were deflation to set in firmly. Monetary policy alone doesn’t have the scope to deal effectively with such potentially bleak external economic conditions such as deflation in our external markets. What could have dealt with the situation was a broadening of the base of our economy since long. That required long-term strategy to insulate ourselves from adverse external developments.
Monetary policy can go up to a point to make for economic redress. A recent research article from the Sloan School of Management (“The behaviour of aggregate corporate investment” by S P Kothari, Jonathan Lewellen and Jerold Warner) based on US data from 1952 to date, has found that tight (higher interest rates) or loose (lower interest rates) monetary policy is irrelevant to the investment decisions of firms. Their research shows that firms’ investments grow most quickly in response to a surge in profits, i.e., past circumstances, and not on how changing circumstances (expected interest rate declines) may affect future returns. In fact the research finds that investment by firms often rises when interest rates go up and financial market volatility increases, not the other way around. Seen from that angle, the BoM’s attempts to increase the Key Repo Rate in past years should be seen as sheer confidence-building vis-à-vis savers.
The time may therefore have come to let monetary policy do what it can and employ other relevant policies to take our heads above water, the more so as deflation, rather than inflation (which central banks have been tackling since the 1980s), appears to be the world’s principal concern in days to come.
* Published in print edition on 7 November 2014