[ Interview with Frank Harrigan, Asian Development Bank ]

“Katrina will be felt internationally”

Who has caused the rise in oil prices?
The rise in oil prices reflects underlying fundamental forces of demand and supply, as well as a significant risk premium that reflects geopolitical and cost uncertainties. Demand from OECD countries still takes up the bulk of total demand: 49.5 of the global 82.1 million barrels a day in 2004 according to the International Energy Agency. However, non-OECD demand is increasing rapidly – driven by the People’s Republic of China, India and the rest of developing Asia. On the supply side, inadequate investment in production and refining after relatively low and stable oil prices in the 1990s has left surplus capacity tight. This situation is aggravated when there are interruptions to supply in major production areas. As the oil industry moves from an exploitation and production phase to an exploration and investment phase, higher prices also reflect expectations of higher long-run marginal costs of production.

To what extent has hurricane Katrina made matters worse internationally?
The effect of Katrina will be felt internationally through higher prices for oil products, and through Katrina’s effect on growth in the US economy. Although the release of strategic reserves by the US and Europe has helped lower crude prices, this effect is likely to be temporary. Katrina has aggravated an already tight supply situation and has highlighted the susceptibility of the oil market to supply-side disruptions. At some point, strategic reserves will have to be replenished. Oil prices could yet resume their upward climb and this will harm Asia as a large net oil importing region. The impact of Katrina on the US economy is difficult to estimate but most agree that it will cut growth in the short run. It will also add to inflationary pressures. However, experience with other natural disasters tends to suggest that negative impacts on growth are likely to be temporary, and that growth will rebound as rebuilding gets underway. But if Katrina were to act as a tipping point for US consumer and investor confidence, and US growth were to slow over a protracted period, it would clearly be negative for the international economy.

As you said, China and India have particularly contributed to rising commodity prices on the world market. How will the high price levels affect them in the medium and long run?
The long-run trend of energy demand in these countries has only one way to go: up. On the back of strong growth, their oil demand has been growing rapidly, at about seven percent per annum since 1990, whereas world demand grew at 1.3% during the same period. In the near future, a rapid increase in the demand for transportation fuel is likely as incomes approach levels that make ownership of private vehicles affordable. Partly because of measures to shield businesses and consumers against price rises, through subsidies and price regulations, high oil prices have as yet made little visible impression on growth in India and the People’s Republic. It is also difficult to know the impact of high oil prices as other changes are occurring at the same time. However, pressures are now building, and it is increasingly likely that the burden of high oil prices will be passed on to households and businesses and that this will cut growth of their incomes. We estimate that if oil prices were to rise to $70 per barrel, this could cut one percentage point off growth in both countries. Both India and PRC are susceptible to high oil prices as they are net oil importers, and both are energy inefficient compared to industrial countries. Over the longer-term, the challenge for both countries is to promote energy efficiency and a diversified energy mix. Among other things, this will require that the prices of oil products fully reflect their true cost, including their environmental costs.

What are the consequences for smaller middle income nations?
The immediate outlook is one of slowing growth. Outside the People’s Republic, we expect East Asia to grow 3.8%, which represents a significant downward revision from 4.4% growth we forecast in April. Meanwhile, growth in Southeast Asia in 2005 has been revised down to 5.0% from 5.4%. While a variety of factors, such as poor harvests and slowing of the Global IT cycle explain the weaker outlook, high oil prices have been a major culprit in the slowdown.

What problems do least developed nations face?
Generally, the impact of high oil prices is most severe on oil importing countries that are poor. Such countries tend to have lower levels of foreign exchange reserves, higher external debts, and limited access to international capital markets. Faced with higher oil import bills, poor countries that are payments constrained have less room to manoeuvre to cushion the impact and domestic demand may have to contract – or, at least, grow more slowly – to stabilise external balances.

What must be done to help them cope?
In the most difficult cases, the need for balance of payments support and other assistance on highly concessionary terms may need to be looked at. But if high oil prices persist, difficult domestic adjustments will be unavoidable. Over the longer-term, highly vulnerable countries need to consider ways of improving their energy efficiency and moving towards a more diversified energy mix, to the extent that that is possible.

How do you assess the risk of windfall profits distorting and actually harming the economies of developing countries with natural resources such as oil and gas?
In the short run, a booming oil sector typically creates domestic inflationary pressures. Accelerating inflation presents short term challenges for monetary management. And fiscal authorities need to be careful not to aggravate inflationary pressures by rushing to spend any windfall revenues that may accrue from higher oil prices. Higher oil prices can also lead to pressure for a real exchange rate appreciation for net oil exporters. The danger of a large and abrupt appreciation of the real exchange rate is that it can lead to a lop-sided or imbalanced economy in which non-oil, traded goods sectors gets squeezed out. If a country’s economic base becomes too narrow, it will then be vulnerable to a reversal of fortunes in oil markets or it could face difficult adjustments as its oil supplies dwindle. To reap the benefits of higher oil prices, while avoiding the risks, oil exporters should aim to invest additional oil revenues in a way that provides a future stream of foreign exchange resources that may then be used to support the foreign currency costs of projects and programs that serve long-term national development objectives. These are some of the challenges likely to face net oil exporting countries in Central Asia.