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Thursday March 28, 2024

New challenges for the economy

By Hussain H Zaidi
January 01, 2017

Two recent significant international developments that have come about are likely to cast their shadow on the economy of Pakistan. These include, the agreement reached between the Organisation of Petroleum Exporting Countries (Opec) on the one hand and non-Opec oil exporters on the other to cut back on oil production and the rise in interest rates in the United States.

The price of oil is determined essentially by the interplay of demand and supply forces. When demand ratchets up relative to supply, prices go up; when demand ratchets down relative to supply, prices go down. It is not merely the actual demand and supply that shape price – the projected or perceived demand and supply also play a significant role. Thus speculations that oil demand will increase in the wake of, say, the likely acceleration in economic growth in major oil importing countries, will put an upward pressure on oil prices.

Paradoxically enough, in an era in which free market and perfect competition are counted among the watchwords of rational economic behaviour, the prices of arguably the world’s most valuable commodity are to a large measure set by the cartel named Opec. Comprising 13 major oil producing countries drawn mostly from the Middle East and Africa, Opec manipulates oil prices by setting production targets or quotas for its members. Higher or lower agreed output levels have a corresponding effect on the ‘black gold’s’ world market price.

Two factors, in the main, militate against Opec’s collusive or anti-competitive price fixing. The first one is the perceived dichotomy between individual and collective interests – the common fate of all collusive alliances. While cooperation is in the collective interest of the cartel, each member has the incentive to cheat –in case of Opec countries – members overshoot the agreed production ceilings. The second factor is the ability of major oil exporters outside Opec, such as Russia, to influence the commodity’s price.

In recent weeks, Opec countries have made attempts to offset both the afore-mentioned constraints. On November 30, 2016 at the 171st meeting of Opec ministers in Vienna, it was decided to cut oil production by 1.2 million barrels per day through a new quota deal for all members. The decision will take effect on the first day of the new year.

Then, on December 10, Opec members reached an agreement with some major non-Opec oil producing countries, including Russia, Oman, Brunei, Azerbaijan, Kazakhstan, Oman and Bahrain, whereby the latter agreed to cut their combined output levels by 558,000 barrels a day for one year. The two agreements will drive up world oil prices and thus bring substantial export revenue for the oil producing nations.

The agreements, however, are bad news for oil importing countries including Pakistan, whose economies have drawn immense benefits from the glut in the international oil market in recent years caused mainly by technology-driven doubling of the commodity’s output in the US.

Petroleum products account for a substantial portion of Pakistan’s import bill. In 2011-12, Pakistan imported $18.9 billion worth of crude oil but courtesy of the steep fall in the commodity’ international price, oil imports came down to $7.9 billion in 2015-16. The savings on oil import enabled the country to increase the purchase of machinery and other capital equipment essential for development without having the current account deficit shoot up.

Not only that, low oil prices were instrumental in keeping the general price level from rocketing. Thus more than any other factor, low oil prices were responsible for single-digit inflation during last two years. But the higher oil prices will stoke inflation and put pressure on the balance of payment position and foreign exchange reserves.

Since oil is the major source of electricity generation in Pakistan, the hike in petroleum products’ prices may make it difficult to significantly ease power outages. The silver lining is that increased oil prices will push up economic growth in Gulf countries, which are a major source of remittances for Pakistan. Needless to say, the remittances are one factor that has sustained the economy over past several years.

In another development, interest rates in the US have increased. In recent years, the globe’s largest economy experienced a protracted period of turbulence caused by the 2007-2009 housing and financial crises.

To ward off the economy’s descent into depression, like the one that shook the country in 1929, interest rates were slashed with a view to curtailing the cost of borrowing and doing business. But as the economy is beginning to look up, the US central bank, the Federal Reserve (Fed), has increased interest rates by 25 basis points from 0.5 percent to 0.75 percent. The hike in interest rate was indicated by the Fed in September last but the decision was delayed until December.

There is a direct relationship between interest rates and the value of domestic currency – in this case the American dollar. All else equal, the hike in interest rates leads to currency appreciation as investors see higher returns on their investments in dollar-denominated assets. But for Pakistan, the appreciation of greenback means depreciation of the rupee.

Currency depreciation casts a significant impact on some key economic indicators. One, imports become expensive and should therefore decrease. However, since as a rule, import and export contracts are made several months in advance, pre-contracted imports rise in value, worsening the terms of trade. Besides, the demand for the bulk of Pakistan’s imports such as oil, food and machinery, is largely inelastic meaning the price increase will not significantly reduce their purchases. Thus, on this account, the import bill is likely to go up.

Two, depreciation tends to make the price of exports competitive. Therefore, exports, which have gone down during the last two years, may rise. However, several other factors, such as lack of value addition, energy shortage and a narrow manufacturing base, may go against capitalising on currency depreciation significantly.

Three, the fall in the value of the rupee will put an upward pressure on the general price level. Finally, the appreciation of the dollar will add to the external debt which has increased from $51.2 billion on June 30, 2013 to $62.4 billion on September 30, 2016.

Pakistan has recently completed a three-year $6 billion credit programme with the IMF and the government has claimed that the country will not go back to the multilateral donor. However, the afore-mentioned developments may make such claims appear too optimistic. Not only that, they may also put the government on the spot on the political front.

As 2016 ends, the ruling PML-N seems stronger than it was during any other period since it assumed power in 2013. However, the new year is likely to bring tougher economic, and by implication political challenges for the rulers.

 

The writer is a freelance countributor. Email: hussainhzaidi@gmail.com