This paper briefly discusses the macroeconomic effects of low international oil prices and places particular emphasis on the policy implications for Commonwealth countries. It draws on recent studies by the International Monetary Fund (IMF) and World Bank that discuss available policy options, and uses this to assess the efficacy of Commonwealth oil price-policy responses.

At the time of first drafting, international oil prices had registered an annual decline of 59.3 per cent – from US$108.4 per barrel in June 2014 to US$44 per barrel in August 2015. Since then, oil prices have fallen by a further 28.5 per cent to US$31.5 per barrel (between August 2015 and end January 2016), marking the lowest oil price on record since 2009. Supply-driven factors linked to the Organization of the Petroleum Exporting Countries’ (OPEC) shift from price targeting; greater than expected oil supply from non-traditional markets (USA and Canada); limited spill-over effects from various geopolitical factors; a significant appreciation of the US dollar; and demand-driven factors such as slowdowns in major emerging economies (e.g. in China and India), have all been named as contributors to the recent decline in international crude prices (World Bank 2015; IMF 2015; Baffes et al. 2015).

The World Bank predicts that oil prices should recover in 2016, but expects that prices will remain below US$80 per barrel, at least over the next five to seven years (World Bank 2015). Such a sustained trend in low oil prices is anticipated to have a mix of macroeconomic effects, dependent on whether countries are net importers or net exporters of oil, and on their chosen policy responses. The macroeconomic effects also depend on the nature of the price change, its permanence and the various price transmission mechanisms.

In the following sections, the paper briefly discusses: the likely macroeconomic effects; IMF recommendations for optimal policy responses; current Commonwealth policy responses; and Commonwealth perspectives. The paper concludes with a brief reflection on key points.

Macroeconomic effects of low international oil prices

Transmission mechanisms

Both the IMF and World Bank assert that the majority of the crude price decline has been supply driven. In this case, price movements are expected to last at least into the medium term, while actual feed-through effects will be determined by the length of time oil price changes take to impact prices at the pump. Countries with subsidies or other administrative controls on energy prices usually have a limited pass-through to fuel prices in such cases, meaning that windfalls from lower oil prices in these countries accrue to government rather than to households. Here the effect on the economy would depend on government actions.

In this situation, the government has to decide whether it is more advantageous to save windfalls in order to create fiscal buffers, or spend them to boost economic current activity. When there is full pass-through, on the other hand, windfalls accrue to households; research here suggests that households, mainly in advanced economies, normally save increases in income, especially when the price change is temporary. However, when the price change is permanent, households tend to undertake an adjustment in spending patterns. For both oil-importing and oil-exporting countries, the impact on the economy will also be a function of the level of a country’s energy intensity.

Impact on the real economy

Oil importers

In general, low oil prices lead to lower inflation, and propel increases in real income and consumption in oil-importing countries. They also lower the cost of production in oil-intensive industries and, through confidence effects, unlock increases in capital investment. According to the World Bank, a 10 percent decrease in oil prices could raise growth in oil-importing economies by some 0.1 to 0.5 percentage points, depending on the country’s share of oil imports in gross domestic product.

Additionally, where there is a high share of oil imports, low oil prices can improve the current account balance. And for many countries that subsidise energy, lower prices for oil can create necessary fiscal space, which can either be saved or channelled towards priority areas. More indirectly, lower oil prices can boost trade through terms of trade effects. For example, they can boost the demand for tourism services as travel costs decline.

Nonetheless, the effects of low oil prices can also be negative, especially if lower oil prices lead to a currency appreciation, and if depressed export earnings in oil-exporting countries trigger a fall in demand for oil importers’ goods and services or reduced remittances and aid. While presenting opportunities to move towards a low carbon economy, low oil prices can also reduce the incentive to become more energy efficient and to increase the share of renewables in the energy mix.

Oil exporters

The immediate impact of lower international oil prices is a loss of oil revenue for oil-exporting countries. The macroeconomic effects are particularly severe when government finances rely heavily on taxes from the oil sector. For net oil exporters, lower oil prices will also generally have adverse balance-of-payment effects and could precipitate a currency depreciation. The World Bank reports that a reassessment of growth prospects of oil-exporting countries has already contributed to capital outflows, reserve losses, sharp depreciations and/or rising sovereign credit default swap (CDS) spreads.

Investment, particularly in energy projects, could also decline. The Bank of Canada (2015) estimates that if oil prices are sustained at US$50 to US$70 per barrel, investment in Canada’s oil and gas sector could swiftly drop by about 30 per cent. Overall, this could depress real GDP by 1 per cent in 2015 and by an additional 0.4 per cent in 2016.

Through second-round effects, depressed growth in oil-exporting countries can put strain on the balance sheets of corporates, and those of banks, by way of increased non-performing loans. Moreover, contagion can take place in the event that oil exporters’ ‘petro-dollar’ investments in foreign assets are repatriated to support fiscal spending, creating capital outflows and financial strain for other economies. Lower oil prices can also translate into reduced non-commodity prices – for example, for natural gas and for fertiliser (where natural gas is a key input) and, in turn, for agricultural commodities.

Optimal oil price-policy response

Optimal short-run policy responses

The IMF recommendations for oil price-policy adjustment are taken here as signifying potential ‘optimal policy responses’, recognising of course that country views may differ considerably. The employment of the IMF’s recommendations in this paper has the main purpose of allowing for an assessment of current oil price-policy responses by countries in the Commonwealth.

Oil importers

The main policy decision faced by oil importers during periods of low international oil prices is whether to save or spend oil windfalls (that is, where there are limited pass-through effects). The IMF suggests that policy choices should be dictated by countries’ existing vulnerabilities (fiscal, external and inflation risks), and their position in the business cycle. In general, the IMF recommends that the higher the level of vulnerabilities, and the more advanced countries are in the business cycle, the more they should save, particularly to rebuild policy buffers and to slow the impact on aggregate demand.

For example, for those countries with:

• No vulnerabilities and which are operating below potential output: Here, the IMF recommends that country policies allow domestic demand to rise by the full amount of the windfall. It also recommends that countries consider increasing energy taxation, while reducing other distortionary taxes or raising priority spending.

• Fiscal and external vulnerabilities: In this case, countries should put fiscal and external positions on a more sustainable path by lowering energy subsidies and saving the fiscal windfall; and reducing public debt levels and using the improved current account position to increase international reserves. Countries should also consider raising energy taxation.

• Deflationary risks: Here, countries should not save the windfall, but spend to ensure that inflation expectations are anchored, accompanied by accommodative monetary policy if necessary.

Oil exporters

For oil exporters, the IMF suggests that policy choices should take into account the permanence of the oil price fall, existing vulnerabilities and the exchange rate regime. The general recommendation is that should oil exporters focus on fiscal adjustment, supported by stronger medium-term fiscal frameworks.

For example, for those countries with:

• No vulnerabilities with fiscal and external buffers and limited policy risks: In this case, countries can consider adjusting to lower oil prices gradually, and use their policy buffers to smooth the transition.

• Fiscal vulnerabilities, external vulnerabilities and inflation risks: Here, countries should adjust quickly to mitigate the external and fiscal impact through flexible exchange rate adjustment, in cases of free floating regimes, and where there are no major balance sheet mismatches (e.g. high dollarisation). For those with fixed regimes, countries should tighten macro policies, particularly fiscal policy, or change the nominal anchor to reduce internal adjustment costs.

Optimal medium-term policy responses

In the medium term, the IMF recommends that countries consider a number of structural reforms, particularly in the case of oil exporters. The advice from the IMF is that, in the medium term, fiscal policies should be adjusted to the new norm of low oil prices and that the speed of adjustment to this new regime should be determined by the extent of vulnerabilities, growth considerations, equity considerations and the need to develop the non-commodity sector. Additionally, oil exporters should undertake: diversification; financial sector reform; exchange rate reform (considering a more flexible regime if possible); and reform of energy prices and taxation. The latter is relevant to both exporters and importers, and would involve better targeting and/or removal of fuel subsidies, increasing energy prices/taxes for increased fiscal space, and broadening access to reliable and renewable energy sources. See Table 1 in the appendix for the full array of IMF recommendations.