MACROECONOMIC ANALYSIS OF HIGH OIL PRICES ON PAKISTAN’S

ECONOMY

Introduction:

Demand, supply and speculative factors,

and their interrelationships have all led

to a steady rise in oil prices until

2008.The low level of stocks in

industrial countries and their rebuilding

in a period of supply uncertainty also

contributed to increased demand. This

was primarily because there was a high

risk premium on oil, since supply from

main producers was considered unstable.

Geopolitical uncertainties and tight

market conditions encouraged

speculative funds to enter the market and

further push up prices in the short term

(ADB 2004). This trend affected the

macroeconomic variables of Pakistan’s

economy negatively.

Pakistan - Energy Scenario:

Pakistan is a nation of over 158.17

million peoplei and amongst the lowest

users (0.49 TOE/capita) of energy. This

is due to severe constraints on the

i Federal Bureau of Statistics, Government of

Pakistan, 2008

development of indigenous energy

resources. The country is heavily

dependent on imported energy resources.

Sectoral share of energy consumers was

43.9% industrial, 27% transport, 21.1%

domestic, 3.8% commercial, 2.1%

agriculture and 2.1% other government

usesii. Pakistan currently meets only

19.9% of its oil demand from indigenous

production and as such imports 15.54

Mtoe of petroleum and petroleum

products during 2005-6.

The total installed capacity of Pakistan’s

power generation is 19521 MW

(Megawatt). This includes thermal

power plants in the public and private

sectors; hydel and nuclear power stations

in the public sector. The thermal plants

are either Oil fired or Gas fired.

Large amount of oil reserves today are

located in areas where consumption is

low due to lower populations (the

ii Hydro Carbon Development Institute, Pakistan Energy yearbook 2007.

Middle East, and Northern Europe). This

scenario makes more populated nations

like Pakistan net importers of oil. An

increase in oil price leads to increased

import bills, which also affects other

macroeconomic fundamentals of the

economy.

Pakistan’s GDP growth has been rising

during the last few years, with growth

rate reaching 8.4 percent in 2004-05, 6.6

percent in 2005-06, and a moderate

recovery to reach 7% in 2006-07. The

energy sector has a direct link to the

economic development of a country. In

line with the rising growth rate of GDP,

demand for energy has also grown

rapidly. Per capita energy consumption

of the country is estimated at 14 million

Btu and the energy consumption has

grown at an annual average rate of 4.4

percent from 1990-91 to 2005-06.

Pakistan’s Oil Dependency:

According to Malik (2008), a country’s

vulnerability to oil shocks can be seen

through a number of indicators. Firstly,

the oil self sufficiency index, which is

calculated as the difference between oil

production and oil consumption divided

by oil consumption. This ratio is

negative for oil importers (with -1 being

the extreme value). Pakistan had a value

of -0.79 in 2005-2006, indicating its high

susceptibility to oil shocks. Secondly,

Vulnerability to rising oil prices also

depends on the intensity with which oil

is used. The intensity of oil use in energy

consumption index measures the share

of oil in an economy's primary energy

consumption. Pakistan had a value of

0.32 in 2005-2006, showing slight

decrease from the past due to shift

towards alternatives. Thirdly, Energy

Intensity measures the energy intensity

for an entire economy (measured as

percentage change in energy

consumption divided by percentage

change in GDP).

A decrease in energy intensity is

considered as the most promising route

for reducing vulnerability to oil shocks

(Bacon and Kojima 2006). For Pakistan,

this has remained more or less constant

at about 0.9 in 2005-2006, showing that

there has not been much improvement in

this area.

Finally, the net oil imports in GDP

represent the magnitude of the direct

effect of a price increase. Pakistan had a

value of -5.24 in 2005-2006.

Hamilton (2005) argues that a potential

macroeconomic effect of oil price is on

the inflation rate as long run inflation

rate is governed by monetary policy, and

so ultimately it depends on how the

central bank responds to oil prices.

The Dynamics of Pakistan’s Energy

Economic Problems:

In Pakistan, household and industrial

demand for energy products, such as

kerosene and gasoline, is highly inelastic

(Burney and Akhtar 1990).A rise in the

price of oil by 100%, led to an increase

in demand of 19% over the period

between 2003 and 2007. This denotes

low price elasticity – the percentage

change in quantity demanded/consumed,

divided by the percentage change in

price- meaning the demand for oil in

Pakistan is relatively inelastic to changes

in price.

Source: Hydrocarbon Development Institute of

Pakistan (2008)

The low price elasticity tells us that as

prices rise there is limited or no effect on

demand, thereby increasing the

monetary (Dollar) amount of quantity

consumed. Thus the net import bill

consists of the 100% increase in price of

oil, in addition to the 19% increase in oil

consumed.

In Pakistan, major import cost in the

energy sector is the cost of importing

(85%) oil and its products and these are

mainly used in the transport sector. The

difference between the consumption and

the domestic production of oil adds to

the import bill of Pakistan leading to a

growing trade deficit. The Balance of

Payments of Pakistan has shown a

growing trade deficit, increasing from

approximately $5 Billion in 2005 to over

$20 Billion as of 2008. This destabilizes

the macroeconomic fundamentals of the

nation.

Macroeconomic Model- Relation

between Oil Prices and Inflation

The economic model used to explain the

effects of rising oil prices on the

economy of Pakistan is as follows. As

oil prices increase so does inflation due

to the rise in costs of imported oil,

leading to a rise in production,

transportation, and all other energy

costs. High consumer inflation results in

a drop of total consumption which in

turn slows down the economic growth.

This decline is due to lower

discretionary income left with the

consumers to buy other goods during the

period of high inflation. When inflation

gets out of control, central banks usually

tighten the money supply, which can

further shrink the economy.

According to Kiani, Khaleeq (2007)

higher oil prices directly raise consumer

prices via the higher price of imported

goods and petroleum products in the

consumption basket.

Another implicit effect of higher oil

prices is that producers pass some part of

their higher input (oil) costs to the price

of final goods. Moreover, consumers

who experience a loss in real income

may consider seeking wage increases,

which leads to higher production costs,

and then into prices.

Price of Oil and Trade Deficit:

As the price of oil increases, the value of

imports rise, causing a negative impact

on the trade deficit. Asian Development

Bank, ADB (2005) has estimated the

impact of high oil prices on the net

import bill. By assuming 75% rise in oil

prices (approximately the increase in

prices between the start of 2005 and end

August), the estimated impact on the net

import bill for Pakistan was almost -

4.17. Similarly, the percentage point

growth in exports that was needed to pay

for a 75% rise in the cost of imported oil

was potentially very large (i.e., 18 %).

The government failed to improve the

export performance which also explains

that the causality of such a scenario runs

from the macroeconomy to the oil

markets.

The main issue is the effect of rising

prices on the national economy and the

corresponding changes within the

economic model.

Rising prices of oil have caused

increased unanticipated inflation, and

lower economic growth, with a negative

impact on the economy. This can be

shown through a simple macroeconomic

model of:

GDP = Y = C + I + G + (x-m), where

C= consumption, I= investment

spending, G= Government Spending, x=

exports, and m = imports.

As price of oil goes up, inflation

increases as price of every item in the

basket of goods rises. The increased

prices lead to lower discretionary

incomes which leads to less C

(consumption), hence decreasing the

total amount of Y (GDP).

The other effect of rising oil prices is

that as oil prices go up, and as Pakistan

is importing majority of its oil, there will

be a rapid increase in the value of m

(imports), leading to an increased trade

deficit, hence lowering the trade balance,

or creating a trade deficit which will

result in lower Y (GDP).

The approach used here to measure and

quantify GDP is the expenditure method.

The whole economy is divided into 2

sectors according to the official Federal

Bureau of Statistics division in Pakistan;

Production Sector, and Service sector.

Empirical Outcomes

Price of Oil and National Income

Accounting

Verifying the simplified analytical

model mentioned above, one finds very

similar results to what actually happened

in Pakistan during the period when oil

prices rose exponentially. The numbers

from the following table showing the

GDP (Y) of Pakistan, the total

Consumption Expenditure I, Investment

(I) & Government Spending (G), and the

net Exports (x-m) were used for

analysis.

Source: Federal Bureau of Statistics, Govt. of

Pakistan (2008)

Increase in Value of Imports

Here it is seen that the GDP has been

steadily increasing at the given prices

from year to year. Comparison between

the balance of trade in 2007 and 2008

shows the rate at which the trade deficit

increased was (20.59-13.45)/13.45 =

53%. In 2007, it is seen that:

Y=C+I+G+(x-m), so Y= 120+32.35+

(16.05-29.5) = $138.9 Billion

With Investment and Government

spending (I+G)=32.35

In 2008 the value of m increased (high

oil prices), leading to a negative effect

on the growth of Y.

Unexpectedly the value of imports rose

to $40 Billion. The GDP rose but at a

decreasing rateY=129.78+35.46+

(16.05-40) = 140.65 ($BILLION)

With Investment and Government

spending (I+G) =35.46

GDP growth rate fell from 17.9% in

2005, to 4.1% in 2008. It is evident here

that a rise in the oil price translated into

a growing trade deficit which is seen

above with the growth of imports

(35.3%) being much higher than the

growth of exports (7.8%) between 2006

- 2008.

Oil Prices and GDP Growth Rate:

So an increase in oil prices squeezed

income and demand. At a given

exchange rate, more domestic output

was required to pay for the same volume

of oil imports. This led to domestic

currency being depreciated in response

to induced payments deficits, which

further decreased the purchasing power

of domestic income over imported

goods. As important trading partners

were also likely to suffer income losses,

slower growth of external demand

aggravated these direct impacts. Higher

oil prices also reduced aggregate supply,

since rising intermediate input costs

swept producers’ profits and made them

cut back on output. Lower profits

resulted in a decline in investment

spending, which finally caused potential

output to fall over a long period, Malik

(2008).

This shows that a rise in the value of

imports led to a fall in the growth rate of

Gross Domestic Product, in nominal

terms. As oil is predominantly imported

in Pakistan, the rise in the price of oil,

increases the value of imports (m)

leading to a negative impact on the

growth rate of national income(Y).

Linkage between Oil Prices, Inflation,

and lower GDP growth:

Increased imported oil prices caused

inflation, as the costs of production,

storage, and distribution rose. Increased

inflation lowered the buying power of

consumers in addition to lowering

discretionary income left (after buying

more expensive energy) with households

to spend on other goods. This led to

lower growth in consumption spending,

further weakening the economic outlook

of Pakistan. The following table shows

that although total consumption

spending did grow, the change in

percentage terms declined in Pakistan.

Source: Federal Bureau of Statistics, Govt. of

Pakistan (2008)

Proving that higher oil prices are

leading to lower economic growth, as

lower growth in consumption (C) means

lower growth in GDP (Y). In addition to

lower consumption growth, higher

growth in imports (m) further

deteriorated the situation, as shown

earlier.

Summarized Negative Affects of

Rising Oil Prices on Pakistan:

So the high price of oil has had 2 major

macroeconomic affects on the economy

of Pakistan.

Effect 1. Increased value of imports (m),

led to decreased GDP growth rate.

Increased prices of imported oil also

brought inflation which decreased

buying power of money, and increased

the energy costs for consumers and

producers, resulting in lower spending.

Effect 2. Lower spending has

contributed to the declining rate of

consumption growth (C), lowering GDP

growth rate further.

The above effects are illustrated below

from the actual data obtained.

Effect 1

Increased Imports (oil price) leading to a

decreased trade balance or an increased

trade deficit as follows. Trade deficit

was expected to reach $9-10 billion by

the end of 2008 (Khan 2008). It is

interesting to note the similarity between

the following two perceptions. The

Dutch disease concept says that in the

long run a country’s dependence on its

natural resource exports diminishes its

economic growth due to increased

imports and decreased exports. Similarly

in Pakistan’s case the high oil prices led

to high oil import costs resulting in

increased trade deficit and diminishing

Pakistani GDP. The literature reviewed

for Pakistan does not provide much

substantial evidence that high oil prices

increased the returns from the exporting

sectors and thereby enhanced GDP

growth. However, Malik (2008) suggests

reasons for a spur in GDP growth even

in the presence of high oil prices in

Pakistan. One reason was that consumers

had been shielded by limiting the direct

pass through to final oil prices using

extensive fuel subsidies and strong

foreign reserve position at that time. In

addition, the continued strong

performance of the services sector had

made contribution to the GDP outcome.

On the demand side it was the

consumption expenditure that had

proved to be the main source of growth

in GDP. The credit flow to private sector

in the form of consumer financing

played a significant role.

Source: Federal Bureau of Statistics, Govt. of

Pakistan (2008)

Effect 2

Increased imported energy prices have

led to increased prices in Pakistan

leading to increased inflation. Increased

inflation decreased the discretionary

income of households, leading to

decreased spending. Decreased

discretionary spending resulted in slower

consumption growth.

Source: Federal Bureau of Statistics, Govt. of

Pakistan (2008)

Source: Federal Bureau of Statistics, Govt. of

Pakistan (2008)

Lower Consumption growth, and higher

trade deficit resulted in decreasing

economic growth depicted as follows.

Source: Federal Bureau of Statistics, Govt. of

Pakistan (2008)

Price of Oil and Natural Gas –

Deductive Model:

A deductive model is seen, assuming

that both oil and gas are equally

accessible, substitutable and are normal

goods. As the oil price increases,

demand falls, keeping all other factors

constant. Then with lower prices of gas,

demand increases, keeping all other

things constant, the demand curve shifts

to the right. This shift normally leads to

increased prices of gas, but due to

government intervention with subsidies

for suppliers, the supply curve shifts to

the right, maintaining the equilibrium

point. This means that oil and gas can be

regarded as perfect substitutes, with

prices of one going up, increasing the

demand for the other.

Source: Hydrocarbon Development Institute of

Pakistan (2008)

The above figures clearly validate the

deductive model of oil and natural gas as

near perfect substitutes, where increase

in oil price of 70% from 2004-2007, led

to an increase in demand for gas of

48.8%, and decrease in oil demand of

2.3%.

According to Mehta Ahmed (2006) “Gas

import pipelines can deliver energy at

competitive prices in the near term to

meet the demand of priority consumer

segments such as the residential,

industrial and power sectors.”

Coal and Nuclear Options

According to the US Department of

Energy, only 7.6 percent of Pakistan’s

energy supply in 2005 was coal.

Pakistan has coal reserves of 3,362 Most

and in 2004 used only 3.5 Most (Energy

Information Administration), which

would last over 950 years. By looking at

the amount of coal Pakistan has in

reserve and the amount that it actually

uses, one can conclude that coal is

extremely underused. There is enormous

potential for the use of coal in Pakistan

to produce electricity. Khan (2006)

acknowledges that Pakistan is behind the

rest of the world in coal based power

plants and needs to catch up quickly.

Coal is used to produce a majority of the

electricity produced in India, the United

Kingdom, and the United States, and

should be used to the same extent in

Pakistan.

This solution may seem costly at first,

but further analysis leads to the

conclusion that it is very cost effective in

the long run. There will be high initial

cost of building and developing the

plants. However, building these plants

will create thousands of new jobs and

help improve the country’s economy.

These plants will also save money

because they will reduce the amount of

oil that needs to be imported into

Pakistan. The positives of increasing the

use of coal vastly outweigh the

negatives. In return for high initial costs,

increasing the use of coal based power

will help solve Pakistan’s energy

shortage, create thousands of new jobs,

save money on importing fuels, diversify

the energy mix and promote energy

independence.

The biggest concern with an increased

burning of coal is the damage that is

done to the environment. Coal is known

to release many pollutants and green

house gases, contributing to

environmental problems such as acid

rain, smog, and global warming. Dr.

Javaid Laghari, a professor of Electrical

and Computer Engineering, insists in his

article “Power Vision for Pakistan” that

these harmful effects of burning coal can

be diminished. Clean coal technologies,

which minimize or eliminate impurities

and pollutants from coal, are being

developed and advanced around the

world.

In Pakistan, nuclear power makes a

small contribution to total energy

production and requirements, supplying

only 2.34% of the country's electricity.

Nuclear power represents an important

benefit to Pakistan, but to achieve this

benefit requires co-operation between

the supply and demand side in

overcoming problems which might

inhibit nuclear power growth.

These problem areas for Pakistan

include: financing (in particular, foreign

currency requirements), adequate local

industrial and engineering infrastructure,

the need for a free and open nuclear

market, access to advanced technology

and an assured supply of nuclear fuel

and fuel cycle services. Ahmad (2008),

points out that even after large-scale

development of indigenous energy

resources, the energy import dependence

of Pakistan increases. If access to

advanced nuclear power reactors

becomes available to Pakistan, then

nuclear power can make a sizable

contribution in meeting the future

electricity needs, reducing stress on the

international supplies of oil and gas with

concurrent benefits for the environment.

Macroeconomic Policy Implications

As discussed earlier, the direct effect of

high oil prices on Pakistan’s economy

were felt through the worsening of the

balance of payments and the resulting

contraction of the economy. The use of

foreign exchange reserves and increased

borrowing may give short term relief,

but this is not a sustainable option.

For net oil importers like Pakistan the

appropriate macroeconomic response to

higher oil prices would be to fine tune

both fiscal and monetary policy to

accommodate, not resist, needed

adjustments in output and prices.

According to Malik (2008), the growth

in demand for petroleum products in

Pakistan has been growing at a negative

rate. The volume of imported oil has

been steadily increasing at a negative

rate, but the dramatic increase in the

price of oil has led the value of those

imports to rise exponentially. The study

further shows that as the rise in the price

of oil started in early 2003, Pakistan’s

economy steadily grew at a rate of over

6%. This negates the conventional

direction of the economic growth when

price of oil rises. An upward trend in the

price of oil usually squeezes income, and

demand, leading to less consumption,

and lower corporate earnings, leading to

lower economic growth. From 2005, the

economic growth rate has grown at a

decreasing rate, citing the effects of the

rise in prices of imported oil as a

primary cause.

Rising prices of imported oil increased

the amount of foreign exchange reserves

required to finance the purchase of the

oil. As the price went up, the foreign

exchange reserves decreased, and the

value of debits rose on the current

account of Pakistan’s trade balance,

leading to a trade deficit. A very large

trade deficit caused the value of the

domestic currency to drop as a way to

increase the competitiveness of local

exporters to offset the growing trade

deficit.

Hsieh (2008) showed that, by applying a

model using simultaneous equations for

Korea (oil importer) real output is

positively associated with money supply,

real deficit spending and real stock price

and negatively associated with the real

depreciation of the Won.

Depreciation in the local currency had its

own negative effects, as it resulted in

lower returns, and net capital outflows,

as investing in a country where the

currency was falling in value lead to

higher foreign exchange risks. Lower

capital meant lower investment

spending, thus weakening the economy

further. State Bank of Pakistan’s (SBP)

effort were required to eliminate

mismatches between inflows and

outflows i.e. purchasing when market

has excess foreign exchange inflows and

selling the same for oil payments.

A study by Khan and Schimmelpfennig

(2005) points out that correlation

between an expansionary monetary

policy and rising inflation is very strong.

This means increasing money supply

would result in inflation but lower

unemployment also [according to the

Phillips Curve]. The significance of this

study here is that in the period preceding

the recent oil price crisis, Pakistan had

the largest credit expansion in the world.

Pakistan’s economy experienced an

average increase of 22% in broad money

and 30% in credit growth between 2004

and 2006.

Although expansionary monetary policy

does aid inflation, the effects of a

growing money supply between 2004-

2006 were minimal in raising

inflationary pressures in Pakistan.

Conclusions and Recommendations:

The analysis of the price of oil and its

consequences for economic growth in

Pakistan shows that the effects were

certainly disturbing for the

macroeconomic stability of Pakistan,

which is highly dependent on imported

oil. On the contrary macroeconomic

spillovers of Pakistan’s existing fragile

economy are seen as a major cause for

the level of economic disorder faced due

to high oil prices. Pakistan is oil-

intensive and less able to weather the

financial turmoil wrought by high oil-

import costs. This further emphasizes the

importance of diversifying Pakistan’s

energy mix.

It is seen how increase in the price of a

commodity that has a relatively inelastic

demand can disrupt the macroeconomic

fundamentals, such as the level of

inflation, the growth in consumption, the

value of imports, and the trade deficit. A

growing negative impact of these

indicators has led to slower economic

growth in Pakistan. The major

consequences on the economy of

Pakistan have been:

Increased value of imports (m) led to an

increased trade deficit, which has

resulted in a decreased GDP growth rate.

Increased prices of imported oil have

also brought Inflation which has

decreased buying power of money, and

increased the energy costs for consumers

and producers resulting in lower

discretionary spending.

Lower discretionary spending has

contributed to the declining rate of

consumption growth (C) lowering GDP

growth rate further.

The positive outcome in Pakistan has

been the rapid development of Natural

Gas, as an alternative to imported oil.

Natural Gas is produced domestically,

and this has kept the price of natural gas

significantly lower than the price of oil

in Pakistan. Pakistan is also eyeing a

trilateral project known as Iran-Pakistan-

India gas pipeline, which would further

help Pakistan’s energy needs. Other

alternatives to fossil fuels such as Oil

and Natural Gas exist in the form of

Solar Power, Wind Power, Bio-Diesel

and Geo-Thermal Power, but require an

enormous amount of capital investment.

An overall analysis of the framework for

the most economic and least costly fuel

mix for power generation in Pakistan

needs to be reviewed by the government.

Such a framework has been presented by

Choudhary (2008) that builds upon the

indigenous availability, technical and

commercial feasibility, capital and fuel

costs, environment impact, and

indigenous capabilities to handle various

power generation technologies. It further

argues that price distortions between

different categories of consumers should

be removed and import of oil for power

generation be considered only after

exhausting the locally available options.

For investor’s to have confidence in all

energy sectors, a predictable and

transparent framework is essential. A

better investor climate will in turn

increase supply and help stabilize prices.

Within the framework of a national

energy policy, a number of specific

measures to promote energy efficiency

and diversity will help in reducing

vulnerability to high oil prices (Asian

Development Bank 2005). The

government must diversify the country’s

energy supply mix to reduce the risk of

oil price fluctuations in the global energy

market.

Energy conservation programs should be

applied. There is a need to seriously

promote efficiency improvement and

demand management of the energy

portfolio.

In another interesting study by

Choudhary (2008), it has been

established that load forecasts and power

generation projections of Pakistan in the

medium term development framework

have serious discrepancies, and so each

segment of the power development plan

needs to be verified based on practical

implementation. This will in turn have

consequences on revising the strategy to

counter imported oil dependence of

Pakistan.

There is also a need to rationalize

taxation/levies on petroleum products to

help reduce the imbalance in the pattern

of consumption. It would result in

predictable government revenues,

balanced consumption of petroleum

products and a decrease in import

dependence. For the improvement of

balance of payment, Pakistan should

make serious efforts to boost its exports

to counter high oil payments.

At the macro level, government policy

cannot completely eliminate the adverse

impacts of high oil prices but appropriate

policy response can minimize it.

"Overly contractionary monetary and

fiscal policies to contain inflationary

pressures could exacerbate the

recessionary income and unemployment

effects. On the other hand, expansionary

monetary and fiscal policies may simply

delay the fall in real income necessitated

by the increase in oil prices, stoke up

inflationary pressures and worsen the

impact of higher prices in the long run."

(IEA 2004; p. 6)

_____________________________

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