Free fall in oil prices may cut both ways for emerging markets

Bear market for crude has hit producers like Nigeria hard but given other developing countries a chance to put finances in order

PUBLISHED : Thursday, 27 November, 2014, 7:59am
UPDATED : Tuesday, 28 April, 2015, 11:16am

Is the 32 per cent drop in the price of crude oil since June a blessing or a curse for emerging market economies? For Nigeria - Africa's largest oil producer, which relies on the commodity to provide more than 70 per cent of its revenues - the damage has been plain for all to see.

Since early August, the naira, Nigeria's currency, has fallen 10 per cent against the US dollar, forcing the central bank to burn through its dwindling foreign exchange reserves in a futile attempt to defend the naira's peg against the greenback.

On Tuesday, Nigeria's central bank was forced to raise its main interest rate to a punitive 13 per cent - its first rate rise in three years - and undertake an 8.5 per cent devaluation of the naira in an effort to fend off an oil-driven speculative attack against the currency.

Other oil-producing nations - notably Venezuela, which depends on oil for half of its revenues (and 95 per cent of its exports) and is now perceived to be at greater risk of defaulting on its foreign debts - are in dire straits.

Yet for Indonesia, a large oil importer with a US$23 billion fuel-subsidy bill that places huge strain on its public finances, the fall in prices could not have come at a better time.

Last week, Indonesia's new president, Joko Widodo, fulfilled a key election pledge by raising the price of subsidised petrol and diesel in order to free up funds for much-needed infrastructure development.

Plunging oil prices made it easier for Widodo to undertake what would otherwise have been a much more politically contentious cut in subsidies.

According to a report by Bank of America Merrill Lynch (BAML), lower oil prices will also help narrow Indonesia's current account deficit, with both a 10 per cent decline in prices and the cuts in fuel subsidies "reducing the oil import bill and improving the current account by about 0.5 per cent of GDP".

Indeed, for most of the developing world, plunging oil prices should provide a timely fillip to growth just when most emerging market economies are slowing significantly because of external and domestic factors.

This is because energy importers account for about 70 per cent of the developing world's gross domestic product, according to BAML, which also notes that oil-importing nations account for 85 per cent of the market capitalisation of emerging market companies. This partly explains why the stock market of India, a major oil importer, has risen 3 per cent over the past three months.

The collapse in oil prices is also good news for many emerging market central banks that are struggling to tame inflation. Although food accounts for over a quarter of the "shopping basket" of goods and services that make up emerging market consumer price indices, energy accounts for a further 10 per cent.

India's elevated inflation rate, which forced the central bank to raise interest rates last year and stood at 8 per cent as recently as July, has fallen to 5.5 per cent, significantly below the bank's 6 per cent target for January 2016 and increasing the chances of a rate cut at its closely watched rate-setting meeting next week.

Yet as ratings agency Fitch notes, the windfall benefits from lower oil prices partly hinge "on how policymakers respond - whether they use budget windfalls to increase spending or reduce [fiscal] deficits".

Indeed, the collapse in oil prices could prove a double-edged sword for emerging markets if it relieves pressure to implement much-needed fiscal and structural reforms - already a concern given the resilience of many of their bond markets to worries about the anticipated tightening in US monetary policy.

More importantly, a sharp decline in oil prices stemming from a glut in supply - the main reason for the fall according to analysts - is one thing. A bear market for oil due to a marked deterioration in global economic conditions is quite another.

With China's economy slowing significantly, a sharp drop in diesel demand across Asia and a euro zone flirting with recession, it is clear that the fall in oil prices is not entirely attributable to a supply glut.

The longer oil prices stay low, the greater the risk of a "growth scare", which could undermine sentiment towards emerging markets. With Opec showing no signs of agreeing on production cuts ahead of its meeting in Vienna yesterday, downward pressure on oil prices looks set to continue.

Nicholas Spiro is the managing director of Spiro Sovereign Strategy