Oil will bring a pinch, not slump

By Frederic Neumann

It’s all been going quite well for a while. Asia, with Korea in the lead, delivered one of the most impressive economic recoveries in living memory.

The region’s economic output is now over a third higher than it was at the peak before the Global Financial Crisis. Even Japan’s earthquake, while immeasurably tragic, will in itself not derail the region’s momentum.

But there is a cloud on the horizon: oil prices. The cost of crude has risen sharply in recent weeks, partly reflecting political tensions in the Middle East.

In the past, such price spikes have usually heralded a global recession. You only need to turn the clock back to 2008.

Most attribute that year’s economic slump to the financial shock stemming from the collapse of Lehman Brothers in the autumn. But, look closely, and you’ll find that the sudden jump in oil prices, with one benchmark hitting almost $150 per barrel over the summer, was equally to blame, depressing consumption and investment in Asia well before the spark of financial contagion hit. So far this year, oil is up some 30 percent.

And there may be more to come. Leaving aside developments in the Middle East, which are virtually impossible to predict, there are two other key drivers of oil prices. The first is the weak dollar.

The greenback has been on a steep slide for some time now, pushing up everything denominated in it, notably the costs of raw materials, gold, as well as crude. This will continue.

The chairman of the Federal Reserve, Ben Bernanke, only recently confirmed that America’s central bank is in no mood to tighten any time soon. As a result, the dollar is bound to weaken further and, in the process, push the price of commodities higher still.

The second driver of oil prices is the rapacious demand in emerging markets. China alone accounts for about 11 percent of global crude consumption, which is a little more than half of what the United States currently guzzles.

But, what really matters for prices is the relative growth in demand. Here, China’s appetite is rising so rapidly that it easily accounts for some 40 percent of the annual increase of global consumption.

The balance, meanwhile, is entirely accounted for by other emerging markets, as demand in the advanced markets is still stagnating. So far, there is little sign that growth is letting up across Asia, Latin America and other developing economies.

All considered, $150 for a barrel of oil looks suddenly quite plausible. The question, therefore, is whether this would once again drag Korea and its neighbors into a nasty recession. Well, let’s not panic.

First, it matters how quickly prices spike up. A gradual rise can be more easily digested, psychologically as well as physically. One difference between now and 2008, for example, is that the cost of crude is up only about 50 percent over the past year, but had doubled in the run-up to the global recession.

Of course, if price gains accelerate, the price shock would be felt more keenly. Still, markets seem calmer nowadays - lingering uncertainties notwithstanding.

Second, while the dollar price of oil keeps climbing relentlessly, the rise in costs in local currency terms, say in Won or Renminbi, is not quite as painful. Exchange rate appreciation helps to buffer local economies and offers scope for further relief.

Perhaps more importantly, Asian economies are now on such a roll that they can take the rise in oil prices in their stride. With labor markets tight and wages rising, for example, motorists can still afford their gas, even if climbing costs are an understandable irritant.

This last point, however, highlights the real risk of rising oil prices.

It is not so much local demand in Asia that is at risk, but spending in the West where incomes are hardly growing amid stubbornly high unemployment.

Higher gas prices, in this case, imply cut-backs elsewhere. Thus, the main risk for Asia, and especially for highly export dependent markets like Korea, is that shipments to advanced markets will take a hit.

Still, we shouldn’t exaggerate the impact. The IMF, for example, estimates that if oil climbs to $150 per barrel, and stays there through year-end, this would only shave 0.75 percentage points off the region’s growth this year. That’s a pinch, not a slump.

Frederic Neumann, PhD

Co-head of Asian Economics