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The economics of oil price adjustment in Bangladesh

SADIQ AHMED
Between July 2003 and August 2005, the international crude oil price increased by more than 200 percent, accelerating from around $26 per barrel to over $60. When Hurricane “Katrina” hit the USA, the oil price galloped to $70 per barrel. This has adversely affected the economies of all oil importing countries, with especially difficult consequences for low income economies. Yet, the reality is that much of the underlying price increase reflects structural changes in the international oil market relating to high demand, low stocks and related supply constraints, and the changing nature of oil transactions through the international mercantile exchanges. So, while the effect of temporary disruption caused by the Katrina disaster is being reversed as the supply lines are restored, the current expectations are that crude oil prices will likely stay above $50 per barrel over the next 18-24 months.
Given that much of the global oil price increase is likely to persist over the medium term, economies will
need to adjust to this reality. In advanced economies like the OECD countries, oil prices are market based and international price changes are passed through to consumers on a regular basis. So, while consumers are unhappy because this hurts their real incomes, there is no debate whether or not to raise domestic prices. In developing countries like Bangladesh, where domestic oil prices are policy determined due to price control, this has posed a serious political and economic dilemma. Politicians and consumers do not want to see any increase in domestic prices. They argue that higher domestic oil prices will fuel inflation and hurt the poor. Politicians also worry that this will adversely affect their electoral prospects in the national elections. These concerns are understandable and have been voiced in all oil importing developing countries. The question is can economies get away without adjusting to the reality of the international prices? Is it reasonable for consumers to expect their governments to shield them fully against the adverse effects of the surge in international oil prices? The answers to these questions lie essentially in understanding better the underlying economic issues. Much of the debate seems to emerge from a poor knowledge of the facts and the possible consequences of different policy options, including the option of not adjusting. The objective of this piece is to address this knowledge gap and promote a better understanding of the economics of oil prices in Bangladesh.
External adjustment: Let us first look at the immediate implications of the rise in international oil prices for the Bangladesh economy. The country's import cost for oil has increased rapidly from about $900 million in FY2003 to $1.6 billion in FY 2005. Other things remaining unchanged, this implies a loss of income for Bangladesh in an amount of $700 million in FY05 over FY03 due to the rise in oil price. This is a huge terms of trade shock equivalent to some 1.3 % of gross national income (GNI). Without offsetting increases in
exports or reduction in other imports, the trade balance will worsen by $700 million putting pressure on the exchange rate and the reserves. The actual trade balance worsened by $ 1.0 billion between these two fiscal years despite increases in exports, due to the combined effects of the oil import bill and the growth in other imports. This was partly offset by an increase in remittances, but the current account balance worsened by $700 million between FY03 and FY05. This was financed through higher capital flows and a run down of reserves. A part of the adjustment also happened through a depreciation of the exchange rate, which rose from taka 58 per US dollar to taka 65 per US dollar. In a flexible exchange rate environment as in Bangladesh, this is an essential part of the adjustment process.
TO BE CONTINUED
The author is the Sector Director for Poverty Reduction and Economic Management in the South Asia Region of the World Bank. The views expressed herein are those of the author and not necessarily those of the World Bank Group.