The Oil Shock
International Monetary Funds Note on Global Prospects and Policy Challenges
While global growth will receive a boost from the decline in oil prices, the outlook has been revised down. The oil price decline, which reflects to an important extent higher supply, mainly a rise in production in the United States and OPEC’s decision to maintain current production, will boost global growth by lifting private demand. However, this boost is projected to be more than offset by negative factors, including the drag in investment associated with diminishing medium term growth prospects. Accordingly, global growth in 2015/ 16 is revised down by a quarter percentage point to 3.5% and 3.7% respectively.
Market volatility has increased and there have been adjustments in credit and currency markets. Currencies have depreciated and spreads have risen in many emerging markets, notably but not only in commodity exporters. Spreads on high-yield bonds and products exposed to energy prices have widened, but long-term government bond yields have declined in advanced and emerging economies.
Risks are more balanced than in October. Upside risks arise from the demand boost due to lower oil prices, but uncertainty about their future path, which depends on the drivers of the price decline, has also increased. Downside risks linked to financial market sentiment – given prospects for U.S. monetary normalisation – are compounded by potential external and balance sheet vulnerabilities in oil exporters.
Strong policy action is needed to raise growth and mitigate risks:
Advanced economies should maintain supportive policies. In most advanced economies substantial output gaps and below-target inflation suggest that the boost to demand from lower oil prices is welcome, and that the monetary stance should remain accommodative. Where risks of further decline in inflation expectations are present—notably the euro area and Japan—continued monetary accommodation is needed, and the recent ECB announcement of an asset purchase program is welcome. Fiscal policy should be growth friendly, including by moderating the pace of consolidation and enhancing infrastructure investment in countries with identified needs, large output gaps, and relatively efficient investment processes.
In many emerging economies policy space to support growth remains limited. In some, lower oil prices will alleviate inflationary pressures, allowing for a more gradual tightening of monetary policy. Oil exporters that have accumulated savings and have fiscal space can let fiscal deficits increase and allow a more gradual adjustment of public spending. For others with less policy space, exchange rate flexibility will be a critical buffer to the shock. Some will have to strengthen their policy frameworks to avert persistently higher inflation and adapt to a protracted deterioration in terms of trade. Similar to advanced economies, and with the same caveats, infrastructure investment is needed to ease supply bottlenecks in some emerging economies.
Lower oil prices offer an opportunity to reform energy subsidies and taxes in both oil exporters and importers. The removal of general energy subsidies should be used toward more targeted transfers and to lower budget deficits where relevant.
There is an urgent need for structural reforms to raise potential output across the G20 members. Labor market reforms in advanced economies undergoing population aging should aim at raising labour participation, and actions to increase labour demand and remove impediments to employment are also needed in euro area economies and some emerging markets. Reforms to improve the functioning of product markets are also needed in Japan and the euro area, and reforms to improve productivity and raise potential output are key in many emerging economies. A new momentum is needed in the global trade dialogue.
Financial Developments in the Context of the ‘Oil Shock’
Financial market volatility has increased – although from low levels compared to historical averages – and there have been adjustments in credit and currency markets. Recent developments in financial markets can be summarised as follows:
Tightening financial conditions in corporate bond markets and emerging economy sovereign bonds: A significant number of U.S. high yield bond issuers are energy companies, which also account for a significant share in the global corporate bond index.
Spreads in the U.S. high yield market have risen by 65 basis points since early-December, and the corporate emerging markets bond index (CEMBI) has increased by about 165 basis points over the last six months, pushed by oil and gas companies.
This takes place amid weak balance sheets i.e. interest coverage ratios below 2 in many energy sector companies in emerging economies. Also, over the last six months, the global EMBI spread has widened from 281 to 402 basis points, pushed to a large extent – but not only – by higher spreads in oil exporting countries like Russia, Venezuela, and Ecuador, which likely reflects in part the fact that many large emerging market oil corporates are state-owned.
Currency depreciation: The currencies of several oil producers in emerging economies have depreciated sharply since end-June and there was an increase in volatility in bond, equity and currency markets. Risk-off behaviour in several emerging economies led to currency depreciations even for some oil importers. This may create balance sheet tensions in some emerging economies, especially in the context of substantial foreign debt loads build by corporations over the last years.
Pressure on corporate earnings: Prospects for lower earnings have already been reflected in equity prices for companies in the oil and gas sectors, which fell by 24% over the last six months. Accordingly, a significant decline in corporate earnings in energy sector companies is likely to take place.
The above developments may have further implications:
Banking sector: The exposure of some global banks to oil and gas companies is substantial – between 2 – 8% of total assets for some banks and an increase in non-performing loans would have an impact on the balance sheet of those banks.
Capital flows – As earnings from oil corporations in emerging market exporters decline, equity inflows are likely to fall. Mutual fund flows to emerging markets have fallen during the last six months.
This executive summary is from a note by the Staff of the IMF prepared for the February 2015 G20 Finance Ministers and Central Bank Governors meeting in Istanbul, Turkey.