Oil is used intensively in Pakistan in its bid to meet energy requirements, transportation and industrial uses. All these requirements lead to oil being imported in bulk quantities thus leading a large import bill with oil being the single largest contributor to it. Pakistan spends about 45% of its export earnings on oil imports. Added to the problem is that Pakistan makes low value exports and does high value imports which make their balance of trade negative. The problem of imbalances may not necessarily be deemed as a bad thing but the problem of persistent trade imbalance, current account balance and balance of payment imbalance signals that the country is not able to pay its liabilities and problem worsens if the country is not curtailing upon its consumption pattern. Pakistan’s increased dependence on oil import is further deteriorating it’s balance of payments deficit and current account deficit, especially in the context of oil shocks in which the prices of oil has increased immensely, has contributed to deteriorating macro-economic factors and Pakistan being a debt ridden country
Pakistan has been in a persistent deficit since the last four decades which has led to increased foreign debt, rising interest rates, inflation, devaluation of currency.
Background of the topic:
Oil Shocks:
The first oil shock occurred was in 1970-73 as a result of OPEC oil embargo and YOM KIPPUR war. The second major oil shock occurred in 1978-79 when OPEC put restraint on its production and Iranian revolution. Third and fourth took place in 1990 due to Iraq-Kuwait invasion and OPEC restraint on its oil production. The latest to occur was from 2003-2008 which was one of the biggest shocks to oil prices on record which occurred as a result of low supply, increased demand, unclear speculation and other reasons.
Impact of oil import on Pakistan:
Pakistan is a Low Income developing country which is highly dependent on oil import because of its negligible oil producing and refining capability. Pakistan’s cost of oil import relative to GDP is also increasing. This is widening the already large and persistent current account deficit and is thus causing balance of payments imbalance. This is making our currency weaker in context to other currencies which automatically make our exports cheaper and imports expensive. More expensive imports lead to a greater import bill hence leading to a current account deficit. Devaluation in exchange rate also raises the general price level in the country which has led to inflation. Also, rising costs has led to closure of industries and has led to a widespread unemployment. Pakistan has been in a situation of persistent current account deficit over the past four decades which has made it a country liable to debt and increased interest payments. The country has also been in a trade deficit over the years, all factors contributing to a negative balance of payments which causes inflation and puts downward pressure on exchange rate, depreciating it.
Pakistan is a high oil importing country (about 80% of oil requirements is met through import of oil), so, an increase in the price of oil shifts income from oil importing to oil exporting countries resulting in a loss of GDP.
Importance of the study with respect to Pakistan:
My study poses implications for policy makers to look upon the root causes of discrepancy in economic indicators of the country. The root causes lie with the fact that there is large deficit in the macro-economic indicators such as current account etc. which lead to micro-economic problems such as inflation, unemployment. It is not feasible every time for the policy makers to tighten or loosen the monetary policy in order to cut short the impact of inflation but it would be worth looking at a broader prospect and make broad policies in order to curtail the root causes of such micro-economic discrepancies.
Also, policy makers may have to look upon the alternative sources to oil for their industrial, energy and transportation requirements as oil import constitutes the single largest figure in the whole of our import bill. In order to lower our current account deficit and consumption we will have to cut short on our spending of oil and have to look upon alternative sources that are cheaper.
My study is pointed towards policy makers to look upon the broader picture and identify the root causes of economic hurdles in order to come up with solutions.
Importance of the study with respect to the World:
The importance of my study in regard to the rest of the world poses the same stance for other PRGF (poverty reduction growth facilitated) countries to cut short on their high expenditure of oil which is deteriorating their current account balance and worsening their exchange rate with respect to the world. My study proposes that oil should not be taken as an end resort to all energy requirements and alternative ways should be found out in order to lower the dependence of oil in the world. Oil is fast becoming a finite resource and that country which has oil is seen as a power house. My study proposes that alternative methods like solar energy; thermal energy etc. should be used in order to curtail the dependence of the world on oil.
Research Question:
Is the quantity of oil import a big enough factor which is leading to balance of payments imbalance in Pakistan?
CHAPTER 2
LITERATURE REVIEW
Malik (2008) explored the consequences and challenges that Pakistan would face due to rising oil prices, internationally. She mainly used four indexes to check for the dependency of oil to a price shock namely, oil sufficiency index, oil intensity in energy consumption, energy intensity index and net oil import in GDP index. The Oil sufficiency index which is percentage change in oil production minus consumption had remained persistent at -0.8 since 2000. The Oil intensity index which is intensity to which oil is used by a country had declined due to switching alternatives to oil, most prominent of which was gasoline. The Energy intensity index which is the percentage change in energy consumption to percentage change in Gross Domestic Product was almost constant since 1990, thus pointing that there has been no improvement in efficiency. To calculate direct impact of high oil prices on Gross Domestic Product is through net oil import to GDP ratio which showed that it had risen to -5.5 in 2005-06, thus, pointing the fact that oil price increase had affected the Gross domestic Product of the country negatively. Further concerns were raised that there is a need for a tight monetary policy to be applied in order to control inflationary pressures. There is a need for exploration of Pakistan’s own oil and gas reserves and to the use of coal as a switching alternative as vast amount of energy requirements could be met through the use of coal.
IEA, Gandill (2004) examined the effect of oil prices on the macro-economy and the degree of vulnerability of OECD and developing countries to it. To test the impact on the macro-economy and how vulnerable OECDs and developing countries are to it, the OECD’s macro-economic model was used. Two scenarios were examined. One was OECD’s base scenario in which the price of oil was assumed to be constant at $25 per barrel over a five year period i.e. 2004-2008. The second was OECD’s sustained higher oil price case at which the prices are taken at $35. Exchange rate was held constant in both cases.The higher price model estimated that Gross Domestic Product deteriorates by 0.4% in the short run as terms of trade deteriorate. Inflation rises which is measured by Consumer Price Index that showed 0.5% increase. Unemployment rate rises by 0.1% and OECD’s current and trade account also worsens. The impact across OECD countries vary depending upon the degree to which they are importers of oil, however, oil-exporting OECD countries experience GDP growth in the short run but it declines in the long run due to decline in exports of non-oil goods and services. The impact of oil price increase is graver. According to IMF estimates, the reduction in GDP would account to 1.5% only after one year. Developing Asian countries would experience a deterioration of more than 8 million in their current account balance. Inflation in countries like China would increase by 1%, let alone other Asian developing and under-developed countries. The impact on developing countries would be higher depending on the degree of their dependence upon oil import according to which Africa and Asia would suffer more than Latin America. Oil intensity of OECD countries stands at 100 while China and India stands at 232 and 282, respectively. This shows that developing countries are more dependent and oil intensive than developed countries. Also, the vulnerability of developing countries to higher oil price is high due to their limited ability to switch to alternatives. This tends to drive up inflation and deteriorate trade balance. The impact of high oil price is less on developing countries than that of developed countries if taken as a group, because the improvements of current account balance of oil exporting developing countries offset the deterioration of current account balance of oil importing ones more than developed countries. The impact on both the developed and developing countries from an oil price increase, it is deduced that the net effect would ultimately be negative. There will be a net fall of 0.5% in global GDP.
Caesar (2000) argues whether the impact of an oil price increase can be lessened or not using a general equilibrium model of the Philippine economy. Negative impact is referred in terms of GDP growth, inflation, and government budget and income inequality. Results from the model indicate that import tariff policy is one tool to lessen the effects. The model used was termed as PCGEM (Phillipines Computable General Equilibrium Model). PCGEM is a medium sized GCE model and is coded in software called General Algebraic Modeling Systems (GAMS). It is a square model with 2272 equations and 2272 variables. According to the model, increase in oil price results in GDP decline of 2.5% . The government balance improves to become positive from zero. This results due to decline in government expenditure and improvement in its revenue as figured out by the dynamics of the model. Income also decline, but the decline is faster in the income of poor segments than that of rich segments. Seven different scenarios are discussed and the best choice depends upon six criteria like GDP growth, income inequality, government budget balance, government revenue implications, import growth of oil and composite price of oil products which are measured by GINI coefficient. The two best solutions that are derived are: while viewing economic impact, solution of percentage reduction in indirect tax and import tariff appears to be the best. But it can result in crisis due to lower revenue generated from indirect sources. The other solution offered is a high percentage reduction of tariff imported oil products.
Jimenez, Marcelo (2003-05) oil shock on Low Income Countries and steps that these countries took to cope with the shock. The low income countries discussed are 55 out of eligible 78 Poverty Reduction and Growth Facility countries. Econometric Analysis is applied to calculate change in current account, capital account, oil import and export and the overall reserve position of the countries during the 2003-2005 period. Elasticity of oil import to price was also measured during three time periods: 1965-99, 1980-99 and 2000-05. Oil Intensity Index was also calculated. Cross-country differences in borrowing were also taken into account. Oil Intensity index showed that the oil imported by PRGF countries had fallen only by 7% from 1973-2003. The econometric tests applied showed that current account of these countries fell by 2.3%. Oil imports increased by 1.4% while non-oil imports increased by 3.5%. Exports rose by 1.7%. However, the capital accounts position of most of these countries improved by 3%. Reserve levels also rose by an average of 0.7% of GDP. Overall borrowing of Low Income Countries fell. It was concluded that most of these PRGF countries were better positioned to meet the adverse affect of these oil shocks than previous shocks due to a favorable environment and more importantly rise in exports and capital account improvement. However, results showed that Pakistan neither improved upon neither its current nor its capital account and their reserve position deteriorated further.
Schubert (2009) studied the effect of an oil price shock on the current account. The model he used was studied on an open economy with time non-separable preferences included. The non-separable preferences contained some assumptions to the model used in order to come up with a real depiction of the current account. The results depicted a J-curve of the current account which showed that the current account first deteriorates but steadily improves due to improvement in non-oil trade balance over time as the non-oil trade balance negates he negative effects of an oil price shock. However, the limitations of this model is that oil is viewed as having a small share in GDP and this model is tested for a short-run with permanent increase in oil price.
Hamilton (2000) studied relationship of linearity between oil price change and GDP. He conducted regression analysis to test a null hypothesis of linearity against alternative non-linear models. The results depicted a non-linear relationship in the sense that an oil price increase affects the economy more than does an oil price decrease. The effect concluded was tested on GDP growth and the results showed that an oil price increase effects the GDP more in a negative manner than does an oil price decrease.
The study of Azizi (2009) focused on whether the Keynesian or Monetary approach to Balance of Payments is the correct theory to be applied on an open economy like Iran. The study was focused on finding out whether the Keynesian theory of balance of payments which points out that devaluation of exchange rate and price level will affect the Balance of trade which in the case of Keynesian theory is the most important account in the balance of payments is better option when applying fiscal and monetary policies to counter balance of payments imbalance in an open economy like, Iran. The monetary approach to balance of payments focuses that disequilibrium in money forces like, income level, interest rate, exchange rate imbalances the money forces and causes the imbalance in balance of payments. The methodology applied was that data on Iran and the rest of the world was collected, the rest of the world being China, Korea Rep and Japan. Comparison between Keynesian approach and monetary approach was done applying sign test using the Polynomial Distributed Lag (PDL) model. Regression test was also applied which led to the conclusion that imbalances in the balance of payments is due to disequilibrium and money supply and demand forces in the case of and open economy like Iran.
Hamilton in his research work compared the causes and effects of the 2007-08 and the previous oil shocks on the economy. His research was aimed at finding the causes that led to the latest oil shock and comparing them to mainly five previous oil shocks that had hit the economy of the world hard. He wanted to look at the position of macro-economic variable like GDP growth had there been no oil shock. He examined previous study of Blanchard and Gali (2008) to understand the effect oil prices had on the overall economy. Their study was based on a vector auto regression with three oil shocks and two output indicators (real GDP and total hours worked) . The calculate two separate versions using VAR from 1960-83 and 1984-2007. Blanchard re-examined the tests using VAR co-efficient to calculate the average GDP growth over 1974-75 and at the time of other oil shocks, also using CPI, deflator, wages, GDP and hours worked. His conclusion was that, had there been no oil shocks, GDP would have grown in at least some of the scenarios when oil shocks took place.
Blanchard re-estimated many of Edelstein- Kilian regressions for the same sample period they used to see real consumption expenditures response to historical energy price increase. His results show decline in consumption expenditures following increase in energy prices.He also used econometric tests in order to come up with the causes of 2007-08 oil shocks naming reduced supply, increased demand and the role of speculation in spiking the real prices of oil to all-time high.
CHAPTER 3
METHODOLOGY
Research Type:
My research is quantitative in nature as all my variables under observation such as oil price, exchange rate volume of reserves etc are quantitative variables.
Data Type and Research Period:
All of my data under consideration is secondary data available from secondary source (i.e. internet). The data would be time-series in nature as figures have been given according to their annual volume in number of years. The reference period of years is 1996-2008.
Source of Data:
All of the data that is being under observation is extracted from the internet. The main source would be credible sources like World Bank and Asian Development Bank and State bank of Pakistan’s yearly reports, respectively.
Theoretical framework and variables under consideration
Balance of payments:
A record of all transactions made between one particular country and all other countries during a specified period of time.
Current account:
The difference between a nation's total exports of goods, services and transfers, and its total imports of them.
Trade Deficit:
An economic measure of a negative balance of trade in which a country's imports exceeds its exports. A trade deficit represents an outflow of domestic currency to foreign markets.
Oil consumption:
Oil consumption is the yearly intake of oil of a country during a year.
Hypotheses:
Ho: Trade deficit and resultant current account deficit have unbalance impact on balance of payments of Pakistan.
Hi: Trade deficit and resultant current account deficit does not have an unbalance impact on balance of payments of Pakistan.
Ho: Due to high quantity of crude oil import by Pakistan, price hike in international market causes balance of payment imbalance in Pakistan.
Hi: Due to high quantity of crude oil import by Pakistan, price hike in international market does not cause balance of payment imbalance in Pakistan.
Ho: Increased crude oil consumption expenditure causes balance of payment imbalance
Hi: Increased crude oil consumption expenditure does not cause balance of payment imbalance
Ho: Slow paced exploration of local petroleum reserves oriented production increases petroleum import demand and thus cause balance of payment imbalance.
Hi: Slow paced exploration of local petroleum reserves oriented production does not increase petroleum import demand and does not cause balance of payment imbalance.
CHAPTER 4
RESULTS AND ANALYSIS
For the purpose of testing my hypotheses, I conducted an in-house based multiple regression analysis. My dependent variable for the analysis was Balance of payments of Pakistan from fiscal year 1996-2008. Independent variables that were considered were Current account deficit, Crude oil import, crude oil demand and local production of crude oil in Pakistan. The time period for my independent variables was the same i.e. 1996-2008.Multiple regression was run on the statistical software Minitab and data compiled was annual figures taken from IEA and State Bank Pakistan. The useful measures for interpreting the multiple regression result was the t-statistic, R-squared value and the p-value. The t-statistic is the regression co-efficient of an independent variable divided by its standard error; the higher absolute value of the statistic reveals that the parameter is not equal to zero. R-square value indicates how much better the function predicts the dependent variable than just using the mean value of the dependent variable. R2 statistic adjusted is a more conservative estimate of the percent of variance explained, especially when the sample size is small compared to the number of parameters.
The F value is the ratio of the mean regression sum of squares divided by the mean error sum of squares. The F- value' statistics test the overall significance of the regression model. Specifically, they test the null hypothesis that all of the regression coefficients are equal to zero. The P-value, which directly depends on a given sample, attempts to provide a measure of the strength of the results of a test, in contrast to a simple reject or do not reject.
After computation of the multiple- regression, the result provided was as follows:
The regression equation was:
BOP = - 4.99E+10 + 0.578 Current Account + 65005 Petrol import + 22825 Petrol consumption + 526060 Petrol production.
Predictor Coef SE Coef T P
Constant -4.99082E+10 17412298871 -2.87 0.024
Current Account 0.5776 0.1466 3.94 0.006
Petrol import 65005 35540 1.83 0.10
Petrol consumption 22825 36790 0.62 0.555
Petrol production 526060 222988 2.36 0.050
S = 1815477659 R-Sq = 79.8% R-Sq(adj) = 68.2%
Analysis of Variance
Source DF SS MS F P
Regression 4 9.10747E+19 2.27687E+19 6.91 0.014
Residual Error 7 2.30717E+19 3.29596E+18
Total 11 1.14146E+20
The t-statistic for the independent variable current account turns out to be 3.94 which shows that the variable is significant and has an impact on the dependent variable i.e. Balance of payments. Secondly, the p-value turns out to be 0.006 which provides strong evidence of accepting our null-hypothesis and rejecting our alternative hypothesis of current account. P-value indicates a strong impact of the independent variable i.e. current account, upon Balance of payments.
The t-statistic for crude oil import comes out to be 1.83 while its p-value turns out to be 0.10 which provides suggestive evidence of accepting our null-hypothesis and rejecting our alternative hypothesis. The p-value indicates good evidence of an impact of oil import upon balance of payments.
T-statistic for crude oil consumption turns out 0.62 while p-value is 0.55 which leads us to reject our null-hypothesis and accept the alternative hypothesis.
T-statistic for crude oil production is 2.62 while its p-value is 0.05 which provides ample evidence to accept our null-hypothesis and reject our null-hypothesis. P-value provides suggestive evidence of a strong relationship between petroleum production and balance of payments.
Our r-squared value of 0.798 suggests that the model is a model of good-fit model.
Coming towards the hypothesis testing, the first hypothesis was
Ho: Trade deficit and resultant current account deficit have unbalance impact on balance of payments of Pakistan.
Hi: Trade deficit and resultant current account deficit does not have an unbalance impact on balance of payments of Pakistan.
Based on the result, our null hypothesis stands true and we reject our alternative hypothesis. So, we conclude that current account deficit does cause an imbalance in the balance of payments.
Ho: Due to high quantity of crude oil import by Pakistan, price hike in international market causes balance of payment imbalance in Pakistan.
Hi: Due to high quantity of crude oil import by Pakistan, price hike in international market does not cause balance of payment imbalance in Pakistan.
Based on the result I accept my null-hypothesis and reject my alternative hypothesis. So, this leads to the conclusion that high import of crude oil is a significant enough factor in causing balance of payments imbalance.
Ho: Increased crude oil consumption expenditure causes balance of payment imbalance
Hi: Increased crude oil consumption expenditure does not cause balance of payment imbalance
Results conclude that I accept my alternative hypothesis and that increased consumption of crude oil is not a significant factor in causing balance of payment imbalance.
Ho: Slow paced exploration of local petroleum reserves oriented production increases petroleum import demand and thus cause balance of payment imbalance.
Hi: Slow paced exploration of local petroleum reserves oriented production does not increase petroleum import demand and does not cause balance of payment imbalance.
Based on the results, I accept my null hypothesis and reject my alternative hypothesis. So, this concludes that slow local crude oil production is a significant factor in causing balance of payments imbalance.
Conclusion:
The aim of my study was to investigate factors related to crude oil in causing balance of payments imbalance. My study was based on the proposition that large volume of crude oil import is a significant factor in causing macro-economic disequilibrium (current account deficit, trade deficit, balance of payment imbalance) in Pakistan. My study was also aimed at policy makers in order to look upon oil as a significant factor in causing macro-economic crisis. Balance of payments weakens the position of the currency which results in our currency becoming cheaper in respect to other currencies, thus raising price and interest rates.
As explained in my literature review of previous studies and after conducting my own research work, I concluded that Pakistan is and has been in a state of constant current account deficit, balance of payments imbalance, trade deficit and is taking no adequate steps in order to counter them. Result is such that this all leads to budget deficit, inflation and unemployment. The policy makers are busy in looking and solving the micro-economic aspect of the problem but not the macro-economic root aspect, which is lead to the problem.
Results conclude that all my independent variables crude oil import, current account and local oil production are a significant factor in causing a balance of payments imbalance. Pakistan is consuming more than what it is producing. Pakistan is engaged in high value imports and low valued exports which results in trade deficit and resultant current account deficit. Another important aspect of my study highlights the fact that Pakistan does not use any alternative source to meet its energy requirements. Almost all of its energy requirements is met through oil. Prices of oil are at an all time high and were a major cause of 2007-08 recessions. Statistical data and research study proves that most of the times that a recession has taken place; oil has been a complementary factor in it. This poses implications upon policy makers in order to look upon alternative sources of oil for their energy requirements. Also, my study points out that Pakistan have a tendency to import oil rather than look and explore, itself. Pakistan has potential reserves unexplored which may be explored in order to cut short its import expenditure.
Lastly, I wish my study make some immense in the minds of the readers who propose my given solutions.
BIBLIOGRAPHY
Afia Malik, 2007.
"How Pakistan Is Coping with the Challenge of High Oil Prices," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 46(4), pages 551-575.
Paolo Dudine & Luzmaria Monasi & Joerg Zeuner & James John & Mark Lewis & Helaway Tadesse, 2006.
"Weathering the Storm So Far: The Impact of the 2003-05 Oil Shock on Low-Income Countries,"
IMF Working Papers 06/171, International Monetary Fund.
James D. Hamilton, 2009.
"Causes and Consequences of the Oil Shock of 2007-08,"
NBER Working Papers 15002, National Bureau of Economic Research, Inc.
Ahmad Jafari Samimi, Seyed Fakhreddin Fakhrehosseini, Khosro Azizi.
Journal of Applied Sciences Research, 5(10): 1639-1645, 2009
Hamilton, James D., 2003.
"What is an oil shock?," Journal of Econometrics, Elsevier, vol. 113(2), pages 363-398, April.
Schubert, Stefan Franz, 2009.
"Dynamic Effects of Oil Price Shocks and their Impact on the Current Account,"
MPRA Paper 16738, University Library of Munich, Germany.
Analysis of the impact of high oil prices on the global economy
The Impact of Higher Oil Prices on the Global Economy
Cororaton, Caesar B., 2000.
Discussion Papers DP 2000-33, Philippine Institute for Development Studies.
APPENDICES
by
danny890 (student)
