Responses to oil price volatility for Guyana’s emerging oil economy

0

The occurrence of certain events is probable in the precarious economic environment created by Oil Price Volatility (OPV); inflation and unemployment are both likely to increase, while investment, stock market returns, consumer demand, and industrial production are likely to decrease.

However, under certain circumstances, counterbalancing influences and moderating responses can offset some of the economic effects of OPVs. As such, for new oil-producing economies like Guyana, considerations must be examined as to whether OPV will necessarily lead to a decline in the constituent elements of aggregate demand and supply, in the short, medium, and long-term. This type of policy analysis will help to clarify the trade-offs involved with minimising price volatility and help to prioritise the areas of interest for policymakers who are faced with the task of minimizing the adverse macroeconomic impacts of OPV.

OPV directly impacts three primary macroeconomic channels: consumption, investment, and industrial production. The precise extent to which these variables are affected is dependent on two factors: the degree of uncertainty generated by OPV; and the attitudes of economic agents to uncertainty.

  1. Consumption

Declining consumer demand under OPV reflects the fact that the uncertainties advanced by OPV, regarding future income and employment prospects, decrease consumer confidence and prompt consumers to adopt precautionary savings behaviour at the opportunity cost of current consumption. This confirms the principal prediction of precautionary savings literature that by reducing the average propensity to consume (the percentage of income spent rather than saved) greater economic uncertainty should result in declining aggregate consumption. In the medium-term, volatility driven unemployment augments downward pressures on aggregate consumption by increasing consumer pessimism regarding future economic prospects and reinforcing existing precautionary savings motives.

Some economic models on consumption, also suggest that by increasing the uncertainty about future income, OPV should increase the stochasticity (randomness) of consumption (Hall 1978).

  1. Investment

Since investment is most responsive in areas where consumer demand is either resilient or expected to grow, the effects of OPV on aggregate consumption have a significant impact on investment decisions. Real options valuation literature suggests that, due to the uncertainties relating to the profitability of investment in a volatile energy environment, the benefits of holding a more risk-averse investment portfolio outweigh the future advantages gained from current commitments to irreversible investment expenditures. Evidence of decreasing aggregate investment as a result of OPV suggests that firms do indeed optimise their investment expenditures in this fashion and that, parallel to the attitudes of consumers under OPV, investors are risk-averse.

This commonality is in part driven by the fact that investment is determined by expected trends in consumer demand. In other words, the deterioration of aggregate consumption as a result of OPV has a negative bearing on current investment decisions by leading to the downwards revision of future demand expectations. Additionally, random consumption, in conjunction with the increased unpredictability of marginal production costs under OPV, has been found to significantly deter investment by amplifying the uncertainties related to future demand (and, hence, investment profitability).

However, as a result of differences in aggregate risk preferences between investors in financial and real markets, as well as the differences in the quality of risk compensating mechanisms in financial and real markets, financial investment may be positively correlated with OPV. Stock market returns, for example, may necessarily appreciate during periods of acute OPV, as investors demand higher risk premiums to compensate for increased investment risk (Henriques and Sadorsky 2009). Furthermore, while frequent price deviations increase the chances of financial loss, such deviations also shape perceived opportunities for arbitrage. Thus, one consequence of OPV may be the deterrence of risk-averse investors and the attraction of risk-loving investors to financial markets. The degree to which volatility is detrimental or beneficial to stock market investment is thus a function of the prevailing risk preference in financial markets at any given time. In a risk-loving market, stock market investment can realistically increase alongside OPV (Ebrahim et al. 2014).

The negative relationship between real investment and OPV is, additionally, only specific to the short and medium-run and disintegrates in the long-run, reflecting the fact that further delays to investment are subject to an increasing opportunity cost over time, as the strategic effort to establish market share through commitment to new technologies acquires greater importance. In the long-run, therefore, aggregate investment will recover to pre-volatility equilibrium levels, regardless of the extent of price volatility in the market. Moreover, price volatility may actually drive increasing investment in the long-run if the volatility-induced switch in household behaviour from consumption to precautionary savings in the short to medium-run enlarges the pool of savings available for funding investment (Başkaya et al. 2013).

  1. Industrial Production

Industrial production generally declines in response to aggregate price volatility, but the essentiality of oil as an input into industrial processes means that OPV has an especially adverse effect on industrial production growth. Although the time horizons considered in investment and production level planning differ markedly, the central determinants of investment (expected consumption and returns) are also common to industrial production. The decrease in industrial production as OPV increases is a response to the expected decreases and increased unpredictability of consumption as well as production and delivery cost uncertainty.

However, unlike the predetermined negative relationship between aggregate investment and OPV in the short term, industrial production levels may be maintained in the short term despite of the uncertainty created by price volatility, reflecting the differing production cost risk management mechanisms commonly used by industrial producers and investors: contrary to the investor response

of delaying expenditure as production cost uncertainty increases, industrial producers maintain production levels by increasing product prices to incorporate an uncertainty premium in order to compensate for increased production cost uncertainty.

Indirect Responses to OPV

The impact of price volatility on consumer, investor, and producer behaviour, strongly influences both the level of inflation and the level of unemployment within oil-dependent economies such as Guyana. Emphasis must be placed on the extent to which inflation and unemployment may indirectly increase in the short, medium, and long term as a result of OPV, the relationship between inflation, unemployment and OPV, and the extent to which monetary policy can effectively regulate both the inflationary and deflationary pressures of OPV.

  1. Inflation and Monetary Policy

Inflation is a natural by-product of the premium that industrial producers attach to the prices of their goods under production cost uncertainty. Inflation may be interpreted as a ‘necessary evil’ in maintaining industrial production levels under OPV. The source of inflation, however, remains crucial in determining whether the impact of inflation on industrial production is positive or negative. If high energy prices are the cause of inflation, a negative correlation should characterize the relationship between industrial production and inflation, because higher energy prices imply an increase in production costs and a corresponding reduction in profitability. On the other hand, if inflation is the product of an expansionary monetary policy response to OPV, industrial production is likely to be positively correlated to inflation.

While supply-side responses to OPV create inflationary pressures, demand-side responses, such as lower consumption and investment expenditure, create deflationary pressures. In the short-run, inflationary pressures created by supply-side responses to production cost uncertainty are likely to outweigh the deflationary pressures created by demand-side expenditure shifts, because of the lag before which consumers are able to form accurate expectations of how OPV will affect both the future economic outlook and the future level of inflation. Consumers, therefore, do not immediately adjust expenditures downwards in response to OPV. In the medium-term, however, deflationary pressures created by reduced demand-side expenditure are likely to outweigh inflationary supply-side pressures, as fully formed inflation and growth expectations reduce consumption and force a proportional decrease in production levels. In the long term, inflationary pressures are likely to accumulate as the decline in investment expenditure in response to OPV in the short to medium-term reduces production capacity and increases supply-side inelasticity.

Changes in inflation expectations strongly influence the orientation of monetary policy. OPV exacerbates the traditional policy dilemma faced by monetary policy authorities of lowering interest rates to directly promote economic growth (accommodative policy) or raising interest rates to limit inflation (tight policy), by creating inflationary pressures and simultaneously lowering economic activity. This conflicting policy choice is likely to be fluid and responsive to business cycles as well as to the overall condition of the domestic economy.

In low-inflation economies, monetary policy authorities have more flexibility to pursue an output target, due to the greater capacity of low-inflation economies to sustainably absorb further inflation. Therefore, in a low-inflation environment, as is the case of Guyana, monetary policy authorities have a stronger incentive to focus on supporting consumption, investment, and production through expansionary monetary policy rather than limiting inflation through contractionary monetary policy. In addition to its beneficial impact on real investment, such a monetary policy response implies that financial investment could increase regardless of OPV, because a decrease in the interest rate should result in an increase in the value and share returns of companies. Such conditions could feasibly precipitate an increase in financial investment, as investors rush to benefit from a market in which stock returns are appreciating.

However, such a simplistic view of monetary decision making does not account for the role of expectations in determining the effectiveness of the policy. A significant risk posed by the use of expansionary monetary policy to boost consumption, investment, and production under OPV, is the creation of a liquidity trap. [The liquidity trap as formulated by John Maynard Keynes in his General Theory of Employment, Interest and Money, refers to a situation in which the approach of the nominal rate of interest toward zero fails to reverse the preference for saving. Since the nominal rate of interest cannot be negative, conventional monetary policy ceases to be effective in stimulating the economy when the nominal interest rate reaches zero.]

OPV directly increases the risk of a liquidity trap by adversely affecting consumer confidence (International Energy Agency 2012). In an environment in which low consumer confidence pervades, the cheaper availability of money is unable to overturn the precautionary savings behaviour of consumers, which OPV encourages. This bottleneck has two fundamental implications for the future direction of monetary policy: the management of OPV should lie beyond the remit of monetary policy, and monetary policy should be more conservative. This reflects the fact that the necessarily forward-looking or pre-emptive nature of monetary policy, is ill-suited in addressing short-term price volatility. Moreover, despite the fact that the term structure of inflation under price volatility is predictable, price volatility itself is difficult to predict. A less conservative expansionary monetary policy approach may unintentionally augment the inflationary pressures created by price volatility because of the limitations involved in the forecasting of OPV.

  1. Unemployment

The increasing rate of unemployment under OPV is precipitated by the decline in both industrial production and overall economic activity as OPV intensifies. In periods of excessive OPV, an increase in the rate of unemployment occurs because the industrial workforce in the short to medium-term is more likely to wait in anticipation production level restoration (and commensurate job opportunities in the industrial sector) than to retrain for jobs that require alternative skill sets (Davis 2001).

The extent to which unemployment is affected by price volatility depends on the contribution of the industrial sector to GDP and the structure of labour market laws. OPV is likely to lead to higher unemployment in economies in which the industrial sector holds a fundamental place in the sectoral composition of economic growth, than in economies in which the industrial sector plays a comparatively less important role. The structure of labour market laws also plays a crucial role in determining the extent to which adverse industrial production and consumption under OPV are translated into higher unemployment.

  1. Stagflation

The rigidity of unemployment levels in countries with less flexible labour markets such as Guyana may also explain the trade-off between inflation and unemployment implied by the short-run Phillips curve. Unemployment and inflation, may instead, rise in conjunction with one another, while economic growth is either stationary or declining, a condition known as stagflation. The finding that OPV both increases inflation and unemployment and decreases economic growth, suggests that OPV also pushes the economy into a stagflationary mode.