Asian Fuel Subsidies Distort the Energy Market

Asian Fuel Subsidies Distort the Energy Market
Philip Bowring
23 May, 2008

Asian governments ignore market forces to their peril

Asian leaders contemplating the high price of oil and related energy need to ask how much they themselves are to blame this for this state of affairs. At US$135 a barrel, oil may be in a bubble but do not expect prices to fall back much below $100 – its level at the start of 2008 – if shortsighted Asian government policies continue to be so important at the margin where world prices are set, sustaining demand at a level far above that which it would be in market forces were left in charge.

Developing Asia now accounts for 60 percent and rising of the increase in oil usage. As a percentage of import demand increases, it is close to 80 percent because most of the rest of the demand increase has been in the oil-rich countries of the Middle East and the former Soviet Union. So although developing Asia still accounts for only 20 percent of the global total demand, it is the key to prices.

Developing Asia may as yet be only small per capita consumer of hydrocarbons but rate of consumption growth in the populous countries of Asia, particularly China, India and Indonesia, are all very high, and all give massive subsidies to consumers in the name of helping the poor.

For sure, some of the poor suffer when fuel prices go up. Kerosene is widely used for cooking everywhere. Almost everyone uses electricity to some extent. Many farmers depend on oil for pump irrigation. Many lower-income people, especially in Indonesia and India, need motorbikes to get to work. Farmers need gas-based nitrogen fertilizer whose prices are linked to energy.

But the efforts to shield these groups from the impact of high prices usually ends up mainly benefiting the owners of cars, the users of air-conditioners and large screen TVs, and energy- and capital-intensive industries rather than the labor-intensive ones most needed to create employment.

China may think it can afford to subsidize its aluminum smelting industry but there are surely better ways of spending such money – incidentally also reducing pollution from coal-burning power stations. What would be the impact on Jakarta’s traffic jams and air pollution if vehicles paid the full price for their fuel? What would be the impact on rural development, or public health or public transport infrastructure if those subsidies were diverted to needier causes?

It is not as if there aren’t good developed-country examples to follow. Japan and almost all European countries have long used fuel pricing to limit demand through high taxes. But much of Asia seems determined to follow what has proved the disastrous US policy of not taxing energy, or now of giving it massive subsidies. Malaysia is likely to cease to be a net exporter within five years. Indonesia is already in that position. Even prosperous Taiwan, entirely dependent on imported fuel, last year imposed a cap on fuel prices for reasons of short-term political gain – the new government has said it will be removed.

Some governments are beginning to come to their senses. Indonesia, which is spending 15-20 percent of its budget on subsidies, has signaled a 30 percent rise in fuel prices. It spends almost 30 percent of its budget on subsidies, more than on development, producing a government deficit which has led to a downgrade of its credit rating. Cheap fuel has helped the (inefficient) car industry but is a curious priority for a middle income country with pollution problems and abysmal public transport in its Kuala Lumpur/Klang Valley region. De facto Finance Minister Nur Mohamed Yacob said this week that the subsidy system must be changed but getting away from the addiction to cheap oil in a country which has very high car ownership relative to income levels will be politically difficult, particularly in the wake of the recent election and turmoil in the ruling party.

India and China both use national oil companies as conduits for massive subsidies which do not immediately show up on government books but ultimately have the same effect on the public purse. In India, the electoral cycle must take some of the blame and reform may follow after the next one. But that is scant excuse in China where price controls on oil, coal and electricity now have huge impact on oil, coal, power generation industries and subsidize some industries more than consumers and deprive predominantly state owned companies of profits. Other countries with subsidies that they can ill-afford include Thailand and the Philippines.

Another factor underpinning wasteful subsidies is that every country in Asia has a balance of payments surplus and thinks it can afford expensive imported energy. For now, that is true. But it will not be true for much longer if higher import price are followed by a sharp decline in foreign markets for manufactures once the energy bill (and the banking mess) squeeze incomes in the US and Europe.

Subsidies not only have a short-term impact on demand, they leave a longer term consequence. In the same way as cheap oil encouraged the SUV culture in the US, so cheap fuel in Asia has led to increases in average engine size in countries such as China and Malaysia.

It is impossible to calculate how much these subsidies increase global demand for oil. However, given the sensitivity of global oil prices to the marginal supply/demand situation, and given that Asia currently accounts for two thirds of global demand growth, it would not be difficult to argue that without them global demand would be 2 percent less and prices half current levels. In other words, the subsidies are handing a huge gift to oil producers at the expense of those government which claim to be using subsidies to protect their local consumer economies.