Macroeconomic Vulnerability to Oil Price Fluctuations in Kuwait - Literature review Example

Critical Analysis on the Macroeconomic Vulnerability to Oil Price Fluctuations in Kuwait Student’s Name Course Tutor’s Name Date: Introduction As the 10th largest oil producer in the world in 2012, Kuwait has an oil production capacity that does indeed affect the international oil market. However, it is also worth noting that the international oil market affects the Kuwait economy as well. Like most other oil exporting countries, Kuwait’s economy heavily relies on revenues generated from crude oil exports, which represent 90% of the total export earnings in the country, more that 50% of total Kuwaiti government revenues. Consequently, any shocks in the world oil markets have tremendous effects on the country’s macroeconomy. History shows that the dependence on oil has exposed Kuwait to severe financial dislocation during the 1980s, and in the 1990s, the country experienced reductions in its rentier revenues and public reserves (Moore, 2002). This paper conducts a critical analysis on the macroeconomic vulnerability of Kuwait to oil price fluctuations and notes that the country is vulnerable to multiple macroeconomic situations courtesy of oil price fluctuations, the most serious one being the risk of deflation, which would culminate in a recession should the oil price fluctuations lead to too much reduced earnings. Kuwait is an oil-based economy and oil exports account for 90 percent of the country’s exports (Eltony, 2008). Starting in the 1970s when oil prices boomed, Kuwait, just like other oil producing countries, spent the vast revenues generated from oil exports in expanding its infrastructure development and enhancing social service provision to the citizenry (Eltony, 2008). Over the years, the government set a precedent where it became the sole supplier of critical public services and utilities such as health, education and sanitation services. Such are provided without any charges by the government. Additionally, the government has used the oil revenues to heavily subsidise other services and utilities such as oil products, gas, fresh water and electricity (Eltony, 2008). It is estimated that consumer subsidies and public-sector salaries in Kuwait account for an average of 82.5% of the government’s total spending (Eltony, 2008). Notably, the private sector does not have much role to play in the provision of services and basic utilities to the citizenry, and this too means that the government does not earn much tax from the private sector either. In any case, 2006 estimates reveal that Kuwait’s non-oil economy accounted for just 6% of the country’s revenues, and 5% of its total export earnings (Cassinadri & Mitchell, 2008). Perhaps more related to the macroeconomic vulnerability of Kuwait is the point that fluctuations in world oil prices always have an effect on the country’s economy. When the world oil prices are high, Cassinadri and Mitchell (2008) note that Kuwait has a budgetary surplus; the opposite also is also true. When the prices are down, the government has to contend with a deficit in its budget. Even more critical to Kuwait is that the government has an expansionary fiscal policy, which takes advantage of budgetary surpluses whenever high oil prices favour such a move. It has been argued that the expenditure commitments in the country are hard to sustain especially if the world oil prices keep fluctuating as they do. Oil dependence and macroeconomic vulnerability As with most oil exporting countries, the phases between 1974 and 1976, 1978 and 1983, and 2006 and 2007 marked growth in oil revenues as oil prices were on an increase. In Kuwait, Cassindari and Mitchell (2008) note that oil revenues (either when prices are high or low) are used to fund the deficit occurring in the non-oil sector, consequently stimulating growth in the economy. Additionally, the foreign exchange earned through the export of oil is used in purchasing imports for the non-oil sector (Barsky & Kilian, 2004; Olomola & Adejumo, 2006; Wakeford, 2006). For as long as oil revenues are higher than the fiscal deficits in the non-oil sector, surplus are realised, and the resulting money can be used for investments, or for paying off debts (Cassinadri & Mitchell, 2008). Kuwait has two main investment forums in which it channels a significant amount of its surplus revenues. One is the Fund for Future Generations, in which 10% of all government revenue is assigned. The second forum is the General Reserve Fund, in which budget surpluses are channelled (i.e. after the 10% deduction for the Fund for Future Generations is made) (Cassinadri & Mitchell, 2008). Whenever a deficit occurs, the Kuwait government is at liberty to draw funds from the General Reserve Fund. Curiously though, Kuwait’s non-oil sector dependence on oil increases just as the oil prices increase. Closely tied to this is that oil prices are determined exogenously, and in addition to this, Kuwait is a member of the Oil Producing and Exporting Countries (OPEC), and as such, has been assigned a production quota which it cannot exceed (Eltony, 2001). The foregoing means that it cannot adjust its supply beyond an allocated quota to compensate for reductions in the worldwide oil prices. Using Vector Autogression Model (VAR), Eltony (2001) investigated the effect that oil price fluctuations had on macroeconomic variables and found out that oil prices were determined by conditions in the world market and happenings in the Kuwaiti economy did not really matter. Eltony (2001) further found out that government expenditure in Kuwait is largely determined by oil revenues generated in each economic year. In a different study, Eltony (2006) found out that government expenditure in development projects in Kuwait was the most sensitive to oil price shocks compared to current expenditure. A connection between imports into Kuwait and the level of government expenditure was also established. The amount of expenditure spent on development activities was also found to be linked with oil prices in that when prices were high, a lot more revenues would be used in development-related activities, but when prices were low, the level of development activities would decline. Variation in oil prices (and revenues) was also found to affect the amount of imports coming into the country (Beck & Kamps, 2009; Eltony, 2001). Money supply was found to be affected negatively whenever oil prices shifted downwards (Eltony, 2001). The most significant finding by Eltony (2001) however was that fluctuation in oil prices mainly affected government development expenditure as recurrent expenditure still had to be financed. Imports were also affected by fluctuations, but the effect on imports was tied to government expenditure. Specifically, consumer goods (e.g. food imports) did not suffer much even with oil price fluctuations. However, development-related imports were negatively affected whenever government reduced its spending on development-related projects due to reduced oil prices in the international markets. Since the government owns the oil wealth in Kuwait, the findings by Eltony (2001) are not surprising, since it effectively means that fluctuations in oil prices affect the level of government revenues, ultimately affecting the finances that the same government can use and invest within the economy. A report by the International Monetary Fund (IMF) reveals the macroeconomic vulnerability facing Kuwait even further. For starters, the report notes that the private sector is largely reliant on government spending (IMF, 2012). The foregoing means that should the government adopt contracted spending measures due to reduced oil revenues based on oil fluctuations in the international market, the private sector would suffer too. Fortunately, the country has experienced external and fiscal surpluses for more than a decade, but that does not mean that the oil prices do not stand the risk of taking a dip in future. Lessons learnt from the 2008 financial crisis imply that oil prices need to be at par with the fiscal and current accounts to avoid adversely affecting consumer confidence (Mehrara & Mohaghehg, 2011; Rasmussen & Roitman, 2011). Additionally, maintaining oil prices at a breakeven point with the fiscal and current account would ensure that the country’s growth prospects remain positive and that the fiscal space would not face any limitations (IMF, 2009). However, that will only be the situation if oil prices fluctuations lead to increases in oil prices. Should the oil prices be lower than the fiscal and current account, Kuwait could be exposed to vulnerabilities which include a decline in consumer confidence, limitations in the fiscal space, and dampened economic growth prospects. Another vulnerability in the macroeconomic situation in Kuwait rises from government’s control of a majority of the country’s sectors (Reuters 2011). For example, 80% of Kuwaiti workers are employed by the government. This places an imbalance in the labour market, in that should oil prices fluctuate negatively for a prolonged time, the country’s ability to support the workforce would be compromised. Notably, the macroeconomic performance of any country is affected by the gross domestic product (GDP) and inflation. In oil-dependent economies like Kuwait, the GDP is directly linked to oil prices. Inflation levels on other hand are closely linked to fluctuations in oil prices because upward fluctuations translate into increased money supply into the economy, and hikes in price levels are common as the economy tries to absorb excess liquidity. One of the economic sectors that have suffered the consequences of excess liquidity in the market following rising oil prices before the 2008 financial crisis was the real estate market. According to Eltony (2006), houses (commercial or residential) in Kuwait are pretty expensive especially considering they are in high demand and that people have money to spend on the same. This occurs because “too much money in circulation causes the money to lose value” as noted by Ferdous and Shahid (2013). But what would happen if the economy does not have as much money as evident during the upward oil price fluctuations? Economic reasoning implies that should oil price fluctuations lead to decreased revenues in Kuwait, the risk of deflation would be possible. Deflation would lead to the risk of higher unemployment rates in the country, which would be occasioned by low demand levels in the economy, and economic depression would be a likely culmination of low oil prices. Although unlikely (because of the high demand of oil in the world, and the impact that OPEC has on controlling the supply of oil in a manner that prevents prices from fluctuating to extremely low prices), Kuwait should remain aware of the depleting nature of its resources. It is estimated that by 2050, the country may not have as much oil wealth as it has now. Perhaps the best analogy describing the macroeconomic vulnerability to oil price fluctuations in Kuwait is best indicated by Setser (2007), who argues that oil exporting economies were “moribund when oil hovered in the $20s for most of the 1990s – and at risk of bankruptcy when oil dipped to $10 a barrel in 1998”(p. 1). Notably, oil price fluctuations in recent times have favoured the incomes of oil exporting countries. But what would happen when the ‘good prices streak’ ends? The most probable thing in some countries like Kuwait is that the economies would start ‘eating’ into their savings (e.g. by drawing from the General Reserve Funds or liquidating some of the investments the country has made abroad). Setser (2007) indicates that most oil exporting just need $40 a barrel to cater for their import bills and budgets. With oil trading for more than $90 a barrel, it is rather obvious that such countries have enough surpluses to invest elsewhere. Such investments would ideally provide a good fallback should the oil price fluctuations lead to decreased oil revenues for the affected countries. Conclusion The over-dependence on oil by Kuwait exposes it to macroeconomic vulnerabilities related to oil price fluctuations. Currently, the economic fortunes of the country are favourable based on the high oil prices. However, a downward trend in oil prices would lead to reduced spending by government especially on development projects. Seeing that the government finances most of the social sector including health, education and sanitation services, it would have to continue financing the same sectors even with reduced oil revenues. In such a scenario, the government would need to dig into its savings and perhaps investments in order to sustain the economy. As noted herein, deflation is also a likely scenario especially if a reduced supply of money into the economy leads to job losses and decreased spending power. If this happens, the economy would stand the risk of falling into recession. Notably, there appears to be a need for further investigations into how individual macroeconomic factors would be affected by oil price fluctuations as the existing literature does not offer any insight into the same. References Barsky, R. & Kilian, L. (2004). Oil and macro economy since the 1970s. Journal of Economic Perspectives, 18(4, Fall), 115-134. Beck, R. & Kamps, A. (2009). Petrodollars and imports of oil exporting countries. European Central Bank Working Paper Series, 1012, 1-37. Cassinadri, E. &Mitchell, J. (2008). Resource depletion, dependence and development: Kuwait. Chatham House Working Paper, EEDP 11/08, 1-29. Eltony, M.N. (2001). Oil price fluctuations and their impact on the macroeconomic variables of Kuwait: A case study using VAR model for Kuwait. International Journey of Energy Research, 25(11), 939-959. Eltony, M.N. (2006). Industrial energy policy: A case study of demand in Kuwait. 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