What if oil prices stay higher for longer?

ASEAN economies are in the part of the cycle where growth has cyclically picked up and inflation has also risen, although to still manageable levels and remaining within or below central banks' inflation targets.

With oil prices veering closer to US$70/bbl since the start of the year, there have been concerns about macro implications from oil prices staying higher for longer.

Specifically, would the change in terms of trade hurt the growth recovery, and would higher oil prices pose upside risk to inflation and hence policy rates? In addition, what implications would higher oil prices have for fiscal balance sheets?

On the growth front, higher oil prices are positive for Malaysia, but less so for the rest of Asean. Indeed, Malaysia is the sole net oil exporter in Asean, whilst the other Asean economies run oil trade deficits.

In particular, higher oil prices are most negative for Thailand's terms of trade. Thailand's dependency on road, rather than rail, transport has likely led to oil inefficiency, and its oil trade deficit is the widest in Asean.

That said, it is important to differentiate whether higher oil prices are driven by demand or supply-side factors. To the extent that higher oil prices reflect better global demand, this mitigates downside risk to growth.

Separately, higher oil prices bolster Malaysia's weakening current account surplus, but pose a drag on current account deficits for Indonesia and the Philippines. Meanwhile, although higher oil prices also weaken the current account balance for Singapore and Thailand, these economies enjoy high current account surpluses and are unlikely to face external funding pressures even as higher oil prices eat into their external surpluses.

On the inflation front, higher oil prices will lead to cost-push inflation pressure for most economies. Assuming full pass-through, we estimate that every 10% rise in oil prices adds 0.9-1.5ppt to headline CPI from first- and second-round impact amongst the Asean economies.

There are several factors that will help mitigate the inflation impact for Indonesia, Malaysia and Thailand. Specifically, in Indonesia, policymakers have committed to keeping retail fuel prices and the electricity tariff stable up till the end of 2018, which dampens the inflation impact from the rise in oil prices but means that subsidy costs will rise.

Managing price volatility

Meanwhile, in Malaysia, policymakers are contemplating the reintroduction of fuel subsidies should retail fuel prices exceed RM2.50/litre for three consecutive months, which would help put a lid on inflation. In addition, to the extent to which the ringgit is an oil currency, ringgit appreciation would also dampen inflation upside. In Thailand, policymakers could make use of the oil stabilisation fund to manage price volatility, which means that the inflation impact from higher oil prices may not be one-for-one.

On the monetary policy front, we expect four out of five central banks in Asean to normalise policy rates from low levels this year, with BNM already the first to hike in January. We think central banks are unlikely to react to cost-push inflationary pressure alone, but will react when cost-push inflation from higher oil prices leads to second-round demand-pull inflationary pressures.

In this context, we see the most upside risk to policy rate in the Philippines, and to a lesser extent Malaysia.

Specifically, we expect BSP to hike by 50bps in the first half of 2018, as there are overheating risks. We see inflation veering towards the upper end of BSP's inflation target range amid policy-induced and demand-pull inflationary pressures.

Indeed, GDP growth has been strong, and the tax reform measures will also add to policy-induced inflation. Meanwhile, higher oil prices and currency depreciation also imply inflation risks.

In Malaysia, if oil prices stay higher for longer, stronger growth and higher inflation could lead BNM to hike another time, to 3.5 per cent, but this is not our base case.

Meanwhile, economic slack in the remaining Asean economies mitigates risks of significant demand-pull inflation pressures.

How will oil prices affect the fiscal balance? Within Asean, this discussion is most relevant for Malaysia and Indonesia, since they are oil producers and may run fuel subsidies. For Indonesia, we estimate that every US$10/bbl rise in oil prices lifts oil-related government revenue by 0.2 per cent of GDP and increases the fuel subsidy burden by 0.2 per cent of GDP, all else being equal.

To the extent that a wider gap between the subsidised price and actual market price may prompt more arbitrage activity, the subsidy burden may rise in a non-linear manner as oil prices go up. Policymakers indicate that the fuel subsidy burden would be borne by Pertamina initially, with the government taking it on their balance sheet subsequently.

In Malaysia, fuel subsidies have been abolished since December 2014, and we estimate that every US$10/bbl increase in oil price lifts oil-related revenue by 0.5 per cent of GDP, all else being equal.