GCC Oil Subsidies Removal Could Cause ‘Stagflation’

Experts say that subsidies should be gradually removed to avoid sudden short-term economic shocks.



The withdrawal of fuel subsidies in the GCC could lead to a steep hike in inflation and hamper the region’s economy in the short-term, according to experts.

“The removal of oil subsidies in the short term could severely hit the competitiveness of the economy and drive down economic activity, while resulting in increased prices of all goods and materials due to higher production and transportation costs,” said Mohammed Atif, Middle East area manager, DNV GL.

“This could lead to the phenomenon of ‘stagflation’, which is falling growth with rising prices.”

Fuel is heavily subsidised in the GCC region, which has led to a sharp rise in consumption – a report by British think tank Chatham House estimates that the GCC consumes more primary energy than the whole of Africa despite its population being only one-twentieth the size of the continent’s.

The Gulf’s domestic energy consumption is forecast to grow further in the coming years thanks to a growing population and comparatively low prices.

According to a study published by consultants IHS, the energy needs of the GCC are likely to rise more than 50 per cent in the next 17 years. It also estimated that over $1 trillion of investment is needed by 2031 to meet demand for gas and electricity in the Middle East and North Africa.

High consumption rates have also caused subsidy bills for the Gulf governments to shoot up. The International Monetary Fund (IMF) estimated that energy subsidy costs in some of the GCC countries ranged as high as 28 per cent of government revenues in 2011.

Gulf states have realised that the subsidy system is unsustainable in the long run, but the issue is a sensitive topic for regional governments.

Recently, Bahrain announced plans to hike diesel prices from mid-January, but the proposal is currently under a review after parliament members protested the subsidy removal.

Kuwait too has been reviewing a proposal to cut down its lavish subsidies on petrol, water and electricity after the IMF warned of its burgeoning state expenses. But the government faced stiff opposition from its parliament where lawmakers are campaigning to raise benefits available to its citizens.

Experts emphasise that the continuation of fuel subsidies could be detrimental in the long-term for the GCC, as it will strain their exchequers.

“Fuel subsidies lead to fast-rising domestic oil consumption which reduces the amount of oil available for export,” said Robin Mills, head of consulting at Manaar Energy.

“This increases the financial burden on governments, especially those that are not major oil producers like Dubai, Sharjah and Bahrain, and reduces the money they have available for other investments such as health and education.”

Atif said that a sudden rise in prices could cause short-term shocks to the economy, with long lasting effects.

“The household sector would be impacted harshly and commercial businesses would also have to move higher fuels costs onto consumers,” he said.

“In the short term, this would result in contracting demand for goods and services in the economy.”

While a sudden removal of subsidies could severely impact the economy, Atif added that governments should work on a long-term transition plan to cushion the impact of the move.

“It has to be accepted that cost reflective prices cannot be reached overnight without severe short terms shocks and political fallout,” he said.

“Therefore, prices need to be adjusted gradually in a phased approach and at the same time there needs to be a push on innovation and productivity improvements in all parts of the economy to counter some of the increase in the fuel price on general prices.

“The government could also embark on policies to encourage inward investment thereby strengthening its currency which would help dampen the impact of fuel costs due to a stronger currency versus other currencies.”

Mills concurred about adopting a slow approach in phasing out subsidies.

“The government should give the population clear information and explain the reasons for the decision; and possibly offer targeted support to vulnerable groups who would be particularly affected. This would minimise the negative impacts.”

Atif suggested that the government withdraw subsidies for consumer heavy sectors while retaining them in other industrial sectors in order to soften the initial blow of rising costs.

“It may be that governments prolong fuel subsidies but shift them away from households to industry only, thereby encouraging more efficient behaviour on the part of consumers,” he said.

“Meanwhile it should continue to give infant industries the opportunity to develop a competitive base from which to generate national income for the economy over and above the cost of the fuel subsidy.”