By Carmen M. Reinhart
CAMBRIDGE – The global oil market is a volatile place. But, abstracting from high-frequency fluctuations, average annual world prices (in US dollars) plummeted about 60% between 2012 and 2016. So how do countries like Russia, Saudi Arabia, Iraq, and Venezuela cope with a collapse in the price of their dominant (and in some cases, only) export?
A textbook response suggests that a government should adjust fiscal expenditures in response to permanent (or very persistent) drops in export and budget revenues. A government can finance external and fiscal deficits if the shock is perceived as short-lived.
Highlighting the dramatic economic effects of oil producers’ reversal of fortune, the figure below compares the sum of the balances (surplus or deficit) in the general government’s budget and the external balance, as measured by the current account, for 18 oil producers, with both components scaled to nominal GDP. In the majority of cases, the twin surpluses of 2011, prior to the peak in oil prices, gave way to substantial twin deficits in 2016. A swing amounting to 30 percentage points of GDP (and sometimes much larger) is not uncommon in this group.
The fact that the twin deficits remain so large in most cases is an indication that even with substantial adjustment efforts in some countries, much of the shortfall in export and fiscal revenue was financed with new domestic and external debt. In hyperinflationary Venezuela, printing money was the primary method of government finance.
Some countries, notably Saudi Arabia, which issued the largest volume of external debt of any emerging market in October 2016, started with a clean balance sheet – no outstanding debt and a high stock of assets. But even with such favorable initial conditions in “stocks,” the combination of record or near-record twin deficits financed through reserve losses and US dollar-denominated debt has led to a spate of credit-rating downgrades, with the most recent coming from Fitch last week. Of course, not every downgrade is followed by a default; but the direction is hardly encouraging, especially given the pace of deterioration.
Will an oil-price recovery reverse this trend?
Cycles in oil and commodity prices are notoriously difficult to predict. Some oil-market bulls nowadays are pointing to a recovery in global demand. Arguments for this view range from those emphasizing comparatively low inventories in Europe, Japan, and other places, to those pointing to the recent surge in North America of consumer purchases of gas-guzzling vehicles, like SUVs and trucks.
But the bullish view is by no means unchallenged. Prevalent among the reasons listed by those forecasting a continued slump in oil prices are some of the old usual suspects. The Saudis’ inability to rein in production among some of OPEC’s poorer members in dire need of foreign exchange is an old (and usually relevant) story. Complicating matters for Saudi efforts to stabilize prices is the comparatively new challenge of rapid growth in US production.
Indeed, the most recent data indicate that the recent setback in the WTI Crude Oil price has not slowed the growth in the Crude Oil Rotary Rig Count, which increased sharply in the week ending March 24. The rise took the Rig Count to its highest level since September 2015, as US production has replaced cutbacks by OPEC and other producers, and US inventories have set new record highs each of the last five weeks.
Judging from their actions, the governments of several oil-producing countries appear to be betting that the slide in oil prices is either over or about to end soon. Gulf countries are forecast to issue sovereign debt in possibly record magnitudes. As for external debt, these countries are expected to drive the bulk of 2017 sovereign issuance, according to a recent report by Bank of America Merrill Lynch, which estimates that Saudi Arabia, Qatar, and Kuwait, together with Argentina, will account for 37% of the total. Like Saudi Arabia until recently, Kuwait has no external sovereign debt outstanding.
If oil prices fail to recover, however, this surge in debt issuance could backfire. Furthermore, issuing dollar-denominated debt carries an additional risk and cost in the event of currency depreciation (or devaluation) for those with an exchange rate pegged to the US dollar.
While the future of oil prices is uncertain, the fate of countries that have treated adverse shocks as temporary and reversible, and were then proven wrong, has seldom been encouraging. The fact that international financial markets welcome the placement of new debt by countries with obviously large and unresolved twin deficits primarily reflects their search for any kind of yield in an era of exceptionally low global interest rates. These countries’ leaders should not interpret demand for their debt as a vote of confidence in their policies and economies.
Carmen Reinhart is Professor of the International Financial System at Harvard University’s Kennedy School of Government.