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News : Global Economy Last Updated: Apr 11, 2011 - 5:08 AM

Rising demand for oil could have detrimental effect on world growth IMF warns
By Finfacts Team
Apr 8, 2011 - 5:30 AM

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Sources: Global Financial Data; IMF Primary Commodity Price System; and IMF staff calculations. 1) U.S.-dollar-denominated commodity prices are deflated by the U.S. consumer price index in log deviations from the sample mean. Deviation between filtered components and price is accounted for by noise, business cycle frequencies, and random walk drift where. 2) First-principal component (standard deviation from mean) normalized to have unit variance.

Rising demand for oil could have a detrimental effect on world growth, the International Monetary Fund (IMF) warned on Thursday.

In a paper released yesterday that will be part of the semi-annual World Economic Outlook to be issued next week, the IMF said that it expected oil supply to become more thinly spread over the coming years because of rapidly rising demand in emerging market economies such as China, and the fact that maturing oil fields will limit some producers' ability to add new production.

Improvements in oil supply have been slow, reflecting investment bottlenecks and other constraints, and the IMF expects net capacity will build only gradually.

Oil still dominant

Oil remains the most important source of primary energy in the world, accounting for about 33% of the total. The two other fossil fuels, coal and natural gas, account for 28 and 23%. The analysis says that renewable sources of energy are in a rapid growth phase, but they still account for only a small fraction of primary energy supplies.

Despite the capacity constraints, the IMF research shows that it is premature to conclude that oil scarcity will inevitably be a strong constraint on global growth.

“Our simulation analysis shows that gradual and moderate increases in oil scarcity, consistent with supply projections by others, may only be a minor constraint on global growth in the medium to long term,” the IMF economists say. In particular, an unexpected sizable downshift in oil supply trend growth of 1 percentage point  - - from 1.8% to 0.8% - - slows annual global growth by less than ¼% in the medium and long term.

However, such relatively mild effects on global growth should not be taken for granted since scarcity or its growth effects could be more significant, the WEO analysis shows.

Threats to oil supplies, including geopolitical risks, imply that oil scarcity could be more severe and may materialize in large and abrupt changes. The negative global growth effects would be correspondingly larger.

In addition, the Fund said it's uncertain whether the world economy can adjust as smoothly to increased scarcity as the researchers assume, given redistribution and sectoral shifts. When oil becomes more scarce, it implies losses to labour and owners of capital in high oil-intensity sectors. Increasing production in low oil-intensity sectors will eventually offset some of these losses, but there could be resistance to change. Another concern is larger negative growth effects because oil scarcity may not just lead to higher costs and lower productivity levels but also hold back productivity growth.

Implications of a supply shock

A persistent adverse oil supply shock would likely result in a widening of current account imbalances, creating greater instability in the global economy. The economists say this underscores the need to reduce the risk associated with growing current account imbalances and large capital flows.

Continued progress in financial sector reform is also critical, as the efficient intermediation of these flows is a prerequisite for financial stability.

Policy response

The research shows two broad areas for policy action to mitigate the impact of oil scarcity.

  • Given the potential for unexpected large increases in the scarcity of oil, policymakers should review whether current policy frameworks facilitate the adjustment to such events: macroeconomic policies to ease adjustment in relative prices and resources and structural policies to strengthen the role of price signals would be desirable;

  • Consideration should be given to policies aimed at lowering the risk of oil scarcity, including through the development of sustainable alternative sources of energy.

Advance chapters from next week's  planned Global Financial Stability report, cover: the issue of housing finance and its relationship to financial stability and secondly, on systemic liquidity risk, the risk that markets dry up simultaneously, causing funding difficulties for a large fraction of financial institutions.

The IMF says the chapter on housing finance tries to take a step back and take a broader view to see how experiences in various countries, through a cross-country analysis, can draw out best practices that could help the set up of housing finance arrangements in such a way that they help preserve financial stability, rather than, in some cases, damage it.

While movement towards best practices cannot happen overnight, given the fragile nature of some of these markets in a number of the affected countries, a long-range goal is clearly identified in the chapter to get back to basics. And, to help make sure that future booms and busts in housing cycles are attenuated.

It recommends that the US government should reexamine the mortgage interest deduction.

The staff say the mortgage interest deductibility is expensive and it is regressive. Most countries have some sort of mortgage interest deductibility. They also have deductibility of capital gains taxation when you sell your own home while they don't tax imputed rent. So at least for a first step they recommend at least a cap on mortgage interest deductibility. They say that there is a proposal by the US Fiscal Commission to lower the limit from $1m to $500,000 and to let it only apply to primary residences. That would be a very welcome first step.

The Fund's staff also say it could consider market borrowing as part of efforts to build a global liquidity safety net.

Such a mechanism could allow the IMF to rapidly increase lending resources without requesting commitments from its 187 member countries and would give the Fund the means to scale up its response to global liquidity needs in times of crisis, it said.

“Establishing the modalities for the Fund to borrow from the markets at short notice to supplement its existing resources could be worth exploring,” IMF staff wrote in the report, which focuses on strengthening the international monetary system. “This could have the added advantage of offering a relative safe haven asset during times of global market stress.”

Other proposals include regular injections of liquidity in the global system, following the $250bn pumped in at the request of the G-20 in 2009.

It also suggested expanding the currency basket used by the IMF, the so-called Special Drawing Rights, to
“the most widely used emerging market currencies.”

World Economic Outlook Extracts

Global Financial Stability Report Extracts


Greece's 2010 budget deficit will be revised to above 10 % of GDP, requiring corrective measures to stem spillover effects, it was reported on Thursday.

The government's latest official estimate of the 2010 deficit was 9.4 %, while its lenders - - the 'troika' of European Commission, IMF and ECB - -  anticipated it at 9.6 % compared with a target of 8% of GDP at the time of last year's bailout.

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