The Impact of high energy prices on the Jamaican economy - Part 1

Published: Friday September 19, 2008

High energy prices have had a deleterious effect on the Jamaica economy. Energy prices affect the domestic economy via its effect on the cost of production (high energy bill) which in turn affects all commodities. However, it is the effect of high oil prices on other commodities, particularly grains and wheat, which has hit home hard in terms of the immediate pass through effect to domestic inflation.

The act of "growing food for energy" has led to increased competition between those who would need wheat and grain for consumption (and animal feed) and those who would use grain (particularly corn) for the production of energy (ethanol). This increased competition combined with speculative trading by overseas brokers, adverse weather activity plus increased demand from the rapidly growing emerging economies of Asia (China, India) have led to massive increases in commodity prices.

For the September 07 quarter, oil prices (bench-mark West Texas Intermediate-WTI) increased by 16.2% followed by a 20.2% increase for the December quarter. In fact, since the 2006 pull-back, when oil prices declined to US$50.48, oil prices have surged by 187.6% to peak at US$145.18 before making a sharp drawback (-18.65%) to US$118.1 as at August 27. The prices of corn, wheat and soybean also reached historic highs in the December-07 quarter before showing signs of easing in the September 08-quarter. The average price of US hard and soft winter wheat rose by 24.4% and 21.9% in the December quarter alone. This followed respective increases of 33.6% and 43% in the September-07 quarter.

Jamaica felt the effect of these high energy and commodity prices via increased inflation. The pass-through of the increased costs to fertilisers and feedstock had an adverse impact on the prices of meat, dairy products, edible oils and other food items. The energy-related components of the CPI also felt the burden with the electricity, gas and other fuels (12.8% of index), transportation (12.8%) and restaurants and hotels (6.2%) sub-sectors feeling the major direct first round effects of the rate increases.

Inflation surged as a result of the commodity price increases with the inflation target consistently coming out at the upper band of Bank of Jamaica's (BOJ) quarterly inflation projections. As at July-08 the 12-month inflation rate stands at 26.2%, the highest since the index was adjusted with new weights for the different sectors. If we track back historically we see that (using the old index & weights) inflation last surged to these heights in 1996 when the country was entangled in the financial sector crisis. It is important to note however that the high inflation is not only due to international commodity prices but also weather related shocks such as hurricane Dean.

The text-book policy response to increased inflation is higher interest rates. The central bank obliged in an attempt to appease investor confidence because of negative real returns and to improve the competitiveness of open market instruments. The BOJ increased interest rates across the board by an average of 265 basis points. Rates were increased in January, February and June 2008.

The increased rates were positive in that investor confidence and appetite for holding local Jamaican dollar denominated debt improved. There was little currency depreciation as few investors followed the hoarding effect/sought to hold the US dollar as a store of wealth during the ongoing challenging period. Consequently, the currency has depreciated by a mere 2.11% year to date (September 3) compared to 4% for the similar period in 2007. With the central bank having little need to enter the foreign exchange market to defend the local currency, Net International Reserves (NIR) returned to the US$2 billion mark. The NIR is very important to international investors as it is used as a measure of the sovereign's external vulnerability indicator, which gives an indication of the country's capacity to meet its short term debt obligations in the event of a crisis.

While we believe that the BOJ's policy response to inflation has been timely and has calmed the market, we are also concerned about the fiscal side of the story. Every 100 basis point increase in interest rates adds between J$4 and J$6 billion to the debt based on internal estimates. The bench-mark six-month treasury bill rate (and the three-month T-bill rate) also acts as a point of reference for variable rate instruments. As the six and three month T-bill rate increases the cost of interest expenditure to the government also increases. This is of importance because in excess of 50% of all new GOJ instruments issued in 2007 were variable rate.

The interest rate increases will also pose a problem for the current fiscal deficit target. Note that a part (in June-approx-50 bsp across the board) of the rate increases were implemented after the fiscal deficit target (4.5% of GDP) was set. Thus the interest expenditure sub-section of the monthly fiscal numbers should see a deviation from budget going forward.


Source: Jamaica Observer
http://www.jamaicaobserver.com/magazines/Business/html/20080919T000000-0500_140324_OBS_THE__IMPACT_OF__HIGH_ENERGY_PRICES_ON_THE_JAMAICAN_ECONOMY___PART__.asp