April 26, 2012

The Asia-Pacific Sovereign Seesaw: If Oil Prices Soar, Some Ratings Could Fall
Primary Credit Analyst: KimEng Tan, Singapore (65) 6239-6350; kimeng_tan@standardandpoors.com Secondary Contact: Elena Okorochenko, Singapore (65) 6239-6375; elena_okorochenko@standardandpoors.com

Table Of Contents
Growth Of Energy-Intensive Economies Will Be Hit Subsidies Weigh On Government Finances Climbing Oil Prices Could Magnify External Weaknesses Policy Decisions Determines Rating Impact Endnote

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The Asia-Pacific Sovereign Seesaw: If Oil Prices Soar, Some Ratings Could Fall
Tensions in the Middle East are likely to keep oil prices elevated in the near future despite recent declines. Most observers don't expect the U.S.-Iran standoff to escalate into conflict. Even so, it has already begun to hurt economically. Energy costs have increased at the same time that the global economy struggles with headwinds from the fiscal troubles of European Economic and Monetary Union (or eurozone). Standard & Poor's Ratings Services believes that a widely expected weak year for economic growth now has the potential to worsen. A further large increase in crude oil prices would adversely affect most Asia-Pacific economies. The region is a large net importer of oil, much of which comes from the Middle East (see chart 1). Many Asia-Pacific economies are also energy-intensive, requiring more energy to generate a unit of GDP than in Europe and the U.S. Several countries subsidize oil consumption to soften the economic impact, but this strategy weakens fiscal and external indicators. Lowering subsidies, on the other hand, may risk political instability for some sovereigns.
Chart 1

If average oil prices stay above US$150 per barrel for more than a year, an event we consider to have a modest likelihood at this time, it could trigger negative credit rating actions for some Asia-Pacific sovereigns. Sovereigns that subsidize oil consumption are the most vulnerable to downgrades. In India and Sri Lanka, we expect fuel and related subsidies to markedly worsen fiscal and external deficits unless subsidy levels fall. In the absence of offsetting positive developments, these sovereigns could see negative rating actions as a result. (We base average oil prices on

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The Asia-Pacific Sovereign Seesaw: If Oil Prices Soar, Some Ratings Could Fall

the equal-weighted average price of U.K. Brent, Dubai medium and Texas heavy blends, as computed by the U.N. Conference on Trade and Development.) Overview Tensions in the Middle East and Eurozone troubles risk sending oil prices significantly higher from already-elevated levels. Some Asia-Pacific sovereigns that subsidize oil consumption may come under rating pressure if average oil prices stay above US$150/barrel for more than a year. A sustained increase in average oil prices could deepen fiscal and external deficits where there are already sovereign credit weaknesses. Policy responses, specifically toward oil subsidies, will determine the impact of inflated prices on sovereign creditworthiness.

Growth Of Energy-Intensive Economies Will Be Hit

High oil prices are a bigger drag on growth in economies that rely heavily on the commodity as an energy source. Car ownership is often prevalent in such economies, reflecting oil's importance as a fuel for motor vehicles. In motor-vehicle producing countries such as Japan, Korea, Malaysia and Thailand--where car ownership rates are typically very high--oil accounts for sizable portions of their energy supply (see chart 2), even if little oil is used to produce electricity (see endnote 1).
Chart 2

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The Asia-Pacific Sovereign Seesaw: If Oil Prices Soar, Some Ratings Could Fall

Higher oil prices won't affect the Malaysian economy to the same extent as the other gas guzzlers in the region. Malaysia is a net exporter of oil because of its significant domestic oil production. Therefore, a part of the Malaysian economy benefits from higher oil prices. Japan, Korea and Thailand, however, are highly reliant on imported energy. As a result, there's little to offset the negative effects of high oil prices (see chart 3).
Chart 3

Economies that use limited oil could still see growth slow if they use energy much less efficiently than elsewhere or if their key industries are energy intensive. Asia-Pacific's most energy-intensive economies are Mongolia, Vietnam, and China (see chart 4). When oil prices go up, the costs of other energy sources often rise as well. This is especially so if the relevant non-oil energy sources are internationally tradable, such as coal and liquefied natural gas (LNG). Their prices tend to move much more closely with international oil prices than those of domestic sources of energy.

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The Asia-Pacific Sovereign Seesaw: If Oil Prices Soar, Some Ratings Could Fall

Chart 4

We have created an index to reflect the economic impact of high oil prices on each economy as result of the following factors: (1) dependence on oil as an energy source; (2) dependence on imported energy; and (3) energy intensity. The index for each economy indicates its relative vulnerability to an oil price shock, with a higher number indicating greater vulnerability. We've based the indices primarily on statistics for each country that the International Energy Agency has published using this formula:

(Energy intensity)x(Share of oil)x(Share of imported energy in gross energy supply)

. The index suggests that the Korean economy is likely to feel the impact of high oil prices the most keenly (see chart 5). The indices for Japan, Thailand, and Taiwan indicate that they could also be significantly affected. At the other extreme, Bangladesh, Australia, China, and Indonesia are likely to be the least affected economies in Asia-Pacific.

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The Asia-Pacific Sovereign Seesaw: If Oil Prices Soar, Some Ratings Could Fall

Chart 5

Subsidies Weigh On Government Finances

Sovereigns that subsidize energy consumption could see their fiscal positions weaken more than elsewhere in an oil price shock scenario. Energy subsidies are more common in lower-income economies, including several in Asia-Pacific, where we assess that the negative impact on economies arising from high oil prices will be relatively milder. Despite this assessment, governments often justify fuel subsidies on the basis that they help low-income households and support economic growth. The fiscal costs of such support are clearer in countries such as India and Indonesia, where subsidies are partly paid out of government funds. Subsidies are indirect in many other cases. The Chinese government, for instance, caps fuel prices and electricity tariffs at levels that earn energy companies low or even negative returns. The costs of indirect subsidies fall initially on the energy companies concerned. However, the government is likely to have to provide financial support to these companies subsequently.

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Chart 6

The International Energy Agency estimated that in 2010 energy subsidization rates in Asia-Pacific would range from zero in high-income economies, such as Australia and Japan, to more than 46% in Bangladesh (see chart 6). In terms of GDP, the subsidies amounted to almost 5% (about US$5 billion) in Bangladesh. However, Bangladesh may see less fiscal pressure than some other sovereigns if oil prices trend sharply higher. Like many other developing countries in the region, much of Bangladeshi subsidies are for electricity consumption. And most power generators in the country use domestic natural gas as fuel. The difficulty of smuggling natural gas across borders reduces the risk of a significant increase in demand if oil prices cause a hike in natural gas prices in neighboring countries, too. As a result, energy subsidies are unlikely to rise rapidly with oil prices. Unlike natural gas or hydropower, transporting oil across borders is relatively easy. Smugglers often buy cheap oil in subsidized markets to sell in markets where they fetch higher prices. Such activities have been well known to occur, for instance, in Bangladesh and Indonesia. In Indonesia, Malaysia and Sri Lanka, much of the subsidies support oil consumption. If oil prices rise substantially, the subsidy bills in these countries could rise sharply (exacerbated by increased smuggling) unless the subsidy policies change. In Malaysia, governments have been raising fuel prices to prevent such a large increase. In Indonesia, however, the latest attempt to raise fuel price failed. In the absence of further price increases, the fuel subsidies in Malaysia, Sri Lanka, India and Thailand could increase by at least 1 percentage point of GDP if the

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average oil price rises to US$150 in the next one to two years. The changes could worsen fiscal performance scores on some of these sovereigns.

Climbing Oil Prices Could Magnify External Weaknesses

Surging oil prices could damage external indicators that underpin sovereign credit ratings. The external trade balance, for instance, could weaken significantly. In principle, exchange-rate depreciations could mitigate this weakness by reducing demand for oil and increasing external demand for the affected economy's exports. However, governments often balk at steep exchange rate depreciations. The economic adjustments that depreciations bring include higher inflation and weaker domestic demand. So, just as governments provide energy subsidies to prevent these developments, they could also try to support their exchange rates against downward pressures when oil prices rise. The incentives to support the exchange rate strengthen if the economy is a sizable net external debtor. In this situation, a weaker exchange rate also increases the debt-servicing burden of domestic borrowers of foreign currencies. Propping up the exchange rate, however, weakens the external balance sheet. The deterioration is worse if oil subsidies exist and cross-border fuel smuggling increases the trade deficit. The government may have to run down its foreign exchange reserves. Or the economy may have to increase foreign borrowing. It could also be a combination of the two. In any case, these developments undermine the economy's resilience to an economic shock and damage sovereign creditworthiness.

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Chart 7

Most Asia-Pacific territories where Standard & Poor's assigns sovereign ratings are net oil importers. Within the group, Malaysia was the only net oil exporter in 2011 (see chart 7). Vietnam's fast-rising oil consumption in recent years led its oil balance to turn negative for the first time in many years in 2011. Malaysia's positive oil balance is also small at about 1% of GDP. Although Indonesia and Mongolia export crude oil, they import even more refined oil products for domestic use. The external balances of India and Sri Lanka are likely to markedly deteriorate if oil prices exceed US$150 per barrel without a significant reduction in oil subsidies. Their net oil trade deficits could rise to 6%-7% of GDP in this scenario, up from about 4%-5% in recent years. Both economies had current account deficits above 2% of GDP in 2011. These levels could worsen to more than 4% of GDP if oil prices are sustained at above US$150. Such developments undermine their sovereign creditworthiness.

Policy Decisions Determines Rating Impact

Policy outcomes that exacerbate existing credit weaknesses are likely to trigger negative rating actions if oil prices rise sharply. We believe that maintaining existing oil subsidies could be damaging to sovereign creditworthiness in many cases. In some, subsidies support the economy where growth is not an important rating constraint. However, this could come at the cost of fiscal instability and wider current account deficits that are greater rating weaknesses. India and Sri Lanka are among several sovereigns that would be particularly vulnerable to a downgrade if crude oil

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prices are sustained at above US$150 per barrel for more than a year and their oil subsidies remain unchanged. The direct impact of high oil prices on economic growth is unlikely to change many sovereign ratings. The experience of the past decade, in which oil prices rose from an average US$18 in 1999 to US$97 in 2008, suggests that most economies adjust to higher oil prices without large permanent losses in growth rates. The most oil-dependent economies are mostly higher income ones that provide little or no energy subsidy. Consequently, we expect further adjustments to mitigate the impact of higher oil prices without severely affecting their long-term growth prospects. However, the economic impact could be much greater and rating implications more severe if Middle-East oil exports are substantially disrupted. This scenario could see a sharp drop in Asia-Pacific oil supply. Prices are likely to soar well above US$150 per barrel to strangle growth in some of the most important Asian economies. The IMF's recent World Economic Outlook publication addressed this risk. It estimated that a 50% increase in oil prices caused by a supply shock could lower world GDP growth by about 1.25 percentage points. However, we see a low likelihood that this scenario would unfold in the next year or two. Credit metrics of almost all sovereigns in Asia-Pacific would weaken from a scenario of rising oil prices. But policy decisions would affect the severity of the deterioration and the impact on various credit factors. These will determine how, and if, sovereign ratings change.

Endnote
In Singapore and Taiwan, oil consumption is sizable because of their large oil-refining and petrochemical industries. These industries use oil as a non-energy input. In 2009, non-energy uses accounted for 73% of oil consumption in Singapore and 52% in Taiwan. Consequently, the importance of oil as an energy source is exaggerated by the shares represented in chart 2 for these two economies. Korea's oil consumption is also similarly affected. Non-energy use of oil is 44% of oil consumption. In contrast to these economies, non-energy uses are significantly less important for most others, such as Japan (21%), Malaysia (3.7%), and Thailand (27%). We do not directly adjust for the variations in non-energy uses of oil because such activities could also slow due to weakening demand when oil prices rise. Consequently, they also exert a negative impact on GDP growth.

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