The impact of higher oil prices on global financial stability is difficult to assess but deserves attention.
While the full effects of sharply higher oil prices have yet to manifest themselves, the immediate attention of observers seems to centre around their macroeconomic implications, in particular the impact on consumption and inflation, and consequently their policy implications for US interest rates. Relatively little attention is being paid to the implications for global financial stability and, frankly, I find this somewhat surprising.
I find the oil market, in particular its dynamics, rather difficult to understand. Oil prices have more than doubled since early 2002. To the extent that there has been a supply-side shock, it was not a severe one by historical standards. Demand has increased due to strong growth in the global economy and it is obviously quite price inelastic. At the same time, one hears a lot about the involvement of highly leveraged and speculative position-taking in the forward market. This is probably a market mainly for professionals and so there should not be a lot of investor-protection concerns. The professionals ought to be able to protect themselves. But it is possible that, rather than having the beneficial, stabilising effects on the spot market that theoretically come from the forward market, these activities are instead leading to higher volatility. And the market is not a very transparent one. We do not know the market concentration, the financial strength of the active players, how leveraged they are and to what extent the lending institutions are exposed. We therefore do not know the likely impact of a sharp reversal of recent market trends on the viability of those players and on the lending institutions. It could well have systemic implications for the global financial system. While I will follow developments in this area with keen interest, I am glad to note that banks in Hong Kong, at least, do not have significant exposures to the oil market, directly or indirectly.
There is another aspect that has received a little more, but still inadequate attention, and that is the effects of what amounts to a terms-of-trade shock to oil-importing economies on global financial stability. Sharply higher oil prices present oil-importing economies with a terms-of-trade shock, in that the prices of imports relative to those of exports increase suddenly. The import bill becomes larger over a short period of time, leading to deterioration in the current-account balance of international payments. Such deterioration has implications for the exchange rates of the currencies of the oil-importing economies. We have recently seen some significant movements in the exchange rates of a couple of Asian currencies that had to be stabilised by higher interest rates, attracting considerable attention from currency strategists and possibly currency players. It is still too early to tell how these episodes will play out. Hopefully, the accumulation of substantial foreign reserves in recent years, together with the restrictions on the availability of domestic currencies to speculators that have become popular since the Asian financial crisis of 1997-98, have lowered the probability that these recent movements will be magnified and become destabilising.
The terms-of-trade shock will also mean a relative shift in foreign reserves accumulation from the oil-importing economies to the oil-exporting economies. To the extent that the behaviours of the two groups of economies in foreign reserves management differ, the funding of the US external imbalance may become less (or more) reliable. This, coming at a time when there is increasing concern about the external imbalance and the willingness of Asian central banks to continue to fund it, may increase (or decrease) the potential for volatility in the foreign exchange and financial asset markets. I obviously do not know enough of the reserves management strategies of oil-exporting economies to take a definite view on the matter. It may be that the windfall oil revenues go into the hands of private-sector oil producers and exporters rather than the official sector. If so, it is even more difficult to assess the likely impact. But I draw attention to this viewpoint for what it is worth.
Joseph Yam
27 October 2005
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