Asia-Pacific Investment Report 2014 — The Window a Cheap Barrel Opens

The oil price collapse described in the Global Investment Outlook 2014 was, for most of the Asia-Pacific region, straightforwardly good news of a size that is easy to understate.

The mechanism is a terms-of-trade gain. An economy importing a large volume of oil pays less for the same quantity. The saving is a direct transfer from producing economies to consuming ones, and it requires no policy decision, no borrowing and no implementation.

Why this is the cheapest stimulus available:

• It arrives immediately, without legislation or administration.
• It requires no fiscal cost — unlike the investment programmes described in the Asia-Pacific Investment Report 2009, which had to be financed.
• It is distributed widely, reaching every household and firm that uses energy.
• And it improves the external position simultaneously, since the import bill falls.

The second and more consequential effect was on policy. Many economies in the region subsidised fuel — selling it domestically below world prices, at very large fiscal cost. These subsidies are widely understood to be poor policy and are extremely difficult to remove, because removal means a visible price rise that falls on everyone at once.

A collapsing world price changes that calculation completely. If the subsidy is removed while the underlying price is falling, the domestic price can stay flat or even decline while the subsidy disappears. The fiscal saving is captured and the political cost is largely avoided.

Several economies used the window, and the reforms achieved in this period were among the more consequential fiscal changes of the decade — achieved not because the politics improved but because a price movement created a temporary opening.

The year's third theme is divergence. The region's economies, which had moved broadly together for a decade, separated: one large economy slowing as its investment model matured, another pursuing aggressive reflation, and a group of importers benefiting from cheaper energy. "Asia" stopped being a usable single exposure.

The cheapest stimulus there is

The terms-of-trade mechanism is simple and its magnitude is routinely underestimated, so it is worth quantifying structurally.

The calculation: an economy importing oil equal to some share of its output, facing a price fall of roughly half, receives an annual saving equal to half that share. For a substantially import-dependent economy this is a meaningful fraction of GDP — comparable to a large fiscal stimulus, delivered without a single decision.

Where the gain goes, and why the timing differs:

• Households see it in fuel and transport costs. The response is fast for the spending, slower for the saving decision, since a fall assumed temporary is saved rather than spent.
• Firms see it in input and logistics costs, improving margins. Whether this passes to consumers, workers or shareholders depends on competitive conditions.
• Governments see it in lower subsidy costs where subsidies exist, and in lower inflation, which creates room for monetary easing that would otherwise be unavailable.

The monetary point deserves emphasis. Lower energy prices reduce headline inflation directly. For a central bank that had been constrained by inflation, this opens space to cut rates — so the terms-of-trade gain arrives with a monetary easing attached, compounding the effect.

The distributional consequence within the region was large, because it split cleanly:

• Large net importers received a substantial gain.
• Net exporters in the region experienced the opposite — deteriorating terms of trade, fiscal pressure and currency weakness.

The same price series was a windfall for one set of economies and a fiscal crisis for another. Any regional aggregate obscures this entirely, which is why the region stopped functioning as a single exposure.

The only moment a subsidy can be removed

The subsidy reform window is the report's most practically interesting finding, and the mechanism generalises to any administered price.

Why fuel subsidies persist despite being widely understood as poor policy:

• They are regressive. Benefits accrue in proportion to consumption, and wealthier households consume far more fuel — they own vehicles, larger homes and more appliances. A subsidy intended to help the poor delivers most of its value to the better-off.
• They are fiscally enormous, frequently exceeding health or education spending in the economies that maintain them.
• They encourage consumption of the subsidised good, which is environmentally perverse and increases import dependence.
• And they are open-ended. The cost rises with world prices, so the fiscal exposure is largest exactly when the budget is most stressed.

Why they persist anyway:

• Removal is visible, immediate and universal. Every consumer sees the price rise on the day.
• The benefit of removal is diffuse and delayed — better fiscal position, funds available for other spending, eventually.
• The beneficiaries are numerous and the reform has no organised constituency.
• And attempts at removal have historically produced serious unrest, which makes governments reasonably cautious.

This is the same concentrated-versus-diffuse structure as the rebalancing politics in the Asia-Pacific Investment Report 2012 — except here the losers are diffuse and numerous, which is if anything harder, since it is a mass rather than a lobby.

What a falling world price changes:

If the world price is falling faster than the subsidy is being withdrawn, the consumer price falls while the subsidy disappears. The reform's entire political cost is absorbed by the price movement.

The window is genuinely narrow. It requires the price to be falling, the government to be prepared, and the change to be implemented quickly. Several economies had reform plans ready and executed them within months, which is the difference between having a plan and having an opportunity.

The durable design lesson, adopted by several reformers, was to replace the subsidy with targeted cash transfers to lower-income households. This costs a fraction as much, since it does not subsidise wealthy consumers, and it is far easier to adjust later.

When a region stops being one thing

The divergence of 2014 is worth stating explicitly because it changed how the region should be analysed.

Through 2009–2013, the region's economies had moved broadly together, driven by common factors: developed-world demand, the stimulus and commodity cycle described in the Asia-Pacific Investment Report 2009, and the capital flows described in the 2010 report.

In 2014 the common drivers weakened and idiosyncratic ones dominated:

• The largest economy was slowing structurally as the investment-led model reached the limits set out in the Asia-Pacific Investment Report 2012, with a property cycle turning and credit growth being restrained.
• A large developed economy was pursuing aggressive reflation, per the Global Investment Outlook 2013 — a deliberate attempt to change expectations after two decades of flat prices.
• Commodity exporters faced deteriorating terms of trade and fiscal pressure.
• Net importers benefited from cheaper energy and, in several cases, from reform windows.
• And external funding vulnerability varied sharply, per the discrimination described in the Asia-Pacific Investment Report 2013.

The investment consequence:

• A regional index or aggregate exposure became substantially less informative, since it blends economies experiencing opposite shocks.
• Correlations within the region fell, which is genuinely useful — it makes intra-regional allocation a source of return rather than a source of duplicated exposure.
• And the analysis required becomes economy-specific, which is more work and is the actual state of the world.

The general point: a regional label is a hypothesis about common exposure, not a fact. It holds while common drivers dominate and stops holding when they do not. The 2014 divergence is the clearest date at which it stopped holding for this region, and the Asia-Pacific Investment Report 2016 develops the resulting framework.

Property, credit and a maturing model

The largest economy's slowdown deserves specific treatment because it was structural rather than cyclical, and the distinction determines what to expect afterwards.

A cyclical slowdown reverses. Demand falls, policy responds, demand returns, and the growth rate recovers to its previous level.

A structural slowdown does not, because the growth rate itself has changed. The economy is not underperforming its potential; its potential has moved.

The evidence for the structural reading:

• The catch-up growth sources were exhausting, per the middle-income analysis in the Asia-Pacific Investment Report 2012 — surplus rural labour absorbed, technology gap narrowed, capital deepening at diminishing returns.
• Demographics had turned, on the schedule that report describes.
• The investment share was at or past its ceiling, so further increases would generate progressively less output.
• And credit growth was being deliberately restrained, which reduces measured growth by design.

The property cycle's role: property had been both a savings vehicle for households, per the Asia-Pacific Investment Report 2010, and the collateral for the local government financing described in the 2009 report. A property slowdown therefore transmits to household wealth, local government finances, construction employment and bank collateral simultaneously — which is the concentration this archive repeatedly identifies, in one asset.

Why the policy response was measured rather than aggressive: the authorities appeared to accept slower growth as the cost of managing the credit and property adjustment. This is a deliberate trade — a faster response would have required more credit, which is the thing being restrained.

The Asia-Pacific Investment Report 2015 and 2016 cover how the adjustment proceeded, and the Global Investment Outlook 2015 covers the global consequences of the slowdown in commodity demand.

The other side of the transfer

The region's commodity exporters experienced 2014 as the inverse, and their adjustment is instructive because it exposes a fiscal design flaw that is common and avoidable.

The problem is that commodity revenue is volatile and public spending is not.

What typically happens during a boom:

• Revenue rises far above the long-run average, since both prices and volumes are elevated.
• The extra revenue is treated as available, and spending expands to use it — often on recurring commitments such as public sector wages, subsidies and transfers.
• The budget is balanced at boom prices, which looks prudent and is not, because the balancing price is far above the long-run average.
• And borrowing capacity expands too, since debt ratios look comfortable against boom-inflated output.

What happens when the price falls:

• Revenue collapses immediately.
• Spending cannot fall correspondingly, because most of it is recurring commitments that are politically and contractually hard to reverse.
• The deficit appears at once and is large.
• And it must be financed exactly when the currency is weakening and borrowing costs are rising, which is the procyclical bind the Global Investment Outlook 2013 describes for external borrowers.

The observable diagnostic is the fiscal breakeven price — the commodity price at which the budget balances. It is published by the IMF for major producers, free, and it is the single most informative number about a commodity exporter's fiscal resilience. A breakeven far above the long-run average price is a structural deficit that has been concealed by the cycle.

The design that avoids this was well understood before 2014 and adopted by a minority:

• A stabilisation fund receiving revenue above a reference price and releasing it below, which smooths spending across the cycle by construction.
• A fiscal rule based on a long-run reference price rather than the current one, so the budget is set on a conservative assumption and surpluses accumulate automatically.
• And separating recurring spending from capital spending, so a revenue fall reduces investment rather than wages — painful but reversible.

A commodity exporter's fiscal position during a boom tells you almost nothing. The breakeven price tells you everything, and it is published free.

The economies in the region that had built these mechanisms adjusted with far less disruption, which is the strongest available evidence for the design. Those that had not faced simultaneous fiscal, currency and growth pressure — the same correlated bind that a stabilisation fund exists to break.

What an allocator could act on

Size terms-of-trade effects explicitly. Oil imports as a share of output, multiplied by the price change, gives a transfer comparable to a large fiscal stimulus that requires no policy and no financing.

Note that an energy price fall arrives with monetary easing attached. Lower headline inflation creates room to cut rates that would not otherwise exist, compounding the direct effect.

Watch for reform windows opened by price movements. A falling world price is the only moment an administered price can be liberalised without a visible increase, and governments with prepared plans capture it within months.

Prefer targeted transfers to universal subsidies when assessing fiscal quality. A subsidy delivers most of its value to high-consumption households; the same objective costs a fraction as much when targeted.

Test whether a regional label still describes common exposure. It is a hypothesis, and 2014 is when it stopped holding for this region — a regional aggregate now blends economies receiving opposite shocks.

Distinguish structural from cyclical slowdowns. A cyclical one reverses and a structural one does not, and the difference determines whether weakness is an entry point or a new level.

What 2014 established

• A terms-of-trade gain is stimulus with no fiscal cost, arriving immediately and distributed widely.
• A falling world price is the only viable window for removing an administered price subsidy.
• Fuel subsidies are regressive and fiscally large, persisting because removal is visible and their cost is not.
• The region diverged, ending the period in which a regional aggregate was informative.
• The largest economy's slowdown was structural, so weakness was a new level rather than a cyclical entry point.