This article was first published in the February/March 2020 China edition of
Accounting and Business magazine.

Oil prices surged recently as markets feared a clash between the US and Iran. While they eventually settled lower as a serious confrontation looked less likely, risks have not gone away and a prolonged spike in oil prices is possible. In such a scenario, Asian economies are likely to be substantially hurt.

The Middle East remains in ferment, with Libya, Syria, Iraq and Yemen in the throes of worsening violence. The start of this year has seen tensions rise in Iran while last year’s missile attacks on Saudi Arabian oil fields led to the temporary shutdown of half of the country’s oil production. There is a growing risk of disruption in the Strait of Hormuz; since more than 30% of the world’s traded oil passes through that narrow body of water, any dislocation there would cause oil prices to go up dramatically.

Certainly, the growth of oil supplies, especially shale oil in the US, has helped to cap oil price surges in recent years. However, supplies are unlikely to grow as rapidly in 2020 as producers are finding it increasingly difficult to obtain the credit they need to expand. Hence a political shock is now more likely to cause oil prices to adjust up sharply.

For Asian economies, a sharp increase in oil prices could be damaging, undermining business confidence and creating higher costs of energy, transport and related inputs. Income would also be diverted to a narrow set of oil producers with a lower propensity to spend. Businesses are already anxious because of uncertainties over the US-China trade war, the fraught prospects for big economies and the disruptions caused by new technologies. An oil-price shock would deepen this nervousness and cause capital spending – a major determinant of Asian exports – to dive.

Second, higher oil prices could cause consumer prices to accelerate, forcing Asian central banks to tighten monetary policy just as weaker global growth was compromising their own economic expansions. Monetary authorities in Asia have generally been cutting policy rates, so anything that limits such support would be unwelcome.

Third, higher oil prices would also cause the external deficits of countries such as India and Indonesia to worsen. These countries depend on volatile portfolio capital flows to finance their deficits – but these could be compromised if investors become much more risk-averse and withdraw capital from emerging markets.  

Finally, countries such as India, Indonesia and Malaysia have fuel subsidies in place, and higher oil prices will increase the fiscal burden. Since these countries have rules on maximum size of budget deficits, a weaker fiscal position could force them to cut back in other areas.  

Economies with the policy toolkit to respond effectively, such as mainland China and Singapore, should be able to absorb such shocks. However, India, Indonesia and the Philippines could be more at risk given their dependence on volatile capital flows to finance their external deficits.

Manu Bhaskaran is CEO at Centennial Asia Advisors.