MACROECONOMIC ANALYSIS OF HIGH OIL PRICES ON PAKISTAN’S

ECONOMY

Introduction: market conditions encouraged

Demand, supply and speculative factors, speculative funds to enter the market and

and their interrelationships have all led further push up prices in the short term

to a steady rise in oil prices until (ADB 2004). This trend affected the

2008.The low level of stocks in macroeconomic variables of Pakistan’s

industrial countries and their rebuilding economy negatively.

in a period of supply uncertainty also Pakistan - Energy Scenario:

contributed to increased demand. This Pakistan is a nation of over 158.17

was primarily because there was a high million peoplei and amongst the lowest

risk premium on oil, since supply from users (0.49 TOE/capita) of energy. This

main producers was considered unstable. is due to severe constraints on the

Geopolitical uncertainties and tight

i
Federal Bureau of Statistics, Government of
Pakistan, 2008
development of indigenous energy Middle East, and Northern Europe). This

resources. The country is heavily scenario makes more populated nations

dependent on imported energy resources. like Pakistan net importers of oil. An

Sectoral share of energy consumers was increase in oil price leads to increased

43.9% industrial, 27% transport, 21.1% import bills, which also affects other

domestic, 3.8% commercial, 2.1% macroeconomic fundamentals of the

agriculture and 2.1% other government economy.

usesii. Pakistan currently meets only Pakistan’s GDP growth has been rising

19.9% of its oil demand from indigenous during the last few years, with growth

production and as such imports 15.54 rate reaching 8.4 percent in 2004-05, 6.6

Mtoe of petroleum and petroleum percent in 2005-06, and a moderate

products during 2005-6. recovery to reach 7% in 2006-07. The

The total installed capacity of Pakistan’s energy sector has a direct link to the

power generation is 19521 MW economic development of a country. In

(Megawatt). This includes thermal line with the rising growth rate of GDP,

power plants in the public and private demand for energy has also grown

sectors; hydel and nuclear power stations rapidly. Per capita energy consumption

in the public sector. The thermal plants of the country is estimated at 14 million

are either Oil fired or Gas fired. Btu and the energy consumption has

Large amount of oil reserves today are grown at an annual average rate of 4.4

located in areas where consumption is percent from 1990-91 to 2005-06.

low due to lower populations (the

ii
Hydro Carbon Development Institute, Pakistan
Energy yearbook 2007.
Pakistan’s Oil Dependency: percentage change in energy

According to Malik (2008), a country’s consumption divided by percentage

vulnerability to oil shocks can be seen change in GDP).

through a number of indicators. Firstly, A decrease in energy intensity is

the oil self sufficiency index, which is considered as the most promising route

calculated as the difference between oil for reducing vulnerability to oil shocks

production and oil consumption divided (Bacon and Kojima 2006). For Pakistan,

by oil consumption. This ratio is this has remained more or less constant

negative for oil importers (with -1 being at about 0.9 in 2005-2006, showing that

the extreme value). Pakistan had a value there has not been much improvement in

of -0.79 in 2005-2006, indicating its high this area.

susceptibility to oil shocks. Secondly, Finally, the net oil imports in GDP

Vulnerability to rising oil prices also represent the magnitude of the direct

depends on the intensity with which oil effect of a price increase. Pakistan had a

is used. The intensity of oil use in energy value of -5.24 in 2005-2006.

consumption index measures the share Hamilton (2005) argues that a potential

of oil in an economy's primary energy macroeconomic effect of oil price is on

consumption. Pakistan had a value of the inflation rate as long run inflation

0.32 in 2005-2006, showing slight rate is governed by monetary policy, and

decrease from the past due to shift so ultimately it depends on how the

towards alternatives. Thirdly, Energy central bank responds to oil prices.

Intensity measures the energy intensity

for an entire economy (measured as

The Dynamics of Pakistan’s Energy consumed. Thus the net import bill

Economic Problems: consists of the 100% increase in price of

In Pakistan, household and industrial oil, in addition to the 19% increase in oil

demand for energy products, such as consumed.

kerosene and gasoline, is highly inelastic In Pakistan, major import cost in the

(Burney and Akhtar 1990).A rise in the energy sector is the cost of importing

price of oil by 100%, led to an increase (85%) oil and its products and these are

in demand of 19% over the period mainly used in the transport sector. The

between 2003 and 2007. This denotes difference between the consumption and

low price elasticity – the percentage the domestic production of oil adds to

change in quantity demanded/consumed, the import bill of Pakistan leading to a

divided by the percentage change in growing trade deficit. The Balance of

price- meaning the demand for oil in Payments of Pakistan has shown a

Pakistan is relatively inelastic to changes growing trade deficit, increasing from

in price. approximately $5 Billion in 2005 to over

$20 Billion as of 2008. This destabilizes

the macroeconomic fundamentals of the

nation.
Source: Hydrocarbon Development Institute of
Macroeconomic Model- Relation
Pakistan (2008)
between Oil Prices and Inflation
The low price elasticity tells us that as
The economic model used to explain the
prices rise there is limited or no effect on
effects of rising oil prices on the
demand, thereby increasing the
economy of Pakistan is as follows. As
monetary (Dollar) amount of quantity
oil prices increase so does inflation due who experience a loss in real income

to the rise in costs of imported oil, may consider seeking wage increases,

leading to a rise in production, which leads to higher production costs,

transportation, and all other energy and then into prices.

costs. High consumer inflation results in Price of Oil and Trade Deficit:

a drop of total consumption which in As the price of oil increases, the value of

turn slows down the economic growth. imports rise, causing a negative impact

This decline is due to lower on the trade deficit. Asian Development

discretionary income left with the Bank, ADB (2005) has estimated the

consumers to buy other goods during the impact of high oil prices on the net

period of high inflation. When inflation import bill. By assuming 75% rise in oil

gets out of control, central banks usually prices (approximately the increase in

tighten the money supply, which can prices between the start of 2005 and end

further shrink the economy. August), the estimated impact on the net

According to Kiani, Khaleeq (2007) import bill for Pakistan was almost -

higher oil prices directly raise consumer 4.17. Similarly, the percentage point

prices via the higher price of imported growth in exports that was needed to pay

goods and petroleum products in the for a 75% rise in the cost of imported oil

consumption basket. was potentially very large (i.e., 18 %).

Another implicit effect of higher oil The government failed to improve the

prices is that producers pass some part of export performance which also explains

their higher input (oil) costs to the price that the causality of such a scenario runs

of final goods. Moreover, consumers

from the macroeconomy to the oil The other effect of rising oil prices is

markets. that as oil prices go up, and as Pakistan

The main issue is the effect of rising is importing majority of its oil, there will

prices on the national economy and the be a rapid increase in the value of m

corresponding changes within the (imports), leading to an increased trade

economic model. deficit, hence lowering the trade balance,

Rising prices of oil have caused or creating a trade deficit which will

increased unanticipated inflation, and result in lower Y (GDP).

lower economic growth, with a negative The approach used here to measure and

impact on the economy. This can be quantify GDP is the expenditure method.

shown through a simple macroeconomic The whole economy is divided into 2

model of: sectors according to the official Federal

GDP = Y = C + I + G + (x-m), where Bureau of Statistics division in Pakistan;

C= consumption, I= investment Production Sector, and Service sector.

spending, G= Government Spending, x= Empirical Outcomes

exports, and m = imports. Price of Oil and National Income

As price of oil goes up, inflation Accounting

increases as price of every item in the Verifying the simplified analytical

basket of goods rises. The increased model mentioned above, one finds very

prices lead to lower discretionary similar results to what actually happened

incomes which leads to less C in Pakistan during the period when oil

(consumption), hence decreasing the prices rose exponentially. The numbers

total amount of Y (GDP). from the following table showing the

GDP (Y) of Pakistan, the total Y=C+I+G+(x-m), so Y= 120+32.35+

Consumption Expenditure I, Investment (16.05-29.5) = $138.9 Billion

(I) & Government Spending (G), and the With Investment and Government

net Exports (x-m) were used for spending (I+G)=32.35

analysis. In 2008 the value of m increased (high

oil prices), leading to a negative effect

on the growth of Y.

Unexpectedly the value of imports rose

to $40 Billion. The GDP rose but at a

decreasing rateY=129.78+35.46+

(16.05-40) = 140.65 ($BILLION)

With Investment and Government

spending (I+G) =35.46

Source: Federal Bureau of Statistics, Govt. of
GDP growth rate fell from 17.9% in
Pakistan (2008)
2005, to 4.1% in 2008. It is evident here
Increase in Value of Imports
that a rise in the oil price translated into
Here it is seen that the GDP has been
a growing trade deficit which is seen
steadily increasing at the given prices
above with the growth of imports
from year to year. Comparison between
(35.3%) being much higher than the
the balance of trade in 2007 and 2008
growth of exports (7.8%) between 2006
shows the rate at which the trade deficit
- 2008.
increased was (20.59-13.45)/13.45 =

53%. In 2007, it is seen that:

Oil Prices and GDP Growth Rate: This shows that a rise in the value of

So an increase in oil prices squeezed imports led to a fall in the growth rate of

income and demand. At a given Gross Domestic Product, in nominal

exchange rate, more domestic output terms. As oil is predominantly imported

was required to pay for the same volume in Pakistan, the rise in the price of oil,

of oil imports. This led to domestic increases the value of imports (m)

currency being depreciated in response leading to a negative impact on the

to induced payments deficits, which growth rate of national income(Y).

further decreased the purchasing power Linkage between Oil Prices, Inflation,

of domestic income over imported and lower GDP growth:

goods. As important trading partners Increased imported oil prices caused

were also likely to suffer income losses, inflation, as the costs of production,

slower growth of external demand storage, and distribution rose. Increased

aggravated these direct impacts. Higher inflation lowered the buying power of

oil prices also reduced aggregate supply, consumers in addition to lowering

since rising intermediate input costs discretionary income left (after buying

swept producers’ profits and made them more expensive energy) with households

cut back on output. Lower profits to spend on other goods. This led to

resulted in a decline in investment lower growth in consumption spending,

spending, which finally caused potential further weakening the economic outlook

output to fall over a long period, Malik of Pakistan. The following table shows

(2008). that although total consumption

spending did grow, the change in buying power of money, and increased

percentage terms declined in Pakistan. the energy costs for consumers and

producers, resulting in lower spending.

Effect 2. Lower spending has

contributed to the declining rate of

Source: Federal Bureau of Statistics, Govt. of consumption growth (C), lowering GDP
Pakistan (2008) growth rate further.
Proving that higher oil prices are
The above effects are illustrated below
leading to lower economic growth, as
from the actual data obtained.
lower growth in consumption (C) means
Effect 1
lower growth in GDP (Y). In addition to
Increased Imports (oil price) leading to a
lower consumption growth, higher
decreased trade balance or an increased
growth in imports (m) further
trade deficit as follows. Trade deficit
deteriorated the situation, as shown
was expected to reach $9-10 billion by
earlier.
the end of 2008 (Khan 2008). It is
Summarized Negative Affects of
interesting to note the similarity between
Rising Oil Prices on Pakistan:
the following two perceptions. The
So the high price of oil has had 2 major
Dutch disease concept says that in the
macroeconomic affects on the economy
long run a country’s dependence on its
of Pakistan.
natural resource exports diminishes its
Effect 1. Increased value of imports (m),
economic growth due to increased
led to decreased GDP growth rate.
imports and decreased exports. Similarly
Increased prices of imported oil also
in Pakistan’s case the high oil prices led
brought inflation which decreased
to high oil import costs resulting in played a significant role.

increased trade deficit and diminishing

Pakistani GDP. The literature reviewed

for Pakistan does not provide much

substantial evidence that high oil prices

increased the returns from the exporting

sectors and thereby enhanced GDP

Source: Federal Bureau of Statistics, Govt. of
growth. However, Malik (2008) suggests
Pakistan (2008)
reasons for a spur in GDP growth even
Effect 2
in the presence of high oil prices in
Increased imported energy prices have
Pakistan. One reason was that consumers
led to increased prices in Pakistan
had been shielded by limiting the direct
leading to increased inflation. Increased
pass through to final oil prices using
inflation decreased the discretionary
extensive fuel subsidies and strong
income of households, leading to
foreign reserve position at that time. In
decreased spending. Decreased
addition, the continued strong
discretionary spending resulted in slower
performance of the services sector had
consumption growth.
made contribution to the GDP outcome.

On the demand side it was the

consumption expenditure that had

proved to be the main source of growth

in GDP. The credit flow to private sector

in the form of consumer financing

 Source: Federal Bureau of Statistics, Govt. of
Source: Federal Bureau of Statistics, Govt. of
Pakistan (2008)
Pakistan (2008)
Price of Oil and Natural Gas –

Deductive Model:

A deductive model is seen, assuming

that both oil and gas are equally

accessible, substitutable and are normal

goods. As the oil price increases,

demand falls, keeping all other factors

Source: Federal Bureau of Statistics, Govt. of
constant. Then with lower prices of gas,
Pakistan (2008)
demand increases, keeping all other
Lower Consumption growth, and higher
things constant, the demand curve shifts
trade deficit resulted in decreasing
to the right. This shift normally leads to
economic growth depicted as follows.
increased prices of gas, but due to

government intervention with subsidies

for suppliers, the supply curve shifts to

the right, maintaining the equilibrium

point. This means that oil and gas can be

regarded as perfect substitutes, with Coal and Nuclear Options

prices of one going up, increasing the According to the US Department of

demand for the other. Energy, only 7.6 percent of Pakistan’s

energy supply in 2005 was coal.

Pakistan has coal reserves of 3,362 Most

and in 2004 used only 3.5 Most (Energy

Information Administration), which

would last over 950 years. By looking at

Source: Hydrocarbon Development Institute of
the amount of coal Pakistan has in
Pakistan (2008)
reserve and the amount that it actually
The above figures clearly validate the
uses, one can conclude that coal is
deductive model of oil and natural gas as
extremely underused. There is enormous
near perfect substitutes, where increase
potential for the use of coal in Pakistan
in oil price of 70% from 2004-2007, led
to produce electricity. Khan (2006)
to an increase in demand for gas of
acknowledges that Pakistan is behind the
48.8%, and decrease in oil demand of
rest of the world in coal based power
2.3%.
plants and needs to catch up quickly.
According to Mehta Ahmed (2006) “Gas
Coal is used to produce a majority of the
import pipelines can deliver energy at
electricity produced in India, the United
competitive prices in the near term to
Kingdom, and the United States, and
meet the demand of priority consumer
should be used to the same extent in
segments such as the residential,
Pakistan.
industrial and power sectors.”
This solution may seem costly at first, to release many pollutants and green

but further analysis leads to the house gases, contributing to

conclusion that it is very cost effective in environmental problems such as acid

the long run. There will be high initial rain, smog, and global warming. Dr.

cost of building and developing the Javaid Laghari, a professor of Electrical

plants. However, building these plants and Computer Engineering, insists in his

will create thousands of new jobs and article “Power Vision for Pakistan” that

help improve the country’s economy. these harmful effects of burning coal can

These plants will also save money be diminished. Clean coal technologies,

because they will reduce the amount of which minimize or eliminate impurities

oil that needs to be imported into and pollutants from coal, are being

Pakistan. The positives of increasing the developed and advanced around the

use of coal vastly outweigh the world.

negatives. In return for high initial costs, In Pakistan, nuclear power makes a

increasing the use of coal based power small contribution to total energy

will help solve Pakistan’s energy production and requirements, supplying

shortage, create thousands of new jobs, only 2.34% of the country's electricity.

save money on importing fuels, diversify Nuclear power represents an important

the energy mix and promote energy benefit to Pakistan, but to achieve this

independence. benefit requires co-operation between

The biggest concern with an increased the supply and demand side in

burning of coal is the damage that is overcoming problems which might

done to the environment. Coal is known inhibit nuclear power growth.

These problem areas for Pakistan balance of payments and the resulting

include: financing (in particular, foreign contraction of the economy. The use of

currency requirements), adequate local foreign exchange reserves and increased

industrial and engineering infrastructure, borrowing may give short term relief,

the need for a free and open nuclear but this is not a sustainable option.

market, access to advanced technology For net oil importers like Pakistan the

and an assured supply of nuclear fuel appropriate macroeconomic response to

and fuel cycle services. Ahmad (2008), higher oil prices would be to fine tune

points out that even after large-scale both fiscal and monetary policy to

development of indigenous energy accommodate, not resist, needed

resources, the energy import dependence adjustments in output and prices.

of Pakistan increases. If access to According to Malik (2008), the growth

advanced nuclear power reactors in demand for petroleum products in

becomes available to Pakistan, then Pakistan has been growing at a negative

nuclear power can make a sizable rate. The volume of imported oil has

contribution in meeting the future been steadily increasing at a negative

electricity needs, reducing stress on the rate, but the dramatic increase in the

international supplies of oil and gas with price of oil has led the value of those

concurrent benefits for the environment. imports to rise exponentially. The study

Macroeconomic Policy Implications further shows that as the rise in the price

As discussed earlier, the direct effect of of oil started in early 2003, Pakistan’s

high oil prices on Pakistan’s economy economy steadily grew at a rate of over

were felt through the worsening of the 6%. This negates the conventional
direction of the economic growth when Hsieh (2008) showed that, by applying a

price of oil rises. An upward trend in the model using simultaneous equations for

price of oil usually squeezes income, and Korea (oil importer) real output is

demand, leading to less consumption, positively associated with money supply,

and lower corporate earnings, leading to real deficit spending and real stock price

lower economic growth. From 2005, the and negatively associated with the real

economic growth rate has grown at a depreciation of the Won.

decreasing rate, citing the effects of the Depreciation in the local currency had its

rise in prices of imported oil as a own negative effects, as it resulted in

primary cause. lower returns, and net capital outflows,

Rising prices of imported oil increased as investing in a country where the

the amount of foreign exchange reserves currency was falling in value lead to

required to finance the purchase of the higher foreign exchange risks. Lower

oil. As the price went up, the foreign capital meant lower investment

exchange reserves decreased, and the spending, thus weakening the economy

value of debits rose on the current further. State Bank of Pakistan’s (SBP)

account of Pakistan’s trade balance, effort were required to eliminate

leading to a trade deficit. A very large mismatches between inflows and

trade deficit caused the value of the outflows i.e. purchasing when market

domestic currency to drop as a way to has excess foreign exchange inflows and

increase the competitiveness of local selling the same for oil payments.

exporters to offset the growing trade A study by Khan and Schimmelpfennig

deficit. (2005) points out that correlation

between an expansionary monetary macroeconomic stability of Pakistan,

policy and rising inflation is very strong. which is highly dependent on imported

This means increasing money supply oil. On the contrary macroeconomic

would result in inflation but lower spillovers of Pakistan’s existing fragile

unemployment also [according to the economy are seen as a major cause for

Phillips Curve]. The significance of this the level of economic disorder faced due

study here is that in the period preceding to high oil prices. Pakistan is oil-

the recent oil price crisis, Pakistan had intensive and less able to weather the

the largest credit expansion in the world. financial turmoil wrought by high oil-

Pakistan’s economy experienced an import costs. This further emphasizes the

average increase of 22% in broad money importance of diversifying Pakistan’s

and 30% in credit growth between 2004 energy mix.

and 2006. It is seen how increase in the price of a

Although expansionary monetary policy commodity that has a relatively inelastic

does aid inflation, the effects of a demand can disrupt the macroeconomic

growing money supply between 2004- fundamentals, such as the level of

2006 were minimal in raising inflation, the growth in consumption, the

inflationary pressures in Pakistan. value of imports, and the trade deficit. A

Conclusions and Recommendations: growing negative impact of these

The analysis of the price of oil and its indicators has led to slower economic

consequences for economic growth in growth in Pakistan. The major

Pakistan shows that the effects were consequences on the economy of

certainly disturbing for the Pakistan have been:

Increased value of imports (m) led to an alternatives to fossil fuels such as Oil

increased trade deficit, which has and Natural Gas exist in the form of

resulted in a decreased GDP growth rate. Solar Power, Wind Power, Bio-Diesel

Increased prices of imported oil have and Geo-Thermal Power, but require an

also brought Inflation which has enormous amount of capital investment.

decreased buying power of money, and An overall analysis of the framework for

increased the energy costs for consumers the most economic and least costly fuel

and producers resulting in lower mix for power generation in Pakistan

discretionary spending. needs to be reviewed by the government.

Lower discretionary spending has Such a framework has been presented by

contributed to the declining rate of Choudhary (2008) that builds upon the

consumption growth (C) lowering GDP indigenous availability, technical and

growth rate further. commercial feasibility, capital and fuel

The positive outcome in Pakistan has costs, environment impact, and

been the rapid development of Natural indigenous capabilities to handle various

Gas, as an alternative to imported oil. power generation technologies. It further

Natural Gas is produced domestically, argues that price distortions between

and this has kept the price of natural gas different categories of consumers should

significantly lower than the price of oil be removed and import of oil for power

in Pakistan. Pakistan is also eyeing a generation be considered only after

trilateral project known as Iran-Pakistan- exhausting the locally available options.

India gas pipeline, which would further For investor’s to have confidence in all

help Pakistan’s energy needs. Other energy sectors, a predictable and

transparent framework is essential. A have serious discrepancies, and so each

better investor climate will in turn segment of the power development plan

increase supply and help stabilize prices. needs to be verified based on practical

Within the framework of a national implementation. This will in turn have

energy policy, a number of specific consequences on revising the strategy to

measures to promote energy efficiency counter imported oil dependence of

and diversity will help in reducing Pakistan.

vulnerability to high oil prices (Asian There is also a need to rationalize

Development Bank 2005). The taxation/levies on petroleum products to

government must diversify the country’s help reduce the imbalance in the pattern

energy supply mix to reduce the risk of of consumption. It would result in

oil price fluctuations in the global energy predictable government revenues,

market. balanced consumption of petroleum

Energy conservation programs should be products and a decrease in import

applied. There is a need to seriously dependence. For the improvement of

promote efficiency improvement and balance of payment, Pakistan should

demand management of the energy make serious efforts to boost its exports

portfolio. to counter high oil payments.

In another interesting study by At the macro level, government policy

Choudhary (2008), it has been cannot completely eliminate the adverse

established that load forecasts and power impacts of high oil prices but appropriate

generation projections of Pakistan in the policy response can minimize it.

medium term development framework

"Overly contractionary monetary and delay the fall in real income necessitated

fiscal policies to contain inflationary by the increase in oil prices, stoke up

pressures could exacerbate the inflationary pressures and worsen the

recessionary income and unemployment impact of higher prices in the long run."

effects. On the other hand, expansionary (IEA 2004; p. 6)

monetary and fiscal policies may simply

_____________________________
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