Little choice but to reduce oil subsidies

Hardev Kaur New Straits Times

Oil prices are hitting record highs.

In New York, the price of crude oil for September delivery reached a high of US$47.45 a barrel. Future prices are also higher by $10 (RM38) a barrel since the end of June which means the market expects the price of oil to remain high in the months to come.

This should be good news for producers as it means increased revenues for them. But they are not jumping with joy as they are also consumers and it means higher costs. This has adverse impact on inflation and economic growth. Governments, from both producing and consuming countries, have over the years tried to stabilize the price so as to avoid fluctuations in the domestic market and avoid disruptions as well as to check inflationary pressures.

Malaysia is no exception. The government had in the 1980s introduced the automatic pricing formula to determine the price of petroleum at the pump. In addition, taxes and subsidies have been used as stabilizing factors. But this cannot go on indefinitely. Government resources are limited and there is a need to take into account requirements of the less fortunate, including provision of health and education facilities.

The government spends some RM3 billion on petroleum subsidies alone. This is in addition to tax rebates. The cost to the government as a result of the subsidy and tax rebates has been rising steadily. In the first six months of this year alone the revenue foregone, due to petroleum subsidy and tax rebate, was in the region of RM1.4 billion. It was RM3.6 billion in 1999.

Undoubtedly, this has ensured price stability. And Malaysians have come to expect that the government will continue to cushion them from rising world crude prices and fluctuations. The argument often used is that Malaysia is an oil producer and the increased oil prices benefit the country and that this should be passed on to the consumers.

This has been done over the years. Due to the subsidy and tax rebates offered, Malaysia's pump prices are among the lowest in the region and prices have remained stable with no violent fluctuations.

For example, the pump price of petrol in Malaysia in June was RM1.37 per liter, in Singapore it was RM3.26 and in Thailand RM1.74. Similarly the price of diesel in Malaysia in June was 78.1 sen per liter, in Thailand it was RM1.39 per liter and in Singapore RM1.81 per liter.

In June, the government's subsidy for a liter of diesel was 37.18 sen while that for petrol was RM1.04. The lower prices, compared to those in neighboring countries, lead to "leakages" and could encourage smuggling. Motorists from neighboring countries drive into the border towns, fill up and drive back home. It appears that Malaysia is subsidizing foreign consumers.

Even domestically the benefits of the subsidy accrue, among others, to the motorists, many of whom are affluent and least need it. Those in the rural areas, the farmers and the fishermen do not derive the full benefits. It is thus timely for the government to review the subsidy and ensure that it benefits those who need and deserve it most. There could be differentiation between the needs of the commercial and retail sectors, for example.

But this has to be very carefully monitored and managed. This is even more critical due to concerns that the removal or reduction of oil subsidies will fuel inflation. The fact remains that transport operators and the retail businesses will take advantage of higher fuel prices even though the oil price may contribute to only a very small portion of their total cost. But the increase in transportation charges will have far-reaching impact on a multitude of economic activities.

As for its impact on economic growth, it is estimated that every US$10 increase in oil price could result in a 0.3 percent decline in Malaysia's Gross Domestic Product (GDP). The International Energy Agency estimates that if oil prices remain at current levels for a year, Thailand's GDP would be cut by 1.8 percent, the Philippines by 1.6 percent and India by one percent. And according to the Asian Development Bank, Singapore would lose about 0.4 percent of its GDP.

If prices remain above $40 a barrel until the end of next year, inflation in Asia will rise over one percent and real income will fall by 0.8 percent.

In the 1980s, crude prices were generally stable and there was not much of a problem. But times have changed and so have the oil markets. The new situation calls for a review and a relook at the subsidy. In fact in the ongoing world trade negotiations there is increased pressure for countries to remove subsidies.

Prime Minister Abdullah Ahmad Badawi pointed out that "when the prices go up, the subsidy element will get bigger and bigger". And this has an impact on government finances as there is an immediate increase in cost (to the government) due to the subsidy.

Since this will affect the government's ability to balance the books, it has little choice but to review all subsidies, which have risen to a staggering RM9 billion from RM1.5 billion in 1984. In the interest of fiscal consolidation, the government had signaled earlier this year that such a huge subsidy was becoming unsustainable, depleting the public coffers and reducing the amount of funds available for essential development programs. The government may have no other choice but to take an early decision of removing the subsidy and keeping inflation in check.