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Energy subsidies weigh heavily on emerging markets

If you want another reason not to quickly put your money back into emerging markets, you should think about the cost of energy. The falling value of currencies, such as the Indonesian rupiah, the Turkish lira and the Indian rupee, has sharply increased energy bills and for many emerging market governments, it is worsening the already massive burden of subsidising fuel.

Almost everything has been blamed for the rout in the EM financial markets – the end of money-printing by the U.S. Federal Reserve, the slowing down of the Chinese economic motor and various political crises in Brazil, Turkey, Thailand and Ukraine. The one that tends to escape notice is the soaring cost of buying U.S. dollar-priced energy with depreciating EM currencies. Moreover, the cost of fuel to the consumer is heavily subsidized in many EM economies, notably those that are oil producers, such as Nigeria, Russia and the Arab states. In an effort to rein in the $30-billion (U.S.) annual bill for subsidizing fuel, the Indonesian goverment raised prices by 44 per cent in June last year but the collapse in the rupiah has eliminated much of the saving.

The International Energy Agency estimates the cost of fossil fuel subsidies worldwide to be greater than half a trillion dollars annually. Such a large distortion of markets tends to stimulate excessive demand for fuel and promotes inefficiency. However, it is the short-term effect on the current account of EM countries and the burden on government finances that is worrying the markets. As the Fed turns off the flow of cheap dollars, the EM countries are finding it hugely expensive to fund wasteful energy habits but it is not easy for governments to raise fuel prices, especially those politicians that have to court the popular vote.

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Nowhere is this more evident than in India where political parties are promising ever larger handouts to entice voters in national elections, due within the next two to three months. India has been spending between $20– and $30-billion per year capping the cost of diesel and cooking fuel for the rural poor and in an election-grabbing move last week, the ruling coalition government led by Prime Minister Manmohan Singh promised to boost the number of subsidized liquified petroleum gas (LPG) cylinders available to each household. The subsidy reduces the cost of bottled gas to a third of the market price and the total cost to the Indian exchequer is expected to be $800-million.

The emerging market countries are hamstrung by energy. According to the IMF, debt rating agencies and orthodox economics, the subsidies are a drag on government finances. They are wasteful, promote inefficiency and distort costs which in the end makes a country uncompetitive. However, so entrenched are the subsidies that their removal can provoke social unrest, already seen in Nigeria. Still, there are signs, such as in Indonesia, that some EM governments are touching the nettle, if not fully grasping it.

An upward surge in energy costs and higher interest rates would be harsh medicine for many emerging economies, enough to severely depress growth rates, even if civil unrest was avoided. It is not surprising that the EM governments are unenthusiastic. However without a conversion to market prices, we should expect worsening fiscal deficits, currency crises and stop-and-go economic growth – something we used to expect from developing countries, before they became emerging markets.

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About the Author

Carl Mortished is a Canadian financial journalist and freelance consultant based in the U.K. With a career spanning investment banking, journalism and consulting for global companies, he was for many years a financial writer and columnist for The Times of London. More

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