World Bank: Income distribution better than energy subsidies

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In a comprehensive analysis of growth in East Asia and the Pacific, the World Bank has warned that policy responses to distortions in food and energy markets may reduce funding for infrastructure, health and education.

The World Bank has reported a strong return to growth in East Asia and the Pacific region, despite China losing momentum as it seeks to curtail the spread of the Omicron variant of Covid-19. However, the bank also warns that there are real risks ahead and that some measures taken now may have damaging consequences for the future.

Strong return to growth
The region’s economy rebounded in the first half of 2022 despite a loss of momentum in China. The robust recovery of private consumption in the first half of 2022, after the Delta wave of Covid19 in the latter half of 2021, has been positive. At the same time, the sustained global demand for exports of manufactured goods and commodities has strengthened growth further, although there are signs this demand may be weakening.

The relatively limited tightening of fiscal and monetary policy has helped demand to continue to drive growth too but pressures to tighten policy are rising ahead of 2023, the report warns. As a result, most of the region is projected to grow faster and have lower inflation than other regions throughout the rest of this year before facing challenges next year.

Problems on the horizon
The World Bank report says that countries are facing a combination of external and self-created challenges. These include a slowing global economy that will dampen external demand, and an increasing debt burden exacerbated by increasing interest rates and depreciating exchange rates.

Debt and the high costs of debt, is a particular problem for developing nations as they work to build the infrastructure needed to end poverty and adapt to climate change. This was recently highlighted by the president of the African Development Bank.

Price distortions are a problem too
The report warns that alongside the global economic slowdown, there are real problems with distortionary domestic measures taken by several countries to deal with high inflation – particular in food and energy prices.

Inflation abroad is prompting an increase in interest rates, inducing capital outflows and exchange rate depreciation in the region’s countries, all of which are raising the burden of servicing debt. This in turn weakens the region’s ability to borrow to invest in new infrastructure.

Inflation is being dampened by price controls on food and fuel but the bank suggests that this distorts consumer and producer choices. Just as importantly, the subsidising of food and fuel prices reverses progress away from subsidies and generates unwanted outcomes.

Why subsidy policies matter

The World Bank report suggests that the muddying of price signals in food, fuel, and finance will inhibit the region’s development. In both food and fuel, governments must meet the triple goals of affordability, security, and sustainability. In both cases, the political imperative today is to prioritise affordability for consumers and firms. Keeping prices low will provide relief to consumers and producers and may be the only immediately feasible measures, but they come at a cost. That cost includes inhibiting switching of consumption to cheaper sources, as well as drawing tax-payer money away from expenditure on infrastructure, education and health.

In fuel in particular, the temporary crisis measures to keep prices low run contrary to the efforts in major countries to reduce fuel subsidies. At the same time, production of coal is being revived even in countries that were beginning to shut down coal mines. These actions could compromise emission reduction commitments as well as perpetuate dependence on imported fossil fuels and hence vulnerability to future energy price shocks.

Alternative measures may be preferable
Price controls supported by subsidies are motivated by the desire to protect consumers or to avoid disruptions in production. However, the report warns that support through income transfers would be preferable to price regulation because transfers do not distort choices and can be targeted to those most in need. It also avoids distorting the market in favour of high priced energy (notably gas and oil at present prices).

The report illustrates by looking at Thailand, where both fuel subsidies and cash transfers are mitigating the poverty impacts of price increases. Reducing poverty by one percentage point in Thailand would require THB11.2bn in fuel subsidies, five times more than the THB2.2bn of cash transfers needed to have the same effect.

As a result, the bank suggests that more targeted measures that offer support to vulnerable households and companies would be cheaper for governments and have less impact on future growth plans.