Is energy subsidy reform in an oil-exporting small economy beneficial to trade? Illustrations from Kuwait

Although pervasive, subsidies have long been accepted by economists as a generally inefficient, costly means of resource allocation that leads to wasteful consumption and distortion of international trade and local markets. Oil-exporting economies have adopted energy pricing reform since the collapse of the oil price in mid-2014, despite lingering fears that such efforts would hurt industries’ competitiveness internationally. The World Trade Organization (WTO), a proponent of subsidy reform, has advanced that had targeted effectuating subsidy reform through the use of trade rules.  Yet there is limited evidence on the linkages between trade and energy subsidy reform in the context of oil-exporting economies. This Insight gives a non-technical commentary of a paper which attempts to fill a gap in the literature by examining the impact of fossil fuel subsidy reform on trade (inflow and outflow) in an oil-producing, ‘almost’ small economy, focusing on the case of Kuwait. It employs a two-region economy-wide model with oligopoly behaviour to quantify the impact of Kuwaiti subsidy reform on trade. The model extends that of Shehabi (2017) by differentiating consumer- and industry-specific subsidy rates, and it also embodies unique elements of Kuwait’s economic structure (rigidities) and distortions in its industrial structure and labour market. The results show that the impacts of subsidy reform on trade are driven by existing idiosyncratic economic rigidities and distortions. Simulations clarify the fact that energy production subsidies have minimal effect on the international competitiveness of Kuwaiti non-energy sectors, due to the pervasiveness of oligopolies that sustain large markups and collusive pricing. As such, contrary to what the WTO’s polices suggest, the expansion of non-oil exports is constrained in its ability to moderate reform impacts in a low oil price environment due to institutional, political, and economic constraints. Yet with appropriate incentives, such dynamics could be considerably more effective—leading to potential expansion. Subsidy reforms have higher pro-trade effects if implemented in a low oil price environment because their negative effects are partially offset by efficiency gains and reduction in oligopoly markups. The analysis shows that in developing oil exporting economies characterized by pervasiveness of oligopolies, microeconomic reform can be a channel through which the pro-trade effects of energy subsidy reform can be achieved.  The results have great policy implications, including that organizations like the WTO should use benefits other than non-energy expansion to encourage oil economies to reform energy subsidies.

By: Manal Shehabi

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