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Gone (sand) fishing …

November 28, 2006

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I am going to be away from my desk for a few days, giving a talk on petrodollars (and petroeuros).   Posting will likely be rather sporadic. 

Talking about petrodollars (and petroeuros) to group that presumably knows far more about petrodollars (and petroeuros) than I do is rather intimidating.  

I suspect they needed an outside speaker because the folks who actually manage the world’s petrodollars don’t want to inadvertently reveal what they are doing with the money.  I, alas, don’t have any secrets to reveal.    I work with the (extremely incomplete) data collected by the US and the Bank of International Settlements.  (Reviewed in detail here; RGE subscription required)

I am not complaining though.  These kinds of talks help pay the bills.  And I am interested in hearing what folks in the GCC think about the dollar right now, and about the GCC’s peg to the dollar. 

The GCC’s aggregate current account surplus (around $200b) is only a bit smaller than China’s surplus.  And the GCC pegs to the dollar.  I suspect that creates some constraints.

Presumably one of the smaller central banks in the GCC – say the central bank of the UAE -- could shift some of its reserves out of the dollar without moving the dollar/ euro.  The big money in the UAE isn’t in the central bank in any case.   I am not so sure that the same argument works for the Saudis.  The Saudis have been adding to their reserves (SAMA foreign assets) at a rather impressive clip.  

I don’t think the oil exporters have quite as much of their fortune tied to the dollar as many East Asian central banks.   But I also expect the GCC countries have more exposure than say Russia or India – countries that presumably have only about half their reserves in dollars.   

I am also interested in learning a bit more about how folks inside the GCC view their peg to the dollar right now.   

The composition of ADIA and SAMA’s portfolio is a secret.  But my views on the GCC peg are not

I think the GCC’s dollar peg is an impediment to global adjustment.   More importantly, I don’t think the dollar peg creates an appropriate framework for monetary policy in the Gulf.   

Think of it this way: there are times when the oil exporters shouldn’t “import” the monetary policy of an “oil importer.”

1998 was on such time.  Oil prices were tanking even as the US was booming.   The GCC didn’t need a strong currency.  Or US interest rates.  

Interestingly, right now may be another time when importing the monetary policy of an oil importer may cause problems for oil exporters.  

The US may or may not be heading toward a recession.  But the US economy did slow in the second half, and the market now seems to expect that the Fed will lower rates next year.  The US needs the stimulus provided by a weaker dollar to offset a fall in the housing market. 

The GCC, by contrast, neither needs a weaker currency or looser monetary policy. 

Rather the opposite actually.   

Inflation has started to pick up in the Gulf as countries start to spend more of the oil windfall.   Sure, the GCC countries tend to import most goods and a lot of their labor, and that helps to hold inflation down.   But importing labor also puts pressure on the rental market – and bids up demand for a lot of services.    It isn’t a panacea.    Inflation in some GCC countries is well above inflation in the US (even if energy prices have been held down).  

And ironically, the bigger the boom, the higher inflation and the lower the real interest rate  …  Think of Spain – where a booming economy has pushed up inflation and resulted in lower real rates than in the rest of the Eurozone.  Then think of Spain on steroids.  That seems to be the current situation in Dubai and Qatar, the most frothy economies in the GCC.  

Much has been made of how the GCC countries have avoided the fiscal profligacy that marked the last oil boom.   Fiscal surpluses are huge.    

But fiscal policy is only half the macroeconomic policy equation.    Fiscal policy hasn’t been as contractionary as it could have been.   But monetary policy is increasingly stimulative.   I am not sure that is an ideal policy mix.   The Gulf may avoid a boom in social spending, but not a boom (and subsequent bust) in investment.

It certainly seems to me like the dollar’s recent weakness is coming at a particularly bad time for the GCC countries.   Big fiscal surpluses effectively kept most of the oil windfall out of the local economy.   The big surpluses acted as a form of sterilization.  So long as the government never sold many of the dollars the state oil company earned in global markets for local currency, the central bank didn’t have to withdraw the local currency from circulation by selling sterilization bills.   Fiscal sterilization (large surpluses) and growing government oil funds substituted for monetary sterilization and growing reserves. 

(one little footnote – the Saudi government has lots of dollars on deposit with the Saudi Monetary Agency … pushing up Saudi reserves.  But the mechanics are still different than in say China, where exporters convert dollars into RMB at the central bank and the central bank has to sell sterilization bills to withdraw the RMB from circulation)

But all signs indicate that most GCC countries are scaling back their “fiscal” sterilization as they ramp up investment and otherwise start to put more of their oil windfall to use domestically.   

There is nothing wrong with that.   If you are a country with a lot of oil – enough to last for several generations and oil’s long-term price is say $50 a barrel, there isn’t a strong case for keeping spending at the equivalent of $20 a barrel and saving $25 a barrel (assuming oil costs $5 to produce).   Particularly if a large fraction of the funds that are being saved have been parked in dollars – dollars that may not hold their value over time.

But more spending isn’t consistent with sustaining the real depreciation of the GCC currencies brought about with the dollar peg.   Keeping the GCC’s real rate low requires saving most of the oil windfall.    Spending even some it is already putting upward pressure on prices.    That pressure should continue – as both the weaker dollar (and higher import prices) and new investments in the pipeline put pressure on prices. 

There is an interesting contrast between the GCC and China.   Both after all peg to the dollar.   Both have large current account surpluses.   Both have currencies that have depreciated in real terms over the past few years, as the dollar has fallen against Europe.  

In China’s case, sustaining the real depreciation has required a set of policies that have locked up a lot of China’s savings in the banking system by restraining investment.   Martin Wolf has put it best: to turn the RMB’s nominal depreciation into a sustained real depreciation, China had to pursue a set of policies that pushed up national savings and kept the growth in investment below the growth in savings.     China’s banks are – as Denise Yam of Morgan Stanley has noted – now sitting on a huge amount of (RMB) cash.      

In the GCC’s case, sustaining the real depreciation also required a set of policies that raised national savings.   The GCC countries didn’t need to lock the country’s savings up in the banking system by restraining bank lending, as China did.   The government controlled most of the oil revenue directly and so long as it didn’t spend a large chunk of the oil windfall, it could raise national savings directly.   Rather than locking up savings in the banking system and leaving the banks no alternative but to lend to the central bank, the GCC countries locked up the oil windfall in offshore accounts.

At least they did.  They are slowly letting more of those funds flow into the local economy.   Just as every municipality in China wants to be the next Shanghai, there seem to be lots of cities in the Gulf (and on the Saudi side of the Red Sea) that hope to be the next Dubai.     

Monetary and exchange rate policy was – by chance – sort of restrictive in the Gulf in 2005.    The dollar rose from its 2004 lows, and the Fed was raising rates.  Fiscal policy was also fairly restrictive – only something like 1/10 of the oil windfall was spent in 2005.  But with the Fed on hold and the dollar sliding, monetary conditions in the gulf are no longer restrictive.   Particularly since high regional inflation rates imply low – and in some cases negative real rates.   Fiscal policy is also a lot less restrictive than it was.   The IMF estimates about 40% of the 2006 oil windfall will be spent.    In 2007, I suspect that the dollar peg will lead the GCC to import looser monetary policy than it should have, particularly as fiscal policy continues to be less restrictive.

There will be less fiscal sterilization.   And more – I suspect – inflationary pressure.    That is what has to happen in some sense.   A surge in the real price of oil shouldn’t lead to fall in the real value of the currencies of the biggest oil exporters.   And so long as the GCC pegs tightly to the dollar, the only mechanism for the real value of GCC currencies to rise is a pick up in domestic inflation.   

At least that is how it seems to one observer looking in from afar.  It may seem different up close.   And the people who matter on the ground may have an altogether different view. 

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