from Follow the Money

Iran, oil, dollar, euro

March 27, 2007

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Iran indicated that it plans to reduce the dollar share of its portfolio to below 20%..  Something tells me it might not want to shift into pounds – a fairly popular alternative to the dollar – right about now either.  And for that matter, if it has euros on deposit in London …

It also indicated that China is now paying for its Iranian oil in euros.    Interesting.   

That brings up a question that Steve Kyle raised sometime ago over at Angry Bear – one that I have been meaning to address for sometime.   Does it matter that oil is priced in dollars?    

Steve’s answer is basically no.    And I don’t really disagree.   I certainly don’t think that the fact that most countries pay for their oil imports in dollars implies that either oil importers or oil exporters should keep their savings in dollars – and that is what really matters.  But I want to introduce one small nuance to his argument. 

First, though, does the fact that oil is settled in dollars imply that oil imports and oil exporters need to hold a lot more dollars than they otherwise would?    My answer is the same as Steve’s answer.  No.   Not really.     Sure oil importers probably need to keep some dollars on hand for transaction purposes.   But that fact alone doesn’t explain the huge dollar reserve holdings of many central banks.

Indeed, suppose an oil-importer wanted to set aside some funds back in 2002 to pay for its 2007 oil imports.   Should it have kept those funds in dollars?  Or in Euros?   The answer is pretty clear.  A euro buys less oil now than it did in 2002.   But a dollar buys far less oil now than in 2002.   Oil rose relative to both the dollar and euro, but it rose by more v. the dollar.  An oil importer would be better off holding its saving in euro, and then converting its euros into dollars when it needed to settle its 2007 oil import bill. 

By the same token, should an oil-importer hold its savings in dollars just because it gets paid in dollars?   The answer is not necessarily.    An oil exporter may want to hold assets that match the currency composition of its future imports (if you import a lot from Europe, you can limit your exposure to exchange rate moves by holding euro-denominated assets), not the currency of payment for its exports.   Or an oil-exporter may want to hold assets whose value is expected to appreciate not depreciate.   Clearly, in a backward looking sense, any oil exporter that set aside some money in 2002 would be a lot better off it held its savings in euros rather than dollars.    And as Steve Kyle notes, the currency that oil exporters opt to hold matters a lot more than the currency that they get in exchange for their oil.

“What really matters is what denomination they choose to HOLD their wealth in. After all, if an oil exporter accepts dollars and then converts them to euros 10 seconds later in order to hold them in that form it is the euro that ends up stronger and the dollar that gets weaker. So what really matters to the value of the dollar is whether the central banks of oil exporters like to have a portfolio heavy in dollar assets or heavy in other currencies.” 

So why do I think the fact that oil is still primarily settled in dollars may still matter?

Well, in part because a lot of oil exporters (still) peg to the dollar.   That means that they don’t want to drive the dollar’s value down, because it implies driving their own currencies down.   And with oil back above $60, the dollar flirting with 1.34 and inflation rising in a lot of oil-exporting economies, the last thing say the Gulf needs is an even weaker dollar.   Or to hold steadfastly to their current pegs as the dollar slides.  Kuwait and the UAE increasingly recognize this; the Saudis, not so much. 

That at least raises the possibility that oil exporters – especially those big enough to have an impact on global markets – might find it difficult to sell the dollars they receive in exchange for their oil without moving the market.   And specifically without moving the market in ways that push their own currency – which is tied to the dollar down.   

This is presumably a particular concern during periods of dollar weakness.  If my theory is right, some oil exporters who are paid in dollars may conclude that they have to hold the dollars they get, because selling the dollars would weaken their own currency. 

China incidentally is in a similar position.  It doesn’t export oil.   But it does intervene primarily in the dollar/ RMB market, so in the first instance, it accumulates more dollars than euros.  Keeping its portfolio balanced consequently requires ongoing dollar sales.  And when the dollar is under pressure, it may opt not to sell.

At least that is one theory.  I don’t really have a way of testing it.  China doesn’t reveal the currency composition of its portfolio.   The Gulf states don’t either.    China reveals the growth in its external portfolio – though it increasingly tries to conceal the pace of its growth.   So too does the Gulf.    Central bank reserve growth is pretty easy to track, but the growth in oil investment funds isn’t.    That makes it hard to know precisely how fast official assets are growing, let alone if Gulf states refrain from selling the dollars they get from their oil during periods of dollar weakness. 

There is another intriguing possibility.   Central banks may act a bit differently than oil investment funds, and specifically care a lot more about the impact of their reserve portfolio on the exchange rate than investment funds.  That implies that the Saudis – who keep most of their oil revenues on deposit at their central bank – end up holding a lot of dollars, while Kuwait, Qatar and Abu Dhabi – all of whom give most of their oil revenue to their investment funds – don’t. 

Or put differently, the Saudis work to stabilize the dollars’ value v. the euro even though some of the pressure on the dollar is coming from the sale of dollars by others in the Gulf.  

Call it free-riding by oil investment funds on central banks.

I am pretty sure that the various institutions that manage the GCC’s oil wealth don’t coordinate.  Yet several are big enough to move global markets.  

And as the management of China’s foreign assets gets split among different institutions, some of the same issues arise.   The PBoC might find it compelled to increase its dollar allocation – or at least to avoid selling dollars for euros – to offset pressure on the dollar that comes in part from the State investment company.

At this stage, though, this is all pure speculation.  I have some suspicions.  But my suspicions go far beyond what I can document …

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