from Follow the Money

Oil and the dollar

July 20, 2007

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Oil is once again quite strong.    Last summers’ rally was driven in part by a rise the geopolitical risk premium.   This summers’ rally seems a product of both strong global growth and relatively restrained supply growth.    The latest IEA report certainly seemed to suggest that high oil prices are here to stay absent a lot more investment in either oil or renewables.

The dollar is once again quite weak.  It is now very weak against almost all the G-10 currencies.  Every day it seems that Bloomberg has a new headline indicating that some currency – the pound, the euro, the Australian dollar, the New Zealand dollar  – has hit a multiyear high against the dollar.   The yen is the obvious exception: According to Mitsubishi UFJ securities, the yen is now weaker in real terms than in was before the Plaza accord.

The dollar isn’t weak against most emerging economies – and it isn’t hard to figure out why.   I smile when I read that the dollar floats.   It is true that the US doesn’t intervene in the market.   But that doesn’t mean the dollar floats – not when other central banks intervene like mad.   Right now, the dollar floats v about half the world.    That matters.  A growing fraction of US trade is with those countries that do not let their currencies move (by much) against the dollar –

It certainly seems though that neither high oil prices nor the weak dollar are attracting as much attention the second time around.  Back in 2004, the magazine cover indicator was screaming red – as all sorts of publications did big stories on dollar weakness.   Not now.   And it certainly seems like the risks stemming from high oil prices were a much bigger topic of discussion back in 2004 – and in the summer of 2006 – than they are now.   Now there seems to be more talk about sub-prime, private equity and the Dow … 

Tim Duy is right.   The longer the US economy sort of absorbs various shocks – I say sort of because housing clearly has reduced the pace of US growth recently even if it hasn’t slowed the stock market – the less attention certain shocks get.    Financial markets have come to expect that central banks will finance the US when private markets don’t want to – so they expect (correctly, at least so far) that dollar weakness won’t push up US rates, at least not by much.   And if the US absorbed the last oil shock, why won't it be able to absorb the current shock? 

Still, there are some differences between the current strong oil/ weak dollar combination and the strong (tho not nearly as strong as now) oil/ weak dollar combination of late 2004 -- or for that matter, the strong oil/ strong dollar combination of much of 2005.

For one thing, a lot more voices argue that it no longer makes sense for the oil-exporting economies to peg to the dollar.  The Morgan Stanley currency team – or at least Serhan Cevik – notes: “pegged exchange rate regimes in the Middle East have led to even greater currency misalignments and therefore come under more pressure. We see no valid justification for delaying currency revaluation.”   

For another, Europe was in the doldrums in 2004.   Now it is doing reasonably well.  That may not be an accident. 

While oil has gone up by a factor of between 3 and 4 against the dollar since late 2001 (when brent traded at $19 a barrel/ 21 euros to the barrel), it has gone up by only a factor of between 2 and 3 against the euro or the pound.    That helps.   As does the fact that Europe’s economy is far more energy efficient than the US economy.  I agree with Paul De Grauwe.  The discussion of structural reform shouldn’t just focus on labor market rigidities; other kinds of rigidities matter too.    The US capital structure – think of a dispersed housing far from mass transit/ many workplaces and an automobile fleet that is biased toward bigger, heavier and less fuel-efficient vehicles – makes it a bit harder for the US to adjust to an energy shock.

Then throw in the fact that Europe simply sells a lot more goods – and I mean a lot – to the oil exporters, and well the US might have a bit of a problem.   Europe sells ten times more stuff than the US to Norway, Russia, Algeria and Libya.    It only sells two times more stuff to Saudi Arabia and Kuwait – but even that number is overstated.    Europe accounts for 34% of the UAE’s imports, and the US only accounts for 1.5% (2005 data) – and Dubai is a big transshipment hub for other parts of the Gulf.    Some European exports to Dubai are re-exported, and there aren’t any US exports to Dubai to speak of.    

At least the US does well in Venezuela, and OK in Nigeria.

Hat tip Claus Vistesen.  I never would have found the ECB’s useful data (see Table 3 on p. 78) without his help. 

The oil exporters almost certainly still buy more US financial assets than European financial assets.   If you look at the net flow of oil from oil-exporting economies to oil-importing economies, the US and Europe both account for a bit less than 1/3 of net oil imports (the US uses more oil than Europe, but it also produces more oil) and Asia accounts for a bit over a third.

If you look at the net financial flow from oil exporting economies to oil-importing economies, the US certainly accounts for well over a third of the net flow, and Asia accounts for far less than a third.    That incidentally is why there is huge potential pent-up demand for an Asian reserve currency that yields more than the yen … 

Norway exports a lot more oil than most realize – and it saves most of the resulting oil revenues, so it has a huge financial surplus.  And among the oil exporters, it probably puts the least into dollars – only about 1/3.    Russia chalks in at about 50% (unless it has diversified some more).  

The big Gulf investment funds are harder to track.  ADIA likes emerging economies and Asia, and it is big.  But at least in 2006, it also preferred US treasuries to bunds and JGBs.   KIA likes European equities.  DIC has more assets in Europe than it wants, but it is small, and mostly plays with borrowed money.     Some of the big Gulf investment funds may be putting only 50% of their funds in dollars – and the Emirates, Qatar and Kuwait account for about ½ of the gulf’s current account surplus.

Saudi Arabia has the other half, and it doesn’t have an investment fund.  The Saudis are super-secretive. I would guess that SAMA has a higher dollar share in its foreign assets than the big Gulf investment funds, though perhaps a bit less than the 90% dollar share of UAE’s central bank (there are hints that the UAE wants to go lower; in general, Gulf central banks generally hold more dollars than Gulf sovereign wealth funds). 

Venezuela has reduced the dollar share of its reserves, but not by all that much –  80% of its reserves are in dollars.  Or perhaps were in dollars – who knows what has happened since December.   Some of the African oil exporters also have a lot of their reserves in dollars.  I am thinking of say Nigeria, but countries like Algeria and Libya that sell almost all their oil to Europe still seem to hold a decent share of their reserves in dollars.

Put it all together, and well, the US still likely gets a substantial financial inflow from the oil exporters – or rather the US sells a lot of financial assets to Europeans managing dollars for the oil exporting economies. Lots of petro-savings are in dollars but not in the US – but they still support the dollar and allow European intermediaries to buy lots of US assets without taking the exchange rate risk. 

But relative to say 2004 or even 2005, the oil exporters are spending and investing a lot more, which means that they are importing a lot more – and thus spending a lot more on European goods.   

And relative to 2004 or 2005, I suspect that the oil exporters are putting a somewhat smaller share of their savings into dollars.   Russia is the most obvious example – it lowered the dollar share of its reserves from around 70% to 50% or less.   And some of the Gulf countries likely have been paring their exposure to the dollar as well –

Though if they are investing in Asia, well, they are just supporting Asian reserve growth, and letting Asian central banks take on the burden of financing the US.  Someone is still buying.   The Fed’s custodial holdings are up $20b or so in the first three weeks of July, and almost all the inflows are going to Treasuries, not Agencies.  And today at least, the central banks seem to have had some company in the Treasury market …  

Update: Richard Berner's thoughts on this subject; he thinks OPEC -- and specifically the Gulf -- cuts supply to try to increase dollar prices to try to increase dollar revenues in the face of dollar weakness.    And he also hints that diversification by oil-exporters may be contributing to dollar weakness.   That sounds like a vicious circle.  Maybe the Gulf should see what happens if they stopped pegging to the dollar instead.  

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