from Follow the Money

Oil up, dollar down

October 26, 2007 12:52 pm (EST)

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Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

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Oil currently trades above $90.

It currently takes more than 1.43 dollars to buy a euro.   

The dollar isn’t just at a record low against the euro either.  It is weak against a host of currencies.  Even though the dollar remains quite strong relative to two key Asian currencies, the broad real dollar index is back where it was in the early 1990s. 

A hundred dollars bought about 5 barrels of oil at the end of 2001 (and around 110 euros).   A hundred dollars now just buys a single barrel and change, and about 70 euros.   Oil may be priced in dollars, buy anyone who set aside a bunch of dollars to assure their ability to pay for their oil import bill would be sorely disappointed.  

The falling dollar has another implication as well: a lot of oil-exporters -- those who are producing more than they need to cover their import bill -- have traded an appreciating asset (oil in the ground) for a depreciating asset (dollars in the bank).  

Yet a host of oil-exporting economies in the Gulf – Kuwait excepted – still seem determined to follow the dollar down.   Serhan Cevik of Morgan Stanley:

""There is one simple reason behind this intriguing case of exchange rate misalignment (not just in Saudi Arabia but also in the rest of the Gulf region) and that is the exchange rate regime pegged to the US dollar," the author writes."

Gulf inflation is already high, and looks set to get higher.   Real rates are close to zero in Saudi Arabia, and negative in many smaller economies.  They are set to turn even more negative.   All this adds to the current boom -- but carries with it large future risks. 

The IMF, though, doesn’t seem terribly concerned.    The IMF certainly hasn’t been willing to criticize the Gulf countries for their dollar pegs – even though inflationary real adjustment with negative real rates hardly seems like the kind of policy the IMF would endorse. 

 The IMF’s staff – in their Article IV report – pretty much endorsed the UAE’s dollar peg.   The IMF staff also indicated that the UAE’s real exchange rate was about right.   Paragraph 24 on p. 14 goes out of its way to argue that there is “no misalignment of the dirham” – despite some evidence of a “modest” undervaluation -- given the uncertainties of an oil-exporting economy.    

Really?  The UAE’s real exchange rate did appreciate in 2005 and 2006, as UAE inflation topped the inflation of its trading partners.   But that appreciation came after a real depreciation in 2003 and 2004.   The dollar fell even faster in 2003 than in 2007.    In real terms, the dirham is probably flat over the past five years.   In real terms, oil has soared.   If the IMF expects oil to remain far higher than in 2002, I am not sure why evaluating the real exchange rate of oil-exporting economies poses any particular difficulties. 

I think that the IMF’s real exchange rate model predicts that, over time, the real exchange rate of an oil-exporting economy will appreciate by about half as much as the real price of oil.    In dollar terms, oil is up by more than 300% relative to the end of 2000 -- and more than 400% from the end of 2001.    But most Gulf currencies have depreciated in real terms since the end of 2001.  This combination seems to suggest that the Gulf currencies – and especially the Saudi Riyal -- are quite undervalued, and will need to appreciate substantially in real terms over time.    

The IMF did note that the Saudi real exchange rate -- which has depreciated by about 20% since 2000 according to the latest IMF real exchange rate data – is moderately undervalued.     But the real undervaluation was so small that, in the eyes of the IMF, it was nothing that a bit of inflation couldn’t fix.    That after all is the implication of fiscal expansion and quasi-fiscal investment spending; both imply less fiscal sterilization.

Directors noted the staff view that the Saudi riyal appears to be moderately undervalued at present. Many saw this as a transitional phenomenon reflecting the positive terms-of-trade shock. Several other Directors considered that the riyal is broadly in line with fundamentals. ….  Further, they noted that any undervaluation of the real effective exchange rate can be expected to reverse in the near term as the external current account surplus declines in response to the authorities' expansionary fiscal stance and the investment programs that have been launched. Directors also considered that the current pegged exchange rate regime has served the economy well, although a few Directors were of the view that a more flexible exchange rate would help reduce fluctuations in the face of oil price volatility.

One of my habits -- noted by IMF uber-blogger Simon Johnson -- is to read the IMF's World Economic Outlook from back to front.   But I have other bad habits.  I also like to compare the WEO’s assessment of real exchange rates to the assessment in the IMF’s country reports. 

That comparison though produces a puzzle, at least in my mind.

Through the end of June, Canada’s real exchange rate has appreciated by around 35% since the end of 2000.  Relative to its value at the end of 2001, it has appreciated by even more 940%).   When the IMF adds more recent data to the IFS data series, it will show an even bigger real appreciation.  Canada’s dollar just hit a new high in nominal terms.   The IMF, in the WEO, noted that the Canadian dollar is fairly valued – presumably because Canada’s real appreciation has been matched by a large increase in the real price of its commodity exports. 

I can see – though with a bit of difficulty -- how the IMF could find the GCC’s real exchange rate is now fairly valued and the Canadian dollar is over-valued.   And I can easily see how the IMF could find the Canadian dollar is fairly valued and the GCC is under-valued.   But I cannot really see how the IMF can find that Canada's real exchange rate and the Gulf’s real exchange rate are both appropriate.  

Both export commodities.  Both have enjoyed a large increase in the real price of their exports.   One has experienced a substantial real appreciation.   The other has not.

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