I tend to agree with Stephen Roach more often than naught.
But every now and again, I do disagree with him. And I am not convinced that petrodollars, are well, no longer petrodollars. That is, the oil windfall is being held in assets that are not denominated in dollars, as Roach argues:
"While sharply higher oil prices may have generated close to a $300 billion revenue windfall for Middle East oil producers, the reflow back into dollars through the petro-dollar effect is largely missing in action."
The array of statistics and anecdotes that Roach marshaled after his trip to Dubai and Abu Dhabi did not convince me that the Gulf States are putting their petrodollars at work at home and in Europe, and thus not financing the US.
Here is why. But first a warning -- this is a long, wonky, data-rich kind of post, and it does not even have a totally satisfying conclusion.
Yes, Gulf stock markets are up. Way up: "the capitalization of the Dubai and Abu Dhabi equity markets, combined, is now around US$200 billion -- up dramatically from less than $15 billion in 2000." But the fact that the capitalization of these markets has increased by $185 billion since 2000 doesn't mean that anything like $185 billion has actually flowed into those markets. The price of a stock is set by the marginal buyer; relatively small inflows into small and relatively thin markets can have a big impact on price. And Gulf real estate is booming too.
But the balance of payments data doesn't lie. A country's current account surplus is what is left over after all the investment in the local economy, including investment in real estate. A higher stock market generally does lead to higher imports - companies issue stock to finance new investment, and that new investment implies more imports. More domestic wealth leads to higher spending - something we in the US have taught the world. But even taking those effects into account, the oil states of the Middle East are expected to run a current account surplus of $220 billion. Add in Russia, and the oil exporters will run a current account surplus of well over $300 billion. And the IMF estimate may be on the low side: Saudi Arabia alone will have a surplus of $100 billion this year
That's $200 billion that has to be invested outside of the Middle East - whether in Asia, Europe or the US.
And given that Asia's current account remains in surplus and Europe's is basically in balance, it has to end up - one way or another - financing the US.
The easiest way would be for the countries in the Gulf to buy US assets directly. That clearly doesn't happen. The Patriot act and all. US data suggests that inflows from the oil exporting states of Asia are down in 2005 - even though there current account surplus is way up. And inflows in 2004 were not all that impressive to begin with. Roach is right that you sure won't find any evidence of oil flows in the TIC data. If petrodollars are flowing to the US, the funds clearly flow to the US indirectly.
And for the sake of simplicity, I am going to assume that the Gulf countries are not big investors in China. No doubt some Gulf money is flowing to China (just as some Chinese money is flowing into oil exporting states in central Asia). Abu Dhabi and Kuwait are interested in investing $1 billion in the Chinese banking system for example. But my general sense is that these flows are relatively small. China's central bank intermediates between Taiwanese and Korean savings and the US, turning direct investment by Asian companies in China (and hot money flows) into demand for US bonds. I don't think it intermediates petrodollars as well. That's an assumption.
That leaves two potential ways for the Gulf States to finance the US without appearing to finance the US.
One is that they are piling up dollars in various offshore accounts, investing dollars in various offshore (but dollar-denominated) hedge funds, and generally financing the US through dollar-based intermediaries. In all such cases, the oil exporters retain the dollar risk.
The other is that they are investing a ton of money in Europe - and buying lots of European assets denominated in various European currencies. And Europeans in turn are buying a ton of US assets, and consequently taking the dollar risk.
To make matters even more complicated, Europe doesn't just attract capital flows from the Middle East; it also attracts capital from the US. Remember, European equity markets have done rather well at points this year ...
So Europe's capital account can balance if say the eurozone is attracting $100 billion in capital flows from the US (say purchases of French and German stocks), while eurozone investors invest $100 billion in the US. Or it can balance if the eurozone is attracting $100 billion in capital flows from the US and an additional $100 billion in capital flows from the Middle East (and Russia) and invests $200 billion in the US. In the first scenario, Europe is not a net source of financing for the US; in the second it is.
So how can we try to guess at what is going? The best way I have thought of is to look at capital flows into and out of the eurozone. If the eurozone is acting as an intermediary between the oil exporters and the US, one would expect to see:
Strong inflows into the eurozone, and to see those inflows rise along with the current account surplus of the world's oil exporters. According to the IMF, the oil exporters (Middle East, Russia and Central Asia) current account surplus was around $100 billion in 2003, maybe $160 billion in 2004 and over $300 b in 2005. That implies a significant increase in inflows
And large outflows toward the US.
What does the data show?
1. There is some evidence that capital flows into Europe picked up in 2005 relative to 2004 - q2 2005 was particularly strong. The 12 month cumulative total for portfolio inflows into Europe is euro 558 billion - well up from the euro 325 total of 2003 and 2004. (Data from p. S60 of the ECB monthly report, "the monetary presentation of the Balance of Payments)
But much of the surge seems to be the result of very large flows into European equities in July, flows that may not be sustained. And at least some of of the equity inflows came from the US, not from the Middle East though I am open to hearing a different explanation. From Q4 2004 through Q3 2005, US data suggests that Americans bought $118 billion in foreign stocks -- a bit more than in the comparable period in 2003-04.
There does not seem to have been a comparable surge in interest in eurozone debt (see the chart on p. S60 of the ECB's monthly report) -- at least not the kind of sustained rise that one would expect if petroeuros were being invested in say German bunds. Yes, flows in Q2 were up, but data for the first two months of Q3 suggest a big fall off.
All in all, though, this dats is ambiguous: maybe the oil sheiks like European stocks ...
2. Alas, I don't see evidence of the second half of the "petroeuros get turned into investment in dollars inside Europe" story -- namely large net outflows from the Eurozone to the US.
European holdings of US equities increased by euro 5.5 billion, their holdings of debt by euro 35 billion, their direct investment in the US by 8 billion euro, and various bank loans to the US by euro 30 billion - for a total outflow from the eurozone to the US of euro 79 billion.
The problem: the net flow to the US is sort of small - as the US FDI in the eurozone was 16 billion euro, and US bank claims increased by 66 billion euros. That adds up to 82 billion euros - and it leaves out portfolio inflows. (Notes: I edited the preceding paragraphs slightly after posting them; and the data from S61 and S62 of the ECB bulletin).
There just doesn't seem to be evidence of big net flows from the eurozone to the US - even though those flows are needed for the global current account to balance if the oil sheiks are investing in Europe rather than the US.
The eurozone balance of payments data may be off, I may be reading the data wrong, or I may be looking in the wrong place - maybe the oil windfall is all going into Swiss francs. My search for the oil windfall is very much a work in progress.
But all in all, it seems hard to tell a tale of large net inflows from the oil exporters into the eurozone offset by large net outflows from the eurozone to the US. So I still suspect a decent chunk of this year's oil windfall is held in dollars, and probably intermediated in various ways through London and other offshore centers.
The Saudi monetary authorities assets alone have increased by $46 billion so far this year (the 2004 increase was $28b; the 2003 increase $18b). They have to invest those assets somewhere.
All that said, I don't totally disagree with Stephen Roach. Even if a large share of this year's oil windfall has been stashed away in offshore dollar denominated bank accounts and otherwise invested in dollar denominated assets, I would not bank on the same thing happening next year - or in 2007 for that matter. Rather I would expect the forces Roach identifies to take over.
"All too often, these days, I hear a knee-jerk reaction in describing non-US preferences for the dollar: "Where else are they going to put their money?" Go to the Middle East and see for yourself. Dollar-based assets are now only one item on the region's investment menu. ... There's always the possibility that the asset bubble(s) in the Middle East could burst -- sparking a flight to safety back into dollars. But the pin that pops that bubble would most likely be a sharp drop in oil prices -- a jolt that would also imply less oil revenues to recycle back into any asset class, including dollars. Notwithstanding the potential risks of such a post-bubble shakeout, the basic macro conclusion is inescapable: Dollar and Treasury bulls need to think twice before presuming that an energy shock begets an automatic surge of petro-dollars."
Over time, more petrodollars will be invested at home. Government spending will rise too, as budgets are revised to incorporate higher expected oil prices. So long as oil prices stabilize, that implies smaller current account surpluses. Indeed, given the huge gap between oil exporters 2005 oil revenues and their 2005 spending, I suspect spending will move up even if oil prices move down a bit in 2006.
And since I doubt many in the Gulf are totally wed to the dollar, I also suspect that they will want to diversify their portfolios as their portfolios get more dollar heavy - particularly if interest rate differentials start to fall a bit.
So I guess I disagree a bit with Mr. Gross as well - he is a bit more confident than I am that there will be plenty of spare savings outside the US looking for a home, and that will keep long-term US bond yields down despite the US savings shortfall ...
But all this analysis is based on looking for traces of the oil windfall as it moves through the global economy - so it relies far more on inference than I would like. I stand ready to change my mind in light of new evidence.
One last aside: the fact that the US data is not picking up any petrodollar flows casts doubt, at least in my mind, on arguments that dollar liquidity is shrinking. Those arguments rely heavily on the dollar balances the world's central banks hold at the Fed. And it is pretty clear that the oil exporters hold their dollars elsewhere - so the shift in reserve accumulation from Japan to the middle east has led to a big fall in recorded central bank inflows to the US, and consequently to a fall in recorded dollar liquidity.
But that is a separate post!