Monday, April 07, 2003

Petro Dollars or Petro Euros?

I have a mail from Maynard this morning asking me about seignorage on the dollar, and the importance of a dollar-euro switch. He also informs me that: "internet conspiracy theorists....claim that operation Iraqi Conquest is based on a fear of oil sellers switching to selling in euros rather than dollars". I have a number of comments. Firstly this area is a good deal outside my competence. On currency questions I normally limit myself to listening to what those who know more say, and citing those comments I feel are intelligent and to the point. In this sense I feel you cannot do better than Morgan Stanley's own Stephen L Jen. On the other hand, whilst I am sure conspiracies abound everywhere, I am equally convinced that few of them ever succeed in obtaining the results intended. Since the future is not ours to see, I find the whole idea absurd. Imagining, just for the moment, that the euro were a conspiracy, then it surely seems like one that is destined to fail. Or take the late 90's 'new economy boom': there seems plenty of evidence that consultants contrived to sell products they themselves didn't believe in. But I can hardly believe they intended to produce the market crash which was, in fact, the end product of their best endeavours.

In this sense I am deeply manichean: if there were to be a god, we would undoubtedly be a totally unexpected outcome of his or her endeavours. So following Occam and Einstein on the simplicity front: I am sure there may be conspiracies, but theoretically speaking their existence or otherwise is an entirely extra-to-requirements assumption. We have enough to think about by considering the repercusions of the activities of well intended men and women. Those in doubt should read Borges, and if you're still not convinced try his Argentinian colleague Roberto Arlt.

Now on the substance. Stephen Jen among others reminds us time and again that the Asian dollars are in fact more important than the petro ones - he estimates by a factor of ten to one. Secondly, bringing down the price of oil by bringing Iraqui oil on-line after the war would probably reduce the importance of the petro dollars even more. Thirdly, it seems to be a US Treasury mid-term objective to bring down the value of the dollar (among other reasons because of fears about deflation, but also to correct the current account deficit). None of this would seem to suggest that US strategic thinking is motivated by dollar seignorage arguments. Additionally the greatest threat on this front may well come from global central bank currency reserve holdings. Here is what Jen recently had to say on the issue

In light of the geopolitical developments in recent months, it is possible that one of the factors weakening the USD may have been a growing share of petrodollars being re-invested in non-USD assets. In this note, we revisit this issue, and conclude that re-direction of petrodollars is likely to have had a positive effect on EUR/USD, reflecting more the rising concerns about the USD and the nature of the geopolitical tensions, rather than the higher oil prices per se. However, this is not likely to have been a ‘dominant’ factor behind the descent in the USD in recent months but, more likely, only a modest USD-negative.

Tracking the petrodollars to help us think about the evolution of the G3 currencies is not new. In fact, we first analysed this issue back in October 1999, in ‘Tracking the Petrodollars’. While how petrodollars are re-invested is very important for the USD, the absence of data on these flows has always posed the most serious obstacle to us in reaching unambiguous conclusions. At the same time, the paucity of data has also fuelled many ‘conspiracy theories’ about how petrodollars may be redirected away from USD assets. In the various pieces of analysis we have conducted since then, and including this piece, we have only been able to draw tentative conclusions that are conditional on specific assumptions. Having said this, there are several aspects of the flow of petrodollars that are worth remarking on.

There is the argument that, in fear of funds being confiscated or frozen by the US, petrodollar owners have shied away from USD-assets, and that this has been a major factor driving the USD lower. We don’t find this argument convincing. First, there is a difference between investing through US-based funds and investing in US Dollar-assets. These investments in question could be shifted to off-shore accounts and still be invested in USD-assets. Further, suspicious investments would not be ‘off the hook’ just because they are not in USD-assets. Second, this argument presumes that most of the petrodollar investments are ‘suspicious’ in nature, and that the US is feared to indiscriminately freeze funds. Both of these presumptions are not reasonable, in our view.

There is no mystery to the 12% decline in the Fed’s major USD index since the beginning of 2002. Not only was the USD very over-valued, but the cyclical fundamentals of the global economy permitted the USD to correct in three mini-phases (‘USD Twin Deficits — USD No Longer Lord of the Currencies’ Stephen L Jen, 16 Jan 2003). We believe there are compelling ‘conventional’ justifications for the USD to correct. Even petrodollar owners themselves may have limited their holdings of USDs and increased their exposure to the EUR, not for fear of being investigated by the US intelligence services, but simply because they think the USD is overvalued. In other words, there could be nothing special or mysterious about petrodollars. This is not to say that such a re-direction away from USD-assets did not take place, but a redirection due to petrodollars was most likely of secondary importance, being only part of the general USD selling seen over the period.

Whatever the true story on petrodollars, they are not large enough to significantly move markets alone, in our view. Petrodollar receipts are large, but not that large. OPEC oil export revenues are estimated by the EIA (US Energy Information Administration) at US$179.6 billion for 2002. This amount is dwarfed by the total export receipts of the Asian countries (around US$1.6 trillion in 2001), and which are also predominantly denominated in USDs. Even though the sharp oil price increase could push total OPEC-10 export revenues above US$300 billion this year, a change in the re-investment pattern of Asian exporters is, on this basis, potentially much more important than that of the petrodollar owners. The Asian exporters and central banks divesting from USD-assets alone would be powerful enough to drive the USD weaker.

This is the ‘flow’ aspect of the discussion. There is also a ‘stock’ aspect we need to consider. Most Asian economies have been capital-surplus economies (indicated by running a current account surplus) in recent years, as have most of the OPEC-10 (according to OPEC estimates). Looking at cumulative current account (C/A) balances can give an indication of an economy’s cumulative gross foreign assets (a ‘stock’ concept). Cumulative C/A balances for the OPEC-10 over the period 1981-2001 are US$110.5 billion, while those of the Asian economies sum to US$1.9 trillion. Hence, this suggests that gross foreign assets held by Asian economies are likely far larger than those of the OPEC-10. The point here is that the Asian exporters and central banks deciding to raise the weighting of the EUR at the expense of the USD, because of the structural negative trend in the USD, would be a powerful enough USD-negative to dominate the decision by petrodollar owners over whether to do the same.
Source: Morgan Stanley Global Economic Forum

Which brings us to Europen government strategy. It is I suspect a widely held belief here in Europe that a significant part of contemporary American prosperity is based on the fact that the rest of the world is prepared to subsidise US consumption by holding dollar denominated assets. This, like most theories, is partly true. But only partly, and begs the real question as to why many in the world, including many Europeans, have been prepared to hold dollar denominatd assets. The reasons for this may be many and complex, and this is not the time to go into them in any depth, but suffice it to say that the performance of many of the leading US corporations, in comparison with the rather lacklustre showing of their European equivalents, in particular in the so-called 'new economy' sector (where, for example, are the European Amazons, Googles and Yahoos?) may offer some part of the explanation. The cart is again being put before the horse, and the relations of cause and effect reversed. America is not wealthy because it is powerful, but powerful because it is wealthy, and rich because of it's wealth creating capacity.

So what worries me most about the euro in this context is that its very existence may be based on an illusion, the illusion that runs along the lines of an 'if only we too could only get some of the additional seignorage action'. It is a moot point today whether the rise in the euro will encourage central banks worldwide to rebalance their currency holdings by accepting more euros. It is another moot point whether short term tendencies (like the fall of the dollar) will be reversed mid -term if the European economies cannot hold the weights to do the heavy lifting. It is a complete unfathomable whether any of the euro zone governments may or may not have been influenced, either individually or collectively, in their Iraq war allignments by the prospects of more favourable euro receptions in the third world. And it is the mootest point of all whether the rise in the euro/dollar rate that any such pro-euro sentiment might provoke would be beneficial or downright harmful mid-term for the European economies. Finally, and without prejudice to any of the above, it is extremely doubtful whether 'conspiracies' which have no idea if the end result of their intended actions would be beneficial or harmful for the 'conspirators' really deserve the name of conspiracy at all. Confederacy of Dunces sounds more like it.

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