Brad Setser

Brad Setser: Follow the Money

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And the money keeps rolling in …

by Brad Setser
July 27, 2006

Russia’s reserves are up $12.3b in the first three weeks of July.    Expect a $15b increase this month.  I like to check on Russia because it reports its reserve growth on a regular basis (unlike some; the Saudis haven’t released their end June data) and because it has a ton of oil and gas.   So it is decent proxy for the growth in oil state foreign assets.  Reserve growth is the sum of the current account and capital account, and Russia does not attract private inflows.  But let's asume the current accout explains the entire $15b expected July increase.

Russia accounts for roughly a quarter of the total production (around 40 mbd) of the main oil exporting regions and countries.   The US and China obviously produce some oil of their own, but they are equally obviously net importers of oil.   Russian exports are substantially lower than its production, but it also exports a lot of gas.   So it isn’t a bad proxy for the oil exporting world. 

Multiplying Russian reserve growth by four consequently generates one estimate for the increase in the foreign assets of the big oil exporters.    $60 billion is real money.    Some of it shows up in central bank reserves, some of it is hidden in the offshore accounts of the big state oil companies, some shows up in various countries (non-reserve) oil investment funds and some is hidden in offshore accounts of other kinds. 

There is another way to get a $60b estimate.    Assume that the oil states are spending producing 40 mbd for export, selling that oil at $75 and spending $25.   $25 is actually about right for spending – budgets haven’t been adjusted up.     Some spend more, but some still spend less.   40 mbd*30 days*$50 net savings per barrel = $60b a month.

How did I get 40 mbd in oil exports?  From the supply and demand data in this IEA report, I calculated that Russia and Central Asia (the former Soviet Union) exports a bit over 8 mbd, the Middle East and Latin America (OPEC+non-OPEC Middle East + non-OPEC Latin America) export around 29 mbd and Africa produces 4.1 mbd – and probably exports a good chunk of it (I didn’t find African consumption numbers).  It works out to around 40 mbd. 

And that leaves out Norway.

$60b a month for these countries may be a slight overestimate.   But $50b a month certainly seems realistic.    

Either sum dwarfs China’s reserve growth.   Though the fact that China is adding $20b to its reserves a month and running a $15b a month current account surplus even as its oil import bill soars is a big part of the global story.  But that is a topic for another post.

Right now, the flow of savings from oil states to the world (and one assumes, from oil states to the US via various intermediaries) dominates the global flow of capital.  

I suspect Martin Wolf is right: the size of the oil surplus has (temporarily) increased the size of the sustainable US current account deficit.

And I suspect these oil-state flows also have something to do with London’s emergence as the global financial center par excellence.   London is physically a lot closer to the big oil exporters than New York.   It doesn’t have all of the United States political baggage.  And the UK never has worried very much about taxing oil money moving through London …

24 Comments

  • Posted by Dave Chiang

    Hi Brad,

    As I have previously mentioned, there is an economics-textbook myth that foreign-exchange rates are determined by supply and demand based on market fundamentals. Economics tends to dismiss socio-political factors that shape market fundamentals that affect supply and demand. The current international finance architecture is based on the US dollar as the dominant reserve currency, which now accounts for 68 percent of global currency reserves, up from 51 percent a decade ago.

    Ever since 1971, when US president Richard Nixon took the dollar off the gold standard (at $35 per ounce) that had been agreed to at the Bretton Woods Conference at the end of World War II, the dollar has been a global monetary instrument that the United States, and only the United States, can produce by fiat. The dollar, now a fiat currency, remains at a trade-weighted high despite record US current-account deficits and the status of the US as the leading debtor nation.

    World trade is now a game in which the US produces dollars and the rest of the world produces things that dollars can buy. The world’s interlinked economies no longer trade to capture a comparative advantage; they compete in exports to capture needed dollars to service dollar-denominated foreign debts and to accumulate dollar reserves to sustain the exchange value of their domestic currencies.

    This phenomenon is known as US dollar hegemony, which is created by the geopolitically constructed peculiarity that critical commodities, most notably oil, are denominated in dollars. Everyone accepts dollars because dollars can buy oil. The recycling of petro-dollars is the price the US has extracted from oil-producing countries for US tolerance of the oil-exporting cartel since 1973. By definition, dollar reserves must be invested in US assets, creating a capital-accounts surplus for the US economy.

    Regards,

  • Posted by Scott Peterson

    Dave,
    I agree with you with one quibble; in you last sentence I think the correct statement would be that “dollar reserves must be invested in dollar denominated assets”. For example, Eurodollar bonds could be purchased.

  • Posted by Dave Chiang

    Hi Scott,

    Thanks for the correction. I should have stated that “dollar reserves must be invested in only dollar denominated assets”. Due to US Dollar hegemony, the monetary value of the US dollar has become detached from economic fundamentals of the US economy. In order to act as consumer of last resort for the whole world, the US economy has been pushed into a debt bubble that thrives on conspicuous consumption and Enron-style fraudulent accounting.

    There is an urgent need to restructure the global finance architecture to return to exchange rates based on purchasing-power parity, and to reorient the world trading system toward true comparative advantage based on global full employment with rising wages and living standards. The key starting point is to focus on the hegemony of the US dollar.

    A new global finance architecture is required. The starting point is for the major exporting nations each to unilaterally require that all its exports be payable only in its currency, so that the global finance architecture will turn into a multi-currency regime overnight. There would be no need for reserve currencies and exchange rates would reflect market fundamentals of world trade. However, it is extremely unlikely that the Washington Consensus and Wall Street will agree to any structural shift of global economic influence.

    Regards,

  • Posted by Guest

    Dollar Hegemony

    By

    Henry C K Liu

    (Originally published as [US Dollar Hegemony has to go] in AToL on April 11. 2002)

    There is an economics-textbook myth that foreign-exchange rates are determined by supply and demand based on market fundamentals. Economics tends to dismiss socio-political factors that shape market fundamentals that affect supply and demand.

    The current international finance architecture is based on the US dollar as the dominant reserve currency, which now accounts for 68 percent of global currency reserves, up from 51 percent a decade ago. Yet in 2000, the US share of global exports (US$781.1 billon out of a world total of $6.2 trillion) was only 12.3 percent and its share of global imports ($1.257 trillion out of a world total of $6.65 trillion) was 18.9 percent. World merchandise exports per capita amounted to $1,094 in 2000, while 30 percent of the world’s population lived on less than $1 a day, about one-third of per capita export value.

    Ever since 1971, when US president Richard Nixon took the dollar off the gold standard (at $35 per ounce) that had been agreed to at the Bretton Woods Conference at the end of World War II, the dollar has been a global monetary instrument that the United States, and only the United States, can produce by fiat. The dollar, now a fiat currency, is at a 16-year trade-weighted high despite record US current-account deficits and the status of the US as the leading debtor nation. The US national debt as of April 4 was $6.021 trillion against a gross domestic product (GDP) of $9 trillion.

    World trade is now a game in which the US produces dollars and the rest of the world produces things that dollars can buy. The world’s interlinked economies no longer trade to capture a comparative advantage; they compete in exports to capture needed dollars to service dollar-denominated foreign debts and to accumulate dollar reserves to sustain the exchange value of their domestic currencies. To prevent speculative and manipulative attacks on their currencies, the world’s central banks must acquire and hold dollar reserves in corresponding amounts to their currencies in circulation. The higher the market pressure to devalue a particular currency, the more dollar reserves its central bank must hold. This creates a built-in support for a strong dollar that in turn forces the world’s central banks to acquire and hold more dollar reserves, making it stronger. This phenomenon is known as dollar hegemony, which is created by the geopolitically constructed peculiarity that critical commodities, most notably oil, are denominated in dollars. Everyone accepts dollars because dollars can buy oil. The recycling of petro-dollars is the price the US has extracted from oil-producing countries for US tolerance of the oil-exporting cartel since 1973.

  • Posted by Guest

    Dave, shouldn’t you be giving credit to Liu in your post?

  • Posted by Anonymous

    Dave may be busy at the moment consulting with Doris Kearns.

  • Posted by MrBill

    “And I suspect these oil-state flows also have something to do with London’s emergence as the global financial center par excellence. London is physically a lot closer to the big oil exporters than New York. It doesn’t have all of the United States political baggage. And the UK never has worried very much about taxing oil money moving through London”

    London became The Financial Centre in response to US capital controls and the emergence of the eurodollar market. Bolstered by its straddling the Asian and American time zones. And certainly helped by eastward expansion out of The City and into Canary Wharf that liberalized the property market in London making larger dealing rooms possible.

    Another advantage in London are liberal hiring & firing laws, and its ability to attract a lot of foreigners with their various language skills and personal ties to the rest of Europe. In addition to being closer to EEMEA and that oil.

    Perhaps the competition from the USA played a role in squeezing out smaller European financial centers that centralized their European operations in London. But part of that was tax and labor law driven as well.

  • Posted by MrBill

    “the dollar has been a global monetary instrument that the United States, and only the United States, can produce by fiat.”

    Apparently, the North Koreans with their imported Swiss printing machines produce an even better US dollar than the Americans. They even made some minor improvements to it.

    Nothing stops the rest of the world from carrying on trade in euros, yen or any other freely convertible currency. Syria even sells their oil in euros as will Iran eventually I am sure. So what? What matters is in which currency oil exporters choose to save and invest their economic surpluses. If they move away from the dollar, there is nothing the USA can do to stop them. So much for dollar hegemony.

  • Posted by MrBill

    Oil exporters use windfall billions to spur growth

    “A year of record-breaking oil prices could earn the world’s top exporters $700 billion and give them the confidence to build the foundation for decades of economic growth.

    But unlike the 1970s oil boom, which saw fortunes frittered away and U.S. treasuries the asset of choice, producers now are paying down debts, spending massively on infrastructure projects and diversifying their portfolios to include Asia and Europe.

    Top exporter Saudi Arabia and its Gulf Arab neighbors may earn more than $300 billion in petrodollars this year, enough to buy a firm the size of Exxon Mobil”
    Source: http://today.reuters.com/news/newsArticle.aspx?type=reutersEdge&storyID=2006-07-27T141338Z_01_L27601473_RTRUKOC_0_US-ENERGY-EXPORTERS.xml

  • Posted by Guest

    Have to wonder how, or if this might alter global capital flows.

    Feb. 2006 – “… The Currency Transaction Tax (CTT) is ready for implementation. It is now only a question of political will… for the distribution of the revenues a new international body will be needed… Unlike previous organisations it has a democratic governance structure and applies a concept of conditionality that differs radically from that of IMF and World Bank. Instead of linking credits to market liberalisation and investor-friendly policies it would link financial distribution to the governments’ performance in fighting poverty and achieving development…”

    http://www.weltwirtschaft-und-entwicklung.org/cms_en/assets/s2dmain.html?http://www.weltwirtschaft-und-entwicklung.org/cms_en/wearchiv/531686976e0d30204.html

    Global Forex market context, L. A. Denys, June 2006, http://www.google.com/search?q=cache:h5xEESUKi0IJ:www.oesfo.at/static/mediendatenbank/root03/04%2520Presse/Praesentation%2520Denys.ppt+transaction+tax+london+city&hl=en&ct=clnk&cd=6

  • Posted by Guest

    Looking at Mr. Bill’s post and this morning’s news about what appears to be a rapidly deteriorating, escalating situation in the middle east, and I hope things aren’t getting a bit too interesting for you there, wondering when and where the effects of what appears to be an increasingly unstable real economy feed through to the markets.

    “John Tiner, chief executive of the Financial Services Authority, said on Thursday there was a risk of sharp and related corrections within a number of asset classes in financial markets… Tiner added that the FSA has already highlighted concerns about the level of unsecured debt. He also warned of risks that may come from a possible deterioration in the UK labour market.” http://today.reuters.co.uk/news/newsarticle.aspx?type=fundsNews&storyid=2006-07-27T105328Z_01_NOA739107_RTRUKOC_0_MARKETS-FSA-RISK.xml&src=rss

  • Posted by zp

    The currency transaction tax should rightly be credited to James Tobin, the Yale Nobel Economist who came up with the idea in 1978… which is why it is commonly referred to as the Tobin Tax.

    “James Tobin, David Felix, Rodney Schmidt, Paul Bernd Spahn and others have examined the possibility of levying a charge on international monetary transactions as a means to reduce exchange rate volatility and promote international economic stability. In addition, considering that annual currency trading is 10 times the global GNP, the revenue generating potential of a tax is tremendous. A modest 0.25 percent tax would generate over $300 billion per year (the total UN annual budget is about $10 billion) for peace and sustainable development.”

    read more at: http://en.wikipedia.org/wiki/Tobin_tax

  • Posted by MrBill

    RE Tobin’s Tax

    It is a really bad idea. It is so bad it should not even be contemplated! If programs need to be funded let governments tax their own citizens or allocate funds to the UN to tackle these problems.

    The idea of taxing capital flows is equating flow with profitability. Many currency trades are not profitable. Fifty percent to be precise. Others are a transaction linking investment into either debt or equity and are therefore also not generating a profit to be taxed away.

    If you must, tax the dividend or coupon or capital gain from the underlying investment in equity or fixed income, not the currency transaction to go from dollars to euros or yen.

    This is just one more attempt by faceless bureaucrats to impose a tax on some faceless users of capital markets instead of open, honest and transparent taxation at the national level, which politicians may have to explain to voters.

    It is such a bad idea it makes me sick! Reform the UN and the World Bank and the IMF while you’re at it, but do not invent any new supranational organizations, which will be open to influence peddling and cronism.

    As for reducing currency volatility, there is absolutely no evidence. Freely convertible currency markets and transparent, independent central banks have already dramatically reduced currency volatility, while stamp duties on houses have done nothing to reduce volatility in housing prices. How does a tax reduce volatility? It doesn’t. It makes transactions more expensive. Leading to fewer transactions. Fewer transactions make currency markets more volatile not less!

    If you want to tackle development problems, raise taxes domestically, and then explain to your voters why you are raising those taxes. Anything else is just a tax by stealth and dishonest. Something for nothing.

  • Posted by MrBill

    And further more, pure currency speculation that leads to a profit, is already taxed in most countries as income. And currency crises are not caused by currency trading per se, but poor government policies including, but not limited to corruption and cronyism.

    These authors would even like to reward poor governance by “Instead of linking credits to market liberalisation and investor-friendly policies it would link financial distribution to the governments’ performance in fighting poverty and achieving development.”

    No, you would not want to link aid good governance, strong institutions and fighting corruption that are the real drivers behind reducing poverty and achieving development. Nope, let’s raise the money and then figure out how to throw it at problems. I am sure Jeffery Sachs likes that solution?

    And this from EU governments that think 20% VAT on top of high marginal tax rates are the key to growth and prosperity! No wonder they are looking for new and innovative ways to raise even more taxes. It’s for prosperity, stupid! ; – )

  • Posted by Guest

    The CTT proposal gives some credit to Tobin, but states that it is a different approach to the idea. I share Mr. Bill’s deep skepticism.

    Still thinking about GDP. Luxembourg is the EU’s clear winner, looks like its trying to close in on almost three times the average, about twice that of the UK’s and Netherlands, well ahead of Ireland. Should we also be paying some attention to the Luxembourg exchange?

    “…The ability of the Grand Duchy providers to service offshore funds received crucial impetus two years ago when a ministerial decree, complemented by a CSSF circular, authorised the Luxembourg Stock Exchange to accept for listing foreign funds including those established in Cayman and the BVI – a crucial element in attracting administration business that Dublin has exploited with great success…”

    http://www.hedgeweek.com/articles/detail.jsp?content_id=27212

  • Posted by Guest

    And having thoroughly trash talked the whole CTT idea, and looking at the Luxembourg exchange site and Hedgeweek’s morning news, wondering if we can put any faith in hedgefund innovation:

    “Once upon a time, when hedge funds were all either global macro or long/short equity, their administration was relatively straightforward, and gearing up for growth in business simply meant hiring more fund accountants. But in a world of ever more exotic financial instruments and increasingly complex and sophisticated strategies, administration itself has become a more cutting edge business and the skills that are employed in it include some that you might not expect…”
    http://www.hedgeweek.com/articles/detail.jsp?content_id=26109

  • Posted by bsetser

    Hmmm — not sure that because oil is settled in dollars you have to hold your savings in dollars. Suppose you worried aobut your future capacity to buy oil in 2001. you could have held dollars. Or you could have sold dollars for euros, say the dollar value of the euro rise, and been far better able to afford oil today …

    Mr. Bill — agree that London benefitted immensely from the UK joining the EU — which allowed the City to cherry pick talent from the continent … some of the liberalization was the product of UK policy, some kind of happened by accident. French quants doing derivatives in London … and luxembourg is a nice little tax haven. the details of the US BOP released in the survey of current business show that US firms ran down their assets in luxembourg in 05 … wonder why (hint: homeland invesmtent act)

  • Posted by Steve Waldman

    I broadly agree that the “dollar hegemony” case is overstated, and that what matters is not the currency the commodities are priced in, but the currencies that savers choose to hold. But let’s give the devil his due here: Suppose, with regard to your oil consumpution, you are not chasing returns, but looking to reduce risk. You have little faith in your ability to outguess currency markets. You know you will need oil in a year, and wish to lock in current prices. In many cases, you will have little choice but to purchase a dollar-denominated forward contract. By locking in today’s 1-year forward price in dollars, you’ve now traded commodity price risk for currency risk. To hedge the currency risk, you’ll need to purchase enough dollars such that holding at USD interest rates yields sufficient cash in a year to fund your commitment to buy the oil. In this way, ubiquitous pricing of commodities in dollars does indeed increase the fraction of world savings held in dollars.

    I have no idea what the magnitude of this effect would be. But I think it does capture something real. While looking backwards, it may have been better to hold euros since 2001 to fund 2006 oil purchases, an old-fashioned, non-financial, oil-consuming firm would have wanted to avoid currency speculation, and would have bought forward and held dollars.

  • Posted by Guest

    Trying to picture a foreign exchange market crash:

    “British American Tobacco, the world’s second biggest cigarette maker, yesterday reported a better than expected 15% rise in first half operating profits, but chairman Jan du Plessis said the results had been boosted by foreign exchange gains that were unlikely to continue…”

    http://business.guardian.co.uk/story/0,,1832001,00.html

  • Posted by MrBill

    RE FX spot & forward risks

    What you say is true, if you hedge by buying oil and/or hedge by locking in your one year forward, but how many companies do this? All or part? And do they expect their central bank to do it for them? Would they not take a directional strategy using options instead, so they do not lock in a bad exchange risk? How many times has VW screwed themselves by locking USD/DEM or EUR/USD at the wrong time and then gushed losses when the dollar weakened off and they were caught with production in strong DEM or EUR for example? It is a commercial decision of course and we cannot all get it right, but central banks get it wrong as well, just ask Negara! ; – )

    I think that prudent hedging means taking into account the probability of your currency moving against you otherwise there would be an arbitrage opportunity. By the same token one of the biggest mistakes or misconceptions made by many is to assume that doing nothing with your currency risk is less of a risk than hedging!

  • Posted by Steve Waldman

    Mr. Bill: I think it’s fairly orthodox advice for nonfinacial firms to hedge risks unrelated to core activities and not try to outsmart the markets. It’s expected that 50% of the time this works against the hedgers. But it’s part of CFO training 101 how to explain to the CEO that an ex post facto derivatives loss associated with a hedge does not mean an ex ante poor decision. And really, it doesn’t. “[T]aking into account the probability of your currency moving against you” is not good advice for most firms, because most firms cannot consistently outguess FX markets. Options are, well, another option for firms that wish to hedge (lower risk, higher priced), but a similar argument would hold. If the derivatives are USD denominated, the hedger has to hedge currency risk as well as price risk, and hedging currency risk means holding dollars or FX futures or options (that somebody else has to hedge or bear speculative risk).

  • Posted by HK

    Brad–The so called dollar hegemony is nothing but a self-reinforcing practice of any money use. Why the euro is used in the euro area? Because it is used there. There is no restriction of the use of the dollar or the yen in the euro area. Of course, you cannot pay tax in the dollar or the yen there. But the dollar also cannot be used as tax payment outside the US. So, the hegemony of the dollar as the international currency is a volunatry and self-reinforing phenomenon. As such, it is very difficult to change. If it was forced by the US, it would have been easier to change.

    Having said that, the US should better manage the situation carefully. If the US continues to disregard its mounting current account deficit, leave fluctuation of the dollar value as it is, and negate countries like Saudi, Russia, and China to freely acquire the US companies, eventually dollar hegemony will evaporate. Then the US will loose huge seniorage and financial sector gains it now enjoys.

  • Posted by MrBill

    “Mr. Bill: I think it’s fairly orthodox advice for nonfinacial firms to hedge risks unrelated to core activities and not try to outsmart the markets. It’s expected that 50% of the time this works against the hedgers.”

    Sure, all I am saying is that hedging is all about cost-benefit analysis, and sometimes not doing anything, is the best alternative.

    1. Identify all financial and non-financial risks
    2. Mitigate those you can, like matching assets & liabilities, or cleaning-up your documentation or legal risk for example
    3. Reduce those you cannot, by exiting non-core businesses if you must
    4. Hedge those you can using the products available
    5. Do nothing ff the cost to hedge outweighs the advantages, but
    6. Continue to monitor the risk in any case as things can and do change

  • Posted by Guest

    Brad-
    the russian economy STINKS! Ask any russian. You continuously focus on the wrong metrics to assess economic vitality. Russian balances are driven by oil exports (also weapons) not a vibrant economy. For that matter almost all the CA positive economies of teh world have unhealthy economies as measured by their populations well being.