Cevik: the Gulf needs to revalue, and fast
Serhan Cevik has published a series of interesting notes on the Gulf. Last week, he gave away the Gulf’s dirty little secret: an awful lot of the Gulf’s foreign assets are still in dollars. This week, he highlights how the GCC’s dollar peg – combined with an understandable desire to put the GCC’s oil money to work at home – is leading to rapid inflation. Cevik:
…Exchange rate regimes pegged to the US dollar have also turned into a channel for importing inflation …. Consumer price indices show a clear upward trend in inflation in all oil-producing countries, but we believe that measurement errors in outdated official figures understate the degree of acceleration in inflation. For example, in the United Arab Emirates, independent surveys point to an inflation rate of 15-25%, as opposed to 10% according to the official index. Given the extent of liquidity abundance and the mix of extremely accommodative macroeconomic policies, the behaviour of non-tradable prices is the obvious culprit. But we should not overlook the role of imported inflation. Pegged to the dollar, the currencies of oil producers in the Middle East have tracked the dollar’s sustained depreciation since 2002, even as their export earnings have soared to record levels. And since the majority of imports come from Europe and Asia, the dollar’s weakness has become a major source of inflation by pushing up the price of imported goods and services.
Indeed. Oil states dollar pegs combined with surging oil state revenues have led to monetary instability. The necessarily real adjustment has come from inflation – and with the dollar falling, generating a real appreciation has required a lot of inflation, and led to negative real rates that risk leading to over-investment.
Saudi Arabia is the exception. Inflation ticked up in 2006 (recorded inflation) but it still remains remarkably low, all things considered. However, the odds are that Saudi inflation is higher than the reported number, as is the case in the UAE. More importantly, low inflation rates may not last once the Saudis get around to really spending their current oil wealth. The Saudis currently seem to have a bit of Dubai envy: $650b in planned “infrastructure investment” certainly has caught the eyes of London’s vigilant I-bankers. The Saudis have — up til now — saved far more of the oil windfall than most. That looks set to change.
Cevik also highlights something that I think should get more attention. Real interest rates in most GCC countries – for that matter, most oil countries that peg their currencies – are negative. Very negative. Dubai has inflation of say 20% and US dollar interest rates. No wonder there is an investment boom.
Russia is less extreme, but real interest rates are negative there too. No surprise, it too has its mega-projects (Gazprom tower, Gazprom city … ). And, like Dubai, its own property boom. Moscow property prices are way up.
Much is made of how the oil exporters learned the lesson from the last oil boom, and aren’t ramping up wasteful spending. Samih Massoud highlights the conventional wisdom:
certain Gulf oil States, especially the GCC member States have learned valuable lessons from the first oil boom and are now exerting great efforts to control and improve the management of public spending …
He argues that the current oil windfall is being used more productively, both at home and abroad. At home, wasteful spending has given way to useful investment. Abroad, the Gulf is buying more real assets — and financing the construction of more petrochemical plants — while buying fewer "unproductive" Treasury bonds.
Perhaps true. But the argument shouldn't be pushed too far. The gulf states still buy far more financial assets than real assets. Look, for example, at the growth in the financial assets held on the balance sheet of the Saudi Arabian Monetary Agency. Conventional spending certainly has trended up. And perhaps most importantly, I suspect that the wave of unproductive spending in the last oil boom will give way to an a wave of unproductive investment this time around.
Make no mistake: a lot of that investment will be financed by the government. Some such financing comes about indirectly: when the government repays its domestic debt, it provides the banks with funds to lend to the government’s favored mega-projects. Cevik:
Since the beginning of 2002, oil exporters have spent less than half of the windfall on imports of goods and services, compared to more than three-quarters during the previous oil booms. While a number of countries in the region have dedicated extra funds to debt repayment — lowering debt-to-GDP ratios by as much as 50% — the abundance of liquidity has also led to rapid credit growth
Initially a lot of that liquidity flowed into local stock markets. Right now, I expect a lot is flowing into property – and into various government-sponsored mega-projects.
And in some cases, the government’s funds — and its borrowing capacity — will be deployed more directly to support favored projects. This shouldn’t be a surprise: the government gets the oil revenue, so it is the one with the cash to spend, or invest.
Throw in an exchange rate policy – pegging to the dollar and allowing real appreciation through high levels of inflation – that generates negative real interest rates and the oil countries are almost begging to create the conditions for a classic investment boom/ bust cycle. With negative real rates, you don't even need exotic mortgages to generate a real estate boom …
I’m glad the GCC are better using oil funds on infrastructure than simply importing more junk. But they’ve made a Faustian bargain of militarily guaranteed security (by the US) in exchange for affordable oil prices to the US. Hence the dollar peg. For all of our sakes, so we can all get on with reordering our economies, I wish they would float their currencies. Let the price of oil rise to a non-barter price, and conservation begin. I’ll junk my Cadillac for the cause, if need be.
It remains highly unlikely that the Gulf Arab states will move to unravel the US Dollar hegemony regime by breaking the implicit agreement with the United States. With the failed state status of Iraq and the rising Shite influence of Iran, the weak Gulf Arab states are more dependent than ever before on US military power projection in the region for their physical survival. Neither the Russians nor the Chinese have the military-industrial capability and geo-political ambition to replace the US hegemony over the fractured Middle East region. The US broke Iraq, now the US owns Iraq forever.
Brad–As I argued before, apart from Saudi Arabia, most of Gulf states are small and dominated by the traded sector (oil for exports and most other goods for imports). This means that exchange rate adjustment would have only limited impacts on the economy (except on prices). Therefore, although currency appreciation would be good for reducing price inflation, real estate boom and big current account surplus would not be much affected by it. Even price inflation may not matter much, since most of leaders, poiticians, bureaucrats, business people are more concerned about dollar prices rather than prices in their domestic currency.
And what would be the effect on the US economy if these countries revalued? Would the dollar price of oil rise?
guest, Yes, oil prices in dollars would rise. As it is, oil prices in Euros are falling somewhat, and dragging Dollar prices upwards from time to time. It’s a sloppy system of pegs made and pegs broken by price changes and output changes.
HK, You’re right about what they’re concerned about at the leadership level, but the leadership level is backward looking and more interested in status quo than forward prospects. “price inflation may not matter much” to the leadership, but there’s a seething mass of Arabs who are trying hard to keep up, and with great difficulty.
The main benefit to the US would be higher oil prices, which would force genuine economic changes - conservation and replacement of oil. That would loosen the obligations to protect some of the rotten regimes in the Middle East. Egypt can protect the Gulf, if they choose to do so, and if the GCC is willing to pay them instead of the US. I don’t frankly care very much how it works out in a region ruled by madmen trying to drag the world back to medieval times.
I don’t think there would be much impact on the dollar (or euro) price of oil — that is a function of demand and supply in the oil market.
what would change with a GCC revaluation:
a) the countries in the region would have more external purchasing power (with current local currency salaries), so imports of goods and services would go up
b) the need to purchase financial assets to hold the XR constant woudl go down
c) inflation would be lower than it is now projected to be (with real appreciation coming from the XR not inflation)
d) there would in principle be less need to use fiscal policy to sterilize big fx inflows from the oil windfall (but lots of countries haven’t really done this — hence the inflation).
Let’s ignore for a moment WHY this would happen… and just think about the effects. What happens if the yen craters? Does the dollar get a safe-have bid? Do carry related currencies wreck as everyone rushes to sell them to lock in ultra cheap yen that they sold via carry trades? Any ideas out there?
Again… not really concerned with WHY it would happen… let’s assume the possiblilty is remote, but that it exists on some minute level.