Brad Setser

Brad Setser: Follow the Money

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Meanwhile, over in the (Arabian) Gulf …

by Brad Setser
May 21, 2007

Kuwait decided to shift (back) to a basket peg, and in the process it allowed the Kuwait dinar to appreciate (though not by much) against the dollar.   Its central bank presumably bought a substantial quantity of dollars today to keep the Kuwaiti dinar from appreciating by more.  

Kuwait’s move isn’t a total surprise.  It always has been the GCC country least committed to the dollar peg.  Its investment fund already holds a relatively diverse portfolio.  It presumably thought all the GCC countries should have adopted a Kuwaiti-style basket peg rather than a Saudi-style dollar peg in the run-up to the GCC’s planned (but increasingly uncertain) monetary union.

Moreover, Kuwait’s initial move was rather modest.    Shifting to a euro/ dollar basket after the dollar has already depreciated substantially against the euro doesn’t accomplish much.     It protects the dinar from following the dollar down even further. But, if it is a true basket, it also means the Kuwait dinar wouldn’t appreciate along with the dollar if the dollar rebounds against the euro.   That isn't enough. 

Most of the oil-exporters need to appreciate against a euro/dollar basket – not just against the dollar.   After all, oil has appreciated substantially in real terms, and that usually implies over time a real appreciation in the currencies of the oil exporters.  If that appreciation doesn’t come from a nominal appreciation, it has to come from higher levels of inflation. 

It consequently shouldn’t be a surprise that inflation has picked up substantially in the Gulf – and in a lot of other oil exporters – as these countries started to use more of the oil surplus domestically, whether to finance more spending or more property investment.   

I don’t think Kuwait’s move goes far enough.   Kuwait would benefit from an exchange rate regime that allowed its currency to appreciate against a basket, not just a basket peg.   For more – a lot more – see my paper for the Peterson institute/ Bruegel institute/ KIIEP conference.    Or read something by Serhan Cevik

Still, not following the dollar down is a start.

And if Kuwait’s move prompts some of the other GCC states to reconsider their dollar pegs, all the better.   Real adjustment from high inflation — with very negative real interest rates — strikes me as rather risky. 

Up until know the Gulf states have insisted that any discussion of alternatives to dollar was off the table until after their 2010 monetary union.  But it is now pretty clear that the monetary union won’t happen in 2010, and it may not make sense to insist on following the dollar down between now and the time when the GCC is really ready to form a monetary union.   As Steve Brice of Standard Chartered notes, that time may not come for some time:

One of the criteria of monetary union was a common monetary policy. Now of course we don't have that … We didn't think the single currency was likely, at least by the 2010 deadline, and we are getting less convinced that it is going to happen at all.

It never really made sense, in my view, for oil-exporting countries with large external surpluses to tie their currencies so tightly to the currency of an oil-importing country with a large external deficit.

One of the ironies of Kuwait’s move is that it is, at least among the Gulf countries, perhaps the one that has had the smaller problems with inflation.   Its pre-2003 basket peg helped, as has its more conservative fiscal stance.    Kuwaiti inflation is no longer low (5.15% in q1) and is clearly rising, but it remains well below inflation in Qatar and the UAE.   It is a bit higher than reported Saudi inflation (3%).   But I don’t believe the reported Saudi numbers.   

There are also some intriguing parallels with China, the other part of the world economy with a really large external surplus and something close to a dollar peg.  

Both China and the GCC generally pegged to the dollar throughout the period of dollar weakness, and both are perhaps moving toward basket pegs.    Kuwait isn’t the Gulf, and China doesn’t really seem to have a basket peg – so the “perhaps” is important.   For different reasons – oil in the Gulf, a mix of capital inflows and a current account surplus that has risen even in the face of the oil shock for China – both have experienced rapid money growth, as an influx of foreign exchange hasn’t been fully sterilized.    Both have experienced a surge in domestic asset prices.   In China, housing surged before the stock market.  In the Gulf stocks surged before housing.   

Both now have very low – if not negative – real interest rates. 

And looking ahead both still have large external surpluses despite their domestic booms, and both are looking to invest that money aggressively.   Both soon will have placed money either in or with private equity funds.  China here is catching up with the Gulf …  more on that later.

17 Comments

  • Posted by Dave Chiang

    Brad,

    China does have a basket peg, but the rise in the Euro and decline in the yen result in little movement for the yuan.

  • Posted by Dave Chiang

    Brad,

    Until Kuwait and other Gulf Arab states depeg oil exports from the US Dollar into the Euro, the exchange rate shift to a currency basket is meaningless. In order for the structural imbalances to be resolved, US Dollar hegemony implicitly backed by the Gulf Arab energy reserves must be eliminated. It is the structural result of US dollar hegemony in which the world’s central banks must buy up the dollar inflow from both trade and investment.

  • Posted by Emmanuel

    (1) You are of course referring to the Flint–I mean, Blackstone deal. It’s just a small stake of less than 10% as China is not keen on it being seen as FDI, just a wee bit portfolio investment. Call it Premier Hu’s yabba-dabba-doo.

    (2) What is this newfound fad for getting into monetary unions? Naysayers kept dumping all over the EMU for the longest time until the Euro became a real alternative to the leetle green depreciation machines. Given the still-ongoing problems of integration among some of the world’s most developed economies, what chance is there that East Asians and GCCs will be able to pull off a similar feat? Let’s just say I have my doubts.

  • Posted by Guest

    dun, dun, dun, dun… another (partial) defection from BWII. how many managed baskets (closet crawls) will it take to unravel dollar hegemony?

    it’s certainly fraying at the edges and no one wants to be left holding the bag, yet there are some interesting “race conditions” — in EE-speak — whereby (false?) _signaling_ can determine wildly different (unpredictable?) outcomes, which may or may not be in ‘equilibrium’ :P

    cheers!

  • Posted by Guest

    DC, until PBoC diversifies its (70%+ dollar) reserves, china is a fully paid-up member of BWII dollar hegemony, if not in good standing…

  • Posted by gab

    I swear to God, the next time someone writes “dollar hegemony” I’m going to puke. Find another friggin’ theme, will you?

  • Posted by Guest

    CHICAGO (Reuters) – Bank of Canada Governor David Dodge said on Monday it was “possible” there could at some point be a unified North American currency… borders between Canada, the United States and Mexico have “gotten a bit thicker” in recent years…” http://www.globeinvestor.com/servlet/story/ROC.20070521.2007-05-21T191453Z_01_NAT002731_RTRIDST_0_BUSINESS-BOC-DODGE-COL/GIStory/

  • Posted by koteli

    Hi, Brad, did this last guest meant that the “amero” would be possible at some point, although the countries borders have “gotten a bit thicker”?

    Does the Governor tell something or he’s jus crying? Any sense?

  • Posted by Guest

    The Saudi numbers are right, just heavily regulated by non-market forces. Last April’s massive cut to retail gasoline price, determined by government not market forces, helped lower inflation. That’s a problem with emerging economies more generally – without respect for market forces, we have no idea what prices are really doing.

  • Posted by Guest

    Halliburton Shifts Focus Toward Mideast
    Tuesday May 22, 8:33 am ET
    http://biz.yahoo.com/ap/070522/halliburton.html?.v=2

    CEO Says Halliburton Is Shifting Focus Away From North America and Toward the Mideast

    DUBAI, United Arab Emirates (AP) — Halliburton Co., the Houston, Texas-based oil services company, is shifting the company’s focus and capital investments away from North America and toward the oil and gas-rich Middle East, its chief executive Dave Lesar said here Tuesday.

    The company seeks Arab investors and a share listing on Dubai’s new international stock exchange, Lesar said. Halliburton has already hired 4,800 of the 14,000 new workers it plans to bring aboard this year, many of them in the Arab world, he said.

    “We’re looking for as many young Arab and Asian engineers, technicians and professionals to come and join our organization,” Lesar said while swigging a Coke in a swanky hotel meeting room.

    “As we build up our headquarters offices here it’s not going to be by transferring people from the U.S., it’s going to be by hiring locals,” he said. “Unlike the States, there are more people in this part of the world who are interested in careers in the oil and gas industry.”

  • Posted by bsetser

    my sense is that the saudis weight goods (including gas) more heavily than services, and thus understate inflation (stronger in services than goods). the saudi bank report linked to in one of my blogs also reported very high retail price increases across a range of goods — 20% y/y increases that seemed hard to square with a 3% y/y increase, even taking into account gas price cuts.

  • Posted by Guest

    has anyone come to agreement on the definition and boundaries of ‘the dollar zone’? Thought is was interesting that Dodge referred to labour issues as factors in the establishment of a ‘one currency’ North America. I don’t know, but tend to doubt labour mobility issues are (were?) a factor in the Gulf currency union deliberations. Also wondering if geographic blocks make more sense as the base for unions, rather than other considerations.

  • Posted by Guest

    re: Haliburton/KBR and the middle east oil & gas industry

    “At least 146 contract workers were killed in Iraq in the first three months of the year… Among them… a Georgia woman killed in a missile attack in March while working as a coordinator for KBR, the contracting company…” http://www.ufppc.org/content/view/6187/

  • Posted by Guest

    re: “the saudis weight goods (including gas) more heavily”

    might this include water, as there are domestic supply issues – they are importing some quantity right now, aren’t they? – and if this may be more of a factor going forward.

  • Posted by Anonymous

    Ummm…. Don’t you mean the Persian Gulf. Did you know that the term Arabian Gulf is racist?

  • Posted by bsetser

    I was under the impression the Arabs on the southern shore of the Gulf call the Gulf the Arabian Gulf not the persian gulf — at least that is what time out’s Dubai guide seemed to convey … I think the name “Arabian Gulf” was on the map in the guide book as well. I’ll check.

  • Posted by bsetser