The Gulf has — by virtue of its peg to the dollar — entered into an era of “single digit interest rates and double digit inflation.” So writes the Global Financial House in its report on the Gulf’s economic outlook:

the region would have to “live with the paradox of single-digit interest rates and high double-digit inflation”, said Ala’a al-Yousuf, Chief Economist at GFH.

Moreover, loose monetary policy is generating pressure to loosen fiscal policy, as it is hard to explain why real wages for government workers are falling when oil revenue is soaring. That too will add to inflationary pressure:

So far, the government response to spiralling inflation has been in the form of higher wages, increased subsidies and other cash incentives, the report said, in the absence of any relief from the currency effect of the dollar peg.

“In our opinion, the GCC is entering a phase of loose monetary-fiscal policy spiral, which, together with a wage-inflation spiral, have trapped the region between two impossible trinities,” said Hany Genena, Senior Economist at GFH.

Government spending is set to rise 25% this year, reaching $300 billion. That is roughly half of the Gulf’s likely oil export revenues, assuming roughly 15 mbd of exports, an average oil price of around $120 for the year and $5 a barrel production costs. And that total leaves out — I think — a lot of government sponsored investment projects.

No wonder the region is booming. Monetary and fiscal policies are both wildly expansionary. This will, over time, help to reduce the oil exporters surplus and thus facilitate global adjustment. But it also risks laying the ground for big problems if the price of oil turns down.

Letting the exchange rate adjust up — and down — with the price of oil still seems to me to be a better way of managing commodity price volatility.

One thing though is clear: at current oil prices, the small Gulf states are once again fabulously wealthy.

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Capital flows through London are often taken as a proxy for petrodollars. Bloomberg’s Daniel Kruger, for example, argues that the buildup of Treasuries (and I would assume Agencies) in the UK reflects oil money.

The Organization of Petroleum Exporting Countries held $153.9 billion in Treasuries at the end of April, Russia had $60.2 billion and Norway owned $45.3 billion, according to the Treasury Department. Combined, that represents a 113 percent increase from 12 months earlier. Oil producers own a majority of the $251.4 billion in Treasuries held in the U.K., an 85 percent increase.

Unicredito’s Dr. Harm Bandholz also uses capital flows through London as a proxy for petrodollar flows.

This isn’t unreasonable. London probably manages more petrodollars — and more Gulf sovereign wealth fund money — than any other financial center. And there is a reasonably close correlation between the UK’s purchases of Treasuries and the price of oil (or my estimate of oil foreign asset growth).

Correlation though, doesn’t imply causation. There is also a close correlation between purchases of Treasuries and Agencies through London and China’s reserve growth.

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Dubai is rather frothy. Landon Thomas of the New York Times reports that rents are up 40%. New supply has to be coming onto the market, but I guess it has yet to catch up with demand. And it isn’t hard to see why. Oil is — thankfully — off its recent highs. But at close to $130 a barrel, it is still well above its average 2007 price of around $70 a barrel.

The rise in prices between 2008 and 2007 has, obviously, come a lot faster than the rise in prices from say 2003 to 2007. The following chart* shows the estimated export revenue of the world’s major oil exporting economies as a share of world GDP if oil averages $120 a barrel this year. An average price of $120 a barrel requires $130 oil for the remainder of the year.

I also plotted the y/y increase in oil export revenues — both in billions of dollars and as a percent of world GDP. If oil averages $120, the 08 rise in oil export revenues would be comparable in size — relative to world GDP — to the rise in 74 and 79. An average oil price of $120 a barrel would increase the export revenue of the oil exporters by about $900 billion.

This calculation assumes that the oil exporters will export about 45 million barrels a day of oil.
Each $5 increase in the average price of oil increases the oil exporters’ revenues by about $80 billion, so if oil ends up averaging $125 a barrel this year rather than $120 a barrel, the increase in the oil exporters revenues would be close to a trillion dollars.

I consequently was a bit slow putting this post up. If I had put it up a few days ago, I could have talked about the “Trillion dollar oil shock.” I learned the value of a catchy headline last week.

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The FT’s leader concisely summarizes the arguments against the Gulf’s peg to the dollar.

“The UAE either keeps its currency pegged to the dollar, in which case too many dirhams will chase too few goods, and prices will inevitably rise; or else revalue the dirham so each one is worth more dollars.

There is also a specific problem with pegging to the dollar. Gulf currencies have actually had to depreciate against the euro in order to follow the dollar, the exact opposite of what they need, and a shift that will cause even more inflation.”

Alan Greenspan has suggested that the Gulf should allow their currencies to float. It would be hard, though, for the UAE and Qatar and Kuwait to float if Saudi Arabia remains pegged — especially if they aspire to form a monetary union. If the Saudis floated, the rest of the Gulf could peg to the riyal, but that also seems like a remote possibility.

The FT suggests that the GCC shift to a basket peg. The risk of shifting to a basket peg now though is that it locks in the Gulf’s depreciation against the euro. If the dollar were to rebound against the euro, a basket peg would imply that the Gulf’s currency would need to depreciate against the dollar to avoid appreciating against the euro by too much — no matter what happens to the price of oil. That doesn’t make much sense. A basket peg protects against further dollar depreciation, but it doesn’t address the core problem: the Gulf, like China, needs to appreciate against the ensemble of its trading partners.

The FT suggests addressing this by combining a revaluation with a basket peg. It then goes one step further and suggests that the Gulf should consider including oil in their basket.

“The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak. That would make for smoother adjustments than double-digit inflation.”

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If oil stays at $140, the Gulf — based on projections that imply GCC spending and investment will rise so that the GCC needs $55 to $60 oil to cover its import bill — the big GCC funds and central banks should add close to $400 billion to their foreign assets in 2008.

That isn’t bad for a region whose total GDP was about $400 billion as recently as 2003 (see the IMF).

It is also a reminder that the institutions that manage the Gulf’s foreign assets will do more than determine the size of some investment bankers’ bonuses. They increasingly will shape global capital flows.

The graph showing the estimated overall increase in the GCC’s assets also shows the estimated inflows into individual funds. That is my little contribution to increasing global transparency.

Each of the big Gulf funds is worth getting to know a little bit better.

SAMA is the Saudi Arabian Monetary Agency. It now has around $365 billion in foreign assets — and manages additional funds for the Saudi pension system. Its asset allocation isn’t disclosed, but it is likely to be the most conservative of the big Gulf funds.

ADIA is the Abu Dhabi Investment Authority. It has a revamped, but still not very informative website. SAMA isn’t as slick, but it releases more data – and the Saudis aren’t known for their transparency. Business Week’s profile of ADIA has far more information than the web site). That said, we now pretty much know that ADIA doesn’t have as much money as some investment banks are claiming. The IMF’s Moshin Khan has said as much. So has Abu Dhabi’s emir– Sheik Khalifa. He is among the few who certainly knows ADIA’s true size. Unless someone has better information (or believes that Sheik Khalifa is understating ADIA’s size), I would argue that journalists should stop using $825 billion as an estimate for ADIA’s size — let alone the $1.25 trillion estimate sometimes thrown around. It is very big — especially given Abu Dhabi’s small population — but not quite that big. There is a risk that the Setser/ Ziemba estimate ($650b at the end of 2007) may be a bit on the high side. $250 billion was bandied about a little less than two years ago.

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I did a podcast for cfr.org that presents my thinking on this topic.

The simplest reason why oil is up and the dollar is down is that the world economy has been far stronger than the US economy. Weakness in the US economy translates into a weak dollar. Still solid global growth translates into strong demand for oil at time when supplies are a bit tight.

It is also striking, at least to me, that the countries that subsidize oil consumption the most also tend to peg to the dollar or manage their currencies against the dollar. US economic weakness consequently has translated into low US interest rates — and low US rates have translated into low nominal rates – and even lower real rates — in the other, booming dollar zone economies. See Martin Wolf. Combine low real rates with subsidized (or at least below-world-market-prices) oil and there has been a big increase in demand for oil in many countries that peg to the dollar or manage their currencies against the dollar.

I also was persuaded by the analysis of Goldman’s fx team. They argue that there are fundamental reasons to think that a rise in the price of oil should be bad for the dollar. The US economy is energy and oil intensive. The US has the largest existing external deficit of any major oil-importing region. The US exports relatively little to the oil-exporting economies. And the oil-exporting economies seem a bit less inclined to hold dollar-denominated financial assets than in the past.

That said, I wish I had concluded by noting that there are two clear paths that could end the current “oil up, dollar down” pattern.

Weakness in the US economy could drag down global oil demand, pulling both the dollar and oil down. Asia’s 1997-98 crisis led both Asian currencies and the price of oil to fall.

Or a rebound in the US economy could push up the dollar while adding to oil demand. In 2000, a booming US pushed up oil prices and the dollar.

The dollar isn’t always weak when oil is strong. And the dollar isn’t always strong when oil is weak. But so long as global growth is far stronger than US growth, there is reason to think that oil prices will respond to global demand while the dollar will reflect conditions in the US.

It is nice to be in good company. Ken Rogoff is as confused by US policy toward dollar pegs as I am. Rogoff:

Does it make sense for the United States Treasury Secretary, Hank Paulson, to be touring the Middle East supporting the region’s hard dollar exchange-rate pegs, while the Bush administration simultaneously blasts Asian countries for not letting their currencies appreciate faster against the dollar? Unfortunately, this blatant inconsistency stems from the US’s continuing economic and financial vulnerability rather than reflecting any compelling economic logic. Instead of promoting dollar pegs, as Mr Paulson is, the US should be supporting the International Monetary Fund’s efforts to promote the eventual de-linking of oil currencies and the dollar.

The macroeconomic logic of the US position is hard to decipher.

If the US thinks monetary flexibility would help China – and the rest of Asia — limit inflation, why wouldn’t monetary flexibility help the Gulf do the same? The Gulf certainly has an inflation problem. Saudi inflation is now over 10%. Qatar’s inflation is just under 15%. I would bet the UAE’s inflation rate, honestly calculated, is just as high, if not higher.

The Gulf’s peg the dollar — which is likely to depreciate in the face of the oil shock — certainly has complicates both the Gulf’s own adjustment to higher oil prices and the broader process of global adjustment. Menzie Chinn has calculated that a 10% rise in the price of oil implies a roughly 2% real depreciation of the currencies of most oil-importing economies, including the US.

In Chinn and Johnston (1996), a 10 percentage point rise in the real price of oil induces a 2 percentage real depreciation in a typical OECD country real exchange rate.

A real depreciation in the oil-importing OECD implies an a real appreciation of the oil exporting economies. Yet so long as the Gulf pegs its currency of the oil-importing economy with the largest pre-existing current account deficit (at least among the major economies), the only way this real adjustment can happen is through inflation. In that sense, inflation isn’t a problem — it is the way the Gulf has chosen to adjust.

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In 2009, the US expects 33% of the corn it produces will go to biofuels. The FT:

In Chicago, spot corn hit a record high of $6.43 a bushel and corn for delivery next year – by which time the US forecasts that about 33 per cent of its corn crop will be consumed by the biofuels industry – hit a high of $6.97 a bushel.

Given how much corn the US Midwest grows, that strikes me as a lot.

Update: Economics of contempt – in a comment — argues that the US biofuels industry is set to consume at least 13% of global corn production.

That at least seems to be the Treasury’s policy.

Krishna Guha of the FT reports that the US believes that dollar pegs can help countries manage commodity price volatility.

Mr McCormick said that oil producers were not in the same position as large manufacturing exporters such as China. “A commodity-driven economy with a lot of volatility in commodity prices could be a beneficiary of a pegged regime,” he said.

So much for the notion that the Treasury is open to a change in the Gulf’s peg.

And so much for any illusion that I might have some influence over US policy.

In my Peterson institute policy brief, I argued that commodity price volatility is a reason not to peg to the dollar. A peg assures that fluctuations in the dollar price of a commodity (say oil) will translate one for one into volatility in countries local currency revenues from commodities. By contrast, a currency that appreciated when commodity prices appreciated and depreciated when commodity prices depreciated would tend to stabilize a country’s local currency revenues.

And I am not quite sure how pegging to a currency that has depreciated in real terms even as oil has appreciated in real terms has helped smooth out macroeconomic volatility in the oil-exporting economies; it seems to have produced high levels of inflation, negative real interest rates and a wildly pro-cyclical macroeconomic policy mix.

It isn’t hard to see why Paulson is intent to signal that the US remains open to foreign investment from sovereign wealth funds — and why he is pushing the Gulf to allow more foreign investment in its oil sector. A sharp fall in financing for the US would be disruptive, US investment banks are keen to do business with sovereign funds and the Bush Administration is keen to spur more investment in oil production in the big oil-exporting economies. The Wall Street Journal reports (in an article that was perhaps buried a bit more than it should have been) that the big oil exporters are exporting less this year than last.

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There has been a lot of speculation this week about the role speculation has played in the recent run-up in oil prices.

There is little doubt, though, about the short-term economic impact of higher oil prices: an enormous transfer of wealth from the oil-importing economies to the oil-exporting economies.

Back in November, I calculated that a $10 a barrel increase in the price of oil would, absent any increase in domestic spending or domestic investment in the oil-exporting economies:

Increase the US trade deficit by about $50b over the course of the year.

Lead to a $46b (euro 31b) deterioration in the EU-25 trade balance. The EU-25 imports a bit less oil than the US (12.6 mbd v 13.7 mbd) even though it produces less oil than the US and has a somewhat larger economy.

And conversely, each $10 increase in the barrel of oil means:

An additional $57b for the GCC states (Saudi Arabia, Abu Dhabi, Dubai and the other emirates, Kuwait, Qatar, Bahrain and Oman).

An additional $25-26b for Russia.

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