Changing the Pegging Order?
There has been a lot of fuss lately surrounding the recent rather violent decline of the USD against almost everything which moves. Much of the debate has of course centered quite naturally on the continuing state of Bretton Woods II, whether the Euro would ascend to take over from the Dollar as well as whether of course China and the petro exporters would finally de-peg, at least partly, from the Dollar or perhaps even diversify into other 'higher' yielding assets. These questions are of course interesting in and of themselves but I would also like to see a more general debate on the global imbalances in the sense that we need to ask whether in fact importers will turn into exporters (and vice versa) as well as a general appreciation that what we are seeing is not 'de-coupling' in the traditional sense but rather a 're-coupling' in the global economy of a rather historic character. The Economist recently ran a nice piece on this same topic as well as Edward pin-pointed the issue well in a recent note over at AFOE. Please also note, essentially as an 'aside' in this immediate context that even though emerging markets indeed are powering forward there are considerable differences once we get down to those ever important details. As such, this is how Edward paraphrases it ...
This isn’t “decoupling” as some people imagined it (of Europe and Japan from the United States), but it is a massive “recoupling” of the global economic train, and one which is of historic proportions, with some developing economies now assuming a role from which it seems there will be no turning back. Clearly the ability of these developing economies to withstand a major financial crisis and economic slowdown in the developed economies is what precisely remains to be seen, and in particular it will be interesting to see who will withstand better than who.
Meanwhile and turning to the actual topic of this post Macro Man informs us that the word on the street in finance-town is the potential and possibility that the petro exporters will de-peg in the very near future. Bloomberg consequently also delivers a large report on the story and even though official from the petro exporters are trying to plug holes in the story markets seem convinced that something is stirring.
When central bankers in the Middle East say they have no plans to end their fixed exchange rates to the dollar, the currency market hears the opposite. Merrill Lynch & Co. predicts either the United Arab Emirates or Qatar will cut their dollar peg within half a year.
Now, it should not surprise you to learn that Brad Setser is all over this too since a potential process of de-pegging/gradual floating of the petro exporters' currency vs. the Dollar is a topic very dear to Brad's heart. In essence the basic economic case for such a move seems rather overwhelming at the moment in the sense one of the major macro concerns on the petro exporters' table at the moment is inflation. In this way, it does not exactly make much sense to peg to a currency which is basically the global whipping boy at the world's private/retail as well as business/wholesale FX trading desks. Or does it? As per usual I am quite skeptical that the majority of the woes and imbalances as a result of the BW II system can be made to vanish on the back of currency corrections alone. Yet, as Brad Setser also notes; this is pretty much a one way street from a market perspective.
Even a small 2% revaluation in early December produces a roughly 24% annual return on holding GCC currencies over the next month. That is kind of tempting. GCC interest rates have fallen, cutting into the return, but not enough to make such a bet unattractive. See Simon Derrick of the Bank of New York. After all, the GCC currencies offer a one-way bet. They either will revalue, shift to a basket (likely with a small revaluation) or do nothing. They won’t devalue.
This seems about right to me so even though all kinds of fundamentals are in play this may have little bearing once the wheels are set in motion. Let me also be perfectly clear at this point in the sense that I fundamentally agree with Setser in his 'textbook theory' application of the issue at hand. In many ways, it seems as if a more flexible link to the Dollar is long overdue. Let me still however attach a few qualifiers which may as always serve to muddy the waters a little bit.
1. De-pegging does not mean diversification. I know that Setser is not talking about this at all but I still think it is an important thing to remember in the sense that it means that the entire relative correction in currency values would fall on the CGC currencies themselves. Anything else would amount to liquidity going elsewhere and this is where of course the Euro, Yen or any other candidate really needs to be ready and able to make the capital work.
2. The US still represents, and with quite a gap to the runner-up, the biggest consumer of oil in the world and thus the CGC countries' biggest customer. As such, another textbook theory can be applied here in the sense that oil as an import good will be relatively more expensive from the point of view of US consumers proportional to a given change in the relative values of the USD relative to the CGC currencies. Now, wealth is of course a pretty arbitrary concept in the context of the petro exporters and I don't think that anybody in Middle East is lying restless at night thinking about potential loss of oil revenues. Yet, the US consumer is ever strained at the moment and a sudden violent increase in energy prices could represent a tipping point not least if this prompted the Fed to shift strategy and actually act against mounting inflation. This is in and of itself an important issue and so I think is this ... (from Bloomberg linked above)
If the GCC weakens its ties, oil producers will have less reason to recycle their revenue into dollar assets. OPEC members increased their holdings of Treasuries by 14 percent this year through September to $125.7 billion, Treasury data show. Petroleum exporters are buying U.S. bonds three times faster than other foreign investors, the data show. Yields on 10-year notes are 21 basis points lower because of petrodollars, New York-based consulting company McKinsey & Co. said last month. A basis point is 0.01 percentage point. The 10-year note yield was at 4.16 percent.
``Government institutions and residents would likely move assets out of dollars into alternative currencies,'' said Tristan Cooper, senior sovereign analyst for ratings company Moody's Investors Service in Dubai.
So, this won't be free and this brings us right smack back into this idea of how investors are going to shun USD denominated assets. Well, we can all understand why this might seem a plausible outcome with a large US current account deficit, a Fed on its way down, and general slowdown on the way in the economy. However, this would also bring us back into the whole idea of de-coupling and the fact that the money actually has to go somewhere and as such that the real issue actually revolves around which countries that are actually able to run a respectable external deficit and thus suck up the global excess liquidity.
3. This brings me to my final point then and the following point made by Setser;
On the other hand, there isn’t really a good reason for Saudi Arabia to be salting away all the oil windfall right now. Not after a rise in the long-term price of oil has dramatically increased the Saudis wealth as well as their current revenue. Rather than adding to their stock of financial assets even as the value of their underground oil reserves soars, the Saudis really ought to be finding ways (a dividend check from Saudi Aramco to all Saudi citizens not just the Saudi Treasury?) to distribute the oil revenue widely …
I hardly think that anyone can argue against the need for oil revenue to be distributed more widely not only for obvious economic reasons but essentially for social and socio-economic reasons too. Yet, this is also part of the problem; when and how fast will this happen? And until that happens the CGC economies' ability to create capacity and thus absorb investment rests on the willingness to build more of those fancy luxury hotels and condos. In short; those cranes of Dubai are indeed red hot but how much longer can they continue to build real estate for which there are real opportunities to secure yield?
Well, just some thoughts and do remember that I fundamentally agree with Setser :).