Morgan Stanley's Global Economic Forum, Friday, April 5, 2002
Currencies: USD: The Dog that Hasn't Barked
Stephen L. Jen & Melanie Baker (London)
Why Did the USD Not Rally?
The dollar is the dog that hasn’t barked. Elevated geopolitical tensions in the Middle East and higher oil prices should have been very positive for the USD. The fact that the USD failed to rally is remarkable, in my view. The focus of this note is not on how high oil prices will go, or on the Middle East. Rather, it is on how the dollar has (not) performed in response to these shocks. In our view, the absence of a strong performance in the USD in the past few weeks is consistent with our assessment that the USD may be approaching a structural peak. Specifically, we are concerned that (1) questions about the US dollar policy and USD valuation may be repelling geopolitical safe haven capital, and (2) for some OPEC countries contemplating a 1973-like oil embargo, a boycott on USD assets would also be likely. Some of the flows of "petrodollars" back into the US may be cut off, undermining the USD.
The Risk of an Oil Embargo
Oil prices have risen by around 40% since the beginning of the year and by 60% since the post-September 11 low in Nov 2001. Part of this increase reflects an earlier-than-expected global recovery, but most of the rise seems to be related to the heightened geopolitical tensions in the Middle East, whose nature has changed sharply with the escalating tensions between Israel and the Palestinians. Earlier in the year, it was the risk of the US attacking Iraq that pushed up oil prices. However, more recently, Iran and Iraq have called for an embargo on crude oil shipments to use as a "weapon" against supporters of Israel. Even action by Iraq and Iran alone could be a serious threat in my view, because together, Iraq and Iran’s oil output (6.0 mbpd = 2.3+ 3.7) is comparable to the excess capacity of global oil production today. In addition, if the situation between Israel and the Palestinians deteriorates further, the risk of a repeat of a 1973-like oil embargo cannot be dismissed.
Why the USD Should Have Performed Well
The USD usually performs well in environments such as the current one. We have documented how the USD has consistently rallied when global geopolitical tensions rose. We saw this pattern in the Gulf War in 1991 and following September 11 in 4Q 2001. When geopolitical tensions rise, "capital tends to go home." For many developed countries such as Japan, the UK, Europe, and Switzerland, "home" is home. However, for other countries, including especially the capital-surplus countries in Asia, the most liquid and secure "home" asset is USD cash. This is likely why, against expectations, the USD actually rallied in 4Q 2001, despite the fact that the US was the target of the terrorist attacks and there was a palpable risk of a repeat of 9/11: safe haven flows from Asia were simply overwhelming. In addition, higher oil prices tend to be supportive for the USD, despite that fact that the US is the heaviest oil consumer among the G-7. We believe that the main reason is that "petrodollars" -- the USD receipts of oil exports -- are traditionally very USD-friendly. The global daily oil output is around 76 mbpd. At US$25/bbl, the annual value of this output is around US$685 billion. Of this, the OPEC-11 account for around US$230 billion. While oil prices and OPEC’s oil revenues change, this rough order of magnitude of OPEC’s petrodollars is significant in any case.
Why the USD Is Not Performing Well
We have the following thoughts on why the dog did not bark.
(1) Further safe haven flows may have been repelled. What is different now, compared with the period following September 11, is that there has been more focus on the issue of USD valuation and the yawning external imbalance of the US. We believe that the structural environment for the dollar has materially changed in the first months of the year. First, the decision to invoke safeguard duties in imported steel and lumber runs counter to the free trade agenda of the Bush administration. To push the administration to introduce such a bad economic policy, the value of the USD is likely to have exceeded some policy makers’ threshold of tolerance. As we have pointed out, the issue is not just the decision to impose these tariffs, but also the timing of the announcement, which came two weeks after the string of surprisingly strong data on the US economy, starting with a strong read on the 4Q GDP growth. Normally support for protectionism tends to be strongest in the depth of an economic downturn. However, in the case of the tariffs on steel, the announcement was made just when the data began to suggest that the US is likely to lead the rest of the world out of the global growth recession. What this implies is that some policy makers (perhaps more those in the White House than the US Treasury) may be concerned about the widening current-account deficit with the USD already trading at such a strong level. Second, the strong dollar policy is finally being questioned. On this, we believe that there has been too much fixation on whether the US Treasury will abandon the strong dollar policy. If the strong dollar policy has indeed contributed to a misaligned USD, then abandoning this policy could trigger a collapse in the USD. If, on the other hand, this policy did not distort the valuation of the USD, then why should the Treasury abandon it? The point here is that there is no justification, from a strategic perspective, for the US Treasury to explicitly abandon the strong dollar policy at this point, regardless of what their true view is on the US’s savings investment balance and on the valuation of the USD. Rather, a reasonable "exit strategy" on the USD would be to tinker with the definition of the strong dollar policy, as Secretary O’Neill has already begun to do (see my pieces "Safeguarding Steel or Safeguarding the Dollar?" and "Global Decoupling and the Strong Dollar Policy"). In any case, with all this talk about the valuation of the USD, the strong dollar policy and the widening current-account deficit, geopolitical safe haven flows may have been repelled.
(2) A boycott on USD assets is as big a risk as an oil embargo.
Iraq has issued an explicit threat of an embargo. Though several OPEC countries (in particular Saudi Arabia, Kuwait, and Indonesia) have downplayed this threat, such a scenario is still severe enough for us to consider it seriously, even if the probability of this event is relatively low. The key point we make is that, if the OPEC countries do come to the decision to impose an oil embargo on the US or the West, why would they still pump their petrodollars into USD assets? In other words, we believe that an oil embargo, however improbable, is likely to be accompanied by a boycott on USD assets. This means that much of the petrodollar flows back into USD assets, which have likely been so supportive of the USD when oil prices rise, will be diverted elsewhere. The question of where these flows will be redirected cannot be fully addressed here. But our guess is that the Swiss franc and gold may be reasonable candidates for the "free liquidity," while the euro could benefit if OPEC uses the proceeds to pay down foreign bank borrowing (OPEC borrows more from European banks than from US banks).
(3) The US economy is very exposed to an oil shock.
Even though high oil prices have historically been supportive of the USD, this was most likely due to petrodollar re-flows. The US economy is actually very exposed to oil. Among the G-7, the US is not only the biggest oil consumer (in percentage of GDP and in absolute terms), it is also the biggest net oil importer in the world. An oil shock could have more impact on the US than other G-7 nations in the current low-pricing-power environment.
Bottom Line
The dollar is the dog that didn’t bark. We believe the USD is either approaching or is already at its structural peak. We see a structural dollar correction as the next big theme in the currency markets.
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