Tracking Petrodollars

The doubling in oil prices from 2002 to 2006 has resulted in a strong growth in export earnings for the oil-producing countries of the Middle East and redistributed large sums of money from oil-consuming to oil-exporting countries. This in turn, has substantially increased the energy-exporters position in the balance of power in the global economy, with regards to reducing global imbalances.

The US Treasury's International Affairs division has highlighted that since 2002, Washington's oil import bill has risen by USD 148bn, equivalent to more that half the deterioration of its overall current account deficit over the period. Meanwhile, the IMF has estimated that in 2006 the current account surplus of the Middle Eastern oil exporters will be larger in dollar terms than that of China plus the rest of emerging Asia. In addition, they will account for a much larger proportion of their economies, averaging a surplus of 25% of GDP.

Such a marked increase in revenue has a number of domestic and global implications. For oil exporting countries, the main question is the best way to utilise the windfall to support the long-term development of their countries. Meanwhile, on a global level, there is the question of what the Middle Eastern countries can do to reduce global imbalances and recycle their export earnings. There are two main ways an oil-exporter can recycle petrodollars. First, by increasing domestic consumption and investment, thereby increasing the demand for imports of goods and services (hopefully from oil-importing countries). In the case of the Middle East, the main sources of imports are from Asia and Europe. Second, through capital account outflows, i.e. petrodollars being saved in foreign assets held abroad.

The oil windfall offers a great opportunity for the regional oil-exporting countries to address economic and social challenges. In the past, the poor utilisation of the windfall has resulted in wasteful expenditure blowouts and a stalling in the economic reform program. Spending was haphazard and not well thought out, resulting in infrastructure being inadequate despite substantially higher spending in this area. Moreover, the lavish projects did little to diversify the economy or create local jobs. However, in the case of many of the GCC countries, the economy or the work force could not provide the goods and services required at that time.

There are indications that regional oil exporters have taken some lessons from their past mistakes and have been prudent with their spending. Until 2005, the majority of Middle Eastern countries were slower to increase spending. This was partly due to concerns that the oil price would weaken, but also to the time needed to formulate investment projects. This is especially the case for GCC countries. Governments have assumed more conservative assumptions for oil prices in their budgets and spending has not kept up with oil price rises and, to a lesser degree, production increases.

The spending multiplier (i.e. the proportion of additional oil revenue being spent by governments) is now lower then during the boom of the 1970s. The IMF estimates that governments have on average spent 30% of their extra oil revenue from 2002 to 2005, compared with 75% in the 1970s and early 1980s. Instead, regional oil-exporting countries are running greater external surpluses, paying of debts and building up assets. Furthermore, a number of countries, such as Egypt and Saudi Arabia, have forged ahead with their economic reform programs.

The absorptive capacity of the regional economies has increased with the larger size of the economy, the strong population growth and a need for upgrading the infrastructure, after years of weak government revenue. This will allow governments to increase investment levels. Importantly, the GCC countries have developed more careful investment strategies; with long-term development projects being a priority. Projects include, increasing oil and gas production levels, upgrading infrastructure, diversifying their economies (in areas such as tourism) and human resource development. These areas are vital in not only maximising the potential from their hydrocarbon sector but also diversifying their economies, which is central in providing jobs for a growing population.

Higher government investment, along with private sector involvement in these projects will help the GCC economies in avoiding the post-boom slump over the next few years. Medium-term investment projects will be the main driver of economic expansion going forward. However, it is vital to maintain spending at a level that can be sustained in the medium-term and thereby avoiding the economic slump that occurred following the first two oil spikes, when a fall in oil prices triggered a sharp contraction in government expenditure.

With greater confidence that oil prices will remain high, regional governments have become more exuberant in their spending in H2 2005 and government expenditure will accelerate in 2006. They have taken a number of measures such as increasing public-sector wages, which they had previously resisted. One of the greatest challenges for governments will be to resist increasing populist spending, but rather continue to direct expenditure towards projects that will have a long-lasting impact on growth, productivity and increasing employment opportunities. Negatively, Iran has gone down the populist route and is not using its windfall in a way that will support long-term growth.

With governments increasing spending relatively more slowly this time around, a larger proportion of oil revenue has been directed towards savings, rather than imports. It is important to look at where the money is going and how it is affecting the global economy. However, unlike the 1970s when the petrodollars were mostly deposited in US and European banks and then lent out to developing countries (ultimately leading to the debt crisis), the money trail has been harder to follow. This is due the surpluses being directed mostly towards investment agencies and oil stabilisation funds; these agencies are subject to less stringent regulations than the central banks and are harder to track. Although central bank reserves have increased, it has been at a much lower level than the increase in the current account surpluses. In addition, the money is being invested through financial intermediaries, making it harder to follow.

Nevertheless, there are indications the Middle Eastern countries have broadened their investment directions from bank deposits. Middle East oil states are holding a cumulative of over USD 1trillion in foreign assets, comprising of stocks, bonds, government debt, real estate and other investments. Indeed, figures from the Bank of International Settlements (BIS) show that there was a greater reluctance to hold deposits in foreign banks; most likely owing the greater scrutiny following the terrorist attacks in the US in 2001, along with falling US interest rates. In 2002 and 2003, OPEC deposits with the BIS fell. However, the BIS indicated that in Q3 2005 OPEC countries deposited a record USD 82bn with international banks; this was the largest quarterly placement by the oil-exporting group. The deposits by OPEC countries were primarily US dominated and were largely due to the increase in US interest rates.

This increase in deposits with the BIS does not take away from the diversification in investment paths compared to the 1970s and early 1980s. First, more money is remaining within the wider region, both in the oilexporting countries themselves and their neighbours; this is especially the case with smaller investors. This is evident by the large increase in the regional stock market indices and in property prices witnessed throughout the region over the last few years. Second, investors are looking more towards the east, with increased investment in China, India and other Asian countries. This includes joint ventures to increase refining capacity, portfolio investments and real estate.

Third, there has been a strong flow of petrodollars into private equity overseas, for example, the Dubai International Capital's USD 1.2bn purchase of a 2% stake in DaimlerChrysler and USD 1.5bn purchase of Madame Tussauds, the British wax museum. Other examples include Dubai's buying P&O and Mubadala Development Company, an investment company of the government of Abu Dhabi, purchase of a 5% stake in Italian carmaker Ferrari. Private equity investment has also increased from wealthy individuals.

Finally, and importantly, for the global economy, the petrodollars are being directed towards US Treasury bonds. However, this has mostly been through indirect channels (Europe and Asia); US Treasury data indicates that OPEC holding of bonds fell in 2005. Instead, investments are being booked through intermediary bases in Europe or offshore financial centres. Private bankers have also indicated greater investments levels are being directed towards hedge funds. In addition, Europe and Asia's exports to oil-exporting countries have risen at a faster pace than the US's, limiting the effect of the high oil price on their trade balance with the region. Export earnings are then invested into US paper. Petrodollars channeled through Europe and Asia could be funding up to 20% of the US's current account deficit.

The recycling of petrodollars through bonds has had a very different effect on the world economy than the bank-mediated recycling of the previous booms. The investment of petrodollars in US paper, alongside similar investments from Asia, has helped to keep US long-term interest rates low, even as the Fed has been increasing short-term rates. The low long-term interest rates have contributed to bolstering consumer spending, softening the impact of the high oil prices. (In addition, it is also important to note, that real oil prices are not currently as high in real terms as compared to the late 1970s and early 1980s. Therefore the negative impact on the global economy of the high oil price has been less.)

Reducing global imbalances remains a key area of concern for international agencies, such as the IMF, along with the US Treasury. These organisations have urged that the Middle Eastern oil exporting countries take a number of measures to help in reducing the imbalance. This includes, for countries with higher absorption capacities, to increase spending in areas that will benefit their long-term development, whilst avoiding wasteful spending. The US Treasury has also called on oil-exporting countries to increase investment in production and refining capacity, in order to reduce tightness in global supply.

However, the region will be limited in the short-term in its ability to help reduce the US's current account deficit via reducing oil prices. The majority of countries are already pumping oil at capacity and the high price is to a large part down to a political risk premium, rather than market fundamentals. In addition, the medium-term investment plans will increase demand for good and services from industrialised countries. However, even as the Middle East increases spending, the majority of the imports will still originate from Asia and Europe. An appreciation of Asian currencies is required against the US dollar to make US imports more competitive. Other measures needed to reduce the US's current account deficit included steps to encourage saving in the US and increase demand in Europe and Japan.