Daily Sources 10/20

1. Brad Setser at Follow the Money has a piece on how the unlimited dollar currency swaps established by the Fed has eased the pressure on large institutions to purchase dollars, but that countries whose currencies have not been afforded unlimited dollar swaps, ie emerging economies, are facing tougher times as a result. Since a large percentage of debt worldwide is denominated in dollars, the lack of access to unlimited dollar currency swaps means that institutions exposed to such debt must either borrow the currency from their own central banks--which have plenty of dollar denominated debt on their books as well, generally speaking--or purchase dollars on the currency markets in order to service their debt.

Setser thinks this may make the gap between the G7 and emerging nations larger and deeper, balkanizing the international financial system in effect. His post is well worth reading in its entirety.

It occurs to me that many of the nations--with the exception of China--being forced to purchase dollars are export-oriented nations, whose interests are served by a weak exchange rate to the dollar insofar as their exports are thus more affordable in the importing nations--of which the US is the most significant.

As long as the price of oil does not climb too high, this might provide the underpinnings of a recovery. One set of nations scrambling for dollars under this "balkanized" scheme are the Gulf nations and most of the OPEC nations. Juan Forero of the Washington Post reports on some of the speculations regarding the effects on the Venezuelan economy. Ariana Eunjung Cha, also of the Post, reported on Saturday on US investors selling off their assets in the stock markets of the emerging economies is helping to push their currencies to new lows. It is bankrupting companies and leaving infrastructure projects unfinished throughout the emerging world. This includes Russia, Mexico, and I deduce Oman--three of the largest oil exporters which are not members of OPEC.

In terms of the rest of the G7, I imagine (as a non monetary economist) there would be less purpose to a strong dollar, especially given that the American share of consumption must fall until new credit can be credibly extended to the American consumer. Exports to the rest of the G7 could lead the way.

China, evidently, is not being affected by the currency swaps given its tremendous reserve of dollar holdings. Corporations do not need to turn to the international markets for dollars, but can simply turn to the Bank of China. However, Ariana Eunjung Cha reported today that China's growth in the third quarter, though high at 9%, was sharply below analyst expectations.

"Economists had expected China's exports to be affected by the slowdown in the United States and in Europe. But the extent to which other parts of its economy had deteriorated -- such as industrial production, government revenue and imports -- was a shock. This is the first time in more than five years that the National Statistics Bureau has recorded a single-digit GDP growth rate."

Analysts are widely quoted as noting that GDP growth must stay at at least 8%, as below that it no longer keeps pace with the growth in the size of the labor market--the number of workers.

Keith Bradsher at the New York Times reports that Beijing is moving quickly to stimulate the economy in response.

"As part of the new policy, the State Council announced that it would increase export tax rebates for everything from labor-intensive products like garments and textile to high-value products like mechanical and electrical products. Banks will be encouraged to lend more money to small and medium-size enterprises and support programs will be drafted to help farmers, the government said."

I wonder how welcome such rebates would be in Washington. Jim Yardley, also at the Times, reported yesterday that Beijing had decided to move forward with land reforms, which allow farmers to sell or lease the land to which they have "use rights."This at a time when high food prices have made farming a much more remunerative occupation in China than it has been in the past. Real Time Economics has a blurb from Hong Liang, an analyst at Goldman Sachs, which indicates that most of the decrease in growth actually comes from declines in domestic demand, as "the nominal trade surplus grew by 13.8% [year-to-year] in [the third quarter] versus -12.1% [year-to-year] in [the second quarter]." I find this hard to square with evidence such as the Baltic Dry Index--and suspect that the increase might have come as a result of the reduction in the cost of oil imports, but it's something to consider. Either way, just now it looks as if China is still mostly depending on exports for economic growth, mainly.

If all the above is a fair statement of the facts, I am led to ask the following questions:

A) If, hypothetically-speaking, China continues to buy dollars indefinitely in order to subsidize its exports, is it likely to alienate the rest of the (non-oil producing) export nation bloc? Presumably oil producers will benefit from a high-dollar currency exchange, even as the price of oil drops. Countries without oil reserves forced to purchase dollars in order to service debts might find this onerous, even if ultimately it would be likely to make their products even more competitive, on a currency-exchange basis, than China's. Would even such additional competitiveness serve to separate China's interests from most of the exporting economies ... except perhaps from Japan's?

B) If OPEC cuts its production, as most expect it to, what happens to the viability of continuing to rely on exports to the US? That is, if the price of oil goes up in response to OPEC cuts--and it did today and Friday, but that really means nothing even short term--at what price will the price of oil make exports to the US from the emerging markets non-viable? Muriel Boselli at Reuters reports that IEA Executive Director Nobuo Tanaka said at a news conference that "The IEA is concerned (an OPEC cut) might have a negative impact on the global economic recovery." Platts also reports that on October 17, UK Prime Minister Gordon Brown said, "I think it is absolutely scandalous that OPEC is thinking of meeting in the next few days to cut oil production so they can push up the price of oil again and we will certainly try and prevent this happening." On the other hand, the IEA is a political child of the consuming nations--which the UK is slated to become--and Nesa Subrahmaniyan at Bloomberg reports that London-based Goldman Sachs analysts said that the first cuts OPEC makes to production in a recessionary environment have historically not supported a price recovery, but only subsequent cuts did so.

The analysts also gave the following helpful estimations:Iran, Nigeria, Venezuela and Indonesia need a crude price of more than $80 a barrel to balance their national budgets, and the United Arab Emirates needs $30, while Saudi Arabia, the biggest OPEC member, requires $54 a barrel, the analysts said.

Aresu Eqbali at Platts reports that Iran's OPEC governor Mohammad Ali Khatibi thinks the organization will need to cut supply by 3 mb/d to see the price of oil recover. It is my sense that supply is still so tight that Iran, Nigeria, and Venezuela, were they to coordinate a cut independently of Riyhad, would be able to drive up the price. Barclays Capital, on the other hand, thinks that a 1 mb cut is unlikely to be made effective, given the imminent addition of 3 mb to the market.

I suspect that $54/b would sustain an export-based growth/recovery of the international economy, but am not sure about $80/b. The general consensus seems to be that supply capacity additions at the margin would require at least $70-80/b, in which case there may be no price at which the international economy can continue to grow on the back of international trade (where ships and planes run on oil anyways). So, to sum, at $54/b, international trade could underpin a recovery via exports, but would the balance of that growth go to nations other than China, given that their currencies will be much worse off vis-a-vis the dollar than the yuan? (The Bank of China has been keeping down the value of the yuan since June.) If that were to prove the case, would it make sense for China to stimulate demand for oil internally--putting it more at odds with the rest of the world?

C) If the dollar falls in value relative to the Euro, will Europe be the destination of choice for exporting countries, given the relative return? Is that possible given consumer behavior in Europe? If the US stops importing a considerable share of the world's exports, is it likely that debt will be denominated in Euros or Sterling? Will the Eurozone be the only area able to bear the cost of transportation inherent in oil-based trade?

D) We might expect the price of oil to rise as it should remain a decent hedge. As the price of oil relative to the Euro falls demand for oil might pick up in Europe--where a small percentage increase means a large absolute increase in oil demand. Would there be more enthusiasm for Euro-denominated oil contracts on the part of producers, even though Europe has been fairly serious about reducing consumption?

2. Stephanie McCrummen at the Washington Post reports that fighting between government forces and a renegade general in Eastern Congo has erupted, creating over 100,000 refugees.

3. Sahar Ahmed at Reuters reports that Pakistan was unable to secure a loan from Beijing and now is looking to the IMF in a meeting at Dubai slated for tomorrow.

4. Thom Shanker at the New York Times writes that the Chairman of the Joint Chiefs of Staff, Adm. Mike Mullen, is visiting Serbia. This is the first visit of a Chairman of the Joint Chiefs of Staff to Serbia.