Dollar May Resume Slide As Foreign Oil Producers Invest in Other Markets

The value of the U.S. dollar has big implications for the global economy. It's also profoundly hard to predict. Still, some intrepid economists believe they have an insight: Follow the oil money.

Over the past few years, the rising price of oil has shifted a big chunk of the world's wealth into the hands of exporters from the Middle East, Latin America and Russia, making their investment decisions an important driver of global markets. Their penchant for dollar-denominated investments has helped buoy the U.S. currency, confounding economists' predictions that the U.S.'s growing debts must eventually scare investors away and cause the dollar to fall.

Now, though, some economists expect oil producers to shift their investments away from dollars, allowing the U.S. currency to resume a slide that started back in 2001. They cite a litany of reasons: renascent economies in Europe and Japan, political reactions in the U.S. against foreign investment and those nagging U.S. debts, among other reasons.

"At the margin, I do think there's an open question as to what portion of this money is going to be committed to dollar investments," says Lewis Alexander, chief economist at Citigroup in New York. "Our sense is that over time, this will put pressure on the dollar."

Citigroup expects the dollar to buy 108 yen, and the euro to buy $1.28, by the end of this year, compared with economists' consensus of 109.2 yen per dollar and $1.25 per euro. As of Friday, the dollar was trading at 118.67 yen and the euro at $1.2111.

The U.S. spends about $800 billion more abroad than it takes in annually, so it needs to attract about that much in net investments to support the dollar's exchange rate. If it doesn't and the dollar sinks, the repercussions will likely be felt around the world. As less money flows into U.S. stocks and bonds, for example, their prices could fall.

On the brighter side, a lower dollar would make U.S. exports more competitive abroad, helping to close a gaping trade deficit that many economists see as a sign that the world economy is dangerously out of balance. But if the dollar drops too far, the stimulating effect on the U.S. could force the Federal Reserve to hit the brakes by taking short-term interest rates higher -- a move that could be disruptive to global growth.

"If we get too much too fast, then it can actually undermine growth in the near term around the world," says Michael Mussa, senior fellow at the Institute for International Economics in Washington.

So far, however, the available data suggest that oil-exporting nations, rather than moving away from dollar-based investments, have played a role in propping up the dollar.

As the price of oil has more than doubled over the past few years, to $69.32 a barrel Friday on the New York Mercantile Exchange, the revenues of major oil-exporting nations have more than doubled as well, to almost $700 billion in 2005, according to a recent paper published by the U.S. Treasury. As a result, oil exporters' bank accounts have swelled to the equivalent of almost $700 billion as of September 2005, compared with less than $400 billion at the end of 2002, according to the Bank for International Settlements. Most of that money is held in dollars, so the growing accounts have boosted the U.S. currency.

If history is any guide, though, all that money won't stay in the bank for long. Past oil booms have seen similar patterns, in which exporters first built up reserves of cash, then spent it or moved it into longer-term investments, says Thomas Stolper, global markets economist at Goldman Sachs in London. "They are still very much in the process of figuring out how to allocate these reserves," he says. "Everything points toward gradually more diversification out of dollars."

Central bankers in the United Arab Emirates and Qatar have signaled in recent weeks that they might move significant chunks of their reserves out of dollars. The most recent data from the Treasury suggest that a shift could already be under way: In the 12 months ended January, oil-exporting countries put less than $50 billion into U.S. securities. A year earlier, that number was closer to $100 billion.

In the coming months, the arguments against dollar investment are likely to get stronger. For one, economies in Europe and Japan are doing better than expected. That will likely prompt European and Japanese central bankers to raise interest rates in an attempt to damp the inflationary pressure that often accompanies growth. That, in turn, will increase the potential return on euro and yen investments at a time when the Fed is likely to end a long series of interest-rate increases, reducing the relative attractiveness of dollar investments.

Data from the bank for International Settlements show that when interest-rate differentials have changed in the past, oil exporters have been quick to switch currencies. In the year after the Fed started raising rates in mid-2004, for example, the dollar share of their bank deposits rose by more than eight percentage points.

Beyond that, domestic political opposition to big foreign investments could make the U.S. a less attractive place for cross-border mergers and acquisitions -- a form of investment that has become increasingly popular among oil exporters. In the year ended last month, they had put about $45 billion into foreign acquisitions, more than twice the level a year earlier, according to Citigroup. But the U.S., after a big political row over the potential management of U.S. port operations by a Dubai-based company, isn't looking like the most welcome recipient.

"The European and Asian markets will benefit more" from oil money, says Dr. Fatih Birol, chief economist at the International Energy Agency in Paris. "There are two major reasons: one is the interest-rate movements, and the second is the general political context. As a consequence, there will be a shift out of dollars into euros and other currencies."

To be sure, foreign investors have also faced political opposition in European countries -- notably France. But Mr. Alexander of Citigroup says the vast U.S. dependence on foreign money puts it, and its currency, in the most vulnerable position. "We need enormous amounts of capital inflows just to tread water," he says.

Write to Mark Whitehouse at mark.whitehouse@wsj.com

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