Oil, the Dollar, and National Reserves

The dollar has depreciated by seven percent against the Euro since the start of the year. According to some estimates the amount that the United States owes the rest of the world now stands at U.S.$3 trillion. This, in my opinion, is the primary reason why the dollar has fallen by so much. Although it would be a nightmare for the Federal Reserve to see the dollar collapse, its devaluation is in a way a convenient alternative to partially redress the United States’ huge current-account deficit. A decline in dollar translates to a fall in the “value” of the deficit.

However, every fall in the dollar is bad news for the Gulf Cooperation Council (GCC). European and Japanese goods become dearer in relative terms and there is a depreciation of the “real” value of the region's foreign (dollar) reserve holdings. In other words, this phenomenon aggravates inflation. The GCC are also losing out on impending revenues in this respect as well because oil and gas are priced and sold in dollars. As a result, while the rise in oil prices was 162 percent in dollar terms, from their low point in January 2002, they actually climbed by less than half that rate when measured in Euros, 77 percent. If the dollar’s value did not change the oil prices would have only risen to U.S.$34 per barrel in October 2004, instead of the actual U.S.$52. As per a study, the correlation coefficient between oil and dollar is -0.7. That is, most of the time, when the dollar fell against the Euro, oil prices rose.

In this light the International Monetary Fund (IMF) has called on the GCC to put an end to its decades-old pegging of the dirham to the dollar. The UAE is one of six members of the GCC, which has pledged to create a single currency by 2010. Mohsin Khan, head of the IMF’s Middle East and North Africa unit, said Gulf States should consider pegging their currencies to a basket of currencies including the Euro and Japanese yen.

Several of the region’s central bankers have been discussing the possibility of shifting their foreign reserve holdings but as yet no substantial action has been announced. The only logical reason given for maintaining the dollar peg is that it is a provisional step towards forming a single GCC currency. This is a good thing but could just as straightforwardly be achieved with a peg to the Euro.

However simple a solution this may sound, its timing is of utmost importance. One should not forget that the Asian central banks have considerable dollar holdings too and if the Gulf central banks lag behind in selling off their dollars they would get much worse exchange rates than what they might get if they are first to sell off their dollars and buy Euros. A very simple play of price based on the demand and supply of Euros. The current state of affairs is a bit like the classic 'prisoner's dilemma.' If any one Asian central bank toggled its reserves into Euros tomorrow it would undoubtedly benefit, but if this is done collectively they would see the value of their reserves fall massively, as a fall in the dollar would adversely affect them all. If they all decide to sell some of their reserves simultaneously, there can be a huge risk of a total collapse in the dollar. It is now estimated that the United States’ U.S.$3 trillion deficit consumes more than 60% of the world’s total current account surplus. Joseph Stiglitz, a former Chief Economist of the World Bank, commented that there is obviously something peculiar about a global financial system in which America borrows more than U.S.$2bn each and every day from other countries (in March the U.S. trade deficit was U.S.$62bn) whilst lecturing them on fiscal responsibility.

It is surely worth the while of the GCC’s central bankers to seriously consider alternative options to the current status quo, as it would be a shame if the considerable economic achievements of the past few years are washed away by maintaining a rigid dollar peg that may be extremely expensive to maintain.