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Gulf states need dollar hedge

With the federal reserve financing the us deficit by printing more money at the risk of inflation, the region's oil exporters must reassess their holdings.

Gulf News

Measures against terrorist financing and Iran sanctions loomed large in official previews of the visit of US Treasury Secretary Tim Geithner to Jeddah and Abu Dhabi this week; but bilateral investment relations will be probably an even more important aspect of his talks in the region.

Oil exporters rivalled China in recent years when it came to financing the US current account deficit. This year, however, their contribution will be significantly reduced as lower oil prices have led to diminished surpluses. In fact, some countries will have budget deficits this year; in the case of Bahrain and Oman, this will be the case when oil prices remain below $70 on average; the thresholds for Saudi Arabia and the UAE are lower at around $50 and slightly under $40 respectively.

Still, it is important for Geithner to speak with his Gulf customers who hold his treasury bonds and other US securities like equities and corporate bonds. He needs to keep them on board because it would be detrimental to the strength of the dollar should they decide to sell part of their holdings. In case the oil price will recover over the coming years like the International Energy Agency (IEA) expects, the surpluses of Gulf countries will also increase again and so will, maybe, their new purchases of US securities.

Thus, it is no surprise that Geithner comes to the Gulf region after he has visited China earlier this year. He will reassure Gulf countries that the US is open to their investments. Somebody who has to finance a budget deficit of over 12 per cent of GDP cannot be picky. But will the Gulf countries be as eager to invest as in the past after they got burned by transactions like Abu Dhabi Investment Authority's (ADIA's) purchase of a 4.9 per cent stake in Citigroup, which has lost most of its value in the meantime?

There are good reasons for the Gulf countries to reconsider their investment allocations as currency markets face a prolonged period of dynamic readjustment. During the last decades the world economy functioned on the premise that the US can consume more than it produces by running a large trade deficit and handing out dollar paper receipts to its creditors. This could not last forever of course, but it was not just a free lunch for the Americans either. Everybody was happy with it; Asian manufacturing countries actually built their whole export-led growth models around it.

Now this mechanism comes to an end and the US Federal Reserve has joined oil exporters and Asian manufacturing nations in financing the US deficit by simply printing money. As interest rates cannot be decreased below zero, it has started a policy of quantitative easing and pumps money into the economy by buying up debt securities of often questionable credibility.

If one does it long enough, money printing usually leads to inflation and currency weakness and the international creditors of the US have started to become nervous. China has called for an alternative international reserve currency in the form of the IMF's special drawing rights (SDR) that comprises several national currencies and Russia has suggested making gold part of the currency basket that defines the value of such SDRs.

As it cannot be printed at will, the ancient metal is enjoying some popularity again - China recently nearly doubled its gold reserves to over 1,000 metric tonnes, which is still very tiny compared to its overall currency reserves. It also has a policy of acquiring other real assets like commodities or shares in companies that have a strategic value for its industrialisation drive. In a remarkable move, China has also made its currency more convertible and allows it to be used in some bilateral trading transactions. To this end it has arranged for swap-lines with a number of countries amongst them Brazil, one of its most important suppliers of raw materials. It thus effectively bypasses the dollar in the respective trading transactions.

These moves should make the Gulf countries listen up as their dollar reliance is very pronounced. Dollar accumulation in China is in the end a function of an export-led growth strategy and an undervalued exchange rate. Should the dollar devalue sharply, China would have at least the capital stock it has built up with this strategy. The Gulf countries however would stand there with nothing, having traded their precious oil for paper, which is of little use for future generations. Their interest in capital preservation and risk-adjusted returns should therefore be even more urgent than for Asian investors.

To weather the coming storms on the international stage the Gulf countries should therefore follow three broad guidelines:

- Like the Chinese they should buy real assets and build up their own strategic industries in fields like petrochemicals, logistics or renewable energies.

- They should engage in cautious currency diversification with gold being the ultimate dollar hedge - other paper currencies have their problems too, the ratios of government debt to GDP in Italy or Japan for example are even worse than in the US. Should China offer the GCC countries a similar deal like Brazil, i.e. settling some bilateral trade in yuan, they should seriously consider it, although China has issues of its own when it comes to rule of law or investors' rights.

- As Saudi Arabia is already a member of the G20 and has a seat on the IMF board, GCC countries should finally actively engage in a reform of the international financial system and seek more influence in a reformed IMF against provision of capital injections.

- Dr Eckart Woertz is Programme Manager, Economics, Gulf Research Centre.

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