This is not a post about the gas tax. Nor is it a post about how the United States existing energy-inefficient capital stock makes it harder for the US to adjust to higher oil prices. Dr. Krugman has already covered that ground well. It is rather a post about how the global balance of payments has to respond to what increasingly looks like a significant oil shock.

Oil is trading above $120.

Saudi Arabia exports more oil than anyone else.     It isn’t unrealistic to think the Saudis oil export revenue could approach $400 billion a year if oil stays above $120.

Saudi economic development has lagged the Gulf boom towns of Doha, Dubai and Abu Dhabi.  Paul Murphy, quoting Goldman’s Ahmet Akarli:

the Saudi economy has lagged badly behind its peers in the Gulf region in terms of both per capita income and overall living standards – in particular, it lags the rapidly diversifying and prosperous economies of the UAE, Kuwait and Qatar.

The right policy course: a bit of austerity.  Yep, spending cuts.   Or least slower spending increases.

That at least is what the Saudi central bank governor suggests.    The FT reports:

Saudi Arabia’s central bank governor on Tuesday called on the government to fight inflation by curbing public expenditure, warning that economic policies in the kingdom faced “a critical situation” ….

“The Saudi Arabian Monetary Agency [the central bank] has taken steps to reduce domestic liquidity by raising the statutory reserve requirement several times. Given the dominance of fiscal policies on the economy, it is necessary to reprioritise spending and programme it to fit the absorptive capacity of the national economy,” Mr Sayari added.

The IMF – which has been arguing for maintaining the dollar peg and limiting inflation with spending cuts – presumably approves.   The IMF’s advice to Oman is presumably not that different from its advice to the Saudis.    Not that the IMF’s views matter.   The US, which is rumored to have put pressure on the Saudis to maintain their peg to the dollar, presumably does too.

Basically, SAMA and the IMF want the Saudis and the Gulf to spend more on global financial assets – as the fiscal contraction only will fight inflation if the oil revenue is sequestered abroad – and less at home.

All just to maintain a peg to a currency that isn’t a good fit for an oil-exporting region.

A currency that rises and falls with oil makes a lot more sense for an oil exporting economy than a currency that falls when oil rises and rises when oil falls.

Right now, the Saudis are trying to cut spending in the face of a (positive) oil shock in order to squeeze the Saudi economy into a depreciated currency.

They should be allowing a stronger currency to create more economic space to enjoy the oil boom.  Or at least room to spread the benefits of the oil boom a bit more widely.

A stronger riyal – assuming the rise in riyal was real not cosmetic -- would make more domestic spending and investment consistent with lower levels of inflation.

In the 1990s, the Saudis had to cut back because they weren’t getting enough revenue from the oil.   The rising dollar added to strong deflationary pressures.   Real rates rose.  Now, the Saudis face pressure to cut back even as oil soars at least in part because they have pegged their currency to the depreciating dollar.

I rather suspect the current policy won’t work.   The Saudis cannot cut spending enough to really bring about a real depreciation of the riyal.   Not with rising public expectations and tons of petrocash.

Goldman’s Akarli expects Saudi inflation to soon reach 15%.   I suspect he is right.   And there is a real risk that the resulting period of negative real interest rates will only add to the Gulf’s history of following big booms with big busts.

I liked the lede of this week’s economist story on the Fed, the dollar and oil:

“THE spirit of St Augustine hovered over the Federal Reserve this week. “Oh Lord, let us stop cutting interest rates, but not yet”

And I liked the analysis even more – perhaps because it draws on an excellent Goldman Research paper by Jens Nordvig and Jeffrey Currie.

The Economist alludes what I think is the most important point: dollar weakness and oil strength and both are manifestations of the fact that global growth has been far stronger than US growth. Weak US growth translates into dollar weakness. Strong growth outside the US – particularly in emerging economies – translates into ongoing growth in demand for oil.

All the more so because many of the most rapidly growing economies in the world keep domestic oil prices below world market prices (this is true for the oil exporters like Russia and Saudi Arabia as well as oil importers like China), helping to keep demand growth up. Combine growing economies with stagnant supply and, well, prices have to rise to bring demand in line with supply.

The impact of strong global growth on oil – and commodities more generally – is one reason why strong growth outside the US doesn’t clearly help to reduce the overall US trade deficit. Strong growth abroad means it is easier for the US to sell more goods abroad. It also increases the price of the United States’ agricultural exports. Alas, those aren’t all that large a share of total exports anymore, in part because a lot of corn is buying converted into ethanol and burned in American SUVs. But strong growth abroad also increases the price of oil. And the US now imports a lot of oil. That means it spends a ton of money on imported oil. Way more than in the 70s in absolute terms, and even relative to world GDP.

The Goldman paper suggests that the United States’ energy inefficiency, its modest exports to the oil-exporting region and a reduced willingness on the part of the oil exporting economies to hold dollars – together with the Fed’s tendency to target core inflation while the ECB targets absolute inflation – explains why the dollar has tended to fall when oil rises. Goldman found that the negative correlation with between the dollar and oil holds even if oil is priced in euros or a basket of global currencies – i.e. a high real oil prices contribute to a weak dollar more than a weak dollar contributes to a high dollar price of oil. The Economist:

“So is the weaker dollar driving oil prices up or are high oil prices driving the dollar down? The Goldman analysts argue the latter because oil exporters import more from Europe than America and hold less of their oil revenues in dollars. A second factor lies with central banks. Because the Fed focuses on “core” inflation (which excludes food and fuel), whereas the ECB targets overall inflation, America’s central bank runs a looser policy in response to higher oil prices, thus pushing the dollar down.”

This negative correlation obviously makes monetary policy particularly difficult for those oil exporters that insist on pegging their currency to the dollar. They are effectively importing a doubly pro-cyclical policy – currency weakness together with low US rates – at a time when high real oil prices are producing a boom. No wonder inflation is now at or above 10% in almost all the big oil exporters that peg to the dollar (or even a dollar-euro basket).

Saudi Arabia just recently joined the club, if 9.6% y/y inflation is rounded up. Though I guess it is possible to argue that 10% inflation isn’t that bad, as Saudi inflation was closer to 30% back in the 70s …

I am particularly interested in one part of Goldman’s argument – the claim that oil exporters hold less of their oil revenue now in dollars. If there is one thing I would like to know even more than the dollar share of China’s reserves, it is what fraction of the overall increase in the official assets of the oil exporting economies that is going into dollars. We know that Russia is putting a lower share of its assets into dollar now than in 2005. Norway too – though the shift is more modest. Iran and Venezuela have likely moved in the same direction, though they are rather less transparent than Russia and Norway.

But we don’t know what the Gulf has been doing. And at current oil prices, the Gulf really matters.

The big Gulf sovereign funds (ADIA, KIA, QIA) seem to hold about the same share of their assets in dollars as Russia, or maybe just a bit less.

But recently the growth in the assets of the Gulf’s central banks, including the Saudi Arabian Monetary Agency (SAMA), has been faster than the growth in the assets of the Gulf’s sovereign funds. And they likely still hold most of their reserves in dollars.

That is why Rachel Ziemba and I argued that the Gulf as a whole hasn’t been able to diversify away from the dollar, even if individual institutions have.

However, our argument depends on a lot of assumptions and inferences. We don’t know for sure.

And the answer matters now more than ever.

The Saudi central bank added $40b to its foreign assets in the first quarter. If oil stays where it is now, the Saudis could add close to the $200b to their foreign assets this year. That is a lot for a country of maybe 25 million people; only a country of 1.3 billion people will do more …

The Economist put the Gulf on its cover this week. It isn’t hard to see why. The Gulf was booming with oil at $ 60 a barrel. It is roaring with oil at close to $120 a barrel.

Consider the following graph, which shows the Middle East’s oil export revenues over time.* For the calculations, I assumed oil will average $120 a barrel in 2008. That is on the high side – as oil would have to average more than $120 a barrel over the remainder of the year to bring the annual average up to $120. On the other hand, oil keeps on rising …

* I calculated oil export revenues by multiplying the oil price (using the IMF's data) by a country's net oil exports (using the BP data set)

Looking at nominal dollars though can be a bit deceptive. Relative to world GDP, the Middle East’s surplus is actually a bit smaller this time around.

Real oil prices are back where they were in 79-80. But the world has become a bit less oil-intensive over time. A barrel of oil produces more output now than in the early 80s – or, alternatively, it takes a bit less oil to generate a dollar of output.

The oil importers though shouldn’t be celebrating too much. At least not the US. The following graph shows US and EU oil imports against the Middle East’s oil exports, both plotted against world GDP.

Two things jumped out at me.

First, if oil does average $120 over 2008, the rise in the United States oil import bill would be as steep as in 1973 and 1979. Going from $70 to $120 in a year would be a shock – not the steady rise of 2003-2006.

Second, the relative position of the US and Europe have shifted. Back in the 1970s, Europe imported more oil (relative to world GDP) than the US. Now the US imports a bit more than Europe. Chalk that down to falling domestic oil production – and a vehicle fleet that is only ½ as efficient as Europe’s vehicle fleet.

The result: US oil imports are as large – relative to the world’s GDP – as in the 1970s, while Europe is importing less than in the 1970s.

What of the Gulf itself?

MORE FOLLOWS

Of oil, that is.

The Saudis just released data showing just how much foreign exchange they added to their stockpile in 2007. Jim Hamilton (cool photos) reports that the Saudis now seem to be working a bit harder than in the past to get the same amount of oil out of their biggest -- actually the world's biggest, by a substantial margin -- oil field.  But they certainly aren't short on cash. The foreign accounts of the Saudi Arabian Monetary Agency (SAMA) swelled by over $75b this year. If oil stays at $90, only the creation of a Saudi SWF will keep the 2008 total under $100b.

SAMA's foreign assets were up $16b in December, and $42.6b (valuation adjusted) in the fourth quarter.

Rather than looking at how the Gulf states are managing their foreign portfolio (today’s topic du jour), I want to look at how the Gulf states are managing their domestic economies.

No doubt the Gulf is booming. How could it not, with oil above $90.

That boom has triggered a very sharp rise in inflation across the region.

The UAE number for 2007 is an estimate that appeared in the press; the other numbers are the latest available data. And there is a fairly broad consensus that the official data understates actual inflation. Some informal estimates would put inflation in the UAE at over 20%.

Commentators who didn’t like Alan Greenspan’s decision to hold nominal US rates below the rate of inflation in the aftermath of the bursting of the .com bubble have even more to worry about in the Gulf.

The GCC leaders didn't agree to change the GCC's peg to the dollar, but the issue is not dead.  Ahmet Akarli of Goldman writes:

Bahrain Foreign Minister Al-Khalifa told Reuters on Sunday that the GCC finance ministers and the central bank governors will gather to discuss "currency revaluations" in the coming few days.... it is clear that the GCC authorities are seriously considering policy alternatives and looking hard into what can be done to bring inflation under control. A currency adjustment is, no doubt, on the agenda.

It certainly should be.   The underlying economics haven't changed.  Unless the Gulf countries are willing to save all the oil windfall, it is hard to see how their currencies avoid appreciating in real terms.   With the GCC currencies depreciating against the world, such "real" appreciation -- a rise in the domestic price level relative to world prices -- can only come from faster inflation. 

Gerald Lyons of Standard Chartered:

"There is a fundamental mismatch between the economy at the centre of a currency system [The US] and those elsewhere [The GCC] ... [The Middle East's] ties to a weakening dollar mean rising inflation, and the US is cutting rates just when the Gulf needs a tighter monetary policy. These tensions will get worse"

They already are.  Recent data indicates that inflation is picking up across the Gulf.

Oil and the dollar have not consistently moved in the same direction over the past ten years.

• In 1997/1998, oil tanked and the dollar soared.
• In 2000, oil and the dollar both rose – in large part because strong demand growth from the US put pressure on global oil prices.
• From 2003 on, the dollar’s slide has coincided with a huge rally in the world oil price. The inverse correlation between oil and the dollar isn’t perfect. Oil and the dollar both rose in 2005. But recently it has been pretty strong.
• Indeed, during the course of 2007 oil has soared to close to $100 a barrel even as the US economy slowed and the US dollar slid against most currencies.

The combination of a weak dollar and high oil prices poses some problems for the US. Countries with strong currencies haven’t seen a comparable increase in oil prices – or in domestic price pressures from rising energy costs.

This combination also poses rather significant – though self imposed -- problems for many of the world’s oil exporting economies. The Gulf is importing both a weak currency and US monetary policy right now. The Economist puts it succinctly in its leader:

The combination of soaring oil prices and the tumbling dollar is distorting their economies and fueling inflation.

Real interest rates in the Gulf are now range from zero (in Saudi) to negative 5 or negative 10 – and those calculations work off the official inflation data, which may well understate inflation. The 3% yield on the two Treasury note is low for the US, though understandable given the weakness in the US housing sector. 3% is way too low for the Gulf. Yet right now Gulf countries are cutting their domestic interest rates to match US rate cuts.

Two years ago, the argument -- made in my Peterson institute policy brief -- that the Gulf countries dollar peg was an anachronism that is no longer in the Gulf's states interest wasn't generally accepted. It wasn't that wildly accepted twelve months ago. The conventional wisdom – which still crops up in say Lex last week -- was that the Gulf countries were a natural part of the dollar block so long as oil was priced in dollars.

Today, however, there is a growing consensus (see the Economist) that the Gulf needs to change in some way. Indeed, there are rumors that the UAE may announce a policy change quite soon.

But there isn’t really a consensus on what should replace the Gulf’s current dollar peg.

I loved the FT.com’s interactive oil map – particularly the graph showing the global flow of oil.

I was also impressed by Qing Wang’s analysis of the impact of rising oil prices on China.   China imported about a bit more than $70b worth of oil in 2006, enough to reduce China’s trade surplus by 2.7% of China’s GDP.   Wang calculates – based on Chinese import data – that $10 a barrel rise in the price of oil over the course of the year would increase China’s import bill by about $13.5b (and, absent an increase in the domestic gasoline prices, cut into the profits of China’s state oil companies by a bit over $14b).   

That was a somewhat smaller increase than I expected – which just shows the advantage of looking at the numbers.   So how much, by comparison, would a $10 a barrel increase in the price of oil impact other economies, assuming no offsetting increase in spending and investment in the oil exporting states and thus no offsetting increase in exports to the oil-exporting states? 

Using the BP data, I estimate that a $10 a barrel increase in the price of oil would: 

• Increase the US trade deficit by about $50b over the course of the year.
• Lead to a $46b (euro 31b) deterioration in the EU-25 trade balance.  The EU-25 imports a bit less oil than the US (12.6 mbd v 13.7 mbd) even though it produces less oil than the US and has a somewhat larger economy.  

And conversely, each $10 increase in the barrel of oil means:

• An additional $57b for the GCC states (Saudi Arabia, Abu Dhabi, Dubai and the other emirates, Kuwait, Qatar and Oman) to spend or invest.
  
• An additional $25-26b for Russia.
• An additional $10b for the Iranian government.
• An additional $9.5 or so for the socially conscious burghers of Norway to stash away in their already quite substantial sovereign wealth fund.
• An additional $8b or so for Venezuela.
  

Some very rough ballpark math:

If the the major oil exporters export around 40 million barrels of oil a day, then every $10 per barrel gap between what the oil exporters spend on imports and what they get on their oil is worth around $150b over the course of the year.  

A tiny bit less actually.  Call it $145b.

If the oil price stays at $95 a barrel or so over the next year, the oil exporters could spend about $50 a barrel, and still have about $45 a barrel left over to invest in a broad range of assets globally.

If oil exporters are getting $95 a barrel, spending $50 a barrel and saving $45 a barrel, they will have about $650b to invest globally.

That is more than China has to play with.   And the fact that China's current account surplus could rise from its 2006 level even with $95 a barrel oil is in some deep sense stunning.   The oil exporting economies also have far fewer people than China.  Even counting Nigeria.

If the oil exporters attract additional (net) private capital inflows, official asset accumulation in the major oil exporting economies could be even bigger.  

And remember, this all assumes that the oil exporters will ramp up spending on imports so that they need $50 a barrel oil to cover their import bill.    Not so long ago, any oil exporter that needed $20 a barrel oil to cover its import bill was taking a big risk ...