In answer to questions and comments made in "Petrodollar Warfare" William R. Clark.

Petrodollar Warfare by William R. Clark

I think that practitioners of the dismal science often disagree with one another over methodology and interpretation of results, especially when trying to compare non-likes. This is normal. I once was speaking at a Mid-West finance convention in Chicago about foreign exchange risk management and I had a very distinguished economist from a university proudly tell me that in his 20-year career he had never made a forecast about the future. I was surprised. It is all well and fine to study what has happened, but if you do not use your results to help predict the future what is the use?

So, yes, direct comparisons of the US to the eurozone are difficult. However, correct me if I am wrong. The GDP of the EU is approximately 75% that of the USA, but they use slightly more oil than the USA. One of the reasons given by some inside and outside OPEC to switch to pricing in the euro. Is this not by definition less efficient? More oil, less economic output?

The US has very large external fiscal imbalances. I think you are right, the IMF, World Bank, OECD, G8, OPEC & many economists both within the US and abroad have criticized the US for failing to address their run away deficits and massive debt. Clearly, as stated before, consuming 70% of the world's current account surplus is not healthy nor sustainable. Okay, we have identified the problem. The USA.

However, I am not as sanguine about Europe's financial situation as you are. First, let us divide Europe into the eurozone, excluding Britain; the EU15, including Britain; and including the new accession countries, the EU25.

Here is my opinion, central & eastern European growth from the Vicegrad countries, along with exports from Germany, are driving growth in Europe. The rest of the growth places like the Club Med countries of Spain & Portugal is golf course economics. They are using cheap money, due to the stability of the EU (today) to literally pave over their coasts to provide vacation and second homes for English people who have seen the value of their homes in London and SW England go up dramatically due to low interest rates and a healthy City of London. The Economist amoung other have repeatedly warned about housing bubbles in the UK, Spain, Holland and other cities around the world (in parts of Australia & USA for example) forming. It looks like the housing bubble in the Netherlands has been pricked, and London is coming off the boil, so I am not sure how durable recent growth in Spain & Portugal are if there is a housing slow down in London?

The US runs a 4.1% budget deficit and has a debt to GDP ratio of about 72% if I am not mistaken. $8 trillion in debt is large no matter how you slice it up.

Aggregate numbers in the eurozone look better. An average budget deficit of 2.7% and debt to GDP ratio of 70% that some analysts expect to fall to 68-69%. However, this masks large, large differences within the EU, which in my opinion make the eurozone vulnerable to misallocations of capital.

Budget deficits. Despite high taxes in the EU 41.5% vs. 29% in the US; high VAT 17% vs. 3.4% in the US; gasoline $5-6 per gallons vs. $2.5-3.0 in the US; and other discrepancies in overall taxation levels in the EU their budget deficits do not look particularly good at 2.7% vs. 4.1%? On a country by county level, Greece has a deficit of 6.6%, Germany 3.7% (I will explain later), France 3.6%, Italy 3.2% (hello? that is the offical no. but it hides some off-balance sheet swaps that inflate that no.), and Portugal a 3.0 deficit. The eurozone's three largest countries are all running deficits over and above what is allowed by the stability pact agree to in the Maastricht Treaty. Portugal, Greece and Italy have all been caught lying about the true state of their finances both before qualifying for the euro and since.

Debts. The EU debt to GDP is 68-70%, which is comparable to the US. It has to be noted that Japan is more indebted than the US in relative terms and the yen is as solid as you could ask for despite zero real interest rates. However again, EU averages hide country by country differences. Belgium has a debt to GDP ratio of 95.7%, Italy 106.5% and Greece a whopping 109.3%. At least on this measure, France & Germany have debts of only 65.10% and 66.40% respectively.

Again, I have to stress that average eurozone numbers look attractive, but these regional differences are putting strain on the eurozone's integrity. These same forces pulled the ERM treaty apart. This time you have no FX risk between the core countries that traded in a tight band around the strength of the deutschmark and those outside this inner core like Spain, Portugal, Italy and Greece, but neither can you stop their governments from issuing too much debt, which threatens the EU stability, and is a tax on more fiscally conservative governments in the form of higher interest rates for all.

External EU trade. The US runs both a massive trade deficit and a massive current account deficit. In comparison, the eurozone runs a small trade surplus. However, Germany's trade surplus alone is larger than the rest of the EU's trade surplus put together. Germany's surplus in July was 9.5 billion euro vs. the eurozone's surplus of 7.2 billion. In fact, Germany and the Netherlands accounted for almost all of the eurozone surplus. Ireland posted a 2 billion euro surplus. The rest of the countries were small plus or negative. Spain -3.2 and France -2.7 billion euro had the largest trade deficits in July.

Why does this matter? They are all in the EU and members of the euro? I think in short it matters because of Germany. Germany accounts for over one-third of the EU15's GDP. Is by far the largest net contributor to the EU budget. It is the EU's and the world's largest exporter. It is Germany that has anchored Europe, first with the deutschmark and now with the euro, and other countries have benefited from lower eurozone interest rates at the expense of Germany having to pay too much. If you look at the convergence of interest rates both before and after the euro was launched you will see rates in candidate countries converging with German interest rates. You will also see a period between the ERM crisis in 1992-93 and the fixing of the locking rates for the euro on January 1st, 1999, when countries devalued their local currencies before locking them to the deutschmark. This was supposed to allow these countries to be super competitive with Germany, but as they did not pursue their own internal reforms there was not enough economic convergence to accompany convergence in interest rates and fixing of the currency into one single currency unit and one internal interest rate.

If you believe this is a zero sum game then someone's gain has to be someone's loss. However, Germany has continued to become more productive due to its fiscal straight jacket and is once again leaving countries like Italy behind who are frustrated because they can no longer devalue their way out of trouble. There are calls already in Italy to withdraw from the euro, so that Italy can once again devalue its lira. This is very short sighted because Italian interest rates would automatically jump from eurozone levels of 2% to 10-12%, as once again financial markets would price in the additional risk of inflation and default. However, how long can Germany keep carrying the laggards? Without fresh growth from the new accession countries, I think we would have reached the breaking point already. At least with high labor costs in Germany and rigid labor laws, German firms have remained competitive by off-shoring manufacturing to CEE countries as well as some to Spain & Portugal. However, this has lead to higher unemployment in Germany, now 12.6% in pan-Germany, and much higher in the former GDR.

In addition to paying more than any other country into the EU budget, which by the way is one reason why Germany's budget deficit is above the 3.0% allowed under the Maastricht criterion, is that it has paid billions of euros per year since 1989 into the former GDR. A financial burden that western Germany may carry for the next several decades, as CEE countries grow faster and attract jobs that might have gone to east Germany except that generous politicians granted overnight east German marks parity with the deutschmark, and allowed wages to rise to western German levels despite large differences in productivity. Literally, the former GDR has become Germany's albatross around their neck. That plus their contributions to the EU budget have been a tax on growth in Germany, especially as eurozone interest rates are higher than what Germany needs. So Europe's main economic engine has artificial constraints placed on it by the EU, and these demands are one reason why European growth has lagged US and world growth.

I give the euro about a 25% probability of breaking-up in the next 10-years. Either European countries like Italy will find that they can no longer compete within the EU or countries like Germany will look at their own domestic economic problems and come to the conclusion that they are better off without all that additional baggage. Another scenario is that global competition will render the EU's centrally planned social model uncompetitive. You can have any social system you want so long as you can pay for it. With the EU running budget deficits (2.7%) in excess of their growth (1.2-2.0%) they are falling behind. The country by country comparisons are even more stark.

Eastward expansion is the best thing that could have happened to a sclerotic EU15. The new members bring in faster growth and more competition and will result in a larger EU economy overall. However, even new members like Hungary are already showing signs fiscal laxity and deficit spending, and it is not certain that a system that coddles French farmers can operate along side a poorer Poland who's farmers receive only 25% of what French farmers receive? Certainly, Germany as paymaster for the EU will have to get more aggressive in fighting against French exceptionalism.

So, you outline many reasons why the US' financial imbalances are unsustainable, and I point out a few reasons why I am not as certain as you are that the EU has a better economic model? We may be both right, in which case it will be a third block of countries, perhaps Asia, that benefit from an unwinding of America's excesses and the economic malaise that I see in Europe? However, before that happens, Asia needs to develop their own capital markets. At the moment European capital markets are too small to absorb all the current account saving surpluses that are diverted from the US treasury market. Already European yields are being depressed to very low levels that do not reflect Europe's fundamentals and individual country risk. Before those flows can go into the ME, Africa or Asia they have to become more transparent, curb corruption and become more sophisticated at intermediating financial risk. To push too much money right now into these economies would be foolish. First reform and then increased levels of investment. In the meantime, if you can stomach real interest rates of zero percent, I suggest that the Japanese economy is looking better now than it has for a very long time.

This is an interesting article from The Economist, it seems to suggest that a) as China was ramping up production it imported a lot of raw materials, but b) now that it ramped up it also produces a surplus of some of those things like steel, coal, aluminun that it once imported, and c) now that it produces a surplus it may start exporting at super competitive prices, and finally d) that this might actually result in depressed commodity prices despite healthy demand growth. It is very interesting and if so you should start selling many of the mining stocks that sky rocketed over the past 5 years on the back of soaring Chinese demand.



From accelerator to brake - China and commodity markets


On the otherhand, here is an article from The Economist about the elusive domestic economy of many Asian countries that still depend too heavily on export lead growth.

In search of elusive domestic demand



Which argues logically enough that export demand will outstrip domestic demand until such a time that consumers feel sufficiently wealthy enough to start spending versus saving. Obviously, the better the social safety net the more confident Asians will feel about spending wealth accumulated versus saving it for a rainy day or their retirement.

Interestingly enough, I read a separate article which predicts that Japan may start pulling its remittances out of the US treasury market as the Japanese population ages, their current earning power decreases and they start drawing on their savings for their retirement. Certainly, higher growth in Japan will also tend to drive repatriation of funds invested overseas when real interest rates in Japan were effectively zero.

Anecdotal evidence from watching CCTV this week seems to be that China's Golden Week celebrations have failed to live up to the government's expectations that Chinese may start spending and shopping more at home. Apparently, the crowds discouraged people from leaving home, as did the traffic and congested airports, and quite possibly the Chinese do not yet feel quite wealthy enough to start spending on holidays and travel when some of their more immediate needs are still unmet. Which is fine by me. It makes sense.

MrBill,
I'm rushed today, but I will quickly address one or two items that confound your premise. You stated:

"However, correct me if I am wrong. The GDP of the EU is approximately 75% that of the USA, but they use slightly more oil than the USA."

Hmm, that's not correct. I do not have the source in front of me, but I believe the 2004 data for the EU-25 GDP is $10.6 trillion, whereas the US is $10.5 trillion (2004 BIS data? - I remember reading this in J. Rifkin's book, The European Dream, and I was surprised to learn the latest data shows the EU as just barely eclipisng the US GDP). I think you might be referring to the data prior to the May 2004 enlaregment from EU12 to EU25, where the GDP of the EU-12 was indeed approx 75% of the US ($7.6T in 2002).

Secondly, regarding oil, the US uses 25% of world's total oil production (2004 data, 20 m/bls/day out of a total production of 80 m/bls/day.) Whereas the EU used approx 18% of the world's oil production in 2004, approx 14.5 m/bls/day. Not sure why you thought the EU used more oil than the US...as I thought it was universally known we are the energy gluttons on the world stage, thanks to SUVs and other spurious energy hogs..

However, while the EU uses less oil in total (about 50% of US consumption per capita), they depend far more on OPEC exports than does the US (we receive 30% of our imported oil from Canada and Mexico, and only 26% from the Persian Gulf, etc.) In essence, more than half of OPEC's oil goes to the EU, which has created momentum towards a petroeuro, which you noted below. Perhaps that explains your previous comment. You also stated:

"One of the reasons given by some inside and outside OPEC to switch to pricing in the euro. Is this not by definition less efficient? More oil, less economic output?"

Actually, I disagree with that logic. I think its the other way around, in calender year 2004 the EU burned 14.5 m/bls/day in oil and maintained a positive trade balance, whereas the US burned 20 m/bls/day and ran a $665 billion dollar trade deficit in 2004. The EU is obviously a much more efficient user of its oil utlization. Logically speaking, if we were efficient in our oil consumption, the US should have a whopping trade account surplus, given our energy consumption levels relative to other industrialized countries that maintian a positive trade balance, such as the EU and Japan.

China of course somehow appears to be the most efficient in producing economic output with their relatively miserly oil consumption relative to the US and EU (which is about 5 m/bls/day, or only 25% of US consumption, and about 30% of EU consumption). Of course China's GDP is much less though, so its easier to compare the US with the EU, and leave China as a seperate entity given their lower aggregate GDP. http://www.cia.gov/cia/publications/fac ... os/ch.html

Anyhow, I find the whole idea of Italy going "back" ot the lira quite implausible. Only one minor Italian politician suggested that earlier this year, and the ruling party quickly denounced that idea as somewhat absurd, stating if I recall: "I don't think that is even possible." Indeed, that currency has not been in circulation for a couple of years now...its all euros since 2002. The benefits of EU participation are just too great.

Incidentally, I should mention the important fact that Italy is one of the larger EU importers for Iran's oil exports. So, if Iran goes "petroeuro" next year, the Italian government should benefit from reduced currency risk for their monthly "oil bill." Can you imagine what would happen to Italy's oil bill if they were somehow able to go back to liros? Again, it's no longer plausible, but the effects would be very adverse, very quickly...(remember the energy price spike and riots from Sept 2000 in the EU? [mainly due to currency risk - a then strong dollar and very weak euro] Imagine that times 10 inside Italy... )

Here a quick reminder of oil currency risk (and why immediately after this crisis the EU began strategies to buy oil in euros from Russia and OPEC...)
http://news.bbc.co.uk/1/hi/world/europe/931901.stm
http://edition.cnn.com/2000/WORLD/europ ... e.fuel.02/

Anyhow, I might recommend that you read T.R. Reid's book, The United States of Europe. He makes the point that what has been cast will not likely become undone. Will there be bumps along the road? (i.e. disagreement re the common Constitution). Of course, and afterall, it took 9 years to ratify the US Constitution (1789), and that was only 13 states. The EU has 25 states, and it may take them 10-12 years to make the concessions, but as Churchill stated in 1946, in order to avoid the "tragedy of Europe," they must become a "kind of United States of Europe," where ancient nationalism gives way to a national grouping of pan-Europeanism. That post-WWII goal is still very much being pursued.

To that I might add, increased investment in the EU will result should the euro become an alternative oil transaction currency, and the whole monetary dynamic will change from that singular development...quite possibly as early as next year due to Iran's bourse. Here's a prediction, if the euro becomes an official petroeuro (which Russia hinted as this week), which creates a de facto 2nd World Reserve Currency, even some UK "euro-skeptics" will begin to consider accending to the euro - as the macroeconomic benefits will begin to outweigh some of that ancient British nationalism.... Only time will tell...

Yes, I was indeed referring to the EU15 excluding the new entrants because the issue was about the EU12 who belong to the eurozone and I do not think many of the new entrants will qualify for membership in the euro until post-2007-09 in many cases, so I cannot start including their economies in the eurozone, although I do admit that their entry into the EU25 has affected pan-EU growth and therefore by default the value of the euro. Just try to compare likes and keep it straight is all.

I think this is the nut of the problem. A United States of Europe. Ever closer union. Not a loose coalition of the willing with a smorgassboard of policies & committments from which each country chooses what it likes and rejects what it does not want. The long-term viability of the euro depends on strictly following the Maastricht criterion on budget deficits and debts. The alternative is to ban the issuance of debt by individual eurozone members.

There is no way you will ever convince me that in the long-run that Italy with a debt to GDP ratio of 106.50% should be able to access the capital markets at just German bunds + 18 basis points (3.457% yield vs. 3.274%) who have a debt/GDP ratio of 66.4%? Italy & Greece (109.30% debt/GDP) access capital markets cheaper than the UK (41.50% debt/GDP) who have to pay 4.402% yield on their 10-year gilt or Sweden who pay almost as much as Greece & Italy (3.19% yield), but only have a debt/GDP ratio of 51.10%. Is this because of the implicit guarantee of the ECB who have explicitly maintained they would not rescue a country that could not repay its debt? However, that is like the US government saying they would not bail-out fannie mae or freddie mac.

I cannot prove it because the portfolios are not published, but my suspicion is that private investors are not buying Italian debt at such misery spreads, but in fact it is the Bundesbank who are forced to buy their debt in order to keep credit spreads in line within the eurozone. And Greece is in even worse shape than Italy, mind you their economy is a lot smaller than Italy's. Interest rates allocate capital and without this important signal it will be misallocated.

But, this leaves the most important question to the last, as it is a Friday afternoon. You still have not explained to me through what mechanism the euro can be held at par with the dollar? In my mind this is impossible and I have seen no argument put forth to sway my opinion. Merely saying it is necessary is not a blueprint for action.

Have a nice weekend. Cheers.

MrBill,
You stated:

"I give the euro about a 25% probability of breaking-up in the next 10-years."

Given the stability the euro has engendered to the global FX and bond markets, along with the accumulation of hundred of billions of euros as reserve currencies in the central banks of the G-8 (plus China and India plus numerous Asia banks), under your 25% scenario, it is irrefuteable that 100% of the entire world economic order would be either 1) in a full-blown meltdown mode, or 2) about to enter into a full-blown meltdown. The 2nd donmino would likely be the Japanese banks defaulting, followed by US Federal Reserve defaulting....

No point in debating anything economic at that point, as we would be in a different paradigm far removed from the post WWII period, and into a Depression with an unpredictable outcome. A "flight to safety" effect would unfold in the US, EU, China, Japan and India, etc...as the era of fiat currency would be over. The only guess I would hazard in your 25% scenario is that desperate attempts would be underway in order to back currency, any currency, with gold or other tangible natural resources. (i.e How many ounces of gold for that barrel of oil???)

Regarding your final question:

"what mechanism the euro can be held at par with the dollar? In my mind this is impossible and I have seen no argument put forth to sway my opinion. Merely saying it is necessary is not a blueprint for action."

That is The Conundrum. How can oil be priced and sold with 2 different currencies while minimizing potential dislocations in the indebted US economy? I do not have an easy answer to that question, but for the sake of world peace, some sort of dual-OPEC oil transaction currency arrangement is certianly needed. However, I will not rule it out as impossible. 10 years ago people said the euro currency was a "great idea" but impossible, and that it would fail within the first year even if the Europeans could ever launch a common currency. 100 years ago someone saying the sterling pound would be displaced by the dollar as the World Reserve Currency would be regarded as impossible, or in British speak "Rubbish, pure rubbish..." Things change, and they are changing.

The idea of dollars and euros at parity for oil transactions could theoretically reduce some unstable currency hedging tactics, but again, I do not have the answer as to how best create this mechanism. It would require a collective effort, and an unparalleled monetary compromise. With global Peak Oil imminent, such a compromise is needed.

While I disagree with several points in the following article, these comments are worth noting:

Dollar on an oily slope, Asia Times, (Jan. 13, 2005)
http://www.atimes.com/atimes/Global_Eco ... 3Dj01.html

US slowdown and the dollar
Slowing economic growth and the increasing cost of the "war on terror" will push the US budget deficit, including state government deficits, to about 6% of gross domestic product (GDP). This will also weigh heavily on the dollar in 2005. With all indicators pointing toward further dollar depreciation, foreign central banks may become more inclined to rebalance their foreign exchange reserves in favor of the euro.

The rebalancing of reserves could swiftly snowball if Russia decides to redenominate its oil and gas exports to Europe from dollars into euros. Both the EU and Russia are interested in such a redenomination. This change would force Europe's central banks to reduce their dollar reserves. It could also encourage the Organization of Petroleum Exporting Countries (OPEC) to redenominate its oil exports into euros.

The redenomination of oil would allow the traditional relationship between oil prices and oil supply and demand to reassert itself. The redenomination of oil into euros would force the dollar to devalue by 30-50%. It would also force foreign central banks, which hold about $1.5 trillion of US Treasury securities, to liquidate a portion of their holdings, pushing US interest rates much higher.

****

Tragically, the neocons have sent thousand of US soldiers and Iraqis to their violent deaths in part over the oil currency issue, and the potentiality for more death and destruction is ever present until an agreement is worked out. I think it will take men far smarter than I to figure out the best mechanism, and I have no confidence that the current administration is even capable of holding such multilateral negotiations.

On a positive note, OPEC may be trying to figure out some sort of mechanism to allow a dual-transaction currency arrangement. Here's what they said in 2002:

"In the long-term, perhaps one question that comes to mind is could a dual system operate simultaneously? Could one pricing system apply to the Western Hemisphere in dollars and for the rest of the world in euros? This will remain the test for the euro, should the currency gain ground in the market of oil transactions.

". . . Should the euro challenge the dollar in strength, which essentially could include it in the denomination of the oil bill, it could be that a system may emerge which benefits more countries in the long-term. Perhaps with increased European integration and a strong European economy, this may become a reality. Time may be on your side. I wish the euro every success."

Footnote: "The Choice of Currency for the Denomination of the Oil Bill," Speech given by Javad Yarjani, Head of OPEC's Petroleum Market Analysis Dept, on The International Role of the Euro (Invited by the Spanish Minister of Economic Affairs during Spain's Presidency of the EU), April 14, 2002, Oviedo, Spain

Others have suggested an entirely new banking system, and currencies, backed only by the actual or anticipated value of energy and other natural and/or human resources. This would facilitate Colin Campbell's proposed oil "Depletion Protocol," and could also transform the global economy towards a sustainable developmental model without ecological or economic collapse. That would require a room full of brillant new Einsteins, along with a good dose of altruistic Ghandi-like qualities too.

...To conclude, I wrote my book in an effort to inform others, and to stimulate debate on these complex issues. We must dispense with the current propaganda, and discuss the significant challenges of the 21st century. Obviously my hope is that Iraq will be the first and only oil-currency/oil-depletion war. Here's the end of the introduction of I]Petrodollar Warfare[/I]

I advocate the reform of the global monetary system including a dollar/euro currency trading band with reserve status parity, a dual-OPEC oil transaction standard, and a UN-sponsored multilateral project regarding broad-based energy reform in alignment with the Upsalla Protocol. These could potentially restore the damaged international stature of the US, while providing new mechanisms to create a more balanced global monetary system. Most importantly, given the imminent peaking of global oil production, monetary and energy reforms are required if we are to avoid the devastating outcome of global warfare over oil currency and oil depletion.

An analysis of current US geostrategic, monetary, and energy polices suggests that the 21st century will be much different from the previous century, with one possible exception. The first half of the 20th century was filled with unprecedented levels of violence and warfare on a global scale (15 million killed in WW I, 55 million in WW II). The first two decades of the 21st century present challenges that could also result in the unleashing of another period of catastrophic human suffering and destruction. In the post-nuclear age, this must not be allowed to transpire. In order to avoid such a terrible fate in this new century, American citizens, more than any others, must accept and undertake sacrifices for the betterment of humanity; we must once again begin living within our means relative to both fiscal and energy policies.

The United States’ founding fathers declared that the most fundamental and patriotic duty was to be an informed citizenry. As such, this book was written from my sense of patriotic duty in an effort to inform readers in the US and abroad. While some may find the analysis presented in Petrodollar Warfare controversial or perhaps disconcerting, it is presented in the hope that the beginning of the 21st century may be crafted by the international community into a more economically stable, energy sustainable, and less violent period than the opening decades of the previous century. Humanity and morality demand nothing less.

Whenever the people are well-informed, they can be trusted with their own government. Whenever things get so far wrong as to attract their notice, they may be relied on to set them to rights.

– Thomas Jefferson, Author of the Declaration of Independence, US President, 1801–1809

In my 25% prediction of the probability of the demise of the euro I am not anticipating it to implode triggering a catostrophic event as you mention, just as I am not accepting that a stronger euro against the dollar represents the end of the dollar and of America. As you yourself pointed out there were adjustments when the dollar replaced the pound as the world's reserve currency, and if one of several national currencies re-appeared post-present day euro, it would not be anything new, but a regression to the way Europe was pre-euro with the deutschmark its anchor currency.

There are already many discussions in European capitals about a two-tier EU with 'a core' of countries moving at a different speeds than other countries are prepared to accept. In my mind the euro experiment is no different. If member countries find it impossible to maintain disciple under the deficit and debt to GDP provisions of the Maastricht criterion, while at the sametime remaining competitive, then they will have to weigh staying in the euro versus leaving?

Clearly this is a decision for each country to make on its own and in consultation with other member countries. If there is a deal of fudging going on now, while national governments adjust to the fiscal straight jacket that the euro demands, it may because this is the so-called first round of harmonization and they are still learning where the boundaries lie? If, however in the long run, they cannot reconcile themselves to this fact, then the euro will not succeed as a credible reserve currency.

However, a core of European countries may be able to retain the euro as their own transaction currency, so long as the fiscally lax are cut loose. A 25% probability makes allowances for measures to counteract the risk over the next 10-years. But, I do not believe that a euro without the Maastricht criterion can survive in the long-term, unless, as I said before, individual national governments are prohibited from issuing their own debt. I think before a country would give up that right that they would leave the eurozone. So, perhaps a better prediction is that one or more of the current eurozone members who are having problems adjusting their economies to the realities of the euro may in the next 10-years decide to leave the euro.

In any case, we have a market dynamic which would suggest that some countries within the euro need to make adjustments; that America needs to make adjustments to shore-up their own fiscal imbalances; and, we have Asian and Middle Eastern countries that through trade have a vested interest in the outcome. This may pressure both America and Europe to reach a consensus that may be eluding them now. However, this is not a great deal different than the period between the launch of the euro in 1999 and now whereby we have seen the euro/dollar trade as low at 0.82 and as high as 1.37 in the past 6-years - a swing of >50%.

If the dollar declines to 1.40 from 1.20 today, and if Fed funds move to 5%, while the ECB keeps eurozone interest rates at 2%, then one will have a compelling argument to buy dollar denominated assets based on the purchasing power parity and interest rate differential of the dollar over the euro, while at the sametime the eurozone's export competitiveness will feel the weight of the stronger euro. If all central banks stop buying any US treasuries, recent research has indicated that this may drive-up yields by between 0.60% and 1.50%, but again a weaker US dollar and wider interest rate differentials would tempt private and institutional investors back into the US treasury market. This would have a large effect on the US economy, but would also affect the value of US treasuries held by foreigners now (higher yield, lower PV), and hurt Asian exports to the US. A pain shared by many, but perhaps necessary.

I think in any debate about the world economy we have to talk about China Inc. You have stated that other countries have maintained their manufacturing industries while the US has lost theirs. Yes and no. Germany and Italy still rely on manufacturing for about 22-25% of their GDP while its importance in the US has fallen to less than 10%. However, it had also fallen lower than German & Italian levels in the UK and Japan as well. Never the less, manufacturing in the US has grown in real terms by 4% p.a. between 1991-2005 even as it's share of the overall economy has fallen. The US is still the largest manufacturer in the world and still manufactures roughly twice what China produces.

First of all, manufacturing data is very arbitrary as has been pointed out by people who study these numbers a lot more closely than myself. They point out that if GM outsources its cleaning staff then this results in a decrease in manufacturing capacity and an increase in its service sectors. Similarly, newspapers are considered manufacturing, while journalism is clearly part of the information age, which more rightly belongs in the service sector. High value-added jobs in the service sector in R&D and writing & designing computers and software are more important to the success of the economy than just making things that are simply labor intensive. Secondly, even countries like S. Korea, Japan & HK who export to the USA offshore labor intensive manufacturing to China, just as Germany offshores some of its lower value-added assmebly to countries in CEE.

So long as countries do not offshore their core competences I do not see a problem. However, they risk giving away the shop if they export sensitive core technologies and proprietary knowledge via joint ventures with local partners who may either steal or internalize this inside know-how, and then freeze their foreign partners out and/or become their competitors. I think this risk is very real in China Inc. If in the rest of the world it is buyer beware then in China I would urge investor to beware.

Many scare mongers believe that China can produce everything better or just as well and cheaper. I seriously doubt this, but even if it is true there is one basic reason why? They do not have to cover the cost of their capital, and in China capital is very cheap as it is subsidized from the State in the form of low interest loans and, in fact, non-collectable debts. The Bank of China recently injected $60 billion into state banks to clean them up, so that they might attract foreign banks as partners (more transfer of foreign expertise by minority shareholders with little long-term leverage). It is estimated that the cost to clean-up non-perfoming loans in China may be upwards of $600 billion. That would wipe out 60% of China's foreign exchange reserves without addressing the underlying problems of over-capacity and uncompetitive, loss-making companies, many with state shareholders or sponsors. With such partners, profitable export orientated companies are often forced to adopt backward country cousins with large unreformed labor practices.

China's manufacturing policy is a make work policy, not a make sound investment decision's policy. China needs social stability. They need 8-9% growth per year to create jobs to absorb excess labor entering the market or from poorly paid villagers leaving the land for jobs in manufacturing in the cities. China fears internal instability more than any external military threat. However, it is very hard to compare the export competitiveness of one country, in which capital is basically free, with countries who's private companies not only have to cover their cost of long-term capital, but who have to generate a rate of return on that capital to pay shareholders dividends and has to be sufficient to generate investment in the first place.

In any kind of balanced scorecard analysis not only is China not covering the long-term cost of their capital, but they are storing-up liabilities for the future in the form of the environmental clean-up their rapid industrialization has created. No US or European government or their citizens would allow the type of growth that has taken place in China at such environmental costs. Keeping in mind that the US has not built a new refinery or new nuclear facility in 30-years, so it is very hard to argue that they are less competitive all things equal.

Given that some of the best supply chain management professionals and engineers are designing new factories all the time, whether they are built in Asia, Europe of the USA, it is a matter of locating those factories where they make economic sense, not that the expertise is being lost. An LPG factory planned for Australia by a Canadian company may suddenly be relocated to Egypt as the price of regional natural gas fluctuates along with the value of the Australian dollar. The expertise is Canadian not Australian or Egyptian (sorry, a little flag waving there).

If, as I expect, that the euro makes up 35% of the world's central bank reserves over the next few years this will leave approximately 55% for the US dollar and the remaining 10% might be split between the others like yen, Sterling and Swiss franc. This would be a slight improvement in the euro's favor.

As has been pointed out not only oil, but 70% of all trade is denominated in dollars. Some predict this hegemony to erode if oil is priced in euros. Perhaps if all oil is priced in euros, but not if only some oil is priced in euros. If some, but not all, oil is priced in euros then the price of oil will be determined by its supply & demand fundamentals. As oil is fungible it will be arbitraged between competing markets based on transport costs & logisitics, and prices between dollars & euros will refect the current euro/dollar exchange rate. Using euros in one half of the world and dollars in the other half will simply reflect the physcial arbitrage between one market and the other, less the foreign exchange risk of buying say oil in the east in euros and selling it in the west in dollars. The euro/dollar exchange rate will reflect all trade, not just in oil, but also current account balances, relative growth rates and interest rate differentials.

There is a reason so much trade is conducted in dollars. It is convenient for both buyer and seller. It is not practical and it is not possible for a company to have nostro currency balances in foreign banks all around the world. This is a very inefficient use of capital, requires monitoring of foreign exchange risks in many currency pairs, and as many currencies are not freely convertible, in many cases, not even possible. Therefore trade in major currenceis like euros or dollars is necessary for both buyers and sellers for price discovery; to compare prices between competing markets; as a transaction currency; and finally as a store of value in either the form of short-term saving or long-term investment.


Not to mention corruption and political interference would make holding excess currency balances in some illiquid currencies of certain non-transparent countries unacceptable to many risk managers and the firm's shareholders.

Certainly no foreign oil or investment company that I know of is going to open trading limits for an Iranian bourse. And in order to attract volume away from the IPE & NYMEX they will have to compete actively for customers who are trade & industry hedgers as well as for profit speculators for volume. If they cannot attract significant overall world volume then they will be marginalized much like regional stock exchanges trade in the shadow on the majors in equities.

As some may not be aware all trade on an exchange takes place in the form of novation. The exchange's clearing house acts as both buyer and seller to every transaction to reduce counterpart risk. Therefore, an Iranian bourse would necessiate an Iranian company or mutual as counterpart for every transaction, unless the exchange is located in France under French law with a French regulator with the Iranians as shareholders. In this case, I see this as a European exchange under European law and not an Iranian exchange. If it is founded in Iran then it will be a still-birth for the reasons I have mentioned.


However, regardless of in which currency oil is priced the seller can repatriate some of those foreign exchange earnings to pay for production in its local currency; plus pay for any domestic programs if it is a national oil company or government; while choosing to invest the remainder in either dollars or euros, or some third currency, based on active investment decisions. If an OPEC country decides that Turkey is a more attractive investment location than US treasury bills then they will divert some of their oil remmittances to investment projects in Turkey, in so far as Turkey lira can effectively absorb that investment. Otherwise, that money might find itself invested in the London property market in pounds or buoying the sales of luxury German motorcars in euros. It is interesting that Dubai has recently launched a new investment exchange in dollars, not euros, to help intermediate oil wealth into pan-Arab companies in the region. They are reporting a great deal of interest from Arab companies as well as Chinese and Indian companies to list.

I foresee a multi-polar world for a long-time to come. If Americans cannot get their financial house in order, then they will be the poorer for it, but the system itself is working fine. Large, transparent capital markets and the intermediation of price & counterpart risk. If only oil reserve numbers were so transparent?

Mr Bill: my knowledge of the subject is fairly rudimentary, but if the Iranian oil bourse opens, won't Countries who will get a better deal by buying or selling in euros (I'm thinking, for example of Russia as seller, and China as buyer), going to do just that.

It seems to me, correct me if I'm wrong, that there is nothing to stop them, and I would also have thought, that if trading for oil in Euros was going to make a profit, then buyers and speculators would be there like a rocket, and the Iranian govt would happily facilitate that as some commission would be going into their pockets.

One further thought: the Iranians surely must have thought through your objections and agreed oil deals already with powerful backers like Russia and China, and probably Venezuela, so this will go ahead,because they can't afford to fail? What have they been doing all this time otherwise - it can't take years to set up what basically is an office building (admittedly I'd build it in an undergound bunker if I was them )

My further 2p is that this will be a seller's market in the most valuable commodity in the world, during a shortage.

IMO buyers will be beating down the doors of the bourse if they can get their hands on oil.....if your point is that an Iranian company has to be involved, then every Iranian entrepreneur worth his rakeoff will have a new brass plate on his office door. Call it Anglo-Persian Oil Company or something

My points are these. Russia as a seller and China as a buyer cannot both have the same interest. If Russia can get a better price for oil in euros by selling it to Europe then they won't want to sell it to China for dollars. But the pipelines are already being built. You don't build a pipeline unless you plan to fill it and keep it filled.

A barrel is a barrel is a barrel. Some of it is higher in sulfur & heavier, some of it is lighter & sweeter, but oil is a prefect substitute for oil. Therefore, oil sold for dollars will compete ounce for ounce with oil sold in euros. Only if all exporting countries refuse to sell for dollars will oil only be priced in euros. If not, then as soon as oil in euros becomes too expensive, then buyers will line-up to buy oil in dollars from another producer. Their appetite will only be limited my arbitrage of the physical product, logistics and their currency risk.

A barrel can flow east or it can flow west. It cannot flow in both directions at the sametime. If supply is 85 mbpd and demand is 85 mbpd it does not matter how you slice it up. Iran can sell in euros and S. Arabia can sell in dollars. It will not affect how much oil is produced or consumed, unless the price gets higher in both euros and in dollars.

As the bankruptcy this week of Refco shows, counterpart risk is a real issue. The clearing house has to above and beyond reproach. They have to have sufficient assets to back all claims against them. Iran does not have the commercial or legal infrastructure to conduct business. Their currency is non-convertible. They are not allowed to bank in US dollars. Now, if I can buy oil from them significantly cheaper than from anyone else, I can find ways to use intermediaries to buy their oil (aka Iraq's oil for food program which was open to massive corruption). However, these are transaction costs that I would prefer to avoid, especially if my home country or regulator does not allow bribes to be tax deductable or forbids paying undisclosed commissions.

We are talking about two different issues. Iran as an oil exporter, and an Iranian bourse in Iran that would compete with the IPE in London and the NYMEX in NYC as the primary exchange for price discovery and hedging of oil. A bourse in Iran will lack significant volume of buyers and sellers compared to the IPE & NYMEX, as you need both buyers and sellers, not just sellers to establish a price. Speculators play an important role in price discovery by providing liquidity. Iran will continue to be an oil exporter, but no Iranian bourse located in Iran will be commercially successful due to their lack of transparency, lack of sophistication of their banks and capital markets, lack of legal recourse in case of dispute and because many banks and brokers who are active on the IPE & NYMEX would not be allowed to invest in Iran. They are not going to trust large amounts of cash to dodgy locals with a name plate on the door.

If Iran opens a bourse in France, using a French regulator, French banks, under European law then this is not an Iranian bourse. Iran is simply one of the main shareholders.

I just love the counter-argument, 'If you're so smart why hasn't anyone else thought of this?' line of thought. I present my own thoughts and ideas. You may feel free to disagree with me and state your own reasons. Proof will come if and when Iran launches a successful rival to the IPE & NYMEX in Iran. My guess is not.

By the way, everyone is convinced that Russia will sell oil in euros. Why? I think Russia doesn't really care. The production of oil is in rubles. They will sell it wherever they get the best price. Russia's largest oil companies have said they don't care whether they sell oil in dollars or euros. As they already have commercial contracts in place and sell oil & gas in large amounts to Europe, I can see no possible reason for them to tear up these long-term supply contracts and change now? Under international accounting standards, most if not all large, publicy traded Russian companies have their assets & liabilities in dollars. Selling in euros introduces foreign exchange risk to their balance sheet.

If in fact the US dollar is a worthless IOU (and everyone knows this) then I would imagine that Europe is quite happy to keep exchanging their more valuable euros for more and more dollars to pay for their oil. They should be thrilled to fix prices at 1.20 euro/dollar and then see the dollar fall to 1.40 by the time they have to pay for those barrels in 2006?

Furthermore, if in fact the IPE & NYMEX felt the competitive threat from a bourse in Iran or in France for that matter, they could offer a parallel contract on the IPE or NYMEX priced in euros, too.

Just like NYMEX has moved into the Brent crude contract in direct competition with the IPE's own Brent crude contract to try to poach business from the IPE. One is open outcry and one is electronic, but they both compete for investors and speculators. This is a healthy dynamic. It brings down transaction costs for all traders.

If the response of the CBOT/CME to Eurex' foray into the US market is any indication, both the IPE & NYMEX will meet any competitive threat from a Iranian/French exchange head-on. At least you will have your oil priced in euros if that is your goal.

Just linking some related posts in case anyone needs to cross reference and of these themes.

[QUOTE]I guess it comes down to this. Perhaps we believe that the markets will save us because we have no choice? The markets automatic adjustment mechanisms of interest rates, integrated capital markets, growth and foreign exchange dynamics have become the sole levers of power that operate rationally and are capable of disciplining prolific national governments. The markets are the only true superpowers left in the world today. Let's hope they brandish their might with care?
[CODE]

The Borrower is Servant to the Lender

Katrina's Cost to the Poor

A few years ago The Economist ran a front page on Africa calling it 'The Lost Continent' which I think fairly summed up most people's thoughts about the chances of Africa joining the world's economy in any meaningful way. Since then, Africa has been getting more attention from debt forgiveness from the G7/G8 to celebrity visits by the likes of Bono, Geldoff and the publicity shy Jeffrey Sachs (sic) with their plans for the Dark Continent. I am divided on my opinions on Africa and as I have seen so little of it firsthand, I don't really think it is fair for me to make many judgements. As I survey the world economy, I will try not to forget about its poorer bits. Here is one such article that deals specifically with the Doha round of the WTO talks and cutting rich country subsidies.



Africa to West: remove subsidies to fight poverty

So these various development banks - the EBRD, ADB, MIGA, IMF, World Bank - run around the world looking for places to invest money based on political rather than economic decisions. Fair enough. If they want to give guarantees and back risky loans then that is up to their shareholders to decide. I think their track record has been patchy at best.

First, if a project is legitimate the interest of the private sector is certainly going to be there to make sure the project goes ahead with or without participation from these agencies. The stamp of approval the agency gives is of very little value in the real-world. Credit guarantees, yes, certifying a country as a market economy and sufficiently transparent and non-corrupt? I prefer to do my own risk assessment, as I am the one who is risking my shareholder's funds, thank you very much.

Secondly, good intentions can have unintended consequences. Wasn't it the good folks at the World Bank who thought that it would be such a good idea if Vietnamese farmers diversified local agricultural production and went into coffee beans? All this accomplished was a worldwide glut in poor quality, green coffee beans, at the expense of South American coffee growers who produced a better quality product. What is the net effect? Vietnamese farmers are not going to get wealthy growing poor quality, less valuable beans and the livelihood of all those poor S. American farmers is destroyed. Good one World Bank. Any more brilliant ideas?

I ran into a situation in Slovakia whereby the EBRD crowded a German bank out of a commercial deal to build a factory there. The project was going to go ahead, but the German commercial bank was squeezed out by a Slovakian bank with the EBRD as a shareholder. This gave them access to more competitive credit. They won the deal. Except the Slovakian bank was owned by an Austrian bank, so all the EBRD accomplished was squeezing out a German bank in favor of a Austrian bank on a deal that was commercially attractive and would have gone ahead anyway? Duh.

Moral risk. What are the IMF even doing talking to Argentina? Argentina just forced a 65% haircut on their creditors and defaulted on $200 billion in debt. Not only that, but they froze foreign commercial assets in Argentina and tore up commercial contracts. So much for the IMF's stamp of good governance approval. Okay, that is yesterday's stale beer, but what is the IMF still doing talking to Kirchner's government?

Once a country defaults the IMF have no right to risk taxpayer's money with further bail-outs. Mainly people speak about the moral risk that investors will lend money to governments that are incompetent because of the perception that the IMF will always bail them out. In this case, defaulting and then resuming talks with the IMF that would pave the way to re-entry into global capital markets is a moral risk that governments no longer see debt default as the worst case scenario and therefore enter into default more often. Kind of like Chapter 11 for struggling airlines. However, this risks that investors will finally tire of lending any money and this would affect flows of FDI & aid to the developing world.

Supranational agencies have a role to play. However, they risk mission creep, squeezing out commerical lending and by their nature distort the normal operation of capital markets which allocates capital based on the risk of default. Remove the risk and more credit will flow. You can either do that through reform and open transparent government and markets or you can do that through insurance and guarantees. But insurance and guarantees do not eliminate the underlying corruption and inefficiencies of the recipient country.

Aid to poor countries is at least transparent whereas these supranationals often hide flows of cash to questionable projects under the guise of a commercial transaction. Call it what it is.