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Currencies
A Petrodollar Tsunami Warning
February 22, 2008

By Stephen Jen & Charles St-Arnaud | London

Summary and conclusions
Oil prices just breached the psychological US$100 a barrel threshold.  High oil prices will clearly boost the global capital flows into petrodollars: after all, high energy prices lead to transfers from oil importers to oil exporters.  Investment decisions – both physical investment and financial investment – made by the owners of petrodollars will obviously be more important the higher oil prices are.

In this note, we remind ourselves of the broad magnitudes of the key factors we need to consider in this discussion.  At US$100 a barrel, the value of the total proven oil reserves in the world is US$121 trillion, US$48 trillion of which belongs to the GCC countries.  On a flow basis, annual oil export receipts of OPEC countries total some US$1.3 trillion, at US$100 a barrel.  High oil prices, in short, will lead to a significant transfer of financial power to the petrodollar holders. 

The meaning of ‘one trillion dollars’
Before we get started, we should familiarise ourselves with the concept of ‘a trillion dollars’: what may have been vaguely referred to as ‘gazillion’ not too long ago is now a unit investors need to fully comprehend, just as we had to be indoctrinated with the concept of ‘a billion dollars’ when we were in school.  The total GDP of Africa is US$1.3 trillion.  The size of Korea and Russia’s GDP are about US$1 trillion and US$1.2 trillion, respectively; that of the UK is about US$2.7 trillion; and that of the US is about US$14 trillion.  The total market capitalisation of publicly traded equities is about US$50 trillion, and that of the bond markets is about the same size.  The total world’s official foreign reserves are around US$6.4 trillion. 

Understanding the true meaning of ‘one trillion dollars’ is essential in this discussion, as it will be the primary unit of account when it comes to petrodollars. 

The basic numbers
How big are petrodollars?  They are big, and getting bigger with the rise of oil prices.  We can look at this issue in terms of the monetary worth of the stocks of proven oil reserves underground, or in terms of flows, i.e., the value of the annual oil exports.  At US$100 a barrel, the total value of proven oil reserves underground in the world is around US$121 trillion: US$48 trillion of this belongs to the GCC member countries, the rest of the OPEC owns another US$44 trillion, while the non-OPEC countries (Canada, Norway, Mexico and Russia) own another US$12 trillion worth of oil reserves. 

At the current pace of production and exports, and at US$100 a barrel, the GCC, non-GCC OPEC and ‘other’ oil-exporting countries are projected to earn a total of US$2.1 trillion annually, with the shares of these receipts roughly evenly split between the three categories of countries.  Since ‘other’ oil exporters are producing at a more rapid pace relative to their proven stocks of oil reserves, they are, collectively, expected to run out of oil in about 15 years’ time, while the GCC and the non-GCC OPEC countries could continue to export oil for another 65-70 years, at the current pace of extraction, assuming no new discoveries.  

Scope for domestic investment in infrastructure
Such large windfall receipts/profits could be invested in domestic physical infrastructure, as has been the case in Qatar and Iran.  But, compared to most of the Asian economies, the investment-to-GDP ratios of most of the oil exporters look low.  While Norway may not have much need for large infrastructure spending, the same cannot be said about Russia or Saudi Arabia.  For countries like the UAE, Qatar, Oman and Bahrain that have been trying to become regional financial and tourism centres, considerable further investment spending is needed in the coming years.  Physical investment is a necessary, though not sufficient, way to help these economies develop a more diversified structure away from the energy sector.  On this issue, it should be stressed that there is considerable disparity among the GCC members regarding the size of the energy reserves.  Bahrain, for example, will run out of oil and gas in five years’ time.  Oman’s oil reserves could last ‘only’ until 2027, at the current level of production. 

A boost of 5-10% of GDP’s worth of investment in the coming years would not be unreasonable, provided that these countries can control the inflation consequences.  5-10% of GDP is only about US$35-70 billion – equivalent to around 10% of the annual oil revenues of the GCC countries.  In short, part of the oil receipts will be diverted to domestic investments in many of these oil-exporting countries.  However, the bulk of the petrodollar windfalls will still not be spent, and will wait to be invested in the global financial markets. 

Likely impact on the financial markets
Using our calculations, for the GCC countries, cumulative oil export receipts could reach US$5 trillion by 2013 (at US$100 a barrel), and US$10 trillion by 2020.  The global total petrodollar flows should be roughly three times this size (US$15 trillion or so) for the next five years or so, before some of the non-OPEC countries start to experience output declines. 

First, as we have written previously, the financial arguments for transforming underground oil wealth into above-ground financial (equities) wealth are quite compelling.  These oil-exporting countries, with the exception of Russia, cannot fully spend the oil receipts, and therefore much of these trade surpluses will be channeled into the global financial markets. 

Second, a good part – we guesstimate half or so – of these cumulative receipts will be recycled through SWFs.  Thus, while there might be a lot of focus on foreign sovereign entities acquiring strategic assets, the root cause of this trend is high oil prices. 

Third, bulging petrodollars will keep global long-term interest rates artificially low, in our view.  As the US savings-investment deficit shrinks, excess global savings are likely to intensify, forcing the world’s cost of capital lower. 

Bottom line
High oil prices will obviously increase the flow of petrodollars.  But exactly how big are these flows?  We calculate that the stock of the world’s proven oil reserves is now worth some US$121 trillion – close to the combined market capitalisation of global equities and bonds, with annual flows (oil export receipts) of US$2.0 trillion.  While up to 10% of these receipts may be spent on infrastructure and other investments, the rest will be invested in the global financial markets.  A tsunami is coming.    

 



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Currencies
When the Torch Burns Out, Beijing Will Still Go for Gold
February 22, 2008

By Stephen Jen & Luca Bindelli | London

Summary and conclusions
This note points out the historical pattern that, since World War II, the economic growth of the host countries of the Summer Olympics usually suffers in the year following the Games.  Will China break this 50-year tradition, particular as the weakness in the US economy could be more protracted and the delayed impact of the interest rate hikes and the CNY appreciation should start to act on the economy just as the Olympic torch burns out? 

Our focus is on both the capex cycle and the (admittedly unmeasurable, fickle and non-mechanical) sentiment effect of hosting an Olympic Games.  While there are a multitude of other factors likely to move the Chinese economy in the next couple of years (including those mentioned above), we assume them away to bring into sharper relief the one-off effects of hosting such an event, through the capital expenditure cycle. 

Historical pattern
We looked at the economic performance of the Olympic host countries (OHCs) since 1956.  The striking common feature is an acceleration in GDP growth in the year in which the Olympics were held, followed by a year of sub-par growth.  Of the 11 cases we examined since 1956, only the US (Atlanta) in 1996 did not show a slowdown following the Olympics.  The slowdown was particularly stark in Australia (1956), Japan (1964), the US (1984) and Korea (1988).  Spain actually fell into a recession in 1993.  In the two most recent Olympics (Athens and Sydney), both Greece and Australia decelerated by 1.5-2.0% between the year before and that after the Olympics. 

We looked at how the growth, industrial production and national investment growth changed in the 10 quarters before and after the Olympics compared to the average over that period.  Average GDP growth deviation from trend tends to decelerate from 1.1% in the year prior to the Olympics to 0.9% in the year of the Olympics, followed by a slowdown to -1.2% in the following year.  For investment, the slowdown is even more pronounced: from a 3.3% growth above-trend surge prior to the Olympics to a peak contraction of close to 7% below-trend post-Olympics (for a peak-to-trough swing of 10%).  Also, in terms of timing, it is visually clear that investment has led this up and down cycle around the Olympics.  Industrial production exhibits a similar trend.  But in terms of severity, it is somewhere between the GDP and the investment trajectories. 

The reasons are intuitive
This growth profile should not be too surprising.  In the lead-up to the Olympics, it is reasonable to expect large investment, particularly in non-dwelling and hotel construction.  Tourism receipts should also surge in the Olympic year.  In the case of Beijing, the issue of ‘prestige’ could also be important, as China tries to showcase its economy and country: doing so costs money and such efforts show up in the GDP.  The front-loading of infrastructural and other physical investments naturally implies a slowdown following the Olympics.  Just as importantly, a positive sentiment effect may accompany the Olympics, buoying consumption and business investment in areas that are not directly related to the Games or the host city.  Such a build-up could be followed by an anticlimactic sentiment effect, as the hype cools down and the world’s attention focuses elsewhere. 

Currency depreciation following the Olympics
We also examined the performance of the currencies of OHCs.  One problem was that, prior to 1971, most of the exchange rates were pegged to the USD and to gold.  Pressures on the economy could not be reflected/expressed through exchange rates.  We thus focused on experiences after 1972.  In Canada (1976), the US (1984) and Spain (1992), the currencies of the OHCs depreciated significantly in the two years after the Olympics.  In the case of Sydney (2000), the AUD weakened modestly in the ensuing year.  However, in the cases of Seoul (1988) and Athens (2004), USD/KRW and EUR/USD remained essentially flat over the two-year period, while the USD actually strengthened following the 1996 Atlanta Olympics.  Therefore, with a few exceptions, the currency of the host country depreciated when its economic growth decelerated following the Olympics. 

The case of China
How will the Summer Olympics affect China’s growth rate and the CNY?  It would be very difficult to have a precise answer to the above question, mainly because there are direct and indirect effects of the Olympics on economic activities and the value of the CNY.  We have the following thoughts:

·         Thought 1.  China is a big country.  The size of the host country is important, as it is essentially only the city that is hosting the Games that should experience large swings in investment and capex cycles.   For countries like the US and China, Atlanta or Beijing hosting the Olympics should not have nearly as big an impact on the economy as, say, Seoul, Barcelona and Sydney would have on Korea, Spain and Australia.   Thus, we suspect that the contraction in capex following the Beijing Olympics is not likely to be as large as the historical average suggests.  The slowdown in US GDP in 1984 (Los Angeles) is miniscule; in 1996 (Atlanta), US growth actually accelerated, for the simple reason that what happens to a city in a big country shouldn’t dominate the country’s GDP. 

·         Thought 2.  China is a diverse country.  China is not monolithic, politically, economically or geographically.  In a way, China can be broken down into the East (the coastal area), the Central and the West. The gradation in the levels of economic development and infrastructure build-up is immense across these three broad regions.  If the negative demand shock from the US hits the East, the demand for infrastructure and other investment is likely to remain high for the Central and the West.  While the positive psychology associated with the ‘Big Event’ is likely to have been a stimulus for the entire country in recent years, we don’t expect the abatement in investment to be very synchronised across the three broad regions right after the Summer Olympics. 

·         Thought 3.  The US business cycle.  In our view, the US business cycle will likely show weakness leading to the Olympics, which starts on August 8, 2008, and strength after the Olympics – precisely out of sync with the typical growth cycle surrounding an Olympic Games.  This should help to smooth out the growth cycle for China between 1H and 2H. 

·         Thought 4.  The PBoC will, for now, treat the economy as innocent until proven guilty.  The PBoC still has its foot on the brake, though it is now more concerned about the prospective recession in the US.  For now, the PBoC has continued to let the CNY appreciate rapidly (so far this year, USD/CNY has moved at an annualised pace of 16%), because inflation remains stubbornly high.  The economy will be assumed to show enough resilience against a growth slowdown.  But as soon as Beijing comes to the view that an outright US recession is the more probable scenario, it is likely to slow down the pace of interest rate hikes and currency appreciation.  But for now, given that the data coming out of the US remain relatively mixed (i.e., not enough to favour a recession over a mere slowdown), USD/CNY may continue to be guided lower at a rapid pace. 

Bottom line
We fully acknowledge the historical regularity with which the growth rate of the country that hosts the Summer Olympics tends to show a pronounced slowdown following the Games, and suspect that we might see this trend in China as well.  However, there are special factors that are likely to mute the magnitude of this slowdown.  Where USD/CNY goes will still be driven more by the overall path of domestic growth in China and the US business cycle.  The Beijing Olympics will likely be a secondary – though legitimate – factor for the growth outlook in China

 



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