Saturday, January 20, 2007

Petrodollars, Asset Prices, and the Global Financial System / Pimco / HALL OF FAME!

wow! this is brilliant stuff and a masterpiece. i urge everybody o take the time and read this summary or the full piece (headline). this is vital to understand how almost every asset market works. this from pimco is much more detailed than the also good stuff from the economist

one thing that pimco as a bond house doesn´t mention is that assets like gold should be one major if not the number 1 beneficiary. can´t blame pimco for this.

der wahnsinn! brilliant und ein echtes meisterwerk von pimco. ich kann jedem nur raten das ganze aufmerksam und sorgfältig zu studieren. das ist entscheidend um zu verstehen wie alle anlageklassen funktionieren. zudem ist es sehr viel detaillierter als das schon super werk vom economist

ein fakt der ausgeklammert wird (da pimpo ein anleihehaus ist und gold generell verteufelt wird) ist das gold ein wesentlicher wenn nicht sogar der hauptprofiteur dieser entwicklung sein wird.

It is no secret that oil producers have reaped an enormous windfall from the surge in energy prices in recent years. And with painful memories of boom-bust oil cycles of the past, the recipients are saving the lion’s share of the windfall this time. The result has been extraordinary, with oil exporters pouring well over $1 trillion into global financial markets since 2001.

Where is this tide of petrodollars going? That is more of a secret. ..... All of these factors make oil investments exceptionally difficult to track. Yet understanding petrodollars is fundamental to thinking about where international financial markets have been in recent years and where they are going. The governments of oil-producing countries are now the largest single source of global savings, surpassing Asian governments in 2005 and on track to add some half a trillion dollars in assets in 2006 alone

Decisions that oil exporting countries make about where to channel these funds affect not only the prices of key financial assets, but also by extension such variables as economic growth around the world, the ability of the U.S. to finance its current account deficit,.....

This note has two objectives. The first objective is to lay out as comprehensively as possible what we know and what we do not know about petrodollars – the volumes, the beneficiaries, and the assets being purchased with oil savings. In doing so, this note presents new information on the extent to which oil savings are accumulating in return-oriented sovereign investment funds versus conservative central bank reserves, derived from a detailed review of country balance of payments statistics. ....

The second objective is to link these facts to a framework for thinking about the impact of petrodollars on global asset prices........

Petrodollar Savings: Who and How Much?
The tripling of crude oil prices from $20 per barrel at the beginning of 2002 to around $60 per barrel at the end of 2006 has turned oil exporters into a major force in international finance. The combined current account surpluses of oil exporters, which totaled $88 billion in 2001, are projected to reach about $577 billion in 2006, From the perspective of global imbalances, consider that combined oil surpluses were equal to about 1/5th of the U.S. current account deficit in 2001 and was on track to be equivalent to about 2/3rds of the deficit in 2006. Ten of the top 20 largest current account surplus countries in 2006 are projected to have been oil exporters.

......The cumulative current account surpluses of the top twelve oil surplus countries between 2002 and 2005 totaled approximately $850 billion. ..........

Oil surpluses are highly concentrated. The top three exporters Russia, Saudi Arabia, and Norwayaccounted for about 60% of the total. The twelve countries listed in the figure accounted for virtually all the combined global oil exporter surpluses.

“Petrodollars” means more than “Middle East.” Russia and Norway accounted for about 40% of cumulative current account surpluses. Adding Venezuela and Nigeria – OPEC members outside of the Middle East – raises that figure to about 50%.

Governments capture the vast majority of oil savings. About 80% of the cumulative current account surpluses in this period were used to build central bank reserves, add to sovereign investment funds, or repay government debt.

The last point is critical. Figure 4 shows that the relationship between crude oil prices and asset accumulation by oil exporter governments is remarkably robust over time. As a rule of thumb, each $10 increase in average crude prices sustained for a year raised asset accumulation by oil sovereigns by $90-100 billion annually. Using this extrapolation, even with crude at $50 per barrel, oil sovereigns would still be channeling some $300 billion of savings annually into global financial markets. Though sustained growth of investment and import demand are likely to reduce these figures over time, they are likely to remain large especially in the near term.

The result of these new savings flows is that the total asset stocks under management by oil producers have increased dramatically......, we estimate that the sovereign assets of oil producers totaled approximately $1.50-$1.85 trillion as of mid-2006 as shown in Figure 5. Union Bank of Switzerland estimates that global sovereign assets are approximately $6.5-7.0 trillion, which would make oil producer assets about 25% of the total. Clearly oil exporters have become key players in the global financial system.Petrodollar Investments: Where To?
Where are these oil funds being invested? ......

There are three key sources: (1) the U.S. Treasury International Capital (TIC) system, which reports foreign purchases of long-term U.S. securities as well as short-term holdings of U.S. securities by foreigners; (2) the Bank for International Settlements (BIS) locational banking statistics, which reports on commercial banks’ deposits and loans vis-à-vis individual countries; and (3) Bloomberg’s database on mergers and acquisitions (M&A). By comparing recorded asset purchases by oil exporters in these three sources to the current account surpluses registered by those exporters, we can estimate what proportion of petrodollar flows is identifiable and where these flows are going.7

größer/bigger a+b


Using this approach, we find that identifiable asset purchases ($464 billion) accounted for over 40% of implied petrodollar savings between 2002 and the first half of 2006, as illustrated in Figure 6a. Several other key points emerge from the data:

Low-risk assets dominate recorded asset purchases. About 66% of total identifiable purchases flowed into bank deposits and short-term U.S. securities (mostly Treasuries and agencies). Only about 10% flowed into U.S. corporate debt and U.S. equities.

....Middle Eastern countries have much more diversified asset preferences than other producers like Russia, where the central bank is the primary recipient of oil savings. Almost 80% of recorded Russian asset purchases flowed into bank deposits and short-term U.S. agency securities.8 In contrast, Middle Eastern countries divided their recorded purchases in roughly equal proportion among short-term U.S. securities, M&A activity, and various long-U.S. securities including equities.

....Bank deposits are a growing destination for petrodollars. Oil exporters added some $200 billion in bank deposits (net of loans) in 2005 and the first half of 2006 – about 1/3rd of the combined current surpluses over this period.

More Middle Eastern oil savings is flowing into corporate acquisitions. Net M&A by Middle Eastern producers totaled $37 billion between 2005 and the first half of 2006. Purchases have been focused in the areas of transportation, telecommunications, natural resources, and property, (just read this pece about dubai ......, here is a small example from london

Evidence of Russian diversification out of U.S. dollars appears in 2006. Russian purchases of U.S. assets closely tracked Russian current account surpluses until the first half of last year, when net purchases of U.S. assets dropped almost to zero........

Impact of Petrodollars on Asset Prices

.....The results of this analysis are summarized in Figure 10. Consider it the most important table presented here because, to paraphrase Willie Sutton, that’s where the money is. The key points

The predominance of central banks implies that the bulk of oil savings has flowed to low-risk assets. Over 50% of oil savings flowing to governments has gone into central bank reserves or other conservative investment vehicles. Low-risk asset holdings of central banks are concentrated in U.S. Treasuries and agency securities, euro-denominated government debt, and dollar- and euro-denominated bank deposits.

At the same time, sovereign investment funds with more aggressive mandates have provided a significant bid for risk assets. About 30% of government oil savings flowed into aggressive, return-oriented sovereign investment funds. This implies a diversified asset allocation, both in terms of currency denomination and risk. The equity allocation in these funds is estimated to be in the range of 40-60%, with substantial interest in Asian equities by Gulf investment funds. These funds also have allocations in alternative strategies like real estate and place a portion of their funds with external managers, both real money managers and hedge funds.


Understanding the asset preferences of oil exporters is only one half of the equation, if we wish to analyze the impact of petrodollars on asset prices. The other half is comparing those asset preferences to the preferences of the other agents in the global economy from whom the oil surpluses were transferred. Figure 11 shows the increase in the consolidated trade surplus of oil exporters with the rest of the world. Between 2002 and 2005, the consolidated surplus increased by $280 billion (from $155 billion to $435 billion). The figure also shows the composition of the increase in the trade surplus by region: the oil exporter surplus with Industrialized Europe increased by $82 billion (29% of the total increase), with Asia by $81 billion (29% of the increase), with the U.S. and Anglophone Countries by $65 billion (23% of the increase), and with Developing Countries by $52 billion (19% of the increase). Therefore in approximate terms, each $1 increase in the trade surplus of oil exporters on average transferred 30¢ to oil exporters from Industrialized Europe, 30¢ from Asian countries, 20¢ from Anglophone Countries (primarily the United States), and 20¢ from Developing Countries. The key question is:

What would those agents have done with the funds vs. oil exporters?

A framework for analyzing this counterfactual is presented in Figure 12. The first step is to enumerate the differences in asset preferences between oil exporters and counterparts in Asia, the U.S., and Europe. As we have seen, oil exporters as a bloc have diversified asset preferences that span non-risk assets and risk assets, as well as dollar- and non-dollar assets. Other agents have more focused asset preferences either in terms of risk (Asian central banks) or currency (home bias in U.S. and Europe).


The second step is to trace out how each $1 increase in oil savings reallocates funds within the global economy. In reality this is a complex general equilibrium process in which a range of variables interact. To simplify the problem, we focus only on whether households in the U.S. and Europe react to a rise in energy prices by reducing consumption of other goods (possibility 1) or not reducing consumption of other goods (possibility 2). Because we consider possibility 2 more plausible – and consistent with the changes in global trade balances observed in recent years – we use this as the baseline assumption for the rest of the analysis here. This is important because some writing on the petrodollar issue focuses only on the contrast between Asian preferences for low-risk assets versus oil exporter preferences for risk assets. The framework here shows that oil exporter preferences must be compared to both Asian asset preferences and U.S./European asset preferences.

Bringing these elements together, one unambiguous conclusion is that a transfer of funds to oil exporters should boost relative demand for non-dollar/non-euro assets, particularly risk assets, which is consistent with the strength of emerging market currencies and equities that we have seen in the last few years. Other outcomes are more ambiguous, for example, the impact on U.S. and European risk assets such as corporate fixed income and equities, for which home bias demand would otherwise be present.

Applying this framework to currencies, we can see that the impact on the dollar against major currencies like the euro is also ambiguous. At first glance, the appreciation of the dollar against major currencies in 2005 – when crude oil prices increased 50% as shown in Figure 13 – seems to run counter to the standard argument that because oil exporters have more diversified currency preferences than other global agents, an increase in oil prices should be negative for the dollar. But by applying the framework, as we have illustrated in Figure 14, we can see that even a relatively modest dollar share preference of greater than 60% by oil exporters is sufficient to lend support to the dollar.

And in 2005, the fact that the increase in oil prices was a “surprise” may have provided an added boost as oil exporters built up dollar deposits above long-term asset allocation preferences simply because they did not have the chance to plan where to invest the funds. Russia is a good example of this, as reserves simply accumulated in the central bank and were invested in conservative U.S. assets, as we saw earlier. Figure 15 provides circumstantial support for this hypothesis, showing the quarterly change in the dollar versus the change in bank deposits by oil exporters. The correlation observed between 2003 and 2005 breaks down in early 2006, possibly indicating a switch to from dollar- to euro-denominated deposits by exporters. Indeed, Russia made several high-profile announcements last year on both currency diversification and the goal of orienting its portfolio more toward generating return. (also lots of comments on gold from russia)Petrodollars and the Future of Bretton Woods II
....A key assumption of BWII is that the principal agents in the system have an interest in maintaining the current regime – an objective to which they will subordinate other goals, such as maximizing financial return. To quote the authors:

...In contrast to Asian central banks, oil exporters are generally not buying assets for the secondary purpose of maintaining exchange rates to promote industrialization. Though ....oil sovereigns in general have greater regard for maximizing financial returns on their assets for the future. Even central banks in oil exporting countries – while not seeking to maximize returns in the same way as investment funds – likely have greater sensitivity to capital losses, since this objective is not subordinated to an overall economic development agenda in the same way that it is for Asian countries.

..., on a flow basis, sustained high oil prices could produce downward pressure on the dollar as oil exporters seek asset diversification on simple portfolio risk/return grounds. As described in the previous section, the dollar may have been supported recently because the large increases in oil prices were unexpected and producers therefore did not have sufficient lead-time to plan their investments. But with the surprise behind us, there will likely be pressure on the dollar to weaken to the extent that oil exporters’ long-term marginal appetite for dollar assets is below the new dollar financing demand and displaced dollar asset demand of oil importers.

Second, on a stock basis, the growing asset base under the management of oil sovereigns increases the fat-tail risks of a sudden adjustment in exchange rates. BWII assumes that Asian central banks will refrain from switching out of their dollar assets in a precipitous fashion, even on signs of dollar weakness, because their concern about capital losses is secondary to their interest in maintaining the stable system of exchange rates.

The rise of petrodollars, however, changes the equation by adding another major player to the system. It is not clear that oil exporters facing the prospect of large capital losses on their dollar portfolios will show the same willingness to stay put in dollar assets. Doing so would risk large capital losses on asset stocks that are needed to sustain consumption levels in future years when oil revenues diminish. The greater willingness of oil exporters to reallocate their large portfolio holdings out of dollars in the face of a potential dollar drop makes such a drop more likely in periods of market stress.

Five Key Conclusions
In closing, we summarize five key conclusions that emerge from the preceding discussion of petrodollars and the global economy:

1. Oil exporter governments are poised to remain the predominant source of global savings even with the decline in oil prices from their record highs.

2. The vast majority (>80%) of the oil savings flow to governments and central banks in oil-exporting countries.

3. Data on asset purchases capture less than half of petrodollar savings, but available data and inferences drawn from where assets are accumulating suggest that the bulk of investment flows have been into low-risk assets.

4. Sovereign investment funds, which captured more than one-quarter of oil exporter savings during the past four years, provide a significant bid for risk assets, particularly in emerging markets.

5. The most profound impact of the rise in petrodollar savings is on the stability of the BWII system given the greater focus of oil exporters on financial return, in contrast to the non-financial objectives of Asian central banks that have maintained the existing regime.
The international economy has witnessed a seismic shift in the global distribution of savings during the last five years as progressively larger volumes of capital have flowed from emerging market countries to the developed world. Petrodollars have been an integral part of that story. ....


disclosure: long gold, goldbugs, short $

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