Market Volatility and the Twilight of the Dollar

The chaos in world financial and commodities markets has its origins in the policy paralysis in the US and will hasten the end of the dollar's pre-eminent position as the world's reserve currency.

Fri, Aug 21, 2015
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US Federal Reserve Board - At the epicentre of the crisis

For those interested in that sort of thing, 20th August 2015 has been a fascinating day in the markets.

Oil has plunged, Kazakhstan and Vietnam have both floated their currencies, the Kazakh currency has fallen by 20% in a single day, and what are politely referred to as the currencies of the “emerging market economies” - which include the rouble - have all fallen in unison.

In Russia the rouble has tracked the fall in the price of oil, with Economics Minister Ulyukaev saying that because oil is likely to continue its fall, the rouble is likely to fall further.

In the meantime - and counterintuitively for those who continue to see the fall of the rouble as some sort of disaster for Russia - Russia’s international reserves have grown by over $4 billion in the last week - confirming incidentally that the Central Bank is not intervening in the foreign currency markets to support the rouble.

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Meanwhile, though the rouble’s fall has now been underway for almost 2 months, the effect on inflation remains subdued.  Rosstat - Russia’s statistical agency - reported deflation (i.e. an actual fall in prices) over the last week.

As for Russia’s overall financial position, the trade balance remains in surplus and the budget deficit has fallen from 3.7% of GDP to just 2.7% of GDP over the first 7 months of the year, despite the ongoing recession and the collapse in oil prices.  

This means that Russia’s budget deficit is now no greater than that of the US - supposedly in the sixth year of recovery - and is half the size of Britain’s - on the strength of the reduction of which Britain’s governing Conservatives have just been re-elected.

As I have explained many times, the reason Russia’s budget deficit is so small and why the balance of trade remains in surplus, is because the government decided to float the rouble last year.  

Of the big emerging market economies I suspect that the one to worry about is Turkey.

Unlike Russia Turkey’s economy operates with a trade deficit.  It has grown over the last decade by importing capital from the Arab world and the West at an ever increasing rate.  That has led to a steep rise in foreign debt, which by some estimates now equals more than half Turkey’s GDP - more than twice Russia’s - but without the large-scale amassing of hard currency liquid assets by Turkish companies that Russia’s companies have achieved.  As was the case in Greece before 2007, much of the debt has gone to fuel a construction boom, which as in Greece before 2007, has been Turkey’s main growth driver.  

The steep fall in the Turkish currency will increase the cost of imports and of servicing the debt, offsetting any benefit to the country from the oil price fall.  Given that the balance of trade is in deficit, it is easy to see how things could go wrong and how the economy could fall into deep recession. 

What explains the extraordinary volatility in world markets?

The Western financial press is blaming China and Saudi Arabia.

China’s economy is supposedly slowing and facing a “hard landing”, supposedly forcing it to devalue its currency to regain competitiveness, thereby allegedly increasing the risk of “currency wars” i.e. of competitive devaluations by countries seeking trade advantages over each other - as happened disastrously during the Great Depression of the 1930s.  Falling Chinese demand for commodities caused by the slowing of China’s economy is supposedly what is causing the price of oil and of other commodities to fall.

Saudi Arabia is being criticised for causing the oil rout, supposedly because it has miscalculated the resilience of US shale oil producers, and is foolishly ramping up production during a period of oversupply, instead of cutting it.  

I do not find either of these arguments convincing.

Concerns about China do not reflect what the statistics coming out of the country are saying, and are hardly justified by what has so far been a very small devaluation, which seems to have been intended primarily to strengthen China’s demand that the IMF include its currency in the IMF's reserve currency basket.  

As is the case with Russia, one should not confuse Western wishful thinking about China with China’s economic reality, which still looks robust.

As for Saudi Arabia, wishful thinking and confusion about its intentions is, if possible, greater still.

First of all, it baffles me that the myth that Saudi Arabia refused to cut production last year in order to hurt Russia as part of some sort of US-Saudi plot refuses to die. The Saudis have made it clear that it is not Russia but the US shale oil producers that are in their sights.  That is a fully sufficient explanation for Saudi Arabia’s actions, and there is no reason to look beyond it.

What of the view that the Saudis have misjudged the resilience of US shale oil producers and that they need to reverse course quickly or risk putting in jeopardy their own economy?

The Saudis are the most experienced and best informed players in the oil market, and it beggars belief that they are not well-informed about conditions in the US oil industry - including the shale oil industry.  

It is difficult to believe the Saudis ever thought a few months of depressed prices would be enough to kill off an entire industry.  Common sense - and basic market intelligence - would have told them that it would take a sustained period of low oil prices - and a general market expectation that oil prices would remain low for a long time - to persuade the shale oil industry’s investors and creditors that there was no point in holding on.

When the Saudis decided last year to maintain production at current levels they must have calculated that prices would remain depressed for a long time - two or even three years at least.  Nothing else makes sense.  

What of claims from the shale oil industry that efficiency savings will enable it to ride out the storm?

I am not an energy industry economist.  What I would say however is that what we are now hearing from the shale oil industry is precisely the sort of thing one would expect to hear from the shale oil industry at this point in the oil price cycle.  They have to say they have the situation under control to reassure their creditors and investors in order to keep them on side, and it is hardly surprising that that is what they are doing.  

I can remember hearing exactly the same things at the crest of the dot.com boom and of the property bubble as both were starting to burst and I see no reason to think it is any different this time.

Despite claims to the contrary, Saudi Arabia’s reserves and the liquidity of its banking system means that despite heavy spending it has the wherewithal to last out a prolonged period of low prices.  

That surely is the Saudis’ calculation and the reason for their actions.  

Given that this is so, there is no reason to expect them to change their policy, and Ulyukaev’s comment on 20th August 2015 shows that he at least doesn’t expect them to.

In any test of endurance between a cash-rich low-cost saver and a heavily indebted high-cost debtor - such as we are now seeing between the Saudis and the US shale oil industry - most people would put their money on the saver.  Nothing I have seen or heard so far would lead me to change that view.

Saudi Arabia’s actions anyway did not cause the original oil price crash, which began in the summer of 2014 - before November’s OPEC decision to maintain production at current levels.  Saudi Arabia’s actions cannot therefore explain the instability in the markets, which is now affecting all commodity markets and not just oil.

For an explanation of the present instability one has to look not at Beijing or Riyadh but to the policy paralysis in Washington.

In 2014 the US Federal Reserve Board finally brought its quantitative easing programme to an end.  

Everyone expected - and the Federal Reserve Board encouraged everyone to think - that this would be followed quickly by a rise in interest rates.  

As I have discussed many times previously, it was this apparent tightening of monetary policy in the US that caused oil prices to collapse last year.

In the event, instead of the rise in interest rates everyone was expecting, the Federal Reserve Board, apparently evenly split between supporters and opponents of a rate increase, has held fire.  

Some of the reluctance to raise interest rates may be because economic performance in the US over the last year has been consistently below expectations, with productivity growth particularly bad.  

It is difficult however to avoid the feeling that behind the failure to take action is pressure from the Obama White House, worried about what an increase in interest rates would do to the Democrats’ chances of holding on to the Presidency in 2016.

It is this uncertainty about the Federal Reserve Board’s intentions which is behind the instability in world markets.  Since no one is sure what the authorities in charge of the world’s main reserve currency are doing or are going to do, no-one can plan ahead, so that positions are taken quickly and are reversed as quickly, as everyone nervously waits for the Federal Reserve Board to make up its mind.

That is why when it appeared last summer that the Federal Reserve Board was going to raise interest rates the oil price collapsed; why when it put off its decision to raise interest rates in the winter the oil price rallied; and why when talk it might be about to raise rates in September began to spread again during the summer the oil price collapsed again - taking other commodity prices down with it.

It remains to be seen whether at the Federal Reserve Board’s forthcoming meeting in September a decision one way or the other is finally made.  The very latest announcement suggests continued uncertainty.

In the meantime - in the absence of a clear decision - the US risks ending up with the worst of all worlds: having the costs of high interest rates without the corresponding benefits.  

Talk of an imminent rise in interest rates must already be causing interest rates to US borrowers - including shale oil producers - to creep up, without however providing the benefit of higher interest rates to US savers, who have had to get by with almost zero interest rates since 2008.  

At the same time speculation that US interest rates are going to rise has caused the dollar to surge and the currencies of the US’s competitors to fall, pricing out US goods and ensuring that most of the benefit of the oil price fall goes to the US’s manufacturing competitors rather than to the US's own manufacturers.

US dithering on this key question is having another effect.  

Governments and business people around the world - or at least outside the Western world - have long been exasperated at how their plans are constantly held hostage by the chaos in decision making in Washington and by the US’s narrow minded focus on its own interests.

Once, not so long ago, US and Western economic predominance was so great this did not matter. Today that is no longer so.  

The result is increasing discussions around the world to end an international trade and financial system based around an increasingly erratic and unpredictable US and its currency, the dollar.  

That ultimately is what all the discussions and agreements between Russia, China, the Eurasian states and the BRICS states, that happened this year, were all about.  

It is also what the discussions between the Russians and the Saudis, which have caused so much surprise and which have attracted so much comment, are also about.

If the market instability of the last year shows the continued importance of the dollar, that same instability explains why the dollar is unlikely to retain that importance for very long.

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