Currency wars: regional implications

CONTRIBUTOR | FEBRUARY 2011 | SOURCE: CPI Financial

GCC economies, with their currencies pegged to the US dollar and their main hydrocarbon exports denominated in dollars, may be susceptible to the after-effects of US quantitative easing (QE1 and QE2), according to NBK’s latest GCC Brief.

Any effects the countries of the GCC are likely to experience in the context of global currency wars will probably stem from US monetary policy and the nominal depreciation of the US dollar that may come about as a result, according to NBK’s latest GCC Brief.

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It warns that such depreciation may transmit to oil prices, trade, headline inflation, and capital inflows to the region’s economies. These factors - especially inflation - have the potential to affect the domestic economic landscape to an extent that may necessitate responses from regional policymakers.

The region may also be called upon to play a constructive role in addressing the issue of global imbalances, the macroeconomic fundamentals behind global currency tensions. Imbalances and current account surpluses have dominated international trade and economic relations of late and feature heavily on the agenda of the G-20.

Oil prices

A sustained period of dollar depreciation may exert a more noticeable effect (at least in the short term) on the oil market indirectly through speculative inflows. Speculation in the oil futures market has the tendency to distort market dynamics, causing oil prices to rise on the back of short-term profit-seeking and dollar-hedging activities.

The surge in the price of oil to within sight of the $100 per barrel price level in recent months across all the major crude oil benchmarks, from Kuwaiti Export Crude (KEC) to West Texas Intermediate (WTI) and Brent Crude, while due in large part to strong demand from China and Europe, may have reflected some pricing-in of the likely spillover effects from QE2.

The Centre for Global Energy Studies (CGES) in their November report attributed part of the nine per cent surge in the price of WTI witnessed in October to the expectation that quantitative easing would result in a flow of dollars to the oil futures market. Since then, the price of oil has moved inexorably upwards, and while there are undoubtedly fundamental factors underpinning such movements, it is difficult to confidently discount the role played by speculation against the backdrop of accommodative US monetary policy.

Indeed, to many observers, current conditions bear a striking resemblance to the situation that existed prior to the recession. From 2003 to 2008, low interest-rates and a nominally depreciated dollar combined with escalating demand from China and other emerging markets to set the stage for oil prices to eventually peak at $147 pb for WTI in 2008, just before the financial crisis took hold.

Conversely, as the CGES has suggested, the broader impact of currency wars on global trade and therefore on oil demand may portend a decline in oil prices in the short to medium term. In the estimation of the CGES, currency conflicts present potentially the greatest downside risk to their oil forecasts in 2011. That such friction could result in a 300,000 bpd drop in oil demand growth has been assigned a probability of 15 per cent by the CGES.

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