Andy Mukherjee: Petrodollars will test Asia's dollar fixation

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By Andy Mukherjee
Bloomberg News Service
Tuesday, January 23, 2007

http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_mukherje...

SINGAPORE -- A glance at stock values suggests that lower energy prices are an unalloyed blessing for Asia. That may not be true.

Morgan Stanley Capital International's emerging-market equity index for Asia has risen 22 percent since oil began its descent in early August last year.

With crude-oil futures hovering at about $52 a barrel in New York compared with $77 on July 14, Asian consumers have reason to be optimistic about their household budgets.

The region's taxpayers too should be happy to see a sustained reversal in crude-oil prices, which more than quadrupled between January 2002 and July 2006.

Governments have subsidized pump prices from China and India to Indonesia and Vietnam.

But if oil keeps plummeting -- because of global warming, the El Nino weather effect, slowing world economic growth, rising crude output, or whatever -- Asia may pay a big price as a financier of U.S. consumerism.

Last year the Asian monetary authorities, together with the central banks and state investment agencies in oil-exporting countries, bought about $770 billion in foreign-currency assets.

These official purchases financed most of the estimated $870 billion U.S. current-account deficit in 2006, according to research by the Federal Reserve Bank of New York.

If the petrodollar surpluses dwindle, the job of sustaining U.S. consumption will fall squarely on the Asian central banks.

Should the monetary authorities in China, Japan, South Korea, and India continue to feed the American spending habit or invest their surpluses elsewhere?

If they keep loading up on U.S. Treasuries and the dollar eventually collapses, Asian central banks may have to sustain large losses on their balance sheets.

If they stop buying "risk-free" U.S. debt, the dollar might decline anyway. That's the dilemma.

Of course, it all depends on the extent of the slide in energy costs. Last year oil-producing nations probably added about $600 billion in assets. "Even with crude at $50 a barrel, oil sovereigns would still be channeling some $300 billion of savings annually into global financial markets," says Ramin Toloui, a fund manager at Newport Beach, California-based Pimco, a unit of Germany's Allianz SE.

Yet Toloui's research shows that compared with Asian central banks' penchant for investing trade surpluses primarily in dollar-denominated "conservative" securities, petrodollars are more likely to have been invested in riskier assets, including emerging-market equities.

It stands to reason, then, that if oil-exporting countries from Russia and Venezuela to Saudi Arabia and Norway earn substantially less for their commodity this year, or if they get spooked by a fall in the dollar, they might be tempted to soup up their total returns by cutting back on U.S. Treasuries and shifting funds to higher-risk, emerging-market assets.

To the extent that such diversification may already be under way, the rise in emerging-market stock and property prices and the narrowing of bond spreads aren't surprising.

While investors in Asia won't complain about petrodollars chasing emerging-market assets, the monetary bosses in the region may not be particularly happy.

A shrinking appetite for dollar-denominated securities, if it leads to a precipitous decline in the U.S. currency, will dent the value of Asian central banks' foreign-currency reserves.

China is most at risk. Analysts estimate that more than two-thirds of the country's $1 trillion foreign-currency reserves may be held in dollar-denominated securities.

There is a strong indication that China will soon set up an institution to invest part of the reserves in riskier assets. Stephen Green, a Standard Chartered Plc economist in Shanghai, estimates the size of this new investment agency at $200 billion.

The transfer of foreign exchange from the People's Bank of China to the new agency has to be gradual. Otherwise it may become another signal for other sovereign and private investors to diversify away from the dollar. As much as China would want to prepare for a weak dollar, it won't want to cause it.

Seeking returns outside the safety of U.S. government bonds is nothing new for countries in the Persian Gulf.

Back in 2005, state-owned Dubai International Capital LLC acquired Tussauds Group, owner of Madame Tussauds waxworks museums and the London Eye observation tower.

The monetary authorities in Asia can't diversify out of the dollar with the same degree of nonchalance as their counterparts in oil-exporting nations. Asia is married to a model of export-led growth whose continued success depends on a strong dollar.

Asia keeps its currencies undervalued in order to sell goods to the U.S. on the implicit understanding that it will also provide the financing -- through the purchase of U.S. Treasury and agency bonds -- to sustain the consumption.

If Pimco's Toloui is right and oil producers now hold a quarter of the world's sovereign assets, Asia and the United States may not be able to continue their private arrangement for long.

Think of it as a game of musical chairs between the United States and Asia. The oil exporters now control the music.

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Andy Mukherjee is a Bloomberg News columnist. The opinions expressed are his own.

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