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FED WATCH: Petrodollar Investment Flows To US January 3, 2007

Posted by notapundit in Economic News.
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NEW YORK (Dow Jones)–Huge oil price increases have played a notable role in adding to the U.S.’ massive global investment shortfall, although those funds have not flowed into U.S. markets directly, says new research from the Federal Reserve Bank of New York.

The paper, entitled “Recycling Petrodollars,” was published by the bank Wednesday. It was written by bank economists Matthew Higgins, Thomas Klitgaard and Robert Lerman. Its findings wade into the ongoing argument over why the U.S. current account deficit, a measure of the nation’s capital shortfall with the rest of the world, is so large.

Now at record levels, most policy makers and private sector economists agree the current account deficit must shrink. But they often disagree over what’s driving it. Some argue the deficit is driven by overspending U.S. consumers scooping up foreign goods. Others cotton to an argument advanced by Federal Reserve Chairman Ben Bernanke. He argued excess global savings flow largely to the U.S. because it is one of the few nations where a decent return can be consistently had, thus imparting a benign edge to the otherwise ugly situation.

The New York Fed paper appears to add weight to Bernanke’s so-called “savings glut” theory, given that much of the rapid rise in the current account deficit has tracked the rising oil prices now fattening the coffers of oil-producing nations.

The “petrodollar” investment flows come with clear short term benefits. “The recycling of petrodollars into the U.S. financial markets has supported activity here by allowing for higher consumption and investment spending than otherwise would have occurred,” the economists wrote. But, “the concomitant cost has been a further expansion of the U.S. economy’s already sizable net international liabilities.”

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The paper notes that since 2002 there has been a $670 billion increase in oil revenues, to around $970 billion, and that those inflows are largely concentrated in the hands of only a few countries.

Much of those inflows are not translated into increased domestic spending in the oil-producing nations. Instead, the money has been employed to buy goods from other nations, or it has been invested abroad. The researchers say these outflows thus far have been evenly split, with Europe and China benefiting most from the purchase of goods.

As for the question of where the investment portion goes, that’s where things get a little more complicated. The researchers note that of the major destinations for investment flows, only the U.S. has shown a willingness to increase its net overseas exposure. Yet, the U.S. only sees modest flows of direct investment from the cash-rich oil producing nations.

“The United States has been the ultimate destination – even if it has not been the direct destination – for petrodollars recycled into the international financial markets,” the paper stated. Their confidence in the theory rests on their observation that “the increase in net financial inflows to the United States since 2002 has roughly matched the increase in net outflows from oil exporters.”

As for the how, the economists describe a likely scenario in which an oil exporting nation buys Japanese assets. Given that nation’s reluctance to become indebted to other nations, the petrodollar inflows effectively free up money that can then be invested in higher- return U.S assets.

“While the oil exporter remains the ultimate source of surplus savings, in our example the United States is the ultimate borrower,” the analysts wrote.

The New York Fed researchers note that these petrodollar inflows should also have an impact on asset prices. It probably does, they found, but given the difficulty of sorting out the source of investment flows into the U.S. and the indirect way some of that money is reaching U.S. shores, it’s not yet possible to answer that question.

The paper also adds a further wrinkle to the ongoing debate in foreign exchange markets over reserve diversification by foreign central banks. Several Middle Eastern central banks – most recently the United Arab Emirates – have said that they either have already or are planning to reconsider their weightings of dollar reserves.

Data from the Bank for International Settlements show that dollar deposits from members of the Organization of Petroleum Exporting Countries slipped to 65% in the second quarter from 67% previously, while euro deposits nudged up two percentage points to 22%.

Michael S. Derby, Dow Jones Newswires

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