Economic Research Department No. 80 – November 22, 2007

The dollar's new structural depreciation: depegging the Persian Gulf  In the Persian Gulf (ie, the United Arab 1

Emirates and Saudi Arabia) pressure is mounting for the national currencies to be depegged from the dollar as the authorities there are worried about the dollar's fall. For them, it means less income from their oil exports and a constant depreciation of their mainly dollar-denominated financial reserves.

 Over in America, financial activity data related to the ongoing so-called "subprime" crisis and the threat of a credit crunch, and on real activity levels (ie, an economic slowdown) are undermining the dollar.

 In Europe, the euro has become "the other global currency". The Europeans appreciate this development for its deflationary and structuring impact, but not to the point of weakening economic growth that is already showing signs of weakness.

 As for the Chinese, the pressures are also mounting for a faster appreciation of the yuan, especially from the US Treasury Secretary, Mr Paulson and more recently, the French President (Mr Sarkozy). The Chinese authorities are intent on limiting the increase, however, to bolster the export sector. That choice, though, comes at the price of high interest rates and imported inflation. A policy of sterilisation does have its limits.

 The dollar is thus entering a structural phase of global depreciation, after the depegging of the yuan, and before that of the Gulf currencies. It had gradually shed its fixed link to the land of abundant labour (ie, China), and we now see it about to shed that link with the land of abundant energy (ie, Saudi Arabia). How are we to understand the effects of this new financial equation on inflation, growth, the markets and industrial and financial property?

Currencies are the nucleus of constellations

It has a reserve value only in a number of given historic cases, as with the Swiss franc, which means that the country in question will have less inflation, but the amount of money involved are limited in size, an attractive, safe haven, tax regime, and management and secrecy rules for foreign assets. Unlike those of small countries, the currencies of large economies are in a better position to develop favourable conditions for measuring, trading and storing value. But there always comes a time when some currencies overtake the others, which makes them the reserve currency of the others. The currencies of the "great countries" are not, therefore, equal. The Swiss franc, sterling and the dollar have thus been the main global currencies that have successively provided the major guarantee of the other currencies which have de facto become secondary. Global currency status has obvious financial advantages, namely seignorage and the denomination of commodities not to mention the fact that it attracts wealth around financial centres, banks, languages or even the rule of law. In systemic terms, that status clearly has a risk attached, namely that of the issuer's indolence. When the governor of the Bank of France, Jacques Rueff, spoke for years about the "pain-free American deficit", he was echoing the celebrated (American) definition of the dollar: "Our currency, your problem". Of course, for each country issuing a global currency, the benefits outweigh the drawbacks. To be more precise, the benefits are both short- and medium-term, while the drawbacks are longer-term. Each global currency supplants another, and periods of cohabitation are always complex and limited: franc/sterling, sterling/dollar, and each time, the gap in the countries' potential made all the difference. We have thus experienced the dollar constellation and the birth, with complications, of the euro constellation. We are also seeing these two universes deforming rapidly before our very eyes.

"Economies of scale" also apply to currencies. The currency of a "small country" does not circulate a lot, nor is it held much. It has high transaction costs. 1

See page 6

(Cont'd page 2)

Jean-Paul Betbèze Phone: +33 1 43 23 45 12 [email protected] Internet: http://kiosque-eco.credit-agricole.fr

Jean-Paul Betbèze Phone: +33 1 43 23 45 12 [email protected]

Exchange rates of "Dollar constellation currencies" (1999=100)

130

Dollar constellation: "Commodity Currencies"

(1999=100)

(Russia, Saoudi Arabia, United Arab Emirates, Koweit, Bahrein; index 100 in 1999)

(China, India, Thailand, Hong Kong, Russia, Saoudi Arabia, United Arab Emirates, Koweit, Bahrein, Argentina, Mexico)

115 110

Appreciation against the dollar

(Yuan : +12%)

120

105

+10%

100

110

95

100

90 85

90 -10%

80

80

75 70

70 99

00

01

So urce : Datastream, CA

02

03

04

05

06

99

07

CNY

INR

THB

HKD

RUB

SAR

AED

KWD

BHD

ARS

MXN

140 Appreciation against the euro 130 120

01

02

03

SAR

Source : Datastream, CA

04

AED

05

06

BHD

07

KWD

RUB

Unlike the dollar, the euro constellation is now shrinking. Because the euro exercises a natural attraction for (eastern European) currencies seeking to join the eurozone, as well as acting as a bellwether for peripheral (Mediterranean rim) countries, it is currently exercising its gravitational pull on two "free" financial currencies, sterling and Swiss franc.

Exchange rates of "Euro constellation currencies" (UK, Switzerland, Sweden, Denmark, Norway, Czech Republic, Poland)

(1999=100)

00

+ 10%

110 100 90 - 10% 80

Dollar constellation: "Mediterranean Currencies"

(1999=100)

(Morocco,Israel, Algeria, Tunisia, Egypt, Turkey; index 100 in 1999)

70 99

00

01

02

GBP

So urce : Datastream, CA

03 DKK

04 SEK

05

06

CZK

PLN

140

07 CHF

120

NOK

100

The dollar constellation is starting to "explode", or rather, to disintegrate, taking with it the Latin American dollar (which will endure), the Asian dollar (which has already begun to fall) and the energy dollar (soon to begin its own fall).

80 60 40 20 0 99

Dollar constellation: "Latin America"

(1999=100)

00

01

02

03

MOR

Source : Datastream, CA

(Argentina, Brazil, Chile, Mexico; index 100 in 1999)

04 ISR

05 ALG

06 TUN

07 EGY

TUR

110 100 (1999=100)

90

UK and Switzerland : Exchange rates against the Euro (UK, Switzerland; index 100 in 1999)

130

80

Appreciation against the euro

70 120

60 50 110

40 30 99

00

01

02

03 ARS

Source : Datastream, CA

04

05

MXN

06

100

07

BRA

CHI 90

99

Dollar constellation: "Asia"

(1999=100)

00

01

02

03

04

05

06

GBP

Source : Datastream, CA

(China, India, Thailand, Hong Kong; index 100 in 1999)

07 CHF

130

To sum up these effects, we can calculate dollar and euro entropy indicators.2 These clearly show the large scale fragmentation of the dollar and the increasing shrinkage of the euro.

120

110

100

90

80

2

70 99

00

01

02

Source : Datastream, CA

No. 80 – November 22, 2007

03 CNY

04 INR

05

06 THB

07 HKD

∑ pays i

⎞ ⎞ ⎛ σ ( e i$ ) ⎛ PIB i2005 ⎟ ⎜ 2005 ⎟ × ⎜ PIB monde E e i$ ⎠ ⎠ ⎝ ⎝

[ ]

e$i: the exchange rate of a country i against the dollar

2

Jean-Paul Betbèze Phone: +33 1 43 23 45 12 [email protected]

FX: monetary entropy 3.0

1.5

The monetary entropy of the euro is decreasing compared to the dollar.

1.4 1.3

2.0

1.2 1.1 1.0

1 0.9

0.0

0.8 00

01

02

03

Relative entropy $/€

04

05

06

07

The economic and political benefit of financing the US consumer in the framework of a "new Bretton Woods"3 is ebbing away. China consequently raised its interest rates and level of compulsory reserves for its commercial banks. It also put pressure on its neighbours to encourage them to pursue a similar policy, with the accompanying protectionist dangers, between the USA and the Asian region. But it is clear that the yuan's appreciation is not THE solution, for three reasons:

EUR/USD (rhs)

Source: Datastream, CA

) the first can be expressed in terms of elasticity. China's competitive advantage is such that it would take a very large increase in the yuan's exchange rate to recreate balanced trade with the United States. In the meantime, it is rather the dollar reserves that are growing, but that dollar is depreciating,

The dollar crisis: the ongoing acceleration The major source of the dollar crisis is domestic. The obsession with growth in order to increase the value of financial assets, and with employment as a guarantee of social and intergenerational cohesion, has resulted in a period where exports were a powerful driver alongside domestic demand. For years, however, growth in the United States has been governed by domestic demand, at a time when the external accounts were in the red. What this means is that the US consumer must be constantly financed and this was done by Japan, the Gulf states, and China.

) the second reason has to do with asset allocation. It is intrinsically increasingly risky to accumulate reserves in a single asset class, namely US Treasuries. Apart from their (low) returns, and the currency's depreciation, there is a problem of liquidity. A dollar-denominated portfolio is in fact becoming increasingly risky, as well as being excessive for the country,

) the third reason has to do with the alternative use of resources. China, having understood the Japanese lesson, will want profitable industrial, commercial and financial assets which enable it to foster stronger domestic demand. It is therefore going to invest to sustain higher consumption, with all that implies in terms of infrastructure, distribution centres, and quality control – which will, in return sustain its exports over the long term. These are the underpinnings of its "sovereign funds" strategy.

For many years, Japan was the biggest holder of dollars in the world, until, that is, the United States pursued a policy towards Japan of: a) selling nonstrategic assets (mainly property, sold at the top of the market) and b) of an appreciating yen. The outcome was the bursting of the Japanese property bubble, a fall in the yen, and a ten-year bout of deflation in Japan. America's lesson to Japan was seen and understood by the other protagonists. For many years, China has been the supplier of cheap goods (and hence of disinflation) and the country financing the acquisition of the goods it exported. Initially, the reserves it built up were a way of averting an exchange rate crisis and economic shocks in China, and subsequently of remaining competitive and curbing domestic inflationary pressures. At the time of the dotcom bubble and the risks of overheating, Alan Greenspan congratulated China for its responsible attitude in not revaluing the yuan, even if that meant not taking advantage of the situation! Today China has the world's largest dollar reserves, far greater than Japan's. But it can no longer continue to stockpile a currency that has become too costly for it. China's foreign currency reserves are clearly excessive, regardless of whether you use the "IMF rule" of three months' imports, or the "Greenspan–Guidotti rule" of coverage of the stock of short-term debt. No. 80 – November 22, 2007

The Gulf states find themselves in a specific situation, since the source of their reserves… flows from their oil reserves. The first idea was to create a stabilisation fund to maximise the oil rent over the mid-term, independently of price changes. But this is no longer the case given that demand from emerging countries is bound to grow. The second idea was to create a fund for future generations, when the oil reserves are exhausted, or too expensive to exploit. But here again, demand from emerging countries is such that is has changed the nature of the problems: the quantities to extract will be greater, prices higher, the fund's resources higher than forecast, and the volume of oil reserves can

3

Michael P. Dooley, Peter M. Garber and David Folkerts-Landau (2003) – An essay on the revived Bretton Woods system, NBER Working Paper No. 9971.

3

Jean-Paul Betbèze Phone: +33 1 43 23 45 12 [email protected]

increase on the strength of technological advances.4 In view of all this, the rational path for sovereign funds to take is to invest domestically to produce more and to move up the energy component of the production chain (ie, into refined products, electricity, aluminium etc.), at the same time as making external financial acquisitions. The idea is therefore to combine a stronger, more integrated oil economy with a more externalised one.

China: CNY vs USD, EUR

105 100 95 90 Oct-05

G7 policies: the present policies, and the right ones In view of all this, it seems counter-productive to hope "simply" that "exchange rates should reflect fundamentals", which is in fact G7 code asking China (and hence the Asia region) to allow the yuan to rise, and Japan to stop undervaluing the yen. Increasingly it is necessary to open up the discussion to the new growth and its effects on energy resources. This is because there is a risk that by arguing for a stronger yuan, you trigger the sequence of a higher yuan leading to higher Chinese reserves leading to higher oil prices and a higher euro with the threat of inflationary overheating among emerging economies and stagflation in the industrialised countries. Given that there is growing pressure to depeg the Gulf states currencies, it should be made contingent on increased investment designed to produce more oil. The fatal risk for global growth is effectively the following sequence: China depegs followed by Saudi Arabia, at a given level of oil production. This causes the dollar to plunge, longterm rates to rise, economic activity in the US and Europe to slow, and the equity markets to get the jitters (at best). We must also make sure that it is not only the dollar that is depegged. In the short-term, the United States has won its trial of strength with China by obtaining an appreciation of the yuan against the dollar alone, but this cannot last.

4

Christian Noyer (2007): Les implications systémiques de l’accumulation des réserves de change, Speech by the Governor to the Salzburg seminar, 1 October 2007, pp.14 AIZENMAN J. (2007): Large hoarding of international reserves and emerging global economic architecture, NBER Working Papers, No.13277, July 207, pp.21.

No. 80 – November 22, 2007

(21/07/2005=100)

110

Feb-06

Jun-06

Oct-06

vs USD Source: Datastream, Crédit Agricole

Mar-07

Jul-07

Nov-07

vs EUR

The yuan must be pegged officially to a basket of currencies that includes dollar, euro and yen and it is also true that the "depegging – basket of currencies" link must also apply to the Gulf states.5 Clearly, this development will lead to an international stabilisation of the monetary system with two "free currencies" (ie, dollar and euro) and two dependent currencies: yuan and Saudi Arabian riyal (SAR). The yuan will be a weighted function of the dollar, the euro, the yen and of other regional currencies, like the Gulf state currencies, on the basis of different (and confidential) weightings. In view of all this, it is also clear that the fall in the status of the dollar is inevitable, but its effective fall is slowed because the US economy will be better able to embark on a period of deficit reduction and rebuilding of savings. Clearly, too, the currencies of emerging countries will appreciate, but the rate of increase in currency reserves should slow, with the emphasis on domestic demand. Given this, the world will grow on the basis of four currencies representing four regional and also four productive trends. It is equally clear that the basket currencies – euro, sterling and yen – should appreciate.

How do you measure the oil price? It's one thing for the dollar not to be the reserve currency any more, but quite another for it not to be the currency used to price the world's strategic goods around the world. Oil is priced in dollars, as are gold, metals, commodities, and even aircraft. If the dollar is no longer the unchallenged global currency, how do we ensure that strategic products are no longer priced in dollars? The benefit of pricing commodities (and not just commodities) in dollars is obvious, since the monetary invariant goes with large numbers of pegs or quasi-fixed relationships. When the price of aircraft is set in dollars, the price of oil and commodities, and hence of all the manufacturing 5

There are several options for Gulf state currencies: appreciation followed by depegging, a crawling peg to the dollar, a crawling peg to a basket of currencies.

4

Jean-Paul Betbèze Phone: +33 1 43 23 45 12 [email protected]

and utilisation costs of the aircraft itself, follows suit. The dollar brings with it the fundamental aspects of manufacture and utilisation costs – at least the most volatile and hence most important ones! This raises the question of what to replace it with. Oil could be priced in one of the Gulf currencies – more precisely, Saudi Arabia's – pegged to the world's leading currencies, with a particular weighting for energy currencies. That currency must not only be strong, ie, linked to a large economy, but, more importantly, it must be a credible one, ie, one linked to a system of measures, (of, eg, inflation), and rules (concerning central bank independence in particular)… which is not yet the case. Far from it. For the time being, therefore, we are seeing the role of the dollar weaken and the offsetting appreciation of the euro. We are witnessing the birth of new currencies, no doubt pegged to baskets of other currencies, which are achieving a degree of independence. True independence, however, can only be born at present out of an institutional situation that is a long way from being achieved. We are therefore in a situation of growing monetary inter-dependence and the question of the accounting currency for commodities is thus a long way from being settled.

Which strategy for the euro? In view of the above, there is space for a full-blown political economy of the external euro in the wake of a policy for the domestic euro. True, the euro has "talked" and been "talked about". But it talked abroad about what it was doing at home. Today, the euro's international role requires a more accurate description of the map of leading currencies, and calls for the Chinese and Gulf state currencies to play a bigger, more responsible role. The euro could thus play an intermediate role as a bellwether currency, given that it cannot have – and does not want – primacy over the dollar. It must therefore contribute to the emergence of the yuan and Gulf currencies on the international stage by sharing its own experience with them. After all, the

No. 80 – November 22, 2007

success of the euro is a recent, significant phenomenon which was never a foregone conclusion. The emergence of new currencies is therefore possible, with similar approaches, (a "community of interests"), appropriate rules, but also, clearly, with invariants such as credibility and independence. The dollar crisis, which is now entering a new phase, allows the euro to play a stabilising role by helping other currencies to emerge, so that it is not, for better or worse, in a symmetrical position to the dollar. In parallel, sovereign funds that are more diversified in terms of their holdings of bellwether currencies are a move in the direction of the new global stabilisation. The fall of the dollar is thus underway. It seems neither possible nor desirable that the euro should succeed it as the world's reserve currency of choice. The time has come for fast-growing regions to have their own currencies, with their attendant responsibilities, for themselves and their regions, and for the benefit of the economic and financial system in its entirety. The map of this new monetary world is now being drawn in the context of China, and soon that of the Gulf, but in a unilateral, and hence destabilising, form. Developments in currency systems must therefore be gradual, avoiding approaches involving corner solutions (peg or floating), and combining baskets of currencies, sliding indexing, credibility and transparency. This situation will put the dollar in its proper perspective and by making it the primus inter pares, among four more or less pares, to be precise. The idea here is not to dream of a completely organised system, but rather one that is clear, predictable and flexible. Cont'd page 6

Saudi Arabia and the UAE: so near, but yet so far

5

Riadh El Hafdhi Phone: +33 1 57 72 33 35 [email protected]

Saudi Arabia and the UAE: so near, but yet so far The United Arab Emirates (UAE: Abu Dhabi, Dubai, Sharjah, Umm al Qwain, Ajman, Ras al Khaimah, Fujairah) and Saudi Arabia share a lot of similarities at economic and political level, but the long-term challenges each faces are nevertheless very different. The UAE and Saudi Arabia have both been members of the Gulf Cooperation Council (GCC) since it was set up in 1981. Its other members are Bahrain, Kuwait, Qatar and Oman. The organisation seeks to boost cooperation, coordination, and integration of member countries in "all areas", and to formulate similar regulations in "various fields such economy, finance, trade, and customs", etc. In 2003, GCC countries created a customs union and decided to implement monetary union by 2010 with a single central bank and a common monetary policy. GCC Key figures (November 2007 estimates): Population: 37.3 million, 0.5% of global population 2007 GDP: USD 790bn, of 2% of global GDP Per capita GDP: USD 20,600 /year 2006 GDP growth: 6.4% Inflation: 6.5% Proven oil reserves: 30% of global reserves Oil export revenue: USD 400bn Chief trading partners by region (share of total trade in 2005): Asia: 32%; Europe: 20%; USA: 16% Saudi Arabia is by far the biggest economy in the GCC and the kingdom derives its wealth from oil, of which it is the world's biggest producer with reserves of close to 25% of total world reserves. The rise in oil prices since 2002 has allowed GCC countries to generate considerable revenue streams. The reserves of SAMA, the Central Bank, stood at a record level of over USD 220bn in 2006. The state, most of whose revenues derive from oil (90% of tax receipts) thus has the resources to pursue large-scale investment programmes. It is highly dependent on oil revenues, but has already shown that it can control its own production level. Saudi Arabia also faces deep-seated structural problems. The private sector cannot absorb the workforce, which is unsuitable for the labour market. With the population doubling every twentyfive years demographics are making the need for both economic and social reform increasingly urgent. The oil money should thus be used to convert a rent-based economy to a "productive" economy, in an environment where part of the population harbours considerable resentment towards the government. No. 80 – November 22, 2007

At the political level, the king is seen as relatively liberal with a degree of room for manoeuvre when it comes to reforms. But as the margin is nevertheless very narrow, he is maintaining a very cautious approach to economic and social reform. Decisions must be arrived at by consensus within the royal family, as well as within the community of Ulema, the religious leaders, while at the same time allowing for a certain amount of cultural conservatism in society. The terrorist risk is still present, but has strongly declined since 2004. Improved management of that risk by the Saudi authorities and the sharp increase in oil revenues, which benefits Saudi citizens, are two of the main reasons for this.

Surface area: 2,240,000 km2 Population: 24.3 million Population growth rate: 2.9% Foreign population: nearly 25% Unemployment rate: 14% (unofficial) GDP (2006): USD 349bn GDP growth in 2006: 4.3% Per capita GDP: USD 14,745 Share of oil in GDP: 45% Oil reserves: 262 billion barrels (80 and 100 years' output at 2006 rates) Inflation: 2.2% Currency: Saudi riyal (SAR): 1 Riyal = 3.75 dollars On the basis of their GDP, the UAE are the second biggest economy in the Persian Gulf and the GCC. This small country, with its population of 4.5 million, only 20% of whom are nationals, enjoys a flourishing economic situation. The small population and large-scale oil reserves have given the UAE one of the highest standards of living on earth. Oil revenues (81% of tax receipts) finance the state and allow it to pursue an aggressive, ambitious

6

Riadh El Hafdhi Phone: +33 1 57 72 33 35 [email protected]

investment policy. Public sector investment is aimed at further diversifying the economy and the UAE are investing massively in services, the hospitality industry, commerce and the financial sector. The investment is also benefiting industry, especially the petro-chemicals and metallurgy industries, which the country's oil and gas resources help to make more competitive. For the economy, therefore, the risks seem limited, but there are concerns about the impact of high inflation (running at nearly 13.5% according to some research), which is hitting the property market particularly hard (+15% in 2006). The sharp increase in property prices could lead to a brutal adjustment. However, the existence of robust financial cushions is helping to minimise that risk. High inflation could nevertheless prompt the country, more than any other member of the GCC, to seek to withdraw from the peg tying its currency to the US dollar. At political level, the good relations between the different Emirates and the King, together with the low level of social unrest, indicate that the UAE will not suffer either in the short or medium term from political instability on the home front, but a relatively liberal economy and society could kindle a risk of terrorist attacks. That risk of terrorist attack is especially high given that 80% of the population is foreign and that the economy is reliant on immigration. Surface area: 83,600 km2 Population: 4.9 million Proportion of foreigners in the population: 80% Urban population: over 80% Population growth rate: 7.4% Unemployment rate: N.A Nominal GDP growth (2006): 23.4% Per capita GDP: USD 35,750 Share of hydrocarbons in GDP: 26.6% Oil reserves: 97.8 billion barrels 2006 Inflation: 13.5% Currency: Dirham. 4 AED=$1 (Pegged to dollar)

To sum up, one can say that the UAE are rich and sparsely populated, and that the main challenge is to diversify the economy to protect it from the impact of oil price fluctuations. Saudi Arabia, for its part, is far more densely populated and per capita oil reserves are dwindling. It is unlikely to be able to sustain its rent model over the long term and must imperatively develop non-oil industry and services. Its economic policy also looks more inflexible than that of the UAE, and social unrest is stronger there. Ultimately, while the economic environments of these two GCC heavyweights are similar, and economic diversification is a priority for them, it is urgent and essential for Saudi Arabia, while the UAE have scope to wait or even to make mistakes along the way.  

Crédit Agricole S.A. — Economic Research Department 75710 PARIS Cedex 15 — Fax: +33 1 43 23 58 60 Chief Editor: Jean-Paul Betbèze Sub-editors: Corinne Chaussebourg – Sophie Bigot Contact: [email protected] Internet: http://kiosque-eco.credit-agricole.fr This publication reflects the opinion of Crédit Agricole on the date of publication, unless otherwise specified (in the case of outside contributors). Such opinion is subject to change without notice. This publication is provided for informational purposes only. The information and analyses contained herein are not to be construed as an offer to sell or as a solicitation whatsoever. Crédit Agricole an its affiliates shall not be responsible in any manner for direct, indirect, special or consequential damages, however caused, arising therefrom. Crédit Agricole does not warrant the accuracy or completeness of such opinions, nor of the sources of information upon which they are based, although such sources of information are considered reliable. Crédit Agricole therefore shall not be responsible in any manner for direct, indirect, special or consequential damages, however caused, arising from the disclosure or use of the information contained in this publication.

No. 80 – November 22, 2007

7