Exporters of oil are saving more of their recent windfall than in previous price booms. It's hard to spot where the money is going

MANY American politicians and pundits explain their country's enormous current-account deficit by pointing at the surpluses of Asian economies, especially China. Undervalued currencies and unfairly cheap labour, they complain, have undermined America's competitiveness. In fact, looking at the world as a whole, the group of countries with the biggest current-account surpluses is no longer Asia but oil exporters, on which high prices have bestowed a gigantic windfall.

This year, oil exporters could haul in $700 billion from selling oil to foreigners. This includes not only the Organisation of Petroleum Exporting Countries (OPEC) but also Russia and Norway, the world's second- and third-biggest earners (see chart 1 below). The International Monetary Fund estimates that oil exporters' current-account surplus could reach $400 billion, more than four times as much as in 2002. In real terms, this is almost double their dollar surpluses in 1974 and 1980, after the twin oil-price shocks of the 1970s—when Russia's hard-currency exports were tiny. The combined current-account surplus of China and other Asian emerging economies is put at only $188 billion this year (see chart 2 below).

Relative to their economies, the oil producers' current-account surpluses are far bigger than China's. Whereas the IMF forecasts China's surplus to be about 6% of GDP this year, it predicts Saudi Arabia's—not much different in money terms, at just over $100 billion this year—to be a whopping 32%. On average, Middle East oil exporters are expected to have an average surplus of 25% of GDP. Russia might record 13% and Norway 18%.

The rise in oil prices represents a big redistribution of income from those who buy oil to those who produce it. Past periods of high prices have not lasted long, but this time oil producers' extra revenues might prove to be more durable. The futures market expects oil to stay expensive, even though the price of a barrel of West Texas Intermediate, an industry benchmark, recently slipped back to around $60.

An enviable choice

What will happen to all these petrodollars? In essence, they can be either spent or saved. Either way, a lot of the money can be recycled to oil-consuming economies and thus soften the impact on them of higher oil prices. If oil exporters spend their bonanza, they import more from other countries and thus help to maintain global demand. They are unlikely to spend the lot, however, because they tend to have higher saving rates than oil consumers: saving is around 40% of GDP in the United Arab Emirates (UAE) and Kuwait, for instance. A transfer of income from oil consumers to oil producers will therefore lead to a slowdown in global demand.

If they save their windfall, but invest it in global capital markets, they can finance oil importers' bigger current-account deficits—in effect, lending the increase in fuel bills back to consumers. And by increasing the demand for foreign financial assets, they can boost asset prices and push down bond yields in oil-importing countries. This in turn can help to support economic activity in these economies.

Experience shows that oil booms can be a blessing or a curse for producing economies, depending on how wisely the extra revenue is spent or saved. Too often, past windfalls have been celebrated with budgetary blow-outs, while the abundance of money has encouraged the postponement of economic reforms. This time, however, oil exporters seem to be spending less, instead running larger external surpluses, repaying debts and building up assets. In 1973-76, 60% of the increase in OPEC's export revenues was spent on imports of goods and services. In 1978-81, the proportion rose to 75%. But the IMF estimates that only 40% of the windfall in the three years to 2005 will have been spent.

In Russia, the government has taken the sensible step of setting up an oil stabilisation fund, which will be used to reduce its large foreign debt. That said, the country has been more eager than members of OPEC to spend its extra money. Around two-thirds of the increase in Russia's export revenues since 2002 has gone on imports. Some analysts also suspect that the government may yet raid the stabilisation fund for a spending spree. The main concern, however, is that while the economy is flush with cash important structural reforms will be postponed.

In most of the Middle East, governments are being more cautious than usual with their extra revenue. Mohsin Khan, the director of the IMF's Middle East and Central Asia department, reckons that most governments in the region are budgeting on an oil price of only $30-40 a barrel for next year. He estimates that governments have on average spent only 30% of their extra oil revenue since 2002, compared with 75% in the 1970s and early 1980s, after previous steep climbs in the oil price. Their average budget surplus has increased from 2% of GDP in 2002 to nearly 15% this year.

Lessons learned, perhaps too well

Oil-exporting governments seem to have taken to heart the lessons of the 1970s and 1980s. First: don't assume that oil prices will stay high for ever: in real terms, OPEC's annual average oil revenue in 1981-2000 was only one-third of that in 1980. Second, don't waste your windfall. In previous booms, oil-producing countries gaily spent their petrodollars on lavish construction projects that required imported equipment and skilled foreign workers, but did little to create local jobs or to diversify economies. In its recently published Regional Economic Outlook for the Middle East and Central Asia, the IMF advises governments to give priority to spending that will have a more lasting impact on growth and living standards.

In fact, believes Mr Khan, Middle East oil exporters have greater capacity to spend petrodollars at home than in the 1970s and 1980s, because their populations have been rising rapidly and because their infrastructure needs upgrading after many years of dwindling government revenues. High unemployment means that there is social pressure for more spending on education and health, and for schemes to encourage private-sector employment.

Saudi Arabia, with one of the world's fastest growing populations, has an unemployment rate of perhaps 20%. After nearly two decades of large budget deficits, the government's debt was 100% of GDP by 2000. Even this year, Saudi Arabia's oil revenues per head will be about 70% less in real terms than in 1980, owing in part to a near tripling of its population. It is using some of its extra money to repay debt, and the government has recently raised civil servants' pay by 15%—the first across-the-board increase in more than 20 years.

As well as spending more on health, education and infrastructure, the Middle East also needs to invest in oil production and refining capacity, to ease future supply shortages and so stabilise prices. The International Energy Agency gave warning this week that oil prices will keep rising over the next two decades unless the region's producers invest substantially more than they currently intend.

The IMF is also—unusually—encouraging these economies to be less thrifty. Increased spending will not only, through diversification, allow Middle East countries to support their future economic development, but by boosting imports from the rest of the world it will also allow a more orderly narrowing of global imbalances. This should help to cushion the world economy against the negative impact of rising oil prices.

So far most of the extra money is being saved, not spent, so where is it going? In the 1970s and early 1980s surplus petrodollars were largely deposited in banks in America or Europe. These banks then lent too many of them to oil-importing developing countries, sowing the seeds of Latin America's debt crisis. This time it is proving much harder to track the money, but much more seems to be going into foreign shares and bonds rather than into western banks. This may reflect a greater reluctance to hold deposits in foreign banks, because of the increase in official scrutiny after the terrorist attacks of September 11th 2001. Figures from the Bank for International Settlements (BIS) show that in 2002 and 2003 OPEC deposits with banks in the BIS reporting area actually fell. Since last year, they have increased, but only modestly. In contrast, Russian bank deposits abroad have risen much more sharply, as have the central bank's official reserves, from $73 billion at the end of 2003 to $161 billion this October.

Russian investment, whether in bank deposits, London property or football clubs, is relatively conspicuous. But even the experts at the IMF and the BIS are finding it hard to track Middle Eastern money, because a large chunk of the surplus is held not as official reserves, but as foreign investment by government oil stabilisation and investment funds and by national oil companies. Official reserves of Middle East oil exporters (including the total net foreign assets of the Saudi Arabia Monetary Agency) have risen by around $70 billion this year, accounting for less than 30% of their current-account surplus.

Follow the money

One puzzle is that, according to data published by America's Treasury Department, OPEC members' holdings of American government securities fell from $67 billion in January this year to $54 billion in August. But Middle East purchases of American securities are probably being channelled through London. Mr Khan reckons that although the bulk of OPEC's surplus revenues has so far gone into dollar-denominated assets, those assets are increasingly held outside the United States. A big chunk is also going into hedge funds and offshore financial institutions, which are unregulated and so impossible to track.

There has also been a flood of petrodollars into private equity abroad. In January, Dubai International Capital took a $1 billion stake in DaimlerChrysler. In March, it bought the Tussauds Group, a theme-park firm. This month, DP World, Dubai's state-owned ports operator, made a £3 billion ($5.2 billion) bid for P&O, Britain's biggest ports and ferries group.

Many smaller private investors in the Middle East are keeping their money closer to home. In the 1970s and early 1980s equity markets barely existed in the Gulf. This time money has flooded into them. Share prices in Saudi Arabia have increased fourfold since 2003, and its bourse now has the largest capitalisation of any emerging stockmarket. The average price/earnings ratio in the region is over 40 and recent share offerings have been oversubscribed several hundred times. A spectacular property boom is under way in many places, notably Dubai, which has become a regional financial centre and leisure playground. The world's biggest shopping mall is being built there and Emirates, the state's airline, has virtually underwritten the launch of the Airbus A380, ordering no fewer than 45 of the super-jumbos, a third of the total (see article).

Despite the lack of hard data, many economists are sure that a big dollop of petrodollars is going into American Treasury securities. If so, the recycling of money via bond markets could have very different effects on the world economy from the bank-mediated recycling of previous oil booms. If petrodollars not spent flow into global bond markets, they reduce bond yields and thus support consumer spending in oil-importing countries.

Buy from Europe, lend to America

Indeed, this leads Stephen Jen, an economist at Morgan Stanley, to challenge the popular notion that Europe is being hurt less by higher oil prices than America. It is certainly true that Europe's exports to oil producers have risen faster than America's in recent years. Europe's share of OPEC's imports has climbed to 32%, compared with America's 8%. A recent report by ABN Amrofinds that while America's trade deficit with OPEC has grown markedly since 1999, the European Union's balance has barely changed (see chart 3).

On the other hand, around two-thirds of petrodollars are thought to have gone into dollar assets, pushing down American bond yields. In addition, America's economy is more sensitive to interest rates than that of the euro zone. Mr Jen therefore suggests that America may have gained more from lower interest rates than the euro area has from higher exports, especially because OPEC still buys less than 5% of the currency zone's exports. Although higher oil prices have increased America's current-account deficit, Mr Jen reckons that it probably runs a balance-of-payments surplus in oil, with capital inflows from exporting countries exceeding its net oil import bill.

How might the flow of oil money affect the dollar? Because oil is traded in dollars, rising prices initially increase the demand for greenbacks. But what happens next depends on whether oil producers buy dollar assets or swap their dollars for euros. Saudi Arabia, Kuwait, the UAE and most other Gulf states peg their currencies to the dollar, which might suggest that, like Asian central banks, they will continue to favour dollars. But unlike China's export surpluses, petrodollars are mostly not managed within official reserves, but by oil stabilisation funds and so forth. These are not subject to the same constraints as central banks to hold liquid assets and their aim is to maximise returns.

This means, says Mr Jen, that oil exporters' assets are more footloose than those of Asian central banks. So far, the bulk of petrodollars may have gone into relatively liquid dollar assets, helping to support the greenback this year. But this money could flit if the dollar starts to slide again. And there is lots of it: for example, the Abu Dhabi Investment Authority, with assets of maybe $250 billion, is one of the wealthiest players in global financial markets. Russia's central bank has reduced the share of dollars in its foreign reserves over the past couple of years, but it is still around 65%. The central bank has said that it wishes to hold more euros.

The correct solution to global imbalances is for America to save more and for surplus countries, including both the oil exporters and the Asians, to spend more

That leaves the dollar dangerously vulnerable. But what about the exchange-rate policies of the oil exporters themselves? Most oil exporters peg their currencies to the dollar or resist appreciation through heavy intervention, in much the same way as China and other Asian countries have done. So should America and others demand that oil exporters revalue their currencies, as they have called on the Asians to do? In fact, revaluation of oil exporters' currencies would do little by itself to reduce America's deficit (nor, for that matter, would a dearer Chinese yuan). The correct solution to global imbalances is for America to save more and for surplus countries, including both the oil exporters and the Asians, to spend more.

Nevertheless, Brad Setser of Roubini Global Economics, a research firm, argues that oil economies should not peg their currencies to the dollar in any case. The currencies of commodity producers, he says, should follow commodity prices. Instead, Middle East oil exporters' currencies have tracked the dollar—mainly downwards—since 2002, even as oil revenues have soared. By raising the relative price of foreign goods, this has discouraged imports. Equally perversely, economies were hurt in the late 1990s when the dollar rose at the same time as oil prices sank.

By pegging their currencies to the dollar, these economies have in effect had to adopt America's monetary policy. With interest rates too low, excess domestic liquidity has stoked inflation and asset prices. The broad money supply of the Middle East oil exporters has grown by almost 24% in each of the past two years and the average inflation rate has risen to almost 9% this year. To curb inflation, Gulf economies need more flexible exchange rates and monetary policies.

Russia officially operates a “managed float” for its exchange rate. But the rouble's rate against the dollar has been held relatively steady over the past couple of years by heavy intervention. Consequent excess liquidity and a boom in domestic consumption have pushed inflation to 12%.

It does not make sense for a country with a large current-account surplus to tie its currency to that of a country with a large deficit—such as America. A fully floating exchange rate may not be desirable, because it may be too volatile, but more flexibility could help oil exporters to adjust better to fluctuations in commodity prices.

If oil prices remain high, so will oil exporters' surpluses. The IMF forecasts an average annual current-account surplus of $470 billion over the next five years (assuming an average oil price of $59 a barrel). The oil exporters will have to play a role in helping to reduce global imbalances. Importing more and letting their currencies rise, as well as increasing government spending and liberalising their economies, would be steps in the right direction.