A few weeks ago, the Independent (a British daily newspaper) ran a story reporting secret discussions between a number of Gulf States, China, Russia, Japan and Brazil to replace the US dollar in oil trading for a basket of currencies including the yen, the renminbi, the euro, gold and the planned GCC1 single currency. The report was swiftly denied by official, but the question of what such a move could entail remains present in investors’ minds.
In our opinion, trading oil in a basket of currencies would prove both cumbersome and inefficient given the lack of liquidity of most of the currencies cited. The only alternative today to pricing oil in dollars is to price it in euros. However, such a switch would in itself have a negligible impact. The real issues to consider are the currency policies of major oil exporters and major oil importers.
Would the Price of Oil Change if Invoiced in Euros?
The price of oil (like any other price) mirrors the available information on both current and future demand and supply. The market is today “cleared” at 78$/b and 53€/b. Quoting the price of oil in euros should not impact the oil price per se as this otherwise would imply a shift away from equilibrium. A decline in the US dollar impacts the price of oil in dollars, but not as such the price in euros. A change in the real oil price (independent of the currency, be it euros or dollars), however, has a significant impact on exchange rates as trade patterns and portfolio allocations shift as a result. Moreover, we note that the volatility of real oil prices in dollars and euros is of similar magnitude. In addition, FX markets offer ample opportunity to hedge in both dollars and euros at a reasonable cost. As such, both oil exporters and importers can easily secure oil is de facto invoiced in the currency of their choice.
Why Do Oil Exporters Peg to the US Dollar?
The debate on trading oil in euros, however, expands well beyond the choice of invoice currency. The real issue is the choice of currency policy. Today just over 40% of both oil exporters and oil importers maintain some form of peg to the dollar. The question is whether trading oil in euros would change this.
The most common argument behind oil exporters’ dollar peg is that oil is priced in dollars. Hence, the idea is that the peg eliminates a mismatch between oil revenues (in dollars) and government expenditures (in local currency). It is further argued that the peg help helps combat Dutch disease2 by preventing the domestic currency from appreciating when oil prices increase. Finally, the dollar peg allows the economy in question to win credibility, importing the US’s fairly stable monetary policy (note, this argument is presented for all emerging economies with pegged exchange rates).
Following on from the logic above, a shift to trading oil in euros would imply oil exporters shifting from a dollar peg to a euro peg. As opposed to merely changing the invoicing currency of oil trades, such a move would have very real consequences since oil exporters tend to save in US dollars as a result of the dollar peg (and not because of oil revenues in dollars). Indeed, selling dollars to reallocate to other currencies, would risk depreciation of their own currencies. Moving to a euro peg would thus entail significant portfolio reallocation. Unless oil exporters believe that trading oil in euros offers higher real oil prices, a shift from a dollar-peg to a euro-peg would not bring any economic gains. The real question for oil exporters is whether to peg their currencies. Indeed, the arguments outlined above suffer from a number of fallacies:
- First, the difficulty in managing oil exporters’ fiscal policies stems from the volatility of oil prices and not the currency mismatch between oil revenues and public spending. It is interesting to note that oil exporters that have flexible currency regimes suffer less volatility in oil revenues.
- Second, Dutch disease is best prevented by a strong fiscal policy framework that prevents “excessive” oil revenues from flowing into the domestic economy.
- Third, the gains of importing US (or Eurozone) monetary policy must be weighed against the cost of importing a policy stance that may be inappropriate for the domestic economy.
It is also worth recalling that the majority of oil importers maintain some form of dollar peg. China officially removed its dollar peg in July 2005 but still maintains a de facto one. The aim of this policy is to protect the Chinese exporters. The question is whether pricing oil in euros would mark a shift in China’s currency policy, and thus to significant portfolio reallocation for its USD 2.3trln of FX reserves. Again, replacing one peg with another is not the long-term answer for China (or any other emerging economy). As domestic growth engines develop, a shift to a more flexible currency regime would be the most appropriate choice.
The real issue is thus one of currency regimes and not of oil’s invoicing currency. As we have argued on previous occasions, a shift to more flexible currency regimes for the major emerging economies would make sense over time as domestic growth engines become more important. In turn, this will ultimately mark the end of dollar dominance. Choices on FX policy, however, will not be driven by the invoicing currency for oil. Moreover, it is important to keep in mind that it is in no one’s interest to see a rapid decline of the dollar, and least of all those countries holding large portfolios of dollar denominated assets.
1 The Gulf Cooperation Countries members are Saudi Arabia, Bahrain, Kuwait, Oman, Qatar and the United Arab Emirates.
2 Dutch disease is the risk that an expanding commodity sector will grab all the resources in the economy, squeezing out other sectors.