How The Petrodollar Quietly Died, And Nobody Noticed

Submitted by Tyler Durden on 11/04/2014 00:42 -0400

Two years ago, in hushed tones at first, then ever louder, the financial world began
discussing that which shall never be discussed in polite company - the end of the system
that according to many has framed and facilitated the US Dollar's reserve currency status:
the Petrodollar, or the world in which oil export countries would recycle the dollars they
received in exchange for their oil exports, by purchasing more USD-denominated assets,
boosting the financial strength of the reserve currency, leading to even higher asset prices
and even more USD-denominated purchases, and so forth, in a virtuous (especially if one
held US-denominated assets and printed US currency) loop.
The main thrust for this shift away from the USD, if primarily in the non-mainstream media,
was that with Russia and China, as well as the rest of the BRIC nations, increasingly seeking
to distance themselves from the US-led, "developed world" status quo spearheaded by the
IMF, global trade would increasingly take place through bilateral arrangements which
bypass the (Petro)dollar entirely. And sure enough, this has certainly been taking place, as
first Russia and China, together with Iran, and ever more developing nations, have
transacted among each other, bypassing the USD entirely, instead engaging in bilateral
trade arrangements, leading to, among other thing, such discussions as, in today's FT, why
China's Renminbi offshore market has gone from nothing to billions in a short space of time.
And yet, few would have believed that the Petrodollar did indeed quietly die, although
ironically, without much input from either Russia or China, and paradoxically, mostly as a
result of the actions of none other than the Fed itself, with its strong dollar policy, and to a
lesser extent Saudi Arabia too, which by glutting the world with crude, first intended to
crush Putin, and subsequently, to take out the US crude cost-curve, may have Plaxico'ed
both itself, and its closest Petrodollar trading partner, the US of A.
As Reuters reports, for the first time in almost two decades, energy-exporting
countries are set to pull their "petrodollars" out of world markets this year, citing a
study by BNP Paribas (more details below). Basically, the Petrodollar, long serving as the US
leverage to encourage and facilitate USD recycling, and a steady reinvestment in USdenominated assets by the Oil exporting nations, and thus a means to steadily increase the
nominal price of all USD-priced assets, just drove itself into irrelevance.
A consequence of this year's dramatic drop in oil prices, the shift is likely to cause global
market liquidity to fall, the study showed.
This decline follows years of windfalls for oil exporters such as Russia, Angola, Saudi Arabia
and Nigeria. Much of that money found its way into financial markets, helping to
boost asset prices and keep the cost of borrowing down, through so-called
petrodollar recycling.

But no more: "this year the oil producers will effectively import capital amounting to $7.6
billion. By comparison, they exported $60 billion in 2013 and $248 billion in 2012,
according to the following graphic based on BNP Paribas calculations."
In short, the Petrodollar may not have died per se, at least not yet since the USD is still
holding on to the reserve currency title if only for just a little longer, but it has managed to
price itself into irrelevance, which from a USD-recycling standpoint, is essentially the same
thing.

According to BNP, Petrodollar recycling peaked at $511 billion in 2006, or just about the
time crude prices were preparing to go to $200, per Goldman Sachs. It is also the time
when capital markets hit all time highs, only without the artificial crutches of every single
central bank propping up the S&P ponzi house of cards on a daily basis. What happened
after is known to all...
"At its peak, about $500 billion a year was being recycled back into financial
markets. This will be the first year in a long time that energy exporters will be
sucking capital out," said David Spegel, global head of emerging market sovereign and
corporate Research at BNP.
Spegel acknowledged that the net withdrawal was small. But he added: "What is interesting
is they are draining rather than providing capital that is moving global liquidity. If oil prices
fall further in coming years, energy producers will need more capital even if just to repay
bonds."

In other words, oil exporters are now pulling liquidity out of financial markets rather than
putting money in. That could result in higher borrowing costs for governments, companies,
and ultimately, consumers as money becomes scarcer.
Which is hardly great news: because in a world in which central banks are actively soaking
up high-quality collateral, at a pace that is unprecedented in history, and led to the world's
allegedly most liquid bond market to suffer a 10-sigma move on October 15, the last thing
the market needs is even less liquidity, and even sharper moves on ever less volume, until
finally the next big sell order crushes the entire market or at least force the
[NYSE|Nasdaq|BATS|Sigma X] to shut down indefinitely until further notice.
So what happens next, now that the primary USD-recycling mechanism of the past 2
decades is no longer applicable? Well, nothing good.
Here are the highlights of David Spegel's note Energy price shock scenarios: Impact on EM
ratings, funding gaps, debt, inflation and fiscal risks.
Whatever the reason, whether a function of supply, demand or political risks, oil prices
plummeted in Q3 2014 and remain volatile. Theories related to the price plunge vary
widely: some argue it is an additional means for Western allies in the Middle East to punish
Russia. Others state it is the result of a price war between Opec and new shale oil
producers. In the end, it may just reflect the traditional inverted relationship between the
international value of the dollar and the price of hard-currency-based commodities (Figure
6). In any event, the impact of the energy price drop will be wide-ranging (if sustained) and
will have implications for debt service costs, inflation, fiscal accounts and GDP growth.
Have you noticed a reduction of financial markets liquidity?
Outside from the domestic economic impact within EMs due to the downward oil
price shock, we believe that the implications for financial market liquidity via the
reduced recycling of petrodollars should not be underestimated. Because energy
exporters do not fully invest their export receipts and effectively save a considerable
portion of their income, these surplus funds find their way back into bank deposits (fuelling
the loan market) as well as into financial markets and other assets. This capital has helped
fund debt among importers, helping to boost overall growth as well as other financial
markets liquidity conditions.
Last year, capital flows from energy exporting countries (see list in Figure 12) amounted to
USD812bn (Figure 3), with USD109bn taking the form of financial portfolio capital and
USD177bn in the form of direct equity investment and USD527bn of other capital over
half of which we estimate made its way into bank deposits (ie and therefore
mostly into loan markets).

The recycling of petro-dollars has benefited financial markets liquidity conditions. However,
this year, we expect that incremental liquidity typically provided by such recycled
flows will be markedly reduced, estimating that direct and other capital outflows
from energy exporters will have declined by USD253bn YoY. Of course, these
economies also receive inward capital, so on a net basis, the additional capital provided
externally is much lower. This year, we expect that net capital flows will be negative for EM,
representing the first net inflow of capital (USD8bn) for the first time in eighteen years. This
compares with USD60bn last year, which itself was down from USD248bn in 2012. At its
peak, recycled EM petro dollars amounted to USD511bn back in 2006. The declines seen
since 2006 not only reflect the changed global environment, but also the propensity of
underlying exporters to begin investing the money domestically rather than save. The
implications for financial markets liquidity - not to mention related downward
pressure on US Treasury yields is negative.
***
Even scarcer liquidity in US Capital markets aside, this is how BNP sees the inflation and
growth for energy exporters:
Household consumption benefits: While we recognise that the relationship is not entirely
linear, we use inflation basket weights for transportation and household & utilities (shown
in the Economic components section of Figure 27) as a means to address the differing
demand elasticities prevalent across countries. These act as our proxy for consumption the
consumption basket in order to determine the economic benefit that would result as lower
energy prices improve household disposable income. This is weighted by the level of

domestic consumption relative to the economy, which we also show in the Economic
components section of Figure 27.
Reduced industrial production costs: Outside the energy industry, manufacturers will
benefit from falling operating costs. Agriculture will not benefit as much and services will
benefit even less.
Trade gains and losses: Lost trade as a result of lower demand from oil-producing trade
partners will impact both growth and the current account balance. On the other hand, better
consumption from many energy-importing trade partners will provide some offset. The
percentage of each countrys exports to energy producing partners represents relative to its
total exports is used to determine potential lost growth and CAR due to lower demand from
trade partners.
Domestic FX moves are beyond the scope of our analysis. These will be tied to the level of
openness of the economy and the impact of changed demand conditions among trade
partners as well as dollar effects. Neither do we address non-oil related political risks (eg
sanctions) or any fiscal or monetary policy responses to oil shocks.
GDP growth
The least impacted oil producing country, from a GDP perspective, is Brazil followed by
Mexico, Argentina, Tunisia and Trinidad & Tobago. The impact on fiscal accounts also
appears lower for these than most other EMs.
Remarkably, the impact of lower oil for Russias economic growth is not as severe as might
be expected. Sustained oil at USD80/bbl would see growth slow by 1.8pp to 0.6%. This
compares with the worst hit economies of Angola (where growth is nearly 8pp lower at 2%), Iraq (GDP slows to -1.6% from 4.5% growth), Kazakhstan and Azerbaijan (growth
falls to -0.9% from 5.8%).
For a drop to USD 80/bbl, it can be seen (in Figure 27) that, in some cases, such as the
UAE, Qatar and Kuwait, the negative impact on GDP can be comfortably offset by fiscal
stimulus. These economies will probably benefit from such a policy in which case our
model-based GDP growth estimate would represent the low end of the likely outcome
(unless a fiscal policy response is not forthcoming).

Global growth in 2015? More like how great will the hit to GDP be if oil prices don't rebound
immediately?
On the whole, we can say that the fall in oil prices will prove negative, shaving 0.4pp from
2015 EM GDP growth. The collective current account balance will fall 0.58pp to 0.6% of
GDP, while the budget deficit will deteriorate by 0.61pp to -2.9%. This probably has the
worst implications for EM as an asset class in the credit world.
Energy exporters will fare worst, with growth falling by 1.9pp and their current
account balances suffering negative pressure to the tune of 2.69pp of GDP. Budget
balances will suffer a 1.67pp of GDP fall, despite benefits from lower subsidy costs. The
impact of oil falling USD 25/bbl will be likely to put push the current account balance into
deficit, with our analysis indicating a 0.3% of GDP deficit from a 2.4% surplus before.
Fortunately, the benefit to inflation will be the best in EM and could help offset some of the
political risks from reduced growth.
As might be expected, energy importers will benefit by 0.4pp better growth in this scenario.
Their collective current account will improve by 0.6pp to 1.1% of GDP.
The regions worst hit are the Middle East, with GDP growth slowing to 0.3%,
which is 3.8pp lower than when oil was averaging USD105/bbl. The regions fiscal
accounts will also suffer most in EM, moving from a 1.7% of GDP surplus to a 1.8% deficit.

Meanwhile, the CAB will drop 5.3pp, although remain in surplus at 3.9%. The CIS is the
next-worst hit, from a GDP perspective, with regional growth flat-lined versus 1.91%
previously. The regions fiscal deficit will worsen from 0.7% of GDP to -1.8% and CAB shrink
to 0.7% from 3% of GDP. Africas growth will come in 1.4pp slower at 2.8% while Latam
growth will be 0.4pp slower at 2.2%. For Africa, the CAB/GDP ratio will fall by 2.4pp pushing
it deep into deficit (-2.9% of GDP).
Some regions benefit, however, with Asia ex-China growing 0.45bpp faster at 5.5% and EM
Europe (ex-CIS) growing 0.55pp faster at 3.9%, with the regions CAB/GDP improving
0.69pp, although remain in deficit to the tune of -2.4% of GDP.

***
And so on, but to summarize, here are the key points once more:

The stronger US dollar is having an inverse impact on dollar-denominated commodity

prices, including oil. This will affect emerging market (EM) credit quality in various
ways.

The implications of reduced recycled petrodollars has significant

ramifications for financial markets, loan markets and Treasury yields. In fact,
EM energy exporters will post their first net drain on global capital (USD8bn) in
eighteen years.

Oil and gas exporting EMs account for 26% of total EM GDP and 21% of
external bonds. For these economies, the impact will be on lost fiscal revenue, lost
GDP growth and the contribution to reserves of oil and gas-related export receipts.
Together, these will have a significant effect on sustainability and liquidity
ratios and as a consequence are negative for dollar debt-servicing risks and
credit ratings.