Energy and Power.

A friend of mine, who is in the risk consultancy business, pointed me towards a blog posting on the New York Times website. The accompanying chart shows how Sovereign Wealth Funds (SWF’s) are related and how the money streams flow. They look uncannily like weather patterns and, like I mentioned before, the clouds are mainly packing on the financial shores of the US and European banks. I was a bit surprised that the writer of this excellent piece mentioned “…sovereign funds have also learned the downside of deal-making: some of their blockbuster transactions have been big money losers so far”. This is truly thinking like an investment banker. If it doesn’t make money, it’s not worth it.

The reality is a lot more complicated though. The enormous sums of money that have been flowing into the oil exporting countries have created massive pools of liquidity. There are only so many houses, Rolls Royces and Ferraris you can buy with cash and if you pump too much in an economy, the US one included, the result will be overheating, inflation, misery and sorrow. You don’t want your customer’s economy to get unhealthy, especially if that customer has the tendency to invade your country if he doesn’t like you.

So the resident sheiks, presidents and assorted other rulers have been looking for ways to spent their money on other things. In contrary to the NYT blog, I think that a lot of SWF’s are not created to invest money but to buy something that’s of much more value: power.

Henry Liu wrote already in 2002 in the Asian Times:” Ever since 1971, when US president Richard Nixon took the dollar off the gold standard (at $35 per ounce) that had been agreed to at the Bretton Woods Conference at the end of World War II, the dollar has been a global monetary instrument that the United States, and only the United States, can produce by fiat. “

The US have always used their vast consumer economy as a weapon of deterrence and influence. It’s not the US military that keep the country on top, but the dependence on the US dollar as the world’s currency. Like a father threatening to withhold pocket money, most countries will do what the US tells them to or risk loosing the privilege to trade in US currency. With oil trade exclusively in dollars, countries need to maintain good amount of U.S. currency in their reserves to buy oil. At the end of 2000, the Bank for International Settlements estimated world dollar reserves of $1.45 trillion, or 76% of the total world reserves of $1.09 trillion.

Banks and other companies trading in US currency (and which bank doesn’t?) have to comply with the regulations set up by the Office of Foreign Asset Control (OFAC) and US Treasury Department's Financial Crimes Enforcement Network (FinCEN) or risk ending up on one of the sanction lists, which basically ends the ability to function on the world market. On the other hand, countries that have the favor of the US have access to the largest consumer market in the world to sell their goods. It’s by using this carrot and stick method that the US is the dominant power in the world.

When Iraq, in September 2000, switched to the Euro to settle oil contracts, it set a very dangerous precedence. If the other OPEC countries would follow, the end of the US dollar as dominant currency and with it the end of the US as dominant power would be in sight. After the Euro increased in value against the dollar, the conversion to petro Euros became a clear and present danger to the US. As a nation addicted to oil, the US would have to buy Euros to pay for its habit, where it could have used dollars before. Furthermore, the US borrow $665 billion annually from foreign lenders to finance the gap between payments to and receipts from the rest of the world. With no improvement in the current account deficit, the external debt of the United States will rise from 24% of total U.S. gross domestic product (GDP) at the end of 2003 to 64% by 2014.

The Chinese and Japanese, who have accumulated enormous dollar reserves, could finally drain this pool by converting to the Euro and hedge against the depreciation of the dollar. The Russians see Europe as an important trading partner and would have no objection to switching either. This creates new blocks that will shift most power from the US.

After the invasion of Iraq, the country quietly switched back to dollars, putting a temporary halt to the threat. It became clear to other countries in the region that there was a heavy price to pay for disobedience. 9/11 not only underlined the contrast between the Eastern “Islamic” world and the Western “Christian” world but made it increasingly more difficult for Middle Eastern countries to spend their petro dollars. When Dubai made a bid for several US ports, the domestic political resistance made it impossible to get the deal done.

So what to do with all those dollars? The US mortgage crisis and the subsequent liquidity crisis was a heaven sent for the dollar swollen SWF’s. Here was an opportunity, not only to get rid of the excess amounts of US currency but to quietly build up a position of power inside the financial bastions of the US and Europe. For funds like Temasek and CIC it may just be good investments. For the Middle Eastern funds there’s much more at stake then good returns.

The urgent need for liquidity made most banks less picky about who invested in them. As I wrote before, this may come back to haunt them. On the top, the posturing of Iran makes it appear that the struggle is about physical domination of the region. Under the surface though, there are much more complicated and bigger things going on. As the Chinese proverb says “may you live in interesting times”.