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”.

Malaysia's brilliant way to deal with high oil prices.

Now oil prices have reached $130 a barrel, the problem starts to affect more than commuting car drivers and budget airlines. Countries like Malaysia, Indonesia and others that heavily subsidize their fuel start to run in trouble. A 2005 article in the Herald Tribune said that an oil price of $65 a barrel would spell big trouble for the Indonesian economy. After the price of gas was increased with 126%, riots broke out in Jakarta and elsewhere. The article never mentioned what $130 a barrel oil would do with the budget. Last month the price had to be revised again resulting in students taking to the streets in protest. I wonder where they get the money to buy a car in the first place?

Malaysia has found another way. Instead of raising the price of fuel, which would make the government undoubtedly unpopular, a wise committee thought long and hard about it and decided that the cause of inflation wasn’t domestic but had to lie with the foreign fuel smugglers. All those rich Singaporeans lining up at the Malaysian pumps were apparently stealing a significant portion of the 56 billion Ringit subsidized fuel. The first idea was to issue every Malaysian a pass to buy subsidized fuel. This turned out to be an expensive and fraud prone project because there are 24,821,286 people living in Malaysia that all would need a pass (or at least the ones old enough to drive). So they decided to outright ban foreigners from buying fuel at stations closer than 50km to the Thai and Singaporean borders.

The committee might have thought a bit longer about this. Singapore has a law that makes it illegal to pass the border with a tank that is less then 3/4 full. Let’s assume that an average fuel tank holds 70 liters. That means that the average Singaporean family can top up their tank with 17.5 liters of sweet subsidized fuel before returning to the land of Laksha and expensive fuel. At the same time this family will probably have lunch and even dinner in Johor Baru, fill the trunk with cheap fruit and vegetables and other groceries, have an ice cream or two or even spend some time at Genting, Malaysia’s version of Vegas. I know how these things go, whenever you’re abroad you always spend more then you intend to. Already the results are visible at the borders with Thailand, where tourism has died down to a trickle. The same will probably be true for Johor, because although the cheaper gas might not have been so cheap after all the extra spending; it’s still a major attraction for thrifty Singaporeans. I wonder how long it will take before the local Johorans will be lining up to buy just a bit of extra gas to sell to Singaporeans and other foreigners. That way the subsidy flows directly into the pockets of the needy. All outside the official gas stations off course…

Fortunately the measure will be effective against the many, many trucks of fuel that were smuggled into Singapore each day. They must have been camouflaged because I’ve never seen them cross the border….

Update. The Malaysian government must have thought a bit longer and decided that increasing the price of gas with 65% will help them a bit more than banning foreigners from buying gas. So far, the country remains quiet...

Update2. Demonstrations are planned this weekend in Kuala Lumpur. Off course this was to be expected.