Stephen King: A transfer of wealth causes a simple shift of emphasis to rob dollar of global status

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The Independent Online

When you travel through the Gulf States, you quickly realise that not every part of the world has succumbed to the sub-prime crisis. The building booms in Dubai and Doha are truly remarkable. High-rise developments are sprouting up all over the place. Never before have I seen so many cranes crammed into such tiny spaces. Then again, never before have oil prices been so high.

The Gulf building boom reflects a transfer of wealth from oil-consuming to oil-producing nations. For the same reason, wealthy Russians have been able to snap up some of the swankier houses in London. But can the story continue?

Higher oil prices reflect all sorts of things – political instability, refinery disruptions, speculative trading, Opec supply constraints – but, above all, they tell us something about the pace of global economic development.

In recent years, thanks to an emerging markets boom, the rate of global economic expansion has been unusually rapid.

The sub-prime crisis threatens to take a big chunk out of economic growth in the industrialised world. If this happens, will oil prices continue to head upwards? And, if they cannot, will the building booms in the Gulf begin to crumble?

During my brief sojourn in the Gulf last week, I discovered that, for the most part, investors were unperturbed by the sub-prime crisis. Rightly or wrongly, Gulf investors believe that the US is a less important driver of the global economy these days.

They're more interested in what's happening in China, where the economy continues to expand at a pace of over 11 per cent from one year to the next, and in India, where earlier dreams of double-digit growth have become a – perhaps temporary – reality. For Gulf investors, economic decoupling is right here, right now.

Indeed, rather than worrying about an economic slowdown, their primary concern is inflation, most obviously because economic growth in the region has been unusually rapid.

Beyond this, though, the Gulf's links with the US dollar are coming under closer scrutiny. The Gulf currencies are dollar "pegs". In effect, Gulf policymakers have handed over monetary policy decisions to the Federal Reserve. That's absolutely fine when the US and Gulf economic cycles are synchronised. However, with the US suffering from a sub-prime hangover which, in turn, is forcing interest rate cuts on the Federal Reserve, it's no longer obvious that the Gulf's economic interests are so readily satisfied by Ben Bernanke and his colleagues. Gulf inflation is on the march.

Inflationary pressures in the Gulf are, however, coming from a rather odd source. The Gulf States export oil but they also import workers. Those workers come from far and wide – most obviously from India, the Philippines, Europe and the US.

The workers are paid in Dirhams or US dollars. In many cases, however, the money is sent back to families in the "home" nation in the form of remittances. That's perfectly acceptable in the absence of major currency movements. With the dollar so weak, however, the "real" value of these remittances is looking a lot less attractive.

For example, the US dollar has lost around 20 per cent of its value against the rupee over the last 12 months. For Indian workers in the Gulf, this implies a 20 per cent pay cut in rupee terms. Under these circumstances, it's hardly surprising that wage pressures are beginning to build.

The Gulf boom is, of course, symptomatic of extraordinary economic strength across a wide range of emerging markets. That strength, in turn, is beginning to have an effect on the industrialised world.

Last week, the US published its first estimate of economic growth in the third quarter. The outcome was considerably stronger than the market consensus, with an annualised gain on the quarter of 3.9 per cent.

Within the overall outcome, housing investment was extraordinarily weak, falling by more than 20 per cent. Earlier in the year, the Federal Reserve suggested that the housing contraction was showing signs of bottoming out. That view is now totally discredited. Nevertheless, despite the severity of the housing downswing, the overall economy is still posting more-than-reasonable gains.

So what's the secret of America's continuing economic success? How can the US economy defy the odds and, seemingly, walk across recessionary waters?

The answer, quite simply, is trade. While US imports rose at a 5 per cent annual rate, exports jumped by more than 16 per cent. Export success, in turn, reflects two key factors. The first, and most obvious, is the progressive decline in the dollar's value against the major industrialised currencies. As the euro and sterling have headed into the stratosphere, American exporters have been making major competitive gains.

The second, a little less obvious, is the ongoing strength of emerging markets. Rapid growth in China and India, an Eastern European economic explosion and the aforementioned Gulf building boom are making a major contribution to US export success.

They are cushioning the impact on the US economy – and, hence, on US jobs – of the sub-prime crisis.

To see why, it's worth making a simple comparison between the US economy's performance this year and the recessionary low point in 2001. Back then, the economy expanded at a 0.8 per cent annual rate (compared with around 2.0 per cent on average in the first three quarters of 2007).

Consumption and investment were a touch weaker, but the differences are only a matter of a few percentage points – small beer in the general scheme of things.

The main difference is trade or, more specifically, exports. In 2001, exports fell 5.4 per cent. In the year to date, they're up well over 7 per cent. This improvement is reflected in a sustained decline in America's current account deficit.

This all sounds like rather good news. Why, then, are markets so jittery? Equity markets, so solid in September and the early weeks of October, have suddenly lost their swagger.

Credit markets have seen another attack of the nerves. And the dollar is setting new lows against the euro. So much for a "strong dollar" policy.

I'd emphasise two points. The first, a "micro" point, is that investors were surely wrong to convince themselves that, with a couple of Federal Reserve rate cuts, the money market crisis of August and September would quickly draw to a close.

There are at least two more phases to go. The second phase – which we're now in – is the admission by banks of the scale of their losses. With resignations left, right and centre, it's now abundantly clear that the summer money market meltdown was no "storm in a teacup" event. The third phase will surely be a squeeze on credit availability which, in turn, will lead to much tougher ongoing financial conditions. Borrowers beware.

The second, a "macro" point, is easier to state, in part because the Federal Reserve has already stated it for me. Following last week's interest rate cut, the Fed's Governors said "... the upside risks to inflation roughly balance the downside risks to growth."

Faced with a potential sub-prime crisis, that's not exactly music to the markets' ears. It is, though, the cost of being bailed out by emerging markets. US exports may be doing well because of emerging market demand, but oil, food and metals prices are elevated for exactly the same reasons. The trade-off between growth and inflation deserves careful scrutiny in the months ahead. If the US economy is finally to succumb to its housing collapse, persistent inflationary pressures stemming from emerging market strength will surely play a part.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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