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Dollar on an oily slope

The unabated rise of international oil prices and depreciation of the dollar will push economic growth in the US down to about 2.5% in 2005, but will have little impact on economic growth in the European Union, where growth is expected to accelerate modestly. Stronger economic fundamentals in the EU will support the continued impressive economic growth in non-Japan Asia.

In cumulative terms, global oil demand increased by 12% between 1999 and 2004. Cumulative global oil supply increased by only 8.6% during the same period. Between 1999 and 2001, OPEC-engineered oil production cuts reduced global oil supplies relative to demand. Beginning in 2002, the "war on terror" also began to hamper global oil supplies.

The "war on terror" has contributed to destabilization in Syria, Yemen, Nigeria, Indonesia and Colombia, preventing foreign investment in oil production. As a result, oil production has declined in all of these countries since 2002. More broadly, the "war on terror" has significantly influenced the depreciation of the dollar in the past two years. The dollar's depreciation has also contained the growth of oil production.

The imports of most oil-exporting countries are dominated by Europe. Though the dollar price of oil has increased substantially in the past two years, the trade-weighted increase in the price of oil has been muted for oil producers in Europe, Africa and the Middle East. Because of this, the dollar's depreciation against the euro has also contained investment in oil production in many countries.

The "war on terror" has crippled US foreign relations with key oil producing countries, including Russia and Venezuela. Deteriorating relations with Washington have encouraged these countries to contain oil production growth in order to push international oil prices higher. The "war on terror" has made investment in oil production unusually unresponsive to sharply higher international oil prices.

With the "war on terror" unlikely to abate, the growth of global oil supply will slow in 2005. Oil production in Europe, Latin America, Africa and Asia will decline, partially offsetting production increases in the former Soviet Union. Periodic instability-related supply shocks will also contain the growth of oil supply.

Global oil demand growth will not slow as quickly as oil supply growth. Like investment in oil production, global oil demand growth has been very unresponsive to rapidly increasing international oil prices in the past two years. The dollar's depreciation has played a significant role in this by offsetting the rising dollar price of oil in Europe and Asia. In addition, large and rapidly growing oil-consuming countries such as China and India subsidize oil prices.

The continued depreciation of the dollar in 2005 will prevent a significant decline in oil demand growth. International oil prices could easily reach $75 per barrel. This will push inflation and interest rates in the US significantly higher, slowing economic growth in 2005.

US slowdown and the dollar
Slowing economic growth and the increasing cost of the "war on terror" will push the US budget deficit, including state government deficits, to about 6% of gross domestic product (GDP). This will also weigh heavily on the dollar in 2005. With all indicators pointing toward further dollar depreciation, foreign central banks may become more inclined to rebalance their foreign exchange reserves in favor of the euro.

The rebalancing of reserves could swiftly snowball if Russia decides to redenominate its oil and gas exports to Europe from dollars into euros. Both the EU and Russia are interested in such a redenomination. This change would force Europe's central banks to reduce their dollar reserves. It could also encourage the Organization of Petroleum Exporting Countries (OPEC) to redenominate its oil exports into euros.

The redenomination of oil would allow the traditional relationship between oil prices and oil supply and demand to reassert itself. The redenomination of oil into euros would force the dollar to devalue by 30-50%. It would also force foreign central banks, which hold about $1.5 trillion of US Treasury securities, to liquidate a portion of their holdings, pushing US interest rates much higher.

America's loss is Europe's gain
The dollar's depreciation against the euro will continue to insulate Europe from rising international oil prices in 2005, preventing a significant increase of inflation. As a result, economic growth in the EU is expected to accelerate mildly. This will allow economic growth rates in the US and Europe to converge for the first time in many years.

Convergence in economic growth rates will be accompanied by lower European inflation vis-a-vis the US. In addition, the EU's current account surplus will be about $75 billion in 2005. This will compare to a current account deficit of about $600 billion in the US. Europe's economic fundamentals will be much stronger than America's in 2005. This will further fuel the dollar's depreciation as investors, including American ones, reallocate assets away from the US stock and bond markets in favor of European stock and bond markets.

Non-Japan Asia: Slow but bright
Slowing US economic growth will reduce export growth in several Asian countries, including China. However, private consumption and investment growth is unlikely to slow in China. China's government can and will reopen the country's credit taps if economic growth slows below 7% on the back of weaker exports to the US.

In addition to continued strong economic growth in China in 2005, slightly stronger economic growth in Europe will help to contain economic weakness in non-Japan Asia. India, in particular, is expected to benefit from expanding exports to the EU. Other Asian countries will also be able to replace exports lost to the US with exports gained to the EU.

Only a mild economic slowdown is likely to occur in non-Japan Asia in 2005. Like Europe, the currencies of most Asian countries will continue to appreciate against the dollar, insulating the region from rising oil prices and higher inflation. With the dollar expected to depreciate against most currencies in the world, the dollar's role as a reserve currency will be tested in 2005.

Jephraim P Gundzik is president of Condor Advisers, Inc, which provides investment risk analysis on emerging markets to individuals and institutions globally. Please visit for further information.

(January 13, 2005)

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