Crude Oil ... But Refined Economic Principles

In today’s world economy the hot money is betted over crude oil. It is a daily necessity of all economies as it is the lifeblood for them. Crude oil prices behave much as any other commodity with wide price swings in times of shortage or oversupply. The crude oil price cycle may extend over several years responding to changes in demand as well as OPEC and non-OPEC supply.

The three current oil markets are all US dollar denominated: North America's West Texas Intermediate crude (WTI), North Sea Brent Crude, and the UAE Dubai Crude. The two major oil bourses are the New York Mercantile Exchange (NYMEX) in New York City and the International Petroleum Exchange (IPE) in London. This means that if you want to buy crude oil you will have to pay in U.S $ and even sell it in exchange of the same. Since, crude-oil cannot be bought or sold in any other currency every nation has to buy U.S $ and gear up their dollar holdings first. The demand for crude oil transforms into demand for U.S $ reserves across the world. From that point, every nation that needed to buy oil had to firstly hold US dollars, which meant that they exchanged their goods and services for dollars, which the Americans just printed.

There is no serious indication that the countries of the world, including the oil exporting countries are ready to accept a Euro based oil market. Since 1986 the oil prices are determined according to complex tables and spot changes in the New York and London exchange markets. OPEC countries are not ready to change the basis for oil transactions so easily. OPEC has tried several times to change the basis for the oil prices to Euro, or Special Drawing Rights (SDRs of the IMF) or a basket of currencies and each time it has been abandoned.

Now, imagine a situation when more and more OPEC nations agree on selling crude oil in exchange of other major currencies like Euro, Yen or Pound. What if even the Americans also have to buy their oil with Euro or Ruble instead of U.S $ (which they just printed)? All nations then would not have the acute necessity to exchange their goods/services for U.S $ and thus the demand for U.S $ would go down. Also, the Americans may face the end of their ‘free lunch’ – the crude oil they bought by printing U.S $.

Professor Krassimir Petrov, from the American University in Bulgaria (his article on this subject has been used by countless sources and websites as an academic argument for the validity of petrodollar wars theory) writes: "... Bush's war in Iraq was not about existing weapons of mass destruction, about defending human rights, about spreading democracy, or even about seizing oil fields. It was about defending the dollar, ergo the American Empire; it was about setting an example that anyone who demanded payment in currencies other than U.S. Dollars would be likewise punished....”

Comedy of Errors!!

In a case of mistaken identity, the stock of Axon Infotech shot into the limelight on Tuesday (August 26, 2008). The stock hit the upper circuit to touch a high of Rs 30.35 during intra-day trading, accompanied by a surge in trading volumes. According to brokers, certain market participants mistook this stock for the company that Infosys Technologies is planning to acquire in an all-cash deal. However, once it was publicised that Axon Infotech has no connection to the UK software major Axon Group, the stock corrected to close at Rs 27.50, still a gain of 8.7 per cent over the previous day’s close of Rs 25.3. Trading volumes surged to 8.57-lakh shares against its two-week average of about 2,600 shares.

According to experts, mistaken identity is not new to Indian markets. According to them, retail investors are often swayed by one of two sales pitches by brokers. In one, brokers actually put investors on notice of such mistaken identity but would advise that investors should go along with the price movements and exit on registering a small profit. In the other, they may keep investors in the dark (mistaken identity), and end their recommendation with a caution that investors should do their own due diligence before investing.

Marketmen said that recently when stock market was upbeat on Reliance Group, shares of Reliance Chemotex Industries, a textile company, also surged along with them though it was not part of Reliance group. From a 52-week low of Rs 19.8 (August 2007), the stock had touched a high of Rs 182 (November 2007), but is now ruling at around Rs 45.

The Cost of Financial Globalization

Opponents of financial globalization see international capital mobility as a destabilizing source in the global economy. There are three main reasons for this: excessive inflows and outflows of capital, worsening income inequality, and international tax competition. As developing countries have liberalized their capital accounts foreign investment has increased. But it has also led to a number of devastating financial crises due to sharp capital flow reversals. When capital inflows quickly turn into capital outflows the domestic financial system may collapse and no longer channel funds from lenders to borrowers, slashing investment and consumption as happened across Asia in the late 1990s. Excessive capital outflows are due to what is known as asymmetric information that exists in financial markets. A lender must assess whether a borrower represents a good or bad credit risk. The borrower knows if she is going to invest the funds in a risky project but the lender does not. Once there are rumours that the debtor is in trouble and may default the lack of information makes creditors worried that this is endemic among all debtors and they begin to withdraw their funds. In a global economy asymmetric information tends to worsen with cultural differences and physical distance.

The Mexican Peso crisis in 1995 is a perfect example of how capital flow reversals, spurred by asymmetric information can be devastating. In the late eighties and early nineties Mexico’s banking system was privatized. At the same time Mexico was also liberalizing its capital account. But, the banking system was incompetent to risk management and the supervision from the central bank was limited. As foreign capital flowed in these funds were channeled into bad investment projects causing an increase in non-performing loans. Bankers like Carlos Cabal were accused of making hundreds of millions worth of bad loans. Cabal was never convicted but as the world interest rate rose and investors realized that Mexico might default on its stand a sharp reversal in capital flow occurred as capital left the country causing a collapse of the financial system and widespread loss in economic activity.

The Asian crisis in 1997 displayed similar features as the Mexican Peso crisis but also illustrated how asymmetric information in the global capital market could cause a financial crisis to spread to other countries. When a country defaults on its stand investors may withdraw their capital from neighbouring countries with similar culture or economic infrastructure because of fear of future default allowing the crisis to spread from country to country.

Financial globalization can also cause problems for developed countries experiencing capital outflows. Capital outflows make workers less productive and therefore cause wages to decline. This may be especially true in industries that employ low skilled labour. So companies such as car producer General Motors have moved some of their production to Mexico where wages are lower, as is electronics producer Thomson RCA. Because the effect is less predominant among high skilled labour wage inequality rises. Financial globalization also poses problems for countries with large welfare programs. These welfare programs are funded by taxing both labour and capital. Without capital restrictions capital tends to flow where taxes on capital are low. So countries may engage in tax competition in order to attract capital. Welfare states cannot afford to reduce capital and must follow suit and lower taxes on capital. In order to maintain the welfare system the lower tax revenues from capital must be compensated with higher taxes on labour. This is a problem for many European countries with large welfare programs and high taxes on labour. Financial globalization may therefore force these countries to reduce the size of the welfare state. Britain’s National Health Service, for example, founded in 1948 is funded exclusively through taxes and provides free healthcare for all. But with patients now suffering long waiting lists and being denied expensive treatments, many say Britain’s welfare state is creaking at the joints.

Financial Globalization: A Controversial Issue

Financial globalization is today perhaps the most controversial issue within international economics. Most economists accept that the trade liberalization is beneficial thus the elimination of barriers to international trades in goods and services. But policy makers and academics are divided over the benefits of financial globalization. Those in favour of financial globalization often refer to the vibrant global capital market of 1870 to 1913 as evidence of potential benefits. They also point towards the growth of international financial markets in the last couple of decades and the menu of different assets that it provides to investors.

But, opponents of financial globalization argue that sudden capital flows in and out of the country can wreck domestic economies and their financial systems as happened in Indonesia where plummeting currency and massive capital flight led to huge riots. Opponents also claim that the global capital market allows the financial crisis in one country to ricochet to other countries. This happened most recently with the Asian financial crisis in 1997 which started in Thailand and spread not only to neighbouring countries such as Indonesia and Malaysia but also to far away countries such as South Korea, Brazil and Russia. These crises had devastating effects on the economies comparable to the great depression in the 1930s.

Global Capital Markets: Risks and Rewards

Today’s world economy is becoming increasingly financially integrated. Funds are flowing in vast amounts across the globe. “In today’s world the money moves instantaneously, the money is like electron somewhere on somebody’s hard drive”, says Jack Blum, UN Consultant. A US citizen can provide funds to a foreign entity like Sony or Toyota by buying stock or bonds issued by these corporations, or a Japanese citizen can lend money to the US Government by purchasing US treasury bills. This is all feasible through financial globalization which is the removal of restrictions on the international trade of financial assets.