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Guess Who’s Buying The US Dollar

FYI | Aug 12 2008

By Greg Peel

The US dollar had been declining for the last few years as the US current account deficit built and built. But when the credit crunch hit and the Fed started cutting the cash rate, the dollar collapsed to multi-decade lows at an index measurement below 72. The bottom in the dollar coincided with the sale of Bear Stearns in March.

Since reaching that level, the dollar has banged along a base, unable to rally but not attempting to fall any further. Part of the reason is that the euro had rallied to US$1.60, and beyond this point the finance ministers of the G7 were threatening intervention to save the greenback, despite never actually doing anything. It was enough for forex markets to assume US$1.60 euro was probably a line that could not be crossed.

In the meantime however, we had Fannie & Freddie. But still the dollar failed to fall further. Then the European Central Bank raised its cash rate, yet still the dollar failed to fall. It looked like a cement floor had formed. An index level of 72 was proving impenetrable. With inflation becoming a growing problem, talk was that the Fed might raise its own cash rate. Despite weakness in the financial sector, traders could just not sell the dollar against that rate hike possibility.

And then the oil price turned around.

The fall in oil was a fillip for the dollar, as were the reasons behind oil’s fall. The market had realised the rest of the world, including Europe, Japan and China, was now moving towards economic weakness. On a relative basis – and exchange rates are only ratios – the softening of global currencies implied a higher US dollar index. The fall in the oil price has been dramatic, given the number of long positions held by commodity funds, and by the same token the world was short US dollars, implying a sharp rally may occur.

But no one was quite prepared for the dollar to race so quickly back to 76 in the index. With ongoing weakness in the US financial sector, talk of the Fed possibly raising began to fade. Okay – so there was economic concerns growing in the rest of the world. But the rally has been quite extraordinary. The euro has fallen from US$1.60 through US$1.50 in a flash.

There is, however, possibly one answer.

The Fed has reported that in the week ending last Wednesday, “official institutions” made the largest net purchase of US debt ever recorded. This means foreign central banks buying US Treasuries. The huge purchases caused a sudden shortage of dollars, and as a result the greenback leapt up 3%.

So what central bank, in their right mind, has bought so much US debt in this time of financial uncertainty? As the credit crunch has progressed, central banks in the Middle East, Japan and China – those with the surpluses to spend – have been very vocal about diversifying out of US dollar assets and into euro and other currencies, and gold. The Japanese government even warned its banks not to buy US dollar debt. Where did this buying come from?

According to talk across the blogs, there my be a clue in a certain news story which came out on Sunday.

In 1997 China had signed a deal with Iraq to develop the Al-Ahdab oil field, with planned production of 90,000 barrels per day. But when the United nations imposed sanctions on the then Iraqi regime in 2003, following the US-led invasion, the deal with China fell apart. In the five years that have ensued, Chinese economic growth has exploded and the oil price has shot up on Chinese and other emerging market demand. But all this time the third greatest supply of oil on the planet was cut off.

The Iraq war is not over, but the new Iraqi government is beginning to reopen its oil industry. Thus on the weekend, government representatives from China and Iraq met in Baghdad with the purpose of reviving the 1997 contract. Iraq announced on Friday it is opening up its massive oil reserves for exploration once more, and wants to return production to the 3mbpd level operating prior to the war, from a current 2.5mbpd. At the end of June it had thrown open six oil fields for tender from 41 different international oil companies.

None of this sounds at all sinister, until you think about who is realistically pulling the strings on the new Iraqi government. Obviously whoever wins those oil tenders, or is allowed any access to Iraqi oil reserves, will have to be US allies. But diplomatic niceties aside, one would not normally count China as part of such a group.

Unless of course, China was willing to do a deal?

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