It is the Oil Price Stupid!

The sub-prime crises might have been what precipitated the credit crunch, but it was arguably the high oil prices that first pushed the world towards recession by catalyzing the US slowdown at the end of 2007.

Whereas historical oil price shocks were primarily caused by physical disruptions of supply, the price run-up of 2007-08 was caused by strong demand confronting stagnating world production. According to a paper by James Hamilton of UC San Diego, although the causes were different, the consequences for the economy appear to have been very similar to those observed in earlier episodes, with significant effects on overall consumption spending and purchases of domestic automobiles in particular. In the absence of those declines, it is unlikely that we would have characterized the period extending from Q4 of 2007 to Q3 of 2008 as one of economic recession for the U.S. The experience of 2007-08 should thus be added to the list of recessions to which oil prices appear to have made a material contribution.

Of course the hand that takes can also give. The fall in oil prices have now helped the world economy to stabilize. In comparison to the stimulus provided by oil, government handouts are peanuts. Last year the world was consuming 88 million barrels per day at an average cost of $100 per barrel, at an annual cost of $3.2 trillion. If this year's average cost of crude oil around $50 per barrel holds up, the annualized savings will be about $1.6 trillion. The International Monetary Fund estimates that the fiscal stimulus to be provided by the G20 countries for this year and next will amount to $1.2 trillion at best, excluding bank bail-outs.

According to a just released report by the International Energy Agency( (IEA), global investment in oil and gas projects is expected to slump 21% this year from a year ago, falling for the first time in a decade.

More than 50 major oil and natural-gas projects around the world have been cancelled or delayed by at least 18 months since October, the IEA, the energy advisor to 28 major energy consuming countries, said in the report. According to the IEA, $170 billion worth of projects, involving around 2 million barrels a day of oil production and 1 billion cubic feet a day of gas output have been cancelled. In addition, 35 projects, involving 4.2 million barrels a day of oil capacity and 2.3 billion cubic feet of gas capacity, have been delayed by at least 18 months

With oil demand expected to rebound next year, following two consecutive years' decline, failure for oil production to keep up with a rising demand could drive up oil prices and put a nascent global economic recovery on screeching halt.

Turkish Lira Update

The scenario I outlined in my March 11th post has been unfolding as forecast. The ruling party has won the local elections, President Obama has made a successful visit to Turkey and Turkey has entered serious negotiations with the IMF. The rumors are that the two sides are discussing a $30-$40 billion stand-by agreement for a 3-4 year horizon to enable Turkey to undertake long term reforms. The Turkish Lira has appreciated against the US dollar from 1.82 to 1.56 recently, a 14% gain.

Reversal of Capital Flows to Emerging Markets Poses Risks

With super low interest rates available in the U.S. and the rest of the developed world, investors may be tempted to chase the juicy yields available on emerging market (EM) debt.

The World Bank estimates that in 2009, 104 of 129 developing countries will have current account surpluses inadequate to cover private debt coming due. For these countries, total financing needs are expected to amount to more than US$1.4 trillion during the year. External financing needs are expected to exceed private sources of financing (equity flows and private debt disbursements) in 98 of the 104 countries, implying a financing gap in 98 countries of about US$268 bn. Should bank rollover rates be lower than expected, or should capital flight significantly increase, this figure could rise to almost US$700 bn. Well over US$1 trillion in EM corporate debt and US$2½-3 trillion in total EM debt matures in 2009, the majority of which reflects claims of major international banks extended cross-border or through their affiliates and branches located in emerging markets.

The outlook for the flow of portfolio investments is even less encouraging. Redemptions of US$41.2 bn out of EM equity funds in 2008 have fully reversed the record US$40.8 bn inflow of 2007. About half of the EM fund purchases that have occurred since 2003 have now been withdrawn. According to the Institute for International Finance (IIF), net private capital flows to emerging markets are estimated to have declined to US$467 bn in 2008, half of their 2007 level. A further sharp decline to US$165 bn is forecast for 2009, with just over three-quarters of the decline due to deterioration in net flows from commercial banks. Moreover, net lending of international banks to emerging countries (excluding Gulf countries) is expected to fall to US$135 bn in 2009 from US$401 bn in 2007 and US$245 bn in 2008.

Expect capital controls, defaults and social unrest caused by austerity measures dictated by the multi-lateral organizations supplying financial rescue packages.

Where is the Turkish Lira Headed?

This has been a wild week for the Turkish Lira, which has seen wild swings in the order of 6% or more in either direction. It is true that the markets' current worries about the foreign-funded FX lending in Central and Eastern Europe and the related exposure of Western European banks does not apply to Turkey. The country's banking system is solid with no exposure to the toxic assets plaguing the banks in the US and Europe. The Turkish banks have the lowest loan-to-deposit ratio and the smallest external indebtedness as a percent of the GDP in Eastern Europe. The slowdown that is currently setting in is directly related to shrinking export markets in Europe, Turkey's main trading partner.

The cause of the extraordinary volatility has been blamed on the external fear factors such as the recent events surrounding GM, GE and Citibank and the decision of a couple of foreign banks to liquidate their Turkish assets. The ensuing Central Bank decision to start foreign exchange auctions have had a calming effect on the Lira.

I beleve we are entering a critical period for the Turkish Lira that spans the end of March-early April. Turkey is slated to have local elections on March 29, where the governing AKP Party is expected to win most municipalities. These approaching elections have acted as a brake on the government's willingness to conclude a $20-30 billion new stand-by agreement with the IMF. The lack of an IMF agreement coupled with agressive interest rate cuts by the Central Bank has decresed the attractiveness of Lire denominated assets.

Turkey is a member of the G-20 that will be meeting on April 2. This will be followed by the NATO summit on April 3-4 and President Obama's visit to Turkey. The latter event is important because it will highlight Turkey's status as a regional power and an energy corridor for the West.

The optimistic scenario to which I subscribe would be for the AKP to get a renewed mandate in the local elections and have the political will to sign an agreement with the IMF around the time of the April summits. Syncronizing the IMF agreement with the Obama visit and the announcement of further political (Kurds, new constitution) and economic reforms to give new impetus to the EU accession talks would have a very good chance of stabilizing the Lira in a much lower band than we have observes this week.