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Monday, March 27, 2000

Excessive currency liquidity fuels speculative rise in crude


Crude oil prices, which just a year ago appeared on the verge of falling below $10 per barrel, began a steep climb this year, at one point hitting $34 per barrel -- the highest level since the Persian Gulf Crisis. There are two major reasons behind this phenomenon.

First, the supply-demand situation has changed. On the supply side, the Organization of Petroleum Exporting Countries made a series of cuts in production quotas, which were observed fairly strictly by the OPEC member countries.

On the demand side, Asian nations have generally recovered from the economic confusion caused by the drastic inflow and outflow of short-term capital. Increased real demand in these countries is pushing up oil prices, and this has prompted the United States to dispatch its energy secretary to ask oil-producing countries to boost output to ease the tightness in supply. But these factors alone do not explain the recent sharp rise.

Other factors we have to note are the inclusion of oil in the commodity market and the changes that excessive money liquidity has caused in the price-making mechanism.

Oil has been a part of the commodity market since West Texas Intermediate went public on the NYMEX in 1983. This in itself is a welcome development since it helps oil prices better reflect worldwide demand and allows for more risk-hedge operations.

The problem is that excessive liquidity in global currency markets has made oil a target of speculative trading.

The value of the market for crude oil is a mere $200 billion -- just a drop in the $12 trillion U.S. stock market and its $2 trillion bond market. Amid growing uncertainty over the course of share prices, some investors have pulled their funds out of stocks and put them into crude. Since the amount of money is enormous by oil market standards, it could have a huge impact. Much of the recent surge in oil prices has been due to this kind of speculative investment.

Then what are the factors behind excessive liquidity?

One is the accumulated external deficits of the U.S. Another factor is the excessive liquidity in Japan, where money is not absorbed domestically and is being utilized to increase yen-carry trading.

A third factor is the expansion in leverage afforded by information technology, enabling a larger number of people with small amounts of capital to move much bigger amounts of money.

Finally, banks have increased lending, particularly in the U.S., where stock-collateralized loans have boosted liquidity to a frothy level. This is one of the reasons behind the U.S. stock market boom, which has pushed the size of the market over the $12 trillion mark.

This abundance of dollars and yen is pursuing new sources of profits. We have to remember that the Asian economic crisis was also caused by excessive cross-border liquidity movements, in combination with structural problems inherent in the Asian economies.

Higher crude oil prices are a major global source of inflation. The interest rates being set by U.S. and European monetary authorities partially reflect a growing awareness of the possible effects this excessive liquidity may cause. It is natural for regions or individual countries to draft policies that fit their own needs, but in this era of rapid economic globalization, the danger posed by the inconsistent monetary policies of advanced industrialized nations must be fully recognized.

It may be prudent for Japan to wait a while longer before raising its discount rate, but I believe the time has come for monetary authorities to take the problem of excessive liquidity into account. The government puts additional liquidity into the market with its dollar-buying currency intervention. Since the yen's rise stems from Japan's current account surplus, the effectiveness of currency intervention will be limited, and the inflation gap will be naturally reflected in foreign exchange rates.

We also need to seriously consider the fact that the decreasing risk of yen appreciation, thanks to currency intervention, is working to encourage yen-carry trading. A similar kind of "dollar-peg" system accelerated the massive inflow of short-term capital into many Asian countries.

Teruhiko Mano is an adviser to BOT Research International Ltd.


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