Bloomberg's Matthew Lynn: Are Commodity Prices Headed for Switch to Euros?

Are Commodity Prices Headed for Switch to Euros?
by Matthew Lynn

Feb. 3 (Bloomberg) -- Oil, metals and even aircraft may one day be priced in euros, not dollars. Dream on?

As the dollar stays weak on foreign-exchange markets, with little sign of a sustained recovery, there is speculation that at some point commodity prices will drop the U.S. currency. If that happens, it would herald a wider realignment of the global financial system -- and would indicate that the dollar's reign as the world's reserve currency was coming to a close.

It is too early to conclude the dollar is finished. Yet the challenge is real and growing. The world may well be set for a period during which the dollar and the euro compete for reserve status -- hardly a promising situation for global stability.

The dollar is being shunned for obvious reasons. The trade deficit grew to a record $609 billion last year, and George W. Bush's administration expects the budget shortfall to reach a record $427 billion in the year ending in September. The New York Board of Trade's Dollar Index, which measures the dollar against a basket of six currencies, has dropped 18 percent since the end of 2001.

There are three key responses to the changing status of the dollar in the global financial system. Central banks may shift their reserves out of dollars. The Asian currencies could end their pegs to the U.S. currency. And lastly, we could witness a breakdown in the pricing of commodities in dollars.

Central banks are already slowly raising the proportion of their reserves in euros, and reducing their dependency on dollars. That is likely to continue. Yet it will be a slow process -- not least because no central bank will want to dump dollars into an already fragile market.

Asian Pegs

Asian nations may or may not end their dollar pegs. Politics as much as economics will play the main role in those decisions.

That leaves commodity prices. If the dollar's unique status is indeed coming to an end, that is where we will see it first.

``It is crucial to the dollar's dominant role as a reserve currency that dollar pricing of oil should continue,'' noted Stephen Lewis, economist at Monument Securities Ltd. in London, in a recent analysis of the currency.

Is there a realistic chance of oil or any other major commodity switching its pricing into euros?

Last month, Hamad al-Sayari, the governor of the Saudi Arabian Monetary Agency, caused a ripple in the market with comments that he thought the role of euros in central-bank reserves would increase in the future, according to the Jeddah, Saudi Arabia-based English-language daily Arab News. More pertinently, he said it didn't matter much whether oil was priced in dollars or euros.

A Bookkeeping Matter

It might not matter to him, yet it does to everyone else.

Take a look at the issue from the perspective of an oil producer -- or a producer of any other major commodity.

At one level, which currency you price your products in is largely a matter of bookkeeping. The Saudis can price their oil in dollars, or the South Africans their gold, or the French all those new Airbus SAS aircraft, without it making much difference to their actual income. As soon as the dollars come in, they can sell them for whatever currency they want. If you are uncertain about the future price that your product is likely to command, then you can buy and sell currencies in the futures market.

Just because you price a product in a currency, you aren't compelled to hold that currency.

In the medium term it does matter. The producers of any product are looking for high and stable prices. If your product is priced in a permanently weak currency, then you have to keep raising the prices. That is far from satisfactory. At some point, the temptation to switch to a stronger currency will become irresistible.

Who Will Break Ranks?

Next, commodity pricing matters to the currency markets. The fact that commodities are priced in dollars is one of the key sources of that currency's strength. Everyone buying big-ticket items such as oil, metals or aircraft must buy dollars for their purchases. That is a major source of demand for the currency.

Who will be the first to break ranks? Right now, that is no more than speculation. Russian oil must be one candidate -- most of it is sold in Europe anyway. Airbus aircraft must be another candidate -- the bulk of its costs are in euros, and it has the luxury of now being the dominant producer in its industry.

Nobody should hold their breath. ``Maybe one day,'' says Airbus spokeswoman Barbara Kracht in an e-mailed response to questions. ``The point is that it is the customers who decide, and for the time being they are asking for quotations in dollars.''

Decline or Rout?

True enough. You need to hold a very strong market position to impose a new currency on your industry.

Much depends on the future path of the dollar. It has been weak for about three years now. So far, producers have responded with higher prices. Two more years of dollar weakness, and they may well decide to take more radical action.

It will only take one commodity producer to break ranks, and the move will be widely imitated. At that point, the dollar's decline could well turn into a rout. Commodity pricing is now the weakest line of defense for the dollar.