Saturday, September 12, 2009

Does It Matter Which Currency Commodities Are Priced In?

Sometimes it has been predicted that the U.S. dollar could some time in the future lose its status as world's reserve currency and the currency in which commodities are priced on global markets to the euro or the yuan, in the same way that the U.K. pound once lost that status to the U.S. dollar. Because of that prediction, it is often discussed whether it matters whether commodities are traded in terms of dollars or in terms of pounds, euros or yuans.

The short answer to that is that it shouldn't matter, but that it in fact does.

The reason why it shouldn't matter is because it doesn't really affect the cost of commodities of anyone in any country. Assume for example that the euro dollar exchange rate is $1.5/€ and that oil is trading at $75 per barrel. The cost of one barrel of oil is than $75 for Americans and €50 for Euro area residents. If oil had been priced in euros and trading at €50 per barrel, then the result would have been the same. The cost of one barrel of oil would have still been $75 for Americans and €50 for Euro area residents.

If everyone did what they should do, which is to say to "translate" quoted prices into their own currency (or the currency relevant for the analysis), then it wouldn't make any difference if the quoted market price was $75 per barrel or €50 per barrel.

However, that is evidently not the case for most people. Most people even outside the United States tend to think of commodity prices in terms of the quoted dollar price. One example of this is how British Telegraph, as well as most other European financial media outlets published articles this week telling of how gold reached a new high at over $1,000 per ounce. For Britons, it shouldn't really matter how gold moved in terms of dollars but in terms of pounds. And while gold rose 1.1% in dollar terms this week, it dropped 0.6% against the pound because tyhe pound rose 1.7% against the dollar. Similarly in terms of Swedish krona, gold dropped 1.3%, in terms of Swiss francs it dropped 1.1% and in terms of euros it dropped 0.9%. So despite the fact that gold became cheaper for Europeans this week, most Europeans appeared to think it became more expensive because the dollar price rose.

Earlier this year we saw a similar but reversed illusion, as most Europeans (I was an exception) failed to realize that gold rose to new all time highs in terms of European currencies (and most non-European currencies) because the dollar price remained well below the all time high.

And when the euro and the price of oil both reached record highs in the summer of 2008 against the dollar, some financial journalist talked of how European companies were hit by the double whammy of $145 oil and a $1.6/€ exchange rate. In a way that was less misleading than the aforementioned gold examples because oil was record expensive even in terms of euros then, but the euro price had risen a lot less than the dollar price, meaning that the strong euro, while causing problem for exporters, did provide relief for consumers.

So because all too many people use the quoted market price in their analysis even in countries where it is not appropriate, it does have some significance whether commodities are traded in pounds, dollars, euros or yuans. In a perfect world it wouldn't have any significance, but this is not a perfect world.


Blogger Celal Birader said...

I suppose if one makes the further distinction that important commodoties like oil are not only quoted in Dollars but also SETTLED in dollars means that all countries who must import oil will have to maintain some reserves in dollars creating an additional demand for dollars which otherwise would not exist would certainly make a difference for that currency.

10:49 PM  
Blogger stefankarlsson said...

Celal, you're right. To the extent that commodity deals are settled in dollars it create extra dollar demand. However, not all commodity trade is settled in dollars.

6:59 AM  
Blogger Tomas said...

I've found it quite annoying that the gold price is in terms of dollars almost everywhere, like Dagens Industri and such. Like you say, it's not that relevant if you're in Sweden.

11:29 AM  
Blogger traumerei said...

Celal's reference to the American "Exorbitant Privilege" does indicate that it would be a big deal for the US - the pundits suggest that the US could not run nearly as large deficits as it does without it. I'd be interested to see the quantitative data though.

5:56 AM  

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