The post-September 11 Middle East was faced with two opposing dynamics, one was pushing the Middle East away from the global financial system and the other was pushing it toward it. The push was prescribed by the need of the West to trace the sources and mechanisms of terrorist financing. The pull was characterized by the need of the Gulf governments and their businessmen, in light of the campaign against terrorist financing, to become more prudent with their global investments. These two dynamics were taking shape as the oil revenues of the Gulf countries were rapidly rising. Oil prices have more than doubled since 2002, although current real oil prices are not as high as compared to those of the early 1980s. From 2002 through 2005, the combined oil revenues of Saudi Arabia, the United Arab Emirates (UAE), Kuwait and Qatar amounted to more than $525 billion. This year these same countries will add another $330 billion worth of oil revenues to their coffers. These figures are staggering, considering that in 1998 the same countries generated a meager $64 billion in oil revenues. Meanwhile, the IMF has estimated that in 2006 the current account surplus of the Middle Eastern oil exporters will be larger in dollar terms than that of China and the rest of emerging Asia. Where is all this money flowing to? There are two main ways oil exporters recycle petrodollars. First, by increasing domestic consumption and investment, thereby increasing the demand for imports of goods and services. In the case of the Middle East, the main sources of imports are from Asia, Europe and the USA. The second way is through petrodollars being invested in multiple foreign asset classes. The first oil boom of the 1970s was characterized by wasteful spending. With the fall in oil prices since the mid-1980s, all oil exporters, particularly those of the Gulf states, incurred huge government deficits. Saudi Arabia’s government deficit in 1999 was 119 percent of GDP (today it stands at 41 percent of GDP). More prudent Middle East oil exporters have changed the pace of their spending. Governments have learned to be more prudent. The spending multiplier (i.e. the proportion of additional oil revenues being spent by governments) is now lower than during the boom of the 1970s. Governments have spent on average 30 percent of their extra oil revenues from 2002 to 2005, compared with 75 percent in the 1970s and early 1980s. Instead, regional oil-exporting countries are running greater external surpluses, paying off debts and building up assets. Although the public/private distinction in Middle Eastern economies is blurred, public petrodollars are funds controlled by central government (i.e. central banks and investment and oil stabilization funds) and private petrodollars are held by businessmen and individuals. Unlike the 1970s, when public petrodollars were mostly deposited in US and European banks and then lent out to developing countries (ultimately leading to the debt crisis of the 1980s), the petrodollar trail today has been harder to follow. One reason is due to surpluses being directed mostly toward investment agencies like those of the Dubai and Abu Dhabi governments. These agencies are less transparent and respond directly to their respective rulers, while central banks must adhere to more stringent requirements. It is estimated that income from the UAE’s foreign investments may be worth as much as 10 percent of GDP. Dubai’s purchase of 2 percent of DaimlerChrysler and Abu Dhabi’s purchase of 5 percent in Ferrari are just a few examples. Petrodollars are also invested throughout the world via multiple financial intermediaries (e.g. in Europe or Asia), offshore agents and hedge funds outside the US, making them hard to trace. The traditional way of placing petrodollars in bank deposits has gone. Specifically, the Bank for International Settlements (BIS) has been unable to account for almost 70 percent of an estimated $700 billion in OPEC’s investable funds generated by the current increase in oil prices (1999 to 2005). This compares to 50 percent during the last windfall (1978 to 1982). The BIS study estimates that of the 30 percent that the BIS has been able to account for, two-thirds has been deposited in BIS reporting banks (significantly lower than in the previous cycle). The remaining third has been used to purchase US official and private assets and, to a lesser extent, German assets. As interest rates in the US rose so did OPEC’s investable assets in the USA. The BIS indicated that in the third quarter of 2005, OPEC countries deposited a record $82 billion with international banks; this was the largest quarterly placement by the oil-exporting group. If petrodollars do not end up buying directly US Treasury bonds, they end up supporting indirectly the US’s current account deficit by increasing their imports from Europe and Asia whose export earnings are then invested in US paper. I estimate that in 2005 around 8 percent of petrodollar export earnings from Europe and Asia and around 11 percent of the Gulf countries’ foreign assets helped support the US’s current account deficit. In 2006 Gulf countries will support a greater portion of the US current account deficit as their imports and net assets grow faster than the current account of the USA. The post-September 11 climate has also dissuaded a lot of petrodollars from flowing into the West. It is true that petrodollars from the second oil boom in the Middle East have been placed in alternative investments which did not exist in the 1970s. A large number of petrodollars have found their way to the wider Middle East region. Absorptive capacity The absorptive capacity of the Middle East economies has grown immensely since the 1970s. Besides public petrodollars, private petrodollars are just beginning to make their way out of the Gulf. Around $1.5 trillion is held outside the Gulf by individuals and businessmen from the Gulf Cooperation Council (GCC) countries, the bulk of which is held by the Saudi private sector. Private petrodollars from the Gulf are just beginning to flow into Syria, Lebanon, Egypt, and Morocco in construction, real estate, tourism and various trade and manufacturing projects. Some of the private petrodollars are also making their way to China, India and other Asian countries. This includes stakes in banks, real estate, high-tech manufacturing and refining capacity projects. (1) This is the first in a series of articles by Dr John Sfakianakis, general manager and chief economist of Saudi British Bank, based in Riyadh, Saudi Arabia.