Friday, July 11, 2008

Dump the Dollar Peg Week

This has been the week of dump the dollar peg in the Gulf States. First, it was reported on Sunday that some officials from Abu Dhabi think the United Arab Emirates should replace its dollar peg with one tied to a basket of currencies. At the same time, Nouriel Roubini posted an article comparing the coming collapse of the Bretton Woords II system with that of Bretton Woods I where, among other things, he too called for the end of the dollar peg in the Gulf States. Then on Monday the Financial Times (FT) published its "Dollar-pegged out" editorial. Here the FT similarly argued the Gulf States needs to abandon the dollar peg and move to a basket of currencies that included the price of oil. The FT's editorial, in turn, made Brad Sester happy who followed up on Tuesday with a posting to his blog that furthered the arguments made in the FT. On Wednesday, Jeffrey Frankel, the originator of the currency-basket-including-oil idea chimed in on this debate with this piece. Then on Thursday the Wall Street Journal RTE blog posted the "Dollar Peg Gets Taken Down a Peg." And today, ordinary people like me are sifting through this debate, considering how such a change would take place and what it would mean in the near term.

But first, let's review the thinking behind the calls for the Gulf States to abandon their dollar pegs. Martin Feldstein explains it this way:
The double-digit inflation problem in Saudi Arabia and its Gulf neighbours is different from that of other emerging market economies. Although the rising price of imported food affects them all, the inflation problem in the Gulf region is exacerbated by their fixed exchange rate policy.

The peg to the dollar contributes to Saudi inflation in two ways. First, the dollar link forces the Saudi central bank to match US interest rates. As the Fed lowered its interest rate from 5.25 per cent last summer to 2 per cent now, the Saudis had to cut their interest rate. If they had not done so, investors around the world would have flooded Saudi Arabia with funds seeking the higher yield on a currency that is pegged to the dollar. While cutting rates was a good policy for the US as its economy weakened, it was a terrible policy for Saudi Arabia, which is experiencing an overheated domestic economy with rapidly rising inflation.

The dollar peg also raises Saudi inflation by increasing the cost of imports as the dollar declines relative to the euro, the yen and other currencies. The US is the source for only about 12 per cent of Saudi imports. The 15 per cent decline of the dollar relative to those currencies during the past year meant that the prices paid by the Saudis for the goods that they bought from Europe, Japan and elsewhere rose more than 15 per cent. The large US trade deficit is likely to continue to force the dollar to decline against other main currencies. The result will be a continuing source of imported inflation in Saudi Arabia and other countries that tie their currencies to the dollar.

Inflation in Saudi Arabia and the other Gulf states is depressing real incomes of millions of low-income workers. The combination of the dollar peg and the declining dollar is also reducing the value of the remittances that large numbers of foreign workers send home to their families in low-income countries such as India and Pakistan. Since these foreign workers make up more than half of the total workforce in Saudi Arabia and an even larger share in the less populous states of the region, their discontent is a significant risk to local stability.
Because of their dollar pegs, then, the Gulf States are importing the highly stimulative U.S. monetary policy at the very time their overheating economies need a tighter monetary policy. The remedy, as argued by the above individuals and media outlets, is to change the composition of their peg to a basket of other currencies and oil. Doing so, would mean that their "currencies would appreciate when oil is strong, and depreciate when it is weak" and "make for smoother adjustments than double-digit inflation" (FT).

It is clear that the dollar peg is distortionary for the Gulf States. It is also clear there is an end game in sight: either the Gulf States change their peg or continued inflation will effectively do it for them. The currency-oil basket makes sense to me as a long-term solution, but what about in the short-term when the transition between pegs would take place? What happens if in abandoning their dollar peg the Gulf States make other important dollar peggers like China nervous about capital losses on their own dollar holdings? This could start a run on the dollar and lead to more distress in our battered financial markets. So when I read these calls for dumping the dollar peg, I agree in principle but get concerned as to what would actually happen in practice.

Is there a way to guarantee the transition will be orderly? My current thinking is that part of the solution lies with the Fed: it should do more to reign in global inflation. This would remove the inflationary pressures in the Gulf States and give them more time to work on a orderly transition. It would also reduce the likelihood of a run on the dollar.

1 comment:

  1. I can not think of any circumstances where the US would allow Saudi Arabia to give up its peg to the dollar. They are our puppets and will do what we say. United Arab Emirates maybe, but is it even a possibility that the Saudis would give it up?