The FT joins the chorus arguing against the Gulf’s dollar peg

The FT’s leader concisely summarizes the arguments against the Gulf’s peg to the dollar.

"The UAE either keeps its currency pegged to the dollar, in which case too many dirhams will chase too few goods, and prices will inevitably rise; or else revalue the dirham so each one is worth more dollars.

Both options achieve the same end result but inflation has greater drawbacks. First, it is slow, whereas revaluation is instant. Second, once started, inflation is hard to stop because workers demand higher wages to compensate. Third, there is a risk of asset price bubbles in the Gulf nations because high inflation means that real interest rates are too low. Fourth, inflation hurts the poor (who do not have direct access to oil revenues), and so harms political stability.

There is also a specific problem with pegging to the dollar. Gulf currencies have actually had to depreciate against the euro in order to follow the dollar, the exact opposite of what they need, and a shift that will cause even more inflation."

Alan Greenspan has suggested that the Gulf should allow their currencies to float. It would be hard, though, for the UAE and Qatar and Kuwait to float if Saudi Arabia remains pegged -- especially if they aspire to form a monetary union. If the Saudis floated, the rest of the Gulf could peg to the riyal, but that also seems like a remote possibility.

The FT suggests that the GCC shift to a basket peg. The risk of shifting to a basket peg now though is that it locks in the Gulf’s depreciation against the euro. If the dollar were to rebound against the euro, a basket peg would imply that the Gulf’s currency would need to depreciate against the dollar to avoid appreciating against the euro by too much -- no matter what happens to the price of oil. That doesn’t make much sense. A basket peg protects against further dollar depreciation, but it doesn’t address the core problem: the Gulf, like China, needs to appreciate against the ensemble of its trading partners.

The FT suggests addressing this by combining a revaluation with a basket peg. It then goes one step further and suggests that the Gulf should consider including oil in their basket.

"The Gulf needs to peg to something. A first step (after revaluation) would be to peg to a basket of currencies that included the euro and the yen. A bolder step would be to include the price of oil in that basket, so that currencies would appreciate when oil is strong, and depreciate when it is weak. That would make for smoother adjustments than double-digit inflation."

I agree. Very much so. Jeff Frankel has argued that commodity exporters should peg to the price of their main commodity export; pegging to a basket that includes the price of their main export "waters" down a pure commodity peg. This makes sure that oil-exporters currencies appreciate when the price of their export appreciates, and depreciates when the price of their main export depreciates -- without having the currencies of commodity exporters move by quite as much as the commodity prices.

It certainly beats a world where the oil-exporters’ currencies depreciate when they are rolling in cash from near record high prices.

The Saudis, according to the Bank of New York, are still not keen to change. Neil Mellor suggests that the Saudis have $800 billion in foreign assets (he calls this their "currency reserve equivalent"; it is a sum more than twice the size of SAMA’s visible foreign assets), and presumably most of them are in dollars. Mellor hints that the Saudis are once again pushing Paulson to take steps to push the dollar up in order to make the Saudis dollar peg a bit easier to sustain:

"we would not be surprised if Saudi Arabia were to bring further pressure to bear upon the US (we recall the recent Sunday Times report of Treasury Secretary Paulson’s visit to the Gulf in late May) to come up with a viable plan to reverse the USD’s six-and-a-half year old decline."

But it isn’t clear what Paulson really can do. He cannot force the Fed to raise interest rates. The Fed is independent. US domestic conditions are far from robust.

He could offer to bailout any bank or broker-dealer that couldn’t survive a Fed tightening campaign, but it isn’t clear that Congress would go along. Nor is it clear that this would change the Fed’s policy.

Paulson could offer to increase the fiscal deficit even more, on the grounds that this would stimulate aggregate demand and tend to put upward pressure on interest rates. Higher rates in turn might push the dollar up. Think of the first part of the 1980s. But the US fiscal deficit is already large. Such a policy works against efforts to reduce the size of the US external deficit. And there is a growing sense that the world’s overall macroeconomic policy is too loose, given constraints on the expansion of commodity supplies.

Finally, the US could intervene directly in the foreign exchange market. But Paulson probably doesn’t want to do this in a big way. And if the Fed is on hold when other central banks are raising rates, it isn’t clear that token intervention would be all that effective. The US isn’t going to turn into China and start intervening to the tune of 20% of US GDP.

The US and the Gulf are in very different stages of their respective economic cycles. So long as that is the case, linking their currencies together create difficulties. Rather than trying to make the peg work, I would argue that both sides would be better off sketching out an orderly transition to a new regime.