US: China shouldn’t peg to the dollar but the Gulf should ...

That at least seems to be the Treasury’s policy.

Krishna Guha of the FT reports that the US believes that dollar pegs can help countries manage commodity price volatility.

Mr McCormick said that oil producers were not in the same position as large manufacturing exporters such as China. “A commodity-driven economy with a lot of volatility in commodity prices could be a beneficiary of a pegged regime,” he said.

So much for the notion that the Treasury is open to a change in the Gulf’s peg.

And so much for any illusion that I might have some influence over US policy.

In my Peterson institute policy brief, I argued that commodity price volatility is a reason not to peg to the dollar. A peg assures that fluctuations in the dollar price of a commodity (say oil) will translate one for one into volatility in countries local currency revenues from commodities. By contrast, a currency that appreciated when commodity prices appreciated and depreciated when commodity prices depreciated would tend to stabilize a country’s local currency revenues.

And I am not quite sure how pegging to a currency that has depreciated in real terms even as oil has appreciated in real terms has helped smooth out macroeconomic volatility in the oil-exporting economies; it seems to have produced high levels of inflation, negative real interest rates and a wildly pro-cyclical macroeconomic policy mix.

It isn’t hard to see why Paulson is intent to signal that the US remains open to foreign investment from sovereign wealth funds -- and why he is pushing the Gulf to allow more foreign investment in its oil sector. A sharp fall in financing for the US would be disruptive, US investment banks are keen to do business with sovereign funds and the Bush Administration is keen to spur more investment in oil production in the big oil-exporting economies. The Wall Street Journal reports (in an article that was perhaps buried a bit more than it should have been) that the big oil exporters are exporting less this year than last.

I wish, though, that the US agenda also included policies, such as the payment of oil dividends, that would tend to disperse the oil windfall rather than concentrating it in the hands of a key states. The Gulf isn’t likely to listen to US advice there, but it also isn’t likely to listen to US calls to open its oil sector up for more foreign investment.

Nor should the US press too hard for Gulf financing, especially if this requires that the Gulf adopt policies that may not be in their own economic interests. The IMF looked at what would happen if the sovereign funds diversified away from the dollar, and concluded that the result would be somewhat higher US real interest rates, a somewhat weaker dollar and a somewhat smaller US external deficit (see the annex of this IMF paper). While the US needs financing as it adjusts to make sure the adjustment is gradual, too much financing from the oil-exporters and China would eliminate necessary pressure to adjust. It isn’t healthy for the US or the world for the US to continue to rely heavily on financing from a surprisingly small number of governments ...

UPDATE: Secretary Paulson has emphasized, appropriately, that the Gulf’s dollar peg reflects the sovereign choices of the Gulf’s governments. In Saudi Arabia, though, he seemed to endorse the region’s peg to the dollar, noting that it "has served this country (Saudi Arabia) and this region well." He also has noted that the region’s governments do not believe that their dollar peg is the main reason for the recent rise in inflation. That is no doubt true. The underlying reason for the rise in inflation is a rise in spending and state-supported investment financed by the surging price of oil. That said, there is little doubt that the dollar’s weakness, together with low US policy rates, has added to rather than reduced the inflationary pressures associated with the oil windfall. It isn’t an accident that nearly every country that pegs to the dollar or a basket that is heavily weighted to the dollar -- Argentina, the Gulf, China and Russia -- all have seen an acceleration in inflation.