The possibility that some Gulf states, particularly the United Arab Emirates, might abandon their long-time pegs to the dollar has been getting increasing attention recently (for example, from Feldstein and, especially, Setser). It makes sense. The combination of high oil prices, rapid growth, a tightly fixed exchange rate, and the big depreciation of the dollar against other currencies (especially the euro, important for Gulf imports) was always going to be a recipe for strong money inflows and inflation in these countries. The economic dynamism — most striking in Dubai – is admirable and fascinating as a onger term phenomenon, but also now clearly shows signs of overheating. Indeed inflation has risen alarmingly, as predicted. Among other ill effects, it is producing unrest among immigrant workers. An appreciation of the dirham and riyal is the obvious solution.
Most often discussed as an alternative to the dollar peg is a peg to a basket of major currencies. This would be an improvement. Kuwait, for example, made this switch a couple of years ago.
But a basket peg does not address the fact that when oil prices rise generally (not just against the dollar), as they have in recent years, monetary policy is constrained to be looser than it should be. Similarly, when oil prices fall generally (not just against the dollar), as they did in the 1990s, monetary policy is constrained to be tighter than it should be. A floating exchange rate regime is the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall, thus accommodating the terms of trade shocks. But there are serious disadvantages to small open countries floating, such as the loss of a nominal anchor for monetary policy.
Today’s reigning orthodoxy is to add an inflation target as the new nominal anchor. But this doesn’t solve the problem, if the targeted price index is the CPI, which gives little weight to oil, the biggest sector in production and exports.
I believe that a better solution would be to include the price of oil in the basket of currencies to which the Gulf currencies would peg. I have laid out the case elsewhere (including also for Iraq). I call it PEP, for Peg the Export Price. I was pleased to see that the FT mentioned this option approvingly yesterday (“Dollar-pegged Out,” July 7):
“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.”
Originally published at Jeff Frankel’s Weblog and reproduced here with the author’s permission.
7 Responses to “UAE and Other Gulf Countries Urged to Switch Currency Peg from the Dollar to a Basket That Includes Oil”
Great post – and very timely given the widely circulating report from the Abu Dhabi economic planning ministry which does a great job listing the costs of the peg for GCC countries. I hope this means your views get more airing as it really doesn’t make a lot of sense for the world’s largest oil exporting region to peg to the world’s largest oil importer. One minor clarification – Kuwait moved to its basket, in which the dollar still holds a 70 or so percent share, last May. But as far as I know tracking the KWD/USD actually shows the KWD hasn’t appreciated as much as one would expect, given the the dollar’s fall.
Are there any precedents of countries pegging to the price of a commodity which dominates their exports?
An export price peg seems like it would agree with the results of Roman Romero’s study "Monetary Policy in Oil-Producing Economies" that a Taylor rule that reacts to both final goods production AND oil production enhances monetary policy effectiveness in terms of consumption and inflation stabilization.
International Monetary Fund rules prohibit the pegging of a currency to gold. Let’s try to use this prohibition to our advantage,(the IMF having, since August 15, 1971, when USA president Richard Nixon broke the Bretton Woods system, no more reason for existence).As oil is being traded for gold and the oil producers have only the real value of gold, not the present US dollar-denominated value of gold in mind, oil pegging is a circumvention of the IMF prohibition.But why should the exchange value of money be anchored, why should the Gulf need to peg to something?The dollar-regime is inflating the price of oil-wealth to such an extent that price inflation in third-world countries is three times as high as in the west. Oil-speculators are therefore not interested in the possession of oil as wealth, but only in concluding wagers over the oil price in order to tap its monetary surplus value. Untapped oil reserves have therefore the same wealth-consolidating function as GOLD.Hence, after de-pegging from the US dollar the Gulf states should allow their currencies to freely float, with their oil and GOLD reserves also freely floating in the background. Why should the exchange value of money be anchored, why should the Gulf need to peg to something?Financial Times argues that the Gulf countries are too small, and dependence on a volatile commodity makes it all but impossible to predict what their purchasing power will be the year after next, and what a sensible monetary policy might therefore be.Is the FT arguing that the Greenspan-Bernanke monetary policy was/is sensible, predictable and designed so as to fit the Gulf countries and the rest of the planet?
Does this mean Oil would have to be priced in the domestic currency instead of the current valuation in dollars?Then otherwise the basket would be biased towards the dollar again.
Given the volatility in oil prices is a PEP regime going to give you a reliable anchor? Crude vol is significantly higher than USD, EUR, JPY vols. I also wonder how different this would be to a free float in practice for some of the least diversified countries. I would imagine some of the local currencies would move very much in tandem with the price of oil under a free float anyway. Curious to know your thoughts.
I don’t think the proposal is helpful for the GCC countries, given their current structural rigidities and their intended optimal currency area. Mainly; The problem is that de-linking the GCC currencies from the US dollar is not going to solve the problem of inflation in the GCC countries. The Kuwaiti experience with de-linking the Kuwaiti dinar from the dollar and the shift to a basket of currencies, does not help to control inflation. On the contrary, inflation rates continued to rise and indeed, they are still rising. What are the implications of PEP for GCC optimal currency area project, which is currently states that all GCC countries should peg to the US dollar as a common anchor? Finally, what are the implications of pegging to the price of oil, on foreign exchange speculation, given the high volatility of the price of oil, and thus, the impact on the stability of their foreign exchange markets?