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How long can the Gulf countries sustain their dollar pegs?

November 15, 2007

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Note: This is Brad Setser, not Michael Pettis.

The UAE is clearly considering changing from a dollar peg to a basket peg.   Qatar may be as well.   The economic case for change is quite clear.  Both countries are in the midst of an enormous boom and face large inflationary pressures.  Yet their currencies are depreciating and their central banks are under pressure to cut their nominal interest rates to match the Fed.     Neither benefits from importing US monetary policy right now.

Indeed, now that the UAE's governor has indicated that change is possible, I suspect the market will force his hand.    The UAE's capital account is pretty open.  Its capacity to sterilize large scale inflows is limited.    Large inflows have already forced interest rates in the UAE down -- the last thing a country facing large-scale inflationary pressures needs.   The dhirham is even more of a one-way bet than it used to be. 

Just shifting away from a basket peg, though, hardly solves the UAE's problem.   The Gulf currencies have already depreciated substantially in nominal terms against many of their major trading partners.   The GCC currencies, for example, have depreciated by over 40% against most European currencies over the last five years.   Shifting to a dollar peg now doesn't correct for the dollar's past fall.  It just insulates the GCC currencies against further falls in the dollar.  

And if Stephen Jen is right and the dollar is poised for a rebound against the euro next, a basket peg would keep the GCC currencies from rising along with the dollar.  

That is why Standard Chartered -- among others -- is calling for a large revaluation of the GCC currencies, and a much broader reassessment of their currency regimes.   I agree -- see my new Peterson institute paper on this topic (more on it later)

Macro man argues, with characteristic force, that dollar pegs are inappropriate for countries with large current account surpluses and high inflation.

the dollar pegs of current account surplus countries, particularly those with high inflation, are wildly inappropriate. The Fed's implicit promise to sacrifice the international purchasing power of the dollar (and by extension under current policies, the renminbi, riyal, dirham, etc.) to support domestic employment as a matter of course is wrong, wrong, wrong for China, Saudi Arabia, the UAE, etc.

George Magnus clearly agrees, at least for China.

The discrepancy between the monetary policy that is right for the US and the monetary policy that is right for the Gulf and China is particularly obvious right now.    Pegging to dollar means negative real rates in the GCC and China at a time when both need positive real rates (See Michael Pettis!).   Capital controls may provide China with a bit of flexibility, but likely only a bit.

Macro man goes further though.   He argues that the Fed's "dual mandate" makes the dollar an inappropriate global anchor.   The Fed, he notes, is legislatively mandated to focus on inflation and US employment.    That effectively means that it is particularly unlikely to direct US monetary policy toward maintaining the dollar's external purchasing power.

He is right.  

But this isn't news, or new.   The United States long-standing preference for floating exchange rates has long reflected the United States desire to use monetary policy for domestic economic stabilization.   

What is new in some sense is that a host of countries tied their currencies to the dollar in the Bretton Woods 2 system without ever insisting that the US commit to maintaining the dollar's external value.  Bretton Woods 2 isn't Bretton Woods 1.   In Bretton Woods 1, US policy was constrained -- at least to some degree -- by the need to maintain the dollar's link to gold.    Bretton Woods 2 imposed no similar constraint on the US.

The United States' position has long been that the United States large current account deficit wouldn't force the US to direct its monetary policy toward defending the dollar, and thus large external deficits posed little risk to the US.   The US never said -- to my knowledge -- that holding dollars didn't pose risks to those countries financing the US.

That in some sense is why the US was been willing to accept the system.   But it is also meant that those countries that decided to peg to the dollar, or in China's case, to manage their exchange rate primarily against the dollar, were voluntarily taking on a much bigger risk than assumed by the "creditor" countries in the later stages of Bretton Woods 1.  

Many emerging economies chose monetary and currency regime that effectively required that they build up their holdings of a currency of a country that explicitly was not committed to trying to maintain its external value.   Their large dollar holdings are not something the US forced on them either; today's dollar pegs are the result of autonomous policy decisions in the emerging world, not pressure from the center.

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