from Follow the Money

What should replace the Gulf’s peg to the dollar? More on my Peterson institute policy brief

November 28, 2007

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Oil and the dollar have not consistently moved in the same direction over the past ten years.    

  • In 1997/1998, oil tanked and the dollar soared.
  • In 2000, oil and the dollar both rose – in large part because strong demand growth from the US put pressure on global oil prices.
  • From 2003 on, the dollar’s slide has coincided with a huge rally in the world oil price.   The inverse correlation between oil and the dollar isn’t perfect.  Oil and the dollar both rose in 2005.   But recently it has been pretty strong.
  • Indeed, during the course of 2007 oil has soared to close to $100 a barrel even as the US economy slowed and the US dollar slid against most currencies.

The combination of a weak dollar and high oil prices poses some problems for the US.   Countries with strong currencies haven’t seen a comparable increase in oil prices – or in domestic price pressures from rising energy costs. 

This combination also poses rather significant – though self imposed -- problems for many of the world’s oil exporting economies.   The Gulf is importing both a weak currency and US monetary policy right now.     The Economist puts it succinctly in its leader:

The combination of soaring oil prices and the tumbling dollar is distorting their economies and fueling inflation. 

Real interest rates in the Gulf are now range from zero (in Saudi) to negative 5 or negative 10 – and those calculations work off the official inflation data, which may well understate inflation.   The 3% yield on the two Treasury note is low for the US, though understandable given the weakness in the US housing sector.  3% is way too low for the Gulf.  Yet right now Gulf countries are cutting their domestic interest rates to match US rate cuts.

Two years ago, the argument -- made in my Peterson institute policy brief --  that the Gulf countries dollar peg was an anachronism that is no longer in the Gulf's states interest wasn't generally accepted.  It wasn't that wildly accepted twelve months ago. The conventional wisdom – which still crops up in say Lex last week -- was that the Gulf countries were a natural part of the dollar block so long as oil was priced in dollars.

Today, however, there is a growing consensus (see the Economist) that the Gulf needs to change in some way.   Indeed, there are rumors that the UAE may announce a policy change quite soon.  

But there isn’t really a consensus on what should replace the Gulf’s current dollar peg.

One option under consideration (and perhaps the only option acceptable to Saudi Arabia) is to revalue against the dollar.   That maintains the link to the dollar, but at a different rate.   Arabian Business thinks the UAE will revalue by 3-5%.

Another option is a basket peg.   That would allow the Gulf countries to avoid following the dollar down any more, but it also means that they wouldn’t follow the dollar up if it rebounds.

Another option is to both shift to a basket and to allow the currency to appreciate against the basket.   Kuwait seems to be doing this in practice.

Another option – suggested by Gerald Lyons and Marios Maratheftis of Standard Chartered (nicely summarized by Mikka Pineda of RGE) – is a large (20%) one off revaluation to correct for the depreciation of the Gulf currencies associated with the dollar’s fall, and then a basket peg.    A 20% appreciation sounds large, but remember the dollar now has appreciated by something like 60% against the euro since early 2002.   The Economist reports that a big move is under serious consideration:

Someone close to the GCC says that some members are advocating a substantial revaluation—perhaps by as much as 20-30%—if the dollar's slide continues. 

Good.   A Chinese style 2% revaluation wouldn’t accomplish much.

I suggest two other options in my policy brief – 

One is a managed float.    Many advanced oil-exporting economies float – Norway and Canada are the obvious examples.   This week’s Economist argues that the Gulf should adopt a managed float once it adopts a common currency.  

In recent years many emerging economies have shifted from exchange-rate pegs to a “managed float”. Instead of aiming for an exchange rate, their central banks have an inflation target. If the Gulf states move to a single currency, as they plan to in the next few years, that currency should surely float. 

Makes sense.  The currencies of oil-exporting economies tend to appreciate and depreciate together with the price of oil.    The Gulf’s currency would almost certainly move in a similar way.

Another option for those oil-exporting economies is pegging to a basket that includes the price of oil.     This idea is derived from Jeff Frankel’s proposal that the oil-exporting economies should peg their currencies to the price of oil.  Including oil in a broader basket keeps the currency from moving as much as oil, dampening some of the moves in the oil price.   But it still assures that the exchange rate moves with the price of oil. 

These proposals are obviously particularly relevant right now.  

But my interest in the oil-exporting economies peg to the dollar is long standing.  It actually started back in the 1990s.   

Back then the oil-exporting economies problem were facing the exact opposite problem that they are facing now.   Oil was selling for a price closer to $10 a barrel than $20 a barrel after the Asian crisis.  The dollar, by contrast, was appreciating against both Asia and Europe.

That wasn’t a good combination.   They oil-exporting economies faced a budget crunch from low oil prices – a crunch that forced spending cuts and introduced deflationary pressure into the economy.   Yet their currencies were appreciating in real terms along with the dollar, inhibiting non-oil exports and adding to deflationary pressures (imports were getting cheaper).    US nominal interest rates were far higher than they are now.    Gulf inflation was WAY lower than they are now. Real interest rates in places like Saudi Arabia were very high when the price of oil was low.   They are now very low when the price of oil is high.   That is a highly pro-cyclical combination. 

I don’t think it is an accident that the Saudi economy was stagnant in the late 1990s – it was going through much of same kind of deflationary adjustment that Argentina experienced.  It just had enough funds stashed away that it could ride out dollar strength and low commodity prices.

Other oil exporting economies – Russia most notably, but also Ecuador – were forced to abandon dollar pegs and default on their dollar debts.   Ecuador did eventually dollarize – effective replacing a dollar peg with the dollar.   But it only did so after first devaluing the sucre in big way.  Ecuador didn’t just dollarize.  It defaulted, depreciated and then dollarized.   

There is growing recognition that pegging to the dollar – and importing US monetary policy – carries large risks for oil-exporting economies.    Economic conditions in oil-importing and oil-exporting can economies can differ.  Right now the Gulf is booming and needs tighter policy while the US is slumping and needs lower policy.

My policy brief makes another argument for more exchange rate flexibility in the oil exporting economies.   Letting the currencies of the oil exporting economies move with the price of oil would help the oil exporting economies better manage the revenue volatility associated with oil price volatility. 

Most oil-exporting economies rely on the cash generated by their national oil company (not taxes) – not taxes -- for revenue.  The Club for Growth can only dream that the US follows their lead.   But dependence on a volatile, dollar-denominated oil revenue stream to finance local currency spending can create trouble.   So long as the oil exporters peg to the dollar, their government revenues rises and falls in line with the oil price.   That works fine when the price of oil rises (so long as spending commitments don’t grow even faster) but creates problems when the price of oil falls.

If the oil-exporting economies let their currencies rise when the (dollar) price of oil increased, the oil windfall – expressed in local currency terms – would be smaller. 

Each dollar in oil export revenue would buy less local currency.

But each unit of local currency would be worth more.

The volatility of the oil exporters revenue stream would fall.

That means that the increase in local currency revenues would be smaller when oil is high.   But that is actually good.  It facilitates a stable budget.   There is less need to ramp up (local-currency) spending when the price of oil soars, or to cut spending back when oil falls.

The volatility of the external purchasing power of existing local currency spending would increase while the volatility of local currency revenue from oil falls.

That too is good.   The same local currency salary would automatically buy more when oil rises.   That would facilitate more rapid adjustment.   The lags associated with increasing spending would disappear.

The same process work in reverse when the (dollar) price of oil fell.   Each dollar in oil revenue would buy more local currency.   That stabilizes the local currency revenue stream from oil.   And the external purchasing power of each unit of local currency would fall. 

Adjustment – to use a horrible economic term – would be a bit more automatic.    The oil exporters wouldn’t face the risk that they face now, namely that they will increase their (local currency) spending too much when oil is high and then find that they lack the funds needed to cover their spending commitment when (or perhaps if) oil falls.

A final issue: Is it in the interest of the US for the Gulf to move off the dollar?

Some worry that any change would eliminate a big source of low cost financing precisely at the moment the US needs financing the most.   The GCC countries probably don’t provide as much support for the dollar as in 2004 or 2005 (their investment funds almost certainly have diversified) but they still hold an awful lot of dollars – and probably more dollars than makes sense in a long-term equilibrium.    If the Gulf moved off a strict dollar peg, it likely would have a bit more freedom to diversify its “flows” without putting pressure on its own currencies. 

Right now I suspect that the dollars the GCC investment funds are selling as they diversify their portfolios are coming right back to the Gulf central banks.     The weaker the dollar gets, the more speculative pressure on the GCC currencies.   The GCC central banks reserves (which are almost all in dollars) are swelling.    In aggregate the gulf isn’t reducing its exposure to the dollar.

That might change with a new policy regime.  

However, any gradual shift likely would be associated with ongoing inflows and ongoing dollar reserve growth.  Look at China.   That limits the risk that the Gulf will suddenly stop buying any dollars.

There are two more fundamental reasons though why the US shouldn’t encourage the Gulf to adopt a currency regime that helps the US finance itself at the expenses of the Gulf’s own economic stability.

The first is that the value of the dollar ultimately hinges far more on economic conditions in the US – and US economic policies – than on what happens in the Gulf.

The second is that the US cannot rely on the cheap financing from the Gulf and China forever.   

The easy availability of financing from the Gulf from 2003 on likely contributed to the fact that – through the end of 2006 -- the United States external deficit actually rose by more than the United States oil import bill.   The US is the only country that can borrow in dollars without taking on a big currency mismatch.  The US absorbed not just the Gulf’s growing surplus but Asia’s growing surplus. 

That has left the US is an uncomfortable position now, as it has to finance a large – though shrinking -- deficit during an economic slump. 

But it doesn’t change the basic case that the US ultimately needs to adjust.  The equilibrium price of energy likely has gone up.   The US is a major net energy importer.   No country – not even the US – can adjust to rise in the price of its imports by just borrowing more forever.   The US needs to import fewer goods (and export more) to make room to pay for a higher oil import bill without borrowing more. 

Adjustment isn’t always easy.   But in this case it is necessary: the US is in a difficult position right now in part because it deferred adjustment for a bit too long.  

And relying on cheap financing from a region that has adopted a currency regime that no longer serves its interests seems rather risky to me.

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