Gulf Countries Urged to Switch Currency Peg from Dollar to a Basket With Oil

The possibility that some Gulf states, particularly the UAE, might abandon their long-time pegs to the dollar is getting increasing attention (from Martin Feldstein and Brad Setser, for instance).

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, but also now clearly indicative of overheating. Indeed inflation, as predicted, has risen alarmingly. 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 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 in the 1990s, monetary policy is constrained to be tighter than it should be.

A floating exchange rate would be the traditional alternative, on the theory that the currency would then automatically appreciate when oil prices rise and depreciate when they fall. 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 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. (I call it PEP, for Peg the Export Price [pdf]) I was pleased to see recently that the Financial Times mentioned this option approvingly ("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.

Comments

[bbzz24:]

Jeff,
We really dont need this paragraph about inflation in UAE. After all they are awash in all excesses one can indulge.

2008 Jul 14 04:59 AM

[yogiudo:]

It is a nice idea - however it will upset the worlds largest super power if you "peg" them out.

And as history has shown - super powers get angry and blow stuff up occassionally.

So they might outpeg the dollar and this could cause them to get pegged with a minuteman missile.

Or maybe they will go full tilt w/ the worlds flour & corn.
I heard people in Haiti are eating sand and OIL mixture..

Ask Norm Chomsky.

My feeling is that they don't have that option unless they can back it up.

2008 Jul 14 07:13 AM

[Disco Bay:]

There is another option of course. One which is simple and straightforward. The UAE could go on to the gold standard. Gold has been an amazingly stable measure of value over the past 2000 to 3000 years. If you examine a chart which plots the price of oil against gold for the last 65 years, you will see that although there are a few fluctuations, the graph is quite flat. One once of gold today buys about the same amount of wheat it did in ancient times.

I agree that small countries must have some defense against the massive hedge funds which wreak havoc with their currencies. During the Asian financial crisis many countries had first had experience and most lost billions to the hedge funds and speculators.

With the UAE on a gold standard this kind of abuse would not be possible. Whilst hedge funds found it relatively easy to push around some of the Asian currencies, the would find it considerably more difficult pushing around the estimated world supply of 150,000 metric tonnes of gold.

I would think that the gold standard would be particularly appealing to small countries. Especially ones that are developing rapidly but are suffering the effects of high inflation. Two examples that come readily to mind are UAE and Vietnam.

2008 Jul 15 04:04 AM

[Comintel:]

How can I invest in the UAE dirham from a US. account, preferably on a leveraged basis? Bonds? Funds?

2008 Jul 20 01:01 AM