28 July 2015
What is currency pegging? Why do countries opt for it?
When a country fixes the exchange rate of its currency to another country’s currency to control the value of a currency, it is known as currency pegging or “fixed exchange rate” or “pegged exchange rate”. For example, if a country pegs its currency to the U.S. dollar, the value of its currency will be controlled so that it rises and falls with the dollar.
The reason why countries opt for a fixed exchange rate or currency peg is to avoids currency fluctuation and eliminate the uncertainty due to exchange fluctuations in international transactions. Higher fluctuations and uncertainties imply firms are not willing to invest in export capacity, lest the value of the currency diminishes. On the other hand, a stable domestic currency and a fixed exchange rate imply that traders do not have to face currency risks, and therefore will be more willing to invest and facilitate trade.
Secondly, a country can maintain trading advantage and protect its economic interest through currency pegging. This is because pegging avoids inflation when the dollar appreciates, causing domestic currency to depreciate. This increases the price of import of raw material and is passed on to the consumers as the price of final products rise. On the other hand, the fall in dollar value will increase price of exports, affecting the competitiveness of domestic firms in the international market. China is one country which pegs the Yuan to the dollar to maintain competitive pricing. GCC countries peg their currencies to the dollar as they export oil in dollars.
How have GCC countries pegged their currencies? What are the benefits and disadvantages?
Kuwait adopted an exchange rate policy pegging the Kuwaiti Dinar (KD) to a weighted basket of major currencies. That policy based the determination of the KD exchange rate on a special weighted basket of currencies of the countries that have significant trade and financial relations with the State of Kuwait. . The other GCC nations have pegged their currencies to the US dollar. Pegged currency in the GCC region has ensured limited transmission of exchange rate fluctuation to the economies. This is a major advantage as international oil prices are quoted in dollars, and linking currencies to the dollar leads to stability of export earnings and protects from probable exchange risks. GCC countries are China’s largest oil suppliers. The US dollar is being used as the principal currency for oil trade as opposed to Chinese Yuan, as dollar is the default currency for oil trade.
The GCC countries have always been protected from impact of regional crises such as Iraq war and tension over Iran’s disputed nuclear program. Saudi Arabia’s financial market being highly correlated to US markets due to the currency peg gives foreign investors an opportunity to invest in emerging economies. This promotes diversification minus exchange rate risks and investment inflow for the GCC region based host country.
GCC economies have not moved at par with the US economy over the last few years. GCC policy makers have to replicate the U.S. Central bank’s monetary policy, even if it is not required in these countries. GCC economies that rely on oil prices face the risk of slowing down if there is a decline in oil prices.
Currency pegging also leads to a loss in monetary policy flexibility as the countries who peg their currencies have to mandatorily replicate the US Fed’s monetary policy.
What are the possible future implications of retaining currency peg in GCC countries?
The U.S. economy is expanding which means the Federal Reserve may soon increase interest rates this year. The economic condition of GCC countries is different than that of the US economy, as they face a risk of slowing down due to decline in oil revenues as a result of lower oil prices. If the US Fed increases interest rates, the GCC central banks have to follow suit as they don’t have their own monetary policy. If the GCC countries increase interest rates, it will further hamper growth of the already slowing economies. If the GCC countries do not follow suit, there will be a gap in interest rates between the US and GCC countries. Currency pegs to the dollar along with high interest rate gaps could lead to arbitrage opportunities.
GCC Sovereign Wealth Fund (SWF) holds more than USD 2 trillion, with Saudi Arabia, U.A.E, Kuwait and Qatar in the Top 10 biggest SWF. Saudi Arabian Monetary Agency (SAMA) holds around 80% of its investments in US treasury bills. An increase in interest rate could trigger a large sale of Saudi Arabia’s investments in US treasury bills, leading to panic selling in US dollar globally. This could lead to a sudden drop in the value of the US dollar, in turn pulling down the exchange rate of the pegged GCC currencies.
What will be the implications if GCC countries move away from currency peg?
Removing the currency peg would imply that the GCC countries have the freedom to design their own monetary policy according to the domestic economic scenario. This will enable adjustment of interest rates to allow money supply to flow according the economic situation and help to counter inflation while sustaining economic growth. If the countries follow a floating exchange rate, there will be volatility, but more flexibility to manage macroeconomic shocks better.
The currency peg was intended towards monetary unification of GCC nations. Removing the peg would imply that this would fall apart, with UAE and Oman already having pulled out of monetary unification.
An unpredictable and unstable situation arising out of exchange rate fluctuation could lead to transaction risks if pegging is removed. Companies involved in international trade could face losses due to fluctuations arising out of prior financial obligations, making investment decisions and international trade riskier. A major portion of the GDP of GCC countries consists of exports and imports, with oil being the main export. Since oil price is fixed in dollars, any exchange rate fluctuation could drastically reduce revenues if currency is un-pegged.
When exchange rate fluctuates and dollar appreciates, imports will be costlier compared to exports, leading to Current Account Deficit, impacting Balance of payment (BOP). Since oil is priced in dollars, some GCC countries are hesitant to give up the US Dollar peg as they prefer a stable currency to a flexible monetary policy.
What are the options if the countries decide to move away from Dollar peg?
The first option could be pegging currencies to a trade weighted basket comprising of major currencies. This will counter exposure to any single currency volatility. If GCC nations opt for monetary unification by adopting a single currency, they will have to price oil or invoice revenues in the common currency as opposed to the US Dollar currently. A managed float or free float can be achieved if oil is priced in the common currency, without having to peg it to any other currency. Two alternatives are possible – either the oil pricing and collection of revenues can be done in the common currency or oil price can be listed in US dollar and the revenues can be collected in the unified currency.
Thus, removal of currency peg is of greater advantage to the GCC countries as they will gain from exchange rate flexibility with strong Forex reserve. They will be better placed to absorb currency shocks in the short run. Although, GCC countries can fully shield their respective currencies, a flexible exchange rate should be aimed for over the long term.
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