The pros and cons shaping the currency peg debate

This article appeared originally in Gulf News: link to original article

There was a gold standard. Then there wasn’t. Then there was.

Then there was the US dollar. And many countries at the time were in one way or another pegged to it. Later on, and especially oil exporters, chose to peg their currencies to it, not only because oil prices are quoted in dollars and that it is the most dominating currency in international trade but also because the peg enables a country to determine what rate is acceptable to maintain or increase its stash of foreign currencies.

This ensures that it withers most storms in foreign exchange markets. Now, let’s examine what happens in two scenarios: First, when there’s a change in oil prices, and second, when there’s a change in US’ Fed interest rates.

Before getting into the scenarios, allow me first to explain how the relationship works between the pegged currencies. When currencies like the Saudi riyal and UAE dirham are pegged to the dollar, the exchange rate will never be different than the pre-decided one. And so when a company based in either country imports products that it needs to pay for in dollars, it is able to get dollars from banks that bought them from the central bank first-hand.

If the US dollar appreciates, central banks in both countries pledge in more resources such as short-term assets to buy dollars if the central bank’s reserves of dollars is not sufficient. If the US dollar depreciates, the opposite happens.

Now for the first scenario: a change in oil prices. When oil prices go up, countries such as Saudi Arabia and the UAE would start accumulating more cash reserves because would now be generating higher revenues, in dollars, which also means that they need to spend less in buying dollars or support the peg and hence their respective currencies.

When oil prices drop, the same countries would be accumulating less cash because of lower revenue generation and having to spend amounts in buying additional dollars.

The second scenario: a change in US’ Fed interest rates. The relationship here is less direct. When the Fed decides to hike interest rates, like it recently did, the dollar appreciates in value as fewer dollars are in circulation, at least hypothetically.

When the Fed lowers the interest rate, which will not happen any time soon after the current hike, the dollar depreciates in value. Knowing this, what happens in each case for currencies pegged to the dollar? Here, whether a country is an oil exporter or not is key in determining how the change in US interest rates would influence its decision. Kazakhstan and Azerbaijan, both being oil producers and net exporters, floated their currencies, though at different intervals. Because of that, they provide a decent understanding of how the decision to float their currencies — the tenge and manat respectively — was shaped.

Kazakhstan did it in August when it was clear that oil prices were not going to rebound any time soon. It at least managed to cut its losses and perhaps encouraged foreign investments, tourism and other exporting sectors by removing its peg to the dollar. It also safeguarded itself from additional costs way ahead of the Fed’s decision to increase interest rate.

That’s when Azerbaijan decided to float its currency, with the overall net result being that its value dropped by more than 50 per cent in 2015.

The peg to the dollar has always been debated, especially in the case of GCC oil exporters. Kuwait is the only GCC country to have previously changed the status quo by pegging its dinar to a basket of currencies highly dominated by dollar.

The UAE Central Bank raised the interest rate when the Fed did, which sacrifices part of domestic consumption to cut anticipated costs of an appreciating dollar. And remember, that is not a one-time hike, neither are oils prices recovering any time soon either.

The last question that I want to leave you with is this: Why not a basket of currencies with a formula based on banks’ requirements, the top five countries traded with, and foreign debt?