This article appeared originally in Gulf News: link to original article
Is there a cost to peg a country’s currency to another? And if there is, how can that be calculated?
In a previous article, I pointed out that pegging a currency to another, as a trend, has ebbed. The number of currencies pegged to other currencies is now at its lowest for the past four decades. Before you continue reading, please bear in mind that this article will not get into the logic behind a peg, or its pros and cons.
It would instead attempt to provide a recipe to calculate the cost of a currency peg, particularly the US dollar.
Post Bretton Woods, and the US dollar replacing gold as the world economy and trade’s main anchor, currencies were naturally pegged to the dollar, and in particular those of petro states — as a currency peg requires a constant stream of US dollars. This is, however, not exclusive to petro states as the main purpose is having a constant income of US dollars, and that could also be attained by investing in the US or by buying US Treasuries.
Supporting a peg, whether it is rigid in terms of exchange rate or allowed to fluctuate within a certain pricing band requires resources. Those resources are used by a country to buy US dollars from the market, at market rates, to provide the same US dollars to banks and companies that need to service their debts, denominated in US dollar, or to spend on imports, etc.
Having a fixed exchange rate guarantees that all the above mentioned banks and companies can always buy US dollars at the same peg rate, making it easier to predict future expenses and providing a safety cushion for banks and companies in their international dealings. With that said, how can the cost of such a peg be calculated?
I list below a few components that could be part of calculating the cost of pegging a currency to the US dollar, given that more than 80 per cent of international transactions are in US dollars. The below could be basis to start calculating the cost of peg, keeping in mind that the right approach is a calculation of total international transactions conducted by the country in the peg currency.
* Debt — Whether government or corporate, having debt denominated in US dollars means that the exchange rate needs to be stabilised to ensure the smoothness in servicing that debt.
* Imports — A central bank’s reserves are sometimes expressed in how many months of imports they can cover. This is also why it is much easier for countries, with currencies pegged to the US dollar, to impose imports duties or taxes to reduce those imports and hence save dwindling foreign currencies reserves… if that’s the case.
* Spending abroad — How many times did you, when you don’t find the currency of the country that you are travelling to, settle for US dollars? Conventional wisdom here states that US dollars are globally accepted and can be exchanged in the destination country. (A side note: I did travel once to a country where US dollars were not accepted.) US dollars purchased by exchange houses could provide an indication of that of how many US dollars are associated with spending abroad.
So if there is a formula to calculate the cost of peg to US dollar for a country, it would at least have the above three components. And in light of that, any other component that involves purchasing US dollars or transactions in US dollars could be added to the same formula.
Note here that an economy’s size, portrayed by its GDP, does not necessarily mean a higher peg cost. Instead, the size of the above mentioned components are the main markers that could inflate or deflate the peg cost.
The last thought that I want to leave you with: by what percentage is the UAE’s dirham overvalued?