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The petrodollar peg

Dec 7th 2006
From The Economist print edition

America should worry more about fixed exchange rates in the Gulf than the gently rising Chinese yuan

AMERICAN politicians and businessmen view China's undervalued exchange rate and its huge current-account surplus as the main cause of America's vast deficit. Thus next week a high-powered delegation led by Henry Paulson, America's treasury secretary, will fly to Beijing to persuade China to take measures to reduce its surplus. But are they heading to the right place? At the global level, the biggest counterpart to America's deficit is the combined surpluses of the oil-exporting emerging economies. They are expected to run a total current-account surplus of some $500 billion this year, dwarfing China's likely surplus of $200 billion (see chart).

Counting only the Middle East oil exporters, the surplus has surged from $30 billion in 2002 to an estimated $280 billion this year. One reason why this gets much less attention than the smaller $160 billion increase in China is that only a fraction of it has gone into official reserves, which are publicly reported. Most of it is stashed in government oil-stabilisation or investment funds, such as the Abu Dhabi Investment Authority, which are much more secretive than the People's Bank of China—but which probably hold just as many dollar assets.

One big difference is that China is now allowing the yuan to rise against the dollar. The exchange rate is up by an annual rate of almost 7% since September. In contrast, the six members of the Gulf Co-operation Council, or GCC (Saudi Arabia, United Arab Emirates, Kuwait, Bahrain, Oman and Qatar), which account for virtually all of the Middle East's surplus, still peg their currencies firmly to the dollar. This is partly in preparation for the GCC's plan to adopt a single currency by 2010. But the bizarre result is that over the past four years of soaring oil prices, their real trade-weighted exchange rates have fallen.

The Gulf economies are running an average current-account surplus of 30% of their GDP, well in excess of China's surplus of 8%. Oil exporters cannot spend their windfall overnight and it makes sense for them to run a surplus when oil prices rise, as a buffer for when oil prices fall. Even so, one can have too much of a good thing.

It might be best for the Gulf states as well as the world economy if they abandoned their dollar pegs and shifted to some sort of currency basket. A more flexible exchange-rate regime would allow them to regain control of their monetary policies and so cool down their overheating economies. By pegging their exchange rates to the dollar, they have had to adopt America's monetary policy, leaving real interest rates too low (often negative) for such fast-growing economies. Credit is growing too rapidly, inflation is rising and the prices of assets, especially property in places such as Dubai, have exploded.

Official price indices almost certainly understate inflation. According to government figures, prices are rising in the UAE at an annual rate of 7%, but independent estimates put it at 15%. The dollar's slide against other major currencies is pushing up the price of imported goods. Only 10% of the GCC's imports come from America (compared with one-third each from Europe and Asia), so from a trade-weighted point of view, the dollar peg makes no sense.

In theory, a higher oil price should imply a rise in oil exporters' real exchange rates; and it is better if this occurs through a rise in the nominal rate rather than higher inflation. The main argument against allowing the exchange rate to rise is that it would harm the competitiveness of the non-oil sector in economies that need to diversify. However, pegging to the dollar has not always been a boon to the economies as a whole. When the dollar strengthened in the late 1990s, non-oil industries were squeezed at the same time that the price of crude was sliding. This is another reason why pegging to a trade-weighted basket would make much more sense.

Oiling the world's wheels

Brad Setser, an economist at Roubini Global Economics, a research firm, argues that the dollar pegs of the Gulf states are also preventing some necessary rebalancing in the world economy. The recent depreciation of their trade-weighted currencies has raised the price of foreign goods and thus may be one reason why the increase in their imports has been unusually weak relative to the increase in exports. If, as seems likely, the dollar continues to fall, it will further drag down their currencies and thus keep external imbalances large.

A fully floating exchange rate would lead to too much volatility, but a bit more flexibility could usefully help oil exporters to adjust to fluctuations in oil prices. A trade-weighted basket, in which the euro had a large weight, would help to stabilise the real exchange rate of the GCC countries and so protect their competitiveness. It still would not ensure that oil exporters' currencies moved correctly in line with the oil price, however.

Some economists have therefore suggested that oil exporters should link their currencies in some way to the oil price. Currencies would rise when oil prices are high and fall when prices were weak. This would help to boost countries' external purchasing power and hence their imports when oil prices boom. It would also help to smooth the local currency value of oil revenues and hence government income, helping to avoid big deficits in bad times and huge surpluses in good times.

Oil exporters argue that they peg to the dollar because oil is priced in dollars and they want to avoid exchange-rate risk. But exchange-rate stability does not guarantee economic stability. On the contrary, a more flexible currency would allow economies to manage oil-price shocks better.

However, a rise in petro-currencies would not be a cure by itself for America's deficit (nor, for that matter, is a dearer Chinese yuan). The main solution to global rebalancing is for America to save more and for surplus countries, including both the oil exporters and China, to spend more. A rise in oil exporters' currencies could play a part in that.