Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Print Print Cite Cite
Style: MLA APA Chicago Close


US: China shouldn’t peg to the dollar but the Gulf should …

by Brad Setser
May 31, 2008

That at least seems to be the Treasury’s policy.

Krishna Guha of the FT reports that the US believes that dollar pegs can help countries manage commodity price volatility.

Mr McCormick said that oil producers were not in the same position as large manufacturing exporters such as China. “A commodity-driven economy with a lot of volatility in commodity prices could be a beneficiary of a pegged regime,” he said.

So much for the notion that the Treasury is open to a change in the Gulf’s peg.

And so much for any illusion that I might have some influence over US policy.

In my Peterson institute policy brief, I argued that commodity price volatility is a reason not to peg to the dollar. A peg assures that fluctuations in the dollar price of a commodity (say oil) will translate one for one into volatility in countries local currency revenues from commodities. By contrast, a currency that appreciated when commodity prices appreciated and depreciated when commodity prices depreciated would tend to stabilize a country’s local currency revenues.

And I am not quite sure how pegging to a currency that has depreciated in real terms even as oil has appreciated in real terms has helped smooth out macroeconomic volatility in the oil-exporting economies; it seems to have produced high levels of inflation, negative real interest rates and a wildly pro-cyclical macroeconomic policy mix.

It isn’t hard to see why Paulson is intent to signal that the US remains open to foreign investment from sovereign wealth funds — and why he is pushing the Gulf to allow more foreign investment in its oil sector. A sharp fall in financing for the US would be disruptive, US investment banks are keen to do business with sovereign funds and the Bush Administration is keen to spur more investment in oil production in the big oil-exporting economies. The Wall Street Journal reports (in an article that was perhaps buried a bit more than it should have been) that the big oil exporters are exporting less this year than last.

I wish, though, that the US agenda also included policies, such as the payment of oil dividends, that would tend to disperse the oil windfall rather than concentrating it in the hands of a key states. The Gulf isn’t likely to listen to US advice there, but it also isn’t likely to listen to US calls to open its oil sector up for more foreign investment.

Nor should the US press too hard for Gulf financing, especially if this requires that the Gulf adopt policies that may not be in their own economic interests. The IMF looked at what would happen if the sovereign funds diversified away from the dollar, and concluded that the result would be somewhat higher US real interest rates, a somewhat weaker dollar and a somewhat smaller US external deficit (see the annex of this IMF paper). While the US needs financing as it adjusts to make sure the adjustment is gradual, too much financing from the oil-exporters and China would eliminate necessary pressure to adjust. It isn’t healthy for the US or the world for the US to continue to rely heavily on financing from a surprisingly small number of governments …

UPDATE: Secretary Paulson has emphasized, appropriately, that the Gulf’s dollar peg reflects the sovereign choices of the Gulf’s governments. In Saudi Arabia, though, he seemed to endorse the region’s peg to the dollar, noting that it “has served this country (Saudi Arabia) and this region well.” He also has noted that the region’s governments do not believe that their dollar peg is the main reason for the recent rise in inflation. That is no doubt true. The underlying reason for the rise in inflation is a rise in spending and state-supported investment financed by the surging price of oil. That said, there is little doubt that the dollar’s weakness, together with low US policy rates, has added to rather than reduced the inflationary pressures associated with the oil windfall. It isn’t an accident that nearly every country that pegs to the dollar or a basket that is heavily weighted to the dollar — Argentina, the Gulf, China and Russia — all have seen an acceleration in inflation.


  • Posted by aim

    I can see why the Treasury wouldn’t want the Gulf going off the peg if it would weaken the dollar and put upward pressure on the price of their main export.

  • Posted by dis

    does the low currency with high commodity prices help alleviate dutch disease?

  • Posted by bsetser

    dis — In principle, a set of policies that avoided real appreciation would held avoid Dutch disease. But even a policy package that sought to avoid Dutch disease wouldn’t normally include a large nominal depreciation of the currency.

    Moreover, avoiding Dutch disease requires– a la Norway — fiscal restraint. A big surge in spending and government sponsored investment will tend to put upward pressure on prices and thus produce a real appreciation through inflation. My sense is that is exactly what is happening in the Gulf — Qatar and the UAE are not cheap, and non-real estate non-oil businesses are getting squeezed.

    Finally, the enormous incentives for real estate over-development created by massively negative real interest rates seem to produce the risk of a “real-estate” driven version of Dutch disease, where the enormous expansion of the real estate sector sucks life out of the rest of the economy.

  • Posted by Emmanuel

    (1) Better cotton up to the Obama team if you want a better chance at influencing US policy. I can see it now: Treasury Assistant Secretary for International Affairs, the Honorable Brad Setser!

    (2) The US is by far the world’s largest oil importer. What would the be the likely effect of GCCs ending their pegs to the dollar on the price of America’s petroleum imports? It seems to me that this is the first question to ask before proceeding to that on US financing…

  • Posted by bsetser

    emmanuel — there doesn’t seem to be much evidence that the GCC’s peg to the dollar has helped to hold down the dollar price of oil … at least not over the past five years

  • Posted by Eyal

    Brad, I’m not clear about your thoughts on this. First, regarding Paulson’s statement about the role of dollar pegs, you say “that is no doubt true”. But then you opine that “it isn’t an accident that nearly every country that pegs to the dollar …all have seen an acceleration in inflation”. Well, is it or isn’t it?

  • Posted by glory

    lex sez: “the reality is that forcing supermarkets to keep prices down is more politically palatable than tampering with currencies. It also has a global stamp of approval. Both the International Monetary Fund and the Asian Development Bank have said countries should consider direct measures to tackle food inflation rather than more orthodox tools that could slow growth. Recent announcements by GCC governments suggest currency reform is, for now, completely off the agenda.”

  • Posted by bsetser

    Eyal — I was perhaps being a bit too coy. If every country in the gulf budgeted for $20 a barrel oil, they could peg to the dollar and see much lower levels of inflation. So in that sense, the fact that the gulf is budgeting for $50 or $60 oil and spending more is the proximate cause for the pickup in inflation. there is less fiscal sterilization.

    then again it is eminently reasonable for the Gulf to be spending and investment more domestically. And that higher level of domestic spending and investment would be consistent with less inflation if the gulf’s currencies appreciated in nominal terms.

    I was trying to avoid a debate over what is the bigger driver of regoinal inflation — more domestic spending (including big state sponsored investment projections) or the dollar peg. Both have contributed. And right now both are pushing in the same direciton — toward more inflation.

    Glory — I have never quite understood why driving your currency down against the currencies of your main trading partners (the gulf trades far more with Europe and asia than the US) by extensive government intervention in the fx market isn’t considered tampering, while any change in a peg to a currency that you don’t trade with it. Oh well. I have not been impressed with the IMF’s approach to the Gulf countries or the currency issue. Right now they are embracing fiscal tightening (which would add to imbalances globally) and price controls rather than currency appreciation as the solution to the gulf’s problems. And in practice they have embraced an adjustment path with a ton of inflation and negative real interest rates. The IMF is trying not to preach and listen more to the emerging world, but if a region’s policy makers are making a big error, the IMF should say so. And I have yet to hear a very compelling reason why it makes sense for the Gulf’s currencies to be depreciating in nominal terms/ why the gulf should have low uS rates.

  • Posted by glory

    lex acknowledges there isn’t a compelling _economic_ reason for gulf pegs, and i think it’s fairly common knowledge (if not ‘PC’ per se) that they’re being kept for political reasons; kinda like fuel subsidies

    btw, any thoughts on resolving global imbalances thru developing world inflation/RER appreciation?

  • Posted by don

    The title (and the implied similarities between the Gulf’s currency pegging and China’s currency pegging) are, in my view, completely misleading. I think Gulf pegging has little effect on shifting global aggregate demand away from other countries to the Gulf. Pegged currency or not, it will take the Gulf some time to adjust their consumption to the new oil windfall. The same is not true for China’s currency pegging.

  • Posted by Peter

    Standard Chartered economists think the Gulf should depeg and revalue, see post today:

  • Posted by bsetser

    Peter — Thanks for the link. I have been very impressed with Dr. Lyons work on the gulf and sovereign funds.