23 November 2008
Fixed exchange rate regimes are increasingly becoming a burden for the China and Gulf countries, but they are unlikely to drop the peg, said Dr Sunil Rongala, Asia-Pacific economist at Deloitte Research.
Currently, the US dollar is the top currency of choice for an anchor currency. The basic reasons for pegging are to increase stability; to make currencies more competitive to benefit trade; to reduce volatility in export receipts when the country has just one major export; and to align a currency before joining a monetary union. Countries can only have two of the following three: A fixed exchange rate, free capital movement, and an independent monetary policy.
In the present environment, it's rare for any country to have full capital control because of the nature of modern financial systems.
For example, China, which imposes controls on inflows of money, finds it cannot fully control the inflow of speculative money. Thus China, along with other countries having a fixed exchange rate and free capital movement will not have an independent monetary policy. If these countries have high inflation, they are not likely to raise their interest rates because of an upward pressure on the currency.
Pegging is also an expensive proposition. A country that pegs has to keep relatively high amounts of foreign reserves to show its credibility in the market and to signal to anyone planning a speculative attack that it will protect the peg at all costs. Pegging is also expensive because of sterilised intervention. Central banks have to pay money on bonds they issue in order to ensure that foreign inflows do not enter the monetary base causing inflation.
Deloitte said the Middle East countries were pegged to the US dollar not to make their currencies competitive but to reduce volatility in their export receipts; their single biggest export, oil, is priced in US dollars.
This worked till 2006 as oil was priced relatively low and the returns that these countries received were not as outsized. Then the price of oil went up. There were large inflows and though central banks intervened, not all inflows could be sterilised creating the classic inflationary situation of "too much money chasing too few goods."
Omar Fahoum, Chairman and Chief Executive of Deloitte & Touche Middle East, said GCC pegged currencies to dollar to reduce volatility in their export receipts. "When the price of oil went up, increased income resulted in asset bubbles especially in the real estate market."
"Saudi Arabia, the UAE, Qatar, and Kuwait all have asset bubbles as well as high levels of inflation. The question now is whether countries that currently peg to the dollar will move fully to the euro or to a basket where the euro has a substantial weight.
"The former is highly unlikely because news of the demise of the US dollar was premature as we are currently witnessing, and countries would have had to revalue their currencies causing their competitiveness to be hit," he said.
"GCC countries will probably remain pegged solely to the US dollar because they have the money to essentially buy themselves out of the situation".
Deloitte projects that the oil-producing countries are also unlikely to move away from their pegs. Kuwait has transitioned from its dollar peg to a currency basket but there are reports that it is a dollar-heavy basket.
A probable reason for staying put with the dollar peg is geo-political. Since these countries have not had their own monetary policy for some two decades now, they likely do not know how to react to the current situation.
However, things could change when the GCC forms its monetary union in 2010, though nothing official has been announced to this effect as yet.
Asset booms and busts
In the past two years, the economies of the industrialised world have been hit by falling asset prices and a crisis in the financial system.
Ian Stewart, Director of Research in London, said asset prices take time, generally measured in years, to reach their lows after the bursting of a bubble.
The IMF estimated that slowdowns and recessions preceded by financial stress are roughly twice as severe as those where financial stress is absent.
Deloitte report said large scale public funding is needed to end systemic banking crises, but the cost to the public can often be recouped as asset prices recover.
Most asset bubbles share a number of features. They tend to have a self-justifying rationale; generally, that some transformative change justifies permanently higher valuations.
For instance, in the 1990s during the dot-com bubble, there was much talk of the infinite potential of technology; Japan's housing boom of the 1980s was widely held to be a function of land shortages and the remarkable vibrancy and strength of the wider economy.
Stewart said asset booms are often reinforced by low interest rates and financial innovations which multiply the returns from leveraged investment. In recent years, for instance, the United Kingdom and the United States have seen exceptionally low real interest rates coupled with an increase in the range of mortgage products available to an ever-wider group of consumers. Securitisation has liberated lenders from reliance on depositors, enabling them to raise money from wholesale markets and boost their own leverage and that of their customers.
At the same time the "originate and distribute" model means that the risks of mortgage default have been passed on from the lender, weakening incentives to maintain credit quality. The result has been a surge in mortgage availability.
Asset booms lead to a mispricing of risk and a perception of permanently high returns. As this happens more borrowers are able to access credit markets and the boom spreads from "prime" assets to more marginal ones, said the Deloitte report. The self-reinforcing relationship between rising asset prices and rising credit can reverse very quickly. Holders of overinflated assets - consumers, corporates, or banks - experience damage to their balance sheet as asset prices fall.
Reduced collateral diminishes the ability of the private sector to borrow.
Confidence sags as asset prices fall. Consumers and corporates are forced to deleverage, in turn leading to a fire sale of distressed assets and additional downward pressure on prices.
Value of assets
One of the most durable findings from previous bubbles is that even in deep liquid equity markets, it takes a long time for asset values to hit a trough and, in the process, asset values decline significantly, the report said.
The more widely held the asset, the more severe are the economic implications of a fall in asset prices. The bursting of a sectoral equity bubble - as in biotechnology in the United Kingdom in the 1980s or tech shares in 2001 - inflicts less economic damage than a fall in house prices. The greatest risk to the economy comes from a "bust" in the financial system and the ensuing financial stress. Such disruption impairs the ability of financial institutions to extend credit to the private sector.
In a banking crisis, Deloitte Research Director Stewart said the aim of government intervention should be to facilitate the adjustment in the banking system - through sales of distressed assets, restructuring and capacity reduction. The workout is designed to get the banking sector back on its feet and functioning normally. But this process is always difficult, expensive, and time-consuming - and sometimes struggles to succeed.
Stewart said successful resolution of a financial crisis is complex, uncertain, and in the short-term, very costly. Such rescues shorten and probably moderate the economic consequences of financial stress; sadly, they do not eliminate them.
Fixed exchange rate regimes are increasingly becoming a burden for the China and Gulf countries, but they are unlikely to drop the peg, said Dr Sunil Rongala, Asia-Pacific economist at Deloitte Research.
Currently, the US dollar is the top currency of choice for an anchor currency. The basic reasons for pegging are to increase stability; to make currencies more competitive to benefit trade; to reduce volatility in export receipts when the country has just one major export; and to align a currency before joining a monetary union. Countries can only have two of the following three: A fixed exchange rate, free capital movement, and an independent monetary policy.
In the present environment, it's rare for any country to have full capital control because of the nature of modern financial systems.
For example, China, which imposes controls on inflows of money, finds it cannot fully control the inflow of speculative money. Thus China, along with other countries having a fixed exchange rate and free capital movement will not have an independent monetary policy. If these countries have high inflation, they are not likely to raise their interest rates because of an upward pressure on the currency.
Pegging is also an expensive proposition. A country that pegs has to keep relatively high amounts of foreign reserves to show its credibility in the market and to signal to anyone planning a speculative attack that it will protect the peg at all costs. Pegging is also expensive because of sterilised intervention. Central banks have to pay money on bonds they issue in order to ensure that foreign inflows do not enter the monetary base causing inflation.
Deloitte said the Middle East countries were pegged to the US dollar not to make their currencies competitive but to reduce volatility in their export receipts; their single biggest export, oil, is priced in US dollars.
This worked till 2006 as oil was priced relatively low and the returns that these countries received were not as outsized. Then the price of oil went up. There were large inflows and though central banks intervened, not all inflows could be sterilised creating the classic inflationary situation of "too much money chasing too few goods."
Omar Fahoum, Chairman and Chief Executive of Deloitte & Touche Middle East, said GCC pegged currencies to dollar to reduce volatility in their export receipts. "When the price of oil went up, increased income resulted in asset bubbles especially in the real estate market."
"Saudi Arabia, the UAE, Qatar, and Kuwait all have asset bubbles as well as high levels of inflation. The question now is whether countries that currently peg to the dollar will move fully to the euro or to a basket where the euro has a substantial weight.
"The former is highly unlikely because news of the demise of the US dollar was premature as we are currently witnessing, and countries would have had to revalue their currencies causing their competitiveness to be hit," he said.
"GCC countries will probably remain pegged solely to the US dollar because they have the money to essentially buy themselves out of the situation".
Deloitte projects that the oil-producing countries are also unlikely to move away from their pegs. Kuwait has transitioned from its dollar peg to a currency basket but there are reports that it is a dollar-heavy basket.
A probable reason for staying put with the dollar peg is geo-political. Since these countries have not had their own monetary policy for some two decades now, they likely do not know how to react to the current situation.
However, things could change when the GCC forms its monetary union in 2010, though nothing official has been announced to this effect as yet.
Asset booms and busts
In the past two years, the economies of the industrialised world have been hit by falling asset prices and a crisis in the financial system.
Ian Stewart, Director of Research in London, said asset prices take time, generally measured in years, to reach their lows after the bursting of a bubble.
The IMF estimated that slowdowns and recessions preceded by financial stress are roughly twice as severe as those where financial stress is absent.
Deloitte report said large scale public funding is needed to end systemic banking crises, but the cost to the public can often be recouped as asset prices recover.
Most asset bubbles share a number of features. They tend to have a self-justifying rationale; generally, that some transformative change justifies permanently higher valuations.
For instance, in the 1990s during the dot-com bubble, there was much talk of the infinite potential of technology; Japan's housing boom of the 1980s was widely held to be a function of land shortages and the remarkable vibrancy and strength of the wider economy.
Stewart said asset booms are often reinforced by low interest rates and financial innovations which multiply the returns from leveraged investment. In recent years, for instance, the United Kingdom and the United States have seen exceptionally low real interest rates coupled with an increase in the range of mortgage products available to an ever-wider group of consumers. Securitisation has liberated lenders from reliance on depositors, enabling them to raise money from wholesale markets and boost their own leverage and that of their customers.
At the same time the "originate and distribute" model means that the risks of mortgage default have been passed on from the lender, weakening incentives to maintain credit quality. The result has been a surge in mortgage availability.
Asset booms lead to a mispricing of risk and a perception of permanently high returns. As this happens more borrowers are able to access credit markets and the boom spreads from "prime" assets to more marginal ones, said the Deloitte report. The self-reinforcing relationship between rising asset prices and rising credit can reverse very quickly. Holders of overinflated assets - consumers, corporates, or banks - experience damage to their balance sheet as asset prices fall.
Reduced collateral diminishes the ability of the private sector to borrow.
Confidence sags as asset prices fall. Consumers and corporates are forced to deleverage, in turn leading to a fire sale of distressed assets and additional downward pressure on prices.
Value of assets
One of the most durable findings from previous bubbles is that even in deep liquid equity markets, it takes a long time for asset values to hit a trough and, in the process, asset values decline significantly, the report said.
The more widely held the asset, the more severe are the economic implications of a fall in asset prices. The bursting of a sectoral equity bubble - as in biotechnology in the United Kingdom in the 1980s or tech shares in 2001 - inflicts less economic damage than a fall in house prices. The greatest risk to the economy comes from a "bust" in the financial system and the ensuing financial stress. Such disruption impairs the ability of financial institutions to extend credit to the private sector.
In a banking crisis, Deloitte Research Director Stewart said the aim of government intervention should be to facilitate the adjustment in the banking system - through sales of distressed assets, restructuring and capacity reduction. The workout is designed to get the banking sector back on its feet and functioning normally. But this process is always difficult, expensive, and time-consuming - and sometimes struggles to succeed.
Stewart said successful resolution of a financial crisis is complex, uncertain, and in the short-term, very costly. Such rescues shorten and probably moderate the economic consequences of financial stress; sadly, they do not eliminate them.
By Waheed Abbas
© Emirates Business 24/7 2008
