The Global Currency System Needs Revision

But Dollar pegs remain most appealing GCC exchange rate policy at present

Riyadh, 31 July 2010 - NCB Capital, Saudi Arabia's largest investment bank, believes that whereas the global economic crisis has seen a growing divergence in economic performance between advanced and emerging economies, exchange rate realignments have not matched the divergent fundamentals, thereby delaying the correction of global economic imbalances.

Writing in NCB Capital's July GCC Economic Monthly bulletin, Dr Jarmo Kotilaine, Chief Economist, notes that the history of the postwar Bretton Woods exchange rate system provides important examples of the difficulties posed by long-term imbalances. Even as policy steps to better match currencies with economic fundamentals are likely to become inevitable, the process will almost certainly prove slow. A number of factors account for this:

· The global currency system has a limited number of truly flexible currencies. They are largely confined to the industrialized OECD economies, most of which share similar structural problems to varying degrees.

· By contrast, most emerging markets more or less actively manage their exchange rates. The recent Chinese decision to discontinue the Dollar peg of the Renminbi is a step in the right direction but unlikely to have a significant near-term imbalance on the external balance.

· While fixed exchange rates can be a source of stability, they have over time contributed to massive and unsustainable global imbalances. While the current cyclical downturn has led to some improvement in the situation, the problems are unlikely to disappear without deliberate policy intervention.

· In spite of the general pressures for a gradual realignment between Western and emerging market currencies, the GCC will likely most benefit from a continued commitment to its Dollar pegs. A fixed exchange rate has served the region well and the high dependency on oil exports, along with the limitations of the regional financial markets militate against a near-term switch. Moreover, uncoordinated currency moves would risk undoing some of the gains of GCC integration. This means that moves toward greater monetary policy autonomy should be carefully aligned with the Gulf Monetary Union project.

While there are pressures for currency realignments, the recent volatility of the key global currencies, along with elevated economic uncertainty, suggest that a more fundamental reform of the global financial system is likely to be necessary. This should both better reflect that sharp shifts in the global balance of economic power and the need for greater monetary stability. Dr Kotilaine, said, "The increased economic instability of recent years has led to growing calls for a more orthodox monetary system. The gold standard and similar ideas are once again gaining currency since gold limits the power of governments to inflate prices through excessive issuance of paper currency. It would also reduce uncertainty in international trade by providing a fixed pattern of international exchange rates."

However, many governments, burdened by significant economic imbalances, are likely to prefer the flexibility afforded by a fiat currency for the time being. At the same time, effective diversification of global reserves is limited by the fact that many emerging market currencies are not traded on a large scale. This is likely to make steps towards reserve diversification gradual but increasingly broad-based, involving both emerging market currencies and key tradable commodities.

In this environment of global uncertainty, The Gulf states are likely best serves by pursuing their current monetary strategy. It is far from clear that policy alternatives - such as this or a peg to a basket or a managed float - offer significant advantages over the current arrangement. The Dollar pegs have been a source of policy transparency, macroeconomic stability, and confidence for the growing numbers of foreign investors in the region. Having come under heavy criticism during the inflationary boom of 2007-2008, the Dollar pegs have acted as a source of stability during the economic crisis by ensuring a combination of policy consistency and monetary stimulus.

Over time, however, the growing stature and diversity of the GCC economies will increasingly argue for increased monetary policy autonomy.

"Greater monetary policy autonomy is a goal that the region should pursue simultaneously with greater economic integration. Under the circumstances, the proposed Gulf Monetary Union still offers the most attractive opportunity for reconciling these two goals," he said. Dr Kotilaine concluded, "The Dollar pegs appear to remain the most appealing exchange rate policy at present. Merely de-pegging in the absence of a better alternative would risk resulting in increased volatility and undermining some of the recent gains made in the area of regional economic integration."

-Ends-

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