Thursday, November 29, 2007

An open letter to the GCC


I wish you all a safe and enjoyable journey to your forthcoming summit meeting next week, and to those residents of the United Arab Emirates I wish you a happy national day this weekend.

Though I would not presume to dictate to you how to run economic policy, I would like to offer a friendly piece of advice on your currency pegs. I write to you from the perspective of a participant in the currency markets, and indeed as someone who has some of the assets that I manage invested in Gulf currencies.

It is quite clear that your peg regime is now suboptimal. I needn't tell you that conditions are completely different now to when your basket pegs were instituted, and that as a result policies which were appropriate in the 1980's and 1990's are now completely wrong for many of your countries.

Simply put, your major export commodity and source of wealth has appreciated to such a tremendous degree that your currencies must appreciate. This can happen in two ways: either the value of your currency must go up against the dollar, or your inflation levels must rise substantially.

While the latter option may seem preferable in the near term, over somewhat longer periods it is much more damaging to your economy and indeed, society. History is replete with angry protests from peasants and workers who cannot afford to feed their families; as far as I am aware, there are no recorded incidents of hotel owners taking to the streets because they've lost a marginal tourist.

All this is probably known to you. What I really wish to bring to your attention is the mechanism of how to adjust your peg regimes. Just about every recent example of a change in currency regime has emphasized gradualism. In recent years, China, Russia, and indeed Kuwait within your own region have changed regimes to what is tantamount to a crawling peg with a slow nominal appreciation against the reference basket.

While it is too soon to judge the efficacy of the strategy for Kuwait, I would suggest to you that the policies have proven to be ineffective in China and Russia. Simply put, the actions required to maintain a slow crawling peg introduce as many if not more distortions to the financial system than not moving the peg at all.

Adjusting a peg, however slowly, is a tacit admission that a currency will move towards its equilibrium value. For the currencies referenced above, as well as the remainder of the GCC, the equilibrium value against the US dollar is far, far away from current levels. By adjusting the peg, however slowly, one encourages a tremendous amount of capital inflow which must be purchased by the monetary authorities to maintain the crawling peg regime. This intervention proves very difficult to sterilize completely, which introduces an even greater inflation threat to the economies in question.

If we consider a simple measure of "excess reserve growth" as the monthly growth in FX reserves in excess of the trade surplus, we observe an interesting phenomenon. In China, after the peg regime was adjusted in July 2005, excess reserve growth slowed for a year or so. However, it has subsequently risen very sharply and indeed, and with it so has inflation.
In Russia, a similar phenomenon has emerged. The rouble was pegged to a USD+EUR basket in February 2005. This initially generated a lower (in Russia's case, more negative) excess reserve growth. However, subsequently excess reserve growth has risen sharply, turning strongly positive this year. At the same time, an eight-year trend of lower inflation has been reversed.

Given that inflation is already a significant problem for some of your countries, I would urge you to look beyond the short term. Yes, a small re-pegging may ease your problems for a few months. In the longer term, however, it will only exacerbate them.
Speaking as a currency speculator, I can tell you that a modest shift in the peg is unlikely to dissuade me from exiting my long GCC currency positions. Indeed, it could well be the case that I and others like me pour even more money into your region on the expectation of future currency appreciation. Were you to shift your pegs 10-20% however, I can assure you that I and others like me will exit our positions and leave your domestic money markets in a state more fitting to your economies' needs.
I urge you to think of shifting pegs like removing a Band-aid. It might seem as if a slow, gradual removal is the appropriate course of action....but in actuality it is much more painful than simply removing it in one shot. China and Russia are trying to take the band-aid off slowly, and are currently paying the inflationary consequences.
Dare to be different. Remove the band-aid all at once.

Macro Man


Anonymous said...

how can retail traders have access to gcc investments?I can buy riyals through my fx broker but the negative carry on the currency is usually very big, it gets even bigger when there is expectation of revaluation so it takes out almost any chance of profit opportunity, almost the same thing on the chinese yuan, negative carry is running at -10% a year there and -3% for the riyal(it will zoom up if news starts to hit the headlines)

Macro Man said...

To be honest I have no idea. The interbank market in those currencies is also pricing in a reval premium, so I can on ly imagine what retail prices would look like.

Anonymous said...

mm, good work, milton friedman talked about this, its the 'tiranny of the status quo, once a government is set in a direction its the hardest thing in the world to get them to change

James said...

I guess like most things in life that are painful the quicker you deal with it the better. That goes for US banks, gulf currencies, and root canals.

david pearson said...

You nailed the maxi-reval argument.

The quesion is, "why wouldn't they?"

Given their scant tourism revenues (from dollar sources), it boils down to two things:

1) Obsessing over not taking "losses" on reserves.

2) Avoiding the blow to U.S. relations.

One wonders how Brazil got over the first one. One never hears word of regret from policy makers there over how much their reserves declined in value. Of course, Brazil could care less about item 2). Certainly Russia doesn't care about that one either.

Am I missing something on the counterargument?

CV said...

Uh oh MM

check out the Economist this week ...



t said...

"check out the Economist this week ... "
nah, they're talking it down; if you want to fade them stay short

OldVet said...

A guy says: ``Revaluation wouldn't be a cure for inflation,'' said Simon Williams, an economist at HSBC in Dubai. It will only provide temporary relief to the ``symptoms,'' he said.

Can't get rid of inflation without a reval either. What dog do these guys have in the fight?

(And I meant Indian rupees, not rupiah from Indon, and I'm happy with it till now. Little humanity involved.)