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The peg precipice

Eleven years after the Asian financial meltdown, economists warn of another possible currency crisis

ECONOMICS REPORTER; [e-mail]

July 23, 2008 at 6:36 AM EDT



http://www.reportonbusiness.com/servlet/story/RTGAM.20080723.wrcurrency0723/BNStory/Business/home

OTTAWA — Inflation control measures in the Middle East are almost as rampant as inflation itself these days.

Qatar just froze the price of steel and cement, and extended a diesel subsidy. Bahrain is spending more than a billion dollars a year to subsidize food and fuel. The mainly foreign construction workers in United Arab Emirates have launched strikes and riots as they watch the value of their savings erode.

Gulf countries are swimming in oil wealth but drowning in inflation - caused in large part by their own unrestrained consumer demand, and their insistence on hanging on to fixed exchange rates, analysts say.

Now, there's a growing fear among the world's opinion leaders that emerging market countries' last-ditch attempts to stifle inflation are akin to sticking a finger in the hole of a leaky dam.

Eleven years after the Asian financial crisis toppled currencies and wreaked havoc in Asia, Latin America, Russia and parts of the North American economy, analysts are again wondering whether the world is on the verge of another currency crisis - this time starting with the U.S. dollar.

The fear is that the inflation dam in emerging markets will break, prompting a quick abandonment of the U.S. dollar as a currency peg and reserve currency - an event that would be destabilizing at the best of times, but would be alarming in an era when the global economy is already dealing with soaring prices, a slowing U.S. economy and a credit crunch. "If you had a big shift in the Middle East, I think it would be a big deal because these countries are accumulating very sizable monthly excess revenues from oil sales. How they place that savings in terms of global currency markets is very important," said Jens Nordvig, senior global markets economist for Goldman Sachs.

"If they move away from the dollar, it would be a signal that they were about to invest more in non-dollar assets."

Pegged exchanged rates prevent those countries from raising interest rates to keep inflation under control. Instead, to maintain the exchange rate, they have to match U.S. monetary policy. Interest rates in the United States are highly stimulative, however, designed for an American economy struggling to avoid a recession - not a Gulf country whose coffers overflow with oil money.

So emerging market demand continues unabated, even encouraged, further exacerbating the inflation problem that governments around the world are scrambling to contain. Qatar's inflation is running at about 14 per cent. Egypt is at 19 per cent.

The average for the region just two years ago was a mere 2 per cent.

Even without a currency crisis, surging emerging market inflation is a major problem for advanced countries, since it pushes up prices for commodities worldwide at the same time as growth in advanced countries is weak - including in Canada.

To add to the difficulties, economists and currency traders wonder whether Gulf countries will soon be forced to move away from their inflexible currency pegs to the U.S. dollar and opt to peg to a basket of currencies or float freely. That would trigger a loss of confidence in the already shaky U.S. dollar and send the greenback into a downward spiral.

"The world may realize that it is no longer reasonable for the dollar to be the anchor currency," writes Sherry Cooper, chief economist at BMO Nesbitt Burns in a recent note called Next Shock: Currency Crisis?

"If several dollar-pegged currencies were revalued, we could expect to see some panic selling in the U.S. dollar, further destabilizing the global economy," she said.

Such speculation has prompted politicians in the United States and the Gulf to frequently deny this would occur.

But Mr. Nordvig doesn't think the world is on the verge of a currency crisis. If American authorities won't let Fannie Mae and Freddie Mac twist in the wind, there's no way they'd let their currency plunge either, he argues.

"Some of these institutions are so crucial to the financial market over all that they cannot be allowed to fail," he said in an interview.

Instead, the United States would intervene to prop up its currency - a move that has been much speculated about but extremely rare in the past 15 years. Since so much of the global economy's well-being depends on a stable U.S. dollar, intervention has now become a real possibility, Mr. Nordvig said.

"This intervention issue has for the first time in a decade basically become something we have to view as a distinct possibility, fairly soon," he said.

"I'm not talking about words. I'm talking about dollar buying."

The Gulf countries, too, will likely take steps to prevent massive instability, say economists at London-based Capital Economics.

"The Gulf [countries] would also want to take account of the potentially negative impact on U.S. financial markets, given their very large holdings of U.S. assets," they say in a recent note to clients.

"The [Gulf] countries will be wary of undermining market sentiment further, especially when relations with the West are already strained over the issue of record high oil prices."

Indeed, the hard currency pegs common among Gulf countries are not nearly as troublesome as the "dirty" exchange rates in Asia, economists say.

Inflation is soaring there too, but real interest rates - the level of interest rates excluding inflation - are negative.

That's because monetary authorities are too busy managing their currencies to stay roughly in line with the U.S. dollar, performing monetary policy contortions in an unsustainable effort to maintain currency stability and keep inflation at bay at the same time.

"The Chinese are between a rock and a hard place because they have all those assets in U.S. dollars, and if they revalue the yuan, or let it float up, that imposes big capital losses on them. On the other hand, if they don't, it's going to inflate out of their control anyway," eminent Canadian economist David Laidler said in a recent interview. "So they are in a mess."

Even the Bank of Canada is asking the currency crisis question, wondering aloud whether moves in China and other emerging markets to tighten reserve requirements and raise rates are enough to cool off the region and keep the global economy on an even keel.

If not, commodity prices, financial markets and the Canadian economy would all be hurt as a result, Mark Carney, the central bank's Governor recently suggested.

Is there a painless route out of the emerging market currency and inflation problem? No, says Mr. Laidler, who has been analyzing economics and currency movements since the 1960s.

"You're going to get huge instability one way or another. You're going to get it if they un-peg, or you're going to get it when the inflation finally gets loose domestically," he said.

But there's a way to manage the pain, Mr. Laidler added. Major emerging economies need to allow their currencies to appreciate more quickly than in the past, and they also need to allow more inflation to trickle down to consumers.

"The critical thing now is to recognize that people did get it wrong, and start thinking systematically about how to get out from under it."