Serious Money:The American dollar, the world's reserve currency, has been under increasing pressure of late. Thus far in 2007, it has declined against the currencies of all 16 major trading nations, save the Mexican peso, writes Charlie Fell.
Jean-Claude Trichet, president of the European Central Bank, has recently joined the growing chorus of policymakers voicing concerns over the dollar's rapid descent.
The drop of more than 40 per cent against the euro since 2001 - and a double-digit decline so far this year - undoubtedly present a threat to European growth, but investors should cast a glance at the oil exporters in the Middle East where greenback weakness and US monetary policy are creating serious problems.
Policymakers face a dilemma as macroeconomic policy can include at most two elements of the "inconsistent trinity" of policy goals - an independent monetary policy, a fixed exchange rate and free capital mobility.
The oil-exporting countries that border the Persian Gulf, apart from Kuwait, peg their currencies to the dollar and, in so doing, must adopt US monetary policies that, as now, are often totally inappropriate to their needs.
High oil prices have led to an embarrassment of riches among the Persian Gulf countries. Current account surpluses amount to more than 30 per cent of GDP and provide a rapid accumulation of foreign exchange reserves to offset upward pressure on fixed exchange rates. Currencies in the region are now seriously undervalued, a trend that has been exacerbated by the dollar's relentless decline.
Macroeconomic models show that, if the nominal exchange rate does not adjust in response to a change in fundamentals, relative prices will eventually adjust through an increase in domestic prices. Furthermore, the necessary adjustment grows larger as the oil exporters' currencies mirror the dollar's decline.
Inflation is on a rising trend among the Gulf countries and some are already sporting rates of more than 10 per cent. Tax revenues have soared with higher oil prices and, not surprisingly, so too has government spending, which has contributed to higher domestic prices.
The inflationary trend is already in place but, rather than tighten monetary policy, the countries are being forced to ease policy as the US lowers rates in the face of the credit crisis. It is clear that what is good for the US is contributing to growing problems among the Gulf states where interest rates are already negative in real terms for most oil exporters.
The current dilemma is the mirror image of the difficulties facing the region in the late 1990s. Oil prices tumbled to just $10 a barrel in 1998, and consequently, government revenues and spending declined significantly. Easier monetary policy was clearly required but interest rates moved higher as the Federal Reserve tightened policy through 1999.
High real interest rates inevitably led to deflation in many countries. Indeed, real rates reached almost 7 per cent in Saudi Arabia at the same time as the economy was contracting.
The dollar peg has clearly contributed to greater economic volatility in the Gulf, and several countries, including Qatar and the United Arab Emirates, appear to be reaching the inevitable conclusion that change is required. Kuwait moved to a basket peg in May and others look set to follow their example before the year is out. Even Saudi Arabia is considering its first currency revaluation in more than two decades.
But what exchange rate regime would be appropriate for the Gulf's oil exporters? There have been some suggestions that the Gulf states should switch from the dollar to the euro, given that the region runs a substantial trade deficit with Europe. This would eliminate the currency mismatch between the oil exporters' revenues and expenditures, which are priced in dollars and euros respectively, but would do little to reduce economic volatility, as one monetary policy regime would be replaced by another which may also prove inappropriate to its needs.
Any currency basket that the oil exporters' adopt should include the oil price given that their economic fortunes are tied to its movements. Indeed, the International Monetary Fund estimates that a doubling in the oil price typically leads to a 50 per cent real appreciation of the oil exporters' currencies.
A basket that includes oil should ensure that the necessary adjustment takes place through a nominal rise in the currency and not via an increase in domestic prices. The benefits of greater economic stability that would result should not be underestimated.
Change is afoot and the dollar pegs are certain to go in the not too distant future. The region's currencies offer exciting investment opportunities.
