Hey! Hands up if you’ve noticed that after 2½ years of free-fall the US Dollar has perked up? The good old greenback has rallied by something in the region of 9% against a basket of currencies over the past month. Now it’s anybody’s guess whether this is more than just the dollar spurting up around the U-bend before it continues down the toilet. There are a lot of factors to consider, for example:

• There’s a growing perception that other economies aren’t doing any better than the US (or some would say the impact of a slowing US on other major economies has been underestimated until now).
• Lower oil prices might lessen inflation and put more money in consumers pockets; That money’s then available to spend on other goods.

However one less-discussed item caught my eye – a few months ago there was a lot of talk about Oil countries breaking their currencies’ dollar pegs. Doing so would have pushed the dollar down even further – but that now seems to be off the table. And there are also hints that China, although it has removed its peg, might not be as ready to let its currency weaken against the dollar just yet. So let’s see if we can get to the bottom of this pegging business.

What’s A Currency Peg?
A currency peg is when one country fixes its currency against that of another country. This means that the pegged currency will rise and fall in line with the currency it’s pegged to.

So, for example, the Saudi Riyal is worth USD 0.2666 and, apart from a couple of months in 2007, has been worth USD0.2666 for over 20 years.

Why peg? Usually, a weaker currency would peg itself to a stronger one, one with a bit more street cred’. You might be the little kid but, by hanging around with the big boys, you can make sure nobody will bully you.

Historically, there have been plenty of examples of pegging. The UK itself tried to peg Sterling to the seemingly powerful European Exchange Rate Mechanism in 1990, but that ended in tears in 1992. However these days, countries tend to peg against either the US Dollar or a basket of currencies.

There’re a whole host of countries now pegged to the US Dollar, but to varying degrees. Let’s have a look:

1. The first group are the hard-core enthusiasts such as Panama and loads of little islands. They like the US Dollar so much they use it as their own currency.
2. The next bunch have their own currency but peg it against the Dollar. Current names in the frame here are Hong Kong, Saudi Arabia and several other oil-producing states in the Middle East.
3. The third lot includes China, Kuwait and Malaysia. They were once fully pegged to the Dollar, but they now target a range against a basket of currencies.
4. Finally there are currencies with dollar in their name, such as Canada, Australia, New Zealand and Singapore. They are red herrings in this content – there’s is no peg and they rise and fall independently.

A Bit More On The Hows And Whys
Currency pegs have often been the result of a currency, or financial, crisis where the quick fix has been to peg the vulnerable currency to one with a bit more street cred’, like the US Dollar.

By putting a peg in place a government deprives itself of the ability to meddle with domestic monetary policy. Interest rates have to be set to maintain the fixed rate against the ‘peg’ and, like the currency, will likely reflect interest rate moves of whatever central bank controls the ‘pegged to’ currency. This gives the assurance of a commitment to price stability, which in turn should eventually allow lower interest rates and help the pegged currency to gain that all-important credibility.

What Are The Risks?
There are some pretty major downsides to currency pegging as it’s slow to reflect relative economic changes between the countries. This forces a weakening country to defend an unrealistic rate against the world’s speculators, and guess who wins?

For example the UK attempted to peg Sterling to the European Exchange Rate Mechanism, dominated by the all-powerful Deutschemark. It ended in humiliation in 1992 and ensured that George Soros entered forex folklore.

The opposite problem with a currency peg is the inability to cope with huge capital inflows. Back in the 1990s when the Asian Tigers were all the rage, their currency pegs to the Dollar allowed speculators to pour money into the region at bargain-basement currency rates (the peg meant that the currency couldn’t rise to reflect either the stronger economic growth or demand for the currency). Eventually the expanding supply of money in the region saw prices inflating like Kerry Katona on a bad day.

China
The opening ceremony to the Olympic Games demonstrated all too well that in China not everything is as it appears on the surface. Likewise in the currency markets, whilst publicly agreeing to revalue the Yuan against the Dollar, there’s a sneaking suspicion that it’s been covertly devaluing its currency.

Until 2007 China was a shining example of a country that benefited from an artificially low exchange rate. Its peg against the Dollar allowed it to flood the good old US of A with cheap goods. US companies were unable to compete with the lower prices; industry suffered.

Eventually, after ‘diplomatic pressure’, in 2007 China ‘unpegged’ from the Dollar and saw its currency rise (a bit). The Renminbi (or Yuan) is now managed against a basket of currencies and is allowed to float against the Dollar in a daily range of 0.5%.

The Chinese might have started out with honourable intentions, but more recently, a sharp drop in the nation’s phenomenal growth rate has caused panic in Beijing. In a pattern now familiar around the world, inflation has been rising as growth has plunged; in July the Chinese manufacturing PMI dropped below 50, signalling a contraction in industry.

This week a report by HSBC suggested that whilst the Chinese government was publicly talking of a rising Yuan, it was hiding behind banking regulations to indirectly weaken its currency. Since March, banks’ reserve requirements have been raised 5 times and now stand at a whopping 17.5% of total lending. As banks in China are required to hold some reserves in US Dollars, every one of those increases leads to selling of its own currency and buying extra Dollars. This pushed the Yuan down and the US Dollar up.

In addition the Chinese authorities have slashed the amount of Yuan that foreign banks can hold, again precipitating large sales of Yuan for Dollars. Again the net result is Yuan down, Dollar up.

Oil Countries
Several of the oil producers from the Middle East have their currencies pegged to the Dollar. This has made sense as their only export, oil, is priced in Dollars. But the question ‘Is this still a good idea?’ crops up in the ‘Any Other Business’ section of most OPEC meetings!

The BIG irony here is that, historically, pegging against the Dollar was a way of demonstrating a commitment to lower inflation. But in recent times the falling greenback has dragged the pegged currencies lower whilst taking no account of their economies. The oil producers have been coining it in, the rising oil price compensating for the fact it’s paid for in Dollars. The money they earn from selling oil and the low interest rates are combining to fund what could be called an ‘over-heating economy’.

Normally in a situation like this a central bank would put up rates and ‘cool’ the economy. However because the currencies are pegged that is not an option. So the boom has caused a shortage of materials and huge rises in food, accommodation and wage demands. Inflation in the Gulf varies from State to State, but 11% is at the lower end of the range.

Last year Kuwait was the first Gulf state to break free from the peg. It now manages its currency against a basket of currencies, still dominated by the Dollar. Significantly though, it now controls its own interest rate policy and, although inflation is still around the 11% mark, it expects a fall to 7 or 8% by the year-end.

In July of this year Abu Dhabi spooked the markets when its planning department floated the idea of targeting a basket of currencies. Although the United Arab Emirates have always remained loyal to the Dollar peg, the idea of an independent currency is one way of tackling their record 11% inflation.

There’s plenty of helpful advice from outsiders. The International Monetary Fund, for example, suggests that pegging against a basket of currencies may not be a bad idea. That would allow the Gulf States to raise interest rates, revalue their currencies, or both. The idea of dropping the peg might find favour with Saudi Arabia. At the height of the US Fed’s rate cutting binge in September 2007 Saudi Arabia, concerned about the inflationary effects of lower interest rates, took a ‘holiday’, dropping the peg until December 2007.

Also there are long-standing plans for members of the Gulf Co-operation Council to have their own single Gulf currency in 2010. But the schedule seems a bit flaky at best.

Summary
So what can we draw from this?

Although speculation about the Gulf States ditching the Dollar comes round as regularly as the FA Cup final and Independence Day, the non-excitable experts reckon it’s not on the cards in the near term. If the Dollar continues to strengthen then pressure on the Arab states to break the peg will lessen. Only this week the United Arab Emirates supported the case for pegging against a strengthening Dollar.

China’s a massive unknown; even if the outside world is slowing down there’re a few parts of China that could benefit from further development. After a smog-free lull for the Olympics many will be looking to see if growth starts to accelerate again. This could take pressure off the Chinese to cheapen their currency and put an end to that avenue of demand for the Dollar.

It looks likely that the Gulf States will remain Dollar friendly, at least on a trading horizon! In the immediate future China looks to be the same way, encouraging the buying of Dollars. And check out the chart at the top of the page; the Dollar Trade-Weighted Index certainly has room to travel a bit further in the ‘up’ elevator.

There’s little here to stand in the way of a stronger Dollar.