Economic Research Forum (ERF)

A new exchange rate regime for oil-exporting countries

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Currency pegs in the Gulf economies have forced monetary policy to be pro-cyclical, exacerbating the effects of swings in the oil market on the business cycle. This column proposes a new exchange rate regime for oil-exporting countries: one in which the currency is pegged to a basket that includes commodities along with currencies.

In a nutshell

The currency-plus-commodity basket proposal would peg the national currency to a basket that includes not only the currencies of major trading partners but also the export commodity (oil).

The goal is to achieve the best of both flexible and fixed exchange rates.

The arrangement is designed to deliver monetary policy that counteracts rather than exacerbates the effects of swings in the oil market, while yet offering the day-to-day transparency and predictability of a currency peg.

The exchange rate regimes of the Gulf countries may have served them well in the 1980s and 1990s. But since the turn of the century, oil-exporting countries have experienced much bigger swings in the dollar price of oil on world markets.

The effects of these swings on Gulf state economies have been exacerbated by their exchange rate arrangements. Saudi Arabia and the smaller Gulf countries have long pegged their currencies to the dollar. Kuwait pegs to a basket that includes both the dollar and the euro. Either way, these currency pegs have forced monetary policy to be pro-cyclical – that is, exacerbating economic fluctuations.

During oil booms, such as 2006-08 or 2011-13, some Gulf countries have experienced unwanted monetary inflows, credit expansion, inflation and asset bubbles. During oil busts, such as 2014-16, they experience worrisome balance of payments deficits and economic contraction.

These problems would have been moderated if the currency had been allowed to appreciate during the boom and depreciate during the bust. During the boom, a strongly valued currency would have dampened monetary inflows, credit expansion, wasteful spending, overheating, inflation, debt and asset prices.

During the downturn, a currency depreciation would have moderated the balance of payments deficit and losses of output and employment. It would also have automatically provided incentives for the private sector to diversify into other traded goods and services, thereby reducing long-term dependence on the oil sector.

The usual way of accommodating trade shocks and allowing monetary policy to be counter-cyclical (stabilising) is to allow the currency to float. In recent research, I propose another way to do it, a new exchange rate regime for oil-exporting countries.

The goal of my plan – called the ‘currency-plus-commodity basket’ – is to achieve the best of both flexible and fixed exchange rates. The arrangement is designed to deliver monetary policy that counteracts rather than exacerbates the effects of swings in the oil market, while yet offering the day-to-day transparency and predictability of a currency peg.

Under the proposed plan, oil-exporting countries would peg their currencies to a basket that includes the export commodity (oil) alongside major currencies. In the simplest case, the basket could assign equal weights of importance to three components: one third to the dollar, one third to the euro and one third to oil.

The arrangement would have much of the advantage of a fixed exchange rate: a firm transparent anchor for the value of the currency. At the same time, it would have the advantages of a floating exchange rate: an automatic appreciation when world trade conditions favour the country’s export commodity, thereby moderating excess monetary expansion and inflation; and an automatic depreciation when trade conditions turn against the export commodity, thereby moderating monetary contraction and recession.

Historical analysis of Saudi Arabia, Kuwait and smaller Gulf countries during the period 2001-16 identifies sub-periods when the existing exchange rate arrangements led to a currency that we label ‘undervalued,’ relative to the higher level it would have attained if the currency-plus-commodity basket proposal had been in place. The other sub-periods we label as having been ‘overvalued’ by this criterion.

The finding is that during the undervaluation sub-periods, the inflation rate tends to be high, a symptom of excess demand or overheating. During the overvaluation sub-periods, the inflation rate tends to be low, a symptom of excess supply or recession. Similarly, during the undervaluation sub-periods, accumulation of foreign exchange reserves tends to be high, while during the overvaluation sub-periods, reserve accumulation tends to be low.

These findings support an important claim: if Gulf countries had followed the currency-plus-commodity basket proposal during the period 2001-16, their economies would have moved in the direction of external balance (a more stable balance of payments) and internal balance (greater stability in growth and inflation).

The research offers a practical blueprint for detailed implementation of the currency-plus-commodity basket proposal by any country’s monetary authorities that might be interested in considering it. Four decisions would have to be made regarding the specific design details of the arrangement:

Choice of major currencies to go into the formula
For the Gulf countries, we assume it would be just the dollar and euro. But some countries might want to consider adding the currencies of other important trading partners, for example, the Russian rouble and Chinese yuan in the case of Kazakhstan.

Oil price index to be used
I suggest the daily settlement price for Brent crude oil set at 19:30 London time on the InterContinental Exchange. Another index could be chosen instead, so long as it is transparent.

Computation of the coefficients on the major currencies and oil
After identifying the major currencies and oil price index that are to enter the basket, the next step for the central bank is to compute and announce regularly (for example, once a year) the numerical weights that are to be assigned to each of these basket components.

Frequency with which the coefficients would be revised
A country operating a currency-plus-commodity basket regime might find in the future that it wishes to alter the importance assigned to major trading partner currencies or to the oil objective. Governments that announce that their currencies will follow basket pegs often wish to preserve more flexibility than a permanent iron-clad commitment to the new regime would imply. The best way to do this is not to keep the formula secret, but rather to announce publicly and transparently the initial parameters and whatever subsequent changes are thought necessary.

Further reading

Frankel, Jeffrey (2017) ‘Currency-Plus-Commodity Basket: A Proposal for a New Exchange Rate Arrangement for Gulf Oil-Exporting Countries’, ERF Policy Brief No. 26.

Frankel, Jeffrey (2017) ‘The Currency-Plus-Commodity Basket: A Proposal for Exchange Rates in Oil-Exporting Countries to Accommodate Trade Shocks Automatically’, ERF Working Paper No. 1111, and forthcoming in Macroeconomic Institutions and Management in Resource-Rich Arab Economies edited by Kamiar Mohaddes, Jeffrey Nugent and Hoda Selim, Oxford University Press 2018.

Frankel, Jeffrey (2017) ‘Four Proposals to Help Commodity Exporters Cope with Price Volatility’, VoxEU.

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