Economic Research Forum (ERF)

A new exchange rate regime for oil-exporting countries

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.

Most read

Fair competition is needed to empower women economically in the Arab world

The participation rates of women in the labour market in Arab countries are the lowest in the world. This column argues that remedying the under-representation of women in the labour force is a social and economic imperative for the region. There are three dimensions for action to realise the potential of Arab women: amending laws and regulations; instilling fair competition in markets; and promoting the digital economy.

Recession without impact: why Lebanese elites delay reform

The survival of Lebanon’s political elites is highly dependent on the wellbeing of the economy. Why then do they delay necessary reform to avoid crisis? This column examines the role of politically connected firms in delaying much-needed economic stabilisation policies.

Competition laws: a key role for economic growth in MENA

Competition policy lacks the attention it deserves in the countries of the Middle East and North Africa (MENA), a region characterised by monopolies and lack of market contestability. As this column explains, there are many questions about the extent of anti-competitive barriers facing new market entrants in the region. What’s more, MENA’s weak overall performance on competition is likely to be hindering economic growth and the path towards structural transformation.

The future of Egypt’s population: opportunities and challenges

Egypt’s potential labour supply depends on the growth and changing composition of its working-age population. This column reports the latest data on labour supply and fertility rates, concluding that the country has a window of opportunity with reduced demographic pressures to try to address longstanding structural challenges for the labour market.

Formidable challenges facing the Middle East require a sea change in economic policies

Weakening global growth, endemic conflicts and increased tensions within the Middle East and North Africa (MENA) – as well as emerging challenges such as climate change and rapid demographic shifts – are likely to have an adverse impact on the region’s economic, social and political stability in the coming years. This column outlines the policy responses that are needed to avert disaster.

Domestic demand and competition: a new development paradigm for MENA

A lack of competition in domestic and regional markets is holding back development in the Middle East and North Africa. This column argues that the region and the international community must ensure that barriers to market entry and exit are eliminated, and that independent regulatory bodies at the national and regional levels help to promote domestic demand as the main engine for sustainable and inclusive growth.

Effects of urbanisation on productivity and wages: evidence from Turkey

Are the substantial productivity gains associated with larger cities in developed countries similar for developing countries? This column provides evidence on urbanised economies in the non-Western world by focusing on Turkey, a country that has experienced fast urbanisation and a high rate of growth of the urban population.

Gender discrimination in small business lending: evidence from Turkey

Discrimination in access to financial services can prevent women from exploiting their entrepreneurial potential. This column reports on a ‘lab-in-the-field’ experiment to test for the presence of gender discrimination in small business lending in Turkey.

How import dependence could lead to corruption in MENA

Export-led development strategies have had little success in MENA countries; what’s more, instruments of earlier import-substitution strategies – such as state-owned enterprises, high tariffs and subsidies – have survived. As this column explains, these legacies have created crony-capitalist industries that have limited the level of competition in many sectors of the economy and furthered the region’s dependence on imports.

Social security for young workers in Arab countries

Social security coverage of young workers in Arab countries is low – in part because many are employed in informal jobs; and in part because they do not see the value of the system. This column reports survey evidence on young workers’ attitudes towards participation in both social security and politics. It also explores policy reforms that might make access to social security universal for young workers.