By Edward Harrison of Credit Writedowns. This is a modified version of an article I posted yesterday at the Big Picture based on two recent articles I wrote on currency news in the Baltics and the Middle East. The question I ask is this: now that finance is global and capital can move in and out of markets and countries on a dime, how can any country protect itself against the volatility of currency markets?
There has been a lot of talk about sovereign debt risk since the Dubai World panic over Thanksgiving. You have seen pressure not only on government obligations in Dubai, but also in Greece, Spain and Ireland and a spillover into other unrelated markets. At issue is how best to weather a crisis given the Impossible Trinity of free movements in capital, independent monetary policy and fixed exchange rates. A country can pick two, but no one can have all three.
The hallmark of a crisis is the wholesale and indiscriminate move to safe havens by investors. The likelihood of market contagion is huge as was well demonstrated during the Asian Crisis and Russian devaluation in 1997-98 and the collapse of LTCM. The events in Dubai certainly show this as well.
How do you protect your domestic financial markets from this kind of thing? Different foreign exchange regimes can be useful in preventing worst case scenarios. But, every solution has its problems; there is no magic bullet for countries looking to escape the volatility of financial market globalization. Until we develop a more stable currency framework, you can expect volatility to play out via FX.
Going it alone
For small countries this is especially problematic. Many had adopted the Icelandic model of free movements in capital, independent monetary policy and flexible exchange rates. This has worked pretty well for the U.S. But when Iceland’s currency collapsed last year, sending that country into depression, it sent shudders down the spines of policy makers in small countries everywhere. If Iceland was brought to its knees by a run on the country’s currency, small countries everywhere have had to re-think how to avoid Iceland’s fate.
Currency union as a solution?
Some countries have adopted currency unions to solve this problem. This is the ‘Euro’ model of free movements in capital, no monetary policy control and internally fixed exchange. The Persian Gulf states of Saudi Arabia, Kuwait, Bahrain, and Qatar are now embarking on that path.
The move will give the hyper-rich club of oil exporters a petro-currency of their own, greatly increasing their influence in the global exchange and capital markets and potentially displacing the US dollar as the pricing currency for oil contracts. Between them they amount to regional superpower with a GDP of $1.2 trillion (£739bn), some 40pc of the world’s proven oil reserves, and financial clout equal to that of China.
Saudi Arabia, Kuwait, Bahrain, and Qatar are to launch the first phase next year, creating a Gulf Monetary Council that will evolve quickly into a full-fledged central bank.
The Emirates are staying out for now – irked that the bank will be located in Riyadh at the insistence of Saudi King Abdullah rather than in Abu Dhabi. They are expected join later, along with Oman.
The Gulf states remain divided over the wisdom of anchoring their economies to the US dollar. The Gulf currency – dubbed “Gulfo” – is likely to track a global exchange basket and may ultimately float as a regional reserve currency in its own right. “The US dollar has failed. We need to delink,” said Nahed Taher, chief executive of Bahrain’s Gulf One Investment Bank.
The project is inspired by Europe’s monetary union, seen as a huge success in the Arab world. But there are concerns that the region is trying to run before it can walk.
Given recent events in Europe concerning Greece, Ireland and Austria, and speculation about a bust up of the Eurozone, one might think the desire to initiate currency unions has weakened. But it has not. I reckon events post-Dubai World make the pull toward a currency union even greater. The disruption caused by this financial crisis has buffeted smaller countries with sovereign currencies because of a lack of currency controls and the destabilizing effects of ‘hot money.’ Iceland, which suffered the worst fate of small nations, has now been fast tracked for EU membership. Latvia has allowed its economy to suffer depression in order to maintain a peg to the Euro in the hopes of escaping the downside of small country monetary independence.
Meanwhile tiny Estonia looks like it may make it in to the Eurozone by 2011. EU statements are fairly non-committal so far. But, I see this as a real test case because Estonia has built a fairly solid case for entry. Moreover, Estonia would be tiny as a percentage of Eurozone GDP and further positive signs of its likely inclusion would help stabilize the situation in Latvia and Lithuania where the budgetary problems are severe.
The problem with internally fixed exchange rates in a currency union is it binds countries into a one-size-fits-all monetary policy. If fiscal policy, business cycles and macro outlooks do not converge, someone will suffer. This was a major reason we saw a massive property bubble in Ireland and in Spain as these countries overheated. And, inevitably, economic collapse and depression is the result.
Currency peg as a solution?
If not internally fixed rates, how about externally fixed rates? Foreign currency pegs are also problematic. Look no further than the escalating tension between China and the U.S. over China’s peg. China is buying up massive amounts of Treasuries, not just because easy money from the Fed encourages a current account deficit in America, but also because the Chinese exchange rate is fixed at an inappropriately low level. Their macro policy serves to import asset price and consumer price inflation into China during boom and deflation during bust. During the bust, acrimony mounts and protectionism can result. For small countries, a currency peg can be especially deadly unless they harmonize their economic policies. Just ask Latvia or Argentina.
The last method countries have used to deal with the Impossible Trinity is by instituting capital controls. Brazil has attempted to deal with this by instituting currency controls, which some are heralding as a necessary measure. Other nations like Nigeria have also revived exchange controls in the wake of crisis. But Iceland used capital controls when it got into problems and it still suffered an economic meltdown. The Russians had a lot of capital controls too before they defaulted on their own government debt in 1998, precipitating the Long-Term Capital management crisis.
There are no silver bullets: not capital controls, not currency union, not pegs. The safest (and probably only) way for a country to weather contagion in a sovereign debt crisis is to maintain low levels of debt in both the public and private sector through appropriate fiscal and monetary policy and robust macro-prudential regulation.
One point I failed to make in my original post on Barry’s site is how much the banking sector has added to volatility in this crisis. So, when I point to macro-prudential regulation, I am really thinking of the banking sector. In small countries especially, regulators should scrutinize moves by lenders abroad because a lack of local knowledge always, always leads to poor investment and lending choices. Look at the Swedish banks in the Baltics or the Austrian and Greek banks in the Balkans or the Swiss banks in CEE. And because these countries are small, the balance sheet bloat of the banks’ foreign adventures makes them too big to bail. That is the problem Iceland faced.
In the lead up to this crisis few nations took the route I am describing and now their citizens are paying the price.