Fall in the Dollar has Far Reaching Implications

Last week the government of Kuwait announced that it plans to de-peg its national currency, the Kuwaiti dinar, from the U.S. dollar in order to control inflation. Similar to the U.S. itself, Kuwait is a major importer of foreign goods and services, in fact probably significantly more so as a percentage of GDP, if you exclude oil exports. Consequently, when the domestic currency falls as a result of the fall in the currency to which it is pegged, namely the dollar, it starts importing inflation. Even in the U.S. itself we are seeing that the Fed is concerned about the inflationary impact of the weak dollar given the continued demand for foreign goods.

Kuwait’s plan is to peg its currency to a basket of currencies, within which the dollar is still a dominant component. However, it is the not the sole component. It is suggested that it will be pegged to basket comprising of euros, Pound Sterling, and Japanese Yen.

Of course, the Kuwaiti economy is far too insignificant to have a major impact on the U.S. dollar by itself; however, the country’s decision to de-peg its currency does have implications far beyond its own direct remit. First and foremost, given the huge debt that the Kuwaiti government owes to the U.S. government for rescuing it from annexation by Iraq makes the fact that they are among the first Middle-Eastern allies of the U.S. to announce such a move significantly more profound than it would otherwise have been. It will certainly make the other countries in the region feel less obliged to maintain their own pegs with the dollar than they would have previously. Syria has also announced that it will de-peg its currency from the dollar, which I am certain has the Fed extremely worried given the giant economy that Syria is. However, as most of our readers are aware, as the number of countries reducing their peg to the dollar increases, the demand for the dollar falls in the global markets, causing further problems for the currency. Consequently, while the decision of these two countries on their own is nothing to be concerned about, should more countries follow suit then it could be quite worrisome. For example, if all of the major oil exporting nations de-peg from the dollar, though the largest, Saudi Arabia, has said that it will not, the aggregate effect could be quite significant.

As I mentioned in a previous Bulletin titled “The economic situation in the U.S. seems to be getting worse,” (https://www.capco.com/WorkArea/showcontent.aspx?id=3360 ) the Chinese and Japanese governments have also started considering diversifying their holdings, which in practical terms has the same implications as de-pegging, the holdings of the main reserve currency/peg falls. If all of these countries together reduce their holdings of the dollar it would be hard to ascertain how far it would fall.

The other implication of the Kuwaiti announcement is that it makes the job of creating a monetary union among the GCC countries almost impossible, unless the others follow in its footsteps. Consequently, the fall in the dollar has also resulted in the failure of a monetary union in the Middle-East. Should the idea of the monetary union be removed from the table, many more of Kuwait’s neighbours might also start considering de-pegging from the dollar. Given that the dollar plays a very important role in most of the world’s economies, its fall could signal the end of a number of monetary unions, as more countries contemplate reducing their exposures to a currency that many feel has a good chance of falling even further than it is, or cause delays in their launch. Of course, they can also peg the union members’ currencies to baskets of currencies, but that will usually take longer, as determining the composition will be harder to agree on among the member countries, especially if a major component keeps on falling, as the dollar would if more countries reduce their holdings. The euro is another alternative, which some in Africa have been contemplating.

Given the huge role that the dollar has played in the world economy for so long it is no wonder that the implications of a major fall in the currency are significantly more far reaching than what one might think at first sight. The continued success of the euro further adds to the dollar’s woes, giving countries another currency, one that for now seems to be more stable, to which they can peg directly, or include as part of a basket.

These kinds of announcements make the job of the U.S. Federal Reserve significantly more difficult than it already is. Trying to ascertain the inflationary implications of more countries de-pegging their currencies from the U.S. dollar or diversifying their foreign exchange reserves is extremely hard. I believe that the challenge facing the new team at the Fed is one that few of their predecessors have had to face. However, what they learn from this experience would be invaluable for the European Central Bank, which sooner or later will face similar problems. At no time in history has a major reserve currency faced this kind of challenge. Let’s hope that Dr. Bernanke and his team are up for the challenge.

If you wish to know more about monetary unions please read the latest issue of the Journal of Financial Transformation at http://www.capco.com/general.aspx?id=107

This briefing is provided as general information, and does not constitute definitive advice or recommendations. Any views expressed in the above articles are those of the author concerned and do not necessarily reflect the views of Capco or any other party. Capco has not independently verified any facts relied upon in any of the comments made in any of the articles referred to. Please send any comments or queries to Shahin Shojai (shahin.shojai@capco.com). Shahin Shojai is the Editor of The Capco Institute journal (www.capco.com).

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