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Monday, November 5, 2007

Currency pegs under pressure

Currency pegs under pressure print article:
Financial Times logo

Published: November 5 2007 09:48 | Last updated: November 5 2007 09:48

There are more than 100 countries with fixed currency regimes of one sort or another. Some economies, such as Panama are effectively dollarised, or in the case of Andorra, “euro-ised”. Many, including Hong Kong, operate strict pegs. In other countries, currencies move within trading bands that allow a little more flexibility. Dollar or euro pegs are the most common, although many countries including Russia and China use a basket of currencies.

With the dollar at eight-year lows against the euro, some fixed exchange rates are creaking. One concern is whether some countries in the Middle East and Asia will abandon their dollar pegs. Oil exporting nations running capital account surpluses cannot use monetary policy to rein in rising inflation. The problem is similar in China, but swap oil for toys. So far inflationary pressures in these countries have not been intense enough to provoke action. If authorities do eventually revalue, or move from a dollar peg to a more accommodating basket of currencies, it is doubtful whether these booming economies would stall.

The situation is very different for those currencies pegged to the rampant euro. Former Communist bloc countries such as Bulgaria and Latvia have asset bubbles, double-digit inflation and yawning current account deficits. In part, this has been caused by low eurozone interest rates, as well as excessive borrowing. With memories of the Asian and exchange rate mechanism crises, speculators are waiting in the wings. Unlike China or Saudi Arabia which have large foreign currency reserves, some eastern European pegs might not survive a concerted attack.

Which countries are most vulnerable? One measure of stress is real interest rates. Assuming economies match their base rates with those of the currency zone they are pegged to, Bulgaria stands out with a negative 10 per cent real interest rate. The dollar bloc is not as stretched, but real interest rates in the United Arab Emirates are now north of 3 per cent. Forget the Middle East and China – the least stable currency pegs may actually be in Europe.

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