In a recent Vox column, Jeffery Frankel argued that the Gulf States should switch their currency pegs from the dollar to a basket that includes oil.
That specific policy recommendation is based on a research agenda that Frankel has been pursuing for several years. In a CEPR Policy Insight released today, he explains his ideas in full. In this column, the Editors briefly sketch Frankel’s argument to highlight the importance of his proposed export price index peg, described extensively in the new Policy Insight.
Commodity prices and currency swingsAmong the many vicissitudes facing developing countries in recent years have been sharp fluctuations in world commodities prices and fluctuations in major currencies, especially the dollar, yen, and euro. Small and developing commodity exporters must indeed protect themselves from swings in their export market and at the same time make a credible commitment to fight inflation. Pegging their currency to export prices can achieve both results. There are two variants:
- Pegging to the export price (PEP) sets the value of domestic currency in terms of that commodity.
- Pegging to the export price index (PEPI) targets a basket of basic mineral and agricultural commodities, since pegging to only one export commodity could lead to unnecessary volatility in the prices of other export goods.
When the dollar price of exports rises, the currency appreciates in terms of dollars and provides the automatic accommodation that is thought to be the promise held out only by floating exchange rates. Such a peg gives the best of both worlds – adjustment to trade shocks and the nominal anchor.
Why export price pegs beat CPI targetingThe desirability of accommodating terms of trade shocks is a good way to summarise the attractiveness of export price targeting relative to the reigning champion, CPI targeting. After a fall in the export price, you want the local currency to depreciate against the dollar. PEPI delivers that result automatically; CPI targeting does not. After a rise in the import price, the terms-of-trade criterion suggests that you again want the local currency to depreciate. Neither regime delivers that result. But under CPI targeting you tighten monetary policy to appreciate the currency against the dollar to prevent the local-currency price of imports from rising. This implication – reacting to an adverse terms of trade shock by appreciating the currency – seems perverse. It could be expected to exacerbate swings in the trade balance and output.
Pegging to export prices has its advantages over traditional pegs too. In recent currency crises, countries that suffered a sharp deterioration in their export markets were often eventually forced to give up their exchange rate targets and devalue anyway; but the adjustment was far more painful – in terms of lost reserves, lost credibility, and lost output – than if the depreciation had happened automatically. Moreover, a basket peg does not address the fact that when commodity prices rise generally (not just against the dollar), monetary policy is constrained to be looser than it should be, and it is too tight when these prices fall.
If a central bank is constrained to hit an inflation target, oil price shocks (as in 1973, 1979, 2000 or 2008) require an oil-importing country to tighten monetary policy. The result can be sharp falls in national output. Around the world, central banks of countries that import food and energy, such as South Korea, have recently experienced the painful inconvenience of having a CPI target in the face of increases in the world prices of oil and agricultural commodities. Thus, a PEPI target would outperform the popular CPI target in all countries, not just commodity-producers.
Worthy of considerationNot all countries will benefit from a peg to their export commodity, and none will benefit in all time periods. One must go through simulations to get a feeling for the variety of possible outcomes. Nonetheless, for countries specialised in a mineral or agricultural export commodity, the proposal that they peg their currency to that commodity deserves to take its place alongside pegs to major currencies and the other monetary regimes.