Case against pegging to a single currency

Markets all over the world are witnessing an exceptional wave of price hikes, which has affected all commodities and services.

Countries have taken different measures to deal with this crisis, which has severely affected purchasing and saving powers of people.

There are two main issues to be considered here. The first is taking immediate action to curb price hikes, while the second has to do with reconsidering economic and monetary directions, which may reduce the impact of such phenomenon in the future.

Rich countries increased salaries and wages, which helped cover some of the extra costs borne by consumer, while poor countries tried to subsidise basic commodities to make them affordable.

There are many reasons behind this wave, including the increase in energy costs and the resulting increase in the prices of manufactured commodities, the sharp decline in the US dollar exchange rate, to which many currencies are pegged, and the hike in property prices.

Reasons also include the increasing demand for commodities and services due to increasing population, especially in developing countries, and speculations and opportunism due to the imbalance of offer and demand.

Last week the US Federal Reserve Bank decided to cut interest rates by 0.5 point to 4.75 per cent, in response to the subprime mortgage crisis, which would have almost blown away the world monetary order had it not been controlled in time. The effects of this problem, however, were evident, which prompted the Federal Reserve to take this step in an effort to increase inflation pressures and prices.

This step is suitable for economic conditions in the US, since it will refresh the economy and save it from a slowdown.

The exchange rate of currencies pegged to the dollar will also decline against other currencies, and the prices of their imports from non-dollar areas will increase, which is a major cause of inflation.

These countries will not be able to increase interest rates to reduce inflation, but will have to go along with the Federal Reserve Bank and reduce interest rates, which has already happened, due to technical factors demanded by pegging currencies.

The main issue is that economic situations in these countries demands taking a step in the opposite direction, which will increase interest rates and curb inflation and hiking prices.

This is why a long-term strategy to handle this becomes very important. Monetary procedures must be related to economic situations, and used as a tool to control economic phenomena, especially inflation.

Fluctuations

Linking a local currency to one currency has positive and negative sides, but it subjects the local currency to sharp fluctuations, and creates a gap between monetary procedures and economic situations, thus causing central banks and monetary authorities to lose a powerful and effective tool through which they can manage monetary and financial situations in line with economic demands and developments.

Hence we come to the conclusion that pegging to a currency basket gives more flexibility in controlling monetary and financial procedures, including interest rates, and using them as tools to decrease price hikes caused by the decline in exchange rates of local currencies.

The change from single currency to currency basket peg is costly, but the rewards exceed the cost, and give banks and financial authorities better flexibility, which will help the stability of economic situations, increase growth rates and curb inflation and price hikes.

The writer is a UAE economic expert.