The U.S. dollar is perhaps the most important currency in the world at this moment. Oil is priced in U.S. dollars, many international business transactions are conducted in U.S. dollars, and several countries tie the value of their currencies to the U.S. dollar.
- Today I want to focus on some of the countries who tie the value of their currencies to the U.S. dollar and discuss how a significant decline in the U.S. dollar’s value can lead to further Middle East instability.
The Currency Peg
We can begin to understand how a decline in the U.S. dollar can potentially lead to further instability in the Middle East by first understanding what a currency peg or fixed exchange rate is.
- A currency peg is an exchange-rate policy where a country attempts to keep its currency’s value fixed at a specific value relative to another currency, a basket of currencies, or a specific commodity (like silver).
- Therefore, a country that pegs its currency to the U.S. dollar has decided that it wants its currency to be valued at a specific level relative to the U.S. dollar.
A country that pegs its currency to U.S. dollar loses some policy independence. To maintain a peg with the U.S. dollar, a country is compelled to intervene in the currency market if the value of its currency becomes out of alignment with its target U.S. dollar exchange rate and is compelled to follow the Federal Reserve’s policies even if the Federal Reserve’s policies have an adverse impact on its economy.
- For instance, a country experiencing bad inflation would normally increase its interest rates in hopes of slowing down the inflation. However, when the country pegs its currency to the U.S. dollar it is compelled to keep its interest rates around where the Federal Reserve has set U.S.’s interest rates (near 0%) to maintain that fixed exchange rate. The country ultimately exasperates the inflation problem instead of addressing it.
The following (excellent) video explains the concept of currency pegs, why some countries peg their currency to another, and the consequences that a country faces when they peg their currency to another country’s currency in an easy to understand way in case you would like to see the topic explained in a different manner: Link
The reason I’ve focused on currency pegs is that several Middle East countries, including some key oil-producing countries, have their respective currencies pegged to the U.S. dollar. The following Middle East countries currently have their currencies pegged to the U.S. dollar:
- Jordan
- Bahrain
- Lebanon
- Oman
- Qatar
- Saudi Arabia
- United Arab Emirates
These countries’ currencies are linked to the fate of the U.S. dollar since they are pegged to the U.S. dollar. This link will continue to exist as long as these countries maintain a U.S. dollar peg.
- Some of the countries listed have considered reviewing their U.S. dollar peg in the past and have considered launching a region currency. However, officials from countries like Saudi Arabia have recently stated that the U.S. dollar peg serves them well, and it seems a single, regional currency is unlikely going to arise in the next few years in the Middle East.
- Oil producing countries of the Middle East have an incentive to maintain a dollar peg to eliminate the exchange-rate risk in their oil revenues (remember oil is priced in U.S. dollars). In other words, these countries want to prevent the value of their oil revenues to fluctuate as a result of a change in the value of their respective currencies against the U.S. dollar.
- Some also see the Euro’s recent instability as a factor has dampened the desire of Middle East countries to end their U.S. dollar peg.
The danger comes if the U.S. dollar’s value begins to fall significantly, which is quite possible in the future considering how indebted the U.S is and how the Federal Reserve tends to engage in money printing to stave off economic downturns in the U.S. In such event, the value of Middle East currencies pegged to the U.S. dollar would also have to fall to maintain the peg.[1] The decline in value of these Middle East currencies would make food, which takes up a large portion of people’s budget in that region of the world, and other essential items consumers need much more expensive in the Middle East.
- Higher food prices are likely going to stir up more unrest as it becomes more difficult for many people to afford food. As I wrote early last month when Middle East protesters were demanding their governments to make food more affordable, “a person can’t live without eating food for a sustained period of time like a person can live without listening to their iPod for a sustained period of time. As seen in many of the ongoing protests around the world, if people are having difficulty obtaining food they’ll put significant pressure on their government to do something about it”.
- The heightened unrest is likely going to put additional stress on Middle East governments (autocracies and potential partial democracies) and could potentially play a role in triggering new uprisings.
Given the currency link between the U.S. and several Middle East countries, it is important to monitor the U.S. dollar’s value. If the value of the U.S. dollar weakens significantly do not be surprised if further unrest arises in the Middle East.
Note
[1] Middle East countries can break the dollar peg at any time. However, there are major political, geopolitical, and economic ramifications associated with breaking the dollar peg that policymakers would need to weigh carefully before they decide to break the peg. In addition, it may be difficult for policymakers to tell if a significant decline in the U.S. dollar’s value is temporary or something that will accelerate. Therefore, Middle East leaders may be somewhat slow when deciding to end the long-standing policy of pegging their respective currencies to the U.S. dollar.
