Global Glance: June 20, 2016
A quick look at intriguing international stories
By John Bostwick, Managing Editor, Radius
Welcome back to Global Glance. This week we look at:
Currency Pegs Explained
Nigeria has been in the news recently for its currency woes. But before exploring that subject, let’s put the horse before the cart and give a brief refresher course on currency pegs.
Many countries fix or “peg” their national currencies to another currency (such as the US dollar or euro), in large part to provide stability against potentially large swings in domestic currency valuations. An article in The Economist titled “Pegs Under Pressure” explains the lure of currency pegs: “Many big oil exporters peg their exchange rates to the dollar because oil is priced in that currency. Anchoring a country’s exchange rate to another, stable currency allows a weak central bank to latch on to the credibility of a stronger institutions, and so keep inflation expectations steady.” (Countries that don’t peg are said to allow their currencies to “float freely” in the global marketplace.)
A 2010 article in The Wall Street Journal summarized how, at that time, China managed its currency by pegging it to the US dollar. In a common hypothetical scenario, the Journal imagined a US company seeking to build a factory in China, for which it must pay using the local currency, the Chinese yuan. The company buys the yuan from a local bank, a transaction that, under a free-floating currency system, would drive up the value of the yuan. In this case, however, where the yuan is pegged to the US dollar, the local Chinese bank sends the US dollars to the People’s Bank of China (i.e., the nation’s central bank), which in turn sends the local bank the equivalent in yuan. “Where,” the Journal asks, "does [the central bank] get the yuan it uses to pay the banks for the US dollars? It prints them.”
That’s just one scenario, of course. As Bloomberg.com explains: “To hold most pegs in place, central banks must deploy foreign reserves, buying and selling in currency markets in a battle with traders to keep exchange rates stable. If pressure builds, they’ll be forced to give up. The peg will slip or break.” In other words, while countries introduce currency pegs to promote stability, factors such as traders betting against pegged currencies can weaken and even destroy that stability. In addition, an Economist article titled “A Peg in a Poke” observes: “Pegs require a lot of discipline. If monetary policy in the target country changes, the pegging country has to follow suit, regardless of the consequences. Other economic priorities have to be subordinated to the currency target.”
The first Economist article mentioned above outlines some of the other risks associated with pegging currencies. It explains that if a nation with a currency peg experiences a sharp downturn in the price of one of its primary exports — such as a drop in oil prices for an oil-exporting country — then an import-export imbalance can result, which will ultimately lead to a depreciated domestic currency. The Economist goes on: “The danger of a peg is that rather than allowing the exchange rate to adjust gradually, imbalances build up. Speculators spot the problem and attack the currency; if the country has to push up interest rates to defend the peg that hurts the underlying economy, but devaluing brings potential ruin to companies that have borrowed in foreign currency.” Some countries in this situation, “build huge reserves to ward off speculators, as Saudi Arabia has done,” but “other pegs have been buckling under global pressures.” Which brings us to the situation in Nigeria.
Nigeria Abandons Peg
Last Wednesday, Nigeria’s central bank announced that it would abandon its practice of pegging the naira to the US dollar effective today. The peg was introduced in Nigeria — Africa’s second-largest crude producer behind Angola — early last year in response to falling oil prices. A Reuters report indicates “Nigeria's central bank previously pegged the naira at 197 to the US dollar but the currency trades at about half that on the black market as [a] slump in oil revenues has hammered public finances and foreign currency reserves.” Reuters adds that after the announcement some economists estimated the free-market value of the naira is “between 280 and 300 against the dollar, although the black market rate is around 370.”
According to Reuters, Nigeria’s policy transition can be described as a “managed float,” with Nigeria’s central bank appointing eight to 10 primary dealers that “will be allowed to sell back 70 percent of any dollars bought from the central bank on the day of purchase.” A Quartz article indicates that the central bank will “periodically intervene in the market” to bolster the value of the naira. Details on the foreign-exchange process can be found in the central bank’s revised guidelines.
Quartz indicates that Nigeria’s decision to remove the peg “has been largely welcomed” after Nigerian authorities’ previous “stubborn refusal to devalue the currency in the face of dipping revenues as a result of the sharp drop in the price of oil, the country’s main resource.” A Wall Street Journal article echoes this, noting, “Economists have long argued that holding the naira’s value unnaturally high was only making critical imports like fuel and food even more scarce.” The Journal explains that Nigeria’s currency challenges are compounded by other domestic problems, including terrorist attacks on oil pipelines and rigs as a result of dissatisfaction with President Muhammadu Buhari.
BBC.com also analyzed Nigeria’s announcement last week, including Nigerian authorities’ previous steadfastness in the face of calls to remove the peg. President Buhari “wanted Nigerian businesses to make what they could not import and to diversify the economy away from the oil industry,” but that the peg “policy led to widespread shortages of raw materials, machine parts and supermarket products.”
Removing the peg and altering the exchange rate will, the article indicates, come as a relief to local businesses “that were forced onto the black market to pay for their imports. On occasions they were paying almost double the official rate for dollars.” BBC.com adds that foreign investors may also be attracted by the changes. The article cautions, however, that “the new exchange rate is likely to push up already high inflation. And that will hurt tens of millions of Nigerians who live in abject poverty.”
The Success of the East African Community
The East African Community (EAC) is an intergovernmental organization with six partner states: Burundi, Kenya, Rwanda, South Sudan, Tanzania, and Uganda. According to the EAC website, the organization was established in 1967, dissolved ten years later and then reestablished in 2000. The EAC partner states have implemented a free trade zone across all countries, and the organization is working to implement a single currency as well. The EAC’s broad goals include improving the political, economic and social environments of the bloc.
In addition, the website’s homepage indicates (a shade sinisterly) that EAC partner states envision “coming together to form a super-state under a single political authority/government.” The website adds reassuringly that “attainment of the [unified EAC] Political Federation is a process and not an event.” Moreover, the EAC goes on, after “wide consultations” it has become clear that “East African citizens want to be adequately engaged and to have a say in the decisions and policies pursued by the East African Community.” In other words, I guess, a single EAC political authority won’t be formed any time soon.
In the meantime, The Economist ran an article on the successes of the EAC so far, as described in a recent research paper released by the International Growth Center titled “Preferential Trade Arrangements and the Pacification of Eastern Africa.” According to the study the customs arm of the EAC has been particularly successful, increasing bilateral trade by 213%. These trade gains have, in turn and according to a summary of the report, “translated in welfare improvements and stability. Real GDP is estimated to have risen by 0.45% in the EAC, and the statistical risk for bilateral conflicts between members decreased by 12%.”
The Economist explains that the study’s authors — Thierry Mayer and Mathias Thoenig — are less sanguine about the EAC’s project to implement a common currency by 2024. The report summary indicates that the single-currency project would likely produce only small gains in the areas of trade and welfare “that may not justify the risks and costs associated with it.” The Economist notes that a 2015 IMF study found that east African economies “move out of sync with each other, using exchange rates to absorb shocks.” In the absence of greater partner-state integration, a common currency “would mean that wages might have to do the work of adjustment, as Greece has become painfully aware.” The euro crisis, The Economist adds, should give EAC policymakers “pause for thought” when proceeding with the common-currency plans.