The currency trap

There is a lot of talk these days of floating the region's local currencies. I have yet to come across someone knowledgeable in finance or economics who has not thought it is an excellent idea. Is it? I am not so sure.

There are two types of people who love the idea of de-pegging our local currencies to the US dollar. The first are those who are in it simply for greed: Once the currency floats, they can make a bundle of money playing currency market fluctuations by spotting gaps in demand and supply, filling it as the market demands.

The second type of people who would like to de-peg are the idealistic. Our sense of pride in our country and the sense of denigration at not being in control of our fiscal destiny is a powerful driver for such people.

I must admit that until I truly thought about it and considered the shock that our pride may bring to our economies if we de-peg, I fell into this category. Why we should not de-peg?

One of the greatest economical crises that we, people who have been financially active in the last past 20 years worldwide, faced was the 1997 Asian Financial crisis that took down the Asian Tigers.

This happened because these countries decided to focus their economies on exports to grow. They followed all the rules that economic growth dictated that they follow to achieve a sustainable high growth rate.

They aimed high and built like there was no tomorrow. Until the crash, they were the envy of the world.

Their secret to success was to keep on injecting their trade surplus into US dollars either through continuous trade with the US at ever higher rates year on year or through the purchase of US Government bonds. They also educated their people and encouraged national savings. So what happened?

Sadly success, if not tempered, breeds its own downfall. These economies had overvalued stock markets, extremely high property markets and a significant amount of foreign monies pushing these markets ever higher.

As property and stock prices kept rising, cautious and more seasoned investors started to think that the growth was not only unsustainable but worrying. Then the tipping point came and all hell broke loose.

Investors were abandoning these investments in droves. Some legitimately, others for more sinister reasons. Never discount the thought that some governments will sabotage others if they feel threatened.

The natural thing to do when you sell an asset in a different currency is to convert the money back into your own. This meant a great demand on the foreign currency while the local currency was dumped.

This led Malaysia to immediately freeze its currency float, much to the annoyance of the US, to protect its own economy after seeing what was happening to its neighbors.

It saved Malaysia in the short term but they were punished in the long term when the US returned its investments to other states while neglecting the Malaysian market.

We have nearly all the symptoms of the Asian Tigers - a great influx of foreign money into our stocks and property markets; a lively stock market; a white hot property market; double digit economic growth.

If we de-peg we will be asking for trouble. Imagine if liquidity is withdrawn in such a massive quantity from here; what would happen to our economy?

We like to think that we are immune and I am sure that the people in the Asian Tiger countries thought that they were as well.

The main difference was that they had a highly educated population and a good national savings scheme to see them through the crisis. We are just starting both.

Most people think that I am negative when I say or write things. I would too. However, as a businessman, I have learnt that the way to survive is to hope for the best, but plan for the worst.

Mishal Kanoo is the deputy chairman of the Kanoo Group. It is one of the largest family owned companies in the Gulf. The Kanoo family is the 11th richest in the Arab world with a fortune of US$6.1bn.

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USER COMMENTS (2 COMMENTS)

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money must have some kind of value
Posted by Ivo Cerckel, Siquijor, Philippines on Monday 23 June 2008 at 12:26 UAE time


There is perhaps a third type of people who love the idea of de-pegging our local currencies to the US dollar because they think that money, as a means of exchange, should have some kind of value. The US dollar has none - which explains perhaps why food and oil prices are going oil of hand on international markets where they are indeed denominated in US dollar.

Interesting points
Posted by Trevor Skinner, Dubai on Sunday 22 June 2008 at 18:14 UAE time

I was a trader in a large American bank in London during the 1997 Asian crisis. I remember it very well...the trigger was the Thai Baht floating in response to a huge foreign debt burden. The subsequent devaluation had those who had borrowed US$ to fund their projects trying to cover..the panic spread to other Tiger economies and the rest is history.

I must admit that I consider myself reasonably knowledgeable about capital markets and hold the contrary view. I do not think that de-pegging at this stage will have the desired effect. It may have been an option 3 or 4 years ago but given the current environment the cure may be worse than the disease. What is often conveniently left out of the de-pegging argument is the subsequent inevitable substantial increase in interest rates to a level that it encourages the savings function and discourages credit expansion. In the current environment within the GCC that is likely to be in excess of 10% (and that's on a wholesale basis). Imagine the effect on those booming real estate and stock market?

The other impediment to a floating rate environment is the lack of capital market sophistication in the GCC and the lack of tools that central bank's use globally to control liquidity and, consequently, the money supply. If you have a floating currency (variable) you have to keep something constant, or at least controlled!! Even if the effort started today it would take some years to build the necessary capacity.

The other oft-quoted option is a peg against a basket of currencies. In real terms it has only a marginal effect...it provides some relief to the small amount of inflation caused by a weaker dollar but very little otherwise.

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