As ‘dollar bloc’ comes apart, policymakers brace for trouble

A clean break in the renminbi’s link to the dollar, which has existed since China started opening its economy in the late 1970s, would herald the demise of a “dollar bloc” that has dominated global finance for decades. While this would not necessarily displace the dollar as the world’s main reserve currency, it would significantly reduce the U.S. Federal Reserve’s (the Fed) role as a global monetary superpower, writes World Review expert Lars Christensen. On December 11, 2015, the Chinese authorities unveiled a trade-weighted index to track the renminbi’s movements against 13 foreign currencies. Financial markets saw this announcement as a clear signal that the People’s Bank of China – the country’s central bank – would strive to keep the currency stable against the basket, rather than continuing its long-term policy of shadowing the U.S. dollar. Ultimately, this relaxation of the dollar peg could be China’s first step toward adopting a floating exchange rate. The official policy of shadowing the dollar meant that the Fed has been setting monetary conditions in China for at least 35 years. In a nutshell, for decades the world’s two largest economies have been operating in a quasi-currency union. Among the members of this unspoken union are the Persian Gulf States, which (with the exception of Kuwait) all peg their currencies to the dollar. The most important of these is Saudi Arabia, which has maintained the riyal in a hard peg to the dollar since 1986. Hong Kong has used a currency board to manage its own hard peg against the dollar. In Africa, Angola also retains a fixed exchange rate against the greenback – even though it was forced to undertake a major devaluation in 2015. The “dollar bloc” began to break up nearly two decades ago, when the Asian crisis of 1997 forced countries like Thailand and South Korea to give up their pegs, followed by Russia and Turkey during their crises of 1998 and 2001, respectively. Nevertheless, many Asian countries continue to shadow the dollar, at least indirectly, and have not yet moved to completely free-floating exchange rates. While most African countries have given up their dollar pegs, there is still a considerable “fear of floating.” This prompts central banks in many emerging markets to manage their currencies so tightly that these countries can be counted as “associate members” of the dollar bloc, effectively importing their monetary conditions from the U.S. Hence, if the Fed tightens monetary conditions and the dollar strengthens, the dollar bloc’s “associate members” might not let their currencies depreciate. Instead, they often try to curb the sell-off by raising interest rates and/or intervening in the currency market. This is exactly what we have observed over the past two years, as a strengthening U.S. dollar forced a sell-off in emerging-market currencies. Central banks tightened monetary policy in response, even though this is not necessarily what the state of these economies called for. Indeed, dollar-peg countries like China, Hong Kong and Saudi Arabia have been forced to follow suit. The Federal Reserve’s status as a global monetary superpower has caused U.S. monetary tightening to be exported to large parts of the global economy. This may ultimately prove to be the dollar bloc’s undoing. Take the oil-exporting Gulf States. Most of these countries have linked their currencies with the dollar and for three decades have had a very easy time defending their pegs. That situation has changed dramatically. Monetary conditions are tightening significantly, just when these countries need monetary easing to cushion the sharp drop in oil prices. To make matters worse, the Gulf States are facing fiscal troubles as oil revenue shrinks. Some now face the difficult choice between severe austerity measures to avoid insolvency or abandoning their dollar pegs. For a more in-depth look at this subject with scenarios looking to future outcomes, go to our sister site: Geopolitical Information Service. Sign in for 3 Free Reports or Subscribe.

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