Thursday, September 20, 2007

Saudi Arabia To Drop Dollar Peg?

The parity between the U.S. and Canadian dollars happened even faster than I expected, as the Canadian dollar briefly traded above its U.S. counterpart today, with the U.S. dollar continuing to collapse against most other mayor currencies as well, not to mention gold and other commodities.

Behind the U.S. dollar meltdown is not only the direct effects of the rate cut, but also a rumour that Saudi Arabia and the other Gulf States might drop their dollar pegs.

Even before the rate cut, the peg created very strong inflationary pressures in Saudi Arabia and the other Gulf states for much the same reason as why China's semi-peg to the U.S. dollar is creating strong inflationary pressures in China. Namely, the central banks were forced to expand their balance sheets so they can accumulate enough foreign exchange reserves to prevent their currencies from rising. The Fed rate cut will aggravate the problem greatly and make the pegs even more irrational and unsustainable than in the past. Now speculations are growing that they will drop the peg, or at least make it less strict like Kuwait has already done. If it happens, the dollar's decline would quickly accelerate.

Given the extreme inflationary pressures in Saudi Arabia, dropping the peg to the U.S. dollar and allowing their currency to rise against it would clearly be in their economic self-interest. Not doing so risks causing them serious problems. The only thing holding them back is likely the fear that the U.S. government will consider it a hostile move.


Blogger Flavian said...

One reason for Britain's run-away inflation in the early 1970's might have been that nobody wanted to keep Sterling as reserve currency.

If the same happens with the dollar, inflation might get out of hands.

I think this is a difficult field and I do not know enough about how and why inflation got out of hands in Britain in the 1970's, but it easy to understand why an increasing number of central banks do not like to hold such junk as the US dollar.

9:29 PM  

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