FX pegs: Faith no more
The SNB's removal of its currency floor with the euro and a rising greenback call into question the strength and wisdom of currency pegs elsewhere, especially in the Gulf and Hong Kong.
The Swiss National Bank’s shock exit from its minimum-exchange rate policy with the euro – combined with the strengthening dollar – threatens to dent market confidence in the integrity of FX regimes from Hong Kong to the Gulf in the coming years, while upending conventional monetary wisdom.
Markets were convulsed mid-January when the SNB ended its three-year cap to the euro – originally designed to address deflationary pressures caused by a strong franc – in a bid to ward off hot-money flows. Tellingly, the arrangement was brought to an end by the SNB itself, rather than by market speculators. After all, in theory, the SNB could joyously print unlimited Swiss francs, backed by its ample foreign-exchange reserves.
Instead, the central bank prioritized financial-stability concerns – a desire to downsize its balance sheet, which had ballooned to defend the CHF peg – over real-economy growth. In effect, the SNB’s FX policy bind reflects the age-old emerging market challenge of maintaining monetary autonomy amid financial globalization.
Mercifully, most emerging markets (EMs) that still operate currency pegs have built up ample foreign-exchange reserves – a lesson from crises of yesteryear – while few hedge funds are actively mulling ‘break-the-peg’ speculation trades in the near-term.
Instead, the impact of the SNB’s move and an ever-strengthening dollar will be felt in the coming years by a more general knock to market confidence in the stability of pegs. It will also ignite calls for a debate about the integrity and costs associated with such regimes.
Diverging economic cycles in Hong Kong and Gulf Co-operation Council (GCC) countries with that of the US, for example, call current dollar pegs into question. A strengthening dollar and Fed-rate hike could burst asset price bubbles in Hong Kong amid likely capital outflows from western investors – a direct consequence of a mechanistic dollar peg – without fiscal redress and offsetting capital flows from China. Hong Kong, therefore, is in a bind. China drives its real GDP, while US drives money growth.
Now is the time for a debate about the HKD’s peg to the dollar, and the benefits of a RMB peg, before the Chinese currency becomes fully convertible.
What’s more, while the GCC is unlikely to de-peg or devalue over the next two years – given the region’s huge reserves – lower oil prices will test regimes in the six nations of the grouping with pure dollar pegs. Kuwait on the other hand has benefited since 2007 from a more-diverse currency basket.
While the GCC has imported loose monetary policy from the US since the global financial crisis, a Fed rate hike will serve as a disinflationary force at a time when the Gulf region is entering a slowdown and rising deficits brought on by a $70 collapse in crude prices over the past seven months.
Of course, for now, regimes in the GCC are backed by huge FX reserves, public support, while interventions are made explicit on an ex-ante basis, in stark contrast to the SNB’s former, and ultimately unsustainable, policy of discretion in its currency floor with the euro.
But prolonged weakness in oil prices, a tighter Fed policy, lower surpluses and the need to boost exports all suggests the GCC would benefit from a more flexible monetary framework, such as a currency basket, in the years ahead.
Although central bankers are creatures of comfort, the SNB’s actions highlight how shifting regimes can shock and roil financial markets in equal measure.