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BizDay Zimbabwe

The Dangers of a Dollar Peg

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Over the last few months the US Fed has been strongly hinting that it is looking to reduce its QE (Quantitative Easing) policies. This has been driven by the fact that the US economy seems to be growing moderately and may no longer require the extraordinary support that the US central bank has been supplying. This decision is based entirely on US factors, but its implications will be felt throughout the world.
We have already begun to see money flows around the world adjust to the news. QE reduced interest rates, allowing banks and other institutions a virtually unlimited supply of money at virtually no cost. This allowed them to make immense amounts of money by borrowing in the US and send the money to the developing world where returns were higher. If QE tapers off, then this flow of money will not only stop but also reverse. We have already seen emerging market currencies fall dramatically over the last few months. In countries as diverse as Turkey, India and South Africa have seen their currencies hit multi-year lows versus the US Dollar.
A sharp drop in a country’s currency is usually viewed positively as it raises the cost of imported goods and thus inflation. However as with most things in economics there are two sides to the coin. A weaker currency also helps a country adjust to a changing global environment. It reduces the costs of exports and increases the costs of imports giving local companies an immediate competitive advantage. This will serve to increase exports relative to imports which will benefit the balance of trade. In addition local employment is likely to rise to produce more exports and to compensate for the drop in imports.
If your currency is pegged, however, then this adjustment mechanism does not work. In a recent real world example, Greece suffered a large recession without an accompanying drop in its currency. Many analysts believe that had the Greeks not been part of the Euro, they would have recovered much quicker as the weaker currency would soon have stimulated their economy back into growth.
In an environment in which other countries are having depreciating currencies and you do not, the situation is even worse.   You are losing competiveness as your currency gains relative to your trading partners. This year alone, manufacturers who operate in Rands may have gained as much as 20% in terms of competitiveness vs those that operate in Dollars.

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