To Peg or Not To Peg, That Is the Question

 

                                            Photo credit: Trade Finance Global

The other day, I was following a conversation on some whatsapp group that I am in; one of those riotous whatsapp groups with more than its fair share of pseudo intellectuals. You know them. They are “Prof” or “Dr” so and so on their user names and they type ferociously and incessantly any time of day, veritable key board “warriors”. They punctuate the long paragraphs that they send with big words like sesquipedalian or verisimilitude and will be quick to dismiss anyone who questions their profound ‘intellect’. The prevailing discussion in our whatsapp group was about the Kenyan shilling whose value against the US dollar has been in a downward spiral for more than a year now. In response to the ensuing debate, a one Prof Robert Einstein suggested that to manage the uncertainties that come with a weakening currency, our Central Bank ought to peg the Kenyan shilling to the US dollar. He argued that pegging the Kenyan shilling on the invariably stable US dollar would among other benefits, make trade more predictable as well as keep inflation in check. According to him, there is no alternate saving grace for the falling shilling which led him to quip, “To peg or not to peg, that is the question.”  

Currency pegging refers to a situation where one currency’s value is attached to another currency or a pool of currencies or another measure of value such as gold. Most often, currency pegging is used as fig leaf for a fixed exchange rate. For example, if the Kenyan shilling is pegged to the US dollar at the rate of ksh. 80, it means that one US dollar will exchange for Ksh. 80 no matter the prevailing circumstances. To maintain this peg, the Central Bank would have to control the value of the shilling so that its value rises and falls with the value of the dollar. It would use monetary tools to do this. If, for example the value of the shilling falls below the peg, the Central Bank would have to raise the shilling’s value and consequently lower the dollar’s value. This means, it will have to use some of its dollar reserves to purchase Kenya shillings on the open market. This purchase of the shilling reduces its supply causing its value to jump and the peg is restored.

            What is the rationale for pegging currencies?

Bretton Woods deliberations in 1944 saw the US dollar established as the world’s most foremost currency taking the mantle over from the Sterling pound whose value had nose-dived after Britain’s economy was wrecked by the World war 2. Since then, most financial transactions on the global scene as well as global trade are carried out in US dollars. This is one of the primary reasons why some countries such as Malaysia and Singapore prefer to have their currencies pegged on the dollar.

Countries that are net exporters to the US also prefer to peg their currencies on the dollar so as to maintain competitive pricing. By pegging, these countries try keep the value of their currencies lower than the dollar since that makes their exports to the US cheaper.

Oil exporting nations such as Saudi Arabia, Kuwait and the UAE prefer to peg their currencies on the dollar since oil is predominantly traded in dollars. Additionally, most Caribbean countries whose economies are heavily dependent on tourism such as the Barbados, Bahamas and Bermuda tether their currencies to the dollar which makes their economies less prone to attacks.

Pegging currencies comes with several benefits. Firstly, currency pegging proffers a stable basis for planning. For countries that purchase essential commodities such as oil and grains from the international market, pegging makes it possible to fix the exchange rate thus iron-cladding the given country in times of volatility. This enables the government to plan for revenues and expenditures without having to worry about currency volatility.

Secondly, pegging helps to ring-fence monetary policy discipline in countries that are floundering on that front. A perfect example of a country whose monetary policy has failed the test in the recent past is Zimbabwe under Mugabe’s reign. In response to rising national debt, Mugabe’s government opted to increase the money supply thus instigating hyperinflation and a constellation of other economic shocks. To stem the occurrence of such scenarios, susceptible nations prefer to peg their currency to a more stable currency meaning their monetary policy becomes somewhat outsourced since they will be bound to follow the interest rates regimes of the country onto which their currency is pegged on.   

Thirdly, and the most obvious of reasons is that currency pegging helps to stem its volatility. On this front, both government and business owners stand to gain. Business owners are able to predict how their goods will be priced on the international market as well as predict the demand of their goods and services.

On the flip side however, pegging currencies comes at a cost. A country that has its currency pegged onto another looses autonomy of its monetary policy. A good example is that of the Hong Kong dollar that has its currency pegged to that of the US dollar. What that means is that, the Hong Kong Central Bank has to follow interest rates set by the Federal Reserve in the US. In the wake of the recession in US in 2008, the Federal Reserve had to lower interest rates and given that the Hong Kong dollar was pegged to the dollar, the Hong Kong monetary authority was also forced to maintain low interest rates even though Hong Kong’s economy was booming and it would have been preferable to raise interest rates so as to manage inflation.

In the 1980’s former UK Prime Minister Sir John Major’s government  in its wisdom or lack of it, opted for the British pound to be pegged to Germany’s Deutsche Mark in the hope that pegging to the Deutsche mark would supposedly import Germany’s monetary policy and help subdue Britain’s rising inflation. However, shortly thereafter, Germany experienced economic difficulties of its own leading the German Bundesbank to hike interest rates so as to curb inflation. Having already pegged its currency to the Deutsche Mark, the Bank of England had to move in tandem and raise its own interest rates too piling even more pressure on the British economy causing it to enter a recession in 1991. The aftermath of it is that in September 16, 1992 the British pound was ejected from the exchange rate mechanism (ERM) of the European Monetary System- causing Briton’s to infamously christen September 16,1992 Black Wednesday.

The other disadvantage of pegging a currency to another is that you would have to hold large reserves of the currency onto which you are pegging to. In the event that these reserves are depleted chaos could unfold. The more the currency reserves there are, the bigger the monetary supply which predisposes an economy to inflation.

            Which way for Kenya?                         

Yesterday, the Kenyan shilling hit 124. 0765 against the dollar- a new record low. What this means is that that the cost of importation (Kenya is a net importer) is set to jump which might also drive up inflation.

To add salt to the injury, the costs of debt repayment (our foreign debt is largely denominated in US dollars) is also set to jump. To put this into perspective, in the fiscal year 2020/2021 the Kenyan government had indicated that it would spend Kshs 154.6 billion in debt repayment.  Experts had projected that in the event that the Kenyan shilling depreciated by 1% then our foreign debt interest repayment obligations for that financial year would jump by Kshs 15.5 billion

Presented with the above facts, could Prof Robert Einstein have been right? Is pegging our currency to the US dollar the right way to go?