In our last lesson we discussed the main factor which will determine whether or not the US Dollar remains the king of the currency world; its status as the world's reserve currency. In today's lesson we are going to continue this discussion with a look at how countries who peg their currency to the US Dollar have a large affect on whether or not the US Dollar remains the reserve currency of the world.
One of the main reasons why many countries hold so many US Dollars, is so they can use those dollars to fix the value of their currency to the US Dollar. They do this to try and give their currency and economy more credibility, which they hope will lead to a more stable economic environment, and/or to keep the prices of their goods low in comparison to other countries, so their exports will be competitive.
As a quick example lets say that country A pegs their currency at a value of 1 to 1 with the US Dollar. While it is all fine and dandy for country A to say they are pegging their currency to the US Dollar at 1 to 1, it is still the market that sets the true price of Country A's currency in relation to the US Dollar. Because of this, country A has to "defend" its currency peg, by buying its own currency and selling US Dollars when the value of their currency weakens below a 1 to 1 rate, and by selling their currency and buying US Dollars when it strengthens above the 1 to 1 rate. Here is a simple illustration of this:
As some of you who are a little more experienced in the markets probably know, some problems can arise with the above scenario, and there have been many examples in history of countries who were not able to hold their currency pegs. Probably the most famous example of this is referred to as Black Wednesday, when the famous speculator George Soros was credited with forcing the Bank of England to abandon their currency peg, causing the British pound to fall over 25% relative to the US Dollar in a matter of weeks.
So what does all this have to do with the US Dollar's Status as the world's reserve currency? Well, one of the main reasons that countries have in the past chosen to peg their currencies to the US Dollar, is because of the relative stability of the US Dollar in relation to other currencies. It is important to understand that not only do the currencies of countries who peg to the US dollar fluctuate in value along with the US Dollar, but their own monetary policy is basically tied to the monetary policy in the United States.
This is all fine and dandy so long as the monetary policy of the United States is considered sound, and so long as the currency does not fluctuate in a manner that adversely affects the economy of the country pegging to the dollar. Problems arise however when the dollar fluctuates in a way that adversely affects the economy of the country with the peg, and/or the monetary policy of the United States is set in a way that is not beneficial to those same countries.
There is a perfect example of this going on as of this lesson, with oil producing countries in the Middle East. As the price of oil has been high for so long, the economies of countries such as Saudi Arabia are booming, and money is flowing into those countries at a rate never seen before, creating all sorts of demand for the Riyal (Saudi Arabia's Currency). At the same time, the United States, the currency of which Saudi Arabia pegs their currency to, is going through an economic slowdown.
So what you have here is a situation where, if anything, monetary policy should be tightening in Saudi Arabia, and their currency should be strengthening. As their currency is pegged to the US Dollar however, they are affected by the loose monetary policy of the United States, throwing fuel on an already hot economy, and weakening their currency when it really should be strengthening. As we learned in our lessons on monetary policy in module 8 of our basics of trading course, this is a recipe for massive inflation, which it seems they are starting to see signs of now.
Scenarios such as this can cause countries to abandon their currency pegs or switch the currencies that they peg to something which is of major importance to the status of the US Dollar as the World's reserve currency.
There are many different scenarios such as the one above which can arise from countries who peg their currency to another. It is important for us to have a fundamental understanding of how to spot these scenarios, as whether or not countries continue to peg their currencies to the US Dollar, or move to a basket of currencies or another currency all together, will have huge affects on the value of the US Dollar going forward.
That's our lesson for today. In our next lesson we will wrap up our discussion on the US Dollar with a look at the final factors to consider when eying the status of the dollar, so we hope to see you in that lesson.
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