Different economies have different exchange rate policy needs. Approximately two-thirds of countries have a fixed / pegged exchange rate, with developing countries particularly favouring a peg to import monetary credibility (amongst other reasons). For more complex and growing countries with economic diversification targets, a floating exchange rate provides greater flexibility to shocks and structural changes, as well as avoids traps associated with disequilibrium of rates.
Oil exporters – even if they are economically advanced – often peg their exchange rate – and especially to the global reserve currency (i.e. US dollar). Every Gulf Cooperation Council (GCC) country anchors its exchange rate to the oil-pricing currency (the US dollar). The lone exception is Kuwait, which pegs to a basket of currencies. There are several key justifications for oil exporters wanting to maintain a peg, particularly to the US dollar. First, they receive revenues from oil sales in US dollars. Second, if they are developing countries they can import the monetary credibility of the anchored nation. Third, if they are small countries, adopting a floating currency may lead to greater vulnerabilities to large swings in the exchange rate.
However, the recent double shock from the fall of oil prices and COVID-19 has increased the importance for countries to consider their exchange rate regime. While the US dollar retains strong advantages as a peg – for example, oil is invariably priced in US dollars as is a majority of global trade – there are alternatives to consider. For example, one argument is to create an anchor that is a basket of both foreign exchange and commodities (i.e. oil). Adding commodities helps to reduce economic volatility, and adding additional currencies, particularly those of its main trading partners(such as Asian economies in the case of the GCC)may also reduce risk. Whatever is ultimately decided for an oil exporter’s exchange rate policy, oil exporters pegged to the dollar should build their positions in alternative relevant currencies and start the task of discreetly exploring the mechanisms and implications of adding oil as a reference in their basket. This may help prepare for an “unexpected” day when exchange rate regimes change.