GCC heading for flexible exchange rates

Gulf oil producers are expected to start determining their exchange rates by market factors as part of a more flexible monetary policy away from their long-standing convergence with the US, a Saudi investment firm said onTuesday.

But the six Gulf Co-operation Council (GCC) countries, which control more than 40 per cent of the world’s proven oil deposits, need to first develop their financial markets and monetary instruments to control possible volatility, said NCB Capital, which is owned by the Saudi National Commercial Bank.

In its July economic bulletin, NCB Capital said it believed the peg between the GCC currencies and the US dollar has served their economies and achieved financial stability despite a surge in inflation during 2007-2008.

“As the GCC continues to grow in stature and economic diversity, greater monetary policy autonomy is over time likely to reassert itself as a key policy concern. This will likely eventually involve a move towards more market-led exchange rate determination,” the study said.

“However, success in this regard is conditional on deepening and further developing the regional financial markets and monetary policy instruments so as to control unnecessary volatility and to enable investors and traders to hedge against exchange rate risks.Moreover, reconciling these objectives with the agenda of regional economic integration remains essential.”

The study warned that a decision by the GCC nations to unpeg their currencies in the absence of a better alternative would risk resulting in “increased volatility and undermining some of the recent gains.”

It noted that with the fiscal convergence criteria already set mostly in line with the ones followed under the Euro treaty, the GCC Monetary Union and the common currency would serve well as a logical basis for greater exchange rate flexibility.

“However, the lessons of the euro crisis are of great importance for the Gulf economies especially when the aim is to replicate the numerous successes, rather than the failures, of EU integration,” it said.

“A clearly defined and comprehensive regulatory framework is of particular importance in this regard. After all, the key drawback with the EU was not a lack of rules but their incomplete implementation and ineffective enforcement.”

NCBC called for proper monitoring and enforcement mechanisms in the GCC to ensure that economic imbalances are detected and remedial measures taken before they problems can pose systemic risks.

“This is especially important in the face of structural price pressures, such as import shock or real estate shortages….. monetary integration, properly managed, can become an instrument for pre-commitment, further enhancing the drive for economic flexibility in line with the region’s tradition of technocratic, strategically anchored policymaking.”

The report said inspite of periods of strain, mainly during 2007-2008, the dollar pegs have generally served the GCC economies well.

It said the peg had created the basis for what it described as a consistent and transparent monetary policy and acted as an anchor for macroeconomic stability.

More recently, with efforts to boost the business climate, the pegs have reassured foreign investors who have significantly increased their presence in the region, according to the study.

“In spite of these compelling benefits, the inflationary bout of 2007-2008 triggered a vocal debate about the sustainability of the current system. Detractors of the fixed rate regime point to its ultimate unsustainability in an environment of rising inflation, long-term pressures weakening the US dollar, and widening divergence between the GCC and the US economic cycles,” it said.

“As much as the global picture is shifting in favor of greater exchange rate flexibility, the Gulf in our view still constitutes an important near-term exception to this. At present, it is far from clear that the policy alternatives – most notably a peg to a basket or a managed float – offer significant net benefits overthe current arrangement given the trade profile and level of financial market development of the GCC countries…. nonetheless, the growing stature and diversity of the region will over time almost certainly militate for increased monetary policy autonomy. However, this should not be permitted to compromise the regional drive for greater economic integration.”

The study said it believed that under the circumstances, the GCC currency union still offers the most attractive and logical opportunity for reconciling the two goals.

It said the global economic downturn, which has also hit GCC economies, has also underscored the benefits of the Gulf dollar peg.

“In addition to echoing the loose monetary stance of the US Federal Reserve, the GCC central banks were free to focus their efforts of key stress points rather than exchange rate management in the face of considerable oil price volatility,” it said. 

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