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29 March 2024

GCC set to maintain dollar peg 'for now'

The GCC exchange rates would not become undervalued if the dollar depreciates next year but oil prices remain stable in the $70-80 per barrel range, says IIF. (AFP)

Published
By Nadim Kawach

Gulf oil producers will likely maintain a long-standing peg between their currencies and the US dollar before they decide on a new single currency for their monetary union, a key Western financial centre has said.

The Washington-based Institute of International Finance (IIF), which groups major Western banks, said the Gulf Cooperation Council (GCC) countries do not need to join China in its recent decision to float its exchange rate on the grounds they have different economic and financial systems.

In a study sent to Emirates Business, IIF listed several options for the GCC in determining a new currency for their monetary union, including a one-off revaluation of their exchange rates against the dollar, a basket of currencies, a floating exchange rate and a trading band.

“China’s recent move to allow more flexibility in its exchange rate has raised again discussions regarding the peg of the GCC currencies to the US dollar.

Unlike China, however, the GCC has not been under pressure to revalue or move to a flexible exchange rate regime,” IIF said.

It said that while a revaluation in China may narrow further the US trade deficit, depending on the extent of revaluation and structural changes in China’s economy, such a revaluation would not do so in the case of the GCC.

 It noted that the response of export and import volumes to exchange rate changes is very weak in the GCC, adding that the boom and bust cycles of oil prices transmit to the current account balances of oil exporters.

Its figures showed the GCC, which controls over 40 per cent of the world’s oil, experienced a sharp increase in current account surpluses amounting to $256 billion in 2008 compared to $426 billion for China.

These surpluses seem to have mirrored partly the deficit of the United States.

In 2009, as a result of lower oil prices, the current account surplus of the GCC shrank to $47 billion while that of China remained high at $297 billion

“Subsequent developments, with the onset of the global financial crisis and recession, appeared to vindicate the GCC authorities' position of staying with the peg. Commodity prices, including crude oil prices, fell sharply in the second half of 2008, domestic demand weakened, inflationary pressures started to dissipate, and capital started flowing out from the region,” IIF said.

“Since mid-2009, currency futures indicate that markets no longer doubt whether the peg will be maintained. Forward rates point to no change for the local currencies…GCC currencies are now broadly aligned with their fundamentals and we expect the peg to the dollar to be maintained.”

The report said it believes large excess capacity in the GCC, combined with the recent appreciation of the dollar vis-à-vis major currencies, will help keep average inflation in the region below four per cent in 2010 and 2011.
“Also, the GCC exchange rates would not become significantly undervalued if the dollar depreciates next year but oil prices remain stable in the $70-80 per barrel range. Our calculations show that the breakeven price of oil that balances the external current account for the region has increased steadily from about $40 per barrel in 2006 to about $60 per barrel in 2010,” it said.

“We share the view that the dollar peg is still the right exchange rate, at least until the GCC nations achieve monetary union when they can revisit their options. The peg (with the exception of Kuwait that has a peg to an undisclosed basket most likely dominated by the dollar since May 2007) has served the GCC economies well in supporting macroeconomic stability and private sector confidence.”

According to IIF, the peg is easy to administer and does not require the necessary institutions for implementing an independent monetary policy.

It stressed that the choice of the exchange rate regime has to take into consideration the structural characteristics of the GCC economies, including the importance of the oil sector in GDP, exports, and fiscal revenue.

“To be sure, fluctuations in the dollar exchange rate could induce inflation volatility, but do not destabilize exports and government revenues which are mostly dollar-denominated….the dollar peg also requires that the business cycles of the U.S. and the GCC countries are synchronized, which as happened in 2007-2008 may not be the case,” the study said.

“Nonetheless, the flexibility of labor markets, prices, and wages - due to a flexible supply of an expatriate workforce - ensures that any potential misalignment is addressed through price or labor force adjustments. In the GCC region, the latter adjustment is affected not through changes in employment of nationals, which has remained stable, but through the officially regulated immigration channel.”

IIF listed four currency options for the GCC members which launched the monetary union early this year - Saudi Arabia, Kuwait, Qatar and Bahrain. The other two GCC countries - UAE and Oman - have quit for different reasons.

“As the GCC approach the time when the monetary union will be established, it is likely that they will consider other exchange rate regimes, including a one-off revaluation and then staying with the peg to the dollar, an exchange rate regime based on a basket of currencies, floating exchange rate, and a trading band around the dollar exchange rate,” IIF said.

It said a one-off revaluation of the dollar peg poses short-term tradeoffs and over the long-term the potential cost of a less firm nominal anchor, creating greater uncertainty and raising the cost of transactions generally.

“A revaluation could provide a one-off alleviation of inflationary pressures in Saudi Arabia as it continued to be subdued in other GCC countries…but it could also induce losses for the public sector and institutions that are long in dollars, and reduce the local purchasing power of government revenues.”

As for a basket, IIF believed it could be a useful way to introduce some flexibility in the exchange rate although if dominated by the dollar, as it is most likely to be, would not offer much of a change.

“However, such an exchange regime poses short- and long-run tradeoffs and would take time to become fully credible. Basket regimes are usually less transparent than single currency pegs, so that gaining a full understanding of and confidence in the regime may take some time,” it said.

“A floating exchange rate would have the advantage of allowing the GCC countries to use monetary policy to smooth business cycles….this rate would also allow the countries to absorb large adverse real shocks more easily than a fixed exchange rate regime.

But moving to a flexible exchange rate requires building capacity to manage an independent monetary policy which could take a long time to achieve. A flexible exchange rate regime, could also lead to loss of credibility if the market were to expect instability in exchange rates during the transition to the monetary union.”

The study concluded that a trading band around the dollar exchange rate would require the private sector in the GCC to manage exchange rate risk and necessitate changes to the foreign exchange operations of the central bank “which may take some time to put in place.”