Gulf nations may opt first for dollar in currency union

Four Gulf nations entering the Middle East's first monetary union pact are expected to peg their single currency to the US dollar in the first phase of the historic project but might opt for a basket later, according to analysts.

Saudi Arabia, Kuwait, Qatar and Bahrain, members of the six-nation Gulf Co-operation Council (GCC), have kept the world guessing on what type of currency they would adopt for their monetary union, which was ratified by their heads of state at their annual summit in Kuwait in mid-December.

But there have been strong official signals that the four countries would not veer away from the US dollar in the first years of the monetary union.

And some of them have indicated that even if a basket of currencies is selected, the US dollar would be its dominant component.

"My feeling is that the Gulf currency would be pegged to the US dollar in the first stages of the monetary union because it is the official price of their oil exports, which account for the bulk of their exports… a large part of their foreign assets is also denominated in dollar," said Mohammed Al Asumi, a Gulf economist.

"A basket of currencies in the early stages of the union would create several technical difficulties for them in their currency and fiscal policy alignment… I believe that a basket could be chosen at a later stage but I am confident the dollar will have the lion's share, say at least 60 per cent of its components."

Gulf central bank

The central bank governors of the four Gulf states will meet in Riyadh soon to create the GCC Monetary Authority, which will pave the way for the establishment of a common central bank to manage their currency union.

The meeting in the next few weeks will cover steps to implement the union, including the formation of the Gulf Monetary Authority (GMA), said Nasser Al Qaoud, the GCC's Deputy Undersecretary for Economic Affairs.

"The meeting will be held within the next few weeks and it will cover the establishment of the GMA and naming of its members… I expect the GMA will be set up within the next two months," he said.

"The GMA is the first actual step towards the full implementation of the monetary union… the GMA's functions include the establishment of a common GCC central bank to be based in Riyadh and enjoy full autonomy. The basic functions of the central bank will be to devise and implement the union's monetary policy and exchange rate policy. The GMA will continue to operate until it is replaced by the central bank once it is created and becomes fully operational."

The currencies of Saudi Arabia, Qatar and Bahrain are pegged to the dollar while Kuwait detached its dinar and linked it to a basket last year in a bid to tackle soaring inflation, caused mainly by the weakening US currency. Experts said Kuwait could revert to the dollar should its partners in the union opt for a dollar peg in their single currency, which could be launched in 2015.

"Preparation for the full enforcement of the GCC monetary union will start next year and a common Gulf currency would materialise in 2015," Abdul Rahim Naqi, Secretary-General of the Dammam-based Federation of GCC Chambers of Commerce and Industry, told Emirates Business.

The UAE, the second largest economy in the 28-year-old Gulf alliance, pulled out of the currency union early this year. Oman opted out in 2007 on the grounds it is nor ready for the project.

Dollar dominates

"I agree. The proposed Gulf currency will be pegged to the US dollar at the beginning because it is the official price of the GCC oil and gas exports and most of the region's assets abroad are in US dollar," said Mohammed Malick, Senior Economist at the Saudi National Commercial Bank (NCB).

"I believe they could adopt a basket at a later stage… this basket will of course take into account the size of the GCC's exports and imports from their main economic partners. But I think the dollar will be the main part of it."

Another expert agreed that the dollar, to which the GCC currencies have been effectively linked for more than two decades, would be the official peg to the new single currency in the first few years of the monetary union.

"It is natural that the GCC countries peg the new currency to the dollar in the beginning since the dollar forms a large part of their trade and foreign assets. I think all regional and global conditions indicate that the Gulf currency would be pegged to the dollar. But this might change at a later stage, depending on what they decide for their currency," said Zuhair Kiswani, Director of the Sharjah-based Al Sharhan Securities, a key UAE investment and brokerage firm.

IMF help

The four members have already sought help from the International Monetary Fund on a possible revaluation of their currencies for the monetary union.

In a working paper released recently, the IMF suggested slight appreciation of the currencies of those members against the US dollar but it warned any leakage of news ahead of the revaluation could spur damaging speculation. "This paper developed from an informal request to one of the authors by a member of the GCC Secretariat for guidance on how to set the conversion values for the new GCC currency," it said.

"If hypothetically the GCC decided to establish the new currency in its original planned date, Saudi Arabia would need to revalue its currency by 2.94 per cent, Kuwait by 5.15 per cent, Qatar by 4.54 per cent, and Bahrain by 1.09 per cent. The methodology provides an estimate of the required adjustment for each currency if the conversion is to take place in 2011, 2012, or 2013."

In a recent study, a noted US economist in Saudi Arabia warned that a sharp appreciation against the dollar would hit the GCC foreign assets. Another negative effect is that their oil sales are priced in dollar and an appreciation means lower crude export earnings in local currencies, said Brad Bourland, Chief Economist at the Riyadh-based Jadwa Investment Company.

"This will again put pressure on their fiscal systems and could create budget deficits when regional states have just reverted to surpluses after painful shortfalls for more than two decades," he said.

"In Saudi Arabia for example, oil revenues are earned in dollars and converted into riyal for budgetary spending. A revaluation would permanently impair the riyal value of oil revenues, reducing the size of the current budget surplus and accelerating the day when the budget falls into deficit. The value of the government's mostly dollar-denominated foreign assets, currently in excess of $400 billion (Dh1.46trn), when converted into riyals would also be cut."

Foreign assets

Figures by the Washington-based institute of International Finance (IIF) showed the GCC's combined foreign assets were estimated at $1.490trn towards the end of 2009, including nearly $1trn for the monetary union members. The official reserves of the four nations stood at about $490bn, including assets held by the Saudi Arabian Monetary Agency (Sama).

In a study on the monetary union released recently, the Saudi American Bank Group (Samba) also expected the new Gulf currency to be pegged to the dollar.

"It is most likely the dollar peg continues to be the preferred exchange rate regime for the bloc in the foreseeable future. Faith in the peg is understandable. There are a number of good reasons why it may be adopted, not least the familiarity that it enjoys," Samba said. "In particular, interest rate transmission signals are weak in the Gulf, given the preponderance of actual and expected government spending on consumption and investment decisions. If changes to nominal interest rates have little impact on the spending patterns of firms and households, then much of the advantage associated with a floating exchange rate is lost."

But it noted that this could change over a longer time horizon, as regional financial and capital markets broaden and deepen, thereby enhancing the potential advantages of a more flexible exchange rate at a later stage.

Flexible rate

"In such conditions, a flexible exchange rate would help encourage a more robust, diversified and competitive non-oil export sector, which in turn could provide the spur to sustainable employment growth," the study said.

It recalled a decision by the GCC nations in 2003 to peg their individual currencies to the US dollar and to maintain the parity until the establishment of full Monetary Union in 2010. A decision on the exchange rate regime for the single GCC currency would be made then.

Despite domestic and global changes ever since, a fixed peg to the dollar remains the most plausible prospective exchange rate regime, it said.

It cited several reasons for this, including the fact that the new central bank would inherit a well-functioning anchor and associated monetary framework.

It said the peg remains reasonably straightforward to administer and does not require the institutions necessary for an independent monetary policy.

"Second, market participants are already familiar and – for the most part – comfortable with the peg. GCC countries' individual pegs are well-established and have provided a degree of stability and comfort during times of oil price weakness or regional political stress," the study said.

A third factor is that the GCC's dominant export, crude oil, is already priced in US dollars while the fourth reason is that the group's flexible labour markets should be enough to support international competitiveness.

Samba noted that a managed float has been proposed by some and its advocates argue that this would allow the countries to absorb large adverse real shocks more easily than a fixed exchange rate regime.

"As such, sharp swings in oil prices could be offset by changes in the nominal exchange rate, thereby imparting some stability to the local currency value of export earnings. Similarly, the impact of higher import prices could also be blunted by exchange rate adjustments.

"Beyond this, an autonomous monetary policy would allow appropriate monetary responses to domestic demand conditions. Thus if demand was in danger of overheating, nominal interest rates could be adjusted accordingly. The credibility of the float would be underpinned by the GCC's vast stock of foreign assets."

According to Samba, an alternative version of the floating rate is a peg to the price of oil. It said the main argument in favour of this regime is that it delivers automatic accommodation to terms of trade shocks, while simultaneously retaining the credibility-enhancing advantages of a nominal anchor.

"Its proponents argue that enabling the exchange rate to move in line with the price of the region's dominant export would allow the real exchange rate to achieve equilibrium and would also decouple oil exporters' monetary policies from those of oil importers," it said.

"Its detractors note that the price of oil is not truly exogenous, since the oil production policies of the GCC countries themselves influence the price. The volatility of oil prices would also present problems, forcing potentially sharp day-to-day swings in the exchange rate, making planning difficult."

Pressure to unpeg

In 2008, GCC countries resisted pressure to unpeg or appreciate their currencies against the US dollar after inflation rates soared to double digit levels in most members because of the weakening greenback and other factors. Their decision prompted a massive withdrawal of speculative funds deposited by international institutions in anticipation of a revaluation.

"We should acknowledge the firm position adopted by the GCC monetary authorities when they refused to end the peg or appreciate their currencies against the US dollar," said Henry Azzam, Chief Executive Officer of Deutsche Bank in the Middle East and North Africa

"They have firmly resisted speculation campaigns which have jolted the Gulf currency markets during the past 10 months… had they bowed to these pressures, Gulf states could have encouraged more speculations in the future and fueled expectation and speculation that local currencies could be depreciated after the US dollar starts to recover."

Azzam, author of several books on regional economies and other subjects, said GCC states had succeeded in maintaining a stable exchange rate for their currencies over the past 23 years by keeping them pegged to the dollar.

"This success has largely lessened exchange rate risks that could have discouraged local and foreign investors. The policy has also encouraged capital inflow and strengthened the credibility of GCC monetary authorities. As a result, speculations have largely receded and this will contribute to reasonable growth in the monetary aggregates in member states," he said.

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