Gulf Arab central banks are struggling to persuade financial markets that they won't tinker with their dollar pegs, as their currency policies are increasingly costly to defend and may have become unsustainable.
After a flurry of public disagreements over currency reform last year, Gulf central bankers are trying to close ranks, talking up the pegs as a source of stability and playing down the dollar's weakness as a temporary phenomenon.
But markets are still betting on the chances that Gulf currencies will be revalued, or that governments may even scrap their long-standing system of fixed exchange rates altogether.
Gulf policymakers have dutifully tracked a series of US interest rates cuts, including two totalling 125 basis points in the past fortnight alone, to deter investors from betting that their currencies will appreciate.
But while the United States worries about an economic slowdown, the booming Gulf states face a serious inflation problem which would usually demand rate rises, not cuts.
Unsurprisingly, the market speculation refuses to go away. Kuwait uncoupled its dinar from the dollar last May and pressure is growing on the remaining Gulf Arab states to follow suit as their economies fall out of step with the United States'.
"The arguments in favour of breaking the policy tie will gain weight as US rates fall but growth and inflation remain high in the Gulf," said Simon Williams, HSBC's senior regional economist.
Policymakers may hold their ground for a while, and put on a show of unity as they are supposed to be preparing for a common currency in the Gulf, but the price will be high.
"A revaluation can be delayed for a long time, but it will come at a cost," said Marios Maratheftis, regional head of research at Standard Chartered Bank. "That cost is inflation."
Inflation has become a political hot potato in the Gulf. It has overtaken official lending rates in five of the six Gulf states preparing for monetary union.
Arguments that the status quo brings stability have begun to ring hollow as governments are forced to raise wages, and impose controls on rents and food prices to contain public discontent.
Banks are complaining about lending curbs, and migrant workers have rioted over the dwindling value of their earnings back home as the dollar's weakness holds down Gulf currencies due to the pegged exchange rates.
PROPERTY MARKET SPECULATION
Inflation is at 16-year highs in Saudi Arabia and Oman, a 19-year peak in the United Arab Emirates and just off record levels in Qatar. Gulf policymakers are intervening directly in loans, property and commodity markets to offset rate cuts.
But there is a limit to what they can do when borrowing costs have fallen through the floor.
Central bankers including the UAE's Sultan Nasser Al Suweidi -- who called fervently for currency reform in November -- have said the dollar pegs are not to blame for soaring real estate prices, the main driver of inflation across the region.
New housing supply will take the heat out of price rises, central bankers, including Qatar's Sheikh Abdullah bin Saud al-Thani, have contended. But real estate price inflation cannot be blamed fully on supply constraints, when the negative interest rates across the Gulf spur demand for credit.
Mortgage lending in the UAE, which opened its property market to foreign investment as early as 2002, almost doubled in the year to June to Dh45.7 billion ($12.45 billion).
"You need to put the brakes on credit growth," said Jason Goff, head of treasury sales at Emirates Bank International Ltd. "The only way to dampen property market speculation is to put higher interest rates in place."
Saudi Arabia is fighting inflation at 6.5 per cent with an official lending rate of 5.5 per cent. This week it said it would raise state employees' salaries by 5 per cent and subsidise everything from shipping costs to driving licence fees.
Other Gulf countries have also introduced social welfare policies, from ceilings on rent rises in the UAE, Oman and Qatar to food subsidies in Kuwait and a 70 per cent wage rise for some Emirati federal government employees.
Qatar said it would boost its port capacity to allow more imports and control the price of building materials to fight inflation at 13.7 per cent in September, just off a record.
"Non-market measures such as higher subsidies, allowances, irrational wage increases, caps on rents are mostly 'soon to be inflationary'," Merrill Lynch said in a note. "With rising costs hidden by subsidies and transfers, domestic demand will continue to grow unabated," it said.
With their hands tied, Gulf Arab policymakers have little choice than to reform currency policy to prevent their booming economies from overheating.
Investors piled into Gulf currencies after the Fed started cutting rates in September, expecting other countries to follow Kuwait. After migrant workers rioted in Dubai, Suweidi made his call in November for the Gulf to sever the pegs and track a currency basket, sending the dirham and Saudi riyal to five-year and 21-year peaks.
Currencies eased in December after Suweidi backtracked on those remarks and Gulf rulers agreed to keep the pegs but much of the speculative money remains in the Gulf. "No one has really mopped up the big inflows we saw at the end of last year," said Caroline Grady, senior regional economist at Deutsche Bank.
Qatar reopened the debate this month when its finance minister said Gulf states could revalue their currencies.
Doha is studying severing its dollar peg as part of reforms to tame inflation, an economic adviser to Qatar's ruler said this week. Any currency basket should go further than Kuwait's, which is heavily weighted in $ , the adviser said.
One-year UAE dirham forwards show investors betting on a 2.5 per cent appreciation in the currency in a year.
Standard Chartered expects 8 per cent rises in the dirham and Saudi riyal by April, while EFG-Hermes, Merrill Lynch and Deutsche Bank expect the UAE and Qatar to revalue this year.
"The reduction in interest rates will reach a point where the Gulf will have to move," said Monica Malik, Middle East economist at EFG-Hermes. (Reuters)
Gulf defence of pegs rings hollow as Fed cuts