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07 December 2023

Revaluation will not solve inflationary problems

By Ryan Harrison




HSBC has forecast that the Gulf region is likely to retain its dollar peg during 2008, and said any attempt at future revaluation would not solve inflationary problems.

In its latest research note, the bank acknowledged that Gulf states faced pressure to decouple after changes in energy markets weakened the link that previously established a loose tie with the US economic cycle.

Simon Williams, HSBC chief economist for Gulf Markets and author of the “Decouple but still shackled” report, said there was therefore a strong chance of some sort of currency reform by the end of the year.

“Despite the arguments in favour of change, policymakers are minded to maintain the status quo and the likelihood is the pegs will remain unchanged in 2008. The costs that this will entail, however, are heavy and we still see a significant possibility of currency reform over the coming year,” he said.

“Changes in the international energy markets have weakened, if not broken, the link that previously established a loose tie between the economic cycle of the US and that of the Gulf. Although the economies have decoupled, maintaining the dollar-peg currency regimes leaves policy still shackled to the US.”

The report argued that although a revaluation would not solve the Gulf’s inflationary problem, it would buy time to introduce other measures and would mark an important step toward a more flexible monetary regime.

It added: “The arguments in favour of the Gulf’s dollar peg are weakening. Pricing oil in dollars suggests that a predictable relationship between the US and Gulf currencies is beneficial. That this needs to be a system of fixed pegs is questionable. That the nominal value of the pegs should be those set a generation ago is more questionable still.”

Experts have observed previously that the contradiction of tied monetary regimes and  decoupled underlying economies between the Gulf and US has been apparent for much of this decade in the value of the regional currencies. HSBC found the Gulf region generated an aggregated, cumulative current account surplus of roughly $720 billion over 2003 to 2007 and $555 billion (27 per cent of GDP) over 2005 to 2007 alone as energy prices strengthened.

Williams said: “Had they been allowed to float, the Gulf currencies would have strengthened substantially. Instead, they weakened 15 to 20 per cent in nominal trade-weighted terms as they were drawn downward by the dollar.”

He added: “The Canadian dollar, which is less exposed to oil prices than the Gulf currencies, rose by more than 60 per cent against USD. The weakness of the Gulf currencies at a time of soaring domestic demand and strengthening global commodity prices contributed to rising inflationary pressures across the region.”

In the past, the influence that US demand had on global energy markets meant that economic cycles in the US and the Gulf were broadly correlated. This gave more credence to the peg the monetary policy requirements of the two regions were often similar.

HSBC argued changes in the global energy market have broken that relationship, and the policy needs of the two regions are now starkly different.

But the dollar peg leaves the Gulf with no autonomy, and instead of adopting a monetary stance designed to manage rapid demand growth, the region is bracing itself for further cuts to interest rates that are already negative in real terms.
This risks exacerbating inflationary pressures that are already pronounced across the region, the bank added.

The UAE’s wealth and its rapid diversification away from oil has placed it as a prime candidate out of the GCC states for change in the currency regime. Despite public disavowal from the central bank, the market also continues to judge that change is a significant possibility.

One-year and two-year swap prices imply revaluations of 3.3 per cent and 4.2 per cent respectively. Williams said: “As the front runner for change, however, the UAE has been displaced by Qatar. The arguments for revaluation in Qatar have long been recognised like the UAE, Qatar faces double-digit inflation for the third year in succession and has sufficiently strong fundamentals to support a significant appreciation in the value of its local currency.”
He added: “The economic boom in Qatar is perhaps even more marked than that of the UAE, and interest rate cuts are even less welcome than they are elsewhere.”

HSBC said it expects a 60 per cent chance of no change in the UAE’s currency peg or revaluation.

“The 40 per cent probability of change taking place this year reflects our view that policymakers could yet have their hands forced in what looks to us to be a brewing perfect storm dollar weakness, falling US rates, high oil earnings  and rising inflation. The likely limited scope of near-term action would not solve the region’s inflationary problems. Executed effectively, however, it would buy the region time, particularly if were coupled with fiscal reform.”

“Adjustment would also mark a first step toward more fundamental change to a monetary regime that the fast-growing, dynamic economies of the region appear to have outgrown,” the report added.



Pressure Mounts


The weakness of the Gulf currencies at a time of soaring domestic demand and strengthening global commodity prices contributed to rising inflationary pressures across the region.

The feed-through from currency weakness varied economy by economy, but each is heavily reliant on imported core goods (including food) and for the inputs associated with the regional infrastructure boom.
The Gulf’s heavy reliance on expatriate workers also meant that currency weakness fed through into wage demands, adding to second-round inflationary pressures, said HSBC.

On a weighted basis, annual average inflation rose from 1.3 per cent in 2003 to 6.3 per cent in 2007 an exceptionally high figure by historical standards that understates the underlying pressures given the extensive subsidies and price controls in place across the Gulf.