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GCC monetary reforms can help US

By Dr Armen V Papazian

Pricing oil in dollars is a key principle of the global economic equation that we live today. While the future may be different, this standard is a global reference, and is useful in the current state of affairs. Today, dependence on the dollar is widespread, and an economic/currency collapse could have drastic consequences across the world.

Therefore, a solution to the current crisis, which has the United States as its epicentre, requires action by all stakeholders. The discussion here focuses on what the GCC can do to support the recovery.

I feel that reforming GCC monetary architecture, with appropriate policy actions, can be a key supporting factor to US economic recovery, while bringing about much needed local monetary empowerment in the region.

The architecture that needs reform is well described by the fact that GCC central banks do not have any significant holdings of government bonds, i.e., no monetisation and no open market operations, and the exchange rate is pegged and domestic currency issuance is backed by foreign currency holdings and/or gold.

The key feature that characterises the GCC central banks is their "dollar standard". This is most clearly revealed in the balance sheet of the Saudi Central Bank due to the reporting format it uses. Table-1 depicts the balance sheet as of 30 June 2007 of the Issue Department of the Saudi Arabian Monetary Agency, Sama.

The vast majority of the foreign currency item is made up of dollars, and gold is only a smaller proportion of the holding: a de facto dollar standard.

The dollar peg is part and parcel of this equation. The other five Central Banks follow the same principle, but they do not report separate balance sheets for their issue departments.

Although there are public debt instruments issued by governments and government owned entities, in dollar and local currencies, central bank participation does not seem to have been on the agenda. Indeed, if GCC states were to use government bonds to back local currency issuance, they could also mobilise billions of dollars, which could then be invested in the US economy, contributing to new levels of activity and enhanced liquidity.

The current structure implies that government oil revenues, petrodollars, are the key driver of local expenditure and money supply growth, and are also the source of foreign savings and investments through Sovereign Wealth Funds.

When governments earn dollars and spend locally, they increase central bank foreign reserves, and simultaneously provide foreign currency for the issuance of local currency. In their turn, central banks invest their foreign reserves through deposits and securities in the form of treasury bills, and other grade bonds.

It should be noted by way of clarification that foreign currency inflows in the region are not limited to government petrodollar revenues.

Indeed, in the recent past, some parts of the region have witnessed a significant increase in foreign inflows in the form of FDI, FPI, tourism, etc.

These have also contributed to levels of foreign reserves with the central banks. A significant amount of such flows has left the region, and created the need for new money injections. This has created an environment where local monetisation capacity would be a welcomed development.

If architectural reform is implemented, government petrodollar revenues can be immediately routed towards direct investments in foreign currency assets, namely US assets. Meanwhile, governments can release new bonds, and central banks can start backing currency issuance through them. This will sever the link between government dollar revenues, and government local expenditure. With the new architecture, central banks will still earn foreign reserves through other inflows, and will still invest and deposit in appropriate instruments. However, government oil revenues will not be a significant contributor to Central Bank foreign reserves. When local currency issuance is backed by local bonds, and when the exchange rate is a managed float, existing central bank foreign reserves could be deployed more productively, and more dollars will be available in the hands of governments to invest in the US or elsewhere.

In other words, the fact that oil revenues finance local expenditure means that a significant amount of dollars are used to run local economic activity, while local expenditures could be financed through local bonds that could also be used to back the currency.

This means that the proportion of oil revenues that was being deployed locally will now be available for investment elsewhere. Indeed, they could be spent in the US market, supporting confidence and demand. The impact of such investments would be more immediate and relevant than indirect purchases and or deposits by the central banks.On the one hand the dollar standard provides predictability, but negatively impacts the region due to the crisis and the inflexibilities it imposes; on the other, getting off the dollar standard could be a key contributing factor to US economic recovery, which is needed in the region, but will imply local discretionary monetary policy, and thus less predictability. Allowing billions of petrodollars to flow back into the US market as quickly as they are earned can be a vital factor in stimulating the US markets. This is so because in case of a prolonged and real decline in US activity, oil and other US assets held by the region would keep on losing value. Table-2 reveals the per cent and value of total government revenues that are petrodollars (2007). Indeed, it is quite interesting to draw attention to the fact that GCC governments, unlike many others, earn more foreign currency than local currency. This is due to the tax free environment. It should also be noted that 2008 revenues will be higher given the high oil prices during the earlier part of the year.

- Dr Armen V Papazian is a Dubai-based senior policy adviser