NCB Capital looks at how the falling US dollar and lowering of interest rates might force the GCC to cut its ties to the dollar-peg
The decades old dollar-peg by GCC currencies has come under increasing calls for a review as falling interest rates, a steady decline in the US dollar, and record high oil prices translate to a flood of liquidity and rising inflation. The peg, which has historically brought stability to the region, faces the challenge of increasingly looking like fitting a square peg in a round hole.
GCC central banks have an unenviable task of conducting independent monetary policy in a fixed exchange rate regime that allows free capital flows.
There are three preconditions required for hard currency pegs that are no longer applicable for the GCC:
Bulk of the adopting country's trade must be with the other country: IMF statistics indicate that just 9.7% of the region's trade was with the US in 2006, with currencies appreciating against the dollar representing 55 per cent to 60 per cent of GCC imports
Business cycles must be well synchronised: While the US combats a credit crunch, GCC regulators are trying to stem inflationary pressures driven by easy liquidity
Adopted currency should be strong and value preserving: Weakness in the US dollar is being perceived as a structural change as global diversification out of dollars gets underway. The US dollar's nominal depreciation against the euro has been a steep 78 per cent since 2002.
Nominal and real import-weighted exchange rate estimates done by NCB Capital indicate that all GCC currencies (ex- Kuwaiti dinar) have effectively depreciated by over 37 per cent in nominal terms since 2002. In contrast, Kuwait has limited its effective depreciation in the Kuwaiti dinar to 23 per cent.
The most appropriate solution is a change of peg to a basket of currencies (with components and weights publicly disclosed in order to avoid speculative pressures) accompanied with a small one-time revaluation (say 4 per cent to 5 per cent, to offset part of the sharp loss in value of local currencies).
While its impact on inflation in the short-term will be insignificant, the move could facilitate greater currency/monetary flexibility. A larger revaluation could be counter-productive, impairing budgetary/current account balances. In contrast, a move to a free float would not be advisable at this time as the region lacks a well-developed debt market that helps transmit interest rate signals (an important pre-requisite for monetary policy to function effectively in a floating-exchange rate regime).
Deposit rates, forced lower to limit speculative inflows, have resulted in negative real interest rates. The current situation is an opportunity to push forward a structural change (i.e. any global slowdown and associated declines in oil prices would lead to lower GCC surpluses, making the burgeoning wage-bills and subsidies that have helped ward-off inflation thus far increasingly difficult to sustain).
Beneficiaries would be: global investors (one-sided currency risk will attract foreign capital leading to higher demand for local assets), capital-intensive industrial projects (lower import costs), companies with external liabilities (US dollar loans become cheaper), GCC importers (where demand is elastic), regulators (greater maneuverability).
Loser would be: central banks (fall in value of their US dollar/gold holdings), investors, sovereign wealth funds, financial institutions and companies with dollar-assets, investments or foreign subsidiaries (one time translation losses will impact incomes statements leading in slower growth in profits), exporters (less competitive).
The quadrupling of oil prices since 2002 and efforts at diversification of income streams have bestowed the GCC region with unprecedented growth, with compound annual growth in nominal GDP at 12.8 per cent between 2005 to 2008E (as per IMF forecasts).
This has enabled the region to decouple from the US, which increasingly exhibits signs of an economic downturn. However, the peg to the US dollar that the constituent nations retain has left the decoupling incomplete.
All the GCC countries, with the exception of Kuwait, have maintained a hard-peg against the dollar for more than two decades now, helping reduce volatility in export revenues (predominantly from dollar-denominated oil exports) due to fluctuating oil prices.
In addition, the peg has also ensured the much-needed stable financial conditions that importers and investors prefer. The sustained slide in the dollar against all major currencies and the US Federal Reserve's anti-recessionary policy of loosening interest rates has brought the peg under increasing stress.
At a time when the US combats a credit crunch, the economies of the GCC are witnessing significant buoyancy with regulators seeking ways to stem rising inflationary pressures driven by easy liquidity. This contradicts a basic pre-condition for the sustenance of currency pegs - synchronized business cycles.
The GCC central banks now have the unenviable task of conducting independent monetary policy in a fixed exchange rate regime that allows for free capital flows, popularly termed as the 'impossible trinity' in economic parlance. Monetary policy in such a regime boils down to liquidity management, aimed at defending the peg. The central banks intervene in the currency markets, buying up excess dollar inflows as market participants anticipate an appreciation of the local currencies. The consequent increase in money supply is then sterilised using various debt market instruments. Unsterilised intervention can potentially cause inflation to rise.
Recession
Money supply excluding government balances, have risen sharply in recent months reflecting the sharp increases in liquidity due to oil prices at record levels and the falling interest rates in the region (mirroring the fall in US interest rates as the Fed moves to ease liquidity and cushion an impending recession).
The current weakness in the US dollar is being perceived as more than just a deviation from the norm - it has acquired a structural character. Recent IMF data show a fall in the dollar-share of foreign exchange reserves, from 65 per cent in June to 63.8 per cent in September 2007. The global diversification out of dollar assets is underway, albeit at a slow pace. Meanwhile, the GCC region is undergoing a transformation that will enable it to reduce its dependency on dollar-denominated oil and enhance intra-GCC trade.
The requirements of the industrial diversification process will have to be supported with appropriate monetary policy responses. As these two long-term phenomena unfold, a fixed-exchange rate regime appears conservative.
The appropriate strategy, from a long-term perspective, would be to move towards a more flexible currency regime that allows for monetary independence. More immediately, repeated deposit rate
cuts, aimed at curtailing speculative liquidity inflows, have turned real rates negative and yet not succeeded in keeping away speculators.
Currency forwards have amply demonstrated this, lately. Defending the credibility of the peg will become tougher with each Fed rate cut and discouraging piece of data from the US. A 4% to 5% revaluation and a peg to a dollar-heavy basket, while incapable of reducing inflation in the near term, will serve to provide some independence in interest-rate setting and set the ball rolling for the flexible regime of the future. At the same time, the move will recognise the current pre-dominance of oil revenues and their investments in dollar assets.
The formation of a common market is evidence of the GCC states' commitment to the eventual currency union, although the 2010 deadline for its formation does not look plausible.
Pan-regional judicial, consultative and executive bodies, like the ones in Europe, will emerge. It would be difficult to imagine policy-making institutions like a regional central bank, function with limited independence.
"The true nature of imported inflation in the GCC region is masked to some extent by government subsidies and price controls for many basic commodities."
"In contrast, a move to a free float would not be advisable at this time as the region lacks a well-developed debt market."
Islamic Business and Finance 2008
