KUWAIT: In its latest commentary on the recent revaluation of the Kuwaiti dinar (KWD) vis-a-vis the US dollar, National Bank of Kuwait (NBK) notes that the May 11, 2006 decision by the Central Bank of Kuwait (CBK) to lift the KWD against the dollar by 1% to 289.14 fils per dollar puts it at its highest level since January 1992. The move also puts the rate at the boundary of the allowable margin for fluctuation set by the CB when it first established the formal peg to the dollar in January 2003. As such, NBK points out that further appreciation in the dinar will not be possible unless the CB is ready to change the parity rate, or the existing exchange rate policy.
The CB indicated that its goal behind the revaluation was to quell inflation pressures arising from the substantial depreciation of the dollar, and thus the dinar, against other major currencies in recent years.
While the revaluation will help reduce some of the inflationary effects of a further possible decline in the dollar on the cost of non-dollar based imports, its overall impact on inflation and the Kuwaiti economy is expected to be minimal given the small size of the move.
Under the current exchange rate regime, the dinar's rate against the dollar is fixed by the central bank within a band 3.5% above and below the parity rate of 299.63 fils. Though the dinar has lately remained fixed against the dollar for extended periods of time, it fluctuates daily against other major currencies, including the euro (EUR), the Japanese yen (JPY), and the British pound (STG).
Fighting inflation
The CB, in its press release announcing the exchange rate revaluation, declared that the move is intended to stem inflationary pressures which had risen substantially in 2005. Inflation was visibly higher, with the consumer price index (CPI) rising by 4.1% and the wholesale price index (WPI) up by 4.4% during the year.
This compares to CPI inflation of only 1.3% in 2004 and WPI inflation of a mere 0.4%.
According to the CB, imported inflation is a real problem, and fighting it must begin with an adjustment of the dinar's exchange rate. The CB sees that the weakening of the KWD vis a vis non-dollar based currencies in recent years has fed into higher domestic prices. Indeed, during 2003 and 2004, the first two years following the KWD's peg to the US dollar, the dinar depreciated substantially against major non-dollar currencies. The dinar fell by 22% against the EUR, 11% versus the JPY and 16% against STG.
However, 2005 saw a partial reversal of this trend. The dinar appreciated by as much as 16% against the EUR in 2005, 14% versus the JPY and 13% vis a vis the STG. While this has eased inflationary pressures significantly, it did not stop inflation from rising that year due to the natural time lag that typically accompanies price adjustments. In other words, inflation rose in 2005 as a response to the dinar's depreciation in the previous two years.
Adjusting the exchange rate is by no means the only tool available to the CBK to fight inflation. Monetary authorities can raise interest rates, to the extent permitted by movements in rates on the US dollar given the dollar link, to curb demand and lower domestic inflation. The CB has been closely tracking increases in the US federal funds rate by raising its key interst rates, including the discount rate and the intervention rate (repo rate) on the KWD, which has had a direct impact on local deposit rates. However, since November 2005 the CBK has abstained from raising the discount rate to which lending rates are tied. It has relied instead on other quantitative measures, primarily a recently introduced ceiling on the loan to deposits ratio, in order to control credit growth.
Dollar pressure
In 2006, following further weakening of the US dollar against other major currencies, the dinar declined once again. During the first four months of the year the KWD was down by 7% against the euro, and by 3.5% and 7.3% against the yen and pound, respectively. While the continued weakening of the US dollar thus far this year, which caused the dinar's decline, may not yet represent the trend for the year, it is in line with the widespread expectation that the dollar is headed for more weakness. As such, it appears that the CBK is seeking to preempt the inflationary impact of further dinar weakness by lifting its rate for the KWD vis a vis the dollar.
As much as the above argument may be valid, it is worth noting that the last time the CBK revalued the KWD/USD rate to 292.05 was when the US dollar, and thus the dinar, was much weaker against major currencies than it is now. The charts below indicating the path of the dinar against the euro, yen and sterling since January 2003, clearly show that recent levels are well within their historical ranges.
Furthermore, given the relative volatility of the US dollar compared to the recent one percent appreciation in the dinar, one has to question how effective this move will be in containing inflation.
Business as usual or signal of a policy shift Market watchers jumped on the news of KWD revaluation and started looking for signals of whether or not other GCC countries would follow suit. We believe the issue to be purely speculative at this stage, considering that the CB move is very much "business as usual" and not a signal of any new policy direction of Gulf oil producers.
Prior to pegging the KWD to the USD at the start of 2003, the CBK maintained an exchange rate policy which pegged the dinar to a basket of major currencies. Though the precise construction of the basket was not publicly announced, it was obvious from exchange rate movements that the US dollar had a major weight in it. Under the old exchange rate regime the KWD/USD was fixed on a daily basis, allowing the dinar to gradually adjust to changes in international currency prices.
Even after swapping the old policy with the peg to the dollar, the CBK continued to provide daily flexibility in the KWD against the currency. It was not until November 2003 that the CB began to fix the dinar's exchange rate for extended periods of time against the USD, adjusting its value only occasionally. Since then, the CBK has revaluated the currency only twice. The first revaluation was at the start of 2005. The May 11 change was the second.
In the past, under the old exchange rate policy, any weakening in the US dollar against other major currencies would also result in a partial weakening of the KWD vis a vis those currencies with an immediate revaluation upwards in the KWD/USD exchange rate. Today, under the current regime, the CB can undertake similar adjustments though it does so only occasionally and within the required band.
One may argue that, far from being an unusual move, the CB's recent adjustment of the dinar's exchange rate against the dollar is business as usual, and represents part of its continued effort to balance changes in foreign exchange rates and the value of the dinar. While the dinar, following its recent revaluation, is the highest it has been since early 1992 when it stood at 287.91 fils per dollar, it remains well within the range it has traded since the early 90's as the chart on the first page shows.
However, it is worth taking into consideration that economic fundamentals today are very different from those prevailing during the previous two decades. Today's economic conditions are more similar to those existing during the 1970s when Kuwait enjoyed significant oil surpluses that financed an investment boom.
Looking at the path of the KWD over a longer time horizon, further revaluation would appear likely had Kuwait still been following its old regime of pegging to a basket of currencies.
What gives credence to this argument is the fact that the KWD/USD exchange rate is currently at the low-end of the band set by the CB and the use of currency revaluation as a tool to fight inflation will not be possible in the future, unless the CB takes the drastic measure of changing the parity rate or widens the band. Such a decision would have strong political overtones considering that Kuwait is the last of the GCC states to adopt a dollar peg in preparation for a currency union in 20 10.
Impact on economy
While the recent revaluation of the dinar upwards by less than 1% is expected to help keep inflationary pressure down, its overall impact on the Kuwaiti economy is likely to be minimal. With Kuwait's oil priced in dollars, the country's income from petroleum exports will decline slightly in dinar terms, though given today's high oil prices, this will be barely noticeable. Foreign assets of Kuwaiti individuals and institutions would also appear lower in dinar terms, but again the enormous size of Kuwait's foreign assets and the rising returns in international capital markets will mask this effect. On the other hand, the KWD's appreciation will slightly reduce the substantial import bill Kuwait has to pay for goods imported from both dollar and non-dollar economies.
© Kuwait Times 2006
