The GCC currency pegs have been taken for granted, leading many Corporate Treasurers and Finance Directors to ignore USD-GCC risks, either in terms of exchange rate risk or the risk that local interest rates could deviate from those in the US. The typical interest rate 'hedge', therefore, has been to hedge local currency floating interest rate exposure via a USD interest rate swap (whereby the bank promises to pay the company a 3-month or 6-month USD floating rate for the duration of the swap; in return, the company pays the bank a USD fixed rate so that it locks in its funding costs). This is a complete market hedge for a company with a floating USD rate liability, but a GCC company that has borrowed in local currency would clearly be exposed to any divergence in GCC and USD short-term interest rates.
The key assumption underpinning this behaviour, that USD-GCC pegs will remain intact, is being increasingly called into question with the merits of regaining control of monetary policy being discussed more widely.
Indeed, officials from both the UAE and Kuwait central banks have indicated an alternative FX system may be more appropriate once the GCC single currency is formed, scheduled for 2010. In this backdrop, there are increasing risks of a removal of USD-GCC pegs and a divergence of local and USD interest rates after 2010.
Due to the lack of a developed QAR interest rate market, quantifying the impact of such a shift on those with QAR floating rate liabilities is difficult. However, looking at the implications for other countries is instructive. In the UAE or Saudi Arabia, the additional cost of a local currency 5yr interest rate hedge over a similar USD hedge is around 30bps.
Therefore, if the peg was to remain intact and local currency interest rates continued to track their USD counterparts, a company 'hedging' via the USD curve would save 30bps annually in servicing its debt.
However, once the assumption of the currency pegs' longevity is removed, then the situation becomes more interesting. If you assume a 10% local currency appreciation against the USD and an increase in local interest rates of 2% relative to those in the US, then (under certain simplifying assumptions) the borrower would be approximately 2.5% per annum worse off by using the USD curve. Of course, if the local currencies were to weaken and local interest rates were to decline relative to their USD counterparts, then those 'hedging' via the USD curve would benefit.
This leads to the natural question of what would be the likely direction of GCC currencies and interest rates were the pegs to be removed. If this were to happen today, the analysis is relatively straightforward the pressure would be for a stronger currency and higher interest rates, a costly scenario for those hedging via the USD curve. The primary reason for this is growth in the region is extremely strong and inflation is picking up in many countries, including Qatar.
In this environment, there are two appropriate policy responses. First, one can raise interest rates to slow the economy, reduce pressure on capacity constraints and thus inflation.
Second, you allow the currency to appreciate to reduce imported inflation pressures. Meanwhile, the natural pressure on GCC currencies, with the 2006 current account surplus for the region expected to be 31% of GDP, is for them to appreciate.
Fast forward to 2010 and naturally the likely pressures become less clear.
With our long-term oil price forecast at USD 40 per barrel, then the current account will likely remain in surplus, keeping the bias for a currency appreciation intact. However, what the monetary policy needs will be at that point will depend on what stage of the economic cycle we will be.
Overall, we believe GCC-based companies taking hedging decisions should be aware of 1) the risks that the currency pegs may not be in place on a three and a half year plus time horizon and 2) the potential financial consequences of this for current hedging techniques. Unfortunately, for Qatari companies, the problem is the market for hedging local currency interest rate risk is undeveloped as the banks need reliable money market fixings in order to price the swaps and manage the associated risks. Until these are created, Qatari companies are likely to have to live with the risks outlined above.
By Steve Brice
Qatar Today 2006
