Over the past 28 years, the Kuwaiti Dinar (KD) has averaged 0.292 fils against the US dollar (USD), despite economical growth and crises. According to the Central Bank of Kuwait (CBK) their policy "aims at maintaining and enhancing the relative stability of the KD against other currencies, and shielding the domestic economy against the impacts of imported inflation". The Kuwait Central Statistical Bureau (KCSB) reported that the inflation rate in June of 2014 was 2.90 percent. The average between 1995 and 2014 was 3.06 percent, reaching an all-time high of 11.64 percent in 2008 and a record low of -1.15 percent in 1998.
In Kuwait, the main components of the Consumer Price Index (CPI) are: housing (26.8 percent), food (18.3 percent), transport and communication (16.1 percent) and household goods and services (14.7 percent). The index also includes other goods and services (9.9 percent), clothing and footwear (8.9 percent), education and medical care (4.7 percent) and beverages and tobacco (0.6 percent). With such fluctuations in inflation rates and worldwide economic instability, it's a wonder how the CBK has managed to keep an average exchange rate against the dollar all while "shielding the domestic economy against the impacts of imported inflation". Or has it?
The purchasing power of the Kuwaiti dinar
In today's market the value of a currency is based on several factors, but generally it's based on the country's economy, supply and demand of that currency, reserves of gold and other foreign currencies. Kuwait being an oil rich country has a strong balance sheet and according to The World Bank, the Gross Domestic Product (GDP) in Kuwait was worth $183.22 billion in 2012. The Purchasing Power Parity (PPP) theory is commonly used to establish the required adjustments needed to any currency exchange rate against the other and indicating whether the base currency is overvalued or undervalued by comparing the cost of the same basket of goods or services in the two countries. Based on The Economist's Big Mac Index (BMI), which takes the McDonald's Big Mac as its basket of goods and compares the price through the world, indicating the variance in currency values compared to the actual exchange rates.
Despite the criticism of The Economist's Big Mac Index (BMI), the McDonald's Big Mac is a great specimen because of the inputs that are required to achieve the same end result around the world. The price of the burger takes into consideration the local or regional raw materials, manpower and other business expenses. The argument about cheap labor affecting the ratio is debatable, because what is cut in base pay is made-up by other expenses like residency, insurance, housing and transportation. Today Kuwait's market exchange rate is 0.282 Kuwaiti Dinars (KD) to every $1; as opposed to the BMI exchange rate of 0.206 KD to every $1. Based on the BMI of January 2014, Kuwait's currency is undervalued by 27.1 percent and followed by neighboring United Arab Emirates (UAE) and the Kingdom of Saudi Arabia (KSA) at 29.2 percent and 36.5 percent respectively against the dollar.
Kuwaiti gold
Further investigation into the value of the Kuwaiti dinar lead us to the CBK annual report with hopes of understanding the bases of valuation. According to the CBK, effective May 20, 2007 by virtue of the Decree No. 147/2007, the KD exchange rate was re-pegged to an undisclosed weighted basket of international currencies. The report also declares that with accordance to the Amiri Decree of July 4, 1978, gold is valued at KD 12.500 per fine ounce.
Baring in mind that the last time the dollar was tied to the gold standard was in 1973 and the fixed value at the time was $42.22 which would have benchmarked the exchange rate at KD 0.296 per dollar. Amazingly the Kuwait Central Bank has managed to keep the exchange rate close to our estimated benchmark over the past 28 years reaching a high of 0.276 in 2011 and a low of 0.306 against the dollar and averaging 0.292 over the same period. Unfortunately the CBK has only published the exchange rates from 1986 to 2013.
In 1978, the price of 1 gold once was $193.40 but the price was pegged at a fifth of the price equaling to $42.22 @ 0.296 the estimated equivalent of KD 12.500. Over the past 35 years the price of gold has risen to reach in 2013 $1204.50 per ounce of gold. Should the government revalue its gold to a fifth of its vale as it did in 1978, Kuwait's gold reserve would be valued at $240.9 per ounce (KD 71.306 @ 0.296) which would increase the declared value of gold from KD 31.7 million to KD 181 million instantly increasing the current value of the Kuwaiti dinar.
The effect of an undervalued dinar From the government's perspective an undervalued currency has both an upside and a downside, the upside is that Kuwait's oil, gas and petrochemical exports gain a competitive price advantage making Kuwaiti exports more attractive to international markets. The downside is that all government foreign assets are inflated leading to false financial positions. In addition all new government investments would carry higher cost due to the undervalued currency. On the flip side, an undervalued currency translates to paying more on imports which contributes to inflation.
Unfortunately, Kuwait is extremely dependent on imports especially in terms of consumer goods. The playing fields would be equal if Kuwait's domestic industries were more developed diverting demand to local made products, this not being the case; the result is that local industries struggle further as they try to compete with goods imported from other developed countries that enjoy an undervalued currency like the United Arab Emirates, Saudi Arabia and Egypt at a regional level and Asian countries like China, India, Taiwan and Malaysia. Simply, we sell more for less and we pay more for less.
Summary Governments around the world continually battle to fight inflation and maintain their currency value; generally the value of the currency is based on the economy performance and reserves or assets. The Purchasing Power Parity (PPP) theory suggests that the Kuwaiti dinar is undervalued by 27.1 percent and considering that the official gold price in Kuwait has not been adjusted since 1978, the PPP theory indication is logical. Although Kuwait is gaining a competitive advantage in oil sales the economy is negatively impacted by the higher cost of investment and cost of living.
© Kuwait Times 2014
