Gulf states still back the greenback

Most Gulf Arab central banks look set to ride out the latest spell of US dollar weakness, although Kuwait could be tempted to hasten a widely anticipated second revaluation this year to contain imported inflation.

Import costs are not a big driver of inflation in other Gulf oil producers with fixed exchange rates, and the dollar's slide to near record lows against the euro has not been steep enough for central banks to risk their credibility on currency policy.

Kuwait broke ranks with its neighbours in the world's largest energy exporting region, ditching a dollar peg in May to contain the impact of rising import costs on inflation.

Other Gulf countries have kept dollar pegs since the 1980s, but pressure to change has increased as their currencies have weakened despite vast current account surpluses and double-digit growth rates.

But with limited impact on their economies of this week's dollar decline and in the absence of a further steep drop, Gulf countries are reluctant to react to what they probably consider short-term fluctuations.

"They want to take their time with any such decision," said Steve Brice, regional head of research at Standard Chartered bank. "With the dollar moving within 5-10% they are unlikely to change their policy. They look at this on a structural level."

Dollar weakness not a main inflation driver

While Gulf central bank governors contend with increased pressure from importers of goods from Europe or Japan during bouts of dollar weakness, most of their inflation problem is domestically driven.

Standard Chartered estimates that about 34% of imports to both the UAE and Kuwait come from the European Union, and this added to inflation as the dollar fell to a record low against the euro in April.

But capacity constraints as Gulf economies grow on the back of a near tripling of oil prices since 2002 are the main drivers of inflation, which surged to 15% in Qatar in the year to March.

Both Qatar and the UAE, where inflation was 9.3% in 2006, have blamed inflation on rents as an influx of expatriate workers strains housing supply.

"The dollar's fall will dismay the central banks but it won't lead to panic," said Simon Williams, economist at HSBC. "They know rapid domestic demand growth is the main inflation driver, not the weakness of the
currency."

The dollar's fall is also not entirely negative as it helps the region develop its non-oil exports, contributing to economic diversification.

"Exports of non-oil goods and services are a majority of the UAE's exports and a key part of its growth strategy," Williams said. "The UAE would like the dirham to be stronger but there is some benefit to these sectors from a weaker currency."

Kuwait's non-oil and gas exports, on the other hand, are only about 4% of total exports and in part explain Kuwait's ability to revalue without much negative effect.

Riding it out

Kuwait's battle with speculators ahead of its revaluation could also dissuade other central banks from following suit.

The bank was forced to slash interest rates despite high inflation to stem massive dinar purchases from speculators in the months before it revalued. Preventing speculators from making profits too quickly could in part explain the small initial revaluation from Kuwait - around 0.37% - and the lack of dinar appreciation since then.

UAE central bank governor Sultan Nasser al-Suweidi said last month the UAE dirham's peg to the dollar, unchanged for a decade, was an anchor of stability for the economy.

"The level of attention Gulf currencies get now is pretty modest, but that would change if they were to revalue once," said Williams. "The markets would conclude that if they change once there would be other adjustments."

Suweidi first raised the possibility of Gulf revaluations in January after the euro had broken $1.30. Speculation about a revaluation grew as the dollar fell in April to a record low.

With the dollar not yet dipping below its April level, Gulf central banks still likely feel the greenback is at tolerable levels.

"We've been at this level before so this is not new to them," said Caroline Grady, economist at Deutsche Bank in London. "I don't think they will be worried about a couple of days but if the dollar weakens much more than we expect it might change the story in terms of speeding up any revaluation."

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