Dead weight?

The weakening of the dollar over the past few years has been a dominant theme in finance conferences, business publications, and for anyone exchanging the greenback for stronger currencies. Even Brazilian supermodel Gisele Bündchen has entered the fray, and is demanding that her contracts be paid in euros because she is uncertain about the strength of the dollar.

In the GCC, there is a lot of buzz about the revaluation of the UAE's dirham and the Saudi and Qatari riyals, especially after Kuwait allowed its dinar to appreciate against the dollar in May. Expatriate workers from Europe and India are eagerly awaiting the abandonment of the dollar peg so their earnings can be remitted at historic valuations, but the Gulf's central bankers have not budged on the issue, and are mimicking US monetary policy in support of the peg. The question many are asking is why hasn't the GCC abandoned the dead weight?

The simple answer to this question is that the dollar is far from being dead weight. It is true that the euro has gained considerable strength and will undoubtedly play a significant role as a global reserve currency. Japan has increased its prime lending rate which makes the yen more attractive, and China's recently de-pegged yuan (RMB) has the potential to play a global role when it becomes fully convertible. But the fact remains that the US economy is the largest in the world, and the dollar is the basis of the majority of world's trading and transactions. It is the universal medium of exchange, it is backed by the US government, and oil is priced in dollars.

With all oil contracts globally priced in a weak dollar and oil at record highs, Dr John Sfakianakis, the chief economist at the Saudi British Bank (SABB), strongly believes that now is not the time for revaluation. He points out that 90% of exports from Saudi Arabia are oil, which is priced in dollars. He then asks "where are we importing from?" and answers "from everywhere - and the currency most used for imports is dollars".

This is the main dynamic that dictates Gulf states' attitude towards the peg. Dr Sfakianakis explains that a revaluation of the riyal from 3.75 to 3.20 to the dollar would make imports cheaper but at "the same time would make the country receive less money in oil revenues". For the expatriates who see their riyals and dirhams lose value against the euro and rupee and are clamoring for a revaluation or de-pegging, the result is that governments in the GCC will bring in less revenue.

The economic party in the GCC is based on the ability of governments to take full advantage of the incredible rise of oil prices in recent years. Firas Mallah, head of Dexia Asset Management in the Middle East, acknowledges that this economic growth cycle has produced inflationary pressures, and maintaining the dollar peg entails following the US monetary policy "which is a real worry, because you don't want to copy the US policy if you don't have the same conditions".

This is exactly what Saudi Arabia and the UAE have had to do in recent weeks. The US is facing an economic downturn due to a variety of reasons such as massive budget deficits and trade imbalances, and precipitated by the subprime mortgage fiasco and a credit crunch. The natural reaction from the Federal Reserve is to lower interest rates - increasing liquidity. A low yield on dollar-denominated assets naturally weakens the dollar (which allows US products to become relatively cheaper), but the GCC, mostly pegged to the dollar, is experiencing growth, liquidity, and inflation. The linkage to the dollar forced central banks in the region to lower interest rates in tandem with the US, which ostensibly places inflationary pressures on a heated economy. Mallah thinks that because GCC countries are forced to follow the US regardless of the local economic environment, "the countries here are looking at the fiscal policy side to handle inflation and other internal matters. A fiscal policy option for countries with a lot of cash is government spending, and this is why we see a huge amount of government spending in the region, which is pretty smart because it is also a chance to expand on infrastructure, and make sure you have sustainable development for the future."