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Sat 4 Nov 2006 08:00 PM

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For a few dollars less

Will the GCC single currency peg itself to the struggling US dollar? Alexandra Dubsky examines the pros and cons.

When the gulf central bankers and GCC secretaries met last Monday in Abu Dhabi’s Emirates Palace to discuss their future monetary union, they certainly had much to talk about. With the launch of the Gulf single currency just three years from now, the bankers still needed to agree on various key requirements – including collective budget deficit levels, public sector debts, foreign currency reserves, and aligned inflation rates.

But above all, the million-dollar question remained: Is the future Gulf currency going to be pegged to the US dollar?

After hours of discussion the governor of the UAE's Central Bank, Sultan Bin Nasser Al Suwaidi, finally announced, “The single currency will continue to be anchored to the dollar.

We have been carefully evaluating what has been achieved through this peg, and we are happy with it. I will not however exclude any other option for the future.”

The decision of the governors certainly came as a surprise, since the dollar peg has caused controversy with many economists calling for increased monetary flexibility away from the weakening greenback.

The US dollar has been revalued by 40% within the last five years – and there is no sight of a halt to its downslide as the US is running huge budget deficits, in an economy expected to further decline. David Bloom, the global head of market strategy at HSBC global markets, warns that there is a growing risk of an outright recession in the US economy - and a heavily flagging dollar.

Bloom says “Following the 2000-01 stock market crash, the US economy staged a miraculous recovery. That miracle is now ending. The US has become a “push-me, pull-you" economy: Companies may be profitable but households, who have been the key drivers of growth, are in trouble. A cocktail of higher energy prices, tighter monetary policy, an end to tax cuts and, more recently, a housing market that appears to be in free-fall threatens to poison the upswing."

He adds “We are cutting our 2007 US growth forecast to just 1.9% and issuing a “recession risk" warning. With little room for any further fiscal boost, Fed funds may drop to 4% by the end of 2007 - and even lower in 2008 despite inflation remaining sticky in the short-term. Bonds will rally with 10-year yields down to 4.25%. The dollar, meanwhile, is heading lower.”

So while the oil-rich GCC economies are witnessing rapid growth, they get a weak US currency for their exports of hydrocarbons – and yet must pay hard euros for most of their imports.

“Most imports in the GCC are euro-based, and are therefore more expensive compared to a frail dollar, which increases commodity prices and therefore price inflation.” Steve Brice, regional head of research for MEPA and South Asia at Standard Chartered Bank, told Arabian Business.

Standard Chartered Bank's own study of inflation paints a very different picture from the Central Bank's view that officially forecasts inflation in the UAE to fall from 6% to 4% this year. The bank's economists instead predict a rise from the current 10.4% to 13.8%. Qatar follows with inflation of 12%. “Rent price hikes have however been the main driver of this trend,” Brice says.

But price inflation is not the only problem when pegging a currency to the dollar, or any other currency. In general a peg grants price stability, and in many emerging markets provides financial credibility. It also takes away the worry of setting interest rates, since these are regulated by the central bank of the anchor currency.

In the case of the GCC countries, the US regulation of the interest rates becomes counterproductive, since the US sets them - to assist a falling dollar and a slacking economy - at a lower level to boost lending and therefore economic growth.

“The problem is that the dollar continues to weaken, but oil prices have been skyrocketing, and the oil-producing nations are accumulating enormous budget surpluses. This would normally call for the tightening of interest rates to limit liquidity. But due to the dollar peg the US Fed regulates interest rates - and puts them with regards to national conditions. The local rates hence have been falling, prompting loans to explode in the Gulf - which increases liquidity and again created inflation,” Brice explains.

“If a single currency was introduced today and the US pegs were to be removed, the pressure would be for a stronger currency and higher interest rates, since the growth in the region is very strong and inflation is soaring in the Gulf," Brice argues.

“In this scenario there are two appropriate policy responses: You can either raise interest rates to reduce the incentive of people to spend and increase the incentive for saving to slow the economy and reduce pressure on capacity constraints - and thus inflation. Or, you allow the currency to appreciate to reduce imported inflation pressure. Meanwhile, the natural pressure on the currency, with oil prices so high and the 2006 current account surplus for the region expected to be 31% of GDP, is for it to appreciate in any case,” he says.

He adds: “Fast-forward to 2010 and naturally the situation becomes less clear in terms of outlook. With the long-term oil price forecast to be around US$40 per barrel, if we assume that is what we will see in 2010, then the current account will likely comfortably remain in surplus, and this will keep the bias for a current appreciation intact.”

“As a general rule, once a currency appreciates the economy slows down - since costs for the private sector will rise and they will be less competitive. But that is a short-term solution, since if you do not revaluate your currency, inflation will go up and again you lose competitiveness,” Philip Khoury, head of research at EFG-Hermes, says.

“We would therefore suggest a free-floating currency that must not become too strong, with firm interest rates,” he adds.

Any change however does not look likely in the near future, given the number of central banks who have to reach agreement first. “But those looking at hedging beyond 2010 should be aware of the risks that currency pegs may not be in place much longer after that date,” Brice says.

Monitoring a currency against a basket of currencies is another vehicle to control prices, but interest rates need to reflect the content of the basket - otherwise central banks might risk the sell-out of their reserves.

“Any kind of peg will stop you from having monetary control, including interest rates,” Brice says. “Currencies can also be pegged to commodities such as gold. Since we have seen how volatile gold prices are it is not advisable to do so,” he adds.

Typically, as markets become more mature and gain in size, they ditch the peg and become free floating.

“The UAE, Bahrain, Kuwait and Qatar central bankers have expressed willingness to eventually drop the peg, but Saudi Arabia is the most resistant," according to Brice.

Globally the number of currencies that are anchored to the dollar is shrinking - Malaysia and China last year gave up their peg and simultaneously announced they would convert some of their foreign currency reserves. China is now so-called ‘dirty-pegged’ and follows a looser exchange rate policy.

A GCC central bank official who spoke to Arabian Business on the condition of anonymity revealed, “The reason to keep the dollar peg is not purely economical but rather political. If the single GCC currency drops the peg it not only gives a signal to the world that the dollar is weakening, but it indicates a step towards an independent currency that might later be used for trading oil - which poses the biggest problem for the dollar.”

Greater currency flexibility would surely encourage diversification of oil revenues, Price agrees. “It is convenient to price oil in dollars, but the GCC single currency area will have significant pricing power in this respect. While it will be subordinate to OPEC in terms of production quotas, oil can then be priced in different currencies, whether in euro, Chinese yuan or Swiss franc,” he says.

“Iran and Malaysia recently suggested starting to trade oil in different currencies. It would be good for the region, but has never been a subject of discussion with Gulf leaders,” he states.

Many economists now suggest a revaluation of the currencies, regardless of the single currency, to keep up with the imbalance. Also, a re-alignment might help converge currency values ahead of monetary union.

All GCC currencies are currently undervalued, according to a study by the Dubai Chamber of Commerce and Industry. Bahrain tops the rank with 27%, followed by Saudi Arabia with 23% and Qatar with 20%, while Kuwait and Oman scored 16%. The UAE is the least undervalued at 12%.

Most local bankers and investors, however, are not used to changes in currency valuations against the dollar. Additionally, oil prices are volatile, and any change can have drastic effects on both the value of currencies and the price of oil.

“The individual Gulf currencies are undervalued but only because of the massive oil revenues. Since the oil price is very unstable and the non-hydrocarbon private sector will suffer from a stronger currency, Gulf nations do not want to let their currency appreciate,” Brice says.

The Kuwaiti Dinar, however, did exactly that last May when authorities decided to allow a 1% revaluation of the currency. Yet Kuwait has been heavily criticized by its fellow GCC member countries for this move, as they argue that the shift could damage the single currency project. Kuwait, the only country with a so-called band that allows a certain plus/minus percentage revaluation did this perfectly in line with its existing exchange rate framework.

“Even if you have a band, it is more or less the same as a peg since revaluation is only possible within a very narrow range,” he says. “Kuwait is now at the very last end of its band.”

Besides fighting inflation, buying abroad would become cheaper for local investors once their currency gets revaluated.

But if Gulf currencies were appreciating today, most GCC assets that are held
in dollars would lose value. “At the moment there is a perceived over-reliance on dollar assets, something that not only appears to be the case with central bank reserves but also with massive public sector assets, which we estimate to be in the order of US$1 trillion to US$1.5 trillion for the region,” Brice says.

“Investors are however already diversifying their assets," he says. “The shift is already taking place and investors seem to be preparing themselves for times when the peg might not be there anymore.”

Buyers can also benefit from arbitrage opportunities. Buying assets in GCC countries at today’s dollar value make a good investment, as they will probably be subject to future upward revaluations.

“If a country were to change to a floating exchange rate system, then this would cause a lot of political problems and would even derail the single currency project altogether. We have already seen the upset caused by Kuwait’s 1% revaluation of its currency within its framework."

“The biggest risk to the currency reform outlook would be continued short delays to the project, which would reduce political freedom for countries to move independently,” Brice concludes.

Whenever the gulf currencies finally appreciate - and if they let go of their peg system when forming their monetary union - is officially set to happen in the next three years.

But whether the region's leaders have fully considered the consequences, and are really prepared for what lies ahead, is anyone's guess.

"Any kind of peg will stop you from having monetary control, including interest rates"

"Most imports in the GCC are euro-based, and more expensive"

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