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Wed 23 May 2007 01:05 AM

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Kuwait ties dinar to imports, investments

Currency basket is 'import and financial related', says Sheikh Salem.

Kuwait said on Tuesday it had tied the dinar's fortunes to currencies it uses for its imports and investments to reduce the influence of the battered dollar on its economy.

The dollar, to which the dinar was pegged until Sunday, would still account for a major share of the currency basket that Kuwait adopted to check inflation caused by the rising cost of European and Asian imports, the central bank governor said.

Although five other Gulf states preparing for monetary union with Kuwait said they would keep their dollar pegs, analysts said the U.S. currency's reign as the cornerstone of stability in the world's top oil exporting region was nearing an end.

"As Kuwait is the frontrunner, it is possible that the others will choose the same path," Merrill Lynch said in a research note.

"While the change was only small in valuation terms at this stage, it provides a signal that countries in the region are thinking about the form of their currency regimes and are willing to become more flexible."

Any such regional shift would go some way toward trimming the global trade imbalances that have weighed on the dollar, which hit a record low against the euro in April.

The Gulf will run a combined current account surplus of $129 billion this year, the International Monetary Fund forecast, even though oil prices have fallen off July's record highs.

The near tripling of oil prices in the five years to July allowed energy exporters in the Middle East and Central Asia to accumulate a current account surplus of $1.1 trillion between 2003 and 2007, according to the IMF, turning Kuwait and its neighbours into key sources of international investment.

CURRENCY BASKET

The currencies of those investment destinations were part of Kuwait's basket, Governor Sheikh Salem Abdul-Aziz al-Sabah told reporters, declining to name any currencies apart from the dollar, which he said still had a major share in the basket.

Markets had been waiting for word of the composition of the basket after Kuwait scrapped the peg. A trade-weighted basket - based on import and export currencies - would still have been dominated by the dollar in which Kuwait prices its oil exports.

If the currency basket mirrored the sources of Kuwait's top merchandise imports, it would roughly be 46 % in dollars, 29 % in euros, 15 % in yen and 10 % in sterling, Monica Fan of RBC Capital Markets said in a note.

The basket was "import and financial related", Sheikh Salem told reporters.

Asked to explain "financial related", Sheikh Salem said: "We set our financial relations, in terms of investment. For example, where we are investing and in which currencies."

The dollar's diminishing allure has been accompanied by growing Gulf Arab interest in Asian economies, both as customers for energy exports and destinations for investment.

Merrill Lynch said the Korean won, the Singapore dollar and other Asian currencies could be part of the new basket.

In 2005, the state-owned Kuwait Investment Authority decided to double the cash allocated to Asian assets to 20 % of its portfolio.

Funds like the Kuwait Investment Authority control the bulk of the Gulf's surplus oil cash. Central banks, which have been diversifying traditional dollar holdings, account for less than 10 % of reserves, but they offer a rare window on official thinking about foreign exchange policy in the Gulf.

REGIONAL RESPONSE

Kuwait's central bank, which Sheikh Salem said had reserves of $21 billion, will have to accumulate fewer U.S. assets to defend its new peg.

"To the extent that the increase in reserves is sustained and a diversification away from the dollar continues, or becomes more broad-based, the repegging of the dinar is worth watching." Phyllis Papadavid of Lehman Brothers said in a note.

Other central bank governors moved quickly to quash market speculation that Kuwait has started a regional trend.

"We are committed to a decision by Gulf leaders to keep currencies pegged to the dollar at a fixed rate," said Sultan Nasser al-Suweidi, central bank chief of the United Arab Emirates, tipped as a likely candidate to follow Kuwait's move.

The central banks of Saudi Arabia, Bahrain, Oman and Qatar had already ruled out a policy shift.

"In no instances would it be likely that the respective central banks will signal a definite move ahead of time," Merrill Lynch said.

"It is most likely that they will continue to deny that a move is possible and will continue to support the currency union.”

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