By David Westley
Kuwait may not back the greenback, but the UAE's policy bodes better for monetary union, says David Westley.
Sheikh Mohammed Bin Rashid Al Maktoum’s assertion yesterday that the UAE would stick to the dollar peg despite the increasing pressure of a depreciating dollar indicates the depth of resolve the UAE presently places in the idea of a GCC-wide single currency.
Monetary union in the Gulf, presently scheduled to be implemented in 2010, is being stress-tested ahead of time. How well the six GCC states can continue to act together reflects how well they will be able to do so if and when there is a single currency.
As such Kuwait's unilateral move on Sunday to switch away from the dollar to a basket of currencies was not a good sign. Nor was Sheikh Mohammed’s assertion yesterday that “the UAE will have reservations on the union if it were to affect our economy.”
Evidence of how difficult times could be ahead comes from Europe. Inflation has been growing in the euro zone as it has in the GCC – although for different reasons. Depending upon the economic cycle, and the underlying strength of the economy, some of its countries have been better able to cope with the remedy - interest rate rises - than others.
Interest rates are used by the European Central Bank (ECB) to determine the cost of borrowing and attractiveness of saving. A higher rate makes loans more expensive, puts more money into interest bearing bank accounts and out of circulation, and eventually lowers the costs of goods and services by making the economy more efficient.
Where countries have been growing strongly in the eurozone monetary tightening has merely tempered that growth. Where growth was fragile or non-existent in the first place recession is now the elephant in the corner.
The differing economic fortunes are turning fractures of political difference into fissures. The Italians - whose politicians have already called for a return to the lira - and the French are pushing for a relaxation of the European Central Bank's monetary policy. The Germans, with a tradition of a strong deutschemark, and a robust export-led economy are arguing that interest rates must be kept high to keep inflation at bay.
This split between Germanic and Latin countries is likely to be echoed in the GCC, this time between those governments whose countries would benefit from a stronger currency, and those that would be harmed by a dollar re-pegging.
One side is represented by Saudi Arabia, the region's largest economy, which would be hit by an appreciation of its riyal.
Saudi is heavily dependent upon petrodollars and its national budget is dominated by its wage bill and welfare spend. Were the riyal to be revalued upwards against the dollar, its wage and welfare costs would rise substantially - more dollars would be required just to maintain existing benefit levels.
One the other end of the spectrum are the smaller Gulf countries, with a larger private sector workforce, less dependence on oil and more diversified economies bringing in goods, services and people from across the globe. The UAE provides perhaps the best example, but it increasingly serves as the role model for its neighbours.
A stronger dirham would go some way to calm rising import costs - and prick inflationary pressures.
Sheikh Mohammed’s decision therefore to reaffirm his commitment to the peg was important. Of all the Gulf countries the UAE probably has most to benefit from an appreciation of its currency. Its decision to hold fire – for the moment – sends out a strong signal to other GCC members. If we can maintain the peg – you can do so too.
However the issue will not go away as long as the greenback continues its decline against other world currencies. Analysts predict that things will get worse before they get better. The US interest rate is set to fall further to re-energize the North American economy. This will add to the downward pressure on the dollar and upward pressure on the euro.
As money in the Gulf continues to lose value so the questions will continue to be asked: can GCC economies really adopt the same policy even as their economic interests diverge? Is there enough political will, and shared belief in the future to bite back on the pain? And do the constituent economies believe enough in the expected long-term benefits of monetary union to absorb the costs of integration?
Kuwait has indicated its answer. The following months will speak for the union’s remaining members.