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Sun 10 Feb 2008 06:51 PM

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Pressure on Gulf to depeg set to ease

Resurgent dollar will ease calls on Gulf Arab states to cut ties with US currency, says Mashreq exec.

Pressure on GCC countries to abandon their peg to the US dollar will ease this year as the greenback regains some of the ground it lost against major global currencies in 2007, the chief executive of Mashreq Capital has said.

“I think that the need to move from a currency peg is probably not as strong this year as it was last year,” Abdul Kadir Hussain told ArabianBussiness.com in an interview.

“A lot of the significant declines in the value of the dollar have already taken place."

The dollar hit record lows against several major currencies last year, dropping almost 12% against the euro and 2.8% against the British pound.

The fall has dragged down the value of GCC dollar-pegged currencies, driving up the cost of imports and fuelling inflation.

To make matters worse, the dollar peg forces Gulf states to track US monetary policy at a time when the Federal Reserve is cutting interest rates while they should be raising rates, adding to inflationary pressure.

Hussain predicted the US currency would start to strengthen against the euro as the monetary policies of the Fed and European Central Bank (ECB) gradually reversed over the coming year.

“One of the reasons you saw that level of decline [in the dollar] was that the ECB was still raising rates,” Hussain said.

“They [the ECB] were still worried about inflation and they were very restrictive in their monetary policy, where in the US they had already started on their rate cutting cycle.

"So the dollar got absolutely beaten up because everybody was sure that that interest rate differential between the dollar and the euro was going to expand.”

The interest rate differential refers to the gap in rates between two monetary systems.

The differential between the US and EU has expanded in the last year as the Fed aggressively cut rates to stimulate the economy while the EU raised them to combat inflation.

Hussain said the interest rate differential would begin to close this year, cutting the difference between the value of the dollar and the euro.

“I expect the ECB to start toning down their typically hawkish statements,” he said.

“The impetus to really go into the euro or put on that carry trade between the dollar and the euro becomes significantly lower, because that differential is not where it used to be.”

When an interest rate differential expands currencies becomes susceptible to carry trades, where currency speculators borrow one currency at a cheaper rate and use it to buy debt in a currency that has a higher yield.

So far this year the dollar has gained slighted against the euro, clawing back around a third of a percent, despite last month's emergency rate cuts by the Fed.

“You’ve essentially had 125 basis knocked off borrowing the dollar this year, basically within a week,” Hussain said.

“But if you look at what the euro has done for the year, it is pretty much where it started the year. The dollar has actually strengthened in the last week or so.

“In my view you’ve got a situation where the downward pressure on the dollar is not as significant as it was last year and the pressure on these countries [Gulf states] to depeg is not as strong as it was last year."

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