A statement on foreign exchange policy by Qatar's central bank governor has struck a nerve in financial markets across the Gulf, reminding investors that decades of currency stability will not last forever.
Five of the six oil exporters in the Gulf Cooperation Council (GCC) - Saudi Arabia, the United Arab Emirates, Qatar, Oman and Bahrain - fix their currencies against the US dollar under arrangements dating back as far as the 1970s.
But late last month, Qatar central bank chief Sheikh Abdullah bin Saud al-Thani suggested economic trends might eventually push Qatar into allowing its currency to fluctuate.
In comments to Reuters, he said the country might one day need a more flexible currency, though it was not at present considering any change to the riyal's peg.
"With increasing integration in international trade, services, and asset markets, a higher degree of exchange rate flexibility may become more desirable to ensure external stability and international competitiveness of our exports," Sheikh Abdullah said.
It was believed to be the first time in years that a top Gulf policy maker had publicly hinted at the possibility of a country removing its peg and letting its exchange rate fluctuate more freely in response to market forces.
In reaction, prices of 12-month foreign exchange forward contracts for Qatar's riyal, Saudi Arabia's riyal and the United Arab Emirates dirham - agreements to trade them versus the dollar a year from now - all fell slightly.
Investors were assuming that since those countries ran big trade surpluses, any greater exchange rate freedom would, initially at least, cause their currencies to appreciate against the dollar, traders said.
So far, Gulf policy makers outside Qatar have not echoed Sheikh Abdullah, and GCC countries will not abandon their currency pegs lightly. The arrangements have mostly worked well for them over the decades, providing a source of predictability in one of the world's most volatile regions.
The pegs have helped to prevent any runs on Gulf currencies during crises such as the Iraq wars and tensions over Iran's disputed nuclear programme. Also, Gulf economies depend heavily on oil exports and oil is internationally traded in dollars, making export earnings more reliable.
The currency pegs limit balance sheet risks since much of the Gulf's external assets are held in dollars, while Gulf monetary policies remain predictable, widely understood and easy to administer, said Farouk Soussa, Citigroup's chief economist for the region.
"So long as oil remains priced in US dollars and the region's exports are dominated by oil, then there will be strong reasons for sticking to the current pegs," said Simon Evenett, professor of economics at the University of St. Gallen in Switzerland.
But the pegs also have major disadvantages. Gulf countries have little room to conduct their own interest rate policy; to avoid excessive flows of money into and out of the dollar, they mostly need to keep their interest rates close to US levels, even if the condition of their economies is very different.
And Gulf economies can find themselves at the mercy of sharp swings in the global value of the dollar. For example, the onset of the global credit crisis caused the dollar to plunge in 2007 and 2008, helping push inflation up sharply in the Gulf states.
This fuelled speculation in the currency forwards market, which ultimately proved incorrect, that they might have to abandon their pegs.
Khalid Alkhater, director of research and monetary policy at the Qatari central bank, cited the threat of inflation when he said in a speech last month that Qatar and other Gulf states should consider moving to more flexible exchange rates.
"We in the GCC need more than an outdated four-decade-old, simple uni-instrument, uni-tool macroeconomic policy framework," he said, stressing that his remarks did not reflect the central bank's official view.
"This framework was suitable for the earlier stages of development. However, the world has changed."
Pressure for the Gulf to change its currency pegs still appears much less than it was in 2007-2008. Qatari riyal forwards imply a 0.1 percent weakening of the currency in the next 12 months; in April 2008, the market was betting on a 4.9 percent appreciation.
Qatar's inflation is rising as it embarks on multi-billion-dollar infrastructure projects, and a stronger currency might help ease external inflationary pressure. But its inflation rate was still only 3.7 percent in April this year, well below the 15 percent record hit in 2008.
"I don't see de-pegging in the near future in any GCC country, as inflation is still in the low single digits and we don't expect it to rise very sharply over the next one to two years," said Khatija Haque, senior economist at Emirates NBD in Dubai.
But in the long term - perhaps a decade - pressure to adopt new currency systems looks set to increase as Gulf economies diversify beyond oil and gas.
All of the GCC countries are scrambling to develop non-energy industries, deepen their capital markets and create more private sector jobs for their citizens so they can ride out the next sharp drop in oil prices, whenever that comes.
The rise of shale oil technology in the United States, which is boosting energy supplies there, has added to the sense of urgency in the Gulf over the past year. To stay competitive in this new environment, Gulf states may need flexible currencies.
"Sustained differences in inflation rates between the peggers and the US have a big impact on competitiveness over time. That's important as many Gulf governments want to diversify their economies and may be tempted to devalue to boost competitiveness," Evenett said.
Alkhater suggested Gulf states might want to look at a Singapore-style currency system. The Singapore dollar is allowed to trade inside an adjustable band, with the central bank buying and selling dollars to prevent moves outside it.
Such a "managed float" could be technically difficult to operate, however, and it might become a target of attacks by speculators. So Gulf countries could hesitate to adopt such a system, at least initially.
Another option would be for GCC states to form a common currency which, backed by the combined weight of their economies, would be strong enough to trade internationally. The GCC has discussed this idea for years, but political divisions between governments, and the troubled history of the euro, seem to be hindering that proposal.
So the most likely outcome may be for Gulf countries to peg their currencies to "baskets" of several currencies instead of merely to the dollar. Kuwait, the sixth member of the GCC, has operated a currency basket since 2007.
The baskets would include the currencies of major trading partners such as the euro zone and China. This could make Gulf states less vulnerable to swings of the dollar, though because Kuwait's basket is heavily weighted toward the dollar, it had little success in lowering inflation during the spike of 2008.
Regardless of what currency models the Gulf states choose, change may be approaching. Citigroup's Soussa said Qatar was unlikely to change its peg in the next year, but "over a 10-year horizon, the change is extremely likely".For all the latest banking and finance news from the UAE and Gulf countries, follow us on Twitter and Linkedin, like us on Facebook and subscribe to our YouTube page, which is updated daily.
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