IF2 - Gulf Currency Peg - Final

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Group 14 Gulf States currency peg

INTERNATIONAL FINANCEASSIGNMENT II GULF STATES CURRENCY PEG

Nowhere are the exchange rate policy dilemmas associated with recent

declines in the value of the US dollar more acute than in the Gulf States, where

virtually all the oil rich states have been pegging their currencies to the US

dollar. This assignment will address the current exchange rate policy options

for the States, and discuss if the link to the US dollar should be modified or

abandoned as some influential commentators have recently argued.

Group14 - Minzhi Xu (080008866)Zhaobin Zhang (070051445)

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Bojan Luburi (080022420)Arman Nurekeyev (080022673)

Table of Content

INTRODUCTION ........................................................................

................................................ 2

1. THE ARGUMENTS FOR THE US DOLLAR PEG

................................................................ 3

2.

TACKLING THE ARGUMENTS................................................................................................. 5

3. EXCHANGE RATE OPTIONS

.................................................................................................... 9

4. POLICY RECOMMENDATIONS

............................................................................................. 11

REFERENCES.............................................................................

.............................................. 13

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INTRODUCTION

Focus of this assignment is the current exchange rate policy of the Gulf

States. Particularly, we will assess the main arguments for pegging the

Gulf States currencies to the US dollar and will try to tackle these by

explaining why they may no longer hold. In addition, several possible

options and suggestions will be considered.

Since the collapse of the Bretton Woods system in the early 1970s, most

major exchange rates have not been officially pegged, but have been

allowed to float more or less freely for the longest period in recent

economic history. Many smaller central banks have adopted, however,

policies of pegging their exchange rates to the major currencies.1

Currency peg is basically the policy of controlling the value of a certain

currency by linking it to another

currency. The U.S. dollar is used

as a peg for many currencies in

the world.

1 Sarno, L. and M. Taylor (2003), The Economics of Exchange Rates, pp. 177.

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The Gulf Cooperation Council (GCC) is an economic alliance consisting of

six countries of the Arab Peninsula (Bahrain, Kuwait, Oman, Qatar, Saudi

Arabia and the United Arab Emirates). The GCC have taken number of

steps in order to endorse further economic integration between the

members, with the aim of setting up a single regional currency. One of

the steps was pegging their currencies to the dollar.

THE ARGUMENTS FOR THE US DOLLAR PEG

In the further discussion, we tried to address quite a few strong

reasons for linking the Gulf States currencies to the US dollar.

First of all, we believe it is important to take into account Stockmans

(1983) study of thirty-eight countries over various periods of time

(including, for instance, the ones whose currencies remained pegged to

the dollar after 1973). This particular study concludes that real

exchange rates are considerably more unpredictable under floating

nominal rate regimes. Thus, countries with pegged exchange rates will

experience lower volatility in the real exchange rate than countries with

flexible exchange rates.2

Moreover, oil and gas exports are the major source of the vast wealth of

Gulf States economies. Given that international oil trade is mainly

dollar-denominated, the dollar peg has served the GCC countries well as

it has proven stable in spite of huge volatility in oil prices. The dollar peg

has facilitated elimination of exchange risks and helped soothe

2Sarno, L. and M. Taylor (2003), The Economics of Exchange Rates, pp. 131.

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fluctuations in financial wealth, which are largely dollar-denominated.

Since the share of non-oil exports of these countries in total is quite

small, external stability and the credibility of the monetary position

have been the main reasons for the GCC member states motivation for

maintaining the Dollar peg.

Basically, this linking to the greenback was to provide an anchor for the

regions economies, many of which are small, open and financially

adolescent. In fact, the Gulf States import Americas monetary policy.

By 2006, the dollar peg, which has been applied for over two decades in

this region, has functioned well enough. According to director of the

Middle East and Central Asia department at the IMF, with this anchor,

steady economic environment and low inflation have been the standard.

3

In addition, the regions monetary officials have some further reasons to

stand by the dollar peg. Any upward revaluation of their currencies

would cut the local currency value of their foreign assets, which are

predominantly held in dollars. Approximately $600 billion has been

channelled from these countries into the global capital markets in the

period 2000-2006.

Ownership of Foreign Assets

Country (US$' Bn)

Bahrain

Kuwait

20

400

3The Economist, Nov 22nd 2007

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Oman

Qatar

Saudi Arabia

United Arab Emirates

10

70

450

600Source: IIF

Additionally, this would probably pace up the GCCs forecasted medium-

term plunge into current account deficit, as the local currency value of

oil exports falls and import volumes rise.

Furthermore, if these countries alter the existing dollar peg, this might

also disturb GCCs plans to trim down their reliance on oil export by

diversifying their economies. This is because their locally produced non-

oil goods would become less competitive in abroad markets while

suffering at home from somewhat cheaper imports. And a more

expensive currency combined with the introduction of exchange rate

uncertainty could diminish enthusiasm for foreign direct investment in

the region.

To summarise, GCC states have been bringing up concerns whenever

the dollar depreciate and the purchasing power of oil, whose price is

denominated in dollars, plunges. Nevertheless, the organisation appears

to have come up with conclusion that riding the cycles is preferable to

trying to design and enforce, for instance, a price based on multiple

currencies.4

4Financial Times, 22 Jan 2009

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TACKLING THE ARGUMENTS

In spite of all the mentioned supporting arguments, there are numerous

reasons that undermine the current dollar peg. As a close ally of the US,

Saudi Arabia has so far tried to stick to the peg, but the link is now

destabilising its own economy.

To be precise, the main problem is that a fixed currency makes it very

difficult for these countries, which are all oil exporters, to adjust to

dramatic fluctuations in the price of oil. Adding to that, monetary policy

in the worlds leading oil-importer (US), which GCCs countries import in

effect, is not at all times right for them.

Spectacular boost in oil prices during the period of several years until

the summer 2008 (see the graph below5) has provided the Gulf

countries with a vast wealth. As a consequence, their real exchange

rates were supposed to rise. Basically, their currencies should

strengthen; however the peg prevents nominal appreciation.

5 Source: www.thisismoney.co.uk

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On top of that, seeing that the dollar deteriorated a lot against the euro,

the cost of imports from the EU and other regions swelled substantially.

Inflation in the region rose to 4.5% in 2006, from an average 0.1% in the

period 1998-2002, according to IMF data. In the UAE prices soared

10.1% in 2006; and in Qatar, 11.8%6. Inflation in the GCC economies

kept on climbing, with each of the six members reaching record double

digit figures. Qatar is one of the countries to have been most affected

by the increase.

The prevailing opinion is that the intensifying inflation in Qatar and

United Arab Emirates has been caused by rising import costs, which are

mainly Euro denominated. Moreover, global trade channels are more

6Bency, B. (2007), Choice of Exchange Rate Mechanism for the GCC Single Currency

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and more shifting towards Europe and Asia, leaving the US with a lesser

share of the total world trade flows. As it is presented by the table

below, for the GCC as a whole, the European Union is the most

important supplier of imports with a share of more than 37% of total

imports. This number is predicted to grow even more in the future. We

strongly believe that this trend gives further support to expectations

that pegging the Gulf currencies to a pure Dollar peg could lead to the

GCC facing even higher import bills and inflation.

Bahrain

Kuwait

Oman QatarSaudiArabia

UAETotalGCC

Sources of Imports(as % of total imports)

EuropeanUnion

22 32 22 51 37 38 37

United States 5 15 9 10 13 15 13

Japan 7 8 17 11 8 8 8

Source: IFS DOTS

Aside from the above piece of evidence that the EU provides a major

chunk of the imports for the Gulf States, the Euro has matured since its

introduction in 1999 enough to become a severe challenger to the

superiority of the Dollar as an international reserve currency. The

liquidity and size of Euro financial markets are rapidly approaching

those of Dollar market. The major consequence is deterioration of

historical advantages of the US Dollar as a reserve currency.

It is vital to mention that the decision to link the currencies to the US

dollar was taken at a time when the dollar was strong relative to all

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major currencies. However, as it is shown by the below graph, the dollar

has lost over 50% of its value against the Euro since 2002:

Source: DataStream

Previous discussion could be summarised in the following quotation:

Although the GCC states could benefit in the short-term by

maintaining their current monetary policies, the dollar cannot

guarantee sole dominance in the marketplace during the next

three to five years In 15 years time, Asia would account for

one-third of global trade and the US one seventh, thus leading to

huge implication for the future currency moves. In the global

perspective, the new trade corridors and new investment flows

would mean that the dollar could not guarantee its sole

dominance in future.7

7http://www.gulftimes.com/site/topics/article.asp?cu_no=2&item_no=150715&version=1&

template_id=57&parent_id=56

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- Standard Chartered Bank chief economist Dr Gerard Lyons

Except for the mentioned reasons to move away from a dollar peg,

there is also the pressure on the Gulf States to increase their non-oil

production and exports in order for their economies to become more

diversified. Some of these countries, Bahrain and Oman in particular,

expect exhaustion of their oil reserves in the near future. Therefore,

they need to implement strategies which will support non-oil sector

growth.

Finally, for years, many emerging countries have pegged their

currencies to the dollar to shield economies that were relatively small,

undiversified and reliant on the United States. However, they are now

the engine of the global economy as the developed nations struggle

with the shattering effects of the credit crisis. Moreover, according to

some financial experts, emerging economies would probably benefit

from having independent monetary policies and flexible exchange rates,

as that would provide them with more space to counter economic and

financial shocks.

EXCHANGE RATE OPTIONS

The current situation in the Gulf with weakening currencies due to rising

inflation and severely limited monetary policy due to the dollar pegs in

concert with interest rates following the decisions made by the Federal

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Reserve is compelling local governments to act towards tighter

monetary conditions. The most widely discussed solutions are to

revalue, to de-peg and shift to a currency basket, or to create a new

single currency.

Repegging the domestic currencies to the greenback at a higher rate

would soothe some of inflationary pressure of the Gulf States but this

would not solve the main imbalance problem between exporters of oil

and a dollar peg. In fact, revaluing a currency does not add any value in

terms of wealth, it destabilizes revenues over time.

De-pegging from dollar and switching to a multi currency basket is

another option being considered for a long time. If the basket included

the strongest currencies around, for example the euro and the yen

along with a dollar, which still represents the biggest economy and

would have a big weight in any basket, could provide significantly more

protection against the volatility in oil prices and might serve as a

cautious transitional strategy toward an even more flexible exchange

rate policy. But this would not be the perfect result since these big

currencies still belong to importers of oil, thus Gulf governments would

have to link their domestic currencies to possibly unsuitable monetary

terms; though the idea of including more than the mentioned three

currencies would help with this, however the selection must be made

very meticulously.

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In the longer term though, the Gulf States should abandon the currency

pegs. There are examples of big commodity exporting countries like

Norway, Iran, Venezuela and Nigeria which have shifted to a floating

exchange rate regime as they have diversified economies with sizeable

non-oil sectors and exports (IMF 2002). Moreover, in the recent past

some emerging economies have chosen managed floating approach

instead of using pegs. This means that the governments and central

banks were actually having inflation targets rather than aiming for an

exchange rate.

In the case the GCC countries finally decide to materialize their single

currency plans the new currency must certainly be floating, though not

during initial period because there is no history, experience or financial

maturity to pursue this important step right from the beginning. It is

obvious that cooperation of Gulf States through single currency will

facilitate development of free trade and reduce dependence of regions

economy on the greenback.

POLICY RECOMMENDATIONS

In the mid to long run the outlook of a dollar is pessimistic. The recent

facts with the Federal Reserve printing and pumping the greenback into

the economy in order to fight the current crisis will certainly have its

side effects. Moreover, in the medium term this approach along with

many other decisions the US government made which were not

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adequate to the nature of the crisis in terms of its length and depth will

inevitably lead to dramatic macroeconomic consequences which might

in fact result in a huge dollar inflation leading to the collapse of dollars

reserve currency status.

The most likely and worst scenario in this case would be disappearance

of the current financial base (dollar and debt) all over the world and

fragmentation of interests of the global systems big players and blocks,

which will lead to quick disintegration of the current international

system and strategic dislocation of big global players.8

There are already talks of new regional currencies, Amero for North

America (USA, Canada and Mexico) and Russian Ruble for Russia and its

closest allies. In this connection, the new single currency plans of Gulf

States could actually be a result of the same considerations.

Now taking into consideration all of the above, we believe that in the

longer run the Gulf States should end their currencies peg to the dollar

and create a single currency with a peg to a multi currency basket. To

do so they should learn from an evident positive experience of the euro

zone. Also GCC countries must produce a well-weighted action plan

which would allow them to avoid inflationary pressure, as long as

develop a concept of a single central bank and define an optimal

timeframe for shifting to a single currency by coordinating and

harmonizing differences in the rules and regulations of financial

8Global Europe Anticipation Bulletin, GEAB #32

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structures, all of which are matters of vital importance in the whole

process. Finally, as well as simultaneously pursuing economic

diversification through increasing competitiveness of non-oil exports in

the future the Gulf States should maybe consider selling their export

commodities for their new single currency?

REFERENCES

Sarno, L. and M. Taylor (2003), The Economics of Exchange

Rates

Kate Phylaktis (2009), International Finance Lecture Notes

Bency, B. (2007), Choice of Exchange Rate Mechanism for the

GCC Single Currency

Global Europe Anticipation Bulletin

www.thisismoney.co.uk

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http://www.gulftimes.com/site/topics/article.asp?

cu_no=2&item_no=150715&version=1&template_id=57&parent_i

d=56

www.crealis.es

The Economist, Nov 22nd 2007

Financial Times, 22 Jan 2009

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IF2 - Gulf Currency Peg - Final

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