from Follow the Money

Cracks in the GCC’s commitment to the dollar peg?

January 11, 2007

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From Simon Derrick of the Bank of New York.

Reuters reports that central bank governors of the UAE will meet in March to discuss currency pegs. The agency cites Governor Sultan Nasser al-Suweidi who said: “We might come up with a decision that says we are OK and stick to the same (regime), or we could come to the conclusion that we need to change”. He added: “Changing the peg is a GCC [Gulf Cooperation Council] decision. We went into it together. We will go out of it together … whether it should be fixed or fluctuating is one issue. Another is issue to change the currency of the peg.”

Interesting.   Very interesting.   Full Reuters story is here.

The cost of the GCC’s peg to the dollar rose sharply in 2006 – the dollar slumped, driving up the price of a lot of GCC imports precisely at the time some GCC countries really ramped up their investment spending (and no doubt other spending too).  The result: very high inflation rates in some countries, notably Qatar and Dubai/ UAE.

Sterilization works differently in the Gulf than in say China.  It is generally done through the budget.   The oil exporters get most of their revenues from their state oil companies – and most of those revenues are in dollars.  If those dollars are converted into the local currency (for the Saudis, the Riyal) and spent, that generally speaking adds to inflationary pressures.  It the dollars are instead deposited with the central bank and never converted into local currency, there is no increase in the money supply and no inflationary pressure (For more on the mechanics of foreign asset accumulation by the official sector in oil exporters, see Higgins Klitgaard and Lerman).   Consequently, big budget surpluses (and growing government dollar deposits with the central bank) constitute a form of “fiscal sterilization.”

So long as the Saudis (the biggest economy in the GCC) were keen on saving rather than spending their oil windfall, they effectively sterilized a big chunk of the region’s current account surplus.  But the Saudis seem to have concluded that they have enough of a fiscal buffer – the government has over $100b on deposit with the central bank, and domestic debt has been paid down in a big way – and are ready to start spending.     They have a bit of Dubai envy.  Look for a bunch of huge state sponsored investment projects.

 More spending and a weaker dollar (compared to say the beginning of 2006) implies more inflationary pressure – and there is good reason to think that real inflation in Saudi Arabia is higher than reported inflation (services are undercounted).

Why does that matter for the peg?   Appreciating v. the dollar  is one way to hold down inflationary pressure.  

Consequently, some oil-rich countries that either already have ramped up (investment) spending and have high levels of inflation and other oil-rich countries that are planning to ramp up spending may be less committed to the dollar peg now than in the past.  That is how I read al-Suweidi’s statement.

Conversely, countries like Oman – which has less oil/ gas that the other GCC economies, and more people – are perhaps less keen on shifting off the dollar.   A weak currency helps them diversify their economy.   

That at least is how some are interpreting Oman’s declaration that it wouldn’t be ready to join the GCC monetary union in 2010, and its current statement that it has no interest in a revaluation.   Emilie Rutledge writes for Gulf News:

The most likely reason why Oman has opted out now, however, is a conflict of interest on the future choice of exchange rate regime for the unified currency.

Oman's economic diversification strategy going forward may well be best served by a relatively weak currency.

On the other hand, states such as Kuwait and Qatar are suffering from "imported inflation" due to the declining dollar, and are likely to want any future unified currency to strengthen vis-à-vis the dollar.

By being part of a stronger unified currency, Oman's nascent non-oil export oriented industries will suffer because its products will be less competitive. And as a tourist destination, Oman will be less attractive to higher-end European visitors if euros buy fewer Gulf Dinars than they currently do Omani riyals.

Dubai's tourism business has also benefitted from the weak dirham -- at least a weak dirham against the pound.   But the rapid increase in prices is eroding that advantage quickly.  Dubai's isn't cheap if you have dollars rather than a real hard currency ...  

What is the counter-argument?  Simple.   Oil is now falling, not rising.   That may trigger a desire not to rock the boat further.  The dollar is also doing better in 07 than in 06.  

The obvious case for change comes when oil is rising and the dollar is falling.   That isn’t the case right now.

But in some sense, the real pressure for change – that is the risk of rising inflation – comes not when oil is rising but when oil financed spending and investment is rising and the dollar is weak.   And while the dollar isn’t currently getting weaker, it is still pretty weak v. the euro.   And the Gulf buys European – not American.

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