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The US housing boom is – rather clearly – over. The Federal Reserve is – at least in the eyes of the market – more likely to cut than to raise US policy rates. The dollar is rather weak, at least against most European currencies (though not v. the Chinese RMB or most Asian currencies). The large US trade deficit suggests that further falls in the dollar are likely. The fact that emerging market central banks need to spend so much propping the dollar up tells the same story.
The Gulf’s petro-construction boom is still going strong. GCC economies are booming. Big, new projects are in the pipeline. All the sheiks with a bit of desert on the southern shore of the Gulf want to be Dubai, or, if not Dubai, a more credible rival. Abu Dhabi – the sheikdom in the UAE with the really big bucks – is a prime case in the point. More and more of the dollars from the Gulf’s oil are being converted into local currency and spent (or invested); fewer are being stashed abroad. The Gulf’s contribution to the global savings glut should shrink this year, at least if oil doesn't rise about $65. Inflation in the Gulf economies is either high or rising. Real interest rates are either low or negative.
The last thing the Gulf states need, therefore, is lower nominal interest rates and a weaker currency. No wonder more and more voices in the Gulf are starting to question the region’s tight peg to the dollar.
Mikka Pineda of RGEMonitor has even found a Saudi bank hinting at a revaluation.
... the SAR will likely head for a sizeable nominal effective depreciation, particularly if the Asian savers (particularly China) decided to revalue and Saudi Arabia maintained its current peg unchanged. …. This imbalance could exert further pressure on GCC central bankers to synchronize a one-off revaluation round in 2007, a policy option that had already surfaced repeatedly during the past couple of months.
The Saudis have been, up until now, the Gulf state most wed to the peg. Some things seem to be changing.
Will the Gulf states’ central bankers agree to a coordinated policy shift – a revaluation, if not a new basket peg —when they meet this week? I certainly don’t know. Local analysts think probably not. But a revaluation presumably is on the agenda in a way that it wasn’t before. The Gulf states don’t want or need an (even) weaker currency. Yet barring a collapse in the price of oil (hardly something the GCC wants), further falls in the dollar are almost certainly necessary to reduce the US trade deficit.
Having the needed real appreciation in the Gulf (and especially in Saudi Arabia) come entirely from a rise in inflation isn’t optimal, at least not in my view.
On the other hand, expectations of a revaluation create problems of their own. Kuwait has signaled for some time that it is worried by rising inflation, and wouldn’t mind a stronger currency. Yet Kuwait’s central bank is also now warning against speculating on the dinar’s revaluation. Apparently, hot money was coming in – and Kuwait was attracting net private capital inflows, not just big inflows of foreign exchange from $60 plus oil. If there are expectations of revaluation, GCC interest rates can fall below US rates (see China). But that is the last thing a region that already has very low and often negative real interest rates needs …
UPDATE: GCC watcher extraordinaire Mikka Pineda notes that Kuwait and the UAE did cut their policy rates to try to deter speculation, even with high inflation (very high for the UAE). But the UAE at least quickly reversed course ... it sure looks like China isn't the only economy struggling to reconcile its desired exchange rate policy with its desired monetary policy stance.
UPDATE 2: The meeting only lasted a day, not the two planned ... and the GCC central bank governors agreed to keep their dollar pegs for the "time being." Nothing sounds very settled.