from Follow the Money

The GCC’s dollar peg …

December 11, 2006

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China will have a current account surplus of over $200b this year.  China has about 1.3 billion people.   The GCC countries (Saudi Arabia and the small states on the Gulf) will also have a current account surplus of around $200b this year, and they only have something like 50 million people …

There are no shortage of critics – and defenders -- of China’s (de facto) dollar peg. 

The GCC’s peg to the dollar – which is now even tighter than China’s peg to the dollar – has attracted a lot less attention.  It has far fewer critics, and fewer defenders.    I can immediately think of only four real critics of the GCC peg: yours truly, Jeff Frankel of Harvard, Steve Brice of Standard Chartered, and one of the Economists’ writers (Pam Woodall?) on the global economy.

But it certainly helps to have the Economist on your side. 

I cannot quite figure out where the IMF stands on this: the spring regional outlook was quite critical of the GCC’s exchange rate peg (and the resulting real depreciation but the fall regional outlook didn’t say much.   The Article IV reports on specific countries tend to be silent on the issue – if they don’t outright endorse the GCC countries plans to keep a tight peg to the dollar in advance of the GCC’s planned monetary union.  The UAE Article IV, for example, indicated that IMF staff “concurred with the authorities” in thinking that “the present exchange rate regime has served the UAE economy well” (despite the acceleration in inflation) even as it welcomed the UAE’s willingness to consider alternatives to dollar peg after the 2010 monetary union.

I am not sure that China’s 6% appreciation against the dollar since 2002 deserves as much praise as the Economist: the 6% appreciation has been too small to prevent massive RMB depreciation against the euro, or a huge surge in China’s trade surplus.  But I fully share the Economist’s critique of the GCC’s peg.

Particularly with oil once again above $60 and the dollar once again sliding against the euro.  The US has a big current account deficit – one that likely will increase without a fall in the trade deficit.   It needs a weak currency for structural reasons.  And with faltering residential investment, it also likely needs a weak currency for cyclical reasons.

The GCC countries now all have huge current account surpluses.   Structurally, the GCC countries need a stronger currency.   And the oil boom towns on the Gulf also need a stronger currency (and higher interest rates) for cyclical reasons. 

Simon Williams of HSBC wrote recently in his (useful) Gulf Weekly:

“Had they been freely floating, rapid economic growth, vast external account surpluses and generally modest inflation would have pushed the value of the GCC currencies upward sharply over the course of this year. However, they have instead lost 10.12% against the euro, 11.7% against the pound, and 0.97% against the yen. Further sharp declines in the value of the US dollar over 2007 will see pressure build for the pegs to be reset, although at present it appears that only Kuwait is institutionally prepared for change.” 

Right now, Dubai is growing at something like 20% y/y.     Doha (Qatar) isn’t far behind.  

Real interest rates in Dubai (and Qatar) are massively negative.   Nominal rates are about the same as in the US.  But inflation in the boom towns is running above 10% (according to most credible estimates; the official numbers are lower), driven by soaring rents. 

One of the surprises of my trip to Dubai though was that the only folks who seemed worried by low real interest rates (and the depreciating dirham) were the expats.   They didn’t object to negative real rates per se, but the expat Brits certainly felt squeezed by rising rents and a weakening dirham.   They were getting priced out of London …..  Getting paid in what amounts of tax-free dollars (dirham) is a lot less attractive when the dollar is tanking.

The locals weren’t as worried.   They were too busy counting all the capital gains on their (huge) real estate portfolio – and anticipating even more.  There are incredible photos of the vast construction site that is Dubai in the June 2006 issue of Vanity Fair, but I cannot find the article online. 

The business of Dubai, inc (and Dubai's ruler, Sheik Mohammed) is real estate.   

Usually, high levels of inflation spook the bond market.  But there doesn’t seem to be much of a local currency bond market in the Gulf.   Certainly not in the UAE.   The local governments haven’t needed to issue bonds to finance budget deficits.   The obvious constituency hurt by inflation just isn’t present.  

And so far, high inflation and low real interest rates have been nothing but good for the local real estate market.   Prices and rents are up.   And that is what matters for the real money in Dubai.

Now, in the US, the great disinflation (and falling real interest rates) has been good for real estate.  So why has high inflation (and falling real interest rates) been good for real estate in Dubai?   

The answer, I suspect, is that Dubai’s real estate market is largely a cash market.    High inflation rates might crimp the availability of long-term dirham financing, but long-term dirham financing doesn’t seem crucial to the market.  Other things seem to matter far more.  Maybe the availability of long-term financing in pounds ... to be honest, this is something I need to investigate further.

The general consensus in Dubai is that inflation will moderate in 2007.   Why?  Simple: Dubai is a huge construction site.   An influx of new supply should help to meet demand – so rents shouldn’t rise as much.  Steve Brice of Standard Chartered calculates that 50,000-60,000 new "properties" will come on line in 2007 and 2008, bringing supply in line with deman, or perhaps pushing supply a bit ahead of demand.  Price increases will moderate, helping bring inflation down.

May be.   I can think of scenarios other than just a moderation in real estate price inflation.    The influx of new supply is going to be truly breathtaking – so prices might tank rather that stabilize.   A lot of buildings may stand empty. 

Or they may not – there is clearly a lot of money in Gulf (and outside of the Gulf) looking for a home.  Buying Dubai property confers with it the right to live in Dubai -- which seems to be the plan B of a fair number of "high-net worth" types in the Gulf, in Iran, in South Asia and in Russia -- including those types who have a high-net worth in cash.  The same forces that have pushed the price of all fixed income assets may also continue to push up the price of Dubai real estate – which is often considered as much a financial asset as any thing else.  

And so long as the construction boom continues to increase demand for guest construction workers, there may still be a mismatch between the available supply (high-end) and the greatest source of demand (low-end housing …)

More importantly, the boom towns in the Gulf – Dubai, Doha and Bahrain are all competing to be regional financial centers and all seem to have real estate booms; see Stephen Roach – aren’t the epicenter of the regional economy.    Saudi Arabia is. 

And my sense is that the Saudis are set to loosen the screws substantially in 2007.  The countries in the region with more oil (Saudi Arabia, Abu Dhabi, Kuwait) have generally had smaller booms than the places in the region that don’t have as much oil, and they are now are looking to join the party (The IMF Regional outlook is the best source on this).  

They aren’t going to follow the 70s game plan and increase direct government spending.   But they are going to dramatically increase government sponsored investment projects.   Dubai, Inc is now the model -- especially for projects like Saudi Arabia’s King Abdullah Economic City. 

Up until now, the Saudis have been the most financially conservative of the Gulf states. 

Saudi spending and imports have increased by less than in the Gulf boom towns.     That reflects, I suspect, the difficulties the Saudis faced in the late 1990s.    Saudi Arabia has more people relative to its oil than Kuwait, Qatar or the UAE.    It actually did have to borrow a fair amount to keep its government running when oil was at $15-20 in 1998/99.    It now has repaid most of that money – and built up a huge fiscal reserves (at the end of October, the Saudi government had $102.1b on deposit with SAMA). 

In broad terms, the Saudis started this decade with a higher level of spending than the rest of the Gulf – and thus started the decade more exposed to low levels of oil prices.   But because of their difficulties in the late 1990s, they increased spending – counting state-sponsored investment projects as part of spending – more slowly than many other counties.   So they are now among the least exposed to falls in oil prices.

And in the process, the Kingdom’s large fiscal surplus and the huge buildup of foreign currency deposits with the Saudi Monetary Agency acted as a form of fiscal sterilization.  

A large share of Saudi’s export earnings from oil were never converted into local currency.  Dollars sitting on SAMA’s balance sheet don’t fuel inflation.  Riyal circulating through the local economy do.

And as the Saudis ramp up investment, I rather suspect that the scale of Saudi fiscal sterilization will fall substantially. 

And since the Saudis are the largest economy in the GCC, the Saudis’ policy shift likely will have implications for everyone.  The combination of less fiscal sterilization in the largest GCC economy and a weaker currency (and higher import prices) suggests higher regional inflation to me.  

New buildings may keep rents down in Dubai, and lowering inflation there – but some of the same dynamics that propelled the recent surge in inflation in Dubai look (at least to me) likely to take hold in the biggest economy in the region. 

High inflation, of course, is one way to bring about the needed real appreciation of the GCC’s currencies.  The Saudi’s export earnings have tripled since 2001, but in real terms, their currency has weakened since 2001.  

That doesn’t make sense.  It won’t last.  But a surge in inflation may not be the best way to bring about the needed adjustment.  

Negative real interest rates can certainly fuel a boom.  Dubai is a case in point.  But sometimes, they lead to the kind of boom that is followed by a bust.

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