Note: This is Brad Setser, Not Michael Pettis
The heads GCC countries will meet in early December. They are expected to announce that the launch date of their currency union will be delayed – and presumably will discuss whether or not to continue to peg to the dollar in the interim.
I understand the need for the Gulf countries to try reach consensus so they can move together, but I am not sure that countries with open capital markets can announce that they are considering a revaluation on a fixed data without effectively being forced to revalue. Bloomberg:
“Six Gulf Arab states will discuss a proposal next month to revalue their currencies, Abdul Rahman al- Attiyah, the secretary general of the Gulf Cooperation Council, said today.”
Even a small 2% revaluation in early December produces a roughly 24% annual return on holding GCC currencies over the next month. That is kind of tempting. GCC interest rates have fallen, cutting into the return, but not enough to make such a bet unattractive. See Simon Derrick of the Bank of New York
After all, the GCC currencies offer a one-way bet. They either will revalue, shift to a basket (likely with a small revaluation) or do nothing. They won’t devalue.
The Saudis insist that they aren’t about to change (Central bank governor al-Sayari denied any plans to change, and Finance minister Ibrahim al-Assaf said that there is `no plan to use a basket of currencies for the Saudi riyal and we do not have a plan to revalue''). But they almost have to say that if they do not plan on changing their policy right now. The sequence of updates of the initial Bloomberg story suggests the official denials followed the initial indication from a source familiar with Saudi monetary policy that a proposal to change the peg had indeed been put on the table.
The UAE rather clearly is ready to move to a basket, but doesn’t want to do so unilaterally. Qatar may be in the same position.
One of the reasons I took interest in the GCC countries is that they present a textbook case of real exchange adjustment coming from inflation if it is not allowed to come through a nominal appreciation. Throw in a textbook case where the right monetary policy for one part of a de facto monetary and currency union (the US, facing a meaningful risk of a recession/ credit crunch) is clearly wrong for another part of the monetary union (The Gulf, now flush with petrodollars that increasingly are being spent and invested at home).
They also present a textbook case of the link between the exchange rate – which directly influences the trade balance – and the savings and investment balance.
Those who argue that exchange rate moves have no impact usually point to the fact that the current account deficit is equal to the gap between savings and investment, so unless changes in the exchange rate impact the savings and investment balance, they won’t change the current account. I generally don’t think the links are all that difficult to find – and in the case of Saudi Arabia, they are quite obvious.
Just listen to the head of Saudi Arabia’s central bank. To curb inflation, he argues the Saudi government needs to cut its spending. Al-Sayari in the FT:
The inflationary pressures, however, are likely to provoke a slowdown in government spending. Mr Sayari made no secret that he would like spending to be "programmed".
"We need to strike a balance between maintaining job creation and economic growth and containing inflation. It shouldn't necessarily be 1 per cent, we will accept some inflation, but we don't want it to go out of hand."
Even when oil revenues are rather high. Nothing like pumping oil out at $2 a barrel (perhaps a bit more counting new production) and selling it for something more than $80 a barrel (counting the discount on Arab heavy …)
Cutting spending in the face of soaring revenue would push up the fiscal surplus, push up government savings and push up the current account surplus.
And it would reduce pressure for both real and nominal appreciation of the riyal.
On the other hand, there isn’t really a good reason for Saudi Arabia to be salting away all the oil windfall right now. Not after a rise in the long-term price of oil has dramatically increased the Saudis wealth as well as their current revenue. Rather than adding to their stock of financial assets even as the value of their underground oil reserves soars, the Saudis really ought to be finding ways (a dividend check from Saudi Aramco to all Saudi citizens not just the Saudi Treasury?) to distribute the oil revenue widely …
But they cannot do so if they want to limit inflationary pressures and continue to peg to the depreciating dollar.
UPDATE: This Thompson financial article offers a nice summary of what various investment banks are saying about the Gulf as well as some preliminary analysis of what changes in the currency composition of the Gulf's reserves might be implied by a shift away from a pure dollar peg. I would note that some Gulf investment funds likely already are reasonably diversified, though they are likely still overweight the dollar relative to the United States share of the import basket and underweight Asia relative to Asia's share of their imports. The Gulf's central banks, by contrast, seem to be very dollar heavy -- and they likely have added quite significantly to their reserves to defend the peg. I would be very interested to know how much the UAE's central bank reserves have increased since the end of q2 ...